Bus 311 Business Law
5ToGo
Principles of Accounting: Volume I
Bridgepoint Education, Inc.
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Principles of Accounting: Volume I
Bridgepoint Education, Inc.
VP of Learning Resources: Beth Aguiar
Editor-in-Chief: Steve Wainwright
Sponsoring Editor: Christina Ganim
Director of Editorial Technology: Peter Galuardi
Development Editors: Denis Ralling and Dan Moneypenny
Assistant Editor: Nick Devine
Editorial Assistant: Laura Wilson
Media Editor: Kimberly Purcell
Composition: Lachina Publishing Services
Cover Image: © T-Pool/Stock4B/Corbis
ISBN-10: 1-62178-014-7
ISBN-13: 978-1-62178-014-4
Published by Bridgepoint Education, Inc., 13500 Evening Creek Drive North, Suite 600, San Diego, CA 92128
Copyright © 2012, Bridgepoint Education, Inc.
All rights reserved.
GRANT OF PERMISSION TO PRINT: Bridgepoint Education, Inc., the copyright owner of this material, hereby grants the hold-
er of this publication the right to print these materials for personal use. The holder of this material may print the materials
herein for personal use only. Any print, reprint, reproduction or distribution of these materials for commercial use without
the express written consent of Bridgepoint Education, Inc. constitutes a violation of the Copyright Law of the United States
of 1976 (P.L. 94-553).
www.bridgepointeducation.com I content.ashford.edu
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Brief Contents
Chapter 1: Introduction to Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Chapter 2: The Accounting System . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Chapter 3: Income Measurement and the Accounting Cycle . . . . . . . 53
Chapter 4: Cash, Receivables, and Controls . . . . . . . . . . . . . . . . . . . . . . 89
Chapter 5: Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
Chapter 6: Plant Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
Chapter 7: Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
Chapter 8: Corporate and Partnership Equity . . . . . . . . . . . . . . . . . . 175
Chapter 9: Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Concept Check Answer Key . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
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Contents
Acknowledgments xi Preface xiii
chapter 1 Introduction to Accounting 1
1.1 Entity Concepts 3
1.2 The Language of Business 4 Disciplines of Accounting 4 Financial Accounting 5
1.3 Key Concepts 5
1.4 The Financial Reporting Model 7 Sources of Capital 9 Comprehensive Illustration 11 Statement of Cash Flows: A Fourth Financial Statement 13
1.5 Usefulness of Accounting in Careers and Life 14
1.6 The Importance of Ethics 15 Concept Check 16 Key Terms 17 Critical Thinking Questions 18 Exercises 19 Problems 22
chapter 2 The Accounting System 27
2.1 System Design 28
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CONTENTS
2.2 Accounts and Debits/Credits 29 Debit and Credit Rules 30 T-Accounts 33
2.3 Transaction Analysis 33 Critical Thinking About Transaction Analysis 34 An Applied Example of Transaction Analysis 35
2.4 General Journal 37
2.5 Chart of Accounts 39 Posting the General Ledger 39 Trial Balance 42 Review of the Sequence of Transaction Recording 42 A Balanced Trial Balance: No Guarantee of Correctness 43 Special Journals 43
2.6 Source Documents 44
2.7 Thinking About Automation 44
2.8 Critical Thinking About Debits and Credits 45 Concept Check 46 Key Terms 47 Critical Thinking Questions 47 Exercises 48 Problems 49
chapter 3 Income Measurement and the Accounting Cycle 53
3.1 An Emphasis on Transactions and Events 54
3.2 The Periodicity Assumption 55
3.3 Revenue Recognition 56
3.4 Expense Recognition 57
3.5 Adjusting Entries 58 The Adjusting Process for Revenues 59 The Adjusting Process for Expenses 60 Understanding When to Adjust 67
3.6 The Accounting Cycle 68 A Comprehensive Example 69 The Adjusted Trial Balance 70 Financial Statement Preparation 71
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CONTENTS
3.7 Reporting Periods and Worksheets 72 Closing the Accounts 73 Classified Balance Sheets 76 Notes to the Financial Statements 78
3.8 Cash Basis of Accounting 79 Concept Check 80 Key Terms 81 Critical Thinking Questions 83 Exercises 83 Problems 86
chapter 4 Cash, Receivables, and Controls 89
4.1 Concepts of Cash 90 Cash Management and Control 90
4.2 Bank Reconciliations 92
4.3 Petty Cash Funds 96
4.4 Accounts Receivable 98
4.5 Direct Write-Off Method 98 Allowance Techniques for Uncollectible Accounts 99 Writing Off an Account Against an Allowance 100 Formalized Receivables and Notes 100 Credit and Debit Card Transactions 101 Concept Check 102 Key Terms 104 Critical Thinking Questions 105 Exercises 105 Problems 107
chapter 5 Inventory 111
5.1 Categories of Inventory 113 Inventory Costs 114 Freight 114 Expanded Income Reporting 115 Consigned Goods 116 Critical Thinking About Inventory Cost 117
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5.2 Cost Assignment 118
5.3 Perpetual Systems 118 First-In, First-Out 119 Last-In, First-Out 122 The Average Cost Approach 124
5.4 Comparing Methods 126 Specific Identification 126 The Retail Method 127 Lower-of-Cost-or-Market Adjustments 127
5.5 The Importance of Accuracy 127 Concept Check 128 Critical Thinking Questions 129 Key Terms 130 Exercises 131 Problems 133
chapter 6 Plant Assets 135
6.1 Ordinary and Necessary Costs 137 Special Rules 138 Materiality Issues 139 Depreciation 139
6.2 Depreciation Methods 139 The Straight-Line Method of Depreciation 140 The Double-Declining-Balance Method of Depreciation 141 The Units-of-Output Method of Depreciation 142 Revisions in Depreciation 142 Two Sets of Books? 143
6.3 Asset-Related Costs Subsequent to Acquisition 143 Sale or Abandonment of Property, Plant, and Equipment 144 Impairment 145 Taking a “Big Bath” 146 Natural Resources 146 Intangible Assets 147 Research and Development Costs 148 Goodwill 148 Concept Check 148 Key Terms 149 Critical Thinking Questions 150 Exercises 151 Problems 152
CONTENTS
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CONTENTS
chapter 7 Current Liabilities 155
7.1 Accounts and Notes Payable 156 Accruals 158 Prepayments, Deposits, and Collections for Others 159 Estimated Liabilities 159 Contingencies 160 Balance Sheet Presentation 161 Being a Better Borrower 161
7.2 Concepts in Payroll Accounting 163 Calculating Gross and Net Pay 164 Payroll Journal Entry 165 Additional Entries for Employer Amounts 166 Accurate Payroll 167 Pension and Other Postretirement Benefits 167 Concept Check 168 Key Terms 169 Critical Thinking Questions 170 Exercises 170 Problems 172
chapter 8 Corporate and Partnership Equity 175
8.1 The Corporation 177
8.2 The Partnership 179
8.3 The Sole Proprietorship 181
8.4 Accounting for Sole Proprietorships and Partnerships 182 Basic Accounting Considerations 182 Initial Investments 183 Income Sharing 184 New Partners 186
8.5 Corporate Equity Transactions 187 Par Value 188 Cash Dividends 188 Treasury Stock 189 Stock Splits and Stock Dividends 190 Income Reporting 191
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CONTENTS
8.6 Corrections of Errors and Changes in an Accounting Method 193 Concept Check 194 Key Terms 195 Critical Thinking Questions 195 Exercise 196 Problem 196
chapter 9 Analysis 197
9.1 Common-Size Financial Statements 198
9.2 Ratio Analysis 202
9.3 Liquidity Analysis 203
9.4 Debt Service Analysis 205
9.5 Turnover Analysis 206
9.6 Profitability Analysis 208
9.7 Other Measures 209
9.8 Recap and Summary Illustration 211 Concept Check 215 Key Terms 215 Critical Thinking Questions 217 Exercises 217 Problems 220
Glossary 225 Concept Check Answer Key 235
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Acknowledgments
The publisher would like to thank all the manuscript reviewers for their feedback . They include Wendy Achilles, Ashford University; Brent Beyer, Ashford University; William Blix, Ashford University; Margaret Diaz-Fugetta, Nicholls State University; Kenneth Edwards, Lincoln University; Laura Lopez, Ashford University; Ronald Pearson, Bay College; and Jess Stern, Ashford University . We would especially like to thank Gregory Gousak of Ash- ford University for his valuable assistance .
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Preface
This text provides students with an essential introduction to financial accounting . Students will develop an appreciation for basic accounting systems and processes and the resulting financial statements . This is followed by a close examination of accounting rules, procedures, and controls that are applicable to cash, receivables, and inventory . Students will also study accounting for investments in long-term productive assets . This background in accounting is essential for proper financial statement analysis, which is the closing unit in this segment .
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chapter 1
Introduction to Accounting
Learning Goals
• Develop a general understanding of alternative forms of business entities.
• Differentiate between financial and managerial accounting.
• Acquire knowledge about the conceptual underpinnings of accounting.
• Learn the fundamental accounting equation and the impact of transactions.
• Discover alternative career paths within the accounting profession.
Copyright Barbara Chase/Corbis/AP Images
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CHAPTER 1Chapter Outline
Chapter Outline 1.1 Entity Concepts 1.2 The Language of Business
Disciplines of Accounting Financial Accounting
1.3 Key Concepts 1.4 The Financial Reporting Model
Sources of Capital Comprehensive Illustration Statement of Cash Flows: A Fourth Financial Statement
1.5 Usefulness of Accounting in Careers and Life 1.6 The Importance of Ethics
The stereotypical accountant is characterized as a boring number cruncher, charged with maintaining the books and accounts of a business. This image may be traced back to the 1843 book by Charles Dickens entitled A Christmas Carol. In that tale, Ebene- zer Scrooge is a penny-pinching miser who cares nothing for the people around him. His sole purpose is making money, and his trusted but suffering accountant is Bob Cratchit, who painstakingly tracks every penny. Mr. Scrooge eventually sees the light, but that’s another story.
Today’s accountant is also another story. The mundane aspects of accounting are now largely accomplished by sophisticated computer software. For small businesses, the soft- ware may reside on a simple personal computer. Larger businesses may use elaborate enterprise resource packages that integrate accounting with all other aspects of managing the business. Such complex business systems may be maintained internally by a specific business or be contracted for through a third-party “cloud computing” service provider.
The changed environment has redefined what it means to be an accountant. Although accountants certainly need to have comprehensive understanding of the fundamental practices, rules, and procedures constituting the foundation of accounting, they are often- times more focused on broader measurement, reporting, and managerial tasks. Less time is spent on data capture, and more time is devoted to analyzing information and helping with sound business decisions.
Furthermore, to understand and monitor results produced by sophisticated information systems, accountants need to be knowledgeable and vigilant. If their organizations solely rely on the data produced by their computers, decision making can be quickly handi- capped by erroneous output. The accountant must have a keen “forensic” eye to make sure that reported information is logical and correct. Indeed, the role of accounting has grown more complex, and with that, the value of the accountant has increased. A large proportion of business leaders start out as accountants.
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CHAPTER 1Section 1.1 Entity Concepts
1.1 Entity Concepts
Broadly speaking, accounting describes the concepts and techniques that are used to measure and report financial information. This information relates to a particular entity. There are many types of entities—business entities, governmental entities, and nonprofit entities. Each type has unique goals, objectives, and attributes, and those ele- ments influence the nature of accounting procedures and reports. This course will focus on business enterprises that come in a variety of forms.
Some businesses are sole proprietorships. This means they are owned by one person. Sole proprietorships can be started informally and are not technically separate legal enti- ties from the owner. Just about any business activity that you undertake without the help of others (or through a formally structured legal entity) can be regarded as a sole propri- etorship. Importantly, a sole proprietor must maintain clearly identifiable business records for such business activities. To judge business success, segregating personal affairs from business affairs is imperative. Thus, the sole proprietorship constitutes a separate entity for purposes of accountability. Throughout your studies, you will learn accounting prin- ciples and methods that are necessary and useful in tracking the business affairs of a sole proprietorship.
When more than one person is engaged in a business activity, the importance of account- ability over their comingled business efforts becomes even more critical. A popular busi- ness form is the partnership (or limited liability partnership). A partnership can come into existence accidentally. No formal action is required to create a simple partnership. A partnership is considered to exist when there is co-ownership of a business activity car- ried on with the objective of making a profit (unless specific actions are taken to avoid the formation of a partnership, such as legally incorporating). Most of the general accounting principles you will study also apply to partnerships. However, a later chapter will look closely at the unique benefits, risks, and accounting issues that are introduced for the partnership form of organization.
A more structured form of business entity is the corporation. A corporation is a legally created entity that is owned by one or more persons. A corporation is both a legal and eco- nomic entity, and it is probably apparent that it represents a unique area of accountability. The corporate form of organization has several key advantages, particularly the ability to attract investment capital from a broad group of investors. However, those investors depend heavily on accounting information about the entity that they have invested in, thus the need for financial reports for each specific entity.
This course will build your foundational knowledge of accounting, beginning with core accounting principles. Although most of the examples will be styled around the corporate form of organization, the basic principles generally relate to each form of entity. Future chapters will draw distinctions as appropriate for unique issues pertaining to alternative forms of business organization.
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CHAPTER 1Section 1.2 The Language of Business
1.2 The Language of Business
As noted, accounting is the collective concepts and techniques used to measure and report financial information about an entity. In essence, accounting is the language of business. Businesspeople are generally expected to possess at least rudimentary knowl- edge of this language. It is not essential that they know every nuance or specific rule, but they must be at least functionally literate in basic concepts. Indeed, it is very difficult to intelligently read and understand essential accounting reports without a firm grasp of accounting principles. No matter what career you pursue, you will come to appreciate the material you will learn in this course.
Disciplines of Accounting
At its core, accounting is a tool for providing information for decision making. Deci- sion makers include owner(s), managers, creditors, employees, government, and other interested parties. In one way or another, these users of accounting information tend to be concerned about their own interests in the entity, and each may have different ideas about the information they seek. This leads to a natural division of specialties within the accounting field.
Some accountants focus on taxation. Tax returns must be prepared, according to estab- lished laws, rules, and regulations. Tax accountants are also heavily involved in planning and strategy. The tax ramifications of significant transactions must be carefully evalu- ated. Businesses must consider complex implications of doing business in multiple states and countries.
Other accountants focus on managerial accounting. Managerial accounting information is intended to serve the specific needs of management. Business managers are charged with business planning, controlling, and decision making. As such, they may desire spe- cialized reports, budgets, product-costing data, and other details that are generally not reported on an external basis. Further, management may dictate the parameters under which such information is to be developed.
Another major area of accounting emphasis is financial accounting and auditing. Finan- cial accounting is targeted toward reporting financial information about a business to external users such as the owner(s) and creditors. These parties often lack direct access to underlying details about day-to-day operations of the business and depend on sum- marized (frequently audited) financial statements to form their opinions about whether to invest in or lend to the business. As a result, their ability to understand and have con- fidence in reports directly depends on the standardization of principles and practices used to prepare the reports. Without such standardization, reports of different companies could be hard to understand and even harder to compare. Auditors provide independent oversight and assurance about the fairness and accuracy of reported financial accounting information. This introductory course is largely about financial accounting. It is the right place to begin your studies of accounting because understanding core financial account- ing principles is essential for business success. Furthermore, many tax and managerial accounting processes are derivatives of the financial accounting model.
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CHAPTER 1Section 1.3 Key Concepts
Financial Accounting
Financial accounting focuses on correctly measuring and reporting information about a business’s transactions and events. This information must be captured and summarized into reports that are used by persons interested in the entity. This task is far more complex than most people appreciate. It involves a talented blending of technical knowledge and applied judgment. Understanding financial accounting begins with an understanding of the overall structure of accounting and the fundamental reporting model that is common to all business entities.
As noted, standardization of reporting is a hallmark of financial accounting. Such stan- dardization derives from certain well-organized processes and organizations. In the United States, a private-sector group called the Financial Accounting Standards Board (FASB) is primarily responsible for developing the rules that form the foundation of financial reporting. The FASB’s global counterpart is the International Accounting Standards Board (IASB). The IASB http://www.iasb.org/ Home.htm and FASB http://www.fasb.org/home work cooperatively on many projects, and a single harmonious set of international financial reporting standards (IFRS) might eventually emerge. This effort to establish consistency in global financial reporting is motivated by the increase in global business.
Financial reports prepared under the generally accepted accounting principles (GAAP) promulgated by such standard-setting bodies are intended to be general purpose in orien- tation. This means that they are not prepared especially for owners, creditors, or any other particular user group. Instead, they are intended to be equally useful for all user groups.
1.3 Key Concepts
The development of GAAP has occurred over many decades, and serious attempts have been made to base individual rules on thoughtful conceptual guideposts. Foremost is the idea of decision usefulness. Financial accounting information is intended to facilitate decisions about investing and lending. At a macrolevel, accounting information is the basis upon which capital is allocated in a free market economy. Investors like to invest where profits are best, and creditors like to loan when they foresee that they are apt to be repaid. The best businesses and business opportunities attract capital via signals about their performance, and those signals emanate from the financial reporting model. Without this flow of information and capital, a modern economy would stutter.
To be useful for decision making, accounting information should be relevant and reliable. Relevance means the degree that accounting information bears on the decision process, primarily by providing timely feedback on an enterprise’s financial condition and per- formance. Information is also seen as relevant if it possesses predictive value. Reliability relates mostly to truthfulness but also contemplates freedom from bias (neutral).
Accounting information should also possess the qualities of comparability and consistency. Comparability generally relates to the ability to make relative assessments of companies. Investors and creditors all have limited resources and will clearly seek to place their funds with companies offering the best returns commensurate with understandable
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CHAPTER 1Section 1.3 Key Concepts
risk levels. This necessarily entails the need to compare companies. Accounting should facilitate such comparisons. This does not mean that all companies must use identical accounting techniques. Accounting disclosures, however, should possess sufficient detail so that careful users can discern differences in firms that are based on economic differ- ences rather than accounting choice. Consistency is a concept that relates to performance assessments over time. Basically, if a firm’s economic activity is consistent from period to period, its accounting measures should also be consistent. Differences in measured out- comes from period to period should be indicative of deviations in business results.
Despite accounting’s appearance as concrete and absolute, this is not quite true. Account- ing information is often based on arbitrary allocations, assumptions, and individual judg- ment. Although rooted in mathematics, it nevertheless remains a social science. This con- cept is often misunderstood, resulting in perhaps excessive fixation on reported results for a single period of time. For example, how much profit is earned in a particular month or quarter when a cell phone is sold for less than cost, but the purchaser is also required to subscribe to a profitable 2-year service plan? There are no absolute answers to such ques- tions; instead accountants routinely embrace estimates and assumptions in the develop- ment of periodic financial reports.
It is also important to note that it has not been accounting’s historic role to value a busi- ness. Accounting information may be useful in supporting this objective, but it is not a primary objective. As such, many transactions and events are reported based on their historical cost. For example, land is typically recorded and carried in the accounting records at its purchase price. The historical cost principle is based on the concept that it is best to report certain financial statement elements at amounts that are tied to objective and verifiable past transactions.
An often-debated alternative to historical cost is the fair value (in contrast to historical cost), or fair market value (FMV), approach. Under this technique, assets and liabilities would be periodically revalued based on assessments of current worth, or FMV. Although problematic to implement, proponents of this view argue that it provides more relevant information for decision making. The competing viewpoint holds that FMV accounting is entirely too subjective to form a reliable basis for reporting. Currently, selected finan- cial instruments may be valued at fair value. Otherwise, most U.S. companies fairly well adhere to historical cost measurement principles. Some global firms deploy more exten- sive fair value reporting, and it is possible that fair value accounting will gain more trac- tion in years to come. The accountant of the future may be called on to develop added skills in valuation methods. This observation is consistent with the ever-changing role of the accounting profession.
There are many other guiding principles that you will be exposed to throughout this course. Table 1.1 provides a very high-level view of additional selected concepts and prin- ciples that drive accounting practice and judgment.
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CHAPTER 1Section 1.4 The Financial Reporting Model
Table 1.1: Selected concepts and principles
Basic Concepts, Principles, and Assumptions
Materiality Accountants are only concerned with decisions about how to account for matters that would bear on a decision-making process about the entity.
Monetary unit Accountants describe the amounts reported on financial statements in measures of money rather than some other basis (e.g., land in acres).
Going concern In the absence of evidence to the contrary, accountants assume that the business will continue to operate into the future.
Periodicity Accountants assume that business activity can be divided into measurement intervals, such as months, quarters, and years.
Economic entity Accountants present information along the lines of distinct economic units.
Full disclosure Accountants hold to the principle that all relevant information is adequately described and presented within financial statements and related notes.
Stable currency Accountants presume that the currency used to measure financial statement elements is not significantly changed over time because of inflationary effects.
1.4 The Financial Reporting Model
Despite major advances in accounting technology and significant growth in the control-ling rule set (there are well in excess of 20,000 specific accounting rules), the intrinsic model has changed little in more than 500 years. The model traces its roots to the Renais- sance era. A monk named Luca Pacioli developed a method for tracking the success or fail- ure of ocean-going trading ventures. Capitalists of that era pooled their money to invest in ships that circled significant parts of the globe to trade goods. These returning ships then sold the collected wares. What was lacking was a way to track the costs and benefits of these efforts. Friar Pacioli met the challenge by developing a mathematical model that is still central to even the most sophisticated accounting systems of the modern age.
Central to the model is the concept that a business entity can be described as a collection of assets and corresponding claims against those assets. Some claims belong to creditors of the business, and the residual claims belong to the owner(s). This gives rise to the fol- lowing accounting equation:
Assets Liabilities Owner’s Equity
Depending on your life’s experiences, this may or may not seem intuitive. If you own your home or car (an asset) but bought it with a loan on which you still owe some amount, you can probably relate. For example, assume that you bought a house for $200,000 but still owe $125,000 on the loan. Your fundamental accounting equation would be
$200,000 (your asset) $125,000 (your liability) $75,000 (your equity)
You would report that you have equity in your home of $75,000. This is the amount you would get to keep if you sold the home for $200,000.
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CHAPTER 1Section 1.4 The Financial Reporting Model
In general, assets are the economic resources of the entity and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, build- ings, equipment, and even intangible assets such as patents and other legal rights and claims. Assets are presumed to entail probable future economic benefits to the owner. As previously noted, many assets are measured and reported at their historical cost in the accounting records.
Liabilities are the amounts owed to others. Such obligations arise from loans, extensions of credit, and other obligations that occur in the normal course of business.
Owner’s equity is the owner “interest” in the business. Because it is equivalent to assets minus liabilities, it also referred to as the net assets of a particular business. For a sole proprietorship, the equity would typically consist of a single owner’s capital account. With a partnership, a separate capital account is maintained for each investor. A corpo- ration’s ownership is represented by divisible units called shares of capital stock. These shares are easily transferable, with the current holder(s) of the stock being the owner(s). The total owner’s equity (i.e., stockholders’ equity) of a corporation usually consists of several amounts. This generally corresponds to the owner investments in the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends. (Dividends are distributions to shareholders as a return on their investment.) These undistributed earnings are customarily termed the retained earnings of the business.
Knowledge of the fundamental accounting equation is key to understanding one of the most basic financial statements: the balance sheet. A balance sheet reveals the assets, liabilities, and equity of a business at a particular time. Examine Exhibit 1.1, the balance sheet for Clearview Window Washers. Note that the balance sheet’s date is as of a particu- lar time, as indicated by the specific date attached to the statement.
Exhibit 1.1: Balance sheet for Clearview Window Washers
Notice that the balance sheet reveals a listing of assets totaling $288,500. The business owes various creditors a total of $61,500, leaving $227,000 of residual equity attributable to the shareholders of the business. The fundamental accounting equation for Clearview Window Washers is
Assets Liabilities
Cash
Accounts receivable
Supplies
Land
Total assets
$ 54,000
135,000
4,500
95,000
–
$ 288,500
$ 4,500
57,000
$ 62,000
165,000
$ 61,500
277,000
$ 288,500
Accounts payable
Loan payable
Total liabilities
Stockholders’ equity
Capital stock
Retained earnings
Total liabilities and equity
Clearview Window Washers Balance Sheet
December 31, 20X3
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CHAPTER 1Section 1.4 The Financial Reporting Model
$288,500 (total assets) $61,500 (total liabilities) $227,000 (total stockholders’ equity)
The equity of $227,000 does not mean that the business is worth $227,000. Remember that many assets are not reported at current value. For example, although the land is reported at its cost of $95,000, it could worth more. Similarly, the business likely has unrecorded resources such as its brand name and customer base. In a contrary fashion, the business may face business risks or pending litigation that might restrict its value. Thus, account- ing statements are important in investment and credit decisions, but they are not the sole source of information for evaluating a business.
Sources of Capital
Clearview Window Washers reported total equity of $227,000. What was the source of that capital? One would generally conclude that it was invested by the company’s share- holders. However, there is another important source of capital to consider, and that is the earnings of the business. Hopefully, over time, a business will prove to be profitable for its owners. The shareholders might receive periodic dividends; however, much of the income will likely be left in the business and reinvested in additional business assets. Thus, equity arises from two principal sources: capital investments and retained earnings.
Before proceeding further, it is important to consider concepts of business income. Income can be thought of as the enhancement to the business as a result of providing goods and services to its customers. Mathematically, it is the result of subtracting expenses from revenues. Revenues are the gross inflows from customers, and expenses are the costs incurred in the process of producing those revenues. It is important to note that income and revenue are not synonymous. Very simply, income is revenues minus expenses. Some refer to revenue as the top line and income as the bottom line. You have already seen a balance sheet for Clearview Window Washers. Exhibit 1.2 is an income statement. Note, in particular, the date range shown on the income statement. It is important to identify carefully the period of time during which the revenues and expenses were generated.
Exhibit 1.2: Income statement for Clearview Window Washers
Perhaps it goes without saying that a business can also lose money. In other words, expenses can exceed revenues. When this happens, the business is said to have a net loss, and this will reduce retained earnings. Severe losses can erode owner investments and result in negative retained earnings, or accumulated deficit.
Revenues
Expenses
Net income
Services to customers $ 40,000
$ 7,000
3,000
10,000
$ 30,000
Clearview Window Washers Income Statement
For the Month Ending December 31, 20X3
Wages
Supplies
Total expenses
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CHAPTER 1Section 1.4 The Financial Reporting Model
When a business pays dividends to stockholders, such amounts are not reported as expenses. Granted, they are an outflow from the business, but they are reported sepa- rate from the income statement. Dividends are a distribution of income, not a reduction in income. Often, a statement of retained earnings is prepared. This statement builds a bridge between the retained earnings that existed at the beginning and end of a particular period. Exhibit 1.3 is an example of the statement of retained earnings for Clearview Window Washers.
Exhibit 1.3: Statement of retained earnings for Clearview Window Washers
If you take time to review the financial statements for a public company that you are familiar with (they are often found on a company’s website under “Investor Relations”), you might find an expanded statement of stockholders’ equity in lieu of the statement of retained earnings. The expanded statement explains not only the periodic change in retained earnings but also shows all other sources of changes in equity. Examples include issuing additional shares of stock, dividends paid in shares of stock, and other unique events. These topics will be covered in a later chapter. For now, let’s stick with the basic statement of retained earnings.
It is important to note that the income statement, statement of retained earnings, and bal- ance sheet mesh together in a self-balancing fashion. Exhibit 1.4 shows how income flows from the income statement into the statement of retained earnings. Additionally note how the ending retained earnings from the statement of retained earnings also appear in the balance sheet. This final tie-in causes the balance sheet to balance.
Beginning balance – December 1, 20X3
Plus: Net income
$ 140,000
30,000
Clearview Window Washers Statement of Retained Earnings
For the Month Ending December 31, 20X3
5,000
$ 165,000 Less: Dividends
Ending balance – December 31, 20X3
$ 170,000
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CHAPTER 1Section 1.4 The Financial Reporting Model
Exhibit 1.4: Flow of income
How the articulation of the income statement, statement of retained earnings, and balance sheet occurs may at first seem mysterious, but the following illustration for Clearview Window Washers will begin to clarify the logic of the self-balancing nature of the core financial statements.
Comprehensive Illustration
A primary objective of this chapter is to examine business transactions using the account- ing equation. You now have a basis for meeting this objective. Recognize that every busi- ness transaction has the potential to impact the assets, liabilities, and equity of a business. That impact will not undermine the self-balancing nature of the accounting equation. The reason should become apparent as you review the following example for Clearview Window Washers.
The following example includes a summary of transactions and events for Clearview for the month of December, followed by a spreadsheet showing how each transaction impacts the overall accounting equation. The beginning-of-month amounts are all assumed, and the ending balances were used to prepare the financial statements illustrated earlier. Table 1.2 lists December’s transactions.
Assets
Liabilities
Cash
Accounts receivable
Inventories
Land
Building
Equipment
Other assets
$ 192,000
128,000
120,000
300,000
100,000
50,000
10,000
$ 900,000
$ 34,000
166,000
700,000
$ 900,000
$ 220,000
480,000
Salaries payable
Accounts payable
Capital stock
Retained earnings
Quartz Corporation Balance Sheet
December 31, 20X9
Stockholders’ equity
Total assets
Total liabilities
Total stockholders’ equity
Total liabilities and equity
$ 200,000
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CHAPTER 1Section 1.4 The Financial Reporting Model
Table 1.2: December’s transactions for Clearview Window Washers
Description Amount Discussion of How Balance Is Maintained
Provided window-washing services for cash.
$10,000 Cash (an asset) and Revenues both increase; revenues increase income, which increases equity.
Provided services on account to customers.
$30,000 The asset, Accounts Receivable (representing amounts due from customers for work already rendered), is increased, which is matched with an increase in Revenues, Income, and Equity.
Collected amounts due from customers for work previously rendered.
$20,000 Cash is increased and Accounts Receivable is decreased, resulting in no change in total assets.
Bought additional supplies on account.
$ 2,500 Supplies increase, as does the Accounts Payable liability account.
Paid amounts due on outstanding Accounts Payable.
$ 6,000 Cash and Accounts Payable are both decreased.
Issued additional shares of stock.
$12,000 Cash and the Capital Stock account are both increased by the same amount.
Purchased land for cash ($20,000) and incurred a $55,000 loan.
$75,000 Land (an asset) goes up by $75,000. This is offset by a $20,000 reduction in Cash. The balancing amount of $55,000 is reflected as an increase in the liability account Loan Payable.
Paid wages to employees. $ 7,000 Cash is decreased, as is Income/Equity via the recording of Wages Expense.
Paid dividends to shareholders. $ 5,000 Cash is decreased and the Dividends account is increased by the same amount (which causes a decrease in Retained Earnings and Equity).
You should carefully each transaction’s impact within the spreadsheet shown in Exhibit 1.5. This will not be immediately intuitive; you will need to think carefully and slowly about each entry, noting in particular how (1) the transaction impacts the various ac- counts and (2) how the equality of the fundamental accounting equation is preserved.
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CHAPTER 1Section 1.4 The Financial Reporting Model
Exhibit 1.5: Spreadsheet for Clearview Window Washers for December
One challenge of accounting is to evaluate each transaction correctly and make sure that it is properly recorded into the accounts. If recording is not done correctly, the fundamen- tal accounting equation will be violated, and it will not be possible to prepare logically “balanced” financial statements. The ability to evaluate and record transactions becomes routine—with practice—much like learning to play a musical instrument. Don’t fret that it is at first a bit confusing. In addition, an actual business would not want to rely on the spreadsheet in Exhibit 1.5 as the heart of its accounting system. Such a system suffers from a number of limitations, which are described in Chapter 2. That chapter will introduce a much better way to record transactions and process them into correct financial statements.
Statement of Cash Flows: A Fourth Financial Statement
In addition to a balance sheet, income statement, and statement of retained earnings, some businesses will also prepare and present a statement of cash flows. This state- ment is intended to show how cash is generated and expended during a specific period of
Assets Liabilities
$ 50,000
+ 10,000
+ 20,000
– (6,000)
+ 12,000
– (20,000)
– (7,000)
– (5,000)
$ 54,000
$ 125,000
+ 30,000
– (20,000)
–
$ 135,000
Stockholders’ Equity
Cash Accounts Receivable
Supplies Land Accounts payable
Loan payable
Capital stock
(increase equity)
Dividends (decrease
equity)
Revenues (increase
income, thus equity)
Expenses (decrease
income, thus equity)
Beginning balances
Services for cash
Services on account
Collect account
Record use of supplies
Buy supplies on account
Pay on account
Additional investment
Pay wages
Dividends
Ending balance
$ 5,000
– (3,000)
+ 2,500
–
$ 4,500
$ 20,000
+ 75,000
–
$ 95,000
$ 8,000
+ 2,500
– (6,000)
–
$ 4,500
$ 2,000
+ 55,000
–
$ 57,000
$ 50,000
+ 12,000
–
$ 62,000
+ 5,000
$ 5,000
+ 10,000
+ 30,000
–
$ 40,000
+ 3,000
+ 7,000
–
$ 10,000
Description
Buy land with cash and loan
Retained Earnings $140,000
$30,000 Net Income
$288,500 Total Assets
$61,500 Total Liabilities
$227,000 Total Equity
$30,000 – $5,000 = $25,000 Increase in retained earnings
Plus beginning retained earnings $140,000
Ending retained earnings $165,000
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CHAPTER 1Section 1.5 Usefulness of Accounting in Careers and Life
time. Recall that some transactions, such as providing services to customers on account, can impact income without producing any immediate cash effects. Although assessing a business’s income is important, it is sometimes important to also monitor periodic cash flows. Thus, the statement of cash flows identifies cash that is generated by operations. In addition, a comprehensive cash flows statement provides additional disclosures about cash generated or consumed through investing and financing activities. Understanding a statement of cash flows is usually predicated on knowing a number of other accounting subjects. As such, coverage of this important statement is deferred until later. For now, simply begin to appreciate that cash flows and income are not necessarily synonymous, and financial statement users need to be keenly aware of both.
1.5 Usefulness of Accounting in Careers and Life
You have probably heard that accounting is a great subject to study, maybe because it is one of the better academic pathways to a good job. In addition, the skills you will learn will prove helpful in managing your personal finances and investments. These are lifelong skills that will continue to serve you for many years to come.
If you decide to become an accountant, you will find that there are many specialty areas. Many accountants specialize in public accounting, which involves providing audit, tax, and consulting services to the general public. To specialize in public accounting usually requires licensing. Individual states issue a license called a certified public accountant (CPA). Auditing involves the examination of transactions and systems that underlie an organi- zation’s financial reports, with the ultimate goal of providing an independent report on the appropriateness of financial statements. Tax services provide help in preparing and filing of tax returns and the rendering of advice on the tax consequences of alternative actions. Consulting services can vary dramatically and include such diverse activities as information systems engineering and evaluating production methods.
Many accountants are privately employed by small and large businesses (i.e., industry accounting) and nonprofit agencies (such as hospitals, universities, and charitable groups). They may work in areas of product costing and pricing, budgeting, and the examination of investment alternatives. They may serve as internal auditors, who look at controls and procedures in use by their employer. Objectives of these reviews are to safeguard company resources and assess the reliability and accuracy of accounting information and accounting systems. They may serve as in-house tax accountants, financial managers, or countless other occupations.
It probably goes without saying that many accountants also work in the governmental sector, whether at the local, state, or national level. Many accountants are employed at the Internal Revenue Service, General Accounting Office, Securities and Exchange Commis- sion, and even the Federal Bureau of Investigation (Table 1.3).
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CHAPTER 1Section 1.6 The Importance of Ethics
Table 1.3: Examples of careers in accounting
Public-sector accounting Audit and assurance services Tax preparation and planning Business consulting and systems design
Private-sector accounting Staff accountant Controller Chief financial officer Tax manager Information technology manager Internal auditor
Federal government Internal Revenue Service General Accounting Office Securities and Exchange Commission Federal Bureau of Investigation
Nonprofit and state, local governmental sector Staff accountant Tax auditor Chief accounting officer/director Budget officer
1.6 The Importance of Ethics
Investors and creditors greatly rely on financial statements in making their investment and credit decisions. It is imperative that the financial reporting process be truthful and dependable. Accountants are expected to behave in an entirely ethical fashion. To help ensure integrity in the reporting process, the profession has adopted a code of ethics to which its licensed members must adhere. In addition, checks and balances via the audit process, governmental oversight, and the ever-vigilant plaintiff’s attorney all serve a vital role in providing additional safeguards against the errant accountant. Those who are pre- paring to enter the accounting profession should do so with the intention of behaving with honor and integrity. Others will likely rely on accountants in some aspect of their personal or professional lives. They have every right to expect those accountants to behave in a completely trustworthy and ethical fashion. After all, they will be entrusting them with financial resources and confidential information.
Being ethical can sometimes be more challenging than you might presume. Accounting tasks naturally relate to money. This is especially true for public companies that have share prices prone to fluctuate based on reported income numbers. Sometimes millions of dollars are ultimately at stake based on what the accountants ultimately report. It is easy for accountants to fall into a trap of trying to cover what is seen as a tempo- rary shortfall in income by some type of accounting gimmick. These stories usually end badly because participants tend to get sucked into an ever-worsening pattern of financial deception. In retrospect, participants in these schemes usually report that they initially acted in haste and under pressure. Nevertheless, the consequences tend to be career end- ing and worse. You must prepare yourself for ethical challenges in advance, so be firm and ready to act in an appropriate manner at all times. Accountants are fiduciaries for others and must act accordingly.
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CHAPTER 1Concept Check
In closing, many students cannot envision themselves as accountants. That’s okay. There are two important things to remember. First, accountants often move on to significant business leadership roles. This is true because their accounting training and experience provide the foundation for understanding and being successful in business. Second, peo- ple in business often remark that they wish they had studied more and knew more about accounting. In business, they quickly discover that accounting knowledge is essential— indeed paramount. Accounting truly is the language of business.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of these issues by selecting the best answer. (The answers appear on p. 235.)
1. The principle of historical cost a. holds that acquisitions of goods and services should be entered in the accounting
records at acquisition cost. b. results in the development of subjective financial statements. c. is ideal for use in periods of high inflation. d. is not acceptable when constructing general-purpose financial statements.
2. Apex Company had owner’s equity of $32,000 on January 1, 20X2. During January, owner investments and withdrawals amounted to $15,000 and $9,000, respectively. In addition, the company generated revenues of $50,000 and expenses of $48,000. What was the amount of owner’s equity on January 31?
a. $ 8,000 b. $36,000 c. $40,000 d. $58,000
3. John Davis recently withdrew $1,000 cash from the Davis Repair Shop, a sole pro- prietorship. This transaction would
a. decrease both assets and liabilities. b. decrease both assets and owner’s equity. c. decrease assets and increase owner’s equity. d. increase both assets and owner’s equity.
4. A company’s ending accounts receivable balance and the period’s advertising expense would be found on which financial statements, respectively?
a. Balance sheet and statement of owner’s equity b. Balance sheet and income statement c. Income statement and balance sheet d. Income statement and statement of owner’s equity
5. X Company had revenues, expenses, owner investments, and owner with-drawals of $45,000, $35,000, $4,000, and $1,000, respectively. What was the firm’s net income?
a. $ 9,000 b. $10,000 c. $13,000 d. $14,000
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CHAPTER 1Key Terms
assets The economic resources of the entity and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangi- bles such as patents and other legal rights and claims.
auditing The examination of transactions and systems that underlie an organiza- tion’s financial reports, with the ulti- mate goal of providing an independent report on the appropriateness of financial statements.
balance sheet A basic financial statement, it reveals the assets, liabilities, and equity of a business at a particular time.
certified public accountant (CPA) A license issued by states that allows an accountant to specialize in public accounting.
comparability The ability to make relative assessments of companies.
consistency A concept that relates perfor- mance assessments over time.
corporation A legally created entity that is owned by one or more persons.
CPA See certified public accountant.
dividends Distributions to shareholders as a return on their investment.
expenses The costs incurred in the process of producing revenues.
FASB See Financial Accounting Standards Board.
fair value An assessment based on current worth.
financial accounting Targeted toward reporting financial information about a business to external users such as the owner(s) and creditors.
Financial Accounting Standards Board (FASB) A private-sector group primarily responsible for developing the rules that form the foundation of financial reporting.
GAAP See generally accepted accounting principles.
generally accepted accounting principles (GAAP) General-purpose standards intended to be equally useful for all user groups.
historical cost The concept that it is best to report certain financial statement ele- ments at amounts that are tied to objective and verifiable past transactions.
IASB See International Accounting Stan- dards Board.
IFRS See international financial reporting standards.
income The enhancement to the business as a result of providing goods and services to its customers; mathematically, it is the result of subtracting expenses from revenues.
income statement A statement that reports income for a particular time period.
internal auditors Those professionals who look at controls and procedures in use by their employer.
International Accounting Standards Board (IASB) The international counter- part to the FASB, the IASB and FASB work cooperatively on many projects.
Key Terms
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CHAPTER 1
Critical Thinking Questions
1. How does financial accounting differ from managerial accounting? 2. What are several limitations of accounting information? 3. How does bookkeeping differ from accounting? 4. Paul Martin is contemplating an investment in the Indiana Company. He has
secured the firm’s audited financial statements, which have been examined by a certified public accountant. How can Martin be satisfied that the statements do not present false and incorrect information to purposely mislead investors?
5. Discuss the use of historical cost in the accounting process. Why is historical cost used, and what is one of its chief limitations?
6. Consider the income statement, the statement of owner’s equity, and the bal- ance sheet. Which of these statements cover(s) a period of time as opposed to a specific date?
Critical Thinking Questions
international financial reporting stan- dards (IFRS) The effort to establish consis- tency in global financial reporting.
liabilities The amounts owed to others, such as obligations to loans, extensions of credit, and others that occur in the normal course of business.
managerial accounting Information intended to serve the specific needs of management.
net assets Another term for owner’s equity.
owner’s equity The owner’s “interest” in the business, the equivalent to assets minus liabilities.
partnership A type of business considered to exist when there is co-ownership of a business activity carried on with the objec- tive of making a profit.
relevance The degree that accounting information bears on the decision process, primarily by providing timely feedback on an enterprise’s financial condition and performance.
reliability The degree that accounting information is truthful and free from bias, or neutral.
retained earnings Earnings of a business that are not distributed.
revenues The gross inflows from customers.
sole proprietorship A business owned by one person.
statement of cash flows A statement intended to show how cash is generated and expended during a specific period of time.
statement of retained earnings A state- ment that builds a bridge between the retained earnings that existed at the begin- ning and end of a particular period.
statement of stockholders’ equity An expanded statement that explains not only the periodic change in retained earnings but also shows all other sources of changes in equity.
tax services Provide help in preparing and filing of tax returns and the rendering of advice on the tax consequences of alterna- tive actions.
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CHAPTER 1Exercises
Exercises
1. Basic concepts. Jean’s Marine Supply specializes in the sale of boating equipment and accessories. Identify the items that follow as an asset (A), liability (L), revenue (R), or expense (E) from the firm’s viewpoint.
a. The inventory of boating supplies owned by the company b. Monthly rental charges paid for store space c. A loan owed to Citizens Bank d. New computer equipment purchased to handle daily record keeping e. Daily sales made to customers f. Amounts due from customers g. Land owned by the company to be used as a future store site h. Weekly salaries paid to salespeople
2. Basic computations. The following selected balances were extracted from the accounting records of Rossi Enterprises on December 31, 20X3:
Accounts Payable $ 3,200 Interest Expense $ 2,500
Accounts Receivable 14,800 Land 18,000
Auto Expense 1,900 Loan Payable 40,000
Building 30,000 Tax Expense 3,300
Cash 7,400 Utilities Expense 4,100
Fee Revenue 56,900 Wage Expense 37,500
a. Determine Rossi’s total assets as of December 31. b. Determine the company’s total liabilities as of December 31. c. Compute 20X3 net income or loss.
3. Impact of business transactions. The following items describe the impact of a busi- ness transaction or event on the components of the accounting equation. Present an example of a transaction or event that correctly matches the described impact.
a. Increase an asset and increase a liability. b. Increase one asset and decrease another asset. c. Increase an asset and increase in owner’s equity from a transaction or event not
related to income-producing activities. d. Increase an asset and increase in owner’s equity from a transaction or event re-
lated to income-producing activities. e. Decrease an asset and decrease a liability. f. Decrease an asset and decrease in owner’s equity from a transaction or event not
related to income-producing activities.
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CHAPTER 1Exercises
4. Analysis of transactions. Set up the following headings across a piece of paper:
Assets Liabilities Owner’s Equity
Using “1” and “2,” indicate the effect of each of the following transactions on total assets, liabilities, and owner’s equity:
a. Processed a $5,000 cash withdrawal for the owner. b. Recorded the receipt of May’s utility bill, to be paid in June. c. Provided services to customers on account. d. Paid the current month’s advertising charges. e. Purchased a $27,000 delivery truck by paying $5,000 down and securing a loan
for the remaining balance. f. Received $11,000 cash from the owner as an investment in the business. g. Returned a new computer and printer purchased earlier in the month on ac-
count. The bill had not as yet been paid. h. Paid the utility bill recorded previously in part (b).
5. Accounting equation; analysis of owner’s equity. Sportscar Repair revealed the following financial data on January 1 and December 31 of the current year.
Assets Liabilities
January 1 $45,000 $20,000
December 31 49,000 31,000
a. Compute the change in owner’s equity during the year by using the accounting equation.
b. Assume that there were no owner investments or withdrawals during the year. What is the probable cause of the change in owner’s equity from part (a)?
c. Assume that there were no owner investments during the year. If the owner withdrew $17,000, determine and compute the company’s net income or net loss. Be sure to label your answer.
d. If owner investments and withdrawals amounted to $13,000 and $2,000, respec- tively, determine whether the company operated profitably during the year. Show appropriate calculations.
6. Balance sheet preparation. The following data relate to Preston Company as of December 31, 20XX:
Building $44,000 Accounts Receivable $24,000
Cash 17,000 Loan Payable 30,000
J. Preston, Capital 65,000 Land 21,000
Accounts Payable ?
Prepare a balance sheet in good form as of December 31, 20XX.
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CHAPTER 1Exercises
7. Income statement concepts. Evaluate the following comments as being true or false. If the comment is false, briefly explain why.
a. An income statement reveals the net income or net loss of an entity for a period of time as opposed to a specific date.
b. Withdrawals are properly classified as an expense of doing business. c. If a company has $50,000 of revenues for March, it stands to reason that cash
receipts for March must total $50,000. d. If expenses exceed revenues, a net loss has been generated. e. A computer acquired late in the year for use in the business should be disclosed
on a firm’s income statement.
8. Financial statement relationships. The following information appeared on the financial statements of the Altoona Repair Company:
Income statement
Total expenses $ 64,900
Net income 7,200
Statement of owner’s equity
Beginning owner’s equity balance $ 113,200
Owner withdrawals 61,300
Ending owner’s equity balance 70,800
Balance sheet
Total liabilities $ 97,000
By picturing the content of and the interrelationships among the financial state- ments, determine the following:
a. Total revenues for the year b. Total owner investments c. Total assets
9. Financial statement presentation. The accounting records of Hickory Enterprises revealed the following selected information for the year ended December 31, 20X6.
Cash investments by the owner $ 59,000
Services rendered to customers 86,000
Cash withdrawals by the owner 12,000
Total year-end assets 177,800
Salaries, advertising, and utilities for the year totaled $68,500. The year-end asset total included a parcel of land that had cost the company $45,000. Hickory’s ac- countant used this amount for valuation purposes rather than the land’s current market value of $75,000 (as determined by a recent real estate appraisal).
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CHAPTER 1Problems
a. Determine the net income to be disclosed on the company’s income statement. b. Compute the increase or decrease in owner’s equity during 20X6. On which
financial statement would this information appear? c. Determine and justify the proper valuation for Hickory’s year-end assets.
Problems
1. Identification of transactions. The following tabulation summarizes several transactions of the Hartford Company:
Assets
Liabilities Owner’s Equity
Cash
Accounts Receivable
Computer Accounts Payable
(Investments 2 Withdrawals) (Revenues 2 Expenses)
$5,000 $13,000 $29,000 $17,000 $30,000
Balances
a. 2800 2800*
b. 1,900 21,900
c. 22,000 22,000
d. 23,000 10,000 7,000
e. 1,500 1,500*
f. 2,500 2,500
g. 900 2900*
$1,100 $12,600 $41,500 $24,900 $30,300
Transactions in the Owner’s Equity column designated with an asterisk (*) were caused by the company’s income-producing activities. The $2,000 and $2,500 figures are unrelated to such activities.
Instructions Write a brief explanation of each transaction.
2. Basic transaction processing. On November 1 of the current year, Richard Parker established a sole proprietorship. The following transactions occurred during the month:
1: Received $19,000 from Parker as an investment in the business. 2: Paid $9,000 to acquire a used minivan.
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CHAPTER 1Problems
3: Purchased $1,800 of office furniture on account. 4: Rendered $2,100 of consulting services on account. 5: Paid $300 of repair expenses. 6: Received $800 from clients who were previously billed in item 4. 7: Paid $500 on account to the supplier of office furniture in item 3. 8: Received a $150 electric bill, to be paid next month. 9: Processed a $600 withdrawal for Parker.
10: Received $250 from clients for consulting services rendered. 11: Returned a $450 office desk to the supplier. The supplier agreed to reduce the
balance due.
Instructions a. Arrange the following asset, liability, and owner’s equity elements of the account-
ing equation: Cash, Accounts Receivable, Office Furniture, Van, Accounts Payable, Investments/Withdrawals, and Revenues/Expenses.
b. Record each transaction on a separate line. After all transactions have been recorded, compute the balance in each of the preceding items.
c. Answer the following questions for Parker.
(1) How much does the company owe to its creditors at month-end? On which financial statement(s) would this information be found?
(2) Did the company have a “good” month from an accounting viewpoint? Briefly explain.
3. Statement preparation. The following information is taken from the accounting records of Grimball Cardiology at the close of business on December 31, 20X1.
Accounts Payable $ 14,700 Surgery Revenue $175,000
Surgical Expenses 80,000 Cash 60,000
Surgical Equipment 37,000 Office Equipment 118,000
Salaries Expense 30,000 Rent Expense 15,000
Accounts Receivable 135,000 Loan Payable 10,300
Utilities Expense 5,000
All equipment was acquired just prior to year-end. Conversations with the prac- tice’s bookkeeper revealed the following data:
Rose Grimball, capital (January 1, 20X1) $300,000
19X1 owner investments 2,000
19X1 owner withdrawals 22,000
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CHAPTER 1Problems
Instructions a. Prepare the income statement for Grimball Cardiology in good form. b. Prepare a statement of owner’s equity in good form. c. Prepare Grimball’s balance sheet in good form.
4. Transaction analysis and statement preparation. The transactions that follow relate to Frisco Enterprises for March 20X1, the company’s first month of activity.
3/1: Received $20,000 cash from Joanne Burton, the owner, as an investment in the business.
3/4: Rendered $2,400 of services on account.
3/7: Acquired a small parcel of land by paying $6,000 cash.
3/12: Received $700 from a client, who was billed previously on March 4.
3/15: Paid $800 to the Journal Herald for advertising that ran during the first half of the month.
3/18: Acquired $9,000 of equipment from Park Central Outfitters by paying $7,000 down and agreeing to remit the balance owed within the next 2 weeks.
3/22: Received $300 cash from clients for services performed on this date.
3/24: Paid $1,500 on account to Park Central Outfitters in partial settlement of the balance due from the transaction on March 18.
3/28: Rented a car from United Car Rental for use on March 28. Total charges amounted to $75, with United billing Frisco for the amount due.
3/31: Paid $900 for March wages.
3/31: Processed a $600 cash withdrawal from the business for Joanne Burton.
Instructions a. Determine the impact of each of the preceding transactions on Frisco’s assets,
liabilities, and owner’s equity. Use the following format:
Assets Liabilities Owner’s Equity
Cash Accounts Receivable Land Equipment
Accounts Payable
() Investments () Revenues (2) Withdrawals (2) Expenses
Record each transaction on a separate line. Calculate balances only after the last transaction has been recorded.
b. Prepare an income statement, a statement of owner’s equity, and a balance sheet in good form.
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CHAPTER 1Problems
5. Financial statement preparation. On October 1, 20X6, Susan Thompson opened Thompson Decorating Services, a sole proprietorship. Susan began operations with $50,000 cash, 60% of which was acquired via an owner investment. The remain- ing amount was obtained from a bank loan. A review of the accounting records for October revealed the following:
• Asset purchases: Van, $16,000; office equipment, $4,000; and decorator (household) furnishings, $17,000. These amounts were paid in cash except for $2,100 that is still owed for the furnishings acquisition.
• Services performed: Total billings on account, $18,300. Clients have remitted a total of $14,200 in settlement of their balances due.
• Expenses incurred: Salaries, $8,700; advertising, $2,500; taxes, $150; postage, $1,800; utilities, $100; interest, $450; and miscellaneous, $200. These amounts had been paid by month-end with the exception of $700 of the advertising expenditures.
Further information revealed that Thompson withdrew $5,500 of cash from the business on October 31.
Instructions a. Prepare an income statement for the month ending October 31, 20X6. b. Prepare a statement of owner’s equity for the month ending October 31, 20X6. c. Prepare a balance sheet as of October 31, 20X6.
waL80144_01_c01_001-026.indd 25 8/29/12 2:43 PM
CHAPTER 1Problems
6. Identification of income statement errors. The following income statement was prepared by Action Tree Service’s bookkeeper:
ACTION TREE SERVICE Income Statement
June 30, 20XX
Revenue
Services rendered 34,900
Accounts receivable 6,100 41,000
Owner investments 6,000
Total revenue $57,000
Less:
Salaries expense 15,600
Advertising expense 3,400
Down payment on truck 1,000
Utilities expense 900
Rent expense 1,200
Tree-trimming equipment 15,000
Loan payment (includes $600 interest)
1,900
Miscellaneous expense 12,000
Supplies used 800
Owner withdrawals 2,000
Total deductions 40,300
Net loss $16,700
Instructions Identify and explain the errors in Action’s income statement. Tell what should be done to correct the errors. (Note: A corrected income statement is not required.)
waL80144_01_c01_001-026.indd 26 8/29/12 2:43 PM
chapter 2
The Accounting System
Learning Goals
• Understand the need for and general characteristics of a proper accounting system.
• Understand accounts and how they are impacted by the debit/credit rules.
• Know how to prepare journal entries to describe the effects of transactions and events.
• Post accounts to the general ledger and prepare a trial balance.
• Apply features and tools that are used to enhance and improve accounting systems and processes.
Copyright Barbara Chase/Corbis/AP Images
waL80144_02_c02_027-052.indd 1 8/29/12 2:43 PM
CHAPTER 2Section 2.1 System Design
Chapter Outline 2.1 System Design 2.2 Accounts and Debits/Credits
Debit and Credit Rules T-Accounts
2.3 Transaction Analysis Critical Thinking About Transaction Analysis An Applied Example of Transaction Analysis
2.4 General Journal 2.5 Chart of Accounts
Posting the General Ledger Trial Balance Review of the Sequence of Transaction Recording A Balanced Trial Balance: No Guarantee of Correctness Special Journals
2.6 Source Documents 2.7 Thinking About Automation 2.8 Critical Thinking About Debits and Credits
Exhibit 1.5 shows how transactions systematically impact the accounting equation and resulting financial statements. Although this system works fine as an introduction to the accounting equation, it is not adequate for managing an actual business. Too many transactions originate in too many places for a single tabulation to capture all business activity reliably. Many small businesses have tried to use a simple schedule or spreadsheet to record and process all their activities; however, chaos quickly rules. A more complete and controlled accounting system is needed.
2.1 System Design
Large and successful businesses have invariably developed robust accounting informa-tion systems. This suggests that the pathway to business success entails more than just product development and marketing. It also entails thoughtful development of well- designed accounting information systems. It is far better to establish a proper system at the outset of launching a business, rather than coming back later and trying to repair an inadequate system. By the time a business discovers that its system is deficient, it is often too late. The business may well have lost control of necessary information for proper busi- ness management. The results are often disastrous.
This naturally leads you to wonder about the core elements of a proper system. Clearly, the accounting system must provide a basis for preparing financial statements. This is the
waL80144_02_c02_027-052.indd 2 8/29/12 2:43 PM
CHAPTER 2Section 2.2 Accounts and Debits/Credits
end objective and reflects the aggregation of all activity. Thus, the goal of an accounting system is to process transactions and events reliably into useful financial statements and reports. However, the system must also maintain retrievable documentation for every transaction. An important feature is to allow a user to query the system for the purpose of retrieving, verifying, or examining individual details of any specific business transaction.
Computerized accounting systems summarize and interpret all business transactions. The result is useful financial data for purposes of investment and business management. Much of the data input can actually originate with the transaction’s execution. For instance, while recording a customer’s purchase at a point-of-sale terminal, accounting records can be updated to reflect the sale. This can additionally trigger adjustments of the company’s inventory records and even generate an order to a vendor to replace depleted stock on hand. While this level of sophistication can simplify the data entry process and increase accuracy of subsequent processing, it also entails considerable risk of “invisible” manipu- lation of data and file destruction.
Thus, a good accounting system must take into consideration the need to control access, verify input, and back up essential records. Even with these important controls, a well- trained accountant must be knowledgeable and vigilant. A basic understanding of debits/ credits, journals, and other basic topics is essential to interpret computerized reports and spot errors that may have been inadvertently (or worse, deliberately) introduced into the system.
Computerized accounting information systems are typically built around a database structure. This means that data are stored in an electronic array, including a variety of descriptive codes and indices. This coding process allows you to query the database to extract desired information instantaneously, based on parameters established by the per- son initiating the request of the accounting system. The long-standing structure of the core financial statements and the basic tools used in their construction are generally pre- served in even the most sophisticated electronic environments. Indeed, it is difficult to understand or work within an automated accounting environment without first being moderately familiar and comfortable with the basic accounting tools. This chapter intro- duces these important tools and helps you understand how they can be effectively used to capture and process information.
2.2 Accounts and Debits/Credits
An account is the master record that is maintained for each individual financial state-ment asset, liability, equity, revenue, expense, or dividend component. Every finan- cial statement element (cash, accounts receivable, inventory, land, accounts payable, etc.) would have its own account and show the impact of all transactions causing a change to that account. The collection of all accounts is known as the general ledger.
Importantly, the collective balance of all accounts should conform to the accounting equa- tion, meaning that the sum of all asset accounts will equal the sum of all liability and equity components. Of course, in considering this equation, you need to be mindful that the revenue account increases equity and expenses and dividends decrease equity.
waL80144_02_c02_027-052.indd 3 8/29/12 2:43 PM
CHAPTER 2Section 2.2 Accounts and Debits/Credits
Beginning students are typically mystified about how this equality is consistently pre- served. There is an answer to this, and the answer’s brilliance helps explain how the fun- damental accounting model has persevered for over 500 years. Indeed, that the model continues to be programmed into today’s highly sophisticated computerized systems speaks volumes about the integrity of the model. The key ingredient is the concept of debits and credits.
Debits and credits are often misunderstood. You may have had your account credited at the bank, you might use a debit card to make a purchase, and you might prepare a credit application! The terms debit and credit are tossed around rather casually in day-to-day activities. At this point, the best thing to do is clear your mind of any meaning that you might already associate with the terms and start anew. Debits and credits are account- ing tools, and you should focus on this important point: Every business transaction can be described in terms of debit/credit impacts on specific accounts so that debits will always equal credits.
That is an amazing concept! By preserving this equality at the transaction level, the overall equality of the fundamental accounting equation is also preserved. You are perhaps skep- tical? Let’s look closer at this model.
Debit and Credit Rules
It is best to begin by memorizing certain “rules” about debits and credits. These rules are not necessarily intuitive, but at least they are not hard to learn. Think of learning them in the same way that you might memorize a few key words in a unfamiliar language, prior to taking a trip to a place where that is the only language spoken. Accountants and busi- nesspeople routinely speak about transactional effects in the context of debits and credits.
Debit (often abbreviated “dr” and sometimes taken to mean “to record on the left-hand side of an account,” as will become apparent shortly) is simply the action of recording an increase to an asset, expense, or dividend account. Conversely, credit (abbreviated “cr” and sometimes taken to mean “to record on the right-hand side of an account”) is the action of recording a decrease to those same accounts. For example, if Cash (an asset) is increased, we say that we are debiting cash. If Accounts Receivable (another asset) is decreased, we say that we are crediting Accounts Receivable. Therefore, if a transaction involves collecting $1,000 cash from a customer who owes us the money (i.e., we have a previously established account receivable on our balance sheet), then we simply say that we are debiting Cash and crediting Accounts Receivable for $1,000. By their nature, asset, expense, and dividend accounts usually have more debits than credits and are said to have a normal debit balance (Exhibit 2.1).
waL80144_02_c02_027-052.indd 4 8/29/12 2:43 PM
CHAPTER 2Section 2.2 Accounts and Debits/Credits
Exhibit 2.1: Assets, expenses, and dividend accounts
Liability, revenue, and equity accounts behave in an opposite fashion. They are increased with credits and decreased with debits. By their nature, these accounts usually have more credits than debits and are said to have a normal credit balance (Exhibit 2.2). Table 2.1 lists many typical accounts, showing the application of the debit and credit rules.
Exhibit 2.2: Liability, revenue, and equity accounts
Normal Balance Is Debit
Decreased With Credits
Increased With Debits
Assets Expenses Dividends
Normal Balance Is Credit
Decreased With Debits
Increased With Credits
Liabilities Revenues
Equity
waL80144_02_c02_027-052.indd 5 8/29/12 2:43 PM
CHAPTER 2Section 2.2 Accounts and Debits/Credits
Table 2.1: Schedule of debit and credit rules for typical accounts
Normal Balance Increased With Decreased With
Typical Assets
Cash
Accounts Receivable
Inventory Debit Debit Credit
Land
Buildings
Equipment
Typical Liabilities
Accounts Payable
Salaries Payable Credit Credit Debit
Notes and Loans Payable
Typical Equities
Capital Stock Credit Credit Debit
Retained Earnings
Typical Revenues
Service Revenue Credit Credit Debit
Sales
Typical Expenses
Salaries and Wages
Utilities
Interest Debit Debit Credit
Rent
Supplies
Taxes
Dividends
Dividends Debit Debit Credit
In addition to the preceding rules, a few select accounts are known as contra accounts. You will be exposed to these accounts in future chapters related to accounts receivable, plant assets, and certain long-term indebtedness. A contra account is an offset to another account and has opposite debit and credit rules. For example, the wear and tear on a plant asset via the passage of time can result in a reduction in the asset’s reported cost. This impact is reflected as accumulated depreciation, which is netted against (i.e., reported as contra to) the plant asset. Thus, the accumulated depreciation is reported within the asset section but has opposite debit and credit rules (e.g., increased with a credit and vice versa). This concept will be covered in more sufficient depth later.
waL80144_02_c02_027-052.indd 6 8/29/12 2:43 PM
CHAPTER 2Section 2.3 Transaction Analysis
T-Accounts
No introduction to accounting would be complete without mentioning T-accounts. A T-account is not part of an accounting system; it is only a device that is used to demon- strate the impact of certain transactions and events. T-accounts are useful teaching tools and are also used by accountants also use them when chatting about accounting effects. You can think of T-accounts as accounting on a napkin. A T-account is shaped like a “T,” with debits on the left and credits on the right. Exhibit 2.3 illustrates T-accounts show- ing the effects of purchasing $50,000 of equipment for $10,000 cash and a $40,000 note payable. In this case, Equipment (an asset) is increased via the debit; Cash (an asset) is decreased via the credit the credit; and Note Payable (a liability) is increased with a credit.
Exhibit 2.3: T-accounts
The only limit to what can be illustrated within T-accounts is the size of the paper on which they are drawn. Exhibit 2.4 shows a T-account for Cash corresponding to all activity that impacted this particular account. Notice that the excess of debits over credits equals the ending cash balance. Later in this chapter, you will see a comprehensive example for Clearview Window Washers, and this particular T-account will correspond to the cash transactions described therein.
Exhibit 2.4: Sample T-account for Cash
2.3 Transaction Analysis
The process of maintaining accountability over a business’s affairs begins with an anal-ysis of each transaction. You must determine what accounts are impacted and how they are impacted (increased or decreased). These increase/decrease impacts are then translated into the accounting language of debits and credits. You may be wondering why it is not possible to just use increase and decrease to describe effects on accounts. Simply put, increases will not always equal decreases.
waL80144_02_c02_027-052.indd 7 8/29/12 2:43 PM
CHAPTER 2Section 2.3 Transaction Analysis
For example, if one purchased inventory (an asset) with an account payable (a liability), both sides of the balance sheet increase. In other words, Cash increases on the asset side, and Accounts Payable increases on the liability side. When converted to debit/credit con- sequence, the same transaction is described as a debit to Cash (assets are increased with debits) and a credit to Accounts Payable (liabilities are increased with credits). Identifying a transaction where debits do not appropriately equal credits is impossible. Conversely, it is possible to identify a mishmash of transactions that display every conceivable combina- tion of increases and decreases, some of which are offsetting and others that are not. Is it starting to make sense why accountants stick with debit and credit nomenclature?
Critical Thinking About Transaction Analysis
Perhaps one of the more frustrating parts of learning accounting is developing the skills necessary to evaluate transactions and describe the debit/credit impacts on all affected accounts. This is akin to learning a new language. For most people, practice and repetition is required. If you try to skip over this part of the learning process, you will find yourself increasingly frustrated with future chapters. Table 2.2 is not exhaustive but is intended to provide you with some added guidance and practice in transaction analysis.
Table 2.2: Transaction analysis
Example Transactions Critical Thinking Conclusion
Provide services for cash.
Cash, an asset, and Revenues are both increased.
Debit Cash. Credit Revenues.
Provide services on account.
Accounts Receivable, an asset, and Revenues are both increased.
Debit Accounts Receivable. Credit Revenues.
Pay an expense with cash.
Expenses are increased and Cash, an asset, is decreased.
Debit Expense. Credit Cash.
Incur an expense on account.
Expenses and Accounts Payable, a liability, are both increased.
Debit Expense. Credit Accounts Payable.
Buy an asset for cash. The specific asset purchased is increased, and Cash, an asset, is decreased.
Debit Asset. Credit Cash.
Buy an asset with debt.
The specific asset purchased and Loan Payable, a liability, are both increased.
Debit Asset. Credit Loan Payable.
Collect an account. Cash, an asset, is increased, and Accounts Receivable, an asset, is decreased.
Debit Cash. Credit Accounts Receivable.
Pay an account. Cash, an asset, and Accounts Payable, a liability, are both decreased.
Debit Accounts Payable. Credit Cash.
Borrow cash. Cash, an asset, and Loan Payable, a liability, are both increased.
Debit Cash. Credit Loan Payable.
Issue stock for cash. Cash, an asset, and Capital Stock, an equity account, are both increased.
Debit Cash. Credit Capital Stock.
Pay a dividend. Dividends are increased and Cash, an asset, is decreased.
Debit Dividends. Credit Cash.
waL80144_02_c02_027-052.indd 8 8/29/12 2:43 PM
CHAPTER 2Section 2.3 Transaction Analysis
An Applied Example of Transaction Analysis
To reiterate these important concepts, let’s revisit the example from Chapter 1 (see Table 1.2). This time, however, the table is expanded to include an extra column showing the debit and credit impacts (Table 2.3). Spend some quality time thinking about each trans- action and how the proposed debit and credit impacts tie in to the debit and credit rules.
Table 2.3: Debit and credit impacts Description Amount Discussion of How Balance Is
Maintained Debit 5 Credit Translation
Provided window- washing services for cash.
$ 10,000 Cash (an asset) and Revenues both increase; revenues increase income which increases equity.
Cash, an asset, is increased with a debit 5 Revenue is increased with a credit
Provided services on account to customers.
$ 30,000 The asset, Accounts Receivable (representing amounts due from customers for work already rendered) is increased, which is matched with an increase in Revenues/Income/Equity.
Accounts Receivable, an asset, is increased with a debit 5 Revenue is increased with a credit
Collected amounts due from customers for work previously rendered.
$ 20,000 Cash is increased and Accounts Receivable is decreased, resulting in no change in total assets.
Cash, an asset, is increased with a debit 5 Accounts Receivable, an asset, is decreased with a credit
Used up supplies in the process of providing services to customers.
$ 3,000 An existing asset, Supplies, is used up and must be removed from the Asset account. This represents an Expense (expenses decrease income and therefore equity).
Supplies Expense, an expense, is increased with a debit 5 Supplies, an asset, is decreased with a credit
Bought additional supplies on account.
$ 2,500 Supplies increase, as does the Accounts Payable liability account.
Supplies, an asset, is increased with a debit 5 Accounts Payable, a liability, is increased with a Credit
Paid amounts due on outstanding Accounts Payable.
$ 6,000 Cash and Accounts Payable are both decreased.
Accounts Payable, a liability, is decreased with a debit 5 Cash, an asset, is decreased with a credit
Issued additional shares of stock.
$12,000 Cash and the Capital Stock account are both increased by the same amount.
Cash, an asset, is increased with a debit 5 Capital Stock, an equity account, is increased with a credit
Purchased land for cash ($20,000) and incurred a $55,000 loan.
$75,000 Land (an asset) goes up by $75,000. This is offset a $20,000 reduction in Cash. The balancing amount of $55,000 is reflected as increase in the liability account Loan Payable.
Land, an asset, is increased with a debit for $75,000 5 Cash, an asset, is decreased with a credit for $20,000, and Loan Payable, a liability, is increased with a Credit for $55,000
Paid wages to employees.
$ 7,000 Cash is decreased, as is Income/Equity via the recording of Wages Expense.
Wage Expense, an expense, is increased with a debit 5 Cash, an asset, is decreased with a credit
Paid dividends to shareholders.
$ 5,000 Cash is decreased and the Dividends account is increased by the same amount (which causes a decrease in Retained Earnings/Equity).
Dividends are increased with a debit 5 Cash, an asset, is decreased with a credit
waL80144_02_c02_027-052.indd 9 8/29/12 2:43 PM
CHAPTER 2Section 2.3 Transaction Analysis
You might have noticed that some transactions can impact more than just two accounts. This example included the purchase of land for cash and a loan payable. Nevertheless, these compound entries are still expected to balance. Exhibit 2.5 is a repeat of Exhibit 1.5 but revised to reflect debits and credits in lieu of pluses and minuses. Carefully note that debits equal credits within each row.
Exhibit 2.5: Spreadsheet for Clearview Window Washers for December
A ss
et s
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ti es
$
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D r
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waL80144_02_c02_027-052.indd 10 8/29/12 2:43 PM
CHAPTER 2Section 2.4 General Journal
Pressing forward, you now have a basis to understand the fundamental way in which businesses process transactions into useful financial reports. It all begins with an analysis of transactions and their conversion into a debit and credit characterization. Obviously, this information must be systematically logged into the accounting records. Sometimes this occurs automatically, such as with a point-of-sale terminal. Other times, a specific human action initiates the recording activity.
2.4 General Journal
You are familiar with the concept of a journal. Perhaps you or someone you know keeps a daily journal of life’s events. Borrowing this concept and applying it to a busi- ness, the general journal is a log of the transactions engaged in by the business. How- ever, rather than just describing transactions in narrative form (such as “collected Cash on an outstanding Account Receivable”), the journal includes this information in debit and credit form. This information is usually logged, or journalized, in chronological order. It is the starting point for collecting information about business activity and has been called the book of original entry.
Exhibit 2.6 is an example journal page for Clearview Window Washers. The entries cor- respond to the activity described in Table 2.3. Also note that debits are customarily listed first within each journal entry and are left justified. Debits are naturally followed by credits and are right justified. These data and entries reflect a summary of all activity for December. More likely, a business’s journal will have an entry for each transaction.
waL80144_02_c02_027-052.indd 11 8/29/12 2:43 PM
CHAPTER 2Section 2.4 General Journal
Exhibit 2.6: Example journal entries for Clearview Window Washers
Date Accounts Debit Credit
10,000
30,000
20,000
3,000
2,500
6,000
12,000
75,000
10,000
30,000
20,000
3,000
2,500
6,000
12,000
20,000
General Journal Page 1
Cash
Provided services for cash
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
Revenues
Accounts Receivable
Provided services on account
Revenues
Cash
Collected outstanding receivable
Accounts Receivable
Supplies Expense
Used supplies from existing inventory
Supplies
Supplies
Purchased supplies on account
Accounts Payable
Accounts Payable
Paid outstanding account payable
Cash
Cash
Issued capital stock for cash
Capital Stock
Wages Expense
Issued capital stock for cash
Cash
Dividends
Paid dividends to shareholders
Cash
Land
Purchased land for cash and loan
Cash
Loan Payable
Dec. 20X5
Dec. 20X5
7,000
5,000
55,000
7,000
5,000
waL80144_02_c02_027-052.indd 12 8/29/12 2:43 PM
CHAPTER 2Section 2.5 Chart of Accounts
2.5 Chart of Accounts
You may be wondering if there is a fixed set of accounts to choose from. The answer is clearly no. Each company’s unique business circumstances will dictate the particular accounts that are logical and useful to support its accounting system. Should the need for a new account arise, it is a simple matter to add an additional account. Furthermore, it is common to assign a unique number to each account. The numbering system is usu- ally called a chart of accounts. It is common for the numbering scheme to communicate information about the nature of accounts. For example, all assets may be numbered in the 1000s, liabilities in the 2000s, and so on. This allows logical sorting of data. Every company’s number system is likely to be unique. The assigned numbers are arbitrary, like zip codes, and merely a tool of convenience for classifying data. Assume that Clearview’s chart of accounts appears as Table 2.4 shows.
Table 2.4: Clearview chart of accounts
Cash $1,000
Accounts Receivable 1,010
Supplies 1,020
Land 1,030
Accounts Payable 2,010
Loan Payable 2,020
Capital Stock 3,000
Retained Earnings 3,100
Dividends 6,000
Revenue 4,010
Supplies Expense 5,010
Wage Expense 5,020
Posting the General Ledger
At this point, you may be wondering how to prepare financial statements from the jour- nal’s information. The short answer is that you would not! You cannot simply look at the journal, for example, and know how much cash Clearview has on hand. The data from the journal must be compiled (or sorted) into relevant accounts. This process is usually called posting, the process of transferring data from the journal into the general ledger. Think of the ledger as a notebook containing a separate page for each account. The Cash account in the general ledger might look like that shown in Exhibit 2.7.
waL80144_02_c02_027-052.indd 13 8/29/12 2:43 PM
CHAPTER 2Section 2.5 Chart of Accounts
Exhibit 2.7: Sample page from the general ledger for the Cash account
Notice that beginning balance of Cash is updated for each transaction. A similar process would apply to each account. In other words, every entry in the journal is posted in the appropriate cell in the ledger. This process enables you to review the ledger and deter- mine the balance for each account. Exhibit 2.8 shows a comprehensive illustration for Clearview’s general journal and ledger for December.
Date Description Debit Credit Balance
$ 10,000
20,000
12,000
$ 50,000
60,000
80,000
74,000
86,000
66,000
59,000
54,000
$ 6,000
20,000
7,000
5,000
Account: Cash
Balance forward
Provided services for cash
Collected receivable
Paid outstanding accounts payable
Issued capital stock
Purchased land
Paid wages
Paid dividends
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
Dec. 20X5
waL80144_02_c02_027-052.indd 14 8/29/12 2:43 PM
CHAPTER 2Section 2.5 Chart of Accounts
Exhibit 2:8: Clearview Window Washing’s general journal and ledger
D at
e D
es cr
ip ti
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D eb
it C
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it B
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$
1 0,
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$
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waL80144_02_c02_027-052.indd 15 8/29/12 2:43 PM
CHAPTER 2Section 2.5 Chart of Accounts
A properly designed system of journals and ledgers will usually include a numeric cross- referencing system that allows you to trace journal entries to the ledger and vice versa. In a manual system, check marks may also indicate that a particular transaction has been posted to the ledger. Without these marks, it would be very easy to fail to post a transac- tion or even to post the same transaction twice. Computerized posting somewhat elimi- nates this particular risk. Sometimes a unique number is assigned to each transaction, further improving the ability to trace transactions through the entire accounting system. However accomplished, a company should maintain an indexing system to allow a user to trace amounts back to the original transaction in the journal and to be certain that each transaction was appropriately processed into the ledger.
Trial Balance
Ledger balances are often tallied up to verify that debits equal credits. This tally can be illustrated in a trial balance. The trial balance is not a financial statement; it is just a list- ing of accounts and their respective balances (Exhibit 2.9). The trial balance can be used to prepare financial statements. For instance, amounts in the trial balance shown can be displayed in financial statement format and would appear identical to those illustrated in Chapter 1 (Exhibits 1.121.3). You should take a moment to compare the trial balance to those financial statements.
Exhibit 2.9: Trial balance sheet for Clearview Window Washers
Review of the Sequence of Transaction Recording
To review, notice that the accounting sequence has entailed (1) analyzing each transac- tion to determine the accounts involved and whether those accounts need to be debited or credited, (2) preparing a journal entry for the transaction, and (3) occasional posting of journal entries to the ledger. This process sounds pretty mundane, and you may be wondering how anyone can think of accounting work as exciting, analytical, or dynamic.
Debits Credits
$ 4,500
57,000
$ 62,000
140,000
40,000
–
$ 303,500
Cash
Accounts receivable
Supplies
Land
Accounts payable
Loans payable
Capital stock
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Revenue
Supplies expense
Wages expense
$ 54,000
135,000
4,500
95,000
$ 5,000
3,000
7,000
$ 303,500
Clearview Window Washers Trial Balance
December 31, 20X5
waL80144_02_c02_027-052.indd 16 8/29/12 2:43 PM
CHAPTER 2Section 2.5 Chart of Accounts
Dismiss the thought. What has been described is really just the beginning of the account- ing process. It has been pointed out that much of this work lends itself to automation. The process just described is bookkeeping, not accounting. Bookkeeping is the skill or process of recording transactions; accounting goes much further.
To extend this thought, you should now begin to appreciate that much of what has been shown thus far is based only on the recording of observed transactions. Other transac- tions or events may have occurred but not yet triggered into the accounting system. For instance, the business may have done some work that has not yet been billed. Utilities might have been consumed, but no bill has been received. Further, some accounts may need to be updated. Recall the earlier reference to accumulated depreciation. As time passes, additional depreciation occurs and should be recorded. There is no automatic trig- gering or observable transaction for this process.
To prepare truly correct financial statements, additional accounting steps are needed to adjust the various accounts within the financial statements. This adjustment process will be demonstrated in Chapter 3. There you will be introduced to accrual accounting concepts and income measurement processes. That is the point where you will begin to understand where true accounting thought begins and bookkeeping ends. First, however, there are few important loose ends to consider. There is no particular order to the follow- ing discussion. They are simply additional important points that you need to know about.
A Balanced Trial Balance: No Guarantee of Correctness
The trial balance proves that debits equal credits. This suggests that all journal entries were in balance and fully posted to the ledger. However, the equality is no guarantee that there are no errors. If the same transaction was recorded twice or part or all of an entry was posted to the wrong accounts, the trial balance would still be in balance. If a trans- action was not recorded at all or some form of end-of-period adjustment was omitted, a trial balance would also fail to reveal these events. So, the trial balance is a great tool to identify some but not all potential problems within the accounting system. Numer- ous other processes are used to verify the correctness of accounts. For example, the Cash account should additionally be verified by periodic bank reconciliations. (Later chapters will introduce methods and procedures accountants deploy as part of the financial state- ment assurance process.)
Special Journals
This text illustrates all journal entries as occurring within the general journal. However, some computerized and manual accounting systems will subdivide some journalizing activity into multiple special journals. For example, all cash outflows might be recorded in a cash disbursements journal. Conversely, cash receipts might all be recorded in a cash receipts journal. Other special journals can be designed to capture sales on account, pay- roll, purchases on account, and other redundant activities.
The benefits of special journals are many. For example, payroll records can be consolidated and housed in a single accounting record. Recording all sales on account within a spe- cially designed journal can be helpful when billing customers. Additionally, special jour- nals can reduce the amount of processing and posting that is necessary within a manual
waL80144_02_c02_027-052.indd 17 8/29/12 2:43 PM
CHAPTER 2Section 2.7 Thinking About Automation
system. Consider that all cash receipts involve a debit to Cash. Thus, it would be possible to post only a single debit to Cash for the aggregate of all transactions listed within the cash receipts journal. Basically, special journals are optional tools that can streamline the components of the accounting system. Strict reliance on only a general journal can result in an excessively voluminous set of accounting records. Nevertheless, any transaction can always be recorded in a general journal, and the general journal is supplemented by spe- cial journals (but not replaced).
2.6 Source Documents
A company must also be careful to maintain source documents. Most transactions are represented by a source document, which provides tangible evidence of the existence and nature of a transaction. Cash disbursements typically occur by issuing a check or bank transfer. Sales to customers are usually accompanied by a receipt or invoice. There are numerous types of source documents. They usually trigger the recording of a transaction and are often analyzed to determine how a transaction has impacted specific accounts.
Source documents should be preserved as evidence of transactions. To provide informa- tion about a past transaction, looking back at a source document is frequently necessary. Electronic imaging has facilitated the ability to retain such documents going back many years. The real trick is not in retaining the documents but to do so in such a way that they can be found. Thus, dating, numbering, and cataloging source documents are all crucial. Accountants may help design and implement a strong information system, and the journal/ledger system will usually link into the source document archives of modern information systems. The days of storing old documents in numbered boxes stacked deep within an old warehouse are rapidly fading away.
2.7 Thinking About Automation
Throughout this chapter, a number of references have been made to computerized accounting. Most accounting software has a number of features in common. For start- ers, programmers know the need to simplify and automate data entry. This invariably includes attempts to integrate the journalizing process with the origin of the transaction itself. Earlier, it was noted that transactions entered in a point-of-sale terminal may also link into the accounting system. Inventory movement may be tracked with radio fre- quency identification chips, and that tracking process can link into the company account- ing system. Time clocks for tracking employee labor-hours can become input devices for payroll accounting.
Automated systems are usually subdivided into modules. There may a separate module for the revenue cycle, which serves to track all sales and collections. Another module can relate only to payroll. Numerous other modules can be deployed. These modules enable subdivision of processing to persons especially familiar with selected portions of a busi- ness. Individual modules may be password protected. For instance, a payroll accountant would not need to be privy to sales activity and vice versa. The consolidated view of the entire business and the ability to view aggregated reports and financial statements should be limited to only those with a need or right to know. Software allows this impor- tant control feature.
waL80144_02_c02_027-052.indd 18 8/29/12 2:43 PM
CHAPTER 2Section 2.8 Critical Thinking About Debits and Credits
Accounting software is also designed to be user friendly. It usually includes click lists, drag-and-drop tools, and auto-complete functions that allow users to quickly select options and enter data, similar to Exhibit 2.10.
Exhibit 2.10: Typical accounting software
2.8 Critical Thinking About Debits and Credits
Earlier you were asked to clear your mind of any preconceived notions about debits and credits. Let’s now try to make sense of how the terms are sometimes used in day-to-day commerce. If a bank informs you that they are crediting your account, they are increasing your account. Bear in mind that your account is reflected as a liability on a bank’s balance sheet because they owe you the money that you deposited with them. In other words, when they credit your account, they are increasing their liability to you, and you have more funds on deposit. Conversely, if you use a debit card when you spend, your cash in the bank is decreasing (and the bank is debiting your account). When you fill out a credit application, you are asking for authorization to increase your debt. Each use of the terms debit and credit can logically be traced back to the effect on one party’s financial statements, and those effects correspond to the debit and credit rules you learned in this chapter.
502 Utilities Expense $1,000.00
Debits Credits
201 Accounts Payable $1,000.00
$1,000.00 $1,000.00
+ » $ √ ∞ ×
Actions List: Create an Invoice Receive a Payment Record an Expense View Statements Manage Accounts Generate a Report
File Edit View Help
Entry in balance
Record entry #756
waL80144_02_c02_027-052.indd 19 8/29/12 2:43 PM
CHAPTER 2Concept Check
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 235.)
1. A credit is used in accounting to a. increase an asset account. b. decrease a liability account. c. increase a revenue account. d. increase an expense account.
2. Popcorn Inc. recently purchased some office equipment on account. The proper entry would involve a
a. debit to Office Expense and credit to Accounts Payable. b. debit to Office Equipment and credit to Accounts Payable. c. debit to Office Equipment and credit to Accounts Receivable. d. debit to Accounts Payable and credit to Office Equipment.
3. Which of the following statements is false? a. Transactions are initially recorded in the journal and then transferred to the
general ledger. b. A company’s accounts are housed in the general ledger. c. Posting is a process by which accounting information is transferred from one
record to another. d. A source document is initially translated into a debit and credit format in the
general ledger.
4. The trial balance a. is prepared at the beginning of an accounting period. b. checks the equality of debits and credits contained in the general ledger. c. is prepared by extracting information directly from the journal. d. is a formal financial statement like the balance sheet.
5. Sofa Company’s trial balance will not balance if a. the $2,900 debit balance in the Cash account is entered in the trial balance’s
credit column. b. the bookkeeper accidentally forgets to record a payment of rent in the journal. c. a credit to Accounts Receivable is posted as a credit to Accounts Payable. d. a $460 purchase of equipment is accidentally entered in the accounting records
at $640.
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CHAPTER 2
Key Terms
Critical Thinking Questions
Critical Thinking Questions
1. Briefly explain how a typical accounting system operates. 2. What is a general ledger? 3. In terms of debits and credits, liabilities are decreased by ________________,
assets are increased by _________________, and revenues are increased by ___________________.
4. Explain the relationship between the accounting equation and normal account balances.
5. Les Howard accidentally debited an expense account rather than an asset account. As a result of this error, determine whether the following items will be overstated, understated, or unaffected.
Total assets will be _________________. Total expenses will be _________________. Net income will be _________________.
6. What is the purpose of a trial balance? 7. What types of errors will not affect the equality of the trial balance totals? 8. A $750 debit to Cash was accidentally posted as a credit to Accounts Payable. a. Will the trial balance be in balance?
b. If your answer to part (a) is no, what will be the difference between the debit and credit totals?
account The master record that is main- tained for each individual financial state- ment asset, liability, equity, revenue, expense, or dividend component.
bookkeeping The skill or process of recording of transactions.
chart of accounts A numbering system in which a unique number is assigned to each account.
credit The action of recording a decrease to an asset, expense, or divided account.
debit The action of recording an increase to an asset, expense, or divided account.
general journal A log of the transactions engaged in by the business.
general ledger The collection of all accounts.
posting The process of transferring data from the journal into the general ledger.
source document Tangible evidence of the existence and nature of a transaction.
special journal A subdivision of a general journal.
T-account A device that is used to dem- onstrate the impact of certain transactions and events.
trial balance A listing of accounts and their respective balances.
waL80144_02_c02_027-052.indd 21 8/29/12 2:43 PM
CHAPTER 2Exercises
Exercises
1. Recognition of normal balances. The following items appeared in the accounting records of Triguero’s, a retail music store that also sponsors concerts. Classify each item as an asset, liability, revenue, or expense from the company’s viewpoint. Also indicate the normal account balance of each item.
a. The albums, tapes, and CDs held for sale to customers b. A long-term loan owed to Citizens’ Bank c. Promotional costs to publicize a concert d. Daily receipts for merchandise sold e. Amounts due from customers f. Land held as an investment g. A new fax machine purchased for office use h. Amounts to be paid in 10 days to suppliers i. Amounts paid to a mall for rent
2. General journal and general ledger content. St. James Services uses a general jour- nal and general ledger to process transactions. Assume that the volume of trans- actions has grown in recent months and that all posting procedures have already been performed. A manager has requested that you provide the following data:
a. The total amounts that clients owe the firm as of May 31 b. The accounts that were increased or decreased by a particular transaction on a
specific date c. The total cash received during May d. The reason for a cash disbursement on May 14 e. A dated listing of all decreases to the Accounts Payable account during the month
Evaluate the data requests of the manager independently and determine whether the requests can be answered most efficiently by a review of the company’s general journal or the general ledger.
3. Basic journal entries. The following April transactions pertain to the Jennifer Royall Company:
4/1: Received cash of $15,000 and land valued at $10,000 from Jennifer Royall as an investment in the business.
4/5: Provided $1,200 of services to Jason Ratchford, a client.
4/5: Ratchford agreed to pay $800 in 15 days and the remaining amount in May.
4/9: Paid $250 in salaries to an employee.
4/19: Acquired a new computer for $3,200; Royall will pay the dealer in May.
4/20: Collected $800 from Jason Ratchford for services provided on April 5.
4/24: Borrowed $7,500 from Best Bank by securing a 6-month loan.
waL80144_02_c02_027-052.indd 22 8/29/12 2:43 PM
CHAPTER 2Problems
Prepare journal entries (and explanations) to record the preceding transactions and events.
4. Trial balance preparation. Brighton Company began operation on March 1 of the current year. The following account balances were extracted from the general led- ger on March 31; all accounts have normal balances.
Accounts Payable $ 12,000 Interest Expense $ 300 Accounts Receivable 8,800 Land ? Advertising Expense 5,700 Loan Payable 26,000 Bob Brighton, Capital 30,000 Salaries Expense 11,100 Cash 22,500 Utilities Expense 700 Fees Earned 18,900
a. Determine the cost of the company’s land by preparing a trial balance. b. Determine the firm’s net income for the period ending March 31.
5. Trial balance errors. You are reviewing the month-end trial balance for Schirmer Enterprises and discover various errors [parts (a)2(f)]. Identify the effect of the errors on the trial balance by using the following codes. Where appropriate, indicate the amount of the error.
1—Debits will exceed credits by $___________. 2—Credits will exceed debits by $___________. 3—Debits will be equal to credits.
a. Failed to record $1,000 of service revenue charged to customers at month-end. b. Incorrectly understated the balance in the Cash account by $2,500. c. Recorded the collection of $400 on account as a debit to Cash and a debit to
Accounts Receivable. d. Recorded the $5,000 balance of Equipment in the credit column of the trial balance. e. Recorded payment of the month’s $700 utility bill as a $700 debit to Utilities
Expense and a $70 credit to Cash. f. Recorded a $3,000 payment on account as a debit to Repairs Expense and a credit
to Cash.
Problems
1. Transaction analysis and trial balance preparation. The T-accounts that follow were taken from the books of Miller Data Processing on December 31 of the current year. Letters in the accounts reference specific transactions of the firm.
Cash (a) 35,000 (d) 3,000 (b) 10,000 (h) 1,500 (f) 8,000 (j) 800 (i) 400
waL80144_02_c02_027-052.indd 23 8/29/12 2:43 PM
CHAPTER 2Problems
Accounts Receivable Computer Equipment (c) 14,000 (f) 8,000 (b) 26,000
(e) 9,000 (g) 7,000
Accounts Payable Loan Payable Miller, Capital (g) 7,000 (j) 800
(e) 9,000 (h) 1,500 (a) 35,000 (b) 36,000
Fees Earned Advertising Expense Utilities Expense
(c) 14,000 (d) 2,000 (i) 400 (d) 1,000
a. Write a brief explanation of each of the transactions (a)2(j). b. Determine the balance in each account and prepare a trial balance.
2. Entry and trial balance preparation. Lee Adkins is a portrait artist. The following schedule represents Lee’s combined chart of accounts and trial balance as of May 31.
110 Cash $ 2,700 120 Accounts Receivable 12,100 130 Equipment and Supplies 2,800 140 Studio 45,000 210 Accounts Payable $ 2,600 310 Lee Adkins, Capital 57,400 320 Lee Adkins, Drawing 30,000 410 Professional Fees 39,000 510 Advertising Expense 2,300 520 Salaries Expense 2,100 540 Utilities Expense 2,000
$99,000 $99,000
The general ledger also revealed account no. 530, Legal and Accounting Expense. The following transactions occurred during June:
6/2: Collected $7,500 on account from customers.
6/7: Sold 25% of the equipment and supplies to a young artist for $700.
6/10: Received a $500 bill from the accountant for preparing last quarter’s financial statements.
6/15: Paid $2,100 to creditors on account.
6/27: Processed a $1,000 cash withdrawal for personal use.
6/30: Billed a customer $3,000 for a portrait painted this month.
waL80144_02_c02_027-052.indd 24 8/29/12 2:43 PM
CHAPTER 2Problems
a. Record the necessary journal entries for June on page 2 of the company’s general journal.
b. Open running balance ledger accounts by entering account titles, account num- bers, and May 31 balances.
c. Post the journal entries to the ledger. d. Prepare a trial balance as of June 30.
3. Journal entry preparation. On January 1 of the current year, MuniServ began operations with $100,000 cash. The cash was obtained from an owner (Peter Hous- ton) investment of $70,000 and a $30,000 bank loan. Shortly thereafter, the company acquired selected assets of a bankrupt competitor. The acquisition included land ($15,000), a building ($40,000), and vehicles ($10,000). MuniServ paid $45,000 at the time of the transaction and agreed to remit the remaining balance due of $20,000 (an account payable) by February 15.
During January, the company had additional cash outlays for the following items:
Purchases of store equipment $4,600
Loan payment, including $100 interest 500
Salaries expense 2,300
Advertising expense 700
The January utilities bill of $200 was received on January 31 and will be paid on February 10. MuniServ rendered services to clients on account, amounting to $9,400. All customers have been billed; by month-end, $3,700 had been received in settlement of account balances.
Instructions a. Present journal entries that reflect MuniServ’s January transactions, including the
$100,000 raised from the owner investment and loan. b. Compute the total debits, total credits, and ending balance that would be found
in the company’s Cash account. c. Determine the amount that would be shown on the January 31 trial balance for
Accounts Payable. Is the balance a debit or a credit?
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waL80144_02_c02_027-052.indd 26 8/29/12 2:43 PM
chapter 3
Income Measurement and the Accounting Cycle
Learning Goals
• Understand fundamental concepts of income measurement and the accrual basis of accounting.
• Apply the core principles that define revenue and expense recognition methods.
• Know why adjusting entries are needed and prepare them for the illustrated types of transaction and events.
• Implement the accounting cycle and the steps that lead to preparing correct financial statements.
• Construct a worksheet to aid in preparing financial statements.
• Cite examples of alternative reporting periods and show how the closing process is used at the end of a typical accounting year.
• Calculate income under the cash basis of accounting and know when it is an acceptable alternative to the accrual basis.
Copyright Barbara Chase/Corbis/AP Images
waL80144_03_c03_053-088.indd 1 8/29/12 2:43 PM
CHAPTER 3Section 3.1 An Emphasis on Transactions and Events
Chapter Outline 3.1 An Emphasis on Transactions and Events 3.2 The Periodicity Assumption 3.3 Revenue Recognition 3.4 Expense Recognition 3.5 Adjusting Entries
The Adjusting Process for Revenues The Adjusting Process for Expenses Understanding When to Adjust
3.6 The Accounting Cycle A Comprehensive Example The Adjusted Trial Balance Financial Statement Preparation
3.7 Reporting Periods and Worksheets Closing the Accounts Classified Balance Sheets Notes to the Financial Statements
3.8 Cash Basis of Accounting
Chapter 2 showed how transactions are entered into the journal and posted to the ledger. The resulting ledger balances were drawn into a trial balance to verify that debit and credit figures matched. In some cases, the trial balance can be used to prepare financial statements. Also pointed out was that accountants often need to adjust certain accounts before up-to-date and correct financial statements can be prepared.
3.1 An Emphasis on Transactions and Events
The basis for determining which accounts require adjustment is tied to understanding the fundamental nature of accounting income. Accounting income is primarily tied to a model based on transactions and events. This means that accountants are not neces- sarily measuring all changes in value as they occur. The historical cost principle is the foundation to many accounting rules. For example, land is recorded at its purchase price, and that historical cost price is maintained in the balance sheet, even though market value may increase over time. Historical cost data are viewed as objective and verifiable. The prevailing income measurement model is primarily driven by a transactions-and-events, historical cost-based approach.
The historical cost information incorporated into the accounting system is drawn from exchange transactions. Exchange transactions generally signify that independent buyers and sellers have agreed on the price for which goods are services are to be delivered.
waL80144_03_c03_053-088.indd 2 8/29/12 2:43 PM
CHAPTER 3Section 3.2 The Periodicity Assumption
These exchanges are often termed arm’s length exchange transactions, and the amount of consideration forms the basis for accounting measurement. Business revenues are the resource (generally, cash and receivables) inflows from exchange transactions. Business expenses are the exchange-related resource outflows arising from the production of goods and services. Income is generally regarded as revenues minus expenses.
One seemingly unavoidable problem with the approach based on transactions and events is the dynamic nature of business activity. Revenue- and expense-generating activities are in constant flux. Each day a business may provide services to customers, but payment occurs only on a specified billing cycle. When is the revenue viewed as being earned for purposes of inclusion in an income statement? Similarly, many business expenses are being continuously generated. Consider the consumption of electricity. At the moment you are reading this, you may be sitting in a heated or air conditioned room, illuminated by an overhead light, with your computer on. Electricity is being consumed constantly. From a business perspective, the cost associated the electricity usage is constantly ongo- ing. How should the measure of electricity expense be pulled into the measure of account- ing income?
3.2 The Periodicity Assumption
The periodicity assumption holds that that business activity can be divided into spe-cific time intervals, such as months, quarters, and years. Indeed, recall that an income statement measures income for a specific time period. Furthermore, a balance sheet reflects the financial condition as of a specific date.
The significance of the periodicity assumption and the related financial statement dat- ing cannot be underestimated. The transactional basis of accounting measurement is not to be interpreted as measuring only the exchange of cash. The cash basis of accounting will be discussed later in this chapter. For now, the focus is on the accrual basis. Accrual is a term that means “to accumulate over time, based on a natural observable increase.” For example, a business will constantly use utilities. The cost of those utilities accrues, or accumulates, with the passage of time. The accrual basis attempts to measure these costs as they accumulate. In contrast, the cash basis would measure the utilities expense only when the utility bill is paid. A key challenge of the accrual basis of accounting is properly identifying the portion of ongoing business activity that occurred during a particular accounting period, as Exhibit 3.1 shows.
Exhibit 3.1: Measuring ongoing activity
BUSINESS ACTIVITY
Accounting Year
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CHAPTER 3Section 3.3 Revenue Recognition
Identifying the amount of business activity to measure in each period involves both rev- enue and expense issues. Principles that guide the measurement of each are discussed in the following sections of this chapter.
3.3 Revenue Recognition
Under the accrual basis of accounting, revenues are to be recorded when they are earned. The measurement of revenue is called revenue recognition and is synony- mous with recording revenues into the accounts. Revenue recognition normally occurs at the time when services are rendered or when goods are sold and delivered to a customer. Revenue recognition normally requires both an exchange transaction and the earnings process to be complete (Exhibit 3.2).
Exhibit 3.2: Revenue recognition
For a manufactured product, revenue should not be recorded until the product is sold and delivered to an end customer. Payment can occur before, after, or at the time of product delivery. What matters is that the customer has accepted the product and the associated duty to pay for it. It is also imperative that the product be completed, such that the manu- facturer has no significant remaining duties (other than honoring routine commitments related to warranty services or occasional estimable returns). Service revenue is not as closely tied to the handoff to an end customer. A law firm may have a large staff that is researching a unique problem. The work is ongoing, and the client is being regularly updated on findings. So long as the law firm reasonably expects to be paid, the earnings process and the related revenue recognition is continuous.
Business transactions are fraught with complexity and give rise to numerous revenue recognition challenges. A majority of significant accounting mistakes relate to misappli- cation of generally accepted accounting principles related to revenue recognition issues. Consider the complexity of revenue recognition for cases like those related to long-term service agreements. Perhaps you have had an offer for a $99 cell phone, satellite dish, or burglar alarm system. The item you are buying likely costs more than $99, and the terms of the offer probably require you to agree to a multiyear monthly service contract. How should the seller record such transactions?
+ =
Production Earnings Process
Complete
Salesman Customer Exchange
Transaction
Accounting Revenue
Recognition
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CHAPTER 3Section 3.4 Expense Recognition
What about an online retailer whose business model only requires routing a customer order to a supplier who handles all logistics? If an item is sold for $100, but the online com- pany only retains $2 of the total as a marketing fee, how much revenue is to be reported on the income statement? These are complex questions, which can lead to more complex questions. It is no wonder that many accounting failures involve misapplication of rev- enue recognition concepts. Accountants have literally thousands of specific rules to draw on in reaching correct accounting conclusions. Those specific rules are generally framed around the principles in Table 3.1, all of which should be satisfied.
Table 3.1: General principles for revenue recognition
There is persuasive evidence of an arrangement.
Delivery of goods has occurred or services have been rendered.
The seller’s price is fixed or determinable.
Collectability is reasonably assured.
Remember from Chapter 2 that accounting is not bookkeeping. Perhaps you are now begin- ning to appreciate the difference. Accountants are highly skilled professionals who are trained to research and apply proper accounting solutions to complex measurement issues.
For now, it bears repeating that payment is not a criterion for initial revenue recognition. Revenues are recognized at the point of sale, whether that sale is for cash or a receivable. Accrual basis accounting contemplates more than just recording cash receipts. Severe mis- representations of income could result if the focus was simply on cash receipts.
3.4 Expense Recognition
Accrual accounting principles also apply to expense recognition. Expense recognition principles have a slightly different theoretical framework. There are three alternative models to apply, depending on the nature of a particular cost.
Some costs are created by and directly associated with a particular revenue-producing event. For example, the sale of an inventory item produces revenue, and it makes sense to offset the revenue by the cost of the inventory. Remember, income is equal to revenues minus expenses. Failure to record the expenses associated with producing revenue would overstate income. Sales commissions would similarly be recorded in the same period as a sale. Many costs bear a direct relationship to revenue and are to be recorded concurrent with the revenue recognition. This concept is referred to as the matching principle. The matching principle explains the manner in which a large proportion of business costs are to be recorded.
Some costs occur on an ongoing basis without regard to the level of revenue produc- tion. Rent, insurance, depreciation of equipment, and so forth are costs that display this pattern. As such, accountants adopt systematic allocation schemes. These schemes can be as simple as recording an equal portion of cost each period. Other patterns might be
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CHAPTER 3Section 3.5 Adjusting Entries
deployed, such as accounting for long-term assets (see Chapter 6). Therefore, accountants use defined allocation models to systematically attribute some costs to expense over time.
Lastly, some costs occur that are not seen as benefiting any future periods and are not linked to any revenue production. If a business asset is consumed by fire, its cost would be expensed immediately; there is no future benefit and no discernible revenue! Therefore, the third approach to recording expenses is immediate recognition.
Recapping, expenses are recognized by matching, systematic allocation, or immediate rec- ognition, as shown in Exhibit 3.3.
Exhibit 3.3: The three approaches to expense allocation
Accountants use the logic just described in trying to decide which approach to apply to a particular cost. As was the case with revenue recognition, note that expense recognition guidelines look well beyond just the payment of cash. Many costs are charged to expense in advance of or after the date of the related cash payment. For instance, the purchase of equipment for cash is initially recorded as follows:
7-1-X2 Equipment 1,000.00
Cash 1,000.00
To record purchase of equipment
Over time, the equipment cost will be transferred to expense in a systematic fashion that approximates the consumption of the equipment via its usage. This process is called depreciation and is discussed later in this chapter.
3.5 Adjusting Entries
The revenue and expense recognition principles provide a foundation for understanding the potential need to adjust account balances prior to preparing financial statements. Revenues may have been earned and expenses incurred that have not yet been recorded.
$$ $$$
20XX
Matching Allocation Immediate
Expenses Revenues
Year 2 Year 1
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
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CHAPTER 3Section 3.5 Adjusting Entries
Conversely, asset and liability accounts may contain balances that are no longer valid. Actu- ally, there are countless scenarios of potential adjustments that go well beyond what can be illustrated in a text. The good news is that if you develop a conceptual understanding of the basis on which adjustments are to be prepared, that knowledge can be extended to develop logical solutions for almost any adjustment-related problem you may encounter.
Adjusting entries are journal entries that are necessary to cause asset, liability, revenue, expense, and all other accounts to contain their correct balance as of a particular reporting date. As a frame of reference, Table 3.2 describes various types of adjusting entries that are necessary for selected revenue and expense items. Notice that revenue and expense accounts are both subject to adjustments for accruals and unearned/prepaid elements.
Table 3.2: Types of adjusting entries
Adjusting Revenues
Accrued revenues
Unearned revenue
Adjusting Expenses
Typical expense accruals (payroll, interest, rent)
Prepaids (Insurance, rent, supplies)
Depreciation
The Adjusting Process for Revenues
To begin, let’s consider the concept of accrued revenue. As mentioned earlier, accruals relate to items that accumulate with the passage of time. A law firm that provides ser- vices to clients accrues additional revenue with each hour of service provided to a client. Hours of service are tracked and periodically billed. Accordingly, revenues may be earned during one month and billed the following. Notwithstanding the billing cycle, revenues should be recorded as earned. When financial statements are prepared, an adjusting entry may be necessary to accrue earned but unbilled revenue. To illustrate, assume that a com- pany is owed $900 as of December 31, 20X5, for services rendered but not yet billed:
12-31-X5 Accounts Receivable 900.00
Revenue 900.00
Year-end adjusting entry to reflect services provided by year-end
An alternative revenue scenario arises when payments are received in advance of provid- ing services. A law firm might require an advance payment from a new client. Because work has yet to be performed, the amounts collected are said to be unearned revenue. A liability is shown on the balance sheet representing the duty to perform in the future. The following entry is used to record the initial cash collection:
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CHAPTER 3Section 3.5 Adjusting Entries
7-1-X2 Cash 1,000.00
Unearned Revenue 1,000.00
To record advance collection from client
If 60% of the work contemplated by the preceding entry was performed by year-end, the following entry would be needed to transfer $600 of the unearned revenue:
12-31-X2 Unearned Revenue 600.00
Revenue 600.00
Year-end adjusting entry to reflect earned portion of advance payment
The income statement for 20X2 would reflect the $600 of earned revenue, and the balance sheet would reflect the remaining $400 of unearned revenue ($1,000 2 $600). This may seem like a lot of trouble to you. Why not just record the initial $1,000 all as revenue when it is collected? The simple answer is that it violates the fundamental revenue recognition principles. Granted, the monetary amounts were very small in this example. However, the amounts can mount into the hundreds of millions for actual companies. Airlines often presell tickets, funeral homes may presell funeral plans, software companies grant long- term licenses, insurance companies presell coverage, magazine publishers presell multi- year subscriptions, and so forth. Correctly measuring revenue is essential to determining the success or failure of a business enterprise, and proper application of revenue recogni- tion concepts is paramount.
The Adjusting Process for Expenses
Properly accounting for expenses requires logic very similar to that for revenues. Many expenses accrue with the passage of time. Payroll is a significant cost for many businesses and is an excellent example of an accruing expense. If you think about a job you may have held, you recall showing up daily for work but only being paid periodically. Businesses usually pay employees on a regular interval, such as “every other Friday.” If an accounting period ended on a Wednesday and the daily payroll (assume a Monday through Friday workweek, and the last payday was the previous Friday) averaged $5,000, then $15,000 (3 days) of payroll is accrued at the end of the period. The following entry would be needed to accrue this expense:
12-31-X6 Salaries Expense 15,000.00
Salaries Payable 15,000.00
To record accrued salaries at end of period
Failure to record this adjusting entry would result in understating expenses (and over- stating income!) by $15,000. Further, the balance sheet would fail to reflect that $15,000 is owed to employees.
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CHAPTER 3Section 3.5 Adjusting Entries
You may be wondering what will happen on the next payday? If $50,000 is paid (10 days at $5,000 per day) on the next payday, the appropriate entry needs to reflect that $15,000 of the amount relates to the previous accrual (i.e., it is paid to satisfy the already recorded liability), and the other $35,000 relates to work performed in the new accounting period:
1-9-X7 Salaries Expense 35,000.00
Salaries Payable 15,000.00
Cash 50,000.00
To record payment of payroll overlapping the end of an accounting period
You should carefully compare the preceding entries to Exhibit 3.4 and note how they result in the assignment of the correct amount of expense to each of the affected account- ing periods.
Exhibit 3.4: Assigning expenses to accounting periods
Another example of an accruing expense is interest on a loan. Interest is the cost for using money and is ordinarily assessed as a stated percentage of the amount borrowed and further based on the length of the borrowing period. Therefore, accrued interest on a loan can be calculated using the borrowed amount (principal), the interest rate (rate), and the length of the borrowing period (time). A simple formula becomes
Principal Rate Time
For example, if $10,000 is borrowed at 8% per year for 24 months, the total interest will amount to $1,600 ($10,000 8% 2 years). Agreements with respect to the frequency of interest payments vary considerably. Some lenders may require monthly checks for accu- mulated interest. Other times, a loan may stipulate that interest only be paid quarterly, annually, or at maturity of the loan. Therefore, it is often necessary to record an adjusting entry to record the amount of accrued interest at the end of an accounting period. If our
December 20X6
M
1
8
15
22
29
S
7
14
21
28
T
2
9
16
23
30
W
3
10
17
24
31
T
4
11
18
25
F
5
12
19
26
S
6
13
20
27
January 20X7
M
5
12
19
26
S
4
11
18
25
T
6
13
20
27
W
7
14
21
28
T
1
8
15
22
29
F
2
9
16
23
30
S
3
10
17
24
31
Paydays Paid Holiday Days Paid for on 9thAccruals
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CHAPTER 3Section 3.5 Adjusting Entries
24-month loan was taken out on July 1, 20X3, and all amounts became due on June 30, 20X5, then all the following entries would be needed over the lifecycle of the transaction:
20X3 ———————————————
7-1-X3 Cash 10,000.00
Loan Payable 10,000.00
Borrowed $10,000 at 8% per annum; principal and interest due on 6-30-X5
12-31-X3 Interest Expense 400.00
Interest Payable 400.00
To record accrued interest for 6 months ($10,000 8% 6412)
20X4 ———————————————
12-31-X4 Interest Expense 800.00
Interest Payable 800.00
To record accrued interest for 12 months ($10,000 8% 12412)
20X5 ———————————————
6-30-X5 Interest Expense 400.00
Interest Payable 1,200.00
Loan Payable 10,000.00
Cash 11,600.00
To record repayment of loan and interest
The complexity is growing, as you can tell. It is important for you to note that the loan spanned three accounting periods and expense was allocated to each via these entries. Because the loan was outstanding for 6 months in 20X3, 12 months for 20X4, and 6 months for 20X5, the interest expense was similarly allocated as $400, $800, and $400, respectively.
Rent sometimes gives rise to an adjusting entry. If a business actually pays rent after the period of time for which facilities are used, then the accumulated unpaid rent at any time is the amount of accrued rent. If a company had accrued rent expense amounting to $4,000 at the end of period, the following entry would be needed:
12-31-X3 Rent Expense 4,000.00
Rent Payable 4,000.00
To record accrued rent at end of period
In contrast to accrued expenses are prepaid expenses. Prepaid expenses would be costs you pay in advance. You probably have some experience with this in the form of rent or insurance. Your landlord might collect a month’s rent in advance each period, or your insurance company might collect on your car insurance every 6 months. The initial expen- diture represents a future economic benefit and is recorded as an asset. As time passes, the asset is consumed and should be transferred to expense with an adjusting entry.
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CHAPTER 3Section 3.5 Adjusting Entries
To illustrate, assume you purchased a $600 6-month auto insurance policy on October 1. The following entry would be needed to record the initial policy purchase:
10-1-X8 Prepaid Insurance 600.00
Cash 600.00
Prepaid a 6-month insurance policy for cash
By December 31, half of the insurance coverage has been used up. This adjusting entry transfers $300 of the asset to expense:
12-31-X8 Insurance Expense 300.00
Prepaid Insurance 300.00
To adjust prepaid insurance to reflect portion expired
The income statement for 20X8 would show an insurance expense of $300, reflecting the amount of coverage purchased and used. The balance sheet would reflect the other $300 of prepaid insurance relating to January, February, and March.
Prepaid rent arises when you pay rent in advance. Assume that an office is leased on August 1 by paying $3,000 that covers the right to use the property for August, Septem- ber, and October. The following entry would be needed to record the initial payment on August 1:
8-1-X7 Prepaid Rent 3,000.00
Cash 3,000.00
Prepaid a 3-month lease
At the end of each month (August, September, and October), the following entry would be need to transfer $1,000 of the prepaid rental asset to an expense account. This reflects consumption of the service via its conversion to an expense.
End of Month
Rent Expense 1,000.00
Prepaid Rent 1,000.00
To adjust prepaid rent to reflect portion consumed
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CHAPTER 3Section 3.5 Adjusting Entries
Supplies are another form of prepaid expenses. When supplies are purchased, the following entry will probably be recorded:
12-1-X5 Supplies 5,000.00
Cash 5,000.00
Purchased $5,000 of office supplies
If $3,000 of these supplies is used during the month, the end-of-month adjusting entry would be as follows:
12-31-X5 Supplies Expense 3,000.00
Supplies 3,000.00
Purchased $3,000 of office supplies
The T-accounts in Exhibit 3.5 illustrate the rental payment and the related assignment to expense over time.
Exhibit 3.5: T-accounts for 3 months of prepaid rent
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CHAPTER 3Section 3.5 Adjusting Entries
The preceding entry both reduces the Supplies account (from $5,000 to $2,000) to equal the amount still on hand and transfers the amount consumed to Supplies Expense.
You may be wondering how you would actually determine the supplies used during a period, especially if there is a beginning supply already on hand. It is probably not prac- tical to track each item (and its cost) as it is used. Instead a business would rely on the formulations in Table 3.3.
Table 3.3 Determining supplies used
Beginning balance of supplies
Plus: Purchases
Equals: Supplies available
Supplies available
Less: Ending supplies on hand
Amount used that should be expensed
If you can visualize a supplies closet, imagine that it contained $500 of supplies (deter- mined by a physical count) at the beginning of an accounting period. During the period, an additional $1,000 of goods were purchased and placed in the closet. If a physical count at the end of the period revealed $300 of supplies, you could conclude that $1,200 worth of supplies was actually used (Table 3.4).
Table 3.4
Beginning balance $ 500
Plus: Purchases 1,000
Supplies available $1,500
Less: Ending supplies on hand 300
Supplies used $1,200
Certain assets have a much longer life than that shown for the prepaid insurance, and they may be tangible in nature (you can touch them). Examples include a business’s buildings and equipment. The accounting logic that must be deployed is to record the purchase of such assets and then gradually (remember systematic and rational allocation concepts) transfer their cost to expense. We call this process depreciation. The logic is not that much different from that applied to prepaid insurance; it just spans a much longer horizon.
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CHAPTER 3Section 3.5 Adjusting Entries
Importantly, depreciation is not a matter of valuing assets of a business but is the trans- ference of an asset’s cost to expense over the expected life of the asset. Accountants have devised several methods for measuring periodic depreciation, but the easiest is just a straight-line approach. With this technique, an equal amount of asset cost is assigned to each year of service life.
For example, if an item of equipment has a $6,000 cost and 3-year life, it is as simple as recording $2,000 of expense each year. It is important for you to note that the depreciation has nothing to do with cash or providing cash for an asset’s eventual replacement. The only cash flow occurs at the time an asset is purchased. As you will see from the following entries, the depreciation transfers the cost to expense over time but has not further bear- ing on cash.
The basic journal entry to record annual depreciation entails a debit to Depreciation Expense. The way in which accountants prepare the offsetting credit is unique. Rather than crediting the asset account directly (as we did for prepaid insurance), they instead credit an account called Accumulated Depreciation:
12-31-XX Depreciation Expense 2,000.00
Accumulated Depreciation 2,000.00
To record annual depreciation expense
Accumulated depreciation is shown on the balance sheet as a subtraction from the equip- ment that it relates to. Contra is a term that means “opposed to,” and an account that is subtracted from another related account is called a contra asset. In other words, contra assets are subtracted from the account to which they relate.
Each year’s balance sheet would report the asset at its $5,000 cost but with a reducing offset for the cumulative depreciation to date. This approach helps balance sheet users’ ability determine at a glance the investment and relative age of a business’s productive asset pool. Exhibit 3.6 illustrates how this item of equipment would appear in the financial statements over its 3-year life.
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CHAPTER 3Section 3.5 Adjusting Entries
Perhaps it is obvious, but do take special note that contra accounts have opposite debit and credit rules. For instance, accumulated depreciation is a contra asset and is increased with a credit.
Understanding When to Adjust
A person must be very familiar with the workings of a particular business to know which accounts need adjustment at the end of each accounting period. This is a task that requires someone who understands accounting measurement and has a deep knowledge of a
Exhibit 3.6: The cumulative depreciation of equipment over 3 years
$6,000 is paid on January 1, 20X1, for equipment with a three-year life
Depreciation Expense $ 2,000
Income Statement For the Year Ending December 31, 20X1
Depreciation Expense $ 2,000
Income Statement For the Year Ending December 31, 20X3
Assets
Truck $ 6,000
(4,000) $ 2,000
Balance Sheet December 31, 20X2
Assets
Truck
Less: Accumulated Depreciation
$ 6,000
– $ 6,000
Balance Sheet January 1, 20X1
Assets
Truck $ 6,000
(2,000) $ 4,000
Balance Sheet December 31, 20X1
Assets
Truck $ 6,000
(6,000) $ 0
Balance Sheet December 31, 20X3
Depreciation Expense $ 2,000
Income Statement For the Year Ending December 31, 20X2
Less: Accumulated Depreciation
Less: Accumulated Depreciation
Less: Accumulated Depreciation
20X1 Income Statement
20X2 Income Statement
20X3 Income Statement
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CHAPTER 3Section 3.6 The Accounting Cycle
particular business. It is easy to overlook selected adjustments, and when that happens, the information communicated by the financial statements is in error. Auditors routinely keep a sharp eye on the need for adjustments that might otherwise go overlooked.
In Chapter 2, you saw how a trial balance could be used to prepare financial statements. You were also cautioned that the trial balance may not be up-to-date and the actual prepa- ration of financial statements would normally follow the adjusting process that you are now familiar with. Therefore, after adjusting entries are prepared and posted, you would construct an adjusted trial balance showing that the equality of debits and credits was preserved throughout the journalization and posting of all adjustments.
3.6 The Accounting Cycle
Reviewing thus far, you should now recognize that the accounting process reflects the following steps: 1. Examine source documents. 2. Record transactions in the journal. 3. Post journal entries to the indicated ledger accounts. 4. Perhaps construct a trial balance. 5. Determine and post adjusting entries. 6. Prepare an adjusted trial balance. 7. Prepare financial statements from the adjusted trial balance.
These steps are customarily referred to as the accounting cycle (Exhibit 3.7), and it is vital that you comprehend how this process leads to the capture and communication of essential accounting information.
Exhibit 3.7: The accounting cycle
$$ $
$$$
3
7
1 2 4
65
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CHAPTER 3Section 3.6 The Accounting Cycle
A Comprehensive Example
At this juncture, it may prove helpful to review a comprehensive example. Assume that Clark Gliders is in the process of preparing financial statements for the year ending 20X5, its first year of operation. Clark Gliders operates out of the Windy Draft Airfield and pro- vides glider rides and tours for paying passengers.
On January 1, 20X5, Clark Gliders received a $40,000 initial investment from sharehold- ers and borrowed an additional $100,000 (at 6% per annum). Much of this money was invested in gliders with estimated lives of 10 years. Its trial balance reflecting 20X5 activ- ity, prior to considering the need for adjusting entries, contained the balances shown in Exhibit 3.8.
Exhibit 3.8: Trial balance for Clark Gliders
Assume that Clark determined that the following adjusting entries were needed at the end of 20X5.
Debits Credits
$ 32,000
5,000
100,000
40,000
143,000
–
$ 320,000
Cash
Accounts receivable
Prepaid hangar rent
Gliders
Accounts payable
Unearned revenue
Loans payable
Capital stock
Dividends
Revenue
Flight expense
Wages expense
$ 110,000
15,000
12,000
90,000
6,000
60,000
27,000
$ 320,000
Clark Gliders Trial Balance
December 31, 20X5
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CHAPTER 3Section 3.6 The Accounting Cycle
12-31-X5 Depreciation Expense 9,000.00
Accumulated Depreciation 9,000.00
To record annual depreciation expense of gliders ($90,000410)
12-31-X5
Wages Expense 3,000.00
Wages Payable 3,000.00
To record accrued wages due to employees at the end of December
12-31-X5
Interest Expense 6,000.00
Interest Payable 6,000.00
To record accrued interest on note payable ($100,000 6%)
12-31-X5
Unearned Revenue 3,000.00
Revenue 3,000.00
Year-end adjusting entry to reflect earned portion of rides sold in advance
12-31-X5
Rent Expense 4,000.00
Prepaid Hanger Rent 4,000.00
Year-end adjusting entry to reflect consumed portion of hanger rent paid in advance
The Adjusted Trial Balance Review the preceding entries and consider why they might be necessary (the amounts are simply assumed). Then, examine the adjusted trial balance in Exhibit 3.9 and take careful note of how the trial balance was updated for the effects of the adjusting entries.
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CHAPTER 3Section 3.6 The Accounting Cycle
Exhibit 3.9: Adjusted trial balance for Clark Gliders
Financial Statement Preparation
The adjusted trial balance is used to prepare financial statements. Trace the amounts from Clark’s adjusted trial balance to the financial statements in Exhibits 3.10, 3.11, and 3.12.
Exhibit 3.10: Balance sheet for Clark Gliders
Debits Credits
9,000
$ 32,000
2,000
3,000
6,000
100,000
40,000
146,000
–
$ 338,000
Cash
Accounts receivable
Prepaid hangar rent
Gliders
Accumulated depreciation
Accounts payable
Unearned revenue
Wages payable
Interest payable
Loans payable
Capital stock
Dividends
Revenue
Flight expense
Wages expense
Depreciation expense
Interest expense
Rent expense
$ 110,000
15,000
8,000
90,000
6,000
60,000
30,000
9,000
6,000
4,000
$ 338,000
Clark Gliders Adjusted Trial Balance
December 31, 20X5
Assets Liabilities
Cash
Accounts receivable
Prepaid hangar rent
Gliders
Less: Accumulated depreciation
Total assets
$ 110,000
15,000
8,000
81,000
–
$ 214,000
$ 32,000
2,000
3,000
6,000
100,000
$ 40,000
31,000
$ 143,000
71,000
$ 214,000
Accounts payable
Unearned revenue
Wages payable
Interest payable
Loans payable
Stockholders’ equity
Capital stock
Retained earnings
Total liabilities and equity
Clark Gliders Balance Sheet
December 31, 20X5
$ 90,000
(9,000)
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CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Exhibit 3.11: Income statement for Clark Gliders
Exhibit 3.12: Statement of retained earnings for Clark Gliders
Notice that the information in the adjusted trial balance is scattered throughout the three financial statements: (1) Assets and liabilities are placed on the balance sheet. (2) Revenues and expenses are placed on the income statement. (3) The statement of retained earnings includes the beginning retained earnings balance (zero, in this case, because this was a new business—but would otherwise be found in the adjusted trial balance), plus the net income carried forward from the income statement, and minus the dividends from the adjusted trial balance.
3.7 Reporting Periods and Worksheets
A company’s annual reporting period may follow the natural calendar and run from January 1 to December 31. This is known as a calendar year. In the alternative, some companies report on a fiscal year that runs from one point of beginning to one year later. Fiscal years are often chosen to follow natural business cycles. Such is the case for agricul- tural companies that may report to match growing and harvesting seasons, retailers that await holiday return cycles, and so forth.
Revenues
Expenses
Net income
Services to customers $ 146,000
$ 60,000
30,000
9,000
6,000
4,000
109,000
$ 37,000
Clark Gliders Income Statement
For the Month Ending December 31, 20X5
Flight
Wages
Depreciation
Interest
Rent
Total expenses
Beginning balance – December 1, 20X5
Plus: Net income
$ –
37,000
Clark Gliders Statement of Retained Earnings
For the Month Ending December 31, 20X5
6,000
$ 31,000 Less: Dividends
Ending balance – December 31, 20X5
$ 37,000
waL80144_03_c03_053-088.indd 20 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
In addition to the annual report, a company may prepare monthly and/or quarterly reports. The shorter the reporting cycle, the more assumptions and estimating calcula- tions become necessary. Continuous business activity must be divided and apportioned among periods. Despite the inherent reliance on assumptions, investors and creditors pre- fer frequent reports. Information timeliness is critical to decision making.
A worksheet is often used to prepare monthly and quarterly financial reports. Formal adjusting entries may not be prepared and entered into the journals and ledgers; however, the effects of adjustments must still be taken into consideration. The worksheet aids in this process. Exhibit 3.13 shows a typical worksheet.
The data and adjustments found in the worksheet correspond to information previously presented for Clark Gliders. The first pair of columns is the unadjusted trial balance. The next pair reflects all adjustments. The third pair of columns combines the trial balance with the adjustments to produce an adjusted trial balance. Information from the adjusted trial balance is extended to the appropriate financial statement. For example, Cash is an asset account with a debit balance and is extended to the debit column of the balance sheet. A similar extension occurs for every item in the adjusted trial balance. Study this process closely.
After all adjusted trial balance amounts have been extended to the appropriate columns, the income statement columns are subtotaled. If credits exceed debits, the company has more revenues than expenses (e.g., $146,000 vs. $109,000 $37,000 net income). An excess of debits over credits would represent a net loss. The amount of net income or loss is transferred from the income statement columns to the statement of retained earnings col- umns, as shown. Similarly, the ending retained earnings (the excess of credits over debits in the retained earnings columns) is transferred to the balance sheet, as shown. This final transfer should bring the debit and credit columns of the balance sheet into balance (e.g., $223,000 $223,000).
Closing the Accounts
Reporting periods rarely exceed a year. This means that Revenue, Expense, and Dividend accounts must be reset to a zero balance at the end of an accounting year, prior to begin- ning the accounting cycle for a new accounting year. This process has resulted in these accounts often being called temporary accounts. This reset is often called “closing the books.” Sophisticated computer programs easily accomplish this task (or may skip it all together because it is possible to query a database structure for any designated time inter- val). However accomplished, the key point is that the temporary accounts are readied to begin accounting anew for the next year’s activity.
You might think this closing process could be as simple as starting a fresh ledger page for each temporary account. Keep in mind, however, that the ongoing recording of each item of revenue, expense, or dividend does not result in an update of retained earnings. Throughout the accounting cycle, the retained earnings balance reflected in the ledger only shows the beginning-of-period balance. An added goal of closing is to update the retained earnings balance to reflect the end-of period balance. Remember that retained earnings is increased for net income and decreased for dividends.
waL80144_03_c03_053-088.indd 21 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Exhibit 3.13: Worksheet to prepare financial statements for Clark Gliders
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waL80144_03_c03_053-088.indd 22 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Closing can entail a series of journal entries to zero out the revenue accounts, the expense accounts, and the dividend accounts and then move their balances into retained earnings. Following is an example of the closing entries necessary for Clark Gliders.
Retained Earnings 146,000.00
To close revenues to retained earnings
12-31-X5
Retained Earnings 109,000.00
Flight Expense 60,000.00
Wages Expense 30,000.00
Depreciation Expense 9,000.00
Interest Expense 6,000.00
Rent Expense 4,000.00
To close all expense accounts to retained earnings
12-31-X5
Retained Earnings 6,000.00
Dividends 6,000.00
To close dividends to retained earnings
Notice that the preceding entries produced a net credit to Retained Earnings of $31,000 ($146,000 2 $109,000 2 $6,000), reflective of the periods increase in retained earnings. In other words, the firm’s $37,000 of net income, less its $6,000 in dividends, resulted in the $31,000 increase in ending retained earnings. The closing process brings the firm’s ledger fully up to date and sets the temporary accounts back to zero. Everything is now ready for the next accounting period to commence!
The Asset, Liability, and Equity accounts are called real accounts because their balances are carried forward from period to period. Real accounts are not closed, and their balances carry forward into the future (e.g., cash does not go away just because a calendar page is flipped). Real accounts are also called permanent accounts and relate exclusively to items that appear on a balance sheet. Companies might prepare a post-closing trial balance (Exhibit 3.14) to reveal the balance of the real accounts following the closing process. Rev- enue, Expense, and Dividend accounts do not appear in the post-closing trial balance, given their zero balance.
waL80144_03_c03_053-088.indd 23 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Exhibit 3.14: The post-closing trial balance for Clark Gliders
Classified Balance Sheets
You likely noticed that the balance sheet for Clark Gliders began to expand quickly to include more accounts. In an actual business setting, many more asset, liability, and even equity accounts can be introduced. To bring order to a report that could quickly become voluminous and disorganized, accountants have devised a somewhat standardized means of presentation called a classified balance sheet. Classified balance sheets include important groupings of accounts, usually listed in an expected order of appearance.
The asset side of the balance sheet may include separate groups for the following:
• Current assets are items expected to be converted into cash or consumed within one year or the operating cycle, whichever is longer. The operating cycle (Exhibit 3.15) is the amount of time that a business needs to convert credit back into cash. For instance, a business may buy inventory, resell it on credit, and then eventually collect the resulting receivable.
Exhibit 3.15: The operating cycle
Debits Credits
9,000
$ 32,000
2,000
3,000
6,000
100,000
40,000
31,000
$ 223,000
Cash
Accounts receivable
Prepaid hangar rent
Gliders
Accumulated depreciation
Accounts payable
Unearned revenue
Wages payable
Interest payable
Loans payable
Capital stock
Retained earnings
$ 110,000
15,000
8,000
90,000
$ 223,000
Clark Gliders Post-Closing Trial Balance
December 31, 20X5
–
Cash
Inventory Accounts
Receivable
OPERATING CYCLE
waL80144_03_c03_053-088.indd 24 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
• Specific current assets are customarily listed in order of liquidity (i.e., nearness to cash). Thus, cash is usually listed first, followed by receivables, inventory, and prepaid expenses.
• Long-term investments are items held for investment purposes, including shares of stock in other companies, idle land, cash surrender value of life insur- ance, and similar items.
• Property, plant, and equipment are items of land, buildings, and equipment that are used in production or services
• Intangible assets are items that lack physical existence but were purchased for the rights they convey. This list includes obvious assets like patents and copy- rights but can also include brand names and more general business goodwill.
• Other assets are items that defy classification in one of the preceding categories, like selected long-term receivables.
The liability side of the balance sheet may include separate groups for the following:
• Current liabilities are obligations that will likely be liquidated with current assets, typically within the next year or operating cycle, whichever is longer.
• Long-term liabilities are obligations that are not current, including bank loans and mortgages.
The appearance of the equity section of the balance sheet depends on the nature of the business organization. Future chapters will cover unique equity elements related to sole proprietorships and partnerships. For now, we focus on the corporation, and stockhold- ers’ equity usually includes the following:
• Capital stock is the amount received from investors for company shares. The attributes of stock can become more complex and result in expanded presenta- tions for issues such as preferred stock, common stock, paid-in capital in excess of par, and so on. (Future chapters introduce these additional details.)
• Retained earnings is the accumulated income less dividends.
Exhibit 3.16 is an example of a classified balance sheet showing typical accounts and their manner of presentation.
waL80144_03_c03_053-088.indd 25 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Exhibit 3.16: A classified balance sheet
Notes to the Financial Statements
In addition to financial statements, companies are also expected to add notes to the state- ments that elaborate on account balance details and more. These notes describe key account- ing policies, significant events, pending litigation, and similar details about the business. The principle of full disclosure dictates that financial statements and related notes are sufficient to allow financial statement users a legitimate basis for making informed judg- ments about the company. Exhibit 3.17 is a typical example of the notes you might encoun- ter on a close review of financial statements. Some of these concepts will already appear familiar to you, and they will all make more sense by the end of this course.
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waL80144_03_c03_053-088.indd 26 8/29/12 2:43 PM
CHAPTER 3Section 3.8 Cash Basis of Accounting
Exhibit 3.17: Notes that might be added to financial statements
3.8 Cash Basis of Accounting
The measurement, recording, and adjusting process presented thus far has relied on the accrual basis of accounting. The accrual basis is required under generally accepted accounting principles (GAAP). However, not all businesses necessarily apply GAAP. Small businesses that do not have an external user base (i.e., privately held companies without significant creditors) may be less concerned with particular details of how to measure income exactly correct for each period. They may be more interested in expe- diency and efficiency in the accounting process. Sometimes, these businesses will forgo GAAP and the accrual basis and opt for the much simpler cash basis of accounting.
Although the cash basis is simpler to apply, it can result in misleading financial state- ments. With the cash basis, revenue is recorded as cash is received (regardless of when it is earned), and expenses are recorded concurrent with their payment. To illustrate, assume
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Ultimate results could differ from those estimates.
Use of Estimates
The Company’s cash, accounts receivable, other current assets, accounts payable, and certain accrued liabilities are carried at amounts which reasonably approximate their fair value due to their short-term nature.
Fair Value
are stated at the lower of cost or market, valued on the first-in, first-out (“FIFO”) method.
Inventories
is stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets.
Property, Plant, and Equipment
is upon delivery of product to the Company’s customer and collectability is reasonably assured. The Company’s ordering process creates persuasive evidence of the sale arrangement and the sales amount is determined. The delivery of the goods to the customer completes the earnings process.
Revenue Recognition
are charged to selling, general, and administrative expense in the periods incurred.
Design, Research, and Development Costs
waL80144_03_c03_053-088.indd 27 8/29/12 2:43 PM
CHAPTER 3Concept Check
that Tanner Company recently provided $5,000 of services on account, 60% of which has been collected. The company additionally received a $1,000 advance payment from a new customer for which work has yet to be performed and provided $10,000 of services for cash. On the cash basis, revenues would amount to $14,000 as follows:
Collections of accounts ($5,000 3 60%) $ 3,000
Advance payment 1,000
Services rendered for cash 10,000
Total cash collections $14,000
This amount can be verified by checking deposits in Tanner’s bank account. It is a simple matter to measure deposits. How much was Tanner’s accrual basis revenue? It would be $15,000, representing the $5,000 of services rendered on account and the $10,000 of ser- vices rendered for cash. Sometimes accrual basis revenues are higher, sometimes lower, than cash basis revenues. In the long run, once all services have been provided and all cash collected, the two approaches should yield the same final outcome. Like revenues, expenses also differ between cash and accrual methods.
Many companies use the cash basis of accounting for purposes of tax return preparation. By accelerating payments, expenses can be reported in an earlier time period. This results in lower income and therefore taxes for that period. Again, however, the long-run effects should work out the same. It is perfectly acceptable to have two sets of books—one for tax purposes and one for accounting purposes—so long as the tax records comply with tax law. Tax accounting methods and approaches sometimes depart from the methods and approaches in use for financial accounting purposes.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 235.)
1. The accrual basis of accounting a. is less popular than the cash basis with respect to use by large businesses. b. better matches expenses and revenues than does the cash basis of accounting. c. recognizes revenues when earned and expenses when paid. d. recognizes revenues when received and expenses when paid.
2. Joe Hamilton contacted Denver Painting Contractors in July to paint his office build- ing. The price was agreed on in August, the painting took place in September, and Hamilton paid Denver in October. In which month would Hamilton recognize an expense under the accrual basis of accounting? Under the cash basis of accounting?
Accrual Basis Cash Basis a. July September b. August September c. September October d. August October
waL80144_03_c03_053-088.indd 28 8/29/12 2:43 PM
CHAPTER 3
accounting cycle Key steps include examining source documents, record- ing transactions in the journal, posting journal entries to the indicated ledger accounts, perhaps constructing a trial bal- ance, determining and posting adjusting entries, preparing an adjusted trial bal- ance, and preparing financial statements from the adjusted trial balance.
accrual basis The idea that transactions and events are to be measured based on their natural growth or increase, not their specific payment.
adjusting entries Journal entries that are necessary to cause asset, liability, revenue, expense, and all other accounts to contain their correct balance as of a particular reporting date.
arm’s length exchange transactions Exchange transactions that generally sig- nify that independent buyers and sellers have agreed on the price for which goods are services are to be delivered.
Key Terms
3. The Supplies account of Design Limited contained a $3,200 balance before adjust- ment on December 31. If $2,400 worth of supplies remains on hand at year-end, what will be the proper adjusting entry?
Debit Credit Amount
a. Supplies Expense Supplies $2,400 b. Supplies Expense Supplies $ 800 c. Supplies Supplies Expense $2,400 d. Supplies Supplies Expense $ 800
4. Kip’s Appliances sells 3-month service contracts to buyers of new appliances. The $32,800 balance in the company’s Unearned Service Contract Revenue account is properly classified as
a. an expense. b. revenue. c. an asset. d. a liability.
5. As of August 31, Sun Shade Auto Tinting owes $600 of interest (as yet unrecorded) to First Bank and Trust. If payment will take place on September 5, Sun Shade would classify the interest on August 31 as
a. a prepaid expense. b. an unearned revenue. c. an accrued expense. d. an accrued revenue.
Key Terms
Collections of accounts ($5,000 60%) $ 3,000
Advance payment 1,000
Services rendered for cash 10,000
Total cash collections $14,000
waL80144_03_c03_053-088.indd 29 8/29/12 2:43 PM
CHAPTER 3Key Terms
calendar year A company’s annual report- ing period that follows the natural calendar and runs from January 1 to December 31.
capital stock The amount of money received from investors for company shares.
cash basis Revenue that is recorded as cash is received (regardless of when earned) and expenses that are recorded concurrent with their payment.
classified balance sheet Important group- ings of accounts, usually listed in an expected order of appearance.
contra asset The record of an accumulated depreciation on a balance sheet.
current assets Items expected to be con- verted into cash or consumed within one year, or the operating cycle, whichever is longer.
current liabilities Obligations that will likely be liquidated with current assets, typically within the next year or operating cycle, whichever is longer.
depreciation The process by which the purchase of an asset is gradually trans- ferred from a cost to an expense.
fiscal year A reporting period that follows a natural business cycle rather than calen- dar year.
historical cost principle Recording cost in a balance sheet according to its history rather than market value this cost is objec- tive and verifiable.
intangible assets Items that lack physical existence but were purchased for the rights they convey and includes patents, copy- rights, brand names, and the more general business goodwill.
intermediate recognition An account- ing model that records assets that have no future benefit and no discernible revenue.
long-term investments Items held for investment purposes, including shares of stock in other companies, idle land, cash surrender value of life insurance, and simi- lar items.
long-term liabilities Obligations that are not current, including bank loans and mortgages.
matching principle The manner in which a large proportion of business costs are to be recorded.
operating cycle The amount of time a busi- ness needs to convert credit back into cash.
other assets Items that defy classification.
periodicity assumption Business activity can be divided into specific time intervals, such as months, quarters, and years.
post-closing trial balance Reveals the balance of the real accounts following the closing process.
prepaid expenses Costs that are paid in advance.
principle of full disclosure Dictates that financial statements and related notes are sufficient to allow financial statement users a legitimate basis for making informed judgments about the company.
property, plant, and equipment Items of land, buildings, and equipment that are used in production or services.
real accounts Asset, Liability, and Equity accounts that are not closed at the end of the accounting period.
waL80144_03_c03_053-088.indd 30 8/29/12 2:43 PM
CHAPTER 3
Critical Thinking Questions
1. Differentiate between a fiscal year and a natural business year. 2. When is revenue generally recognized in the accounting records? 3. Explain the matching principle. 4. What types of items frequently require adjusting entries? 5. In reviewing the records of Yager Company, you find that 3 months’ rent of $750
was prepaid to Savage Property Management on November 1. Both companies use the accrual basis of accounting. In view of this transaction,
a. What account and amount would you show on Yager’s income statement for the month ending November 30? On Savage’s income statement for the month end- ing November 30?
b. What account and amount would you show on Yager’s November 30 balance sheet? On Savage’s November 30 balance sheet?
6. Why is the net income amount (as derived from the income statement columns of the worksheet) also entered as a credit in the balance sheet columns?
7. What are the objectives of the closing process? 8. What is meant by the term accounting cycle? 9. Discuss the limitations of the balance sheet.
10. What is an intangible asset? Give three examples of intangible assets.
Exercises
1. Revenue and expense recognition, accrual basis. Dave Morris began a law practice several years ago, shortly after graduating from law school. During 20X1, he was approached by Delores Silva, who had recently suffered a back injury in an automo- bile accident. Morris accepted Silva as a client and in 20X2 proceeded with a lawsuit against Maddox Motors. The suit alleged that Maddox had knowingly sold Silva an automobile with defective brakes. Late in 20X2, the courts awarded Silva $240,000 in damages. Morris was entitled to 40% of this settlement for his fees. In 20X3, Maddox Motors paid Silva and Morris their respective shares of the judgment.
Morris incurred secretarial and photocopy charges in 20X2 of $12,000—all related to the Silva case. Of this amount, $8,000 was paid in 20X2 and the balance was paid in 20X3.
Assuming that Morris uses the accrual basis of accounting, in what year(s) should the revenue and expense amounts be recognized? Why?
Exercises
revenue recognition The measurement of revenue that is synonymous with record- ing revenues into the accounts.
systemic allocation An accounting model that systematically attributes some costs over time.
temporary accounts Revenue, Expense, and Dividend accounts that have been reset to a zero balance at the end of an accounting year, to be ready for the new accounting year.
unearned revenue Amounts collected in advance of services being provided.
waL80144_03_c03_053-088.indd 31 8/29/12 2:43 PM
CHAPTER 3Exercises
2. Recognition of concepts. Ron Carroll operates a small company that books enter- tainers for theaters, parties, conventions, and so forth. The company’s fiscal year ends on June 30. Consider the following items and classify each as either (1) pre- paid expense, (2) unearned revenue, (3) accrued expense, (4) accrued revenue, or (5) none of the foregoing.
a. Amounts paid on June 30 for a 1-year insurance policy b. Professional fees earned but not billed as of June 30 c. Repairs to the firm’s copy machine, incurred and paid in June d. An advance payment from a client for a performance next month at a convention e. The payment in part (d) from the client’s point of view f. Interest owed on the company’s bank loan, to be paid in early July g. The bank loan payable in part (f) h. Office supplies on hand at year-end
3. Analysis of prepaid account balance. The following information relates to Action Sign Company for 20X2:
Insurance expense $4,350
Prepaid insurance, December 31, 20X2 1,900
Cash outlays for insurance during 20X2 6,200
Compute the balance in the Prepaid Insurance account on January 1, 20X2.
4. Accounting for prepaid expenses and unearned revenues. Hawaii-Blue began business on January 1 of the current year and offers deep-sea fishing trips to tour- ists. Tourists pay $125 in advance for an all-day outing off the coast of Maui. The company collected monies during January for 210 outings, with 30 of the tourists not planning to take their trips until early February.
Hawaii-Blue rents its fishing boat from Pacific Yacht Supply. An agreement was signed at the beginning of the year, and $72,000 was paid for the rights to use the boat for 2 full years.
a. Prepare journal entries to record (1) the collection of monies from tourists and (2) the revenue generated during January.
b. Calculate Hawaii-Blue’s total obligation to tourists at the end of January. On what financial statement and in which section would this amount appear?
c. Prepare journal entries to record (1) the payment to Pacific Yacht Supply and (2) the subsequent adjustment on January 31.
d. On what financial statement would Hawaii-Blue’s January boat rental cost appear?
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CHAPTER 3Exercises
5. Adjustment error. The accountant for Stringer Services failed to adjust the Supplies account to recognize the amount consumed during March. As a result of this error, will the following items be overstated, understated, or unaffected?
a. March revenues will be ________________. b. March expenses will be ________________. c. March net income will be _______________. d. Ending owner’s equity as of March 31 will be _________________. e. Assets as of March 31 will be __________________. f. Liabilities as of March 31 will be _________________.
6. Overview of the closing process. Evaluate the comments that follow as being true or false. If the comment is false, briefly explain why.
a. The closing process is performed after adjusting entries have been journalized and posted.
b. Because they both possess a debit balance, Salaries Expense and Susan Franklin, Drawing, are treated in the same manner when accounts are closed at the end of the period.
c. The Equipment account is closed at the end of the period by a debit to Income Summary and a credit to Equipment.
d. If MultiTech incurred a net loss for the period just ended, the Income Summary account would contain a debit balance after the revenue and expense accounts have been closed.
e. If a $4,900 balance is listed in the adjusted trial balance for Dave Miller, Capital, it stands to reason that Miller’s capital account in the post- closing trial balance would be listed at $4,900 as well.
7. Understanding the closing process. Examine the following list of accounts:
Interest Payable Accumulated Depreciation: Equipment
Alex Kenzy, Drawing Accounts Payable
Service Revenue Cash
Accounts Receivable Supplies Expense
Interest Expense
Which of the preceding accounts
a. appear on a post-closing trial balance? b. are commonly known as temporary, or nominal, accounts? c. generate a debit to Income Summary in the closing process? d. are closed to the capital account in the closing process?
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CHAPTER 3Problems
8. Closing entries. Gomez Company had the following adjusted trial balance on December 31:
Cash $ 2,300 Accounts Receivable 16,500 Prepaid Insurance 1,200 Land 40,000 Accounts Payable $ 1,800 Miguel Gomez, Capital 43,700 Miguel Gomez, Drawing 2,500 Service Revenue 38,000 Rent Expense 9,000 Insurance Expense 5,400 Advertising Expense 3,500 Utilities Expense 3,100
$83,500 $83,500
Prepare the closing entries that Gomez would record on December 31.
Problems
1. Accrual and cash basis. The following information pertains to Beta Company for October:
Services rendered during October to customers on account $14,380
Cash receipts from
Owner investment 7,000
Customers on account 5,650
Cash customers for services rendered in October 6,800
Cash payments to
Creditors for expenses incurred during October 4,400
Creditors for expenses incurred prior to October 2,100
Monroe Equipment for purchase of new machinery on October 1 8,400
Expenses incurred during October, to be paid in future months 3,725
The machinery is expected to have a service life of 5 years.
Instructions Calculate Beta’s net income for October, using the following methods:
a. Accrual basis of accounting b. Cash basis of accounting
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CHAPTER 3Problems
2. Adjusting entries and financial statements. The following information pertains to Fixation Enterprises:
• The company previously collected $1,500 as an advance payment for services to be rendered in the future. By the end of December, one third of this amount had been earned.
• Fixation provided $2,500 of services to Artech Corporation; no billing had been made by December 31.
• Salaries owed to employees at year-end amounted to $1,650. • The Supplies account revealed a balance of $8,800, yet only $3,300 of supplies
were actually on hand at the end of the period. • The company paid $18,000 on October 1 of the current year to Vantage Property
Management. The payment was for 6 months’ rent of Fixation’s headquarters, beginning on November 1.
Fixation’s accounting year ends on December 31.
Instructions Analyze the five preceding cases individually and determine the following:
a. The type of adjusting entry needed at year-end (Use the following codes: A, adjust- ment of a prepaid expense; B, adjustment of an unearned revenue; C, adjustment to record an accrued expense; or D, adjustment to record an accrued revenue.)
b. The year-end journal entry to adjust the accounts c. The income statement impact of each adjustment (e.g., increases total revenues
by $500)
3. Adjusting entries. You have been retained to examine the records of Kathy’s Day Care Center as of December 31, 20X3, the close of the current reporting period. In the course of your examination, you discover the following:
• On January 1, 20X3, the Supplies account had a balance of $2,350. During the year, $5,520 worth of supplies was purchased, and a balance of $1,620 remained unused on December 31.
• Unrecorded interest owed to the center totaled $275 as of December 31. • All clients pay tuition in advance, and their payments are credited to the
Unearned Tuition Revenue account. The account was credited for $75,500 on August 31. With the exception of $15,500, which represented prepayments for 10 months’ tuition from several well-to-do families, all amounts were for the current semester ending on December 31.
• Depreciation on the school’s van was $3,000 for the year. • On August 1, the center began to pay rent in 6-month installments of $21,000.
Kathy wrote a check to the owner of the building and recorded the check in Pre- paid Rent, a new account.
• Two salaried employees earn $400 each for a 5-day week. The employees are paid every Friday, and December 31 falls on a Thursday.
• Kathy’s Day Care paid insurance premiums as follows, each time debiting Pre- paid Insurance:
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CHAPTER 3Problems
Date Paid Policy No. Length of Policy Amount
Feb. 1, 20X2 1033MCM19 1 year $540
Jan. 1, 20X3 7952789HP 1 year 912
Aug. 1, 20X3 XQ943675ST 2 years 840
Instructions The center’s accounts were last adjusted on December 31, 20X2. Prepare the adjusting entries necessary under the accrual basis of accounting.
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chapter 4
Cash, Receivables, and Controls
Learning Goals
• Define cash and cash equivalents.
• Know cash control principles and concepts.
• Prepare the bank reconciliation and related adjusting entries.
• Know how to establish and control a petty cash system.
• Understand the accounting concepts and methods pertaining to receivables.
• Master basic calculations and accounting techniques for notes receivable.
Copyright Barbara Chase/Corbis/AP Images
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CHAPTER 4Section 4.1 Concepts of Cash
Chapter Outline 4.1 Concepts of Cash
Cash Management and Control 4.2 Bank Reconciliations 4.3 Petty Cash Funds 4.4 Accounts Receivable 4.5 Direct Write-Off Method
Allowance Techniques for Uncollectible Accounts Writing Off an Account Against an Allowance Formalized Receivables and Notes Credit and Debit Card Transactions
Cash is an interesting asset. It is usually not the most important asset a company pos-sesses, and it is not a very productive asset. However, try to operate without it, and the results are usually and quickly fatal. It is the accepted medium of exchange and rep- resents the “blood supply” to keep the business functioning. Therefore, proper cash man- agement and control is highly important to business success.
4.1 Concepts of Cash
Cash includes currency, coins, bank demand deposits that can be freely withdrawn, undeposited checks from customers, and other items that are acceptable to a bank for deposit. Some items may seem like cash but are not classified that way: certificates of deposit, IOUs, stamps, and travel advances. These later items are reported as investments, supplies, or other more descriptive classifications.
Some companies will expand their reporting of cash to include cash equivalents. These are very short-term (usually interest-earning) financial instruments like government Trea- sury bills. They are typically deemed secure and will convert back into cash within 90 days. They are close enough to cash that they are considered to be available to satisfy obligations, and proper cash management strategies tend to discourage hoarding of large pools of unproductive currency deposits.
Cash Management and Control
Cash management requires a proper balancing to maintain sufficient cash to meet obli- gations as they come due and to make sure that idle cash is invested to generate returns on business assets. Larger organizations may create the position of treasurer whose job is to manage the business’s cash flows. This person may be responsible for preparing a cash budget, which is a major component of the cash-planning system. It anticipates and
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CHAPTER 4Section 4.1 Concepts of Cash
depicts cash inflows and outflows for a stated period of time. This tool helps identify and adjust for anticipated periods of cash deficits or surpluses.
Based on advance knowledge gained via the cash-budgeting process, a company then has time to develop appropriate strategies to deal with the anticipated potential cash needs.
Companies must also implement strong systems of cash control. Cash controls are intended to safeguard funds, and include the following:
• Limiting access to cash • Separating incompatible duties (e.g., the person maintaining the cash records
should not reconcile bank accounts) • Instituting accountability features such as prenumbered checks and dual
signatures
Typical processes ordinarily maintain a continuous system of accountability and access control from the time a receipt occurs at the point of sale or collection to deposit at the bank. Table 4.1 highlights some significant control features, which you should consider implementing in almost any business environment, for cash receipts.
Table 4.1: Control features for cash receipts
Use point-of-sale terminals to record cash transactions.
Daily, compare cash to register tapes.
Daily, deposit cash receipts in the bank.
The person opening the mail immediately restrictively endorses (e.g., for deposit only) checks received.
The person opening the mail immediately prepares a checklist that is forwarded to the accounting department.
The person opening the mail immediately forwards all checks to the cashier for deposit.
In reviewing Table 4.1, it is important to note that actual checks are immediately sepa- rated from the accounting for those receipts. Separation of duties is a paramount control feature; the person recording the checks in the accounting records is deliberately not the person making the deposit. Later, another person will be charged with comparing com- pany cash records with actual cash on deposit at the bank. By involving multiple parties, it becomes much harder for any one person to commit fraud, and collusion is usually neces- sary. When it requires multiple persons to coordinate activities to perpetuate a fraud, the risk of fraud is greatly diminished.
Disbursements of cash also entail procedures that are intended to permit only authorized payments for actual expenditures. Table 4.2 highlights some significant control features, which you should consider implementing in almost any business environment, for cash disbursement.
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CHAPTER 4Section 4.2 Bank Reconciliations
Table 4.2: Control features for cash disbursement
Use a check (or credit card) to make significant disbursements.
Someone not otherwise regularly involved in the cash business cycle should regularly reconcile bank accounts.
Use formal petty cash procedures for small disbursements.
Establish a proper system of authorization for approval of significant disbursements.
Set up bank accounts that require dual signatures for large disbursements.
You should already be performing a bank reconciliation of your own checking account. Mostly, you perform this process to make sure that your records are correct and agree with the bank. Businesses should reconcile each of their bank accounts. This process should be performed by a person not otherwise involved in the cash receipts and disbursements functions. For a business, the bank reconciliation is needed to identify errors, irregulari- ties, and adjustments needed to the Cash account.
4.2 Bank Reconciliations
There is no single correct way to set up a schedule or worksheet format for the bank rec-onciliation. If you look at your monthly bank statement, you will probably see such a template in preprinted form using the bank’s suggested schedule. However designed, the purpose of the reconciliation is to compare amounts on the bank statement (the docu- ment provided by the bank showing deposits, checks, other activity and balances) with the cash amount contained in the company records. Identified differences help isolate errors and adjustments.
Differences between cash in the company records and the bank statement are caused by the following:
• Items reflected on company records but not yet recorded by the bank: (1) Deposits in transit are receipts entered on company records but not pro- cessed by the bank, and (2) outstanding checks are written checks that have not cleared the bank.
• Items noted on the bank statement but not recorded by the company: (1) NSF (nonsufficient funds) checks are checks previously deposited but have been returned for nonpayment, (2) bank service charges and fees, (3) inter- est earnings on the bank account(s), and (4) cash collections of notes and drafts.
The following example uses a popular two-column bank reconciliation approach. One column compares the balance per the bank statement to the correct cash balance. The sec- ond column reconciles the cash balance per company records to the same correct balance. It is imperative that the analysis is thorough so that the correct balance is obviously the same in each column.
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CHAPTER 4Section 4.2 Bank Reconciliations
Exhibit 4.1 shows the June 30, 20X5, bank reconciliation for Winslow Quilts. The state- ment on the left is the bank statement, and the statement on the right is the company records. Notice that both columns arrive at the correct cash balance of $20,959.75. The following additional data and items of information are needed to prepare and explain the bank reconciliation:
Exhibit 4.1: Two statements for bank reconciliation for Winslow Quilts on June 30, 20X5
• The balance per the bank statement was $16,878.90. • The balance per the bank statement failed to include a deposit in transit of
$9,443.12. • The bank balance had not yet been reduced by three checks (no. 451, 458, and
459) totaling $5,362.27. • The balance per company records (taken from the Cash account in the general
ledger and other records, such as a simple check register) is $18,987.09. • The company’s records had not yet been increased for a note and interest col-
lected by the bank ($1,060). • The company’s records had not yet been increased for credit card postings to
benefit the company’s bank account (e.g., quilts sold by accepting customer credit cards in the amount of $1,777.07).
• Interest earned on the bank account ($28.15) was not previously recorded by the company.
• The company records had not yet been reduced for bank service charges ($75.00), electronic funds transfers to pay a utility bill ($376.56), and a bounced (NSF) check ($441.00).
In preparing a bank reconciliation, the balance per the bank must be increased for the deposits in transit and reduced by the outstanding checks. The balance per books must be adjusted for any actual transactions not yet recorded.
Ending balance per bank statement
Add:
Deduct:
Correct cash balance
$ 16,878.90
9,443.12
(5,362.27)
$ 20,959.75
$ 106.15 2,256.12 3,000.00
Winslow Quilts Bank Statement
For the Month Ending June 30, 20X5
Deposits in transit
Outstanding checks #451 #458 #459
Ending balance per company records
Add:
Deduct:
Correct cash balance
$ 18,987.09
2,865.22
$ 1,060.00 1,777.07
28.15
(892.56)
$ 20,959.75
$ 75.00 376.56 441.00
Winslow Quilts Records Statement
For the Month Ending June 30, 20X5
Note and interest collected Credit card postings Interest earnings
Service charges Electric bill ETF NSF Check
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CHAPTER 4Section 4.2 Bank Reconciliations
The bank reconciliation is prepared by carefully analyzing the bank statement and the related general ledger account or check register. Exhibits 4.2 and 4.3 show the documents corresponding to the preceding reconciliation. To identify all relevant items needed for the reconciliation, you must take time to carefully study these documents. You will also observe that the bank statement includes a few irrelevant checks (like checks no. 448 and 449, probably written in a prior month and shown as outstanding in last month’s recon- ciliation) and deposits ($3,821.13, probably recorded in the prior month and shown as in transit in last month’s reconciliation). Sometimes, tracking down all the reconciling items can be a painstaking process, but it is an essential tool for maintaining accurate records.
Exhibit 4.2: Bank statement
Exhibit 4.3: General ledger account
This statment covers: June 1, 20X5 through June 30, 20X5
Checking account # 4783080
Checks and other debits
Electronic funds transfer - Ready Electric NSF refund check Monthly service fee
Deposits and other credits
Customer deposit Customer deposit Collection item – note receivable ($1,000 + interest) Customer deposit Credit card sales posting Interest earnings
Check 448 449 450
*452* 453
Check 454 455 456 457
*460*
Date Paid 3–Jun 5–Jun 9–Jun 9–Jun 12–Jun
Date Paid 15–Jun 17–Jun 23–Jun 27–Jun 30–Jun 25–Jun 27–Jun 30–Jun
Amount 2134.67 256.09
3334.55 24.56
7112.54
Amount 1313.13 645.38
1788.07 4610.00 349.44 376.56 441.00 75.00
Date 1–Jun 5–Jun 12–Jun 15–Jun 28–Jun 30–Jun
Amount 3821.13 3750.00 1060.00
11524.78 1777.07
28.15
Monthy Summary Previous statment balance on 5-31-X5 Total of 5 deposits for Total of 12 withdrawals for Interest earnings for Service charges for New balance
Statment for: Winslow Quilts 21 East Main Santa Clara
17,375.76 21,935.98 + 22,385.99 –
28.15 + 75.00 –
16,878.90
Santa Clara Bank
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CHAPTER 4Section 4.2 Bank Reconciliations
Because the company’s records show only $18,987.09 in cash, but the correct balance is $20,959.75, cash must be increased by a total of $1,972.66 ($20,959.75 2 $18,987.09). The following journal entries record this increase, along with other debits and credits neces- sary to record the previously unrecorded transactions. Carefully note how each entry cor- responds to one of the reconciling items.
6-30-X5 Cash 1,060.00
Notes Receivable 1,000.00
Interest Income 60.00
To record proceeds of note collected by bank on behalf of the company
6-30-X5 Cash 1,777.07
Sales 1,777.07
To record credit card sales for transactions posted directly to company bank account
6-30-X5 Cash 28.15
Interest Income 28.15
To record interest income earned on bank account
6-30-X5 Miscellaneous Expense 75.00
Cash 75.00
To record adjustment for bank service charge automatically charged against company bank account
6-30-X5 Utilities Expense 376.56
Cash 376.56
To record adjustment for utility bill automatically charged against company bank account
6-30-X5 Accounts Receivable 441.00
Cash 441.00
To record adjustment for returned (NSF) customer check; the intent will be to collect this amount from the customer
The net effect of the preceding entries is to increase the Cash account by $1,972.66. The T-account (Exhibit 4.4) shows this impact.
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CHAPTER 4Section 4.3 Petty Cash Funds
Exhibit 4.4: A T-account for Cash
In lieu of multiple separate entries as shown, companies might instead prepare a com- pound journal as follows:
6-30-X5 Cash 1,972.66
Utilities Expense 376.56
Accounts Receivable 441.00
Miscellaneous Expense 75.00
Notes Receivable 1,000.00
Sales 1,777.07
Interest Income 88.15
To record adjustments necessitated by bank reconciliation
4.3 Petty Cash Funds
Petty cash funds are in frequent use for making small payments that may be impracti-cal to pay by check or credit card. Examples include postage, employee reimburse- ments, office supplies, snacks, and similar immaterial expenditures. A petty cash fund is primarily a tool of convenience, not necessity. A petty cash fund is established by making out a check to “Cash,” cashing it, and placing the cash in a petty cash box under the con- trol of a designated custodian. The following entry would be used to initially establish a $500 petty cash fund:
Date Party Ref# Check
1–Jun
4–Jun
7–Jun
8–Jun
8–Jun
10–Jun
15–Jun
15–Jun
16–Jun
20–Jun
23–Jun
26–Jun
28–Jun
29–Jun
Deposit
Valequez
Nicole
Smith
Zhao
Rollin
Deposit
LeBeau
Pechlat
Valequez
Goodman
Hanks
Anderson
Deposit
Balance
450
451
452
453
454
455
456
457
458
459
460
–
$ 3,334.55
106.15
24.56
7,112.54
1,1313.13
–
654.38
1,788.07
4,610.00
2,256.12
3,000.00
349.44
–
$ 24,539.94
Deposit Balance
$ 3,750.00
–
–
–
–
–
11,527.78
–
–
–
–
–
–
9,443.12
$ 24,720.90
$ 18,806.13
22,556.13
19,221.58
19,115.43
19,090.87
11,978.33
10,665.20
22,192.98
21,547.60
19,759.53
15,149.53
12,893.41
9,893.41
9,543.97
18,987.09
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CHAPTER 4Section 4.3 Petty Cash Funds
3-15-X4 Petty Cash 500.00
Cash 500.00
To establish a $500 petty cash fund
Policies should establish the types and amounts of expenditures that can be paid from petty cash. When a disbursement is made from the fund, a receipt (a petty cash voucher) is placed in the petty cash box. Thus, the sum of the receipts plus the remaining cash should always equal the balance of the petty cash fund. As cash becomes depleted, another check payable to “Cash” is prepared in an amount to bring the fund back up to the desired bal- ance. That check is cashed and the proceeds are placed in the petty cash box. Simultane- ously, receipts are removed from the petty cash box and formally recorded as expenses. The appropriate journal entry is to debit the appropriate expense accounts based on the receipts and to credit Cash.
3-31-X4 Supplies Expense 225.00
Fuel Expense 50.00
Miscellaneous Expense 75.00
Cash 350.00
To replenish petty cash; receipts on hand of $350 for supplies, fuel, and snacks
Take note that the preceding entry did not impact the Petty Cash account. The balance of Petty Cash remains at $500.
On occasion, the petty cash on hand may not exactly match what should be found in the box. Errors can occur, and the actual cash on hand plus receipts may differ from the official petty cash balance. Assume the preceding facts, except that only $125 of cash was actually in the box. Thus, $375 is needed to replenish the fund, as follows:
3-31-X4 Supplies Expense 225.00
Fuel Expense 50.00
Miscellaneous Expense 75.00
Cash Short 25.00
Cash 375.00
To replenish petty cash; receipts on hand of $350 for supplies, fuel, and snacks and $25 for cash shortage
The Cash Short account is like an expense and reflects the missing $25. Hopefully, this will not be a common occurrence.
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CHAPTER 4Section 4.5 Direct Write-Off Method
If a company subsequently increases petty cash, the following entry would be necessary:
3-15-X4 Petty Cash 500.00
Cash 500.00
To increase petty cash fund by $250
Notice that the preceding entry is identical to that recorded to establish a petty cash fund.
4.4 Accounts Receivable
You already know that receivables arise from a variety of claims against customers and others. Most receivables are trade receivables originating from the sale of products or services to customers. Trade receivables are accounted for via the Accounts Receivable account. Other nontrade receivables can originate from loans to employees, deposits left with others, and so forth. Some nontrade receivables may be shown as noncurrent if there is an expectation that they are not going to be converted back into cash during the current cycle.
By selling on credit, a company also assumes certain costs and risks. Companies must be careful when trading goods and services for a future payment. On occasion a customer may not pay, and this can result in a substantial loss. Credit providers must investigate a customer’s credit history and expend considerable effort on billing and collection activi- ties. Furthermore, the creditor temporarily forgoes use of funds while waiting for payment.
You may wonder why anyone would bother to extend credit, but there are certain advan- tages. For one thing, customers are sometimes more willing to buy if they are afforded flexibility on payment terms. This can boost a company’s overall sales. Sometimes, credit terms may include interest charges. This provides an extra source of earnings for the seller. Indeed, some businesses make as much or more money on interest charges as they do on the margin of the product sold.
4.5 Direct Write-Off Method
As noted, unhappily so, some customers may never pay for the goods and services they have received. The seller should not carry the resulting accounts receivable on its balance sheet once it has become clear that it will not be paid. A simple process for accounting for uncollectible accounts is the direct write-off method. When an account is determined to be uncollectible, the following entry would be recorded:
3-20-X4 Uncollectible Accounts Expense 700.00
Accounts Receivable 700.00
To record the write-off of an uncollectible account
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CHAPTER 4Section 4.5 Direct Write-Off Method
Some companies use the term bad-debt expense to describe the cost of the uncollectible items. The entry causes an increase in Expense and a reduction in the Accounts Receivable balance. The problem with this approach is that it causes a poor matching of revenues and expenses. Notice that the Uncollectible Accounts Expense might not be recorded until one or more periods subsequent to the period of recording the sale (and setting up the receivable). Although the direct write-off method might be used in cases where uncollectibles are not material in amount (and for tax purposes, as generally required under U.S. tax statutes), it is not permissible for use under generally accepted accounting principles. The mismatching problem is deemed sufficiently bad that accountants have come up with an alternative.
Allowance Techniques for Uncollectible Accounts
Accountants have developed allowance methods for uncollectibles. These techniques result in the recording of estimates for bad-debt expenses in the same period as the related credit sales. Suppose that Marquez Company has an Accounts Receivable balance of $500,000. It is estimated that 3%, or $15,000, of this total pool of accounts will ultimately prove to be uncollectible. The correct balance sheet presentation would be as follows:
Accounts Receivable $500,000
Less: Allowance for Uncollectible Accounts (15,000)
$485,000
Notice that the allowance account is presented as a Contra Asset account to the gross (total) amount of Accounts Receivable. The resulting $485,000 corresponds to the net realizable value of the receivables pool.
The allowance account to include on the balance sheet can be determined by various methods. In the given example, it was presumed that 3% of the outstanding Accounts Receivable balance was the appropriate level to establish. The actual rate will vary by company and, in each case, should be based on detailed analysis of outstanding receivables balances. This may entail an aging of accounts, which attempts to stratify the receivables according to how long they have been outstanding. There is a presump- tion that older accounts are more likely to be problematic and represent a higher risk of nonpayment. Whether determined by using a percentage of receivables, an aging, or another technique, the estimated amount for the allowance account must be established in the ledger.
Assume that Marquez’s ledger revealed an Allowance for Uncollectible Accounts credit balance of $5,000 (prior to calculating the $15,000 necessary balance). As a result, the fol- lowing entry is needed to bring the accounts up-to-date:
12-31-X8 Uncollectible Accounts Expense 10,000.00
Allowance for Uncollectible Accounts 10,000.00
To adjust the allowance account from a $5,000 balance to the desired balance of $15,000
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CHAPTER 4Section 4.5 Direct Write-Off Method
This approach is a balance sheet approach. That is, an assessment was made of the desired balance for the allowance that is to be reported on the balance sheet. The adjusting entry brought the allowance up to the targeted level. You should carefully note that the amount of the entry is based on the necessary change in the account.
There is a simpler income statement approach. An estimated percentage of total sales (or sales on account) is debited to Uncollectible Accounts Expense and credited to the Allowance for Uncollectible Accounts. This method results in the addition of the estimated amount to the Allowance account. In other words, it incrementally adjusts the allowance account for a portion of each additional dollar of sales. Assume that Zhu Hai Company had sales during the year of $1,000,000, and it estimates uncollectible accounts as accruing at the rate of 2% of total sales. Thus, the necessary entry would add $20,000 ($1,000,000 20%) to the allowance, regardless of the existing balance:
12-31-X8 Uncollectible Accounts Expense 20,000.00
Allowance for Uncollectible Accounts 20,000.00
To add 2% of sales to the allowance account
Any of the allowance methods are acceptable, provided the accountant concludes that they reasonably reflect the anticipated cost of uncollectible accounts and fairly present the balance sheet of the company.
Writing Off an Account Against an Allowance
We have now seen how to record uncollectible accounts expense and set up the related allowance. But, how do we write off an individual account that is uncollectible? This part is easy. The following entry is used:
3-15-X9 Allowance for Uncollectible Accounts 5,000.00
Accounts Receivable 5,000.00
To record the write-off of an uncollectible account
Notice that the entry reduces both the allowance account and the related receivable and has no impact on the income statement. Remember, under the allowance account, the income statement occurs when the allowance is set up (think matching . . .), not when the account is actually written off against the previously established allowance. Because the write-off entry reduces both an asset and contra asset by similar amounts, there is no impact on the net realizable value of the receivables, total assets, or any other accounts.
Formalized Receivables and Notes
Longer-term receivables are sometimes supported by a formal written promise or agree- ment. These notes receivable often entail interest charges. The maker of the note is the party promising to make payment, and the payee is the party to whom payment will be
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CHAPTER 4Section 4.5 Direct Write-Off Method
made. The principal amount of the note is the stated value. The maturity date is the day the note is set to be paid. Interest is the charge for the use of money. The amount of inter- est is calculated as Principal Rate Time. Accountants must understand these terms and concepts to be able to calculate interest and prepare appropriate related entries.
A $100,000, 90-day note, bearing interest at 6% per year, would produce total interest of $1,500 ($100,000 6% 904360). Notice that the time portion of the calculation is a pro- portion of a year. Here, for simplicity of illustration, we assume a 90-day note, out of a 360- day year. A more correct mathematical calculation of time would be 904365. Sometimes notes are based on the 360-day year, perhaps for ease of calculation or because it results in a higher amount of interest. If you are a borrower, you should understand the terms on which interest charges are to be calculated (and you should prefer that the calculations be based on 365-day year).
The following entries show the issuance of the note and subsequent collection with interest.
1-1-X6 Notes Receivable 100,000.00
Sales 100,000.00
To record sale in exchange for formal note receivable
3-31-X8 Cash 101,500.00
Interest Income 1,500.00
Notes Receivable 100,000.00
To record collection of note receivable plus accrued interest of $1,500
If the note receivable were outstanding at the end of an accounting period, the accounting department would want to be certain to accrue interest income for amounts earned but not yet collected. You learned about these types of accruals in Chapter 3.
Credit and Debit Card Transactions
Many merchants will accept popular credit and debit cards such as MasterCard, Visa, and American Express. The financial services companies offering these cards earn money by charging fees to the merchant (such as 1.5% of the transaction amount). In addition, the credit card companies may also charge users service fees and interest. Although poten- tially expensive to merchants and consumers alike, the cards introduce convenience, stim- ulate spontaneous sales, and usually assure collectability for the merchant. Depending on the card and related agreement, merchants may collect the sales price on the day of sale by electronic transfer of funds. This eliminates the need for internal credit departments at many businesses and can accelerate a business’s access to funds.
The accounting for credit and debit card sales depends somewhat on the terms of the card. For bank card2based transactions, funding usually occurs quickly. Therefore, the follow- ing entries may be appropriate in some cases.
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CHAPTER 4Concept Check
1-9-X3 Cash 490.00
Service Charge 10.00
Sales 500.00
Sold merchandise for $500 via debit card with same-day funding, net of 2% fee
If the card/debit sale involved delayed collection, the preceding debit to Cash would instead be reflected as a debit to Accounts Receivable.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 235.)
1. Which of the following statements about the direct write-off method is false? a. The direct write-off method can result in recognizing sales revenue in one period
and expense related to that revenue in a subsequent period. b. The write-off of a customer’s account balance results in a debit to Uncollectible
Accounts Expense. c. The Allowance for Uncollectibles account is not used when the direct write-off
method is employed. d. Sales are essentially recognized by the cash basis of accounting when the direct
write-off method is used.
2. The income statement and balance sheet approaches are used to estimate uncollect- ible accounts. Which of the following comments applies to both of these approaches?
a. The aging process is often used to obtain proper valuation amounts. b. Generally speaking, matching is improved when compared with the direct write-
off method. c. The focus is on the net realizable value of accounts receivable. d. Total credit sales is commonly used as the estimation base.
3. Gonzo Company estimates uncollectible accounts at 5% of ending accounts receiv- able. The company’s records reveal ending receivables of $2,000,000 and a $40,000 debit balance in the Allowance for Uncollectibles. How much would Gonzo’s year- end adjusting entry for bad debts increase its Uncollectible Accounts Expense?
a. $ 40,000 b. $ 60,000 c. $100,000 d. $140,000
4. The following information pertains to Laser Company:
• Accounts receivable total is $100,000, subdivided as follows: 50% are current; 30% are slightly past due; and 20% are long past due.
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CHAPTER 4Concept Check
• Uncollectibles are current accounts, 5%; slightly past-due accounts, 25%; and long past-due accounts, 70%.
• The balance in the Allowance for Uncollectibles prior to adjustment is $24,000, credit.
If Laser uses the aging approach to estimate bad debts, what is the balance in the Allowance for Uncollectibles account after adjustment?
a. $ 0 b. $24,000 c. $48,000 d. Some amount other than those above
5. Find-a-Friend Pet Shop uses the allowance method of accounting for bad debts. The company recently wrote off the $135 balance of Karen Sorrell as uncollectible. As a result of the write-off, Find-a-Friend will experience
a. a $135 decline in income. b. a $135 decline in the net realizable value of Accounts Receivable. c. a $135 increase in the Allowance for Uncollectible Accounts. d. no change in total assets.
6. The collection of an account previously written off under the allowance method will involve two separate journal entries. After both of these entries are recorded,
a. total accounts receivable will be unchanged. b. the Allowance for Uncollectibles account will decrease. c. uncollectible accounts expense will increase. d. uncollectible accounts expense will decrease.
7. What is the maturity value of a $30,000, 8% note receivable, dated December 1, 20X2, and maturing on March 31, 20X3?
a. $30,000 b. $30,200 c. $30,800 d. $32,400
8. The following facts pertain to a note receivable that was discounted at a local bank on December 1, 20X1:
Face amount: $100,000 Term: 60 days Interest rate: 12% Discount rate: 15% Date of note: November 1, 20X1
What is the interest revenue that would be recognized at the time of discounting? a. $ 0 b. $ 725 c. $1,250 d. $1,275
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CHAPTER 4
allowance methods for uncollect- ibles Techniques that result in the record- ing of estimates for bad-debts expense in the same period as the related credit sales.
balance sheet approach The approach in which an assessment was made of the desired balance for the allowance that is to be reported on the balance sheet.
bank reconciliation The process needed to identify errors, irregularities, and adjustments needed to the Cash account.
bank statement The document provided by the bank showing deposits, checks, other activity, and balances.
cash Currency, coins, bank demand deposits that can be freely withdrawn, undeposited checks from customers, and other items that are acceptable to a bank for deposit.
cash equivalents Sometimes included in reporting of cash, very short-term (usually interest-earning) financial instruments like government Treasury bills.
deposits in transit Receipts entered on company records but not processed by the bank.
direct write-off method A process for accounting for uncollectible accounts.
income statement approach A method that employs estimates of uncollectibles based on total sales or credit sales.
interest The charge for the use of money.
maker The party promising to make pay- ment on a note.
maturity date The day a note is set to be paid.
net realizable value The amount of cash expected from the collection of current customer balances.
note receivable A written promise or agreement that sometimes supports lon- ger-term receivables agreement.
NSF (nonsufficient funds) checks Checks previously deposited but have been returned for nonpayment.
outstanding checks Written checks that have not cleared the bank.
payee The party to whom payment will be made.
petty cash Funds used for making small payments that may be impractical to pay by check or credit card.
principal The amount of the note is the stated value.
treasurer The person in a company whose job is to manage cash flows of the business.
Key Terms
Key Terms
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CHAPTER 4
Critical Thinking Questions
1. What items are normally included in the Cash account on the balance sheet? 2. Define the following items and describe how they are classified on the balance sheet: a. Certificate of deposit b. Postdated check c. IOU d. Travel advance
3. What is cash management? Briefly discuss the planning and control aspects of an effective cash management system.
4. What is a bank reconciliation? 5. What is the effect of a bank debit memo on a depositor’s account balance? 6. What are the reasons for the discrepancy between the cash balance reported on the
bank statement and the cash balance in the accounting records? 7. Distinguish between trade and nontrade receivables. Give three examples of the latter. 8. Explain why uncollectible accounts have both income statement and balance sheet
implications for accountants. 9. Briefly describe the two methods that can be used to record losses from uncollect-
ible accounts. 10. Discuss some possible deficiencies of the direct write-off method of uncollectible
accounts.
Exercises
1. Bank reconciliations: missing amounts. The following independent cases relate to bank reconciliations. Compute the missing amounts, assuming that no other recon- ciling items exist.
Case A Case B Case C
Balance per bank $6,000 $4,000 $ ?
Outstanding checks 500 2,100 1,400
Deposits in transit 2,000 ? 1,000
Balance per company records ? 8,000 450
2. Items on a bank reconciliation. You are preparing the June bank reconciliation for Advanced Systems. Identify the proper placement of parts (a)2(f) on the reconcilia- tion by using the following codes:
1—An addition to the balance per bank as of June 30
2—A deduction from the balance per bank as of June 30
3—An addition to the balance per company records as of June 30
4—A deduction from the balance per company records as of June 30
Exercises
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CHAPTER 4Exerises
______ a. Interest earned on the account during June ______ b. A company deposit taken to the bank at 3:00 p.m. on June 30 but not
recorded on the June bank statement ______ c. A $3,000 deposit, entered in the company records as $300 ______ d. A deposit of Advanced Design Systems, incorrectly credited to Ad-
vanced Systems’ account ______ e. A customer’s check returned for nonsufficient funds ______ f. Check no. 765, which has not yet cleared the bank
3. Bank reconciliation and entries. The following information was taken from the accounting records of Palmetto Company for the month of January:
Balance per bank $6,150
Balance per company records 3,580
Bank service charge for January 20
Deposits in transit 940
Interest on note collected by bank 100
Note collected by bank 1,000
NSF check returned by the bank with the bank statement 650
Outstanding checks 3,080
a. Prepare Palmetto’s January bank reconciliation. b. Prepare any necessary journal entries for Palmetto.
4. Accounting for cash. Evaluate the following comments as true or false. If the com- ment is false, briefly explain why.
a. A petty cash fund should be replenished at the conclusion of an accounting period. b. A journal entry is needed in a company’s accounting records to record both a
bank service charge and the firm’s outstanding checks. c. As shown on May’s bank statement, the Nebraska National Bank incorrectly
deducted $200 from the account of Kay’s Auto Parts. When preparing its bank reconciliation, Kay’s should subtract $200 from the accounting records so that the adjusted cash balance (company records) will equal the adjusted cash bal- ance (bank).
d. Customer checks, money orders, and certificates of deposit are properly classified as cash on the balance sheet.
e. To achieve strong internal control, a store cashier should have access to a com- pany’s accounting records for cash.
5. Direct write-off method. Harrisburg Company, which began business in early 20X7, reported $40,000 of accounts receivable on the December 31, 20X7, balance sheet. Included in this amount was a $550 claim against Tom Mattingly from a sale made in July. On January 4, 20X8, the company learned that Mattingly had filed for personal bankruptcy. Harrisburg uses the direct write-off method to account for uncollectibles.
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CHAPTER 4Problems
a. Prepare the journal entry needed to write off Mattingly’s account. b. Comment on the ability of the direct write-off method to value receivables on the
year-end balance sheet.
6. Allowance method: estimation and balance sheet disclosure. The following pre- adjusted information for the Maverick Company is available on December 31:
Accounts receivable $107,000
Allowance for uncollectible accounts 5,400 (credit balance)
Credit sales 250,000
a. Prepare the journal entries necessary to record Maverick’s uncollectible accounts expense under each of the following assumptions:
(1) Uncollectible accounts are estimated to be 5% of Credit Sales. (2) Uncollectible accounts are estimated to be 14% of Accounts Receivable.
b. How would Maverick’s Accounts Receivable appear on the December 31 balance sheet under assumption (1) of part (a)?
c. How would Maverick’s Accounts Receivable appear on the December 31 balance sheet under assumption (2) of part (a)?
Problems
1. Direct write-off and allowance methods: matching approach. The December 31, 20X2, year-end trial balance of Targa Company revealed the following account information:
Debits Credits
Accounts Receivable $252,000 Allowance for Uncollectible Accounts $ 3,000 Sales 855,000 Sales Returns and Allowances 12,900 Sales Discounts 8,100
Instructions a. Determine the adjusting entry for bad debts under each of the following condi-
tions: (1) An aging schedule indicates that $12,420 of accounts receivable will be
uncollectible. (2) Uncollectible accounts are estimated at 2% of net sales.
b. On January 19, 20X3, Targa learned that House Company, a customer, had declared bankruptcy. Present the proper entry to write off House’s $950 balance.
c. Repeat the requirement in part (b), using the direct write-off method. d. In light of the House bankruptcy, examine the allowance and direct write-off
methods in terms of their ability to properly match revenues and expenses.
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CHAPTER 4Problems
2. Allowance method: income statement and balance sheet approaches. Tempe Company reported accounts receivable of $300,000 and an allowance for uncol- lectible accounts of $31,000 (credit) on the December 31, 20X2, balance sheet. The following data pertain to 20X3 activities and operations:
Sales on account $2,000,000
Cash collections from credit customers 1,600,000
Sales discounts 50,000
Sales returns and allowances 100,000
Uncollectible accounts written off 29,000
Collections on accounts that were previously written off
2,700
Instructions a. Prepare journal entries to record the sales- and receivables-related transactions
from 20X3. b. Prepare the December 31, 20X3, adjusting entry for uncollectible accounts, as-
suming that uncollectibles are estimated to be 2% of net credit sales. c. Prepare the December 31, 20X3, adjusting entry for uncollectible accounts, as-
suming that uncollectibles are estimated at 1% of year-end accounts receivable. d. Compute the amount of the adjusting entry in part (c), assuming that $46,000,
rather than $29,000, of accounts were written off in 20X3.
3. Allowance method: analysis of receivables. At a January 20X2 meeting, the presi- dent of Sonic Sound directed the sales staff “to move some product this year.” The president noted that the credit evaluation department was being disbanded be- cause it had restricted the company’s growth. Credit decisions would now be made by the sales staff.
By the end of the year, Sonic had generated significant gains in sales, and the president was very pleased. The following data were provided by the accounting department:
20X2 20X1
Sales $23,987,000 $8,423,000
Accounts Receivable, 12/31 12,444,000 1,056,000
Allowance for Uncollectible Accounts, 12/31
? 23,000 cr.
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CHAPTER 4Problems
The $12,444,000 receivables balance was aged as follows:
Age of Receivable Amount Percentage of Accounts Expected to Be Collected
Under 31 days $5,321,000 99%
31260 days 3,890,000 90
61290 days 1,067,000 80
Over 90 days 2,166,000 60
Assume that no accounts were written off during 20X2.
Instructions a. Estimate the amount of Uncollectible Accounts as of December 31, 20X2. b. What is the company’s Uncollectible Accounts expense for 20X2? c. Compute the net realizable value of Accounts Receivable at the end of 20X1
and 20X2. d. Compute the net realizable value at the end of 20X1 and 20X2 as a percentage of
respective year-end receivables balances. Analyze your findings and comment on the president’s decision to close the credit evaluation department.
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chapter 5
Inventory
Learning Goals
• Know the basics of recording inventory purchases and sales.
• Understand the typical categories of inventory and their contents.
• Understand how an expanded income statement presentation can enhance reporting usefulness.
• Explain how inventory costs are allocated to inventory and cost of goods sold and the importance of this allocation to income measurement.
• Know how to apply FIFO, LIFO, and moving average inventory-costing assumptions.
• Apply specific identification, retail, and lower-of-cost-or-market concepts.
Copyright Barbara Chase/Corbis/AP Images
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CHAPTER 5Chapter Outline
Chapter Outline 5.1 Categories of Inventory
Inventory Costs Freight Expanded Income Reporting Consigned Goods Critical Thinking About Inventory Cost
5.2 Cost Assignment 5.3 Perpetual Systems
First-In, First-Out Last-In, First-Out The Average Cost Approach
5.4 Comparing Methods Specific Identification The Retail Method Lower-of-Cost-or-Market Adjustments
5.5 The Importance of Accuracy
How hard could it be to account for inventory? The basic concept is very simple. When you buy inventory, you record the purchase of the asset, like this: 2-10-XX Inventory 10,000.00
Accounts Payable 10,000.00
Purchased $10,000 of inventory on account
Then, when the inventory is resold, two entries are needed—one to record the sales pro- ceeds and another to remove the inventory and charge it to an expense category called cost of goods sold:
3-15-XX Accounts Receivable 15,000.00
Sales 15,000.00
Sold merchandise on account
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CHAPTER 5Section 5.1 Categories of Inventory
3-15-XX Cost of Goods Sold 10,000.00
Inventory 10,000.00
To record the cost of merchandise sold
This very basic approach would result in the following income statement results:
Sales $15,000
Cost of goods sold 10,000
Gross profit $ 5,000
The gross profit is simply the net difference between the cost of inventory that has been sold and the sales proceeds. It is not the net income because it does not reflect all other costs of doing business. Of course, if inventory accounting was only this simple, there would be no need for a separate chapter. So, what issues could possibly arise to compli- cate the accounting for inventory?
For starters, there are issues about what goods are appropriately included in inventory. What is the appropriate moment to conclude that a transaction has resulted in a sale? What costs, in addition to the direct purchase price, are to be placed into the inventory accounts? How do we attach costs to specific units sold when numerous identical units have been purchased at different costs on different dates, and we are not sure which phys- ical units have actually been delivered to a customer? Suddenly, accounting for inventory appears to present a number of vexing challenges. This chapter helps sort out these issues and provides you with a sound understanding of the accounting principles you need to know to answer these types of questions and more.
5.1 Categories of Inventory
The very simple journal entry that opened this chapter contemplated a retail business model. The company bought goods from a supplier and resold those goods to custom- ers at a higher price point. Retailing is a large segment of the economy but not the only segment. The goods must have been manufactured. Therefore, manufacturers also carry inventory on their books.
A manufacturer’s inventory may consist of goods in various stages of development. It may have raw materials consisting of components and parts that will eventually be put into production. The manufacturer may also have work-in-process inventory consisting of goods being manufactured but not yet completed. A third category of inventory is finished goods. These are completed goods awaiting sale. Consider that the manufacturer’s process entails converting raw material into finished goods. During production, raw materials are converted via the addition of labor and other factors of production (such factory costs are called overhead).
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CHAPTER 5Section 5.1 Categories of Inventory
The process for correctly accumulating and attaching these costs to work in process requires substantial skill and is covered in depth in the managerial accounting course. For now, be aware that much more is to be learned about how costs attach to products in a manufacturing environment. Let’s focus just on the general inventory-accounting princi- ples that would be applicable to most businesses, using scenarios involving the purchase and resale of goods.
Inventory Costs
As a general rule, inventory should include all costs that are ordinary and necessary to put the goods in place and in condition for their resale. Inventory therefore includes the invoice price, shipping costs incurred when buying the goods, and similar costs. Costs like interest charges on money borrowed to buy inventory, storage costs, and insurance are not included in inventory accounts because they do not meet the general rule. Those costs are called carrying costs and are to be expensed in the period incurred.
Freight
Few people think deeply about how significant freight cost can be to the overall cost of bringing a product to market. It can be expressed in very simple terms. If you drive to the store for a gallon of milk costing $3 and spend $3 on gas to make the trip, how much did the milk actually cost? If you were trying to categorize your milk in the refrigerator as an asset on an accounting balance sheet, would your report its cost at $3 or $6? Because of its significance, accountants have been very careful to describe fully a framework for the handling of freight costs. To develop an understanding of this framework begins with specific knowledge about freight terms.
FOB is a common freight nomenclature. It is an abbreviation for “free on board.” What that really means is the point at which the ownership of goods shifts from the seller to the buyer. Thus, goods may be sold FOB shipping point. Once goods are shipped, they are deemed the property of the buyer. Equally important, the buyer must assume responsibil- ity for payment of freight to the destination. Conversely, FOB destination means that the seller owns the goods until they are delivered and must bear the cost of shipping. The implications of freight terms should not be underestimated. There are two highly signifi- cant inventory accounting considerations that are directly affected by the FOB terms.
First, goods sold FOB destination do not belong to the purchaser until they arrive at their final destination. Therefore, goods that have been purchased but not yet received would not be carried in the buyer’s balance sheet at the end of the accounting period. Similarly, no liability would be reported for the payment obligation. Conversely, goods purchased FOB shipping point that have been shipped by the seller should be reflected on the buy- er’s balance sheet, even though they may not be in the buyer’s physical possession. In this case, the buyer needs to show both the inventory and related liability on its books. Accountants can face interesting challenges to determine the status of goods in transit at the end of each accounting period.
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CHAPTER 5Section 5.1 Categories of Inventory
The second major issue pertains to the freight cost. When the buyer assumes the freight cost (as with FOB shipping point), it is deemed to be an ordinary and necessary cost to put the goods in place and in condition for resale. As such, accountants will add freight-in to the cost of the inventory. Thus, the Inventory account will reflect both the invoice cost of the goods, along with any additional amounts for freight. You should be aware that freight-out incurred by a seller of goods faces a different accounting rule. Freight-out is treated like a sales expense and does not increase the cost of goods sold amount; instead, the freight out is subtracted from gross profit in calculating income.
Expanded Income Reporting
The foregoing issues begin to show why a merchant’s income statement can be expanded. Merchants and others frequently present a multiple-step income statement. This for- mat divides business results into separate categories. The first category clearly shows the difference between the selling price of the product and its cost. This difference is called gross profit. Following gross profit are the other expenses of doing business. This usu- ally consists of the selling, general, and administrative expenses (SG&A) associated with running the business. These primary categories on the multiple-step income statement relate to the business’s core performance. An investor would closely follow these num- bers, especially noting trends and changes. Investors often compare cost categories to sales on a percentage basis. For instance, cost of goods sold may be 40%, 50%, or 60% of sales. Monitoring this percentage will reveal pricing power and how the potential impact increases or decreases sales.
However, other business events can give rise to income statement effects. It is common for a business to have incidental transactions that contribute to profits and losses. Exam- ples include the sale of corporate assets (not inventory), losses from catastrophes, and similar events. If significant, these items are typically presented after the SG&A section. Although potentially meaningful, the sometimes nonrecurring nature makes it easier to discount their ongoing impacts to the business. Finally, financing costs are frequently broken out from other expense components. The reason is that investors may wish to evaluate financial performance separate and apart from the cost of funds that are used to finance the business. This does not mean interest is not a real expense. Expense is a real cost, but its different character justifies clearly breaking it out within the income state- ment. This provides information needed to fully understand and evaluate the business’s income generation capacity. Table 5.1 is an example an income statement reflecting these special considerations.
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CHAPTER 5Section 5.1 Categories of Inventory
Table 5.1: An example of an income statement that reflects special considerations
INCOME STATEMENT Example Company
For the Month Ending January 31, 20XX
Sales $179,000
Cost of Goods Sold 100,000
Gross Profit $ 79,000
Selling Expenses
Advertising $10,000
Freight-out 8,000
Depreciation 6,000
Salaries 3,000 $ 27,000
General and Administrative
Salaries $14,000
Depreciation 5,000
Rent 2,000
Insurance 1,000 22,000
Other
Loss on Sale of Stock $ 4,000
Interest Expense 6,000 10,000 59,000
Income Before Taxes $20,000
Income tax expense 6,500
Net income $13,500
Consigned Goods
On occasion, a manufacturer may approach a merchant about stocking a particular prod- uct. The merchant may be reluctant, not wanting to invest in inventory that may not sell. This negotiation may result in a consignment of inventory. A consignment is an agree- ment whereby the inventory’s owner, the consignor, places it with another party in the hope that the goods will be resold to an end consumer. The party holding physical pos- session is the consignee but not the legal owner. It must care for the goods and try to sell them to an end customer. The consignor surrenders physical custody but maintains legal ownership. The consignor would continue to carry the goods in its inventory records.
Consigned goods pose a record keeping challenge. Because physical custody does not represent ownership, it becomes difficult for both consignees and consignors to main- tain proper accountability over consigned inventory. When the consignee sells consigned
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CHAPTER 5Section 5.1 Categories of Inventory
Beginning inventory +
Net purchases
Ending inventory +
Cost of goods sold
Goods available for sale
goods to an end user, the consignee becomes obligated to remit a portion of the final sales price to the consignor. Otherwise, it is understood that the consignee reserves the right to return the inventory without obligation to make payment.
Critical Thinking About Inventory Cost
Consider that a business is likely to open a new accounting period with a carryover balance of inventory from the preceding period. This is probably rather obvious. Just because an accounting period has ended does not mean that unsold goods must be dumped. Instead, the ending balance of one period becomes the beginning inventory balance of the next. Exhibit 5.1 shows how a period’s beginning inventory, plus additional purchases, can be combined to represent the total goods available for sale. Some of the goods available for sale are sold and become cost of goods sold, and the unsold portion represents the ending inventory (which will carry forward into the next accounting period).
Exhibit 5.1: Goods available for sale
Exhibit 5.1 shows how goods available for sale must be split between ending inventory and cost of goods sold. Though a picture may be worth a thousand words, it is also true that accountants rarely communicate with pictures. Thus, the drawing is usually converted to a calculation format such as the following (all amounts are assumed for the time being):
Beginning inventory $100,000
Plus: Purchases 450,000
Goods available for sale $550,000
Less: Ending inventory 50,000
Cost of goods sold $500,000
In the drawing, the units appear as physical units, but the natural commingling of homog- enous inventory sometimes makes it difficult or impossible to truly know which units are which. Accountants therefore express inventory on the balance sheet in units of money rather than physical quantity descriptions.
A critical factor in determining income is the allocation of the cost of goods available for sale between ending inventory and cost of goods sold. Accountants have a significant task to assess what cost attaches to ending inventory and what cost attaches to cost of goods sold, especially in light of the fact that the exact physical flow of goods is probably unknown.
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CHAPTER 5Section 5.3 Perpetual Systems
5.2 Cost Assignment
It is unlikely that each unit of inventory will have the exact same cost. It can be impractical to trace the exact cost of each unit; even when possible, accountants do not require this association. Instead, accountants use inventory cost flow assumptions. These assump- tions do not need to relate to the physical flow of the inventory. Thus, the inventory cost allocation approach is just a systematic approach for dealing with the question of what cost is to be attached to ending inventory and cost of goods sold.
To illustrate this point, consider the case of Umps Baseball Supply. Umps maintains a stor- age bin full of balls. As customers purchase balls, Umps randomly selects them from the bin. As Umps restocks, they dump newly purchased balls into the bin. The balls are con- stantly being mixed up such that Umps has no way of knowing the exact purchase date or price of any particular ball remaining in the bin. During a recent period, the bin had an opening supply of 500 balls and was restocked two different times. At each restocking, 500 balls were added. The balls in beginning inventory cost $2 per ball. The first restock- ing had a unit cost of $2.25. The final restocking was at $2.75. The bin was never allowed to empty completely. At the end of the period, the bin contains 125 balls, probably including some from beginning inventory and each restocking event.
What is the cost of the ending inventory? The answer to this important question will directly impact the calculation of not only ending inventory but also cost of goods sold (and therefore income). Umps must adopt an inventory-costing method. There are several cost flow assumptions to choose from. One is a first-in, first-out (FIFO) approach. Another is the last-in, first-out (LIFO) approach. The third method reflects a more com- plex average cost approach. The complexity arises because the average cost method is not just the simple average of the per-unit price but instead weights the cost by the num- ber of units purchased at each price point. Thus, it is also known as a weighted-average con- cept. In the average cost example that follows, the weighted-average cost is recalculated each time there is a new purchase, resulting in a further refinement of its moniker as the moving-average method.
5.3 Perpetual Systems
Before more closely examining the accounting for Umps’s inventory under the FIFO, LIFO, and average cost approaches, it is first necessary to point out that inventory costs can be accumulated on either a real-time perpetual inventory system or occasional updating via a periodic inventory system. As the name suggests, a perpetual system is one in which inventory records are continuously updated for all inventory changes. As inventory is purchased, it is added into the Inventory account. As inventory is sold, it is subtracted from the Inventory accounts. A periodic system is one in which the Inventory accounts are only updated on designated intervals, such as at the end of each accounting period. At one time, accumulating and assigning costs on a perpetual basis was exceed- ingly difficult because of the extraordinarily tedious recordkeeping that ensues. Then, companies necessarily resorted to simplifying techniques that only periodically updated inventory records. Modern computers have allowed companies to adopt more sophisti- cated real-time, or perpetual, tracking of inventory. These systems greatly improve asset accountability and business decision making. With a perpetual system, each inventory purchase or sale transaction triggers an update of the inventory records and corporate
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CHAPTER 5Section 5.3 Perpetual Systems
general ledger. To begin to see how this operates, closely examine the details about Umps’s inventory purchases in Table 5.2.
Table 5.2: Umps’s inventory purchases
Date Quantity Purchased Cost per Unit Total Cost
Beginning balance July 1 500 $2.00 $1,000
Purchase 2 July 15 500 $2.25 $1,125
Purchase 3 July 24 500 $2.75 $1,375
In addition to information about the purchasing activity, we also need detailed informa- tion about Umps’s sales. Table 5.3 provides detailed sales data:
Table 5.3: Umps’s sales data
Date Quantity Sold Sales Price per Unit Total Sales
Sale 1 July 9 400 $4.00 $1,600
Sale 2 July 20 550 $4.50 $2,475
Sale 3 July 28 425 $5.00 $2,125
Overall, you will notice that Umps had 1,500 units available (500 500 500) and sold 1,375 units (400 550 425), leaving the remaining ending inventory on hand at the end of July at 125 units. We mustn’t lose sight of our accounting goals: to determine the total sales, total cost of goods sold, gross profit, and ending inventory balances to report in the financial statements. To make this determination will require an inventory cost flow assumption.
Importantly, the cost flow assumption is used to describe the flow of the cost of goods through the accounting system. It is not necessary that a cost flow assumption actually correspond to a physical flow, but it useful to visual a cost flow assumption by thinking about physical flow. If you owned a convenience store, you would probably sell milk on a FIFO basis. To minimize spoilage, you would sell the oldest milk first. This is logical. On the other hand, if you sold crushed rock that was dumped in large stacks as it was processed and delivered via a loader scooping from the pile as it was sold, you can likely understand the LIFO cost flow concept. We will first perform Umps’s inventory calcula- tions using a perpetual FIFO method.
First-In, First-Out
Table 5.4 shows the level of detail that is necessary to track the inventory correctly. Study this very carefully. Perhaps you can follow the logic by only tracking amounts in the table; if not, additional explanatory details are provided below the table. Remember, this is a FIFO example. When a sale occurs, the assumption is that the units sold were from the first, or earliest, available units: first-in, first-out.
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CHAPTER 5Section 5.3 Perpetual Systems
Table 5.4: FIFO inventory tracking
Date Purchases Sales Cost of Goods Sold Remaining Inventory Balance
July 1 500 , $2.00 5 $1,000.00
July 9 400 , $4.00 5 $1,600.00 400 , $2.00 5 $800.00 100 , $2.00 5 $200.00
July 15 500 , $2.25 5 $1,125.00 100 , $2.00 5 $ 200.00 500 , $2.25 5 1,125.00
$1,325.00
July 20 550 , $4.50 5 $2,475.00 100 , $2.00 5 $ 200.00 450 , $2.25 5 1,012.50
$1,212.50
50 , $2.25 5 $112.50
July 24 500 , $2.75 5 $1,375.00 50 , $2.25 5 $ 112.50 500 , $2.75 5 1,375.00
$1,487.50
July 28 425 , $5.00 5 $2,125.00 50 , $2.25 5 $ 112.50 375 , $2.75 5 1,031.25
$1,143.75
125 , $2.75 5 $343.75
Notice that a significant amount of detail is in tracking inventory using a perpetual approach; without computers, this becomes nearly impossible to do correctly when vast inventories and large volumes of transactions are involved. However, given a properly programmed computer, the task is inconsequential. Many businesses have a sufficient level of sophistication that inventory records are being updated as each sale is recorded at a point-of-sale terminal.
Be sure to note exactly what is occurring on each date. For example, on July 20, 50 units remain after selling 550 units. This is determined by first noting that 600 units were on hand prior to the sale transaction (consisting of 100 units that are assumed to cost $2.00 each and 500 units that are assumed to cost $2.25 each). After removing 550 units from stock (assumed to consist of 100 units costing $2.00 and 450 units costing $2.25), only 50 remain at an assumed unit cost of $2.25. This cost analysis and allocation process must be repeated with each transaction that results in increasing or decreasing the inventory bal- ance. With FIFO, keep in mind that the layers of inventory assumed to be sold are based on the chronological order in which they were purchased.
The analysis provided within Table 5.4 provides a basis for actually recording the transac- tions into the general journal. Be sure to trace the amounts in the entries back into Table 5.4. Remember, Inventory is debited as purchases occur and credited as sales occur. Fol- lowing are the necessary entries to record July’s activity:
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CHAPTER 5Section 5.3 Perpetual Systems
7-9-XX Accounts Receivable 1,600.00
Sales 1,600.00
Sold inventory on account
7-9-XX Cost of Goods Sold 800.00
Inventory 800.00
To record the cost of goods sold
7-15-XX Inventory 1,125.00
Accounts Payable 1,125.00
Purchased inventory on account
7-20-XX Accounts Receivable 2,475.00
Sales 2,475.00
Sold inventory on account
7-20-XX Cost of Goods Sold 1,212.50
Inventory 1,2,12.50
To record the cost of goods sold
7-24-XX Inventory 1,375.00
Accounts Payable 1,375.00
Purchased inventory on account
7-28-XX Accounts Receivable 2,125.00
Sales 2,125.00
Sold inventory on account
7-28-XX Cost of Goods Sold 1,143.75
Inventory 1,143.75
To record the cost of goods sold
Using selected T-accounts in Table 5.5, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,156.25), and the ending inventory ($343.75).
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CHAPTER 5Section 5.3 Perpetual Systems
Table 5.5: T-accounts for sales, cost of goods sold, and inventory (FIFO)
Sales Cost of Goods Sold Inventory
1,000.00
1,600.00 800.00 800.00
1,212.50
2,475.00 1,212.50 1,212.50
1,375.00
2,125.00 1,143.75 1,143.75
6,200.00 3,156.25 343.75
Last-In, First-Out
Table 5.6 repeats the preceding facts but with the calculations applied on a LIFO basis. When a sale occurs, the assumption is that the units sold were from the last, or most recent, available units: last-in, first-out.
Table 5.6: LIFO inventory tracking
Date Purchases Sales Cost of Goods Sold Remaining Inventory Balance
July 1 500 , $2.00 5 $1,000.00
July 9 400 , $4.00 5 $1,600.00 400 , $2.00 5 $800.00 100 , $2.00 5 $200.00
July 15 500 , $2.25 5 $1,125.00 100 , $2.00 5 $ 200.00 500 , $2.25 5 1,125.00
$1,325.00
July 20 550 , $4.50 5 $2,475.00 500 , $2.25 5 $1,125.00 50 , $2.00 5 100.00
$1,225.00
50 , $2.00 5 $100.00
July 24 500 , $2.75 5 $1,375.00 50 , $2.00 5 $ 100.00 500 , $2.75 5 1,375.00
$1,475.00
July 28 425 , $5.00 5 $2,125.00 425 , $2.75 5 $1,168.75 50 , $2.00 5 $100.00 75 , $2.75 5 206.25
$306.25
Again, carefully observe the action on each date. For example, the 50 remaining units on July 20 consist of those from the very beginning stock (at $2.00 each) because it is assumed under LIFO that goods from the recent purchases are the ones being sold. With LIFO, the layers of inventory are assumed to be sold are based on the reverse order in which they were purchased. Following are the necessary entries to record July’s LIFO-based activity:
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CHAPTER 5Section 5.3 Perpetual Systems
7-9-XX Accounts Receivable 1,600.00
Sales 1,600.00
Sold inventory on account
7-9-XX Cost of Goods Sold 800.00
Inventory 800.00
To record the cost of goods sold
7-15-XX Inventory 1,125.00
Accounts Payable 1,125.00
Purchased inventory on account
7-20-XX Accounts Receivable 2,475.00
Sales 2,475.00
Sold inventory on account
7-20-XX Cost of Goods Sold 1,225.00
Inventory 1,225.00
To record the cost of goods sold
7-24-XX Inventory 1,375.00
Accounts Payable 1,375.00
Purchased inventory on account
7-28-XX Accounts Receivable 2,125.00
Sales 2,125.00
Sold inventory on account
7-28-XX Cost of Goods Sold 1,168.75
Inventory 1,168.75
To record the cost of goods sold
Using selected T-accounts in Table 5.7, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,193.75), and the ending inventory ($306.25).
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CHAPTER 5Section 5.3 Perpetual Systems
Table 5.7: T-accounts for sales, cost of goods sold, and inventory (FIFO)
Sales Cost of Goods Sold Inventory
1,000.00
1,600.00 800.00 800.00
1,125.00
2,475.00 1,212.50 1,225.00
1,375.00
2,125.00 1,168.75 1,168.75
6,200.00 3,193.75 306.25
The Average Cost Approach
If Umps had instead applied the average cost approach, its cost allocation would appear as shown in Table 5.8. In reviewing this data, be sure to notice how the average cost of the total remaining supply of inventory must be recalculated with each purchase of inventory. The decimals associated with the pennies can become very important because the aver- age unit cost is often multiplied times thousands of units (so don’t round significantly!). Another important aspect of these calculations is that you cannot just average the three unit cost values ($2.00, $2.25, and $2.75) because that would fail to weight the cost by the number of units acquired or held at each cost point.
Table 5.8: Cost allocation
Date Purchases Sales Cost of Goods Sold Remaining Inventory Balance
July 1 500 , $2.00 5 $1,000.00 500 , $2.00 5 $1,000.00
July 9 400 , $4.00 5 $1,600.00 400 , $2.00 5 $800.00 100 , $2.00 5 $200.00
July 15 500 , $2.25 5 $1,125.00 100 , $2.00 5 $200.00 500 , $2.25 5 1,125.00
$1,325.00 $1,325.00/600 units 5$2.2083 average
July 20 550 , $4.50 5 $2,475.00 550 , $2.2083 5 $1,214.58 50 , $2.2083 5$110.4217
July 24 500 , $2.75 5 $1,375.00 50 , $2.2083 5 $ 110.42 500 , $2.7500 5 1,375.00
$1,485.42 $1,458.42/550 units 5 $2.7008 average
July 28 425 , $5.00 5 $2,125.00 425 , $2.7008 5 $1,147.82 125 , $2.7008 5$337.60
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CHAPTER 5Section 5.3 Perpetual Systems
Following are the revised journal entries necessary to reflect the average cost flow assump- tion. The account titles are not changed, only the amounts.
7-9-XX Accounts Receivable 1,600.00
Sales 1,600.00
Sold inventory on account
7-9-XX Cost of Goods Sold 800.00
Inventory 800.00
To record the cost of goods sold
7-15-XX Inventory 1,125.00
Accounts Payable 1,125.00
Purchased inventory on account
7-20-XX Accounts Receivable 2,475.00
Sales 2,475.00
Sold inventory on account
7-20-XX Cost of Goods Sold 1,214.58
Inventory 1,214.58
To record the cost of goods sold
7-24-XX Inventory 1,375.00
Accounts Payable 1,375.00
Purchased inventory on account
7-28-XX Accounts Receivable 2,125.00
Sales 2,125.00
Sold inventory on account
7-28-XX Cost of Goods Sold 1,147.82
Inventory 1,147.82
To record the cost of goods sold
Using selected T-accounts in Table 5.9, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,162.40), and the ending inventory balances ($337.60). Let’s see how these entries impact certain ledger accounts and the resulting financial statements:
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CHAPTER 5Section 5.4 Comparing Methods
Table 5.9: T-accounts for sales, cost of goods sold, and inventory (average costing)
Sales Cost of Goods Sold Inventory
1,000.00
1,600.00 800.00 800.00
1,125.00
2,475.00 1,214.58 1,214.58
1,375.00
2,125.00 1,147.82 1,147.82
6,200.00 3,162.40 337.60
5.4 Comparing Methods
At this juncture, it is essential to see that alternative accounting methods result in dif-ferent reported results for specific periods. With FIFO, Umps would report a gross profit of $3,043.75 ($6,200.00 sales 2 $3,156.25). With LIFO, Umps would report a gross profit of $3,006.25 ($6,200.00 sales 2 $3,193.75). With average costing, the gross profit amounted to $3,037.60 ($6,200.00 sales 2 $3,162.40). This outcome is consistent with a general rule of thumb that states LIFO will produce the lowest profits during a period of rising prices. Obviously, income is being charged with higher recent costs. Thus, many companies prefer to use LIFO because it reduces income on which taxes may be assessed. You will probably find it interesting to note that many countries outside of the United States do not permit the LIFO method.
Some may find fault with allowing accounting choices of this nature. Before reaching a conclusion, consider that these differences in income are usually only temporary. If (when) the inventory is completely liquidated, the differences will reverse, and the life- time income of the firm will equal out between the methods. For Umps the annual income difference is not very material; in some cases, accounting methods produce significantly different results, and sometimes they do not. The takeaway message is that a financial statement user should clearly examine financial statements and related disclosures to determine the methods in use. This is particularly important when trying to compare the performance of two firms, especially when each uses a different set of accounting meth- ods and assumptions.
Specific Identification
In lieu of an inventory cost flow assumption like FIFO or weighted-average, some busi- nesses may instead elect to use the specific identification method. The business must be able to match each unit of inventory with its actual cost. The item’s cost remains in the Inventory account until it is sold, at which point it is assigned to Cost of Goods Sold. You can immediately discern that specific identification requires tedious record keeping and would be useful only for inventories with a fairly high per-unit cost and unique iden- tifying characteristics. For example, an automobile dealership might find the technique practical and useful.
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CHAPTER 5Section 5.5 The Importance of Accuracy
The Retail Method
A particular variation of the specific identification logic can be employed by retailers. It is known as the retail method. First and foremost, the retail method relies on an assump- tion that a company’s markup is constant across all items of inventory. If this is true, the process for determining the cost of ending inventory would be to physically count all goods on hand at the end of the accounting period and determine their retail selling value (perhaps by simple reference to their marked selling prices). Then the total inventory at retail would be multiplied by the cost-to-retail percentage. The amount so determined would represent the cost of the inventory and establish the amount to report as inventory at the end of the accounting period.
Lower-of-Cost-or-Market Adjustments
Notwithstanding the cost flow assumption or other inventory valuation technique in use, it is imperative that a company not overstate the reported inventory value on the bal- ance sheet. Sometimes a company may find that it is holding inventory that it cannot sell for its reported value. Obsolescence, defects, cost declines, and similar issues can impair the realizable value of selected inventory items. Accountants are required to periodically assess inventory on hand to ensure that it is not reported for more than its market value.
This testing is known as a lower-of-cost-or-market method review. In other words, although accountants normally report assets at cost, they also avoid reporting them at more than their market value. That is, the accounting principle is to report the asset at the lower of its original cost or current market value. If the accountant finds that inventory is being carried in the accounting records at more than market value, a down- ward reduction in recorded valuations may be in order. These so-called write-downs, or impairments, from the recorded cost to the lower market value would be made by crediting the Inventory account and a debiting a Loss for Reduction in Market Value. This loss reduces income.
In the context of inventory testing, market value is generally but not always considered to be the cost that it would take to replace the goods. This is not the same as expected selling price. Basically, if the inventory on hand can be replaced for a new investment amount that is below reported cost, an impairment reduction is in order. Once a reduction has been recorded, subsequent recoveries in value are not recognized. In essence, the reduced value becomes the new accounting amount to carry in inventory going forward.
5.5 The Importance of Accuracy
What is the effect of a company’s failure to reduce the carrying value of impaired inventory? Or, what is the effect of failing to adjust inventory records for goods that are shown to exist but cannot be physically located? In general, why does it matter that inventory records accurately reflect the goods on hand, as measured under gener- ally accepted accounting principles? The general rule is that overstatements of ending inventory cause overstatements of income, whereas understatements of ending inventory cause understatements of income. Before giving consideration to offsetting tax effects, this
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CHAPTER 5Concept Check
offset is “dollar for dollar.” In other words, if inventory is overstated by $1, so is income for that year. Remember, the total cost of goods available for sale is ultimately allocated either to Cost of Goods Sold or Inventory (i.e., if the cost is not in Inventory, then it must be assigned to Cost of Goods Sold, thereby reducing income).
Despite a company’s best efforts to maintain an accurate perpetual inventory accounting system, errors and discrepancies will invariably creep into the accounting system. Goods may be lost, damaged, or stolen, or transactions may be recorded incorrectly. Therefore, a company should physically examine its inventory on hand at least once each year. This is a highly significant point. Perhaps you have worked for a company and been involved in taking the physical inventory. A physical inventory is the process of actually count- ing and valuing the inventory on hand. Discrepancies should be investigated, and the accounting records should be updated to reflect the balance that is finally determined to be correct—thus the need for accuracy. Employees are often unaware of the connection between a careful count and the final measure of a firm’s income.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 235.)
1. Because of a mathematical error, the 20X8 ending inventory included goods at a $170 figure that had actually cost $710. As a result of this error,
a. net income for 20X8 is overstated. b. net income for 20X8 is understated. c. operating expenses for 20X8 are understated. d. total liabilities at the end of 20X8 are overstated.
2. The inventory cost flow assumption in which the oldest costs incurred become part of cost of goods sold when units are sold is
a. LIFO. b. FIFO. c. the weighted average. d. retail.
3. The LIFO inventory valuation method
a. is acceptable only if a company sells its newest goods first. b. will result in higher income levels than FIFO in periods of rising prices. c. will result in a match of fairly current inventory costs against recent selling prices
on the income statement. d. cannot be used with a periodic inventory system.
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CHAPTER 5Critical Thinking Questions
4. Stanley Company sells two different products. The following information is available at year-end:
Inventory Item Units Cost per Unit Market Value per Unit A 100 $4 $6 B 200 5 3
Applying the lower-of-cost-or-market rule to each item, what will be Stanley’s ending inventory balance?
a. $1,000 b. $1,200 c. $1,400 d. Some other amount
5. Which of the following accounting systems maintains a running (continuous) record of merchandising purchases and sales by inventory item?
a. Perpetual b. Gross profit c. Periodic d. Retail
Critical Thinking Questions
1. What items are reported as inventory for (a) merchandising companies and (b) manufacturing companies?
2. The Potter Company purchased the following merchandise on December 28:
Supplier Terms Amount Pax Company FOB destination $1,800 James Manufacturing FOB shipping point 2,500
Both purchases were shipped December 30, but neither had been received by December 31. Should the purchases be included in Potter’s December 31 ending inventory? Explain.
3. What are goods on consignment? Who has title to goods on consignment? 4. Why is it necessary to take a physical count of inventory at the end of each account-
ing period? 5. Why is the specific identification method of inventory valuation used infrequently? 6. Discuss the difference between the physical flow of goods and a cost flow assumption. 7. In a period of rising prices, which inventory valuation method (LIFO or FIFO)
tends to result in the following?
a. Highest cost of goods sold b. Lowest inventory valuation c. Highest income taxes
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CHAPTER 5Key Terms
8. Discuss the advantages of a perpetual inventory system when compared with a periodic system.
9. Which type of inventory system, periodic or perpetual, is increasing in popularity? Briefly explain.
10. Why are two journal entries required to record a sale under a perpetual inventory system?
Key Terms
average cost A cost flow assumption.
consignment of inventory An agreement whereby the owner of inventory places it with another party in the hope that it will resell the goods to an end consumer.
cost flow assumptions Inventory-costing methods such as first-in, first-out; last-in, last-out; or average cost.
FIFO See first-in, first-out.
first-in, first-out (FIFO) An inventory- costing method, the assumption is that the units are sold from the first, or earliest, available units.
FOB (free on board) A common freight nomenclature indicating the point at which the ownership of goods shifts from the seller to the buyer.
FOB destination A common freight nomenclature indicating that the seller owns goods until they are delivered and must bear the cost of shipping.
FOB shipping point A common freight nomenclature indicating that once goods are shipped, they are deemed the buyer’s property.
lower-of-cost-or-market method A method whereby inventories are accounted for at acquisition cost or market value, whichever is lower.
multiple-step income statement A state- ment format that divides business results into separate categories.
periodic inventory system An updating system in which inventory accounts are only updated on designated intervals, such as at the end of each accounting period.
perpetual inventory system An updat- ing system in which inventory records are continuously updated for all inventory changes.
physical inventory The process of actu- ally counting and valuing inventory on hand.
retail method An inventory-costing method that relies on the assumption that a company’s markup is constant across all items of inventory.
specific identification The method in which a business must match each unit of inventory with its actual cost.
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CHAPTER 5Exercises
Exercises
1. Inventory errors and income measurement. The income statements of Keagle Company for 20X3 and 20X4 follow.
20X3 20X4
Sales $ 100,000 $109,000
Cost of goods sold 62,000 74,000
Gross profit $ 38,000 $ 35,000
Expenses 26,000 22,000
Net income $ 12,000 $ 13,000
A recent review of the accounting records discovered that the 20X3 ending inven- tory had been understated by $4,000.
a. Prepare corrected 20X3 and 20X4 income statements. b. What is the effect of the error on ending owner’s equity for 20X3 and 20X4?
2. Specific identification method. Boston Galleries uses the specific identification method for inventory valuation. Inventory information for several oil paintings follows.
Painting Cost
1/2 Beginning inventory Woods $11,000
4/19 Purchase Sunset 21,800
6/7 Purchase Earth 31,200
12/16 Purchase Moon 4,000
Woods and Moon were sold during the year for a total of $35,000. Determine the firm’s
a. cost of goods sold. b. gross profit. c. ending inventory.
3. Inventory valuation methods: basic computations. The January beginning inven- tory of the White Company consisted of 300 units costing $40 each. During the first quarter, the company purchased two batches of goods: 700 units at $44 on February 21 and 800 units at $50 on March 28. Sales during the first quarter were 1,400 units at $75 per unit. The White Company uses a periodic inventory system.
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CHAPTER 5Exercises
Using the White Company data, fill in the following chart to compare the results obtained under the FIFO, LIFO, and weighted-average inventory methods.
FIFO LIFO Weighted Average
Goods available for sale $ $ $
Ending inventory, March 31
Cost of goods sold
4. Analysis of LIFO versus FIFO. Indicate whether LIFO or FIFO best describes each of the following:
a. Gives highest profits when prices fall. b. Yields lowest income taxes when prices rise. c. Generates an ending inventory valuation that somewhat approximates replace-
ment cost. d. Matches recent costs against current selling prices on the income statement. e. Comes closest to approximating the physical flow of goods of a fruit and veg-
etable dealer. f. Results in lowest cost of goods sold in inflationary periods.
5. Perpetual inventory system: journal entries. At the beginning of 20X3, Beehler Company implemented a computerized perpetual inventory system. The first transactions that occurred during 20X3 follow.
Purchases on account: 500 units , $4 5 $2,000
Sales on account: 300 of the above units 5 $2,550
Returns on account: 75 of the above unsold units
The company president examined the computer-generated journal entries for these transactions and was confused by the absence of a Purchases account.
a. Duplicate the journal entries that would have appeared on the computer printout. b. Calculate the balance in the firm’s Inventory account. c. Briefly explain the absence of the Purchases account to the company president.
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CHAPTER 5Problems
Problems
1. Inventory errors. The income statements of Diamond Company for the years ended December 31, 20X1 and 20X2, follow.
20X1 20X2 Net sales $440,000 $483,000 Cost of goods sold
Beginning inventory $ 95,000 $109,000 Add: Net purchases 380,000 404,000 Goods available for sale $475,000 $513,000 Less: Ending inventory 109,000 127,000 Cost of goods sold 366,000 386,000
Gross profit $ 74,000 $ 97,000 Operating expenses 58,000 67,000 Net income $ 16,000 $ 30,000
Diamond uses a periodic inventory system. A detailed review of the accounting records disclosed the following:
• A review of 20X1 purchase invoices revealed that a clerk had incorrectly recorded a $12,600 purchase as $1,260.
• A $4,800 purchase was made on December 30, 20X2, terms FOB shipping point. The invoice was not recorded in 20X2, nor were the goods included in the 20X2 ending physical inventory count. Both the goods and invoice were received in early 20X3, with the invoice being recorded at that time.
• Goods costing $3,000 were accidentally excluded from the 20X1 ending physical inventory count. These goods were sold during 20X2, and all aspects of the sale were properly recorded.
Instructions a. Prepare corrected income statements for 20X1 and 20X2. b. Determine the impact of the preceding errors on the December 31, 20X2, owner’s
equity balance.
2. Inventory valuation methods: computations and concepts. Wave Riders Surfboard Company began business on January 1 of the current year. Purchases of surfboards were as follows:
1/3: 100 boards , $125
3/17: 50 boards , $130
5/9: 246 boards , $140
7/3: 400 boards , $150
10/23: 74 boards , $160
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CHAPTER 5Problems
Wave Riders sold 710 boards at an average price of $250 per board. The company uses a periodic inventory system.
Instructions a. Calculate cost of goods sold, ending inventory, and gross profit under each of the
following inventory valuation methods:
• First-in, first-out • Last-in, first-out • Weighted average
b. Which of the three methods would be chosen if management’s goal is to
(1) produce an up-to-date inventory valuation on the balance sheet?
(2) approximate the physical flow of a sand and gravel dealer?
(3) report low earnings (for tax purposes) for a separate electronics company that has been experiencing declining purchase prices?
3. Lower-of-cost-or-market method. Davenport Opticians began business on Septem- ber 1 of the current year. The following purchases were made during the first few months of operation:
Reading Glasses Sunglasses Contact Lenses
9/2 1,000 , $20 450 , $10 2,500 , $5
10/15 750 , $22 200 , $15 2,000 , $6
12/6 300 , $25 1,500 , $7
The December 31 physical inventory count revealed the following items on hand: 650 reading glasses, 400 sunglasses, and 1,000 contact lenses. Total sales through year-end were $85,000, and operating expenses (excluding cost of goods sold) to- taled $17,800. Davenport uses the FIFO inventory valuation method coupled with a periodic inventory system.
Instructions a. Compute the company’s inventory as of December 31. In addition, calculate cost
of goods sold and net income through the end of the year. b. Assume that the manufacturer of contact lenses announced a price decrease to
$6.50. Determine the impact of the announcement on the firm’s ending inven- tory valuation.
c. Prepare the journal entry necessary to value the inventory at the lower-of-cost-or- market value.
waL80144_05_c05_111-134.indd 24 8/29/12 2:44 PM
chapter 6
Plant Assets
Learning Goals
• Apply the principles of ordinary and necessary cost, along with other special rules related to capitalization of expenditures.
• Understand conceptual and applied issues pertaining to alternative depreciation methods.
• Know the principles that govern the accounting for asset-related expenditures sub- sequent to acquisition.
• Record transactions related to the disposal of assets.
• Understand the basic elements of accounting for natural resources and related depletion.
• Understand the basic elements of accounting for intangibles and related amortization.
Copyright Barbara Chase/Corbis/AP Images
waL80144_06_c06_135-154.indd 1 8/29/12 2:44 PM
CHAPTER 6Chapter Outline
Chapter Outline 6.1 Ordinary and Necessary Costs
Special Rules Materiality Issues Depreciation
6.2 Depreciation Methods The Straight-Line Method of Depreciation The Double-Declining-Balance Method of Depreciation The Units-of-Output Method of Depreciation Revisions in Depreciation Two Sets of Books?
6.3 Asset-Related Costs Subsequent to Acquisition Sale or Abandonment of Property, Plant, and Equipment Impairment Taking a “Big Bath” Natural Resources Intangible Assets Research and Development Costs Goodwill
Remember that a classified balance sheet includes a separate category entitled Property, Plant, and Equipment. This section typically follows the Long-Term Investments sec- tion. Property, Plant, and Equipment (PP&E) should reflect only the physical assets that are used in the business’s production activities. This would include land, buildings, and equipment. Idle facilities or assets acquired for speculative purposes should be shown in long-term investments. Within the PP&E section, assets are usually listed according to their useful lives. Land is listed first because it has a permanent life and is followed by buildings, then equipment. Table 6.1 shows a typical balance sheet disclosure.
Table 6.1: A typical balance sheet disclosure
Land $ 250,000
Buildings $ 600,000
Less: Accumulated depreciation (150,000) 450,000
Equipment $850,000
Less: Accumulated depreciation (550,000) 300,000 $1,000,000
This balance sheet section would appear within a company’s balance sheet, similar to Exhibit 6.1.
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CHAPTER 6Section 6.1 Ordinary and Necessary Costs
Exhibit 6.1: Mega Company balance sheet
6.1 Ordinary and Necessary Costs
The amount of cost reported for an item of PP&E is the ordinary and necessary cost to get the item in place and in condition for its intended use. These costs are referred to as capital expenditures. Capital expenditures include the direct purchase price and the cost of permits, sales tax, freight, installation, and other usual costs to prepare the item for use. Costs that are not ordinary and necessary, such as repairing damage caused by an accident during installation of equipment, would be expensed. Sometimes, new
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CHAPTER 6Section 6.1 Ordinary and Necessary Costs
machinery requires employee training on its use. Although there are a few exceptions, such costs are normally expensed as incurred.
Equipment often has a list price, but the actual negotiated purchase price may be reduced by discounts and rebates. Perhaps you have purchased a car at less than the amount listed on the window sticker. Accountants use the negotiated price as the basis for accounting measurement, as will be apparent in the following example.
The following journal entry illustrates the recording of a purchase of a new item of equipment. The equipment had a list price of $500,000 but a negotiated purchase price of $425,000. Sales tax was $3,000. Freight and normal installation costs totaled $25,000. The item was dropped during installation, and an additional $10,000 was spent to repair damage.
05-14-X3 Equipment 453,000.00
Repair Expense 10,000.00
Cash 463,000.00
Purchased equipment
Special Rules
If the preceding transaction was financed with debt rather than cash (i.e., credit Notes Payable), none of the interest cost would be added to the asset. Instead, interest is usu- ally charged to Interest Expense as incurred. There is an exception for interest costs associated with debt that is used to finance construction of a particular asset; interest incurred during the active period of construction is added to the cost of the account (it is deemed to be an ordinary and necessary cost associated with the asset’s acquisi- tion). The interest capitalization rules can be quite complex and are usually covered in advanced accounting courses.
Certain costs normally accompany the acquisition of land, like title fees, legal fees, and surveys. Additional costs may be needed to ready the land for its intended use. Examples include zoning costs, drainage, and grading. Because these costs are ordinary and neces- sary, they may be added to the Land account.
To illustrate, assume that Quantum Realty acquired a tract of land that it intended to develop into land for commercial use. A creek that meandered across the property adversely impacted the land. Quantum paid $1,000,000 for the land and incurred survey- ing costs of $40,000. It was necessary to obtain a floodplain permit costing $10,000, and an additional $150,000 was spent rerouting the creek into a channel. All these costs are considered to be ordinary and necessary to get the land in condition for its intended use, and the land should be recorded into the Land account as follows:
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CHAPTER 6Section 6.2 Depreciation Methods
04-15-X5 Land 1,200,000.00
Cash 1,200,000.00
To record cost of land, including costs associated with surveys, permits, and grading
Materiality Issues
Look around your room and consider how many expenditures were for long-lived assets that were relatively minor in value—perhaps a trashcan, a telephone, a picture on the wall, and so forth. If your room were a business, would you capitalize those expendi- tures and depreciate them over their useful life? Or would you decide that the cost of record keeping exceeded the benefit? If so, you might choose to simply expense the cost as incurred (as many businesses do). The reason is materiality; no matter which way that you account for the cost, it is not apt to bear on anyone’s process about the company.
Depreciation
Once an asset’s cost has been appropriately determined, recorded, and appropriately posted to the ledger, it becomes necessary to depreciate the asset. As you may recall from Chapter 3, depreciation is not intended to value or revalue the asset. Instead, depreciation is the process of allocating an asset’s cost to all accounting periods benefited by the asset’s use (i.e., spread the cost over the asset’s service life). The number of periods benefited is known as the service life of the asset.
Your determination of the service life of an asset will depend on professional judgment, taking into account facets such as the rate of the asset’s physical deterioration and the possibility of obsolescence. You should observe that service life might be completely dif- ferent from physical life. For example, how many computers have you owned, and why did you replace an old one? In all likelihood, its service life to you had been exhausted, even though it was still physically functional. Some assets like land have a permanent life and are rarely depreciated.
6.2 Depreciation Methods
Recall from Chapter 5 that companies can use different inventory methods. This is also true for depreciation. The cost of an asset and its service life are important factors that will drive the depreciation amount, but you must also select a specific depreciation method. The method reflects the pattern by which the cost is allocated to specific periods. We will look at three specific techniques: (1) straight line, (2) double-declining balance, and (3) units of output.
Before looking at the unique features of these methods, it is first necessary to learn a few more terms. You have already been made familiar with the concepts of cost and service life. You also need to know about salvage value. Salvage value is also called residual value and is the amount one expects to receive when selling or trading at the end of an asset’s service life. Salvage value is excluded from the amount to be depreciated. As such, the
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CHAPTER 6Section 6.2 Depreciation Methods
depreciable base is equal to cost minus the salvage value. At any point in time, an asset’s total cost minus accumulated depreciation to date can be referred to as the remaining net book value.
The Straight-Line Method of Depreciation
The straight-line method spreads the depreciable base over the service life, with an equal amount of depreciation assigned to each period. Each accounting period should bear an appropriate amount of depreciation. If the business produces monthly financial statements, this means that 1/12th of the annual amount should be allocated to each month for purposes of calculating business income. The following examples illustrate cal- culations of the annual depreciation expense, assuming the asset is acquired on the first day of the year. For assets not acquired on the first day of a year (i.e., most assets), a convention must be adopted. Thus, some business treat all assets acquired in the first half of the year as being acquired on the first day of the year (and assets acquired in the last half of the year as not being acquired until the last moment of the year). Other businesses are far more precise and allocate depreciation down to the number of days in use in a particular period.
The annual charge for depreciation is determined by dividing the depreciable base by the service life. If an asset has a $550,000 cost, $50,000 salvage value, and a 5-year life, then annual depreciation would be equal to $100,000 [($550,000 2 $50,000)/5 years 5 $100,000]. Table 6.2 lists the amounts reported for each of the 5 years.
Table 6.2: Annual depreciation expense and accumulated depreciation for 5 years
Annual Depreciation Expense Accumulated Depreciation
Year 1 $100,000 $100,000
Year 2 100,000 200,000
Year 3 100,000 300,000
Year 4 100,000 400,000
Year 5 100,000 500,000
The appropriate journal entry for each year would be as follows:
12-31-XX Depreciation Expense 100,000.00
Accumulated Depreciation 100,000.00
To record annual depreciation expense
As a general rule, the annual depreciation would be included in each period’s income determination. Remember that Depreciation Expense is a temporary account that is closed each year. In contrast, Accumulated Depreciation is a real account appearing on the bal- ance sheet. Its value builds over time (because the account is not closed), and the appro- priate balance sheet presentation would be as follows at the end of year 4:
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CHAPTER 6Section 6.2 Depreciation Methods
Equipment $550,000
Less: Accumulated depreciation 400,000
$150,000
The Double-Declining-Balance Method of Depreciation
The double-declining-balance (DDB) method “front loads” depreciation to the early periods of an asset’s service life. It is sometimes used when the service quality produced by an asset declines over time or if repair and maintenance costs tend to rise as an asset ages (i.e., the reducing depreciation charge is offset with a rising maintenance charge).
Annual depreciation under the DDB method is determined by multiplying the beginning- of-year net book value of an asset by twice the straight-line rate. Because net book value is decreasing, so is the annual depreciation charge. The mechanics of the DDB method is best shown with a simple example. Let’s return to our $550,000 asset with a 5-year life. First, the straight-line rate is 20% per year (one fifth each year), and twice that rate is 40%. Thus, the first year’s depreciation is 40% of $550,000 (we initially ignore sal- vage value with the DDB method), or $220,000. This leaves a remaining net book value of $330,000 ($550,000 2 $220,000), and the second year’s depreciation expense is only $132,000 ($330,000 3 40%). Table 6.3 lists the entire pattern of depreciation.
Table 6.3: Entire pattern of depreciation
Annual Depreciation Expense
Accumulated Depreciation
Illustrative Calculation
Year 1 $220,000 $220,000 $550,000 3 40%
Year 2 132,000 352,000 ($550,000 2 $220,000) 3 40%
Year 3 79,200 431,200 ($550,000 2 $352,000) 3 40%
Year 4 47,520 478,720 ($550,000 2 $431,200) 3 40%
Year 5 21,280 500,000 See text.
You probably noted how salvage was not reduced against the balance each year in the fundamental calculation of the DDB method. However, it is not ignored completely. In the year when calculated accumulated depreciation begins to exceed the depreciable base, depreciation is discontinued. In our example, this did not occur until the final year 5. Only $21,280 of depreciation was recorded in the final year (despite the fact that the DDB calculations return a higher value). The suspension of the recording of depreciation would occur anytime the accumulated amount of depreciation equals the depreciable base. This could occur well before the last year of use.
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CHAPTER 6Section 6.2 Depreciation Methods
The Units-of-Output Method of Depreciation
In a limited number of circumstances, an asset’s consumption may be associated with a specific measure of use or output. Such would the case for an aircraft engine that might deliver a fixed number of flight hours before a mandatory replacement schedule. When this type of situation is encountered, accountants may resort to the units-of-output method of depreciation. To illustrate, assume that Sky Air uses a jet engine with a 50,000-hour life and $5,000,000 cost (and no salvage value). Sky Air’s hourly engine cost is $100 ($5,000,000450,000 hours). Table 6.4 shows the amount of depreciation to be recorded over the life of the engine.
Table 6.4: Depreciation over the life of an engine
Hours Flown Hourly Rate Total Depreciation
Year 1 10,000 $100 $1,000,000
Year 2 5,000 $100 500,000
Year 3 8,000 $100 800,000
Year 4 12,000 $100 1,200,000
Year 5 5,000 $100 500,000
Year 6 5,000 $100 500,000
Year 7 5,000 $100 500,000
50,000 $100 $5,000,000
During a month in which the engine is flown for 200 hours, the depreciation would be reported at $20,000 (200 hours 3 $100 per hour). The units-of-output method is like the straight-line method, but the unit of allocation is units of use rather than units of time. A simple method, it seems to produce a very systematic and rational cost allocation. Unfor- tunately, the cases in which it can be used are limited. Few assets have such a readily fixed and determinable life.
Revisions in Depreciation
The initial assumptions about useful life and residual value are subject to change. When this happens, accountants have to decide if the effects are sufficiently material to justify a revision in periodic depreciation. Perhaps after completing 5 years of use of an asset with an estimated life of 10 years, someone concludes that the asset will continue in use for 7 more years (bringing the total life to 12 years). This suggests that the annual expense for depreciation is less than originally thought. You may be thinking that you need to restate prior and future years’ depreciation. However, accounting rules take a simpler approach and deal with changes in estimates prospectively. This means that the accountant will revise accounting to adjust only current and future periods. In the case of depreciation, this occurs rather simply as shown in the following example.
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CHAPTER 6Section 6.3 Asset-Related Costs Subsequent to Acquisition
Assume that an asset costing $200,000 and having no salvage value was initially depreci- ated over 10 years. The annual charge for the first 5 years was $20,000 per year ($200,000/ 10 years), and totaled $100,000 ($20,000 per year 3 5 years). Early in the sixth year, the total life of the asset was concluded to be 12 years (in other words, 7 remaining years). Further, it was additionally concluded that the asset would now have a $30,000 salvage value. The revised annual depreciation would be $10,000 per year for the last 7 years of useful life. This amount is calculated by taking the remaining depreciable base of $70,000 ($200,000 cost minus accumulated depreciation of $100,000 and salvage value of $30,000) and spreading it evenly over the last 7 years of useful life.
Two Sets of Books?
You may have heard something about “keeping two sets of books.” Generally, this has a pejorative connotation and implies some form of deception. However, tax laws tend to be rather “friendly” by allowing companies to depreciate assets quickly—much faster than under generally accepted accounting principles (GAAP). The depreciation under the tax rules reduces taxable income and taxes due. Governments are usually pleased to grant this accelerated benefit in efforts to stimulate asset purchases and economic activity. Thus, it is not uncommon for a company’s tax depreciation to initially exceed the amounts allowed under GAAP. This necessarily entails a company keeping two sets of books—one for tax and one for accounting. This is not only not wrong but also absolutely necessary. If you continue to study accounting, you will discover that there are significant complexities associated with measuring and reporting assets and liabilities that have different tax and accounting treatments. For now, you just need to know that accounting and tax rules are not always the same.
6.3 Asset-Related Costs Subsequent to Acquisition
You probably know that the purchase price of an asset is not the only cost of ownership. In some cases, it is only the beginning. Consider your car. It must be fueled, insured, and maintained. Maintenance can include a variety of services like lubrication, tune-ups, shock absorbers, body work, and engine overhaul. Many business assets require such support, and that support can be very costly. Accountants need to account for such costs, and it becomes important to know whether such costs are capital expenditures or not. Remember that a capital expenditure would be recorded as an asset (i.e., debit the asset and credit Cash); if the cost is not a viewed as a capital expenditure, then it is recorded as an expense (i.e., debit the expense and credit Cash). Thus, assessing the nature of an asset- related expenditure (capital in nature or not) becomes highly significant.
Accountants have developed principles that should form the foundation for deciding if an asset-related expenditure is capital in nature. Simply stated, if an expenditure results in the extension of the service life of an asset or the quantity/quality of services expected from an asset are increased, then the cost is viewed as capital in nature. By default, if one or more of these criteria are not met, then the cost would be expensed as incurred. You must be careful not to conclude that routine operating costs meet these conditions. If an expenditure is intended to merely maintain normal operating condition (e.g., lubrication), it is not a capital expenditure; it is instead termed a revenue expenditure.
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CHAPTER 6Section 6.3 Asset-Related Costs Subsequent to Acquisition
The reason for the different treatment relates primarily to the number of periods benefited by an expenditure. The former (capital expenditure) generally describes costs that are regarded as attributable to multiple accounting periods, and the latter (revenue expendi- ture) is usually for benefits that are quickly consumed during the period in which the cost is incurred. Generalizing about all costs and all businesses is very difficult. For instance, new tires on a farmer’s tractor might last 20 years, but new tires on the farmer’s truck might last only 1 year. Thus, it is impossible to develop a uniform capitalization/expensing protocol. Judgment is always required, but Table 6.5 helps frame the concept with specific examples.
Table 6.5: Examples of expenditures
Capital Expenditure Revenue Expenditure
Buying a new motor Tuning up a vehicle
Replacing a parking lot Painting stripes in a parking lot
Installing fire sprinkler system Test checking valves on a sprinkler system
Buying new windows Cleaning windows
Changing out faucets Replacing washers
Installing new duct work for air conditioning Cleaning air filters
Replacing carpet Cleaning carpet
The manner in which capital expenditures are actually recorded in the journal can vary based on the nature of the outlay. Sometimes, a cost is designed to restore an asset to its original condition—for example, replacing a motor in a vehicle. In some ways, this can be seen as partially returning the asset to its new condition. These replacement outlays are usually “capitalized” by debiting Accumulated Depreciation (and crediting Cash), which has the effect of increasing the asset’s net book value.
At other times, the capital expenditures may actually improve the asset beyond its origi- nal condition. For instance, adding a satellite navigation system to a ship that was pre- viously only piloted by a human is actually a betterment beyond the original condi- tion. Accordingly, the expenditure is normally added to the gross cost of the asset directly (debit Ship and credit Cash). Under some accounting systems, asset accounts are unitized. In other words, the cost of a building can be split between the building’s shell and the many improvements within (e.g., ventilation systems). For those systems, any betterment expenditures would likely be recorded into a separate account (e.g., Satellite Navigation System, rather than Ship).
Sale or Abandonment of Property, Plant, and Equipment
An item of property, plant, and equipment may be sold or abandoned. If the asset is aban- doned for no consideration (e.g., taking it to the junk yard), the accounting process would be to record any unrecognized depreciation up to the date of abandonment and then remove the asset and accumulated depreciation from the accounts. For instance, assume that an asset costing $90,000, with a 90-month life, straight-line depreciation, and no sal- vage value is abandoned on April 30, 20X4. Further assume the asset is 80 months old and depreciation was last recorded on December 31, 20X3:
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CHAPTER 6Section 6.3 Asset-Related Costs Subsequent to Acquisition
4-30-X4 Depreciation Expense 4,000.00
Accumulated Depreciation 4,000.00
To record depreciation for first 4 months of the year
04-30-X4 Accumulated Depreciation 80,000.00
Loss 10,000.00
Equipment 90,000.00
Abandoned equipment costing $90,000 and having accumulated depreciation of $80,000
Alternatively, if the same asset were instead sold for $25,000 cash, then a $15,000 gain would result. The following journal entries reveal how this occurs:
4-30-X4 Depreciation Expense 4,000.00
Accumulated Depreciation 4,000.00
To record depreciation for first 4 months of the year
04-30-X4 Accumulated Depreciation 80,000.00
Cash 25,000.00
Gain 15,000.00
Equipment 90,000.00
Sold equipment costing $90,000 and having accumulated depreciation of $80,000 for $25,000.
It bears repeating that the preceding entries to dispose of an asset would only be recorded subsequent to a separate entry to update the depreciation accounting through the April 30 disposal date.
Impairment
An asset’s value may be diminished but not to the point of triggering an abandonment. In other words, the owner does not expect to generate cash flows from the asset sufficient to recover the recorded net book value. Very simply, the fair value of the asset is below its reported value. Accountants tend toward conservatism and try to avoid reporting assets at more than they are worth. Specific accounting rules provide a framework for measur- ing the amount of impairment. The amount of impairment is recorded as a loss (debit the loss and credit the asset). This approach results in reducing the asset’s reported value down to an amount that bears closer proximity to its value/recoverable amount.
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CHAPTER 6Section 6.3 Asset-Related Costs Subsequent to Acquisition
Taking a “Big Bath”
This terminology is sometimes used to characterize significant one-time impairment losses. You may see this occur when a business has gone through a significant down period and is struggling to regain its footing. Coincident with such efforts, a business may evaluate all assets in use and conclude that some assets are impaired. This requires that the carrying value (i.e., the amount reported on the balance sheet) be reduced. Manage- ment has some degree of incentive to engage in this “bath.”
Why? Given that this reduction in carrying value will produce an offsetting loss, isn’t this something that management might wish to avoid? The logic goes like this: Things are already bad, so where is the harm? And, more to the point, future periods’ income will be buoyed by this action because the reduction in carrying value will leave fewer assets that will need to be depreciated in the future. The reduction in future expenses increases the odds of an eventual return to profitability. Memories are short and management may hope that the “bath” will be forgotten once profitability is restored.
Natural Resources
So far, you may have envisioned productive assets as consisting primarily of buildings and machinery, but there are other categories to consider. An energy company may have a significant investment in oil and gas reserves, for example. Such natural resources can pertain to mineral deposits, timber, and countless other assets. There are many industry- specific accounting rules for unique natural resources, making it difficult to generalize about the accounting treatment. However, you should know that natural resources tend to be established in the accounting records at their acquisition cost, plus selected explora- tion and development costs. This recorded cost pool is then allocated to future accounting periods via periodic depletion charges.
Depletion is like depreciation but relates to natural resources instead of buildings and equipment. The process of measuring depletion generally consists of dividing the resource’s total cost, less residual value, by the total expected units of output. This results in a per-unit depletion charge that is either assigned to depletion expense or inventory (if the extracted resource has not been delivered to an end customer). You can think of the depletion as a “first cousin” of units-of-output depreciation.
To illustrate, assume that Copper River Mines invested a total of $1,000,000 in a mineral deposit and that amount is initially recorded into a Copper Ore account on its balance sheet. The deposit contained 500,000 tons of ore. Thus, the ore has a per-unit depletion cost of $2 ($1,000,0004500,000 tons). During 20X5, 100,000 tons of ore were extracted. Of this amount, 75,000 tons were sold, and 25,000 tons were loaded on a barge, awaiting sale to a customer. The total depletion amounts to $200,000 (100,000 tons 3 $2 per ton). Of the depletion, $150,000 would be expensed (75,000 tons 3 $2) and $50,000 (25,000 3 $2) would be carried as inventory. The following entry shows this allocation:
12-31-X5 Depletion Expense 150,000.00
Copper Inventory 50,000.00
Copper Ore 200,000.00
To reduce Copper Ore and allocate depletion to expense and inventory
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CHAPTER 6Section 6.3 Asset-Related Costs Subsequent to Acquisition
Intangible Assets
Remember that a classified balance sheet also contains an area for reporting intangible assets. Recall that intangibles are resources that do not physically exist. Examples include patents, copyrights, trademarks, brands, franchises, and similar items. Some intangibles are internally developed, and some are purchased from others.
As you would imagine, some of a company’s most important intangibles are ones that are not directly purchased from another party. Brands, trademarks, internally discovered concepts that result in patents, trade secrets, and so forth are significant assets that may take years to build up and often have very little specifically identified cost. Despite their tremendous value, these intangibles may not appear on a balance sheet. The cost principle generally requires that a recorded amount on a balance sheet be tied to the asset’s cost. Because the cost is negligible or hard to pinpoint, the result is that much of this value remains invisible.
On the other hand, a company may acquire intangible rights from others. For example, one company may buy a copyright to an artist’s song. Such purchased intangibles are recorded at their cost. This cost is to be expensed over the shorter of its legal life or useful life. For instance, a patent has a 20-year legal life. But, in many cases, the economic value of a patent may benefit a shorter amount of time. The accountant must exercise consid- erable judgment to reach a conclusion on the accounting life of such assets. The process of expensing an intangible over time is called amortization. Amortization is not much different than depreciation or depletion; it is just the process of allocating cost to the ben- efited time periods. If an intangible has an indefinite life, the cost is not amortized at all, but the recorded cost will be periodically evaluated for impairment.
To illustrate the accounting for intangibles, assume that Tremonton Medical purchased a patent for $100,000 and estimated the useful life to equal the 20-year legal life. The appro- priate entries are as follows:
01-1-X5 Patent 100,000.00
Cash 100,000.00
Paid $100,000 to purchase a patent
12-31-X5 Amortization Expense 5,000.00
Patent 5,000.00
To record annual amortization expense ($100,000/20 years)
Notice that the annual amortization entry credits the asset account directly. Intangibles are usually reported net of their accumulated amortization. Unlike with buildings and equip- ment, no accumulated amortization account is necessary.
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CHAPTER 6Concept Check
Research and Development Costs
As noted, a company’s internally developed intangibles are not shown as assets. Under GAAP applicable in the United States, this concept is carried far. All costs that are classi- fied as research and development (R&D) are to be expensed as incurred. These costs pertain to activities related to a planned search for new knowledge, product, or processes. You are probably aware, for instance, that pharmaceutical companies spend heavily in pursuit of new drugs. Many of these costs are likely to generate substantial future ben- efits. Nevertheless, their R&D costs are expensed each year, regardless of the likelihood of success of failure for a project. Thus, balance sheets are often void of some very significant intangible assets. You might find it interesting to note that the global accounting approach often varies from the U.S. approach, and some international companies do in fact report an R&D asset!
Goodwill
One way in which intangible business values are realized is when a business is sold. Then the purchaser will record the assets and liabilities of the acquired company at their fair value. The purchaser may, however, pay far more for the business than just the iden- tifiable pieces are worth. In such case, the excess purchase price is recorded as unique intangible asset called goodwill. Simply, goodwill is the excess of the fair value of a com- pany over the fair value of the identifiable elements. A buyer may be willing to pay the goodwill premium because of the acquired business’s favorable operating results over time, good reputation, location advantages, established customer base, and similar value propositions. When you see goodwill on a corporate balance sheet, it means that the com- pany has purchased one or more businesses in the past and willingly paid a premium. Although goodwill is not amortized, accountants are required to evaluate it for impair- ment at least once each year. In other words, if the acquired business’s value has declined, it can become necessary to remove the goodwill from the balance sheet.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 236.)
1. A company financed a land purchase by paying $120,000 cash and assuming a $100,000 mortgage payable. County fees to record the transfer of the land to the buyer totaled $150. Costs to clear the land of rocks and trees amounted to $850. What is the recorded cost of the land?
a. $120,000 b. $220,000 c. $220,850 d. $221,000
2. Depreciation is a. a system of cost allocation, not valuation. b. a system of valuation.
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CHAPTER 6
amortization The process of allocating cost to the benefited time periods.
betterment A capital expenditure for an improvement.
capital expenditures Ordinary and neces- sary costs such as direct purchase price and the cost of permits, sales tax, freight, installation, and other usual costs to pre- pare an item for use.
changes in estimates To revise the accounting to adjust only current and future periods.
DDB See double-declining-balance method.
depletion Similar to depreciation but relates to natural resources instead of buildings and equipment.
depreciable base The cost of an item of plant and equipment minus any residual value.
double-declining-balance (DDB) method A method of depreciation that “front loads” depreciation to the early periods of an asset’s service life.
goodwill The excess of the fair value of a company over the fair value of the identifi- able elements.
Key Terms
c. recorded in an effort to reduce assets to their fair market value. d. based on an asset’s cost and residual value but not service life.
3. A machine that was purchased 4 years ago for $45,000 has an accumulated depreci- ation balance of $8,000 and a residual value of $5,000. Assuming use of straight-line depreciation, what is the machine’s estimated service life?
a. 4 years b. 8 years c. 20 years d. Cannot be determined from the stated facts.
4. Tiger Lines purchased and began depreciating a new truck on April 1, 20X4. The truck, which cost $60,000, had a 5-year service life and a $12,000 residual value. Assuming use of the double-declining-balance method, what is the 20X5 depre- ciation expense?
a. $13,440 b. $14,400 c. $16,800 d. $18,000
5. Revising a depreciation rate because of a change in a service life estimate a. requires the correction of prior years’ financial statements. b. involves allocating the remaining depreciable base over the future years of use. c. requires that sufficient cash be available to replace the asset at the end of the new
service life. d. is permitted only if the service life is shortened.
Key Terms
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CHAPTER 6
materiality A concept dictating that an accountant must judge the impact and importance of a transaction to determine its proper handling in the accounting records.
natural resources Materials—such as min- eral deposits and timber—that are assets.
net book value An asset’s total cost minus accumulated depreciation to date.
R&D See research and development.
replacement An outlay expenditure designed to restore an asset to its original condition.
research and development (R&D) Internally developed intangibles that are not assets.
salvage value Also called residual value, the amount a business expects to receive when selling or trading at the end of an asset’s service life.
service life The number of periods ben- efited in the life of an asset.
straight-line method A method of depre- ciation that spreads the depreciable base over the service life, with an equal amount of depreciation assigned to each period.
units-of-output method A method of depreciation when an asset’s consumption may be associated with a specific measure of use or output.
Critical Thinking Questions
Critical Thinking Questions
1. Do all items of property, plant, and equipment have a useful life? Explain. 2. How is the acquisition cost of a machine determined? Which of the following items
are included in the cost of an asset: purchase price, freight charges, cost of installa- tion, medical costs of injured installer, special electrical wiring?
3. Explain the proper treatment of interest costs related to the purchase of a new automobile.
4. How should the cost of property, plant, and equipment acquired in a lump-sum purchase be apportioned to the individual assets? Why is such a division necessary?
5. Contrast the accounting treatments for land and land improvements. 6. What does the term depreciation mean in accounting? Is the term used differently by
others? Explain. 7. Define the term depreciable base. 8. Is the units-of-output method of depreciation more appropriate to use for some
items of plant and equipment than for others? Why? 9. How does a change in the estimated remaining service life of a piece of equipment
affect past and future depreciation amounts?
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CHAPTER 6Exercises
Exercises
1. Determining acquisition cost. Well-Made Fabricating Company recently purchased a state-of-the-art metal-cutting tool. The invoice price was $300,000, which reflected a 25% trade discount from the $400,000 list price. Other data related to the machine were as follows:
Freight and installation costs $9,500 Cash discount for prompt payment of invoice 3,000 Materials used during setup and initial testing 800 Finger guards installed around cutting head 2,500 Property taxes paid for first year of ownership 4,500 Advertising brochure to inform customers of new cutting capabilities 1,500
a. Determine the cost at which the machine should be recorded. b. Briefly describe and justify the proper treatment of the items that you excluded in
part (a).
2. Depreciation methods. Betsy Ross Enterprises purchased a delivery van for $30,000 in January 20X7. The van was estimated to have a service life of 5 years and a resid- ual value of $6,000. The company is planning to drive the van 20,000 miles annually. Compute depreciation expense for 20X8 by using each of the following methods:
a. Units-of-output, assuming 17,000 miles were driven during 20X8 b. Straight-line c. Double-declining-balance
3. Depreciation computations. Alpha Alpha Alpha, a college fraternity, purchased a new heavy-duty washing machine on January 1, 20X3. The machine, which cost $1,000, had an estimated residual value of $100 and an estimated service life of 4 years (1,800 washing cycles). Calculate the following:
a. The machine’s book value on December 31, 20X5, assuming use of the straight- line depreciation method
b. Depreciation expense for 20X4, assuming use of the units-of-output depreciation method. Actual washing cycles in 20X4 totaled 500.
c. Accumulated depreciation on December 31, 20X5, assuming use of the double- declining-balance depreciation method.
4. Depreciation concepts. Evaluate the following comments as true or false. If the comment is false, briefly explain why.
a. Depreciation is recorded over the years so that a company’s asset valuations are reduced to reflect lower market values.
b. A depreciable asset’s cost, minus accumulated depreciation, equals book value.
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CHAPTER 6Problems
c. An asset’s depreciable base and book value are identical at the end of the asset’s service life.
d. Straight-line depreciation is probably the most popular accelerated depreciation method used by businesses.
Problems
1. Cost treatment. Consider the following costs of Shamrock Company:
• Cost of grading land prior to construction • Cost of material used during trial runs of new machinery • Delinquent property taxes on newly acquired land • Damage to equipment, which occurred during installation • Fine for fire code violation in building • Freight charges on newly acquired equipment • Cost of parking lot constructed on property • Cost of three wastebaskets purchased for office use • Cost of clearing land prior to construction • Cost of purchasing used equipment • Interest incurred to purchase machinery on credit • Current property taxes on land and building • Attorney’s fees for land and building purchase • Construction costs of fence at company headquarters • Construction costs of new building • Cost of sprinkling system for landscaping
Instructions a. Identify which of the preceding costs should be charged to asset accounts? b. For the costs that you identified in part (a), indicate which asset account(s)
should be increased.
2. Depreciation computations: change in estimate. Aussie Imports purchased a specialized piece of machinery for $50,000 on January 1, 20X3. At the time of acquisition, the machine was estimated to have a service life of 5 years (25,000 operating hours) and a residual value of $5,000. During the 5 years of operations (20X3220X7), the machine was used for 5,100, 4,800, 3,200, 6,000, and 5,900 hours, respectively.
Instructions a. Compute depreciation for 20X3220X7 by using the following methods: straight
line, units of output, and double-declining-balance. b. On January 1, 20X5, management shortened the remaining service life of the
machine to 20 months. Assuming use of the straight-line method, compute the company’s depreciation expense for 20X5.
c. Briefly describe what you would have done differently in part (a) if Aussie Imports had paid $47,800 for the machinery rather than $50,000 In addition, assume that the company incurred $800 of freight charges $1,400 for machine setup and testing, and $300 for insurance during the first year of use.
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CHAPTER 6Problems
3. Depreciation methods, changes in rates, and partial periods. Ridgemar Inc. pur- chased a bus for $200,000 on April 1, 20X1. The bus had a residual value of $50,000 and a 10-year (150,000-mile) service life. On January 1, 20X2, the service life was decreased to recognize 8 years (or 120,000 miles) of remaining service from that date. Miles driven during 20X1 and the first quarter of 20X2 totaled 16,400 and 4,700, respectively. Accumulated Depreciation accounts based on the straight-line, units-of-output, and double-declining-balance depreciation methods follow.
a.
Accumulated Depreciation
12/31/X1: ? 3/31/X2: 4,336
b.
Accumulated Depreciation
12/31/X1: ? 3/31/X2: 5,233
c.
Accumulated Depreciation
12/31/X1: ? 3/31/X2: 10,625
d.
Accumulated Depreciation
12/31/X1: ? 3/31/X2: 7,197
Instructions Determine which Accumulated Depreciation account corresponds to each of the depreciation methods. Ridgemar rounds final depreciation computations to the nearest dollar.
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chapter 7
Current Liabilities
Learning Goals
• Know the classification framework and typical examples of current liabilities.
• Describe the accounting for accounts and notes payable and other typical current liabilities.
• Understand the nature of accruals, deposits, estimates, contingencies, and similar obligations.
• Prepare the current liability section of a balance sheet.
• Understand and apply important concepts in corporate financing.
• Know the basic principles and duties related to proper accounting for a business payroll.
• Interpret amounts reported in financial statements that pertain to employee benefits.
© Corbis/SuperStock
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CHAPTER 7Section 7.1 Accounts and Notes Payable
Chapter Outline 7.1 Accounts and Notes Payable
Accruals Prepayments, Deposits, and Collections for Others Estimated Liabilities Contingencies Balance Sheet Presentation Being a Better Borrower
7.2 Concepts in Payroll Accounting Calculating Gross and Net Pay Payroll Journal Entry Additional Entries for Employer Amounts Accurate Payroll Pension and Other Postretirement Benefits
Current liabilities are obligations that must be settled within 1 year or the operating cycle, whichever is longer. Current liabilities are usually satisfied by transferring a current asset. Accounts payable, salaries payable, utilities payable, taxes payable, and short-term loans are all examples of such current liabilities. Also included are amounts related to collections for others, accrued liabilities, warranty obligations, unearned rev- enue, and the current portion of long-term debt. The formal definition of a current liabil- ity is sufficiently broad to capture each of these amounts. In addition, current liabilities include amounts that will be satisfied by the creation of another liability or provision of a service. For example, unearned revenue is reported as a current liability. It is transferred to revenue at the time when goods or services are delivered to the customer.
It may be helpful to review the concept of an operating cycle. The operating cycle is the length of time it takes to turn credit back into cash. For instance, a business may buy inven- tory, sell the inventory in exchange for a receivable, and eventually collect the receivable. The typical time period during which cash is tied up in the inventory and receivables is the operating cycle. A typical operating cycle might span 45 to 180 days but can be much longer or shorter depending on the business. A fast-food restaurant may have an operat- ing cycle of a mere few days, whereas a winery’s cycle might span years. The diverse nature of operating cycles explains why the definition of current is related to the longer of the operating cycle or one year.
7.1 Accounts and Notes Payable
Let’s turn attention to a closer look as some specific types of current liabilities. Accounts payable are amounts due to suppliers for the purchase of goods and ser- vices. Such payables may be based on very informal credit terms, but those terms usually
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CHAPTER 7Section 7.1 Accounts and Notes Payable
stipulate the expected date of payment. For credit terms, 30 to 60 days is a common time length. Accounts payable incurred in the normal course of business ordinarily do not incur interest charges, although you might find exceptions, especially for delinquent accounts. Accounts payable are almost always shown as current liabilities on the balance sheet.
When a formal written instrument (agreement) shows purchases on credit, the result- ing payable may be reported as a note payable. Specifically, a note payable is a writ- ten promise to pay and will ordinarily incur interest over the duration of its outstanding period. Such notes arise not only with purchases of goods and services on account but also from bank loans, equipment purchases, and simple cash loans. The party who owes is referred to as the maker of the note. This person’s signature on the instrument represents a formal promise to pay the amount of the note, along with any agreed interest levies. If constructed properly, the note can actually become a negotiable instrument, allowing its holder (owner) to sell the collection rights to another person. The written note instrument can be as simple as Exhibit 7.1. A full legal form would typically include specific informa- tion about remedies upon default, place of payment, requirements of demand and notice, and so forth.
Exhibit 7.1: An example of a promissory note
A closer inspection of the note in Exhibit 7.1 reveals that Hillary Li has agreed to pay Vesta Energy $5,150 on December 31, 20X7. The principal amount of the note is $5,000 and the interest is $150. Interest is calculated by multiplying the $5,000 by the interest rates of 6% and time outstanding of one half of a year: $5,000 6% (142) $150. The interest cal- culation formula is often simply expressed as
Principal Rate Time
Assuming the note originated with a cash loan, Hillary Li would initially record the bor- rowing transaction by increasing Cash (debit) and Notes Payable (credit). Had the transac- tion originated by Hillary buying inventory from Vesta, the debit would reflect Inventory (instead of Cash). At repayment, Cash is credited, Notes Payable is debited, and the dif- ference is booked as Interest Expense. The following journal entries reveal this approach:
Issue date Maker Signature
with annual interest of 6% on any unpaid balance. This note shall mature
and be payable, along with accrued interest, on:
FOR VALUE RECEIVED, the undersigned promises to pay to the order of
the sum of:
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CHAPTER 7Section 7.1 Accounts and Notes Payable
7-1-X7 Cash 5,000.00
Note Payable 5,000.00
To record cash borrowed via a formal note payable bearing interest at 6% per annum
12-31-X7 Interest Expense 150.00
Note Payable 5,000.00
Cash 5,150.00
To record payment of note and interest
Notes occasionally have terms that extend beyond one year; these notes may be shown as long-term, rather than current, liabilities. The notes may also have amounts due that span several time periods. This feature can require the accountant to split the note’s presenta- tion into two balance sheet amounts reflecting both the current and noncurrent portions.
Accruals
The interest on a note is said to accrue. This means that it accumulates gradually with the passage of time. On any given balance sheet date, a company would need to calculate the total amount of its accrued obligations and report them in the current liability sec- tion. These amounts are called accrued liabilities (also, accrued expenses). For instance, if the 6-month note previously illustrated had originally been issued on October 1, rather than July 1, then $75 of interest would have accrued by December 31. The company would need to prepare the following adjusting journal entry on December 31, and the accumu- lated interest would appear within the current liability section of the balance sheet:
12-31-X7 Interest Expense 75.00
Interest Payable 75.00
To record accrued interest for 3 months:$5,000 6% (3412 months)
Interest is not the only type of obligation that is said to accrue. Salaries, wages, taxes, and utilities are typical expenses that must be accrued at the end of an accounting period. For instance, recall from an earlier chapter the following example of an entry that was used to accrue salaries:
12-31-X6 Salaries Expense 15,000.00
Salaries Payable 15,000.00
To record accrued salaries at end of period
The accounting department within an organization must be very cautious to correctly identify all such accruals; otherwise, liabilities will be understated and income overstated.
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CHAPTER 7Section 7.1 Accounts and Notes Payable
Prepayments, Deposits, and Collections for Others
A customer sometimes makes an advance payment or deposit. You have probably pur- chased an airline ticket, ticket to a concert or sporting event, or a magazine subscription. Ordinarily, the seller collects the sales price well in advance of delivery of the promised goods and services. When this occurs, the seller cannot recognize revenue at the time of collection. Remember that revenue is only recognized when earned; the mere collection of the sales price is not sufficient. Therefore, the initial entry is for the seller to debit Cash and credit Unearned Revenue.
The Unearned Revenue is reported as a current liability until such time as the goods or services are delivered, whereupon the seller will debit Unearned Revenue and credit Reve- nue. If you are examining financial statements, you will often identify a significant amount related to unearned revenue (often called deferred revenue). So long as you reasonably expect this revenue to be earned by delivery of future goods and services, you can take some com- fort that the business’s liability actually corresponds to a future revenue amount.
Home builders, car dealers, and retailers sometimes collect deposits toward future transac- tions. These down payments are intended to secure a firm customer commitment prior to beginning actual construction of a major or customized project. For example, in a layaway transaction, the retailer agrees to set aside a specific item of inventory in exchange for an initial deposit. Hopefully, the customer deposits are sufficient to ensure that the customer will follow through on their promise to accept and pay for the product. Whether these deposits are refundable or not, they are nonetheless reported as current liabilities. Often- times, such amounts are called deferred revenues, deferred liabilities, or just simply deferrals.
Another potentially large current liability relates to collections for third parties. For instance, businesses are tasked with collecting sales taxes. The seller of taxable goods must collect sales tax from a customer and then turn the money over to a taxing authority. Such amounts are appropriately reflected as a current liability until the funds are remitted to the rightful owner.
Estimated Liabilities
Companies routinely offer prizes, coupons, promotions, warranties, rebates, and other incentives to induce customers to purchase. Each type of transaction introduces unique accounting questions. Some are so unique that specific accounting rules have been devel- oped, and the accountant must perform detailed research to identify and apply appropri- ate principles. The accounting profession, through its primary accounting standard set- ting body, has developed a research database of pronouncements. If you are curious about this database, you might check with your library or a practicing accountant and ask if they have access to the Financial Accounting Standards Board Codification. This tool will let you enter key-word searches, and you will be amazed at the number of pronouncements and references you will find related to these types of estimated liabilities.
Despite the deep and specific detail on accounting for estimated liabilities, it is possi- ble to make a broad generalization. A company should report the estimated amount of future cost associated with those agreements and promises that are probable to occur. This amount, at least, should be presented as a liability on the corporate balance sheet. To
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CHAPTER 7Section 7.1 Accounts and Notes Payable
illustrate using warranties as the example, when goods are sold, an estimate of the future amount of warranty costs associated with the sales should be recorded as an expense. The offsetting credit is to a Warranty Liability account. As warranty work is performed, the Warranty Liability is reduced, and Cash (or other resources used) is credited. This approach not only results in a fair presentation of the remaining liability on the balance sheet but also produces a proper matching of revenues and expenses.
The following entries show how a $40,000 sale of a car—costing the dealer $32,000 and having future estimated warranty work of $3,000—is to be recorded. Also shown is the provision of one element of warranty service. Take special note that seller will make a $5,000 profit consisting of the $40,000 sale and $35,000 of total expenses.
Date of Sale Cash 40,000.00
Sales 40,000.00
To record sale of new car
Date of Sale Cost of Goods Sold 32,000.00
Inventory 32,000.00
To record cost of new car sold
Date of Sale Warranty Expense 3,000.00
Warranty Liability 3,000.00
To record estimated cost of future warranty work to be provided on car
Date of Warranty Service
Warranty Liability 1,000.00
Cash 1,000.00
To provide a portion of anticipated warranty service
Contingencies
Some business obligations seem to take on a heightened degree of uncertainty. In some respects, the aforementioned estimated liabilities can be regarded in this fashion because one does not truly know the eventual outcome. However, there is yet another class of potential liability in which the amount and timing of a possible obligation is far more subjective. These uncertain potential obligations are known as contingent liabilities. Numerous examples include lawsuits, environmental damage, risk of expropriation of assets by a foreign government, and other firm-specific issues.
Accountants have developed a well-defined framework for the reporting of contingen- cies. Before diving in, be advised that this framework is not applied to general business risks, like business fluctuations due to the broader economy, risk of war, risk of weather damage, and so forth. No one can see the future, and investors are presumed to be mature enough to know that these risks are intrinsic to the hazards of investing. Thus, accoun- tants do not include financial statement measurements related to general business risks.
The starting point for justifying contingent liabilities is to make a subjective assessment of the probability of an unfavorable outcome. If an unfavorable outcome is viewed as
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CHAPTER 7Section 7.1 Accounts and Notes Payable
probable, a liability will generally be reported on the balance sheet. The credit to set up the liability is offset with a debit to a loss or an expense account. The amount to record is the estimated amount of loss (if the loss cannot be estimated, a robust footnote to the financial statements will likely explain the obligation and reasons why an estimate is not possible).
For contingencies that are deemed to be reasonably possible (but not quite probable), no accrual (i.e., recording on the balance sheet) is necessary. However, the accountant is cer- tainly expected to disclose the risk with a footnote, possibly indicating the dollar amount of potential exposure faced by the company. Finally, if a contingent exposure is viewed as presenting an immaterial or remote risk, the accountant is permitted to conclude that no balance sheet accrual or footnote is needed. Maybe you thought accountants only did bookkeeping; think again. The accountant is engaged in a number of complex activities related to items like risk assessment!
Balance Sheet Presentation
You may now appreciate how complex the current liabilities section of the balance sheet can grow. Table 7.1 shows a typical presentation for a variety of obligations. Your review of this may leave you wondering about the specific order in which current obligations are to be listed. No one scheme dominates, although it is relatively common to first show the current portion of Long-Term Debt, followed by Short-Term Notes Payable, Loans Pay- able, and then Accounts Payable. Accrued and other liabilities are usually listed last.
Table 7.1: The listing of various obligations
Current Liabilities
Note Payable $100,000
Accounts Payable 125,000
Salaries Payable 80,000
Utilities Payable 20,000
Customer Prepayments 5,000
Warranty Obligation 23,000
Accrual for Pending Litigation 25,000 $400,000
Being a Better Borrower
Accountants learn a lot about business financing and gain some competitive advantages as a result. The skills you have already learned and few added tips may actually put you in a position to gain a competitive edge yourself.
Begin by recognizing that some short-term borrowing agreements may stipulate that a year is only 360 days long. Of course, this is not correct. In years gone by, maybe one could argue that this assumption made it possible to calculate interest more readily. If you hap- pen to see some very old bank statements, you might get a glimpse into the past when tell- ers manually calculated and posted interest. Using a 360-day year (30 days each month)
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CHAPTER 7Section 7.1 Accounts and Notes Payable
made these manual calculations simpler. With calculators and computers, it is just as easy to compute interest for a 360- or 365-day year.
However, some borrowing agreements continue to hold over the 360 day2year provision. Why? Because it favors the lender! For example, interest on a $10,000, 90-day, 6% loan is $150, assuming a 360-day year [$10,000 .06 (904360)], but only $147.95 based on the more correct 365-day year [$100,000 .06 (904365)]. That may not look like much of a difference to you, but it is to the lender if they make enough loans. Caveat emptor means “let the buyer beware;” perhaps let the borrower beware is also an appropriate admonition.
Compounding is another concept that you should grasp. The formula for simple interest, such as used in the preceding paragraph, is
Interest Loan Interest Rate Time
There are more involved formulas for compound interest, which are discussed at length in a managerial accounting course. Compound interest means that interest is earned on the interest. A loan agreement will stipulate how often the interest calculation is applied (e.g., once per day, once per week, once per month, once per quarter, annually). The calculated amount of interest is added to the balance of the loan, and it too begins to accrue interest. The greater the frequency of interest compounding, the greater will be the total amount of interest incurred. Lenders are usually required to present you with an extensive truth-in- lending document that describes the basis on which they will assess interest, but that is no guarantee that the terms are good! Read the fine print and try to negotiate your best deal. Buying the use of money (i.e., borrowing) is no different than buying any other asset; you should negotiate the best possible terms.
Sometimes a lender may try to collect their “interest” up front in the form of points (a single point is equal to 1% of the loan amount), fees, or discounts. This can take many forms but is best illustrated with a note payable issued at a discount. Assume Advantage borrowed $1,000 on January 1, to be repaid on December 31. The stated terms included “10%” interest, or $100, to be withheld up front from the $1,000 loan.” Following is the accounting sequence:
1-1-XX Cash 900.00
Discount on Note Payable 100.00
Note Payable 1,000.00
To record note payable, issued at a discount
12-31-XX Note Payable 1,000.00
Interest Expense 100.00
Discount on Note Payable 100.00
Cash 1,000.00
To record repayment of note and related interest via discount “amortization”
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CHAPTER 7Section 7.2 Concepts in Payroll Accounting
Observe that the $100 discount is initially recorded to a special account. This account is shown on a balance sheet as a contra account to the note payable. Simply, this means that a balance sheet will show the $1,000 note, less the $100 discount, netting to the $900 amount borrowed. Over time, the discount is amortized via a transfer to Interest Expense. The above entry did this at maturity, but it could have apportioned ratably over the life of the loan. At maturity, the “$1,000 loan” is repaid, as shown. It is important to understand that the loan was only $900, on which $100 of interest was paid. This brings the true rate of interest to over 11% ($1004$900).
7.2 Concepts in Payroll Accounting
Payroll is one of the most significant expenditures that businesses may face. It involves not only a significant amount of money but also is subject to strict legal and tax impli- cations. Failure to meet payroll funding and accounting expectations is usually fatal for a business.
The starting point of beginning is distinguishing between an employee and independent contractor. Payroll accounting principles pertain to employees. An employee is someone who provides services to a business in exchange for payment, with the business controlling what, when, and how work will be done. In contrast, an indepen- dent contractor performs agreed tasks but generally decides the processes that will achieve the end result. The distinction is important because tax and record-keeping requirements differ for employees and independent contractors.
It is common for disputes to arise about the classification of a worker as an employee ver- sus contractor; in particular, tax rules have become increasingly specific about the ways in which the differentiation occurs. If you are working for someone else or engaging another to perform a service, you are well advised to research the specific situation carefully to make the proper distinction between employee and contractor. As you are about to dis- cover, the distinction is very important.
Under U.S. tax law, monies paid to independent contractors do not require that the payer incur payroll taxes or withhold taxes. The primary requirement is that the payer obtain the contractor’s tax identification number (usually the Social Security number) and provide the contractor and Internal Revenue Service (IRS) with an annual report of the amount paid. This annual report is known as Form 1099. It is a simple matter to prepare and file this report. The contractor is responsible for paying all income and self-employment taxes on the amounts received from the payer.
Paying employees becomes far more involved. You may have some work experience, and if you do, you know that your paycheck is usually reduced by a variety of charges. The list of potential withholdings is long, including federal income tax, state income tax, FICA (Social Security taxes and Medicare/Medicaid), insurance, retirement contributions, char- itable contributions, special health and child-care deferrals, and other similar items. The total amount you earned is termed the gross pay. The amount you receive after deduct- ing all these charges is the net pay.
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CHAPTER 7Section 7.2 Concepts in Payroll Accounting
When you look at your pay stub and see all the withholdings, you may feel like you are taking two steps forward and one step back. However, don’t blame your employer. The bulk of these withholdings is mandated by law, and certain of them must be matched by your employer. This has the effect of increasing the total payroll cost to the employer to an amount well in excess of your gross pay.
Employers are required to match your FICA payments. Employers additionally pay unem- ployment taxes that are completely invisible and not borne directly by employees. Some employers also contribute to health insurance costs and retirement programs. A business must not only correctly account for the gross pay but also must measure, report, and fund these additional costs as well.
Calculating Gross and Net Pay
For hourly employees, gross pay is the number of hours worked multiplied by the hourly rate. For salaried employees, it is usually a flat amount. Gross pay might be increased or decreased for both hourly and salaried employees based on overtime rules or periods of compensated/uncompensated leaves. Statutes vary by country and state, and global employers must be very careful to understand fully the rules that apply in each jurisdic- tion. Laws tend to punish employers that don’t get it right and typically trigger payments and penalties due to both employees and governmental agencies.
Once gross pay is determined, all applicable withholdings must be considered. Income tax is usually the single most significant amount. Employees ultimately bear the tax on income, but the employer must withhold the money (i.e., it is taken out of the gross pay before dis- bursing payroll to employees). In other words, employees never touch the funds; if too much (or not enough) is withheld over the span of a tax year, final adjustment will occur when employees file their income tax returns for the preceding year.
The employer must periodically remit to the government(s) (based on schedules tied to the amounts involved) all such income tax withholdings. The amount to withhold is based on rates set by federal, state (when applicable), and city (when applicable) governments, as well as employee withholding allowances. Withholding allowances identify the tax sta- tus of employees as it relates to the number of exemptions to which they may be entitled based on marital status and personal dependents. Employers learn about these employee characteristics by having employees fill out a W-4 form.
The Federal Insurance Contributions Act (FICA) establishes a tax that transfers money from those currently working to aged retirees, disabled workers, and certain children. FICA is a blanket act encompassing programs normally called Social Security and Medi- care/Medicaid. You are likely aware that that these programs are becoming increasingly costly and controversial as extended life expectancies, rising health-care costs, and shift- ing imbalances between retired and working persons is calling into question the financial solvency and viability of these programs. It is difficult to predict the future state of this tax. For now, the Social Security tax is levied as a designated percentage of income, up to a certain maximum level of annual income per employee.
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CHAPTER 7Section 7.2 Concepts in Payroll Accounting
Despite regular revisions to the Social Security tax rates and income levels, the method of applying the tax has been relatively stable. For illustrative purposes, let’s assume a 7% rate on a maximum of $120,000 of income. This simply means that an employee making $200,000 per year would pay $8,400 in Social Security taxes (remember, this tax is also matched by the employer, as will be shown shortly). The $8,400 amount is the 7% rate applied to the $120,000 maximum; anything earned over $120,000 per calendar year is not assessed by the tax.
Medicare/Medicaid tax is assessed at fixed percentage on total gross pay, no matter the level. Assuming a 2% rate, the employee grossing $200,000 would pay $4,000 per year. Like Social Security, the employer also matches this medical benefits tax. Do not con- fuse Medicare/Medicaid with health insurance; the former benefits retirees using the government-provided coverage plan, and the latter is for people below the poverty line, retired or not. Active employees and retirees on a company provided plan may not draw Medicare/Medicaid.
Once the mandatory withholdings are covered, it is time to consider more discretionary types of costs. A large cost can arise through company-provided health care for its own work force and retirees. Usually, employees are asked to participate in the costs of these plans, especially if spouses and children are included in the coverage group. Such insur- ance premiums are withheld from gross pay. Similar withholdings arise for employee contributions to various retirement and other cash savings plans. Some companies will manage withholdings for employee charitable contributions, tax-advantaged health and child-care savings programs, and other optional programs in which an employee may choose to participate. Basically, the employer is collecting money from the employee and assuming a duty to remit those funds to another party. This is like accounting for cus- tomer deposits and other collections for third parties.
Payroll Journal Entry
A company will debit Wage/Salary Expense for the gross pay and credit Cash for the net pay disbursed to an employee. The differences reflect amounts due to others (e.g., the government, insurance companies, and charities). Following is a representative monthly entry for a company’s total payroll:
5-31-XX Wage/Salary Expense 300,000.00
Federal Income Tax Payable 30,500.00
State Income Tax Payable 12,000.00
Social Security Payable 18,000.00
Medicare/Medicaid Payable 6,000.00
Insurance Payable 18,500.00
Retirement Contribution Payable 15,000.00
Charitable Contribution Payable 2,000.00
Cash 198,000.00
To record payroll for the month of May
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CHAPTER 7Section 7.2 Concepts in Payroll Accounting
All amounts were assumed in the preceding entry. However, using the earlier tax-rate assumptions, you can see that Medicare/Medicaid reflected the 2% tax ($300,000 2% $6,000). Apparently, some employee(s) had already exceeded $120,000 of annual com- pensation because the Social Security tax was not $21,000 (which would be the case if all employees were still paying the full 7% on all income). As the company remits the amounts withheld from employees, Cash will be credited, and the various obligations will be debited.
Additional Entries for Employer Amounts
The preceding discussion pointed out that employers must match certain taxes like Social Security and Medicare/Medicaid. Additionally, the employer must pay other taxes such as unemployment tax (both federal and state levies). Unemployment taxes are levied and pooled to provide a source of funds to support persons who are temporarily out of work. Here the tax rate varies significantly based on the history of an employer. Employ- ers who rarely lay off or fire employees receive a much lower rate than those who don’t maintain a stable work force. Like Social Security, the unemployment tax is levied only on a base amount of pay; earnings in excess of the base are exempt from the tax. In this text, assume that the federal unemployment tax (FUT) is 1% on a $15,000 base and the state unemployment tax (SUT) is 5% on a $15,000 base.
Employers that offer health insurance coverage to employees usually foot a significant share of the bill. This is an additional cost that increases the overall cost of having an employee on the payroll. Along with optional health care, some states require employ- ers to maintain workers’ compensation insurance. This insurance provides payments to workers for work-related injuries. Other employee benefits can be found in the form of retirement plan contributions, tuition reimbursement programs, training costs, gym memberships, automobile allowances, and so forth. For some companies, the added cost of employee support can be as much as 50% of gross pay. Following is a companion entry to that shown earlier, this time reflecting the employer’s added burden associated with the May payroll. The amounts are assumed and would normally be based on formulas that are situational dependent.
5-31-XX Payroll Tax Expense 31,200.00
Employee Benefits Expense 40,000.00
Social Security Payable 18,000.00
Medicare/Medicaid Payable 6,000.00
FUT Payable 1,200.00
SUT Payable 6,000.00
Insurance Payable 25,000.00
Retirement Contribution Payable 15,000.00
To record employer portion of payroll taxes and benefits
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CHAPTER 7Section 7.2 Concepts in Payroll Accounting
Accurate Payroll
As you can tell, accuracy is vital in payroll accounting. Payroll requires accurate and timely reporting and funding of all related obligations. Because of the complexity of payroll law and the severe penalties for errors, a specialized industry can provide payroll support ser- vices. For a fee, these businesses will manage payroll functions efficiently. The employer provides information about hours worked for each employee and transfers funds to cover the full cost of payroll and payroll taxes. The payroll service firm then pays employees, keeps payroll records, reports compliance, processes tax deposits, and generates payroll tax reports.
Businesses that do not rely on payroll services must establish an accurate payroll sys- tem for tracking information about every employee. It is imperative to pay employees the correct amounts at the agreed time, to make timely payments of withholdings to the appropriate parties, and to file all necessary tax reports associated with the payroll. For example, an employer is required to provide each employee with an annual wage and tax statement known as the W-2 form. This document includes information on gross pay, tax withholdings, and other related information. Copies of this information must also be fur- nished to tax authorities, and they reconcile income reported by employees on their own tax returns to amounts reported as paid by employers.
Remitting tax withholdings to the government is simple and can be done at most com- mercial banks. There is also an online system that is easy to use. It is very important for you to know that the employer’s obligation to protect withheld taxes and make timely remittances to the government is taken seriously. Employers who fail to do so are subject to harsh penalties, and employees who are aware of misapplication of such funds can expect serious legal problems. You should never be party to such an activity.
Pension and Other Postretirement Benefits
Another potentially costly payroll component relates to a company’s retirement savings programs for the benefit of employees. Broadly speaking, these pension plans involve current “set asides” of money into trust, with a goal of current investment and future distributions to retirees. To the extent the company’s trust fund is deemed inadequate to cover anticipated obligations under a pension, a company will disclose underfunded pen- sion obligations as balance sheet liabilities. On a related note, some companies provide postretirement health care, life insurance, and related benefits. These costs can be sub- stantial, and accountants have developed elaborate models for estimating these costs. A company is to report the value of the accumulated obligation as a liability on the balance sheet. This can be one of the most significant liabilities faced by many companies.
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CHAPTER 7Concept Check
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 236.)
1. Which of the following comments is false? a. Current liabilities include prepayments (advances) by customers. b. Current liabilities will be settled within 1 year or the operating cycle, whichever
is longer. c. Current liabilities must be settled by using cash. d. Current liabilities arise from past transactions and events.
2. The Discount on Notes Payable account a. usually has a credit balance. b. is associated with a note payable when interest is included in the obligation’s
face value. c. represents future interest revenue on the note payable. d. is used for notes payable when interest is not included in the obligation’s face
value.
3. A balance in the Estimated Liability for Warranties account at year-end indicates a. that the accounting records have not been closed. b. that the accounting records have not been adjusted. c. the amount incurred during the year to service outstanding warranty agreements. d. future amounts expected to be incurred when outstanding warranty agreements
are honored.
4. Assume that Robert Conrad, a technical engineer, worked 45 hours last week. He is paid $28 per hour, with hours in excess of 40 being compensated at one and one- half times the regular rate. Income tax withholdings amounted to $270; his medical insurance deduction was $30. The Social Security tax rate is 6% on the first $55,000 earned per employee, and Medicare is 1.5% on the first $130,000. Cumulative gross pay before considering the preceding data totaled $54,202. What is Conrad’s take- home pay?
a. $930.25 b. $962.17 c. $982.12 d. Some amount other than those listed
5. Social Security and Medicare taxes are levied on a. employees only. b. employers only. c. both employees and employers. d. either the employee or the employer, depending on the number of withholding
allowances claimed by the employee.
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CHAPTER 7
accounts payable The amounts due to suppliers for the purchase of goods and services.
contingent liabilities A class of a poten- tial liability in which the amount and timing of a possible obligation is very subjective.
employee As opposed to an independent contractor, a person who provides services to a business in exchange for payment, with the business controlling what, when, and how work will be done.
Federal Insurance Contributions Act (FICA) A tax that transfers money from those currently working to aged retirees, disabled workers, and certain children.
FICA See Federal Insurance Contributions Act.
Form 1099 An annual report provided to an independent contractor and the IRS, showing money paid.
gross pay The total amount of wages that an employee earns.
income tax A federal and sometimes state and local tax on earned wages.
independent contractor Someone who performs agreed-on tasks but generally decides about the processes that will achieve the end result.
net pay The amount that an employee receives after deducting charges such as federal and state taxes, FICA, insurance, retirement contributions, charitable con- tributions, special health and child-care deferrals, and other similar items.
note payable A written promise to pay for purchases bought on credit and usually incurs interest during the payment period.
pension A plan that involves current “set asides” of money into trust, with a goal of current investment and future distribu- tions to retirees.
unemployment tax A tax levied and pooled to provide a source of funds to support persons who are temporarily out of work.
workers’ compensation insurance Insur- ance that provides payments to workers for work-related injuries.
W-2 form An annual wage and tax statement—which includes information on gross pay, tax withholding, and other related information—that an employer provides to an employee and the IRS.
W-4 form A form stating the tax-with- holding status—marital and number of dependents—of an employee.
Key Terms
Key Terms
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CHAPTER 7Exercises
Critical Thinking Questions
1. Is a commitment for future goods and services entered in the accounting records as a liability? Explain. 2. Define the term current liability and present six examples. 3. Present three different situations where a business collects monies from customers
and employees and reports such amounts as current liabilities. 4. Briefly discuss the correct treatment of vacation pay in the accounting records. 5. What does the Discount on Notes Payable account represent? 6. Does discount amortization increase or decrease a company’s reported interest
expense for the year? 7. What guidelines must be met for a contingent liability to be recorded in the accounts? 8. Why is a warranty considered a contingent liability? 9. Are internal control procedures important in the area of payroll? Why?
10. What is the purpose of requiring businesses to withhold income taxes (federal, state, and local) from employee wages? How are these withholdings treated in the accounting records of the employer?
11. Which payroll taxes are incurred by an employer? How are these taxes treated in the accounting records?
Exercises
1. Prepayments by customers. Greenland Enterprises began a new magazine in the fourth quarter of 20X2. Annual subscriptions, which cost $18 each, were sold as follows:
Number of Subscriptions Sold
October 400
November 700
December 1,000
If subscriptions begin (and magazines are sent) in the month of sale:
a. name the necessary journal entry to record the magazine subscriptions sold dur- ing the fourth quarter.
b. determine how much subscription revenue Greenland earned by the end of 20X2. c. compute Greenland’s liability to subscribers at the end of 20X2.
2. Accrued liability: current portion of long-term debt. On July 1, 20X1, Hall Com- pany borrowed $225,000 via a long-term loan. Terms of the loan require that Hall pay interest and $75,000 of principal on July 1, 20X2, 20X3, and 20X4. The unpaid balance of the loan accrues interest at the rate of 10% per year. Hall has a December 31 year-end.
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CHAPTER 7Exercises
a. Compute Hall’s accrued interest as of December 31, 20X1. b. Present the appropriate balance sheet disclosure for the accrued interest and the
current and long-term portion of the outstanding debt as of December 31, 20X1. c. Repeat parts (a) and (b) using a date of December 31, 20X2, rather than December
31, 20X1. Assume that Hall is in compliance with the terms of the loan agree- ment.
3. Notes payable. Sentry Security Systems purchased $72,000 of office equipment on April 1, 20X3, by signing a 3-year, 12% note payable to Sharp Inc. One third of the principal, along with interest on the outstanding balance, is payable each April 1 until maturity. (The first payment is due in 20X4.)
a. Fill in the following table to reflect Sentry’s liabilities, assuming a March 31 year- end.
20X4 20X5 20X6
Current Liabilities
Current portion of long- term debt
Interest payable
Long-Term Liabilities
Long-term debt
b. Assuming that interest is properly recorded at the end of each year, present the proper journal entry to record the last payment on April 1, 20X6.
4. Payroll accounting. Assume that the following tax rates and payroll information pertain to Brookhaven Publishing:
Social Security taxes: 6% on the first $55,000 earned Medicare taxes: 1.5% on the first $130,000 earned Federal income taxes withheld from wages: $7,500 State income taxes: 5% of gross earnings Insurance withholdings: 1% of gross earnings State unemployment taxes: 5.4% on the first $7,000 earned Federal unemployment taxes: 0.8% on the first $7,000 earned
The company incurred a salary expense of $50,000 during February. All employees had earned less than $5,000 by month-end.
a. Prepare the necessary entry to record Brookhaven’s February payroll that will be paid on March 1.
b. Prepare the journal entry to record Brookhaven’s payroll tax expense.
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CHAPTER 7Problems
5. Payroll accounting. The following payroll information relates to Viking Company for the month of July:
Total (gross) employee earnings $150,000 Earnings in excess of Social Security base earnings 18,000 Earnings in excess of Medicare base earnings 2,000 Earnings in excess of unemployment base earnings 94,000 Federal income taxes withheld 14,500 State income taxes withheld 3,000 Employee deductions for medical insurance 2,200
The Social Security tax rate is 6% on the first $55,000 earned per employee; Medi- care is 1.5% on the first $130,000 earned. The state and federal unemployment tax rates are 5.4% and 0.8%, respectively, on the first $7,000 earned per employee.
a. Compute the employees’ total take-home pay. b. Compute Viking’s total payroll-related expenses. c. Assuming a stable work force, is total take-home pay likely to increase, decrease,
or remain the same in September? Briefly explain.
Problems
1. Current liabilities: recognition and valuation. The seven transactions and events that follow relate to the 20X2 operations of Blue Giant Products.
• On February 1, the company signed a 1-year contract with the food processors union, agreeing to a 6% wage increase for all employees. The cost of the wage increase is estimated to be $100,000 per month.
• A customer slipped on a soft drink that he had spilled while walking through a Blue Giant store. The customer injured his back and has filed a $50,000 damage suit against the company. Blue Giant attorneys feel the suit is uncalled for and without merit.
• Blue Giant purchased merchandise on October 15 for $4,000; terms 5415, n460. The company overlooked the discount and intends to pay the supplier in Janu- ary 20X3.
• Equipment that cost $12,000 was acquired on November 1 by issuing a 3-month, 10%, $12,000 note payable.
• Office furniture that cost $4,000 was purchased on December 1, with Blue Giant sign- ing a $4,240, 12-month note payable. Interest is included in the note’s face value.
• The company operates in a state that has a 6% sales tax. Sales of merchandise on account during December amounted to $300,000.
• On the last day of 20X2, Blue Giant borrowed $1 million from Monticello Bank. The loan’s principal is due in 10 equal annual installments of $100,000 each, with each installment payable on December 31. The loan has a 9% interest rate.
Instructions a. Indicate which of the seven transactions and events would appear in the Current
Liability section of the firm’s December 31, 20X2, balance sheet.
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CHAPTER 7Problems
b. Show how the items in part (a) would be disclosed. Use proper dollar amounts. c. Indicate how the transactions and events that are not current liabilities would be
handled for accounting purposes.
2. Current liabilities: entries and disclosure. A review of selected financial activities of Visconti’s during 20XX disclosed the following:
12/1: Borrowed $20,000 from the First City Bank by signing a 3- month, 15% note payable. Interest and principal are due at maturity.
2/10: Established a warranty liability for the XY-80, a new product. Sales are expected to total 1,000 units during the month. Past experience with similar products indicates that 2% of the units will require repair, with warranty costs averaging $27 per unit.
12/22: Purchased $16,000 of merchandise on account from Oregon Company, terms 2/10, n/30.
12/26: Borrowed $5,000 from First City Bank; signed a $5,120 note payable due in 60 days.
12/31: Repaired six XY-80s during the month at a total cost of $162. 12/31: Accrued 3 days of salaries at a total cost of $1,400. 12/31: Accrued vacation pay amounting to 6% of December’s $36,000 total wage
and salary expense.
Instructions a. Prepare journal entries to record the preceding transactions and events. b. Determine accrued interest as of December 31, 20XX, and prepare the necessary
adjusting entry or entries. c. Prepare the current liability section of Visconti’s December 31, 20XX balance sheet.
3. Notes payable. Red Bank Enterprises was involved in the following transactions during the fiscal year ending October 31:
8/2: Borrowed $75,000 from the Bank of Kingsville by signing a 120-day note for $79,000.
8/20: Issued a $40,000 note to Harris Motors for the purchase of a $40,000 de- livery truck. The note is due in 180 days and carries a 12% interest rate.
9/10: Purchased merchandise from Pans Enterprises in the amount of $15,000. Issued a 30-day, 12% note in settlement of the balance owed.
9/11: Issued a $60,000 note to Datatex Equipment in settlement of an overdue account payable of the same amount. The note is due in 30 days and car- ries a 14% interest rate.
10/10: The note to Paris Enterprises was paid in full. 10/11: The note to Datatex Equipment was due today, but insufficient funds
were available for payment. Management authorized the issuance of a new 20-day, 18% note for $60,700, the maturity value of the original obligation.
10/31: The new note to Datatex Equipment was paid in full.
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CHAPTER 7Problems
Instructions a. Prepare journal entries to record the transactions. b. Prepare adjusting entries on October 31 to record accrued interest. c. Prepare the Current Liability section of Red Bank’s balance sheet as of October
31. Assume that the Accounts Payable account totals $203,600 on this date.
4. Payroll journal entries. The following tax rates and payroll information pertain to the Syracuse operations of IMS Company for November:
Social Security taxes: 6% on the first $55,000 earned Medicare taxes: 1.5% on the first $130,000 earned Federal income taxes withheld from wages: $4,400 State income taxes: 6% of gross earnings Insurance withholdings: 1% of gross earnings Pension contributions: 2.5% of gross earnings State unemployment taxes: 5.4% on the first $7,000 earned Federal unemployment taxes: 0.8% on the first $7,000 earned
Sales staff salaries amounted to $26,000, $3,000 of which is over the unemployment earnings base but subject to all other appropriate taxes. The company’s branch manager, Tracy Smith, earned her regular salary of $9,000 during the month.
Instructions a. Prepare the journal entry to record the November payroll. Smith’s salary is classi-
fied as an administrative expense by the company. b. IMS matches employees’ insurance and pension contributions. Prepare a journal
entry to record the firm’s payroll taxes and other related payroll costs. Assume that these amounts will be remitted to the proper authorities in December.
c. The owner of IMS asked the firm’s accountant to reclassify all personnel as inde- pendent contractors. The accountant explained that such a reclassification would not be appropriate because, by law, the personnel were considered employees. Briefly comment on the probable reasoning behind the owner’s request.
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chapter 8
Corporate and Partnership Equity
Learning Goals
• Recite the advantages and disadvantages of alternative entity forms.
• Account for the formation of a sole proprietorship or partnership.
• Understand concepts related to distributing partnership income.
• Know the principles related to accounting for the admission/withdrawal of a partner.
• Account for special corporate equity transactions, including issuance of par value stock, dividends, treasury stock transactions, and stock splits.
• Understand and apply principles for reporting of special events that require modifica- tion of the income statement.
© Corbis/SuperStock
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CHAPTER 8Chapter Outline
Chapter Outline 8.1 The Corporation 8.2 The Partnership 8.3 The Sole Proprietorship 8.4 Accounting for Sole Proprietorships and Partnerships
Basic Accounting Considerations Initial Investments Income Sharing New Partners
8.5 Corporate Equity Transactions Par Value Cash Dividends Treasury Stock Stock Splits and Stock Dividends Income Reporting
8.6 Corrections of Errors and Changes in an Accounting Method
Thus far, the examples in this book have relied on an assumption that a corporation is conducting business. However, not all businesses are structured as corporations. There is no such requirement; there are indeed many alternatives. Corporations may be the most familiar because it is usually the entity form that is used to structure larger orga- nizations, the type in which you can easily buy and sell units of ownership (i.e., stock) and the type in which megabusinesses offers products you routinely buy. However, there are many alternative ways that a business can be organized.
Broadly speaking, business activity can be conducted through a corporation, partnership, or sole proprietorship. Within these three broad groupings, there are many subdivisions such as LLCs (limited liability corporations), LLPs (limited liability partnerships), and others. You may hear of other terms, such as S corporations (also called Sub-Chapter S corporations). The finer distinctions are important for legal and tax reasons but don’t sig- nificantly alter the accounting principles. Therefore, we focus our analysis of entity differ- entiation on the broader hierarchy related to corporations, partnerships, and sole propri- etorships. At the outset, you should note that our differentiation relates primarily to issues pertaining to accounting for topics related to owner’s equity. The fundamental accounting for assets, liabilities, revenues, and expenses is rarely impacted by the choice of entity.
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CHAPTER 8Section 8.1 The Corporation
8.1 The Corporation
Because we have been using the corporation for our examples, let’s begin by thinking deeper about its advantages and disadvantages. A corporation is a legal entity having existence separate and distinct from its stockholders. Corporations exist only in the legal sense and cannot exist unless specific actions are taken.
However, one does not have to form a corporation to conduct business. Business can also be conducted via a sole proprietorship or partnership. As you read on, you will quickly find that one should only use the sole proprietorship or partnership by design, not by accident.
Why would you want to consider forming your business as a corporation? For starters, it permits otherwise unaffiliated persons to join together in mutual ownership of a business. Funds can be accumulated and concentrated into one organization. Significant pooling of resources can occur that might not otherwise be possible. A corporate strategy often might entail a large amount of risk with highly uncertain outcomes. Probably you are willing to risk a small amount of your wealth on speculative investments with the potential for a high payoff, but you are unlikely to bet everything you have. This is often the dilemma faced by new businesses.
Some ventures are so large that shared ownership is essentially required. Therefore, the stock of the corporation provides a perfect vehicle for mutual ownership of a business. Each shareholder can invest at a level that matches his or her wealth and risk tolerance attributes. An important aspect of the corporate form of organization is that shareholders are usually only at risk for the amount they invest in the company’s stock. Creditors can- not pursue shareholders for additional claims beyond the shareholder investments.
Most corporations allow shareholders to vote in proportion to their shares, with one vote per share. This democratic process allows shareholders to participate in corporate gover- nance based on the level of their investment. Shareholders vote on matters set forth in the bylaws. The voting is usually conducted on a ballot that is termed the proxy.
Another advantage of the corporate form of organization is the relative ease with which shares of stock can be transferred to another. Stockholders can normally sell their shares to others or buy more shares without direct involvement by the corporation. Transferability of ownership makes stock a relatively liquid asset to its holder. Further, companies can often access additional capital by issuing more shares to current and new shareholders.
In some cases, a company may go public, meaning that it lists it shares on one of the popular stock exchanges, such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotation (NASDAQ) system. An initial public offering (IPO) of shares is an exciting (and costly) decision, and is some- times accompanied by so-called road shows and various other promotions designed to mar- ket the offering. Road shows are company-sponsored events where corporate executives present their business case in the hopes of developing interests among potential investors.
A corporation is presumed to have a perpetual existence. Changes in stock ownership do not cause operations to cease. The death of a shareholder does not bring about a need to dissolve the company. Instead, the beneficiaries of the estate of the deceased become
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CHAPTER 8Section 8.1 The Corporation
new owners. A corporation will continue to exist and operate until it is merged in with another, fails, or a corporate action is undertaken to liquidate the company. When the lat- ter happens, all bills must be paid, and common shareholders are entitled to final distribu- tions of any residual funds in proportion to shares held.
Perhaps one of the most significant advantages of a corporation, especially when com- pared to partnerships and sole proprietorships, is the feature of limited liability. The liability of stockholders is normally limited to the amount of their investment. Stockhold- ers are not personally liable for debts and losses of the company, except to the extent of their investment, or any additional guarantee of corporate debt. However, you should be aware that a corporate entity is not a perfect shield against all liability. If affairs of the shareholders are comingled with the corporation or there is malfeasance by shareholders/ officers, a lawsuit may be filed by damaged parties against the shareholder or officer. It is not always possible to avoid these types of claims, but taking care to meet good legal and accounting practices is a good start. This underscores the need for you to be well versed in proper accounting procedures and internal controls in managing your own businesses and investments.
The preceding advantages may lead you to believe that the corporation is an ideal legal structure for a business. However, there are some big disadvantages. Corporations are frequently taxable entities—that is, their income is taxed. This is a big problem because it can result in double taxation on income. The company pays tax on its income, and then shareholders again may pay tax on this same income when it is distributed to them in the form of taxable dividends. Thus, it is not uncommon for over half of a corporation’s earn- ings to be taxed away prior to being available to shareholders for their own use.
To illustrate this effect, assume that Mega Corporation earned $100,000,000 before tax. Assuming a 35% tax rate, the remaining income after tax would be $65,000,000. If that entire amount was distributed to shareholders in a taxable transaction and assuming shareholders were subject to an average 40% tax rate, then an additional $26,000,000 of tax would be paid ($65,000,000 3 40%). Of the $100,000,000 in pretax income, sharehold- ers would only realize $39,000,000 ($100,000,000 2 $35,000,000 2 $26,000,000).
There are planning vehicles to limit the double-taxation impacts, and various tax rules are occasionally adjusted to provide some relief, but this disadvantage cannot be wholly avoided. A good tax accountant should be consulted in finding the right corporate strat- egy, lest the effects can mitigate much of the profit motive associated with the initial busi- ness objective.
Corporations also suffer under the weight and cost of added regulatory oversight, espe- cially when the stock is publicly traded. Agencies such as the Securities and Exchange Commission (SEC) impose stringent reporting guidelines, including mandatory and expensive audits. Additional rules require companies to have strong internal controls and ethical training. The financial statements must also be certified by senior officers who do so under the risk of prosecution for perjury. To be sure, if you were an officer being required to sign such documents, you would undoubtedly expend ample funds to ensure that the statements were reliable. Suffice it to say, the cumulative cost of meeting regula- tory stipulations is high.
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CHAPTER 8Section 8.2 The Partnership
8.2 The Partnership
A partnership is another form of business organization that brings together multiple parties. The specific definition of a partnership is an association of two or more per- sons to carry on a business for profit as co-owners. However, in some ways, this also seems to describe a corporation. What is it that uniquely pertains to a partnership and sets it apart from a corporation?
For starters, a partnership is not a separate legal entity. It is an association of persons. Part- nerships are formed quite easily, without the necessity of any specific legal action. Indeed, by default, the mere joining together of persons for a profit-oriented business purpose is a partnership, unless some alternative action is undertaken to set up a corporation (or other entity type, such as a joint-venture agreement). This feature does not preclude formaliz- ing a partnership agreement via a written document. As you will soon see, preparation of such documentation, though not a legal requirement, is a good practice. Without such an agreement, the partnership’s governance, profit sharing, and the like will be established by standard practices set forth in statute and case law history. The results at times can be surprising. Thus, it is highly recommended that partnerships agreements be reduced to a written agreement. This written agreement is sometimes termed the articles of partnership, but it is generally not necessary to notify regulatory authorities about the terms or exis- tence of the partnership (except as it relates to tax-reporting issues).
You need to recognize the significant attributes of a partnership. First is the principle of mutual agency. This means that any individual partner has a right to commit or obligate the entire partnership. It is not possible for one partner to disavow the actions of another partner that were taken on behalf of the partnership. This can be a scary proposition. When you enter a partnership, you are bound to honor every contract or debt it under- takes, whether you were consulted or agree.
As an extension of the concept of mutual agency, you also need to know that all prop- erty and income of a partnership is held under co-ownership unless there is a specific agreement calling for an alternative outcome. Technically, the partners own everything in equal proportion and are each entitled to an equal share of income and distributions from the partnership. This feature should not be overlooked. When one or more partners contribute tangible assets to the partnership, they forgo their specific interest in the assets in exchange for a mutual interest in the business. They are not entitled to a return of those specific assets if the partnership liquidates. Instead, they are only entitled to a monetary distribution equivalent of their measured share of total capital.
As the partnership generates profits, each partner accrues an equal share of benefit, regardless of their capital contribution and work effort. This is huge. Rarely will all part- ners contribute equal amounts of capital and effort. Thus, a written partnership agree- ment that modifies this standard provision is paramount to maintenance of equitable out- comes. Written agreements typically include specific provisions related to how income is to be shared, how distributions will occur, and so forth. But without such an agreement, the one-for-all, all-for-one rule of co-ownership is generally deemed to be the appropriate outcome. Perhaps you can begin to see why a partnership, despite its ease of formation, has certain disadvantages. There are, however, additional problems to consider.
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CHAPTER 8Section 8.2 The Partnership
Unlike a corporation, a partnership has a limited life. In other words, the partnership passes with the death of a partner, and the partnership is legally dissolved. A new one may be immediately formed; written agreements usually make provisions for the dissolution and reformation upon the death of a partner. At other times, where a deceased partner was crucial to business operations, the dissolution may also trigger a cessation of business operations and formal liquidation of the entity. Clearly, this complicating feature is yet another limitation on the desirability of doing business as a partnership.
In the strictest technical sense, the concept of partnership dissolution occurs each time a new partner joins (or a prior partner leaves) the partnership. This does not mean that operations cease; it simply means that a new partnership is formed. Dissolutions may be relatively invisible from the perspective of clients and suppliers to a partnership, but it does trigger unique internal accounting aspects to which you will soon be exposed.
Perhaps some of the unique partnership attributes are sufficient to give you pause as it relates to being involved in a partnership. If not, perhaps the next aspect will. Partners in a partnership have personal unlimited liability for the debts, claims, and obligations of the partnership. Each partner is individually liable; one cannot simply resign from the partnership in an effort to escape his or her share of responsibility. This characteristic is directly attributable to the fact that a partnership is not a separate legal entity. Unlimited liability makes a partner’s personal assets at risk to seizure for satisfaction of obligations of the partnership.
Historically, unlimited liability has been a severe limitation to the partnership form of orga- nization and has posed vexing problems for medical practices, law firms, and accounting groups. Many professional service firms have not been able to organize as corporations because of licensing issues that attach to individuals and not businesses (e.g., only an indi- vidual, not a business, can get a CPA designation). Thus, professional service firms tra- ditionally formed up as partnerships. But, the increase in litigation exposure has caused many to back away from consideration of alignment in a partnership. To remedy this problem, many states now also recognize limited liability partnerships (LLP). This form of entity provides that only firm assets may be used to satisfy claims against an LLP. There- fore, the personal assets of individual partners are afforded some degree of protection.
At this juncture you may be wondering why anyone would wish to join a partnership. Despite its shortcomings, the partnership form of organization does have some compel- ling advantages. Recall that the business is easily formed. Indeed, if more than one per- son is involved in a business for profit, the partnership is deemed to be the default form of organization. The ease of formation is a double-edged sword. Although it is a simple process, it also opens up the partners to the challenges already identified. Basically, one should make business choices by reason, not default. This underscores why understand- ing the strengths and weaknesses of the partnership form of organizations is so important.
Partnerships also benefit from their intrinsic agility. Because partners can act on behalf of the partnership, they can behave with operating flexibility and streamlined decision pro- cesses. This can enable rapid action in response to new business opportunities.
In closing, one should not overlook one of the most compelling benefits of a partner- ship. Partnerships are not subject to tax on their income. Instead, each partner’s share of
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CHAPTER 8Section 8.3 The Sole Proprietorship
the income, whether distributed or not, is taxed to the partners. This avoids the double- taxation problem that is associated with most corporate entities, as illustrated earlier. Legally avoiding taxes is a huge business advantage, and can trump the other concerns that persons may have about forming a partnership. As an important point of informa- tion, do not confuse the lack of being taxable with the lack of filing a tax return. A partner- ship must calculate and report its income to the government and partners, but this is an informational process intended to alert interested parties about the amount of income that partners are expected to pay tax on.
8.3 The Sole Proprietorship
In simple terms, you can think of a sole proprietorship as a one-person partnership. It is not a partnership, but the legal and technical requirements operate in much the same way. No specific legal action is necessary to start the business, although there are a number of good practices. For instance, if an individual began doing business under an “assumed name” such as Jan’s All Seasons Lodge, she would likely want to file an assumed-named certificate, register an appropriate Internet site, notify licensing and tax agencies, and so forth. However, she does not need specific authorization to create an entity. Indeed, she is the entity. When doing business under an assumed name, procurement of the assumed- name certification is a very good business practice. This provides protection against other persons “copying” your business identity and is often required to conduct banking and other similar transactions. In many states, obtaining an assumed-name certificate is eas- ily done through a county clerk’s office, takes only a few minutes, and requires paying a small fee.
Sole proprietors are obviously responsible for their debts. If the business fails, the busi- ness owner cannot just apologize and tell creditors the business no longer exists. Gover- nance issues are nonexistent, for perhaps rather obvious reasons. There are no partners or shareholders; thus, sole proprietors answer only to themselves.
Sole proprietorships do not file separate tax returns. Owners will prepare a schedule detailing the business income and include this schedule with their tax return. You prob- ably work in a job where you receive salary and wages, and you likely understand how these amounts are reported in your own tax return. In similar fashion, a sole proprietor- ship’s income is captured as a taxable component in an individual’s income tax return. The business income of a sole proprietorship is subject to not only income tax but also many of the payroll taxes discussed in Chapter 7. Social Security and Medicare taxes are twice the amount imposed directly on employees because the sole proprietor must assume obliga- tion for both the employee and employer components of the tax.
Despite the merging of personal and business income for tax purposes, there is still a full expectation that a sole proprietorship will maintain appropriate business records. Only certain expenses that are ordinary and necessary for the conduct of the business can be deducted from the business’s revenues. You cannot subtract your personal living costs from business income in determining how much taxable income you have derived from your business. Thus, appropriate segregation of personal and business affairs is a must, and good business accounting practices are to be followed for a sole proprietorship.
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CHAPTER 8Section 8.4 Accounting for Sole Proprietorships and Partnerships
Table 8.1 highlights the key features of various forms of business organization. The fea- tures and observations are broad generalizations but provide a frame of reference to con- sider when selecting an entity structure.
Table 8.1: Features of various business organizations
Sole Proprietorship Partnership Corporation
Ease of formation Yes Yes No
Multiple owners No Yes Yes
Transferability Not easily done Not easily done Easily done
Double taxation No No Yes
Liability protection No No Yes
Separate tax return No Yes Yes
Operating agility High Medium Low
Perpetual life No No Yes
Degree of regulation Low Medium High
8.4 Accounting for Sole Proprietorships and Partnerships
You have discovered that sole proprietorships and partnerships are easily formed and by similar actions. Remember, you can think of a sole proprietorship like a one- member partnership. Thus, the basic accounting for formation and most subsequent actions is handled in a virtually identical fashion. A key distinction is that a partnership has multiple capital accounts (one for each partner) representing a subdivision of total equity. This division is unnecessary with a sole proprietorship. Another unique facet is that unique accounting issues can arise when partners join/leave a partnership, and no equivalent counterpart issue exists for a sole proprietorship. Otherwise, it is safe to say that if you understand partnership accounting, you also understand accounting for a sole proprietorship. The following discussion focuses on the more complex partnership issues, with additional notes on modifications that are necessary for a sole proprietorship.
Basic Accounting Considerations
Recall that the choice of the entity rarely impacts the accounting for assets, liabilities, revenues, and expenses. Our focus is on key differences in equity accounting. You know that a corporation’s equity is subdivided into contributed capital (capital stock2related accounts) and retained earnings (the lifetime result of income less dividends). Partner- ships and sole proprietorships divide equity in an entirely different fashion. They report a capital account for each owner. Each capital account reflects the net balance of the owner’s investments and share of net income, reduced for withdrawals. Consider the three equity sections for a corporation, partnership, and sole proprietorship, respectively in Table 8.2.
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CHAPTER 8Section 8.4 Accounting for Sole Proprietorships and Partnerships
Table 8.2: Equity sections for a corporation, partnership, and sole proprietorship
Stockholders’ Equity
Capital Stock $ 100,000
Retained Earnings 900,000
Total Stockholders’ Equity $1,000,000
Partnership’s Equity
Owner Capital, Partner A $ 400,000
Owner Capital, Partner B 300,000
Owner Capital, Partner C 300,000
Total Partners’ Equity $1,000,000
Sole proprietorship’s Equity
Owner’s Capital $1,000,000
Initial Investments
A partnership’s or sole proprietorship’s initial activity usually begins when an owner transfers personal assets (e.g., cash or tangible assets) to the business. The following jour- nal entry shows the recording of unequal cash investments by three separate partners:
1-1-X6 Cash 25,000.00
Owner Capital, Anson 12,000.00
Owner Capital, Ortiz 8,000.00
Owner Capital, Payne 5,000.00
To record initial capital investments by Anson, Ortiz, and Payne
In the event of liquidation, each partner’s final cash settlement will be for the balance of his or her capital account (after bringing all accounts and activities current). This explains the justification for correctly recording each partner’s capital contribution at the correct amount. To do otherwise would set in motion a capital account that is forever out of sync with contributions. Importantly, the capital account proportion does not necessarily cor- respond to the income share; Anson, Ortiz, and Payne may have agreed to share profits and losses equally (or in any other proportion) despite their unequal capital investments.
Assume the preceding scenario is modified slightly such that Anson invested land rather than cash. Assume that the land originally cost Anson $4,000, but the partners all agreed it was worth $12,000 on the day Anson contributed it to the partnership. Under the revised scenario, the following entry is appropriate:
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CHAPTER 8Section 8.4 Accounting for Sole Proprietorships and Partnerships
1-1-X6 Cash 13,000.00
Land 12,000.00
Owner Capital, Anson 12,000.00
Owner Capital, Ortiz 8,000.00
Owner Capital, Payne 5,000.00
To record initial capital investments by Anson, Ortiz, and Payne
By reviewing this entry you can clearly see that the $4,000 land cost has become irrelevant, reflecting the general rule that each partner’s contribution should be measured on the partnership books at its fair value on the date of contribution. Failure to follow this gen- eral rule will inadvertently result in an eventual nonreciprocal transfer of wealth between the partners.
If Anson’s land was subject to a $3,000 note payable and the partnership assumed the obligation to make payments, Anson’s Capital account would be reduced, and the part- nership accounts would take on the debt, as follows:
1-1-X6 Cash 13,000.00
Land 12,000.00
Note Payable 3,000.00
Owner Capital, Anson 9,000.00
Owner Capital, Ortiz 8,000.00
Owner Capital, Payne 5,000.00
To record initial capital investments by Anson, Ortiz, and Payne
Income Sharing
Earlier, it was noted that in the absence of a specific profit-and-loss sharing agreement, income is simply shared equally between the partners. This approach would be fair and logical if all partners contributed equal amounts of capital and time, but such is rarely the case. Partnership agreements usually stipulate a model for splitting income. The models can be become complex but tend to reflect provisions designed to compensate parties for invested capital, time, and other variables that are seen as driving results.
To begin, recognize that partnership income is defined as the excess of revenues over expenses, excluding those expenses related to the income-sharing agreement. In other words, the profit-sharing agreement may designate that each partner is entitled to interest equal to 5% of their invested capital and salary based on hours dedicated to the business. Although interest and salaries are usually regarded as expenses in calculating income, such is not the case when the interest and salary clauses are defined pursuant to a model for sharing income. The interest and salary provisions are just mathematical tools for equi- table distribution of income.
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CHAPTER 8Section 8.4 Accounting for Sole Proprietorships and Partnerships
Partnership agreements need to be sufficiently specific to address what happens in the event that profits exceed the contemplated interest and salary provisions or if the firm experiences a loss. There are numerous scenarios and no standard outcome—thus the necessity for a carefully designed agreement.
To illustrate, assume that Anson, Ortiz, and Payne agreed that their partnership profits would be shared as follows:
1. Each partner receives an interest provision equal to 10% of invested capital. 2. Anson will receive an annual salary share of $25,000, and Payne will receive
$40,000. Ortiz is not active in the business and does not receive a salary. 3. Remaining profits are to be shared on a 4:4:2 ratio.
If the firm’s first-year income totaled $100,000, before salary and interest, then it would be shared among the partners as Table 8.3 shows.
Table 8.3: Income sharing in the Anson, Ortiz, and Payne partnership Anson Ortiz Payne Total
Interest (10%) $ 900 $ 800 $ 500 $ 2,200
Salary 25,000 0 40,000 65,000
Subtotal $25,900 $ 800 $40,500 $ 67,200
Residual (4:4:2) 13,120 13,120 6,560 32,800
Total $39,020 $13,920 $47,060 $100,000
The amount of income attributed to each partner does not necessarily equate to a with- drawal. Instead, it reflects the amount that should be credited to the partner’s capital account, as per the following entry that closes the 20X6 Income Summary account:
12-31-X6 Income Summary 100,000.00
Owner Capital, Anson 39,020.00
Owner Capital, Ortiz 13,920.00
Owner Capital, Payne 47,060.00
To close Income Summary to capital accounts of Anson, Ortiz, and Payne
This entry should appear at least reasonably familiar to you. In this entry, the Income Summary reflects the net summation of all revenues and expenses. It is otherwise very similar to the closing entry that was introduced in Chapter 3, except that the credits are to individual partner capital accounts rather than Retained Earnings. If any partner with- draws cash from the business corresponding to all or part of her or his income share, the following entry would be needed:
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CHAPTER 8Section 8.4 Accounting for Sole Proprietorships and Partnerships
12-31-X6 Owner Capital, Payne 10,000.00
Cash 10,000.00
Payne elected to withdraw $10,000 from the partnership
As an alternative, some partnerships may debit individual Drawing accounts for each partner, but they are eventually closed against the partner’s capital account. Thus, the net effect is as shown. The primary advantage of using separate Drawing accounts is that it shows an accumulated amount of total withdrawals for a period. That information is sometimes needed to monitor compliance with partnership agreement provisions and tax-reporting issues.
New Partners
From time to time, a new person may join the partnership. If the business is prosper- ous, it is reasonable to expect that the new partner will be required to buy his or her interest. There are exceptions, such as when the new partner is bringing an extraordinary reputation (e.g., perhaps you have seen a car dealership sporting the name of a famous sports figure), in which case he or she might be admitted into the partnership without any investment. However, when the new partner is buying his or her way into the business, the payment can flow to an existing partner or the partnership itself. The accounting treat- ment varies based on the nature of the purchase.
When an entering partner purchases his or her interest from another partner, the assets and liabilities of the firm remain constant. A journal entry is only needed to reduce the selling partner’s Capital account and increases the new partner’s Capital account.
1-1-X7 Owner Capital, Payne 21,030.00
Owner Capital, Zhu 21,030.00
Payne sold half of her interest to a new partner Zhu, for an undisclosed amount
There are several points to note about this entry. First, Payne sold one half of her interest. Thus, one half of her capital account must be transferred to the new partner, Zhu. Payne’s total Capital account before the transfer was $42,060 ($5,000 initial investment 1 $47,060 of income 2 $10,000 of withdrawals). It does not matter how much Zhu paid for the one-half interest (i.e., it could have been more or less than $21,030) because the money did not flow to the partnership. Payne might have a personal gain or loss, based on the sale price, but that fact does not bear on the partnership accounts. Finally, this transaction likely required approval from the other partners. Because partnerships are based on a theory of mutual agency, each partner normally preserves a right of input on the admission of a new member.
If Zhu had instead invested directly in the partnership, the accounting can become more involved. A number of scenarios and the accounting go well beyond the scope of this text. However, to illustrate one case, assume that Zhu purchased a 20% stake by transferring $100,000 cash directly into the firm. The partnership’s cash account must be increased by $100,000, as will the total equity. However Zhu’s share of total equity is only 20%. After
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CHAPTER 8Section 8.5 Corporate Equity Transactions
considering Zhu’s injection, the firm’s total equity is $212,000 ($22,000 original capital 1 $100,000 of income 2 $10,000 of withdrawals 1 $100,000 new investment), and Zhu’s share is $42,400 ($212,000 3 20%). What becomes of the difference between Zhu’s $100,000 injection and $42,400 capital share? This $57,600 amount is said to be a bonus to existing partners. It reflects the value they have added to the partnership share that is now trans- ferred to Zhu. Assuming that the partnership agreement stipulated that bonuses were to be shared in a 4:4:2 ratio, the following entry would be needed to record Zhu’s admission:
1-1-X7 Cash 100,000.00
Owner Capital, Anson 23,040.00
Owner Capital, Ortiz 23,040.00
Owner Capital, Payne 11,520.00
Owner Capital, Zhu 42,400.00
To record admission of Zhu, with a bonus to existing partners
Although not illustrated here, similar issues arise when an existing partner leaves the partnership. The existing partners or the partnership itself might buy out the leaving part- ner. The amount paid could reflect a price that is different from the reported amount of equity, and a transfer between capital accounts might be needed to maintain appropri- ately measured equity values.
8.5 Corporate Equity Transactions
To this point, we have assumed a fairly simple corporate structure. The equity section has consisted of capital stock and retained earnings. However, corporate entities may not be so simple. For starters, companies may have more than one type of stock.
The unique attributes for each type of stock are customized to meet the capital needs of the company while trying to appeal to a spectrum of investor demands. Many compa- nies will have only common stock, but other companies expand their equity financing to include other types such as preferred stock. Expanded forms of equity and debt financing will be covered in ACC 206. For now, be aware that alternative types of stock may have different features pertaining to voting rights, dividends, and liquidation preferences.
For example, each share of common stock usually has one vote that can be cast toward the election of a board of directors. Preferred stock usually lacks voting rights. Preferred stock usually gets a fixed amount of dividend each period but does not get to participate in excess profits that might be earned. In the event of liquidation, it is customary that pre- ferred shares receive back a liquidation value prior to any amounts being paid to common stock. The common stock is the residual interest, standing to receive the highest returns from significant business success or to sustain the most loss from business failure.
Even the accounting for common stock can introduce general issues beyond those previ- ously discussed. The next few paragraphs covers additional accounting aspects related to common stock. These topics include par value, dividends, treasury stock, stock splits, and
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CHAPTER 8Section 8.5 Corporate Equity Transactions
stock dividends. Even if you do not intend to be an accountant, this information should prove interesting and informative; you are likely to invest in stocks occasionally, and this knowledge will be help you understand more about your investments.
Par Value
Recall that states authorize the creation of corporations. Within enabling statutes is often a provision requiring newly formed corporations to designate a par value per share (or an alternative called stated value). Par value sets the legal capital of the firm, which is intended to represent the minimum amount of initial capital that investors are theoretically obliged to invest. Par value is usually set at a nominal amount (e.g., $.01 per share), and the actual issue price is typically well above par. Thus, par value is really just a legal formality in most cases. However, it does impact required reporting. The generally accepted account- ing principles (GAAP) require companies to detail the legal capital of the firm, separate and apart from amounts of investments exceeding par. This fact requires accountants to expand the journal entry that is required when stock is issued. Assume that Spice Corpo- ration issued 1,000,000 shares of $1 par value stock for $5 per share. The entry to record this stock issuance would be:
5-15-X1 Cash 5,000,000.00
Common Stock 1,000,000.00
Paid-in Capital in Excess of Par 4,000,000.00
To issue 1,000,000 shares of $1 par value stock for $5 per share
In reviewing the preceding entry, specifically note the new account, Paid-in-Capital in Excess of Par. This effectively separates invested capital into two components, both of which must be prominently displayed within stockholders’ equity.
Cash Dividends
Dividends are distributions to shareholders. Dividends are usually in form of direct cash payments and are intended to encourage and reward shareholders. They generally reflect profitable operations over time and reflect a return on the shareholder’s invest- ment. Dividends on common stock are not mandatory. Shareholders benefit from divi- dends, but they can also benefit when the corporation instead decides to reinvest in new opportunities. Thus, even profitable companies may decide that dividends are not the best use of resources.
When a board of directors does decide to pay a dividend, several events transpire. The first event is a declaration of the dividend. The declaration states the intent to pay a divi- dend and sets forth a legal duty to pay. The following entry is usually recorded at the time of dividend declaration:
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CHAPTER 8Section 8.5 Corporate Equity Transactions
8-10-X2 Dividends 500,000.00
Dividends Payable 500,000.00
To record declaration of $0.50 per share dividend on 1,000,000 outstanding shares of common stock
The declaration statement also needs to set forth other important information. Specifically, shareholders need to know the date of record and date of payment. The date of payment is self-explanatory. The following entry would occur on the date of payment:
10-10-X2 Dividends Payable 500,000.00
Cash 500,000.00
To record payment of previously declared dividends
The date of record precedes the payment date and establishes a cutoff point for determining which shareholders are to receive the dividend on the payment date. As a practical matter, the record date is preceded by a few days by an ex-dividend date. A stock is said to trade ex-dividend when the stock’s seller retains the right to previously declared dividends. In other words, the stock is trading without a right to the dividend. This time lag allows for shareholder records to be updated. Very simply, stockholders on the ex-dividend date will receive the dividends; if some of those holders subsequently sell their shares before the dividend payment date, they will nonetheless be entitled to the dividend payment.
Treasury Stock
When a company’s stock price is viewed as being too low and a company has sufficient cash, the board of directors may authorize that the company itself to reacquire some of the previously issued shares. This effort is seen as supporting the stock price and enhanc- ing value for shareholders who choose not to sell their stock back to the company. Such reacquired shares are termed treasury stock. Other reasons for buying back stock are to lessen the risk of takeover by another (returning cash to shareholders via stock buyback can reduce the attractiveness of a company to others) or to obtain shares that are needed for stock compensation awards to employees.
Accounting rules for treasury stock treat the transactions as purely equity in nature. Gains and losses are not recorded when a company issues stock, nor are they recorded for trea- sury stock transactions. Thus, one acceptable journal entry to record the purchase of trea- sury stock is as follows:
7-7-X7 Treasury Stock 300,000.00
Cash 300,000.00
To record purchase of 10,000 treasury shares at $30 per share
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CHAPTER 8Section 8.5 Corporate Equity Transactions
Under the approach shown, the Treasury Stock account reflects the cost of all shares reacquired. It is reported as a Contra Equity account and results in a difference in the reported number of shares issued versus those outstanding (i.e., issued minus shares held in treasury). If treasury shares are subsequently reissued, Cash would be increased for the amount received, and Treasury Stock would be reduced for the cost of the shares; any dif- ference may be debited or credited to Paid-in Capital in Excess of Par.
Stock Splits and Stock Dividends
Another unique set of corporate transactions relates to stock splits and stock dividends. These events result in a change in the shares outstanding, without any resource inflow to the company or change in total stockholders’ equity. For instance, a company may arrange for a 3:1 stock split. This triples the number of shares outstanding (and reduces the per- share par value into a third of the prior amount). Shareholders will hold three times as many shares but experience no increase in their proportional ownership (a shareholder owning 100 shares out of a total of 100,000 would become the owner of 300 shares out of a total of 300,000). The market value per share would likely be reduced to about one third of the value prior to the split. Of course, stock splits can come in any ratio (2:1, 4:3, etc.). Indeed, companies may also engage in a reverse split (2:3, 1:5, etc.). These reverse splits reduce the number of shares and increase the market value per share.
The reasons typically cited for stock splits are to impact the market price per share and change the number of shares outstanding. A company may do a reverse split to reduce the number of shares and increase the value per share. Some stock exchanges require that stocks trade above $1 per share, and the reverse split is a tool to accomplish this purpose. Conversely, stocks that have appreciated significantly (into the hundreds of dollars per share) may be seen as too pricey by some investors. The stock split will reduce share price to what may seem to be a more attractive price point and increase the shares outstanding, thereby opening up investment to a broader group of shareholders. In the final analysis, a stock split is mostly cosmetic because it does not change the underlying economics of the firm.
The accounting for a stock split is easy. Because the total par value of all shares outstand- ing is not affected by a stock split (i.e., number of shares times par value per share is the same amount before and after the split), no journal entry is needed. Recall that total equity is not changed, and no specific account balance total within equity is changed. Thus, all that is necessary is a notation of the new par value and number of shares.
As a practical matter, stock dividends are much like stock splits but are carried out in a different legal form and require a unique entry. A stock dividend results in an increase in shares outstanding via an issuance of more shares to existing shareholders. For instance, a 10% stock dividend would result in the issuance of 10 additional shares to a shareholder holding 100 shares. All shareholders would have 10% more shares, so the percentage of the total outstanding stock owned by a specific shareholder is not increased. The differ- ence between a stock split and stock dividend is that a stock dividend does not result in a change in per-share par value. Instead, the Retained Earnings account is reduced for the fair value of the additional shares issued. The offset is reflected as an increase in Common stock and Paid-in Capital in Excess of Par. Consider the following entry:
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CHAPTER 8Section 8.5 Corporate Equity Transactions
10-15-X5 Retained Earnings 1,500,000.00
Common Stock 100,000.00
Paid-in Capital in Excess of Par 1,400,000.00
To record issuance of 10% stock dividend, assuming 1,000,000 shares of $1 par value stock previously outstanding and having a market value of $15 per share (1,000,000 3 10% 3 $15 $1,500,000)
The above entry must be modified for large stock dividends, generally regarded as those above 20 to 25%. Instead, only the par value of the newly issued shares is capitalized (i.e., debit Retained Earnings for par of new shares and credit only Common Stock). To illus- trate, assume that a company issues a 40% stock dividend:
10-15-X5 Retained Earnings 400,000.00
Common Stock 400,000.00
To record issuance of 40% stock dividend, assuming 1,000,000 shares of $1 par value stock previously outstanding and having a market value of $15 per share
In the above entry, 400,000 new shares of $1 par value stock are issued (1,000,000 3 40%). The journal entry reflects that the Retained Earnings account is reduced only by the par of the newly issued shares. The market value is ignored for large stock dividends. The accounting rule differentiating between treatment of small and large stock dividends is ostensibly based on the logic that a large stock dividend will cause a material decline in per-share stock price, thus rendering the market value unreliable as a basis for recording the journal entry.
Income Reporting
Within the exception of certain equity-related transactions (such as dividends, treasury stock transactions, etc.), virtually all transactions that result in a change in equity are chan- neled through the income statement. However, accountants sometimes wish to call special attention to special or nonrecurring items. For example, a business may experience a gain or loss that results from an event that is both unusual in nature and infrequent in occur- rence (e.g., an earthquake in a region regarded as having stable geology). Such events are said to be extraordinary items. When both conditions are met (unusual in nature and infrequent in occurrence), the item is separately reported, including its tax consequences, following income from continuing operations. Exhibit 8.1 is a presentation of an income statement including an extraordinary item.
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CHAPTER 8Section 8.5 Corporate Equity Transactions
Exhibit 8.1: An income statement that includes an extraordinary item
Another situation in which the income statement is modified is for discontinued opera- tions. The presentation would appear virtually identical to that shown for Braxton Cor- poration, except that the extraordinary item section would instead reflect the gain or loss (net of tax) on disposal of the line of business. Reporting of a discontinued segment is triggered when a separate major line of business is sold or abandoned. The income report- ing model is intended to segregate discontinued operations from continuing operations. Thus, the discontinued operations section would reflect the results of operating the dis- continued segment as well as any gain or loss on its sale. Exhibit 8.2 is an example of the reporting of a discontinued operation by Saxton Corporation. Saxton was engaged in food and clothing businesses, and recently exited the clothing business.
Sales
Cost of goods sold
Gross profit
Operating expenses
Income from continuing operations before income taxes
Income taxes
Income from continuing operations
Extraordinary item
Net Income
Salaries
Rent
Other operating expenses
Uninsured loss from earthquake at corporate office
Income tax benefit from loss
Extraordinary loss net of tax
$ 16,500,000
9,900,000
$ 26,400,000
3,210,000
$ 23,190,000
1,200,000
$ 21,990,000
1,410,000
$ 20,580,000
$ 1,905,000
405,000
900,000
$ 1,800,000
390,000
Braxton Corporation Income Statement
For the Year Ending December 31, 20X2
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CHAPTER 8Section 8.6 Corrections of Errors and Changes in an Accounting Method
Exhibit 8.2: An income statement that includes discontinued operations
Although beyond the scope of this text, you should be aware that accountants sometimes calculate special adjustments for (1) translating foreign currency2based financial state- ments of foreign subsidiaries, (2) certain pension plan calculations, and (3) changes in market value of selected longer-term investments. These unique accounting adjustments (sometimes referred to as elements of other comprehensive income, or OCI) are not reported as part of income from continuing operations but are afforded full disclosure in an expanded statement of comprehensive income. If you go on to study advanced accounting or rou- tinely look at the financial statements of large corporate entities, you are apt to see a com- prehensive income statement including these unique elements.
8.6 Corrections of Errors and Changes in an Accounting Method
Mathematical mistakes, incorrect reporting, omissions, and the like are regarded as accounting errors. Accountants are obligated to correct errors. If the error is material, all prior periods effected must be corrected and represented using the corrected approach. This is termed a prior period adjustment. It is of course possible that the error will reach back many years; usually it is sufficient to just report corrected statements for the prior 2- or 3-year period and roll the remaining effects into a revision of the opening Retained Earnings of the earliest period presented. In addition to correcting financial reports, it is also necessary to update the ledger account. This typically entails a change to one or more Asset or Liability accounts, with an offsetting balance impact to Retained Earnings.
Another change to previously presented reports can be triggered by a change in accoun- ting method. In other words, a company adopts an alternative accounting principle, such
Sales
Cost of goods sold
Gross profit
Operating expenses
Income from continuing operations before income taxes
Income taxes
Income from continuing operations
Discontinued operations
Net Income
Salaries
Rent
Other operating expenses
Loss from operation of clothing unit, including loss on disposal
Income tax benefit from loss on disposal of business unit
Loss on discontinued operations
$ 11,000,000
6,600,000
$17,600,000
2,140,000
$ 15,460,000
800,000
$ 14,660,000
940,000
$ 13,720,000
$ 1,270,000
270,000
600,000
$ 1,200,000
260,000
Saxton Corporation Income Statement
For the Year Ending December 31, 20X7
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CHAPTER 8Concept Check
as changing from one acceptable inventory method to another. GAAP requires that such changes be made by retrospective adjustment. As a practical manner, this requires the financial information of prior periods to be redone “as though” the newer method has always been in use. Additionally, disclosures must indicate why the newly adopted method is preferable and call attention to differences in reported amounts because of the change.
A change in accounting method should not be confused with a change in accounting estimate. An example of a change in estimate was discussed in Chapter 6. There, it was shown that changes in estimate are handled prospectively by adjusting only the current and future periods.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 236.)
1. Which of the following statements is false? a. All corporations issue preferred stock. b. Stockholders have limited liability. c. Corporate earnings are subject to double taxation. d. Corporations face heavier governmental regulation than sole proprietorships.
2. Which of the following rights do not apply to common stockholders? a. The right to share in dividends if declared by the board of directors b. The preemptive right c. The right to vote on changes in a corporation’s bylaws d. The right to receive dividends that are in arrears
3. Fenton Corporation is authorized to issue 10/000 shares of $5 par value common stock. If 60% of these shares are issued at $20, what amount should be credited to the Common Stock account?
a. $30,000 b. $50,000 c. $90,000 d. $120,000
4. Bright Eyes Inc. has 100,000 shares outstanding of $5 par value common stock and 10,000 shares of $100 par value preferred stock. The preferred stock is cumulative and has a price of $115 per share. If there are no dividends in arrears and total stock- holders’ equity amounts to $4,000,000, what is the book value per share of the com- mon stock?
a. $2.85 b. $5.00 c. $28.50 d. $30.00
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CHAPTER 8
change in accounting method Adopting an alternative but still acceptable method of accounting.
dissolution The breakup of a partnership.
extraordinary item An event causing a gain or a loss that are both unusual in nature and infrequent in occurrence.
initial public offering (IPO) A privately held company’s offering of the first sales of its stock to the public.
IPO See initial public offering.
limited liability A principle of corpora- tions stating that stockholders can only lose the amount of their investment to creditors.
limited life The nature of partnership in that partnership passes with the death of a partner.
liquidation The formal termination of an entity.
mutual agency In a partnership, the indi- vidual partner’s right to commit or obli- gate the entire partnership.
par value Sets the legal capital of the firm, which is intended to represent the mini- mum amount of initial capital that inves- tors are theoretically obliged to invest.
perpetual existence A characteristic of a corporation, meaning that it will continue to exist and operate until it is merged with another, fails, or a corporate action is undertaken to liquidate the company.
prior period adjustment The correction of an accounting error in all periods affected.
retrospective adjustment The require- ment that when a company changes from one acceptable accounting method to another, it must redo financial informa- tion of prior periods as though the newer method had always been in use.
treasury stock The shares reacquired by the issuing company when the stock price is viewed as being too low.
unlimited liability In partnerships, a partner has liability for debts, claims, and obligations of the partnership even after he or she resigns from the partnership.
Critical Thinking Questions
Key Terms
Critical Thinking Questions
1. What is a corporation? Discuss the advantages of the corporate form of organization. 2. Briefly explain the disadvantages of the corporate form of organization. 3. Discuss the meaning of legal capital. 4. Why is stock rarely issued below par value? 5. Do changes in a stock’s market value influence a company’s financial position?
Briefly discuss.
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CHAPTER 8Problem
Exercise
Stockholders’ equity concepts. Evaluate the comments that follow as being true or false. If the comment is false, briefly explain why.
a. Corporations are subject to double taxation. Thus, a 40% tax rate on income be- comes an effective tax rate of 80% to the corporation.
b. Common stockholders are likely to be rewarded with increases in the market value of their shares as a corporation becomes more profitable.
c. Par value virtually always coincides with a stock’s original issue price. d. Par value stock is generally worth more than no-par stock.
Problem
Issuance of stock: organization costs. Snowbound Corporation was incorporated in July. The firm’s charter authorized the sale of 200,000 shares of $10 par-value common stock. The following transactions occurred during the year:
7/1: Sold 45,000 shares of common stock to investors for $18 per share. Cash was collected and the shares were issued.
7/7: Issued 600 shares to Sharon Dale, attorney-at-law, for services rendered during the corporation’s organizational phase. Dale charged $12,600 for her work.
8/11: Sold 20,000 shares to investors for $22 per share. Cash was collected and the shares were issued.
12/14: Issued 30,000 shares to the MJB Company for land valued at $900,000.
Instructions Prepare journal entries to record each transaction.
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chapter 9
Analysis
Learning Goals
• Convert financial statements to a common size and perform trend analysis.
• Perform liquidity analysis by evaluating working capital, the current ratio, and the quick ratio.
• Perform debt service analysis via the debt-to-assets, debt-to-equity, and times- interest-earned ratios.
• Evaluate accounts receivable and inventory turnover.
• Analyze trends in profitability through examining margins and rates of return.
• Calculate earnings per share and book value per share.
Copyright Barbara Chase/Corbis/AP Images
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CHAPTER 9Section 9.1 Common-Size Financial Statements
Chapter Outline 9.1 Common-Size Financial Statements 9.2 Ratio Analysis 9.3 Liquidity Analysis 9.4 Debt Service Analysis 9.5 Turnover Analysis 9.6 Profitability Analysis 9.7 Other Measures 9.8 Recap and Summary Illustration
By now, you have developed an appreciation for the basic principles and practices used to develop key financial reports. As noted many times, financial statements are intended to benefit investors and creditors in their quest to make informed decisions about buying stock from or lending money to a company. The focus now turns to the analytical process by which information extracted from an accounting system can be examined in a thoughtful and systematic fashion.
Users of financial statements often engage in comparative analysis; that is, they have choices. They can make either equity investments or loans, and they likely have multiple firms to choose from. Clearly, the goal is to maximize anticipated returns based on the risk level that they are willing to entertain. Common-size financial statements and ratio analysis are tools that can facilitate this process.
9.1 Common-Size Financial Statements
The concept of common-size financial statements relates to scaling the dollar amounts within financial statements to percentage terms. The purpose of the scal- ing process is to facilitate comparisons across firms and/or time. There are many ways in which this scaling can occur. The following examples will illustrate a few of the possible scenarios and are sufficient to provide you with a conceptual understanding that you can then adapt to almost any type of evaluation.
Exhibit 9.1 is a comparative income statement for Ace Company for 2 consecutive years. This is the traditional format that you are already well acquainted with.
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CHAPTER 9Section 9.1 Common-Size Financial Statements
Exhibit 9.1: A comparative income statement
The 20X3 income statement reveals a profit of $48,000, based on $250,000 in sales. Net income doubled from the prior year’s $24,000 amount; sales did not. Though apparent that income increased significantly, it is not readily apparent why. The cause for the dou- bling in income can be clarified via both vertical and horizontal analyses.
A vertical analysis of income results when each expense category is expressed as a per- centage of sales. In other words, each item within the vertical column of data is expressed in relation to (as a percentage of) the top item in the column: sales. The vertical analysis in Exhibit 9.2 reveals how each line item component of income relates to revenue, on a percentage basis.
Exhibit 9.2: An income statement showing a vertical analysis
By reviewing this vertical analysis of income, you can readily see that cost of goods sold is about 40% of sales. The remaining gross profit of around 60% is allocated to operating expenses, taxes, and net income. On a relative basis, you can also tell that most expenses were at a fairly steady percentage of sales for both years, with a noted exception for the decrease in operating expenses; indeed, a large portion of the increase in income appears to be due to the reduction in the operating expense proportion.
Sales
Cost of goods sold
Gross profit
Operating expenses
Income before tax
Income taxes
Net Income
20X3 20X2
Ace Company Income Statement
For the years ending December 31
$ 250,000
100,000
$ 150,000
80,000
$ 70,000
22,000
$ 48,000
$ 225,000
95,000
$ 130,000
88,000
$ 42,000
18,000
$ 24,000
Sales
Cost of goods sold
Gross profit
Operating expenses
Income before tax
Income taxes
Net Income
100.00% 100.00%
40.00% 42.22%
60.00% 57.78%
32.00% 39.11%
28.00% 18.67%
8.80% 8.00%
19.20% 10.67%
Ace Company Income Statement
Vertical Common Size Report For the years ending December 31
20X3 20X2
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CHAPTER 9Section 9.1 Common-Size Financial Statements
A horizontal analysis can be used to compare data from within two or more periods, side-by-side. In other words, it is intended to show the change in certain accounts from two separate accounting periods. Horizontal analysis can be very helpful in looking for trends in a company’s income. Consider Exhibit 9.3 and the comments that follow.
Exhibit 9.3: An income statement showing a horizontal analysis
The horizontal analysis in Exhibit 9.3 shows that sales increased by only 11%, but gross profit increased by 15%. This is reflective of the slightly reduced cost of goods sold per- centage. Operating expenses decreased by 9%, notwithstanding the increase in overall sales. The impacts of the slight improvement in gross profit, coupled with the decrease in operating expenses, resulted in a dramatic rise in income. This type of analysis is not complex or brilliant, but it is illuminating. It will definitely cause you to focus on changes that need to be monitored closely.
Vertical and horizontal analyses are also applicable to balance sheet presentations. These analyses can be used to pinpoint shifts in key business elements, such as a buildup of inventory, capital investments, changing debt levels, and so forth. Many of these impor- tant trends are additionally monitored by ratios that are discussed later in this chapter. But, the common-size financial statements can cause important trends or problems to “pop off the page” and be noticed. You can almost think of this technique like radar, con- stantly scanning financial reports for emerging storm clouds! Examine the balance sheets in Exhibits 9.4, 9.5, and 9.6 and see what trends that you can identify.
Sales
Cost of goods sold
Gross profit
Operating expenses
Income before tax
Income taxes
Net Income
+ 11%
+ 5%
+ 15%
_ 9%
+ 67%
+ 22%
+ 100%
Ace Company Income Statement
Horizontal Common Size Report 20X3 Change Over 20X2
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CHAPTER 9Section 9.1 Common-Size Financial Statements
Exhibit 9.4: A comparative balance sheet
Exhibit 9.5: A balance sheet showing a vertical analysis
Cash
Accounts receivable
Inventory
Investments
Land
Buildings (net)
Equipment (net)
Total Assets
Accounts payable
Notes payable
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities and equity
$ 80,000
135,000
210,000
500,000
190,000
624,000
400,000
$ 2,139,000
$ 85,000
810,000
$ 895,000
$ 500,000
744,000
$ 1,244,000
$ 2,139,000
$ 100,000
225,000
175,000
600,000
190,000
610,000
435,000
$ 2,335,000
$ 143,000
790,000
$ 933,000
$ 500,000
902,000
$ 1,402,000
$ 2,335,000
Base Corporation Comparative Balance Sheets December 31, 20X5 and X6
20X6 20X5
4.28%
9.64%
7.49%
25.70%
8.14%
26.12%
18.63%
100.00%
3.97%
37.87%
41.84%
23.38%
34.78%
58.16%
100.00%
Base Corporation Balance Sheet
December 31, 20X6 and X5
Cash
Accounts receivable
Inventory
Investments
Land
Buildings (net)
Equipment (net)
Total Assets
Accounts payable
Notes payable
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities and equity
3.74%
6.31%
9.82%
23.38%
29.17%
8.88%
18.70%
100.00%
3.97%
37.87%
41.84%
23.38%
34.78%
58.16%
100.00%
20X520X6
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CHAPTER 9Section 9.2 Ratio Analysis
Exhibit 9.6: A balance sheet showing a horizontal analysis
Common-size financial statements are often reported on investment research websites, in reports prepared by financial statement analysts, and others. The company itself typically does not present them. It is essential that financial statement users and others do their own research and analysis, and converting published financial statements to common- size reports is an excellent starting point.
9.2 Ratio Analysis
An automobile is a complex machine. Think of all the data you must monitor to know that it is functioning correctly. Tire pressure, speed, water temperature, voltage, rpms, and so forth are numbers that you may constantly monitor. Numbers that are out of the normal operating range can serve as early warning signs that something is going wrong. For instance, if the water temperature gauge is rising above 200 degrees, you may suspect that trouble is coming; perhaps your car is losing water from a broken hose. So you fix the minor problem before it becomes major and requires a costly solution. In the same way, investors and creditors may develop their own ratios and keep a watchful eye for trouble. The ratios are divisible into categories related to liquidity measures, debt service, turnover, and profitability. In addition, a host of other measures may be of great interest.
20X6
125.00%
166.67%
83.33%
120.00%
100.00%
97.76%
108.75%
109.16%
168.24%
97.53%
104.25%
109.16%
109.16%
109.16%
109.16%
Base Corporation Balance Sheet
Horizontal Common Size Report December 31, 20X6 and X5
Cash
Accounts receivable
Inventory
Investments
Land
Buildings (net)
Equipment (net)
Total Assets
Accounts payable
Notes payable
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities and equity
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CHAPTER 9Section 9.3 Liquidity Analysis
9.3 Liquidity Analysis
Investors and creditors must be vigilant to monitor a company’s liquidity, or ability to meet near-term obligations as they mature. A company with a strong balance sheet and robust sales can still find itself in deep trouble by running out of cash. This can happen when resources become bound up in receivables, inventory, and plant assets. Therefore, management, investors, and creditors will all follow a company’s liquidity trends and condition. Two ratios, the current and quick ratios, are particularly intended to signal the potential for liquidity challenges.
First, to understand liquidity better, you also need to become familiar with the concept of working capital. It is the amount of current assets minus current liabilities. Assume that Ashcroft Company has current assets of $1,000,000 and current liabilities of $400,000; the working capital is $600,000. Normally, one hopes to find that a company has a signifi- cantly positive amount of working capital. Having positive working capital can provide some comfort that the company has sufficient access to assets that are readily convertible to cash and will therefore be able to meet liabilities as they come due.
The preceding generalization is sometimes not true, however. A firm’s current assets could be invested in slow-moving inventory. These goods would be of little value in meet- ing obligations. Indeed, the obligations may have arisen upon purchase of the goods. The seller of the goods would hardly be interested in receiving them back; they expect to be paid in cash. Conversely, some businesses manage cash flow very effectively. They may provide goods and services and have little invested in inventory or receivables. A restau- rant is an excellent example.
A restaurant may have a relatively small (fresh food) inventory, and customers may all pay with cash or credit cards. The restaurant may purchase their supplies on extended credit terms. The profits and free cash flows that are generated may be constantly pulled from operations and channeled into new locations and facilities. Thus, it is not particularly rel- evant that the working capital is small (or even negative) at a particular time. Nonetheless, careful budgeting needs to be conducted to ensure that too much cash is not redirected from operations because the existing payables do need to be satisfied at some point.
How much working capital is enough? The answer to this question is partially answered by giving consideration to the issues raised in the preceding paragraphs. However, you also need to know about the size of the business. A small business may function well with $100,000 of working capital, while a large business may run short with $100,000,000 of working capital. Therefore, working capital is sensitive to the size of the business. You must also give consideration to the industry that a business operates in. An automobile manufacturer can be expected to have significant amounts of inventory, and this leads to an ordinary condition of a large amount of current assets and working capital. On the other hand, inventory may be totally lacking in service businesses, and they may have a much reduced level of working capital as a result.
Analysts may scale the evaluation of working capital to a ratio that relates current assets to current liabilities. The current ratio reveals the relative amount of working capital by dividing current assets by current liabilities:
Current Ratio 5 Current Assets / Current Liabilities
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CHAPTER 9Section 9.3 Liquidity Analysis
Table 9.1 lists Ashcroft’s current assets and current liabilities.
Table 9.1: Ashcroft's current assets and liabilities
Cash $ 150,000 Accounts Payable $ 50,000
Accounts Receivable 250,000 Wages Payable 125,000
Inventory 400,000 Interest Payable 85,000
Prepaid Assets 200,000 Taxes Payable 140,000
$1,000,000 $400,000
Ashcroft’s current ratio is 2.5:1 ($1,000,0004$400,000). This ratio does not seem to indicate any particular problem with liquidity. One thing you do need to consider is that com- panies may be able to manipulate their current ratio. For instance, suppose Ashcroft’s bank required them to maintain at least a 3:1 current ratio. Using existing resources, how could this be accomplished? The answer is easier than you might think. If Ashcroft used $100,000 of cash to immediately pay $100,000 of taxes payable, total current assets would be reduced to $900,000 and total current liabilities would be reduced to $300,000. This changes the ratio to the target of 3:1. While this might help the current ratio, it could actu- ally restrict the company’s financial flexibility by immediately forgoing part of its cash supply. Although ratios may be subject to short-term manipulation, they are nonetheless highly indicative of business performance, and this limitation should not dissuade you from proper use of these popular techniques for financial statement analysis.
It was already pointed out that current assets include inventory and prepaids that are of little use in satisfying current debts. Therefore, it is also a helpful to calculate a more stringent liquidity measure known as the quick ratio. This ratio is calculated by dividing quick assets by current liabilities. Quick assets are cash and other assets that are readily and quickly converted to cash. The latter includes short-term investments and accounts receivable. The following formula is used to calculate the quick ratio:
Quick Ratio 5 (Cash Accounts Receivable) / Current Liabilities
Ashcroft’s quick ratio is 1:1 ($400,000 of cash and receivables divided by $400,000 of cur- rent liabilities). By removing the inventory and prepaids, you may gain greater insight into the ability of a firm to be truly ready to meet maturing financial obligations.
Before moving on the next category of ratios, consider that obligations that are not yet reflected as current liabilities may also be looming. Suppose the company has a contract that requires them to make monthly payments to a janitorial firm. The commitment is real, but the future services have not yet been received. Thus, neither the expense nor liability is as yet reported. Still, these types of contractual commitments may entail a firm a duty to pay and are sometimes reported in notes to the financial statements. This example provides further evidence that ratio analysis must be used with caution. An informed investor or creditor should thoroughly research not only the ratios but also all available information.
waL80144_09_c09_197-224.indd 8 8/29/12 2:44 PM
CHAPTER 9Section 9.4 Debt Service Analysis
9.4 Debt Service Analysis
The current and quick ratios provide insight on immediate liquidity issues. There is another set of issues related to a company’s broader solvency, or the ability to satisfy long-term structural debt. Even if debt is not due to be repaid in the near term, interest payments must be made. Then, at the time of a long-term obligation’s maturity, it must be paid or refinanced. Thus, users of financial statements have developed another family of ratios and analysis techniques designed to evaluate a company’s ability to service its debt. One such ratio is the debt-to-total-assets ratio. This ratio evaluates the proportion of the asset pool that is financed with debt:
Debt-to-Total-Assets Ratio 5 Total Debt / Total Assets
A variation of this ratio is the debt-to-equity ratio that compares total debt to total equity:
Debt-to-Equity Ratio 5 Total Debt / Total Equity
Both of these ratios are carefully monitored by investors, creditors, and analysts. General- izing, it is difficult to go broke when a business has manageable debt loads, as reflected by small values for these ratios. However, comparative analysis requires careful consider- ation of the industry that a business operates in. Some industries, like public utilities, are customarily financed by large pools of debt financing. Their regulated rates are generally set at a level that is high enough to provide comfort about their debt-serving ability. This is true despite those businesses being highly leveraged with debt.
At other times, even a small amount of debt can become a problem when a business’s future looks bleak. Banks and other creditors may be interested in getting their money back and be unwilling to renew or extend debt financing that would otherwise be a rou- tine transaction. Another challenge in interpreting the ratios is when a company has a large amount of intangible assets. Those assets can be difficult or impossible to convert to cash. Nevertheless, they impact the ratio calculations in a way that paints a picture of financial health. You are likely getting the message again: Ratio analysis is helpful in assessing a company, but only when done with great care.
The times-interest-earned ratio is also used to evaluate debt service capacity. It shows how many times that a company’s income stream will cover its interest obligation:
Times-Interest-Earned Ratio 5 Income Before Income Taxes and Interest / Interest Charges
When this number drops to a small value, it signals that the company’s operating results may become insufficient to cover interest obligations. When that happens, creditors may force foreclosure of assets or other remedies that threaten the company’s ability to exist.
The following list provides facts for Brynn Corporation, followed by calculations of these key debt service indicators.
waL80144_09_c09_197-224.indd 9 8/29/12 2:44 PM
CHAPTER 9Section 9.5 Turnover Analysis
Total assets $800,000 Total liabilities 200,000 Total equity 600,000 Net income 60,000 Income taxes 40,000 Interest expense 20,000
Brynn’s debt-to-total-assets ratio is 0.25, calculated by dividing $200,000 in debt by $800,000 in assets. The debt-to-equity ratio is 0.333, calculated by dividing $200,000 in debt by $600,000 in equity. The times-interest-earned factor is 6, calculated as $120,000 (income before interest and taxes: $60,000 $40,000 $20,000) divided by $20,000 in interest. You may wonder why back taxes and interest are included in calculating the lat- ter ratio. The reason is that the interest reduces both income and taxes, and knowing how many times interest can be paid before incurring those costs is wanted.
9.5 Turnover Analysis
One of the more dreadful problems a business can encounter is selling on credit and then not being able to collect amounts due. A similar problem is building up inven- tory and being unable to sell it at all. Either of these situations can eventually prove fatal to a business. Management must take great care to avoid this outcome. Both investors and creditors can sometimes get an advance hint about such problems by performing turnover analysis.
First, focus on accounts receivable. You already know that much attention is devoted to accounting for bad debts. A company must minimize bad debts by monitoring credit poli- cies, considering the credit history of potential customers, and being certain not to aban- don good sense in trying to generate all possible sales. A business should require custom- ers to prepare a credit application, check credit references, and obtain credit reports. If possible, a security deposit or bank guarantee may significantly reduce credit risk.
The collection rate must also be monitored. A large sum of money is sometimes nested in accounts receivable, and liquidity is impacted if receivables are not actively managed. The accounts-receivable-turnover ratio is a useful tool in this regard. It shows the number of times a firm’s receivables are converted to cash during a year. This tool is useful in signaling if a company is having trouble collecting receivables on a timely basis. If the turnover pace is slowing, it may signal impending collection risks or a general business slowdown. It is also helpful for comparing one business to another because it provides insight into the degree to which credit is extended and monitored. Net credit sales are divided by the average net accounts receivable:
Accounts-Receivable-Turnover Ratio 5 Net Credit Sales / Average Net Accounts Receivable
One method for finding the average net accounts receivable balance is to divide the sum of the beginning and ending receivables balances by 2. For example, assume that Zollinger had annual net credit sales of $10,000,000, beginning accounts receivable of $600,000, and ending accounts receivable of $1,000,000. Zollinger’s turnover ratio is calculated as follows:
waL80144_09_c09_197-224.indd 10 8/29/12 2:44 PM
CHAPTER 9Section 9.5 Turnover Analysis
12.5 5 $10,000,000 / (($600,000 $1,000,000) / 2)
A derivative calculation is the days outstanding ratio. It reveals how many days sales are carried in the receivables category. Zollinger’s days outstanding are 29.2, calculated as follows:
365 Days / Accounts-Receivable-Turnover Ratio 5 Days Outstanding Ratio
365 / 12.5 5 29.2
The significance of values like 12.5 or 29.2 can only be considered in context. They must be compared to industry trends and prior years as well as credit terms used by the company. Changes in values may provide signs of looming problems, such as a weakening economy or bad business decision making.
Inventory-turnover ratios are very similar in nature. Inventory is expensive and subject to obsolescence, damage, and spoilage. It is costly to store and involves a potentially huge commitment of financial capital. It is a delicate balance to maintain levels to adequately support key customers but avoid overstock. Equilibrium in inventory levels is delicate and easily lost. The inventory-turnover ratio is used to maintain focus on proper inven- tory management and to signal failings in this regard. This ratio reveals the number of times that a firm’s inventory balance is turned over or sold during a particular year.
For example, The Home Depot turns its inventory about six to seven times per year, which is a turnover ratio of 6 to 7. This means the “average” item of inventory will sit on the shelf for slightly less than 60 days before finding a buyer. By itself, this datum is interesting but, when used to compare activity from year to year, it can signal improving or worsening economic conditions. It can also be compare to other companies, like Lowes, which has a slightly lower inventory turnover ratio of 5 to 6. In other words, The Home Depot usually turns it inventory faster than Lowes. The inventory-turnover ratio is calculated via the following formula:
Inventory-Turnover Ratio 5 Cost of Goods Sold / Average Inventory
Notice that this calculation bears a striking resemblance to the accounts-receivable- turnover ratio. The average inventory balance can be found by dividing the sum of the beginning and ending inventory balances by 2. When a company’s average inventory is $2,500,000 and cost of goods sold is $25,000,000, the inventory turnover ratio is 10. This means that the inventory stock is turning over about once every 36.5 days (365 divided by 10). The meaningfulness of this information must again be considered in context. A car dealer might be very pleased with this number, whereas a vegetable supplier might find this to be disastrously poor. Probably more important than fixating on the value is to observe the trend in this number. The objective is to detect emerging challenges that might be signified by changes in these numbers. Further, if you are comparing inventory- turnover ratios for competing firms, be sure to note that the choice of inventory methods (e.g., FIFO vs. weighted average) can cause distortions in comparative analysis.
waL80144_09_c09_197-224.indd 11 8/29/12 2:44 PM
CHAPTER 9Section 9.6 Profitability Analysis
9.6 Profitability Analysis
Investors are especially interested in knowing that businesses that they invest in are capable of producing an eventual profit. As a very broad generalization (and therefore subject to many exceptions), the more profitable a firm is, the more valuable it is. Owning 10% of a business making a total profit of $1,000,000, rather than 1% of a business mak- ing $2,000,000 in profits, is more desirable. Thus, it is necessary to evaluate profitability not only in the aggregate but also on a scale, or ratio, basis. There are many ways to perform profit analysis. To begin, two key ratios are the gross-profit-margin ratio and net-profit-margin ratio:
Gross-Profit-Margin Ratio 5 Gross Profit / Net Sales
Net-Profit-Margin Ratio 5 Net Income / Net Sales
Both ratios examine profitability in relation to sales. The gross-profit-margin ratio exam- ines the proportion of sales that is leftover after taking into account only the cost of the units sold. This proportion is then used to absorb selling, general, and administrative costs. The net-profit-margin ratio reflects the final residual amount. If Mega Corpora- tion had sales of $5,000,000, cost of goods sold of $2,000,000, and net income of $500,000, its gross profit margin would be 60% [($5,000,000 2 $2,000,000)4$5,000,000], and its net profit margin would be 10% ($500,0004$5,000,000). As you can see, calculating these two ratios is very simple and based on information prominently appearing on the income statement. Comparing profits rates over time and across companies is perhaps among the most common form of financial statement analysis. Both rates are important to monitor because they provide signals about business scalability and sustainability, regardless of firm size. (These issues are examined in more detail in a managerial accounting course.)
Another way to examine profitability is to compare profits to invested assets and equity. Here, the goal is to compute how effectively assets and equity are being used to generate profits. The return-on-assets (ROA) ratio is calculated by dividing income before inter- est cost by the average assets used in the business:
Return-on-Assets Ratio 5 (Net Income Interest Expense) / Average Assets
The ROA ratio is an attempt to focus attention on the amount of income, before financing costs, that is generated by the business’s assets. In other words, looking at how much the assets earned, exclusive of what it costs to finance them. In some ways, this reflects man- agement’s stewardship and skill at using business assets in an effective and efficient way. The next ratio looks at net income in comparison to invested capital and takes into account the business’s financing costs.
The return-on-equity (ROE) ratio evaluates income in relation to the amount of invested common shareholder equity:
Return-on-Equity Ratio 5 Net Income / Average Common Equity
The ROE ratio evaluates management effectiveness at using shareholder equity. The ratio implicitly recognizes that a business might borrow substantial funds to acquire assets and deploy those assets to earn at a rate that is higher (positive leverage) or lower (negative
waL80144_09_c09_197-224.indd 12 8/29/12 2:44 PM
CHAPTER 9Section 9.7 Other Measures
leverage) than the cost of borrowed funds. In other words, leverage relates to the use of borrowed fund in an attempt to amplify returns to owner-provided capital. To the extent that a business decides to use debt to finance assets, it becomes very important to assess how effective that decision is, and the ROE ratio provides a signal about that effort.
There are alternative theories about the best ways in which to calculate ROA and ROE ratios, but they all share the same goal. The goal is to assess management’s stewardship (i.e., ability to generate returns) with respect to assets and equity; in particular, it provides a basis for knowing whether debt is being managed in a way that is accretive or dilutive to the shareholders’ best interests. One hopes to find that the ROE ratio is at least equal to and hopefully greater than the ROA ratio.
The summary illustration at the end of this chapter shows complete data sufficient to cal- culate both ratios. When you review that, be sure to take note that the ROE ratio is greater than the ROA ratio. This means that the company is using its borrowing effectively to increase overall firm earnings. If the company had instead relied solely on equity financ- ing for its assets, the overall rate of return on shareholder investments would be lower.
9.7 Other Measures
In the preceding discussion on profitability analysis, you were cautioned that evalua-tions of profitability need to take into account the firm size. Public corporations are those that have shares of stock that are easily bought and sold by individual investors over organized stock exchanges such as the NYSE or NASDAQ. Publicly traded compa- nies are required to present earnings-per-share (EPS) information. This is perhaps the most popular “scaled” profitability measure. It allows investors to compare the income of a large corporation having hundreds of millions of shares to the income of a smaller company having perhaps less than 1 million shares of stock. The larger company would perhaps produce a greater amount of overall profit, but it is possible that the smaller com- pany might be doing better on an EPS basis.
EPS data is widely followed. Press releases and business news outlets focus heavily on this number, often comparing actual EPS to projected EPS. Because stock is priced on a per-share basis, it is only logical to expect that earnings are also monitored on a per- share basis. This number is important, but you should be careful not to fixate on a single indicator. EPS data often includes the impacts of nonrecurring transactions and events. A detailed income statement will usually include operating details about income from con- tinuing operations, segregated from the effects of other special events impacting income. Similarly, EPS data is often subdivided into special components, and one must look very closely at the specific composition of each period’s EPS data.
In its simplest form, EPS data is just a fraction determined by dividing income by the number of shares outstanding. EPS can be calculated based on any time period but is most often reported on a quarterly and annual basis. One potential complication arises when the number of shares of stock changes during a period. For instance, a company may issue additional shares during the period, in which case the EPS calculation is based on the weighted-average shares outstanding for the period (not the number outstanding at the end of the period). The following formula summarizes the basic mathematics for simple EPS:
waL80144_09_c09_197-224.indd 13 8/29/12 2:44 PM
CHAPTER 9Section 9.7 Other Measures
Income Available to Common Shares / Weighted-Average Number of Common Shares
To illustrate, assume that Brooklyn Corporation had an annual net income of $2,400,000. Brooklyn started the calendar year with 600,000 shares outstanding but issued an addi- tional 300,000 shares for cash on May 1. The EPS is $3. Determining this value begins with calculating the weighted-average number of shares outstanding. Brooklyn had 600,000 shares outstanding for the first 4 months of the year (or one third of the year) and 900,000 shares outstanding for the last 8 months of the year (or two thirds of the year). Thus,
Weighted-Average Number of Shares 5 800,000 [600,000 (143)] [900,000 (243)]
and the EPS is calculated as $2,400,000 / 800,000 shares.
EPS calculations can quickly grow cumbersome. Later, you will learn that a company may have several types of capital stock. Some shares are called common stock, and other shares may be designated as preferred stock. Common stock is the residual interest in the business. Preferred stock has some advantages, usually in the form of a guaranteed dividend and liquidation preferences. As such, it has first claims on earnings up to the amount of a stated dividend rate. Common shares only stand to benefit to the extent that earnings exceed the preferential dividend. To be more technically precise, EPS is really earnings available per common share. Thus, the proper formulation of calculating EPS would really consist of net income minus any preferred dividends.
The “basic” EPS number may be all that a company is required to report. At other times, a complex company may find it necessary to also report a diluted EPS amount. Some companies may have issued more exotic financial instruments, such as options on stock or debt that can be converted into stock. When this condition is encountered, accountants are required to assess the potential effect on EPS, as if the options were exercised and conver- sion occurred. When the hypothetical issuance of additional shares causes a reduction (a dilution) in EPS, it typically becomes required to report this second EPS measure. The idea of this expanded reporting is to alert shareholders to the impacts on EPS of the potential issue of additional shares.
If you have even a passing familiarity with stock investing, you probably have some knowledge of the price-to-earnings (P/E) ratio. This number is often reported in ana- lysts’ reports and even in newspaper listings of stock prices. As its name suggests, the P/E ratio is calculated as follows:
Price-to-Earnings Ratio 5 Market Price per Share / Earnings per Share
If a stock is currently selling at $25 per share and has an EPS of $2, then its P/E ratio would be 12.5. Low P/E ratios are sometimes indicators of good investment values and vice versa, but this is not always the case. As already noted, earnings measures are subject to nonrecurring distortions of long-term trends. Further, some businesses may be underper- forming in the near term but have excellent long-term prospects. Think of the P/E ratio like a pulse rate; the same person can have a fluctuating pulse based on his or her current status (sleeping, running, etc.), and a full assessment of health requires knowledge of that status. Only a negligent doctor would prescribe a treatment plan based solely on a pulse rate. A similar comparison can be made to investment decisions tied only to the P/E ratio.
waL80144_09_c09_197-224.indd 14 8/29/12 2:44 PM
CHAPTER 9Section 9.8 Recap and Summary Illustration
Not all companies pay dividends. Some companies may prefer to reinvest earnings to expand business operations. For many years, Apple did not pay dividends, choosing instead to reinvest in new product development. Other businesses may not have sufficient earnings to support dividends. But, mature businesses may generate more than enough cash to support ongoing business needs, and those companies will often return profits to shareholders. In recent years, Apple’s successful products were so profitable that the company accumulated an abundance of cash and began to pay dividends.
Another number that you might wish to calculate is the dividend rate. This number is also known as the dividend yield and is determined by dividing the annual cash dividend by the market price per share of the stock.
Assume that Delta Company pays annual dividends of $0.40 per share. If its stock sells for $8.00 per share, the yield would be 5% ($0.404$8.00). Investors may wonder if Delta can sustain this dividend rate. To make this assessment, they would likely examine the Delta’s dividend history and cash supply. These two factors may help predict the future dividend stream. However, it is also important to make sure that ongoing operations can continue to support the dividend. Thus, the dividend payout rate should also be calculated. Its value is determined by dividing the annual cash dividend by the EPS. If Delta earned $1.00 per share, its payout ratio is 0.40 ($0.404$1.00).
Investors may also look at the book value per share. This is the amount of stockhold- ers’ equity represented by each share of common stock. You should be extremely care- ful in thinking about book value per share. It is based on the reported amount of stock- holders’ equity. Remember the fundamental accounting equation: Assets 5 Liabilities Equity. Many assets are listed at their cost, not their value. This is a double-edged sword. Some assets may be worth more than their cost and vice versa. This is especially true for recorded and unrecorded intangible assets. Thus, the residual reported equity may not be very reflective of the intrinsic firm value, and calculations of book value per share may be far afield from what the stock would be valued at on a per-share basis. Nevertheless, it is a popular measure. Some investors look to this number as the floor price below which the stock is seen as a bargain. You are cautioned against jumping to this conclusion.
As with EPS, book value is a per share of common stock concept. For companies with complex capital structures involving preferred stocks, stock options, convertible securi- ties, and so forth, a number of adjustments may be necessary. Because book value per share is a number that is calculated by analysts (i.e., it is not reported by the company’s accountants), there is no generally accepted accounting principle that describes exactly how those adjustments should occur. Generalizing, the idea is to distill the total equity down to a hypothetical amount that would remain after liquidating all noncommon share interests in the company. The remaining equity is then divided by the number of common shares outstanding to find the book value per share of common stock.
9.8 Recap and Summary Illustration
Many new concepts were introduced in this chapter. Table 9.2 summarizes the various ratios and calculations that you were exposed to. The final column includes typical acceptable values for the indicated ratios. However, as noted throughout the chapter, it is impossible to stipulate universal generalizations for the values of these ratios, and the last column should not be given undue weightings. Each situation can vary.
waL80144_09_c09_197-224.indd 15 8/29/12 2:44 PM
CHAPTER 9Section 9.8 Recap and Summary Illustration
Table 9.2: Ratios and calculations Liquidity Current Ratio Current Assets / Current
Liabilities A measure of liquidity; the ability to meet near-term obligations
2:1 or greater
Quick Ratio (Cash Short-Term Investments Accounts Receivable) / Current Liabilities
A narrow measure of liquidity; the ability to meet near-term obligations
1.25:1 or greater
Debt Service Debt-to-Total- Assets Ratio
Total Debt / Total Assets Percentage of assets financed by long-term and short-term debt
0.5 or less
Debt-to-Equity Ratio
Total Debt / Total Equity Proportion of financing that is debt related
1:1 or less
Times-Interest- Earned Ratio
Income Before Income Taxes and Interest / Interest Charges
Ability to meet interest obligations
8 or higher
Turnover Ratios Accounts- Receivable- Turnover Ratio
Net Credit Sales / Average Net Accounts Receivable
Frequency of collection cycle; to monitor credit policies
9 or higher
Inventory- Turnover Ratio
Cost of Goods Sold / Average Inventory
Frequency of inventory rotation; to monitor inventory management
6 or higher
Profitability Ratios Gross-Profit- Margin Ratio
Gross Profit / Net Sales Gross profit rate; for comparison and trend analysis
50% or higher
Net-Profit- Margin Ratio
Net Income / Net Sales Profitability on sales; for comparison and trend analysis
5% or higher
Return-on-Assets Ratio
(Net Income Interest Expense) / Average Assets
Asset utilization in producing returns
10% or higher
Return-on-Equity Ratio
Net Income / Average Common Equity
Effectiveness of equity investment in producing returns
10% or higher
Other Measures Earnings per Share
Income Available to Common / Weighted-Average Number of Common Shares
Amount of earnings attributable to each share of common stock
Positive and increasing over time
Price-to-Earnings Ratio
Market Price per Share / Earnings Per Share
The price of the stock in relation to earnings per share
15 or lower
Dividend Yield Annual Cash Dividend / Market Price per Share
Direct yield to investors through dividend payments
2.5% or higher
Dividend Payout Rate
Annual Cash Dividend / Earnings per Share
Proportion of earnings distributed as dividends
40% or less
Book Value per Share
“Common” Equity / Common Shares Outstanding
The amount of stockholders’ equity per common share outstanding
Positive and increasing over time
Exhibit 9.7 shows comprehensive financial statements for Mossman Company. This infor- mation will be used to demonstrate the calculation of all ratios introduced in this chapter, as shown in Table 9.3. The value of Mossman’s stock was $20 per share throughout the year, and there were 500,000 shares outstanding. All sales were on account.
waL80144_09_c09_197-224.indd 16 8/29/12 2:44 PM
CHAPTER 9Section 9.8 Recap and Summary Illustration
Exhibit 9.7: Financial Statement for Mossman Company
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waL80144_09_c09_197-224.indd 17 8/29/12 2:44 PM
CHAPTER 9Section 9.8 Recap and Summary Illustration
Table 9.3: Calculation of ratios
Current Ratio Current Assets / Current Liabilities $2,600,0004$1,240,000 5 2.1
Quick Ratio (Cash Short-Term Investments Accounts Receivable) / Current Liabilities
$1,400,0004$1,240,000 5 1.13
Debt-to-Total- Assets Ratio
Total Debt / Total Assets $1,965,0004$4,600,000 5 0.43
Debt-to-Equity Ratio
Total Debt / Total Equity $1,965,0004$2,635,000 5 0.75
Times-Interest- Earned Ratio
Income Before Income Taxes and Interest / Interest Charges
$ 1,240,0004$48,000 5 26
Accounts- Receivable- Turnover Ratio
Net Credit Sales / Average Net Accounts Receivable
$ 3,000,0004$575,000 5 5.2
Inventory-Turnover Ratio
Cost of Goods Sold / Average Inventory
$ 1,160,0004$187,500 5 6.2
Net-Profit-Margin Ratio
Net Income / Net Sales $ 770,0004$3,000,000 5 26%
Gross-Profit-Margin Ratio
Gross Profit / Net Sales $1,840,0004$3,000,000 5 61%
Return-on-Assets Ratio
(Net Income Interest Expense) / Average Assets
$ 818,0004$4,307,500 5 19%
Return-on-Equity Ratio
Net Income / Average Common Equity
$ 770,0004$2,275,000 5 34%
Earnings per Share Income Available to Common / Weighted-Average Number of Common Shares
$ 770,0004500,000 5 $1.54
Price-to-Earnings Ratio
Market Price per Share / Earnings per Share
$ 204$1.54 5 13
Dividend Yield Annual Cash Dividend / Market Price per Share
$ 0.104$20 5 0.5%
Dividend Payout Rate
Annual Cash Dividend / Earnings per Share
$ 0.104$1.54 5 6.5%
Book Value per Share
“Common” Equity / Common Shares Outstanding
$ 2,635,0004500,000 5 $5.27
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CHAPTER 9
accounts-receivable-turnover ratio The number of times a firm’s receivables are converted to cash during a year: Accounts- Receivable-Turnover Ratio 5 Net Credit Sales / Average Net Accounts Receivable.
book value per share The amount of stockholders’ equity represented by each share of common stock.
common-size financial statement Relates to scaling the dollar amounts within finan- cial statements to percentage terms.
current ratio Reveals the relative amount of working capital by dividing current assets by current liabilities: Current Ratio 5 Current Assets / Current Liabilities.
Key Terms
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 236.)
1. Vertical analysis a. cannot be used to compare companies of different size. b. provides information about the magnitude, direction, and relative importance of
changes in individual financial statement items. c. is needed to assess the coverage of obligations. d. results in common size financial statements.
2. London Corporation paid $1,000 of accounts payable with cash on the last day of the month. The company had a current ratio of 4 before the disbursement. As a result of this payment, the current ratio will
a. increase. b. decrease. c. remain unchanged. d. fluctuate, but the direction of the change depends on unstated facts.
3. Jedd Inc. has obtained long-term debt at a 14% interest rate and is achieving a return on assets of 42%. These figures indicate that Jedd will have
a. a 28% increase in earnings per share, b. a 28% increase in the profit margin on sales, c. a return on common stockholders’ equity of less than 14%. d. a return on common stockholders’ equity of more than 14%.
4. Annual reports a. are issued to corporate managers but not to stockholders. b. contain a corporation’s financial statements, accompanying notes, and various
other management disclosures. c. contain a corporation’s financial statements but not the auditor’s report. d. focus more on marketing the corporation’s products than on disclosing financial
information.
Key Terms
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CHAPTER 9Key Terms
days outstanding ratio Reveals how many days sales are carried in the receivables category: Days Outstanding 5 365 Days / Accounts-Receivable-Turnover Ratio.
debt-to-equity ratio Compares total debt to total equity: Debt-to-Equity Ratio 5 Total Debt / Total Equity.
debt-to-total-assets ratio Evaluates the proportion of the asset pool that is financed with debt: Debt-to-Total-Assets Ratio 5 Total Debt / Total Assets.
dividend payout rate A value that is determined by dividing the annual cash dividend by earnings per share.
dividend yield A value that is determined by dividing the annual cash divided by the market price per share of the stock.
earnings per share (EPS) Allows investors to compare the income of a large corpora- tion having hundreds of millions of shares of stock: Income Available to Common Shares / Weighted-Average Number of Common Shares.
EPS See earnings per share.
gross-profit-margin ratio Examines the proportion of sales that is leftover, taking into account only the cost of the units sold: Gross Profit / Net Sales.
horizontal analysis Used to compare data from two or more periods, side-by-side.
inventory-turnover ratio Reveals the number of times that a firm’s inventory balance is turned over or sold during a particular year: Inventory-Turnover Ratio 5 Cost of Goods Sold / Average Inventory.
liquidity The ability to meet near-term obligations as they mature.
net-profit-margin ratio Reflects the final residual amount: Net Profit on Sales 5 Net Income / Net Sales.
P/E ratio See price-to-earnings ratio.
price-to-earnings (P/E) ratio A printabil- ity ratio that examines an organization's success during an accounting period. Price Earnings Ratio5 Market Price per Share / Earnings per Share.
quick ratio A stringent liquidity that is calculated by dividing “quick assets” by current liabilities: Quick Ratio 5 (“Cash” Accounts Receivable) / Current Liabilities.
return-on-assets (ROA) ratio Measures profitability from a given level of asset investment. Calculated by dividing income before interest cost by the average assets used in the business: Return-on-Assets Ratio 5 (Net Income Interest Expense) / Average Assets.
return-on-equity (ROE) ratio Evalu- ates income in relation to the amount of invested common shareholder equity: Return-on-Equity Ratio 5 Net Income / Average Common Equity.
ROA See return-on-assets ratio.
ROE See return-on-equity ratio.
solvency The ability to satisfy a long-term structural debt.
times-interest-earned ratio Shows how many times a company’s income stream will cover its interest obligation: Times- Interest-Earned Ratio 5 Income Before Income Taxes and Interest / Interest Charges.
vertical analysis Results when each expense category is expressed as a percent- age of sales.
working capital The amount of current assets minus current liabilities.
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CHAPTER 9Exercises
Critical Thinking Questions
1. Distinguish between horizontal analysis and vertical analysis. Which type of analy- sis results in common-size financial statements?
2. What is one of the basic benefits associated with the use of common-size financial statements?
3. A student once noted, “This ratio stuff is great. It’s unbelievable how ratios can tell the complete story behind the problems of a business.” Comment on the student’s observation.
4. Briefly describe the following types of ratios and identify the financial statement users most interested in each type.
a. Liquidity ratios b. Activity ratios c. Profitability ratios d. Coverage ratios 5. What is the current ratio? Present a short critique of this widely used financial
measure. 6. Why do many analysts prefer the quick ratio over the current ratio for judging
debt-paying ability? 7. What insight can be provided by the accounts-receivable-turnover ratio? The
inventory-turnover ratio? 8. Discuss the differences between the return on assets and the return on common
stockholders’ equity. 9. Briefly explain how the price-to-earnings ratio gives insights about investor attitudes.
Exercises
1. Horizontal analysis. Mary Lynn Corporation has been operating for several years. Selected data from the 20X1 and 20X2 financial statements follow.
20X2 20X1
Current Assets $ 76,000 $ 80,000
Property, Plant, and Equipment (net) 99,000 90,000
Intangibles 25,000 50,000
Current Liabilities 40,800 48,000
Long-Term Liabilities 143,000 160,000
Stockholders’ Equity 16,200 12,000
Net Sales 500,000 500,000
Cost of Goods Sold 332,500 350,000
Operating Expenses 93,500 85,000
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CHAPTER 9Exercises
Prepare a horizontal analysis for 20X1 and 20X2. Briefly comment on the results of your work.
2. Vertical analysis. Study the data pertaining to Mary Lynn Corporation that appear in Exercise 1. Prepare a vertical analysis for 20X1 and 20X2 and briefly evaluate the results of your work.
3. Liquidity ratios. Edison, Stagg, and Thornton have the following financial infor- mation at the close of business on July 10:
Edison Stagg Thornton
Cash $4,000 $2,500 $1,000
Short-Term Investments 3,000 2,500 2,000
Accounts Receivable 2,000 2,500 3,000
Inventory 1,000 2,500 4,000
Prepaid Expenses 800 800 800
Accounts Payable 200 200 200
Notes Payable: Short-Term 3,100 3,100 3,100
Accrued Payables 300 300 300
Long-Term Liabilities 3,800 3,800 3,800
a. Compute the current and quick ratios for each of the three companies. (Round calculations to two decimal places.) Which firm is the most liquid? Why?
b. Suppose Thornton is using FIFO for inventory valuation and Edison is using LIFO. Comment on the comparability of information between these two companies.
c. If all short-term notes payable are due on July 11 at 8 a.m., comment on each company’s ability to settle its obligation in a timely manner.
4. Computation and evaluation of activity ratios. The following data relate to Alaska Products Inc.:
20X5 20X4
Net Credit Sales $832,000 $760,000
Cost of Goods Sold 440,000 350,000
Cash, Dec. 31 125,000 110,000
Accounts Receivable, Dec. 31 180,000 140,000
Inventory, Dec. 31 70,000 50,000
Accounts Payable, Dec. 31 115,000 108,000
The company is planning to borrow $300,000 via a 90-day bank loan to cover short- term operating needs.
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CHAPTER 9Exercises
a. Compute the accounts-receivable and inventory-turnover ratios for 20X5. Alaska rounds all calculations to two decimal places.
b. Study the ratios from part (a) and comment on the company’s ability to repay a bank loan in 90 days.
c. Suppose that Alaska’s major line of business involves the processing and distri- bution of fresh and frozen fish throughout the United States. Do you have any concerns about the company’s inventory-turnover ratio? Briefly discuss.
5. Profitability ratios, trading on the equity. Digital Relay has both preferred and com- mon stock outstanding. The company reported the following information for 20X7:
Net sales $1,500,000 Interest Expense 120,000 Income Tax Expense 80,000 Preferred Dividends 25,000 Net Income 130,000 Average Assets 1,100,000 Average Common Stockholders’ Equity 400,000
a. Compute the net-profit-margin ratio and the rates of return on assets and com- mon stockholders’ equity, rounding calculations to two decimal places.
b. Does the firm have positive or negative financial leverage? Briefly explain.
6. Evaluation of selected ratios. Selected ratios of Glenwood Power Equipment Company and averages for the power equipment industry follow:
Glenwood Industry Current ratio 2.21 1.63 Average collection period of receivables
39 days 21 days
Inventory turnover 4.1 1.9 Net-profit-margin 7.0% 8.8% Return on assets 10.0% 9.5% Debt-to-total assets 31.7% 39.8%
Evaluate these ratios and determine whether you agree or disagree with the follow- ing statements:
a. Glenwood has better debt-paying ability than the “average” company in the power equipment industry.
b. Glenwood is performing below average in managing its inventories. c. The amount of income generated, given the company’s resources, exceeds that
produced by the industry. d. Glenwood may need to improve its management of credit and customer collections. e. In view of the company’s revenues, Glenwood’s ability to produce earnings is
significantly below the industry norm.
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CHAPTER 9Problems
Problems
1 Horizontal and vertical analysis. The following financial statements pertain to Waterloo Corporation:
WATERLOO CORPORATION Comparative Balance Sheets December 31,20X5 and 20X4
20X5 20X4
Assets
Current Assets
Cash $ 11,250 $ 12,500
Accounts Receivable (net) 18,500 25,000
Inventories 38,500 35,000
Prepaid Expense 3,750 3,750
Total Current Assets $ 72,000 $ 76,250
Property, Plant, and Equipment
Buildings (net) $ 102,750 $ 101,250
Equipment (net) 28,500 30,000
Vehicles (net) 32,000 40,000
Total Property, Plant, and Equipment $ 163,250 $ 171,250
Trademarks (net) $ 14,750 $ 2,500
Total assets $ 250,000 $ 250,000
Liabilities and Stockholders’ Equity
Current Liabilities
Accounts Payable $ 49,000 $ 70,000
Notes Payable 13,500 40,000
Federal Taxes Payable 2,500 25,000
Total Current Liabilities $ 65,000 $ 135,000
Long-Term Debt $ 50,000 $ 25,000
Total Liabilities $ 115,000 $ 160,000
Stockholders’ Equity
Common Stock, $10 par $ 25,000 $ 25,000
Retained Earnings 110,000 65,000
Total Stockholders’ Equity $ 135,000 $ 90,000
Total Liabilities and Stockholders’ Equity $ 250,000 $ 250,000
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CHAPTER 9Problems
WATERLOO CORPORATION Comparative Income Statements
For the Years Ending December 31, 20X5 and 20X4
20X5 20X4 Net Sales $ 550,000 $500,000 Cost of Goods Sold 330,000 250,000 Gross Profit $ 220,000 $250,000 Operating Expense 132,500 100,000 Income Before Interest and Taxes $ 87,500 $150,000 Interest Expense 12,500 3,000 Income Before Taxes $ 75,000 $147,000 Income Tax Expense 30,000 58,800 Net Income $ 45,000 $ 88,200
Instructions a. Prepare a horizontal analysis of the balance sheet, showing dollar and percentage
changes. Round all calculations in parts (a) and (b) to two decimal places. b. Prepare a vertical analysis of the income statement by relating each item to net sales. c. Briefly comment on the results of your analysis.
2. Ratio computation. The financial statements of the Lone Pine Company follow.
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CHAPTER 9Problems
LONE PINE COMPANY Comparative Balance Sheets
December 31, 20X2 and 20X1 ($000 Omitted) 20X2 20X1
Assets Current Assets Cash and Short-Term Investments $ 400 $ 600 Accounts Receivable (net) 3,000 2,400 Inventories 2,000 2,200
Total Current Assets $5,400 $5,200 Property, Plant, and Equipment Land $1,700 $ 600 Buildings and Equipment (net) 1,500 1,000
Total Property, Plant, and Equipment $3,200 $1,600 Total Assets $8,600 $6,800 Liabilities and Stockholders’ Equity Current Liabilities Accounts Payable $1,800 $1,700 Notes Payable 1,100 1,900
Total Current Liabilities $2,900 $3,600 Long-Term Liabilities Bonds Payable 4,100 2,100
Total Liabilities $7,000 $5,700 Stockholders’ Equity Common Stock $ 200 $ 200 Retained Earnings 1,400 900
Total Stockholders’ Equity $1,600 $1,100 Total Liabilities and Stockholders’ Equity $8,600 $6,800
LONE PINE COMPANY Statement of Income and Retained Earnings
For the Year Ending December 31,20X2 ($000 Omitted) Net Sales* $36,000 Less: Cost of Goods Sold $20,000 Selling Expense 6,000 Administrative Expense 4,000 Interest Expense 400 Income Tax Expense 2,000 32,400
Net Income $ 3,600 Retained Earnings, Jan. 1 900
$ 4,500 Cash Dividends Declared and Paid 3,100 Retained Earnings, Dec. 31 $ 1,400 *All sales are on account.
waL80144_09_c09_197-224.indd 26 8/29/12 2:44 PM
CHAPTER 9Problems
Instructions Compute the following items for Lone Pine Company for 20X2, rounding all calcu- lations to two decimal places when necessary:
a. Quick ratio b. Current ratio c. Inventory-turnover ratio d. Accounts-receivable-turnover ratio e. Return-on-assets ratio f. Net-profit-margin ratio g. Return-on-common-stockholders’ equity h. Debt-to-total assets i. Number of times that interest is earned j. Dividend payout rate
3. Financial statement construction via ratios. Incomplete financial statements of Lock Box Inc. are presented as follows:
LOCK BOX INC. Income Statement
For the Year Ending December 31, 20X3 Sales $ ? Cost of Goods Sold ? Gross Profit $ 15,000,000 Operating Expenses and Interest ? Income Before Taxes $ ? Income taxes, 40% ? Net income $ ?
LOCK BOX, INC. Balance Sheet
December 31, 20X3 Assets
Cash $ ? Accounts Receivable ? Inventory ? Property, Plant, and Equipment 8,000,000 Total assets $ 24,000,000
Liabilities and Stockholders’ Equity Accounts Payable $ ? Notes Payable: Short-Term 600,000 Bonds Payable 4,600,000 Common Stock 2,000,000 Retained Earnings ? Total Liabilities and Stockholders’ Equity $ 24,000,000
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CHAPTER 9Problems
Further information is the following:
• Cost of goods sold is 60% of sales. All sales are on account. • The company’s beginning inventory is $5 million; inventory-turnover ratio is 4. • The debt-to-total-assets ratio is 70%. • The profit margin on sales is 6%. • The firm’s accounts-receivable-turnover ratio is 5. Receivables increased by
$400,000 during the year.
Instructions Using the preceding data, complete the income statement and the balance sheet.
waL80144_09_c09_197-224.indd 28 8/29/12 2:44 PM
Glossary
accounting cycle Key steps include exam- ining source documents, recording transac- tions in the journal, posting journal entries to the indicated ledger accounts, perhaps constructing a trial balance, determining and posting adjusting entries, preparing an adjusted trial balance, and preparing financial statements from the adjusted trial balance.
account The master record that is main- tained for each individual financial state- ment asset, liability, equity, revenue, expense, or dividend component.
accounts payable The amounts due to suppliers for the purchase of goods and services.
accounts-receivable-turnover ratio The number of times a firm’s receivables are converted to cash during a year: Accounts- Receivable-Turnover Ratio 5 Net Credit Sales / Average Net Accounts Receivable.
accrual basis The idea that transactions and events are to be measured based on their natural growth or increase, not their specific payment.
adjusting entries Journal entries that are necessary to cause asset, liability, revenue, expense, and all other accounts to contain their correct balance as of a particular reporting date.
allowance methods for uncollect- ibles Techniques that result in the record- ing of estimates for bad-debts expense in the same period as the related credit sales.
amortization The process of allocating cost to the benefited time periods.
arm’s length exchange transactions Exchange transactions that generally sig- nify that independent buyers and sellers have agreed on the price for which goods are services are to be delivered.
assets The economic resources of the entity and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangi- bles such as patents and other legal rights and claims.
auditing The examination of transactions and systems that underlie an organiza- tion’s financial reports, with the ulti- mate goal of providing an independent report on the appropriateness of financial statements.
average cost A cost flow assumption.
balance sheet A basic financial statement, it reveals the assets, liabilities, and equity of a business at a particular time.
waL80144_10_glo_225-234.indd 1 8/29/12 2:44 PM
GLOSSARY
226
balance sheet approach The approach in which an assessment was made of the desired balance for the allowance that is to be reported on the balance sheet.
bank reconciliation The process needed to identify errors, irregularities, and adjustments needed to the Cash account.
bank statement The document provided by the bank showing deposits, checks, other activity, and balances.
betterment A capital expenditure for an improvement.
book value per share The amount of stockholders’ equity represented by each share of common stock.
bookkeeping The skill or process of recording of transactions.
calendar year A company’s annual report- ing period that follows the natural calendar and runs from January 1 to December 31.
capital expenditures Ordinary and neces- sary costs such as direct purchase price and the cost of permits, sales tax, freight, installation, and other usual costs to pre- pare an item for use.
capital stock The amount of money received from investors for company shares.
cash Currency, coins, bank demand deposits that can be freely withdrawn, undeposited checks from customers, and other items that are acceptable to a bank for deposit.
cash basis Revenue that is recorded as cash is received (regardless of when earned) and expenses that are recorded concurrent with their payment.
cash equivalents Sometimes included in reporting of cash, very short-term (usually interest-earning) financial instruments like government Treasury bills.
certified public accountant (CPA) A license issued by states that allows an accountant to specialize in public accounting.
change in accounting method Adopting an alternative but still acceptable method of accounting.
changes in estimates To revise the accounting to adjust only current and future periods.
chart of accounts A numbering system in which a unique number is assigned to each account.
classified balance sheet Important group- ings of accounts, usually listed in an expected order of appearance.
common-size financial statement Relates to scaling the dollar amounts within finan- cial statements to percentage terms.
comparability The ability to make relative assessments of companies.
consignment of inventory An agreement whereby the owner of inventory places it with another party in the hope that it will resell the goods to an end consumer.
consistency A concept that relates perfor- mance assessments over time.
contingent liabilities A class of a poten- tial liability in which the amount and timing of a possible obligation is very subjective.
contra asset The record of an accumulated depreciation on a balance sheet.
corporation A legally created entity that is owned by one or more persons.
cost flow assumptions Inventory-costing methods such as first-in, first-out; last-in, last-out; or average cost.
waL80144_10_glo_225-234.indd 2 8/29/12 2:44 PM
GLOSSARY
227
CPA See certified public accountant.
credit The action of recording a decrease to an asset, expense, or divided account.
current assets Items expected to be con- verted into cash or consumed within one year, or the operating cycle, whichever is longer.
current liabilities Obligations that will likely be liquidated with current assets, typically within the next year or operating cycle, whichever is longer.
current ratio Reveals the relative amount of working capital by dividing current assets by current liabilities: Current Ratio 5 Current Assets / Current Liabilities.
days outstanding ratio Reveals how many days sales are carried in the receivables category: Days Outstanding 5 365 Days / Accounts-Receivable-Turnover Ratio.
DDB See double-declining-balance method.
debit The action of recording an increase to an asset, expense, or divided account.
debt-to-equity ratio Compares total debt to total equity: Debt-to-Equity Ratio 5 Total Debt / Total Equity.
debt-to-total-assets ratio Evaluates the proportion of the asset pool that is financed with debt: Debt-to-Total-Assets Ratio 5 Total Debt / Total Assets.
depletion Similar to depreciation but relates to natural resources instead of buildings and equipment.
deposits in transit Receipts entered on company records but not processed by the bank.
depreciable base The cost of an item of plant and equipment minus any residual value.
depreciation The process by which the purchase of an asset is gradually trans- ferred from a cost to an expense.
direct write-off method A process for accounting for uncollectible accounts.
dissolution The breakup of a partnership.
dividend payout rate A value that is determined by dividing the annual cash dividend by earnings per share.
dividend yield A value that is determined by dividing the annual cash divided by the market price per share of the stock.
dividends Distributions to shareholders as a return on their investment.
double-declining-balance (DDB) method A method of depreciation that “front loads” depreciation to the early periods of an asset’s service life.
earnings per share (EPS) Allows investors to compare the income of a large corpora- tion having hundreds of millions of shares of stock: Income Available to Common Shares / Weighted-Average Number of Common Shares.
employee As opposed to an independent contractor, a person who provides services to a business in exchange for payment, with the business controlling what, when, and how work will be done.
EPS See earnings per share.
expenses The costs incurred in the process of producing revenues.
extraordinary item An event causing a gain or a loss that are both unusual in nature and infrequent in occurrence.
fair value An assessment based on current worth.
waL80144_10_glo_225-234.indd 3 8/29/12 2:44 PM
GLOSSARY
228
FASB See Financial Accounting Standards Board.
Federal Insurance Contributions Act (FICA) A tax that transfers money from those currently working to aged retirees, disabled workers, and certain children.
FICA See Federal Insurance Contributions Act.
FIFO See first-in, first-out.
financial accounting Targeted toward reporting financial information about a business to external users such as the owner(s) and creditors.
Financial Accounting Standards Board (FASB) A private-sector group primarily responsible for developing the rules that form the foundation of financial reporting.
first-in, first-out (FIFO) An inventory- costing method, the assumption is that the units are sold from the first, or earliest, available units.
fiscal year A reporting period that follows a natural business cycle rather than calen- dar year.
FOB (free on board) A common freight nomenclature indicating the point at which the ownership of goods shifts from the seller to the buyer.
FOB destination A common freight nomenclature indicating that the seller owns goods until they are delivered and must bear the cost of shipping.
FOB shipping point A common freight nomenclature indicating that once goods are shipped, they are deemed the buyer’s property.
Form 1099 An annual report provided to an independent contractor and the IRS, showing money paid.
GAAP See generally accepted accounting principles.
general journal A log of the transactions engaged in by the business.
general ledger The collection of all accounts.
generally accepted accounting principles (GAAP) General-purpose standards intended to be equally useful for all user groups.
goodwill The excess of the fair value of a company over the fair value of the identifi- able elements.
gross pay The total amount of wages that an employee earns.
gross-profit-margin ratio Examines the proportion of sales that is leftover, taking into account only the cost of the units sold: Gross Profit / Net Sales.
historical cost The concept that it is best to report certain financial statement ele- ments at amounts that are tied to objective and verifiable past transactions.
historical cost principle Recording cost in a balance sheet according to its history rather than market value this cost is objec- tive and verifiable.
horizontal analysis Used to compare data from two or more periods, side-by-side.
IASB See International Accounting Stan- dards Board.
IFRS See international financial reporting standards.
income The enhancement to the business as a result of providing goods and ser- vices to its customers; mathematically, it is the result of subtracting expenses from revenues.
waL80144_10_glo_225-234.indd 4 8/29/12 2:44 PM
GLOSSARY
229
income statement A statement that reports income for a particular time period.
income statement approach A method that employs estimates of uncollectibles based on total sales or credit sales.
income tax A federal and sometimes state and local tax on earned wages.
independent contractor Someone who performs agreed-on tasks but generally decides about the processes that will achieve the end result.
initial public offering (IPO) A privately held company’s offering of the first sales of its stock to the public.
intangible assets Items that lack physical existence but were purchased for the rights they convey and includes patents, copy- rights, brand names, and the more general business goodwill.
interest The charge for the use of money.
intermediate recognition An account- ing model that records assets that have no future benefit and no discernible revenue.
internal auditors Those professionals who look at controls and procedures in use by their employer.
International Accounting Standards Board (IASB) The international counter- part to the FASB, the IASB and FASB work cooperatively on many projects.
international financial reporting stan- dards (IFRS) The effort to establish consis- tency in global financial reporting.
inventory-turnover ratio Reveals the number of times that a firm’s inventory balance is turned over or sold during a particular year: Inventory-Turnover Ratio 5 Cost of Goods Sold / Average Inventory.
IPO See initial public offering.
liabilities The amounts owed to others, such as obligations to loans, extensions of credit, and others that occur in the normal course of business.
limited liability A principle of corpora- tions stating that stockholders can only lose the amount of their investment to creditors.
limited life The nature of partnership in that partnership passes with the death of a partner.
liquidation The formal termination of an entity.
liquidity The ability to meet near-term obligations as they mature.
long-term investments Items held for investment purposes, including shares of stock in other companies, idle land, cash surrender value of life insurance, and simi- lar items.
long-term liabilities Obligations that are not current, including bank loans and mortgages.
lower-of-cost-or-market method A method whereby inventories are accounted for at acquisition cost or market value, whichever is lower.
maker The party promising to make pay- ment on a note.
managerial accounting Information intended to serve the specific needs of management.
matching principle The manner in which a large proportion of business costs are to be recorded.
waL80144_10_glo_225-234.indd 5 8/29/12 2:44 PM
GLOSSARY
230
materiality A concept dictating that an accountant must judge the impact and importance of a transaction to determine its proper handling in the accounting records.
maturity date The day a note is set to be paid.
multiple-step income statement A state- ment format that divides business results into separate categories.
mutual agency In a partnership, the indi- vidual partner’s right to commit or obli- gate the entire partnership.
natural resources Materials—such as min- eral deposits and timber—that are assets.
net assets Another term for owner’s equity.
net book value An asset’s total cost minus accumulated depreciation to date.
net pay The amount that an employee receives after deducting charges such as federal and state taxes, FICA, insurance, retirement contributions, charitable con- tributions, special health and child-care deferrals, and other similar items.
net-profit-margin ratio Reflects the final residual amount: Net Profit on Sales 5 Net Income / Net Sales.
net realizable value The amount of cash expected from the collection of current customer balances.
note payable A written promise to pay for purchases bought on credit and usually incurs interest during the payment period.
note receivable A written promise or agreement that sometimes supports longer- term receivables agreement.
NSF (nonsufficient funds) checks Checks previously deposited but have been returned for nonpayment.
operating cycle The amount of time a business needs to convert credit back into cash.
other assets Items that defy classification.
outstanding checks Written checks that have not cleared the bank.
owner’s equity The owner’s “interest” in the business, the equivalent to assets minus liabilities.
partnership A type of business considered to exist when there is co-ownership of a business activity carried on with the objec- tive of making a profit.
par value Sets the legal capital of the firm, which is intended to represent the mini- mum amount of initial capital that inves- tors are theoretically obliged to invest.
payee The party to whom payment will be made.
pension A plan that involves current “set asides” of money into trust, with a goal of current investment and future distribu- tions to retirees.
P/E ratio See price-to-earnings ratio.
periodic inventory system An updating system in which inventory accounts are only updated on designated intervals, such as at the end of each accounting period.
periodicity assumption Business activity can be divided into specific time intervals, such as months, quarters, and years.
perpetual existence A characteristic of a corporation, meaning that it will continue to exist and operate until it is merged with another, fails, or a corporate action is undertaken to liquidate the company.
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GLOSSARY
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perpetual inventory system An updat- ing system in which inventory records are continuously updated for all inventory changes.
petty cash Funds used for making small payments that may be impractical to pay by check or credit card.
physical inventory The process of actu- ally counting and valuing inventory on hand.
post-closing trial balance Reveals the balance of the real accounts following the closing process.
posting The process of transferring data from the journal into the general ledger.
prepaid expenses Costs that are paid in advance.
price-to-earnings (P/E) ratio A printabil- ity ratio that examines an organization's success during an accounting period. Price Earnings Ratio5 Market Price per Share / Earnings per Share.
principal The amount of the note is the stated value.
principle of full disclosure Dictates that financial statements and related notes are sufficient to allow financial statement users a legitimate basis for making informed judgments about the company.
prior period adjustment The correction of an accounting error in all periods affected.
property, plant, and equipment Items of land, buildings, and equipment that are used in production or services.
quick ratio A stringent liquidity that is calculated by dividing “quick assets” by current liabilities: Quick Ratio 5 (“Cash” 1 Accounts Receivable) / Current Liabilities.
R&D See research and development.
real accounts Asset, Liability, and Equity accounts that are not closed at the end of the accounting period.
relevance The degree that accounting information bears on the decision process, primarily by providing timely feedback on an enterprise’s financial condition and performance.
reliability The degree that accounting information is truthful and free from bias, or neutral.
replacement An outlay expenditure designed to restore an asset to its original condition.
research and development (R&D) Internally developed intangibles that are not assets.
retail method An inventory-costing method that relies on the assumption that a company’s markup is constant across all items of inventory.
retained earnings Earnings of a business that are not distributed.
retrospective adjustment The require- ment that when a company changes from one acceptable accounting method to another, it must redo financial informa- tion of prior periods as though the newer method had always been in use.
return-on-assets (ROA) ratio Measures profitability from a given level of asset investment. Calculated by dividing income before interest cost by the average assets used in the business: Return-on-Assets Ratio 5 (Net Income 1 Interest Expense) / Average Assets.
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return-on-equity (ROE) ratio Evalu- ates income in relation to the amount of invested common shareholder equity: Return-on-Equity Ratio 5 Net Income / Average Common Equity.
revenue recognition The measurement of revenue that is synonymous with record- ing revenues into the accounts.
revenues The gross inflows from customers.
ROA See return-on-assets ratio.
ROE See return-on-equity ratio.
salvage value Also called residual value, the amount a business expects to receive when selling or trading at the end of an asset’s service life.
service life The number of periods ben- efited in the life of an asset.
sole proprietorship A business owned by one person.
solvency The ability to satisfy a long-term structural debt.
source document Tangible evidence of the existence and nature of a transaction.
special journal A subdivision of a general journal.
specific identification The method in which a business must match each unit of inventory with its actual cost.
statement of cash flows A statement intended to show how cash is generated and expended during a specific period of time.
statement of retained earnings A state- ment that builds a bridge between the retained earnings that existed at the begin- ning and end of a particular period.
statement of stockholders’ equity An expanded statement that explains not only the periodic change in retained earnings but also shows all other sources of changes in equity.
straight-line method A method of depre- ciation that spreads the depreciable base over the service life, with an equal amount of depreciation assigned to each period.
systemic allocation An accounting model that systematically attributes some costs over time.
T-account A device that is used to dem- onstrate the impact of certain transactions and events.
tax services Provide help in preparing and filing of tax returns and the rendering of advice on the tax consequences of alterna- tive actions.
temporary accounts Revenue, Expense, and Dividend accounts that have been reset to a zero balance at the end of an accounting year, to be ready for the new accounting year.
times-interest-earned ratio Shows how many times a company’s income stream will cover its interest obligation: Times- Interest-Earned Ratio 5 Income Before Income Taxes and Interest / Interest Charges.
treasurer The person in a company whose job is to manage cash flows of the business.
treasury stock The shares reacquired by the issuing company when the stock price is viewed as being too low.
trial balance A listing of accounts and their respective balances.
unearned revenue Amounts collected in advance of services being provided.
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unemployment tax A tax levied and pooled to provide a source of funds to support persons who are temporarily out of work.
units-of-output method A method of depreciation when an asset’s consumption may be associated with a specific measure of use or output.
unlimited liability In partnerships, a partner has liability for debts, claims, and obligations of the partnership even after he or she resigns from the partnership.
vertical analysis Results when each expense category is expressed as a percent- age of sales.
W-2 form An annual wage and tax statement—which includes information on gross pay, tax withholding, and other related information—that an employer provides to an employee and the IRS.
W-4 form A form stating the tax- withholding status—marital and number of dependents—of an employee.
workers’ compensation insurance Insur- ance that provides payments to workers for work-related injuries.
working capital The amount of current assets minus current liabilities.
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Chapter 1 1. A 2. C ($32,000 1 $15,000 2 $9,000 1 $50,000 2 $48,000) 3. B 4. B 5. B ($45,000 2 $35,000)
Chapter 2 1. C 2. B 3. D 4. B 5. A
Chapter 3 1. B 2. C 3. B 4. D 5. C
Chapter 4 1. B 2. C 3. B 4. D
Chapter 5 1. B 2. B 3. C 4. A ($400 for A 1 $600 for B) 5. A
Concept Check Anwser Key
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CONCEPT CHECK ANSWER KEY
Chapter 6 1. D ($120,000 1 $1000,000 1 $150 1 850) 2. A 3. C ($8,000 / 4 years 5 $2,000 per year; ($45,000 2 $5,000) / $2,000 5 20 years) 4. C (5 year life 5 20% per year; 20% 3 2 5 40%;
$60,000 3 40% 3 9/12 5 $18,000; ($60,000 – $18,000) 3 40% 5 $16,800) 5. B
Chapter 7 1. C 2. B 3. D 4. B ((40 hours 3 $28) 1 (5 hours 3 $42) 5 $1,330; ($55,000 2 $54,202) 3 0.06 5 $47.88;
$1,330 3 0.015 = $19.95; $1,330 2 $47.88 2 $19.95 2 $270 2 $30 5 $962.17) 5. C
Chapter 8 1. A 2. D 3. A 4. C (10,000 shares x $115 5 $1,150,000; $4,000,000 – $1,150,000 5 $2,850,000;
$2,850,000 / 100,000 shares 5 $28.50)
Chapter 9 1. D 2. A 3. D 4. C
Segment Profit Profit Margin on Sales Return on Assets
Airline $20 $20 / $4,000 5 0.5% $20 / $2,000 5 1%
Pencils 80 $80 / $1,000 5 8.0% $80 / $1,600 5 5%
Aluminum Siding 400 $400 / $2,000 5 20.0% $400 / $4,000 5 10%
5. B
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