For Smartwriter only

THE ANNUAL REPORT

SPECIMEN FINANCIAL STATEMENTS:

PepsiCo, Inc.

Appendix A

The financial information herein is reprinted with permission from the PepsiCo, Inc. 2005 Annual Report. The complete financial statements are available through a link at the book’s companion website.

Once each year a corporation communicates to its stockholders and other interested parties by issuing a complete set of audited financial statements. The annual report, as this communication is called, summarizes the financial results of the company’s oper- ations for the year and its plans for the future. Many annual reports are attractive, mul- ticolored, glossy public relations pieces, containing pictures of corporate officers and directors as well as photos and descriptions of new products and new buildings. Yet the basic function of every annual report is to report financial information, almost all of which is a product of the corporation’s accounting system.

The content and organization of corporate annual reports have become fairly standardized. Excluding the public relations part of the report (pictures, products, etc.), the following are the traditional financial portions of the annual report:

FINANCIAL HIGHLIGHTS Companies usually present the financial highlights section inside the front cover of the annual report or on its first two pages. This section generally reports the total or per share amounts for five to ten financial items for the current year and one or more previous years. Financial items from the income statement and the balance sheet that typically are presented are sales, income from continuing operations, net income, net income per share, net cash provided by operating activities, dividends per common share, and the amount of capital expenditures. The financial highlights section from PepsiCo’s Annual Report is shown on page A-2.

A1

• Financial Highlights • Letter to the Stockholders • Management’s Discussion and

Analysis • Financial Statements • Notes to the Financial Statements

• Management’s Report on Internal Control

• Management Certification of Financial Statements

• Auditor’s Report • Supplementary Financial Information

In this appendix we illustrate current financial reporting with a comprehensive set of corporate financial statements that are prepared in accordance with gener- ally accepted accounting principles and audited by an international independent certified public accounting firm. We are grateful for permission to use the actual fi- nancial statements and other accompanying financial information from the annual report of a large, publicly held company, PepsiCo, Inc.

LETTER TO THE STOCKHOLDERS

A2 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Nearly every annual report contains a letter to the stockholders from the chairman of the board or the president, or both. This letter typically discusses the company’s accomplishments during the past year and highlights significant events such as mergers and acquisitions, new products, operating achievements, business philoso- phy, changes in officers or directors, financing commitments, expansion plans, and

2005 2004 % Chg(a)

Summary of Operations

Total net revenue $32,562 $29,261 11

Division operating profit $6,710 $6,098 10

Total operating profit $5,922 $5,259 13

Net income(b) $4,536 $4,004 13

Earnings per share(b) $2.66 $2.32 15

Other Data

Management operating cash flow(c) $4,204 $3,705 13

Net cash provided by

operating activities $5,852 $5,054 16

Capital spending $1,736 $1,387 25

Common share repurchases $3,012 $3,028 (0.5)

Dividends paid $1,642 $1,329 24

Long-term debt $2,313 $2,397 (3.5) (a) Percentage changes above and in text are based on unrounded amounts.

(b) In 2005, excludes the impact of AJCA tax charge, the 53rd week and restructuring charges. In 2004, excludes certain prior year tax benefits, and restructuring and impairment charges. See page 76 for reconciliation to net income and earnings per share on a GAAP basis.

(c) Includes the impact of net capital spending. Also, see “Our Liquidity, Capital Resources and Financial Position” in Management’s Discussion and Analysis.

PepsiCo International

PepsiCo Beverages North America

Frito-Lay North America

Quaker Foods North America35% 5%

32%28%

24%

38%

8%

30%

PepsiCo International

PepsiCo Beverages North America

Frito-Lay North America

Quaker Foods North America

Division Operating Profit Total: $6,710

Net Revenue Total: $32,562

Financial Highlights PepsiCo, Inc. and Subsidiaries ($ in millions except per share amounts; all per share amounts assume dilution)

Financial Statements and Accompanying Notes A3

MANAGEMENT’S DISCUSSION AND ANALYSIS The management’s discussion and analysis (MD&A) section covers three financial aspects of a company: its results of operations, its ability to pay near-term obliga- tions, and its ability to fund operations and expansion. Management must highlight favorable or unfavorable trends and identity significant events and uncertainties that affect these three factors. This discussion obviously involves a number of sub- jective estimates and opinions. In its MD&A section, PepsiCo breaks its discussion into three major headings: Our Business, Our Critical Accounting Policies, and Our Financial Results. PepsiCo’s MD&A section is 22 pages long. You can access that section at www.wiley.com/college/weygandt.

future prospects. The letter to the stockholders is signed by Steve Reinemund, Chairman of the Board and Chief Executive Officer, of PepsiCo.

Only a short summary of the letter is provided below. The full letter can be accessed at the book’s companion website at www.wiley.com/college/weygandt.

FINANCIAL STATEMENTS AND ACCOMPANYING NOTES

The standard set of financial statements consists of: (1) a comparative income statement for 3 years, (2) a comparative statement of cash flows for 3 years, (3) a comparative balance sheet for 2 years, (4) a statement of stockholders’ equity for 3 years, and (5) a set of accompanying notes that are considered an integral part of the financial statements. The auditor’s report, unless stated otherwise, covers the financial statements and the accompanying notes. PepsiCo’s financial state- ments and accompanying notes plus supplementary data and analyses follow.

Consolidated Statement of Income PepsiCo, Inc. and Subsidiaries Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

(in millions except per share amounts) 2005 2004 2003

Net Revenue........................................................................................................................... $32,562 $29,261 $26,971

Cost of sales........................................................................................................................... 14,176 12,674 11,691 Selling, general and administrative expenses ........................................................................ 12,314 11,031 10,148 Amortization of intangible assets ........................................................................................... 150 147 145 Restructuring and impairment charges.................................................................................. – 150 147 Merger-related costs............................................................................................................... – – 59

Operating Profit ..................................................................................................................... 5,922 5,259 4,781

Bottling equity income............................................................................................................ 557 380 323 Interest expense...................................................................................................................... (256) (167) (163) Interest income ....................................................................................................................... 159 74 51

Income from Continuing Operations before Income Taxes ................................................. 6,382 5,546 4,992

Provision for Income Taxes................................................................................................... 2,304 1,372 1,424

Income from Continuing Operations..................................................................................... 4,078 4,174 3,568

Tax Benefit from Discontinued Operations ........................................................................... – 38 –

Net Income ............................................................................................................................ $ 4,078 $ 4,212 $ 3,568

Net Income per Common Share — Basic Continuing operations ....................................................................................................... $2.43 $2.45 $2.07 Discontinued operations.................................................................................................... – 0.02 –

Total .................................................................................................................................. $2.43 $2.47 $2.07

Net Income per Common Share — Diluted Continuing operations ....................................................................................................... $2.39 $2.41 $2.05 Discontinued operations.................................................................................................... – 0.02 –

Total .................................................................................................................................. $2.39 $2.44* $2.05

* Based on unrounded amounts. See accompanying notes to consolidated financial statements.

2003 2004 2005

2003 2004 2005 2003 2004 2005

2003 2004 2005

$2.05

$2.41

$32,562

$26,971 $29,261

$5,922

$4,781 $5,259

$3,568

$4,174 $4,078

$2.39

Net Revenue Operating Profit

Net Income per Common Share — Continuing OperationsIncome from Continuing Operations

A4 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Consolidated Statement of Cash Flows PepsiCo, Inc. and Subsidiaries Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

(in millions) 2005 2004 2003 Operating Activities Net income ................................................................................................................................. $ 4,078 $ 4,212 $ 3,568 Adjustments to reconcile net income to net cash provided by operating activities

Depreciation and amortization ............................................................................................. 1,308 1,264 1,221 Stock-based compensation expense ..................................................................................... 311 368 407 Restructuring and impairment charges ............................................................................... – 150 147 Cash payments for merger-related costs and restructuring charges ................................... (22) (92) (109) Tax benefit from discontinued operations............................................................................. – (38) – Pension and retiree medical plan contributions ................................................................... (877) (534) (605) Pension and retiree medical plan expenses.......................................................................... 464 395 277 Bottling equity income, net of dividends .............................................................................. (411) (297) (276) Deferred income taxes and other tax charges and credits ................................................... 440 (203) (286) Merger-related costs............................................................................................................. – – 59 Other non-cash charges and credits, net ............................................................................. 145 166 101 Changes in operating working capital, excluding effects of acquisitions and divestitures

Accounts and notes receivable........................................................................................ (272) (130) (220) Inventories ...................................................................................................................... (132) (100) (49) Prepaid expenses and other current assets .................................................................... (56) (31) 23 Accounts payable and other current liabilities................................................................ 188 216 (11) Income taxes payable...................................................................................................... 609 (268) 182

Net change in operating working capital.............................................................................. 337 (313) (75) Other..................................................................................................................................... 79 (24) (101)

Net Cash Provided by Operating Activities .............................................................................. 5,852 5,054 4,328

Investing Activities Snack Ventures Europe (SVE) minority interest acquisition ....................................................... (750) – – Capital spending ....................................................................................................................... (1,736) (1,387) (1,345) Sales of property, plant and equipment ..................................................................................... 88 38 49 Other acquisitions and investments in noncontrolled affiliates ................................................ (345) (64) (71) Cash proceeds from sale of PBG stock ...................................................................................... 214 – – Divestitures................................................................................................................................ 3 52 46 Short-term investments, by original maturity

More than three months — purchases ................................................................................ (83) (44) (38) More than three months — maturities ................................................................................ 84 38 28 Three months or less, net ..................................................................................................... (992) (963) (940)

Net Cash Used for Investing Activities..................................................................................... (3,517) (2,330) (2,271)

Financing Activities Proceeds from issuances of long-term debt .............................................................................. 25 504 52 Payments of long-term debt ...................................................................................................... (177) (512) (641) Short-term borrowings, by original maturity

More than three months — proceeds................................................................................... 332 153 88 More than three months — payments ................................................................................. (85) (160) (115) Three months or less, net ..................................................................................................... 1,601 1,119 40

Cash dividends paid .................................................................................................................. (1,642) (1,329) (1,070) Share repurchases — common ................................................................................................. (3,012) (3,028) (1,929) Share repurchases — preferred ................................................................................................ (19) (27) (16) Proceeds from exercises of stock options................................................................................... 1,099 965 689

Net Cash Used for Financing Activities.................................................................................... (1,878) (2,315) (2,902)

Effect of exchange rate changes on cash and cash equivalents ............................................... (21) 51 27

Net Increase/(Decrease) in Cash and Cash Equivalents ......................................................... 436 460 (818) Cash and Cash Equivalents, Beginning of Year ....................................................................... 1,280 820 1,638

Cash and Cash Equivalents, End of Year ................................................................................. $ 1,716 $ 1,280 $ 820

See accompanying notes to consolidated financial statements.

Financial Statements and Accompanying Notes A5

A6 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Consolidated Balance Sheet PepsiCo, Inc. and Subsidiaries December 31, 2005 and December 25, 2004

(in millions except per share amounts) 2005 2004

ASSETS

Current Assets

Cash and cash equivalents ................................................................................................................................... $ 1,716 $ 1,280

Short-term investments ........................................................................................................................................ 3,166 2,165

4,882 3,445 Accounts and notes receivable, net....................................................................................................................... 3,261 2,999

Inventories............................................................................................................................................................. 1,693 1,541

Prepaid expenses and other current assets........................................................................................................... 618 654

Total Current Assets ....................................................................................................................................... 10,454 8,639

Property, Plant and Equipment, net .................................................................................................................... 8,681 8,149

Amortizable Intangible Assets, net ...................................................................................................................... 530 598

Goodwill................................................................................................................................................................. 4,088 3,909

Other nonamortizable intangible assets................................................................................................................ 1,086 933

Nonamortizable Intangible Assets.................................................................................................................. 5,174 4,842

Investments in Noncontrolled Affiliates .............................................................................................................. 3,485 3,284

Other Assets ......................................................................................................................................................... 3,403 2,475

Total Assets................................................................................................................................................ $31,727 $ 27,987

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current Liabilities

Short-term obligations .......................................................................................................................................... $ 2,889 $ 1,054

Accounts payable and other current liabilities ...................................................................................................... 5,971 5,599

Income taxes payable ............................................................................................................................................ 546 99

Total Current Liabilities .................................................................................................................................. 9,406 6,752

Long-Term Debt Obligations................................................................................................................................. 2,313 2,397

Other Liabilities .................................................................................................................................................... 4,323 4,099

Deferred Income Taxes ........................................................................................................................................ 1,434 1,216

Total Liabilities................................................................................................................................................ 17,476 14,464 Commitments and Contingencies

Preferred Stock, no par value ............................................................................................................................. 41 41

Repurchased Preferred Stock ............................................................................................................................. (110) (90)

Common Shareholders’ Equity

Common stock, par value 1 2/3¢ per share (issued 1,782 shares) ....................................................................... 30 30

Capital in excess of par value ............................................................................................................................... 614 618 Retained earnings ................................................................................................................................................. 21,116 18,730 Accumulated other comprehensive loss ................................................................................................................ (1,053) (886)

20,707 18,492

Less: repurchased common stock, at cost (126 and 103 shares, respectively) ................................................... (6,387) (4,920)

Total Common Shareholders’ Equity .............................................................................................................. 14,320 13,572

Total Liabilities and Shareholders’ Equity ................................................................................................ $31,727 $27,987

See accompanying notes to consolidated financial statements.

Financial Statements and Accompanying Notes A7

Consolidated Statement of Common Shareholders’ Equity PepsiCo, Inc. and Subsidiaries Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

(in millions) 2005 2004 2003 Shares Amount Shares Amount Shares Amount

Common Stock 1,782 $ 30 1,782 $ 30 1,782 $ 30

Capital in Excess of Par Value Balance, beginning of year........................................... 618 548 207 Stock-based compensation expense............................. 311 368 407 Stock option exercises(a) ............................................... (315) (298) (66)

Balance, end of year..................................................... 614 618 548

Retained Earnings Balance, beginning of year........................................... 18,730 15,961 13,489 Net income ................................................................... 4,078 4,212 3,568 Cash dividends declared — common .......................... (1,684) (1,438) (1,082) Cash dividends declared — preferred ......................... (3) (3) (3) Cash dividends declared — RSUs ............................... (5) (2) – Other ............................................................................ – – (11)

Balance, end of year..................................................... 21,116 18,730 15,961

Accumulated Other Comprehensive Loss Balance, beginning of year .......................................... (886) (1,267) (1,672) Currency translation adjustment.................................. (251) 401 410 Cash flow hedges, net of tax:

Net derivative gains/(losses) .................................. 54 (16) (11) Reclassification of (gains)/losses to net income .... (8) 9 (1)

Minimum pension liability adjustment, net of tax ............................................................... 16 (19) 7

Unrealized gain on securities, net of tax ...................... 24 6 1 Other ............................................................................ (2) – (1)

Balance, end of year..................................................... (1,053) (886) (1,267)

Repurchased Common Stock Balance, beginning of year........................................... (103) (4,920) (77) (3,376) (60) (2,524) Share repurchases........................................................ (54) (2,995) (58) (2,994) (43) (1,946) Stock option exercises .................................................. 31 1,523 32 1,434 26 1,096 Other ............................................................................ – 5 – 16 – (2)

Balance, end of year..................................................... (126) (6,387) (103) (4,920) (77) (3,376)

Total Common Shareholders’ Equity ................................ $14,320 $13,572 $11,896

2005 2004 2003 Comprehensive Income

Net income .................................................................. $4,078 $4,212 $3,568 Currency translation adjustment.................................. (251) 401 410 Cash flow hedges, net of tax ........................................ 46 (7) (12) Minimum pension liability adjustment, net of tax ....... 16 (19) 7 Unrealized gain on securities, net of tax ...................... 24 6 1 Other ............................................................................ (2) – (1)

Total Comprehensive Income........................................... $3,911 $4,593 $3,973

(a) Includes total tax benefit of $125 million in 2005, $183 million in 2004 and $340 million in 2003. See accompanying notes to consolidated financial statements.

A8 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Our financial statements include the con- solidated accounts of PepsiCo, Inc. and the affiliates that we control. In addition, we include our share of the results of cer- tain other affiliates based on our economic ownership interest. We do not control these other affiliates, as our ownership in these other affiliates is generally less than 50%. Our share of the net income of noncon- trolled bottling affiliates is reported in our income statement as bottling equity income. Bottling equity income also includes any changes in our ownership interests of these affiliates. In 2005, bot- tling equity income includes $126 million of pre-tax gains on our sales of PBG stock. See Note 8 for additional information on our noncontrolled bottling affiliates. Our share of other noncontrolled affiliates is included in division operating profit. Intercompany balances and transactions are eliminated. In 2005, we had an addi- tional week of results (53rd week). Our fiscal year ends on the last Saturday of each December, resulting in an additional week of results every five or six years.

In connection with our ongoing BPT initiative, we aligned certain accounting policies across our divisions in 2005. We conformed our methodology for calculating our bad debt reserves and modified our policy for recognizing revenue for products shipped to customers by third-party carriers. Additionally, we conformed our method of accounting for certain costs, primarily warehouse and freight. These changes reduced our net revenue by $36 million and our operating profit by $60 million in 2005. We also made certain reclassifications on our Consolidated Statement of Income in the fourth quarter of 2005 from cost of sales to selling, general and administrative expenses in connection with our BPT initiative. These reclassifications resulted in reductions to cost of sales of $556 million through the third quarter of 2005, $732 million in the full year 2004 and $688 million in the full year 2003, with corresponding increases to selling, general and administrative expenses in those periods. These reclassifi- cations had no net impact on operating profit and have been made to all periods presented for comparability.

The preparation of our consolidated financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses and disclosure of contingent assets and liabilities. Estimates are used in determin- ing, among other items, sales incentives accruals, future cash flows associated with impairment testing for perpetual brands and goodwill, useful lives for intangible assets, tax reserves, stock-based compen- sation and pension and retiree medical accruals. Actual results could differ from these estimates.

See “Our Divisions” below and for additional unaudited information on items affecting the comparability of our consolidated results, see “Items Affecting Comparability” in Management’s Discussion and Analysis.

Tabular dollars are in millions, except per share amounts. All per share amounts reflect common per share amounts, assume dilution unless noted, and are based on unrounded amounts. Certain reclassifica- tions were made to prior years’ amounts to conform to the 2005 presentation.

We manufacture or use contract manufac- turers, market and sell a variety of salty, sweet and grain-based snacks, carbonated and non-carbonated beverages, and foods through our North American and interna- tional business divisions. Our North American divisions include the United States and Canada. The accounting poli- cies for the divisions are the same as those described in Note 2, except for certain allocation methodologies for stock-based compensation expense and pension and retiree medical expense, as described in the unaudited information in “Our Critical Accounting Policies.” Additionally, begin-

ning in the fourth quarter of 2005, we began centrally managing commodity derivatives on behalf of our divisions. Certain of the commodity derivatives, primarily those related to the purchase of energy for use by our divisions, do not qualify for hedge accounting treatment. These derivatives hedge underlying com- modity price risk and were not entered into for speculative purposes. Such derivatives are marked to market with the resulting gains and losses recognized as a compo- nent of corporate unallocated expense. These gains and losses are reflected in division results when the divisions take

delivery of the underlying commodity. Therefore, division results reflect the contract purchase price of the energy or other commodities.

Division results are based on how our Chairman and Chief Executive Officer evaluates our divisions. Division results exclude certain Corporate-initiated restruc- turing and impairment charges, merger- related costs and divested businesses. For additional unaudited information on our divisions, see “Our Operations” in Management’s Discussion and Analysis.

Notes to Consolidated Financial Statements Note 1 — Basis of Presentation and Our Divisions

Our Divisions

Basis of Presentation

Financial Statements and Accompanying Notes A9

2005 2004 2003 2005 2004 2003 Net Revenue Operating Profit

FLNA...................................................................... $10,322 $ 9,560 $ 9,091 $2,529 $2,389 $ 2,242 PBNA ..................................................................... 9,146 8,313 7,733 2,037 1,911 1,690 PI ......................................................................... 11,376 9,862 8,678 1,607 1,323 1,061 QFNA ..................................................................... 1,718 1,526 1,467 537 475 470 Total division ........................................................ 32,562 29,261 26,969 6,710 6,098 5,463 Divested businesses ............................................. – – 2 – – 26 Corporate .............................................................. – – – (788) (689) (502)

32,562 29,261 26,971 5,922 5,409 4,987 Restructuring and impairment charges................ – – – – (150) (147) Merger-related costs ............................................. – – – – – (59) Total ...................................................................... $32,562 $29,261 $26,971 $5,922 $5,259 $ 4,781

Divested Businesses During 2003, we sold our Quaker Foods North America Mission pasta business. The results of this business are reported as divested businesses.

Corporate Corporate includes costs of our corporate headquarters, centrally managed initia- tives, such as our BPT initiative, unallo- cated insurance and benefit programs, foreign exchange transaction gains and losses, and certain commodity derivative

gains and losses, as well as profit-in-inven- tory elimination adjustments for our non- controlled bottling affiliates and certain other items.

Restructuring and Impairment Charges and Merger-Related Costs — See Note 3.

QFNA 5%

FLNA 32%

PBNA 28%

PI 35%

Division Net Revenue

QFNA 8%

FLNA 38%

PBNA 30%

PI 24%

Division Operating Profit

Frito-Lay North America

(FLNA)

Quaker Foods North America

(QFNA)

PepsiCo Beverages

North America (PBNA)

PepsiCo International

(PI)

A10 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Other Division Information 2005 2004 2003 2005 2004 2003

Total Assets Capital Spending FLNA $ 5,948 $ 5,476 $ 5,332 $ 512 $ 469 $ 426 PBNA 6,316 6,048 5,856 320 265 332 PI 9,983 8,921 8,109 667 537 521 QFNA 989 978 995 31 33 32 Total division 23,236 21,423 20,292 1,530 1,304 1,311 Corporate(a) 5,331 3,569 2,384 206 83 34 Investments in bottling affiliates 3,160 2,995 2,651 – – –

$31,727 $27,987 $25,327 $1,736 $1,387 $1,345

(a) Corporate assets consist principally of cash and cash equivalents, short-term investments, and property, plant and equipment.

2005 2004 2003 2005 2004 2003 Amortization of Depreciation and

Intangible Assets Other Amortization FLNA $ 3 $ 3 $ 3 $ 419 $ 420 $ 416 PBNA 76 75 75 264 258 245 PI 71 68 66 420 382 350 QFNA – 1 1 34 36 36 Total division 150 147 145 1,137 1,096 1,047 Corporate – – – 21 21 29

$150 $147 $145 $1,158 $1,117 $1,076

2005 2004 2003 2005 2004 2003 Net Revenue(a) Long-Lived Assets(b)

U.S. $19,937 $18,329 $17,377 $10,723 $10,212 $ 9,907 Mexico 3,095 2,724 2,642 902 878 869 United Kingdom 1,821 1,692 1,510 1,715 1,896 1,724 Canada 1,509 1,309 1,147 582 548 508 All other countries 6,200 5,207 4,295 3,948 3,339 3,123

$32,562 $29,261 $26,971 $17,870 $16,873 $16,131

(a) Represents net revenue from businesses operating in these countries.

(b) Long-lived assets represent net property, plant and equipment, nonamortizable and net amortizable intangible assets and investments in noncontrolled affiliates. These assets are reported in the country where they are primarily used.

FLNA 19%

PBNA 20%

PI 31%

QFNA 3%

Other 27%

Total Assets QFNA 2%

FLNA 30%

PBNA 18%

PI 38%

Other 12%

Capital Spending

Canada 4%

United States 61%

Mexico 10%

United Kingdom 6%

Other 19%

Net Revenue

Canada 3%

United States 60%

Mexico 5%

United Kingdom 10%

Other 22%

Long-Lived Assets

Financial Statements and Accompanying Notes A11

Revenue Recognition We recognize revenue upon shipment or delivery to our customers based on written sales terms that do not allow for a right of return. However, our policy for direct-store- delivery (DSD) and chilled products is to remove and replace damaged and out-of- date products from store shelves to ensure that our consumers receive the product quality and freshness that they expect. Similarly, our policy for warehouse distrib- uted products is to replace damaged and out-of-date products. Based on our histori- cal experience with this practice, we have reserved for anticipated damaged and out- of-date products. For additional unaudited information on our revenue recognition and related policies, including our policy on bad debts, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. We are exposed to concentration of credit risk by our customers, Wal-Mart and PBG. Wal-Mart represents approxi- mately 9% of our net revenue, including concentrate sales to our bottlers which are used in finished goods sold by them to Wal-Mart; and PBG represents approxi- mately 10%. We have not experienced credit issues with these customers.

Sales Incentives and Other Marketplace Spending We offer sales incentives and discounts through various programs to our customers and consumers. Sales incentives and dis- counts are accounted for as a reduction of revenue and totaled $8.9 billion in 2005, $7.8 billion in 2004 and $7.1 billion in 2003. While most of these incentive arrangements have terms of no more than one year, certain arrangements extend beyond one year. For example, fountain pouring rights may extend up to 15 years. Costs incurred to obtain these arrange- ments are recognized over the contract period and the remaining balances of $321 million at December 31, 2005 and $337 million at December 25, 2004 are included in current assets and other assets in our Consolidated Balance Sheet. For additional unaudited information on our

sales incentives, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis.

Other marketplace spending includes the costs of advertising and other marketing activities and is reported as selling, general and administrative expenses. Advertising expenses were $1.8 billion in 2005, $1.7 billion in 2004 and $1.6 billion in 2003. Deferred advertising costs are not expensed until the year first used and consist of: • media and personal service prepayments, • promotional materials in inventory, and • production costs of future media

advertising. Deferred advertising costs of $202 mil-

lion and $137 million at year-end 2005 and 2004, respectively, are classified as prepaid expenses in our Consolidated Balance Sheet.

Distribution Costs Distribution costs, including the costs of shipping and handling activities, are reported as selling, general and administra- tive expenses. Shipping and handling expenses were $4.1 billion in 2005, $3.9 billion in 2004 and $3.6 billion in 2003.

Cash Equivalents Cash equivalents are investments with original maturities of three months or less which we do not intend to rollover beyond three months.

Software Costs We capitalize certain computer software and software development costs incurred in connection with developing or obtaining computer software for internal use. Capitalized software costs are included in property, plant and equipment on our Consolidated Balance Sheet and amortized on a straight-line basis over the estimated useful lives of the software, which gener- ally do not exceed 5 years. Net capitalized software and development costs were $327 million at December 31, 2005 and $181 million at December 25, 2004.

Commitments and Contingencies We are subject to various claims and contingencies related to lawsuits, taxes and environmental matters, as well as commitments under contractual and other commercial obligations. We recognize lia- bilities for contingencies and commitments when a loss is probable and estimable. For additional information on our commit- ments, see Note 9.

Other Significant Accounting Policies Our other significant accounting policies are disclosed as follows: • Property, Plant and Equipment and

Intangible Assets — Note 4 and, for additional unaudited information on brands and goodwill, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis.

• Income Taxes — Note 5 and, for addi- tional unaudited information, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis.

• Stock-Based Compensation Expense — Note 6 and, for additional unaudited information, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis.

• Pension, Retiree Medical and Savings Plans — Note 7 and, for additional unaudited information, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis.

• Risk Management — Note 10 and, for additional unaudited information, see “Our Business Risks” in Management’s Discussion and Analysis. There have been no new accounting

pronouncements issued or effective during 2005 that have had, or are expected to have, a material impact on our consoli- dated financial statements.

Note 2 — Our Significant Accounting Policies

A12 Appendix A Specimen Financial Statements: PepsiCo, Inc.

2005 Restructuring Charges In the fourth quarter of 2005, we incurred a charge of $83 million ($55 million after- tax or $0.03 per share) in conjunction with actions taken to reduce costs in our opera- tions, principally through headcount reduc- tions. Of this charge, $34 million related to FLNA, $21 million to PBNA, $16 million to PI and $12 million to Corporate (recorded in corporate unallocated expenses). Most of this charge related to the termination of approximately 700 employees. We expect the substantial portion of the cash payments related to this charge to be paid in 2006.

2004 and 2003 Restructuring and Impairment Charges In the fourth quarter of 2004, we incurred a charge of $150 million ($96 million after-tax or $0.06 per share) in conjunc- tion with the consolidation of FLNA’s manufacturing network as part of its ongo- ing productivity program. Of this charge,

$93 million related to asset impairment, primarily reflecting the closure of four U.S. plants. Production from these plants was redeployed to other FLNA facilities in the U.S. The remaining $57 million included employee-related costs of $29 million, contract termination costs of $8 million and other exit costs of $20 million. Employee-related costs primarily reflect the termination costs for approximately 700 employees. Through December 31, 2005, we have paid $47 million and incurred non-cash charges of $10 million, leaving substantially no accrual.

In the fourth quarter of 2003, we incurred a charge of $147 million ($100 million after-tax or $0.06 per share) in conjunction with actions taken to streamline our North American divisions and PepsiCo International. These actions were taken to increase focus and eliminate redundancies at PBNA and PI and to improve the efficiency of the supply chain

at FLNA. Of this charge, $81 million related to asset impairment, reflecting $57 million for the closure of a snack plant in Kentucky, the retirement of snack manufacturing lines in Maryland and Arkansas and $24 million for the closure of a PBNA office building in Florida. The remaining $66 million included employee- related costs of $54 million and facility and other exit costs of $12 million. Employee-related costs primarily reflect the termination costs for approximately 850 sales, distribution, manufacturing, research and marketing employees. As of December 31, 2005, all terminations had occurred and substantially no accrual remains.

Merger-Related Costs In connection with the Quaker merger in 2001, we recognized merger-related costs of $59 million ($42 million after-tax or $0.02 per share) in 2003.

Depreciation and amortization are recognized on a straight-line basis over an asset’s estimated useful life. Land is not depreciated and construction in progress is not depreciated until ready for service. Amortization of intangible assets for each of the next five years, based on average 2005 foreign exchange rates, is expected to be $152 million in 2006, $35 million in 2007, $35 million in 2008, $34 mil- lion in 2009 and $33 million in 2010.

Depreciable and amortizable assets are only evaluated for impairment upon a significant change in the operating or macroeconomic environment. In these circumstances, if an evaluation of the undiscounted cash flows indicates impair- ment, the asset is written down to its estimated fair value, which is based on discounted future cash flows. Useful lives are periodically evaluated to determine whether events or circumstances have occurred which indicate the need for revi- sion. For additional unaudited information on our amortizable brand policies, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis.

Note 3 — Restructuring and Impairment Charges and Merger-Related Costs

Note 4 — Property, Plant and Equipment and Intangible Assets

Average Useful Life 2005 2004 2003 Property, plant and equipment, net Land and improvements 10 – 30 yrs. $ 685 $ 646 Buildings and improvements 20 – 44 3,736 3,605 Machinery and equipment,

including fleet and software 5 – 15 11,658 10,950 Construction in progress 1,066 729

17,145 15,930 Accumulated depreciation (8,464) (7,781)

$ 8,681 $ 8,149

Depreciation expense $1,103 $1,062 $1,020

Amortizable intangible assets, net Brands 5 – 40 $1,054 $1,008 Other identifiable intangibles 3 – 15 257 225

1,311 1,233 Accumulated amortization (781) (635)

$ 530 $ 598

Amortization expense $150 $147 $145

Financial Statements and Accompanying Notes A13

Nonamortizable Intangible Assets Perpetual brands and goodwill are assessed for impairment at least annually to ensure that discounted future cash flows continue to exceed the related book value. A perpetual brand is impaired if its book value exceeds its fair value. Goodwill is evaluated for impairment if the book value of its reporting unit exceeds its fair value. A reporting unit can be a division or business within a division. If the fair value of an evaluated asset is less than its book value, the asset is written down based on its discounted future cash flows to fair value. No impairment charges resulted from the required impairment evaluations. The change in the book value of nonamortizable intangible assets is as follows:

Balance, Translation Balance, Translation Balance, Beginning 2004 Acquisition and Other End of 2004 Acquisition and Other End of 2005

Frito-Lay North America Goodwill $ 130 $ – $ 8 $ 138 $ – $ 7 $ 145 PepsiCo Beverages North America Goodwill 2,157 – 4 2,161 – 3 2,164 Brands 59 – – 59 – – 59

2,216 – 4 2,220 – 3 2,223 PepsiCo International Goodwill 1,334 29 72 1,435 278 (109) 1,604 Brands 808 – 61 869 263 (106) 1,026

2,142 29 133 2,304 541 (215) 2,630 Quaker Foods North America Goodwill 175 – – 175 – – 175 Corporate Pension intangible 2 – 3 5 – (4) 1 Total goodwill 3,796 29 84 3,909 278 (99) 4,088 Total brands 867 – 61 928 263 (106) 1,085 Total pension intangible 2 – 3 5 – (4) 1

$4,665 $29 $148 $ 4,842 $541 $(209) $5,174

A14 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Note 5 — Income Taxes

2005 2004 2003 Income before income taxes — continuing operations U.S. ................................................................................................................................................... $3,175 $2,946 $3,267 Foreign.............................................................................................................................................. 3,207 2,600 1,725

$6,382 $5,546 $4,992

Provision for income taxes — continuing operations Current: U.S. Federal ....................................................................................................................... $1,638 $1,030 $1,326

Foreign .............................................................................................................................. 426 256 341 State ................................................................................................................................. 118 69 80

2,182 1,355 1,747 Deferred: U.S. Federal ....................................................................................................................... 137 11 (274)

Foreign .............................................................................................................................. (26) 5 (47) State ................................................................................................................................. 11 1 (2)

122 17 (323) $2,304 $1,372 $1,424

Tax rate reconciliation — continuing operations U.S. Federal statutory tax rate .......................................................................................................... 35.0% 35.0% 35.0% State income tax, net of U.S. Federal tax benefit.............................................................................. 1.4 0.8 1.0 Taxes on AJCA repatriation................................................................................................................ 7.0 – – Lower taxes on foreign results .......................................................................................................... (6.5) (5.4) (5.5) Settlement of prior years’ audit ........................................................................................................ – (4.8) (2.2) Other, net .......................................................................................................................................... (0.8) (0.9) 0.2 Annual tax rate ................................................................................................................................. 36.1% 24.7% 28.5%

Deferred tax liabilities Investments in noncontrolled affiliates ............................................................................................ $ 993 $ 850 Property, plant and equipment ......................................................................................................... 772 857 Pension benefits ............................................................................................................................... 863 669 Intangible assets other than nondeductible goodwill ....................................................................... 135 153 Zero coupon notes ............................................................................................................................ 35 46 Other................................................................................................................................................. 169 157 Gross deferred tax liabilities............................................................................................................. 2,967 2,732 Deferred tax assets Net carryforwards ............................................................................................................................. 608 666 Stock-based compensation............................................................................................................... 426 402 Retiree medical benefits................................................................................................................... 400 402 Other employee-related benefits....................................................................................................... 342 379 Other................................................................................................................................................. 520 460 Gross deferred tax assets ................................................................................................................. 2,296 2,309 Valuation allowances........................................................................................................................ (532) (564) Deferred tax assets, net.................................................................................................................... 1,764 1,745 Net deferred tax liabilities ................................................................................................................ $1,203 $ 987

Deferred taxes included within: Prepaid expenses and other current assets .................................................................................. $231 $229 Deferred income taxes .................................................................................................................. $1,434 $1,216

Analysis of valuation allowances Balance, beginning of year ............................................................................................................... $564 $438 $487

(Benefit)/provision ........................................................................................................................ (28) 118 (52) Other (deductions)/additions........................................................................................................ (4) 8 3

Balance, end of year ......................................................................................................................... $532 $564 $438

Financial Statements and Accompanying Notes A15

For additional unaudited information on our income tax policies, including our reserves for income taxes, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis.

Carryforwards, Credits and Allowances Operating loss carryforwards totaling $5.1 billion at year-end 2005 are being carried forward in a number of foreign and state jurisdictions where we are permitted to use tax operating losses from prior peri- ods to reduce future taxable income. These operating losses will expire as follows: $0.1 billion in 2006, $4.1 billion between 2007 and 2025 and $0.9 billion may be carried forward indefinitely. In addition, certain tax credits generated in prior peri- ods of approximately $39.4 million are available to reduce certain foreign tax liabilities through 2011. We establish valuation allowances for our deferred tax assets when the amount of expected future taxable income is not likely to support the use of the deduction or credit.

Undistributed International Earnings The AJCA created a one-time incentive for U.S. corporations to repatriate undistrib- uted international earnings by providing an

85% dividends received deduction. As approved by our Board of Directors in July 2005, we repatriated approximately $7.5 billion in earnings previously consid- ered indefinitely reinvested outside the U.S. in the fourth quarter of 2005. In 2005, we recorded income tax expense of $460 mil- lion associated with this repatriation. Other than the earnings repatriated, we intend to continue to reinvest earnings outside the U.S. for the foreseeable future and, there- fore, have not recognized any U.S. tax expense on these earnings. At December 31, 2005, we had approximately $7.5 bil- lion of undistributed international earnings.

Reserves A number of years may elapse before a par- ticular matter, for which we have established a reserve, is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. During 2004, we recognized $266 million of tax benefits related to the favorable resolu- tion of certain open tax issues. In addition, in 2004, we recognized a tax benefit of $38 million upon agreement with the IRS on an open issue related to our discontinued restaurant operations. At the end of 2003,

we entered into agreements with the IRS for open years through 1997. These agreements resulted in a tax benefit of $109 million in the fourth quarter of 2003. As part of these agreements, we also resolved the treatment of certain other issues related to future tax years.

The IRS has initiated their audits of our tax returns for the years 1998 through 2002. Our tax returns subsequent to 2002 have not yet been examined. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, we believe that our reserves reflect the probable outcome of known tax contin- gencies. Settlement of any particular issue would usually require the use of cash. Favorable resolution would be recognized as a reduction to our annual tax rate in the year of resolution. Our tax reserves, covering all federal, state and foreign jurisdictions, are presented in the balance sheet within other liabilities (see Note 14), except for any amounts relating to items we expect to pay in the coming year which are included in current income taxes payable. For further unaudited information on the impact of the resolution of open tax issues, see “Other Consolidated Results.”

Our stock-based compensation program is a broad-based program designed to attract and retain employees while also aligning employees’ interests with the interests of our shareholders. Employees at all levels participate in our stock-based compensa- tion program. In addition, members of our Board of Directors participate in our stock- based compensation program in connec- tion with their service on our Board. Stock options and RSUs are granted to employ- ees under the shareholder-approved 2003 Long-Term Incentive Plan (LTIP), our only active stock-based plan. Stock-based compensation expense was $311 million in 2005, $368 million in 2004 and $407 million in 2003. Related income tax benefits recognized in earnings were $87 million in 2005, $103 million in 2004 and $114 million in 2003. At year- end 2005, 51 million shares were avail- able for future executive and SharePower grants. For additional unaudited informa-

tion on our stock-based compensation pro- gram, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis.

SharePower Grants SharePower options are awarded under our LTIP to all eligible employees, based on job level or classification, and in the case of international employees, tenure as well. All stock option grants have an exercise price equal to the fair market value of our common stock on the day of grant and generally have a 10-year term with vesting after three years.

Executive Grants All senior management and certain middle management are eligible for executive grants under our LTIP. All stock option grants have an exercise price equal to the fair market value of our common stock on the day of grant and generally have a 10-year term with vesting after three years. There have been no reductions to the exer-

cise price of previously issued awards, and any repricing of awards would require approval of our shareholders.

Beginning in 2004, executives who are awarded long-term incentives based on their performance are offered the choice of stock options or RSUs. RSU expense is based on the fair value of PepsiCo stock on the date of grant and is amortized over the vesting period, generally three years. Each restricted stock unit can be settled in a share of our stock after the vesting period. Executives who elect RSUs receive one RSU for every four stock options that would have otherwise been granted. Senior offi- cers do not have a choice and are granted 50% stock options and 50% RSUs. Vesting of RSU awards for senior officers is contingent upon the achievement of pre-established performance targets. We granted 3 million RSUs in both 2005 and 2004 with weighted-average intrinsic val- ues of $53.83 and $47.28, respectively.

Note 6 — Stock-Based Compensation

A16 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Method of Accounting and Our Assumptions We account for our employee stock options under the fair value method of accounting using a Black-Scholes valuation model to measure stock-based compensation expense at the date of grant. We adopted SFAS 123R, Share-Based Payment, under the modified prospective method in the first quarter of 2006. We do not expect our adoption of SFAS 123R to materially impact our financial statements.

Our weighted-average Black-Scholes fair value assumptions include:

2005 2004 2003 Expected life 6 yrs. 6 yrs. 6 yrs. Risk free interest rate 3.8% 3.3% 3.1% Expected volatility 23% 26% 27% Expected dividend yield 1.8% 1.8% 1.15%

Our Stock Option Activity(a)

2005 2004 2003 Options Average Price(b) Options Average Price(b) Options Average Price(b)

Outstanding at beginning of year 174,261 $40.05 198,173 $38.12 190,432 $36.45 Granted 12,328 53.82 14,137 47.47 41,630 39.89 Exercised (30,945) 35.40 (31,614) 30.57 (25,833) 26.74 Forfeited/expired (5,495) 43.31 (6,435) 43.82 (8,056) 43.56

Outstanding at end of year 150,149 42.03 174,261 40.05 198,173 38.12

Exercisable at end of year 89,652 40.52 94,643 36.41 97,663 32.56

Stock options outstanding and exercisable at December 31, 2005(a)

Options Outstanding Options Exercisable Range of Exercise Price Options Average Price(b) Average Life(c) Options Average Price(b) Average Life(c)

$14.40 to $21.54 905 $ 20.01 3.56 yrs. 905 $20.01 3.56 yrs. $23.00 to $33.75 14,559 30.46 3.07 14,398 30.50 3.05 $34.00 to $43.50 82,410 39.44 5.34 48,921 39.19 4.10 $43.75 to $56.75 52,275 49.77 7.17 25,428 49.48 6.09

150,149 42.03 5.67 89,652 40.52 4.45 (a) Options are in thousands and include options previously granted under Quaker plans. No additional options or shares may be granted under the Quaker plans.

(b) Weighted-average exercise price.

(c) Weighted-average contractual life remaining.

Our RSU Activity(a)

2005 2004 Average Average Intrinsic Average Intrinsic Average

RSUs Value(b) Life(c) RSUs Value(b) Life(c)

Outstanding at beginning of year 2,922 $ 47.30 – $ – Granted 3,097 53.83 3,077 47.28 Converted (91) 48.73 (18) 47.25 Forfeited/expired (259) 50.51 (137) 47.25

Outstanding at end of year 5,669 50.70 1.8 yrs. 2,922 47.30 2.2 yrs. (a) RSUs are in thousands.

(b) Weighted-average intrinsic value.

(c) Weighted-average contractual life remaining.

Other stock-based compensation data

Stock Options RSUs 2005 2004 2003 2005 2004

Weighted-average fair value of options granted $13.45 $12.04 $11.21 Total intrinsic value of options/RSUs exercised/converted(a) $632,603 $667,001 $466,719 $4,974 $914 Total intrinsic value of options/RSUs outstanding(a) $2,553,594 $2,062,153 $1,641,505 $334,931 $151,760 Total intrinsic value of options exercisable(a) $1,662,198 $1,464,926 $1,348,658 (a) In thousands.

At December 31, 2005, there was $315 million of total unrecognized compensation cost related to nonvested share-based compensation grants. This unrecognized compensation is expected to be recognized over a weighted-average period of 1.6 years.

Financial Statements and Accompanying Notes A17

Our pension plans cover full-time employ- ees in the U.S. and certain international employees. Benefits are determined based on either years of service or a combination of years of service and earnings. U.S. retirees are also eligible for medical and life insurance benefits (retiree medical) if they meet age and service requirements. Generally, our share of retiree medical costs is capped at specified dollar amounts, which vary based upon years of service, with retirees contributing the remainder of the costs. We use a September 30 measurement date and all plan assets and liabilities are generally

reported as of that date. The cost or benefit of plan changes that increase or decrease benefits for prior employee service (prior service cost) is included in expense on a straight-line basis over the average remaining service period of employees expected to receive benefits.

The Medicare Act was signed into law in December 2003 and we applied the provi- sions of the Medicare Act to our plans in 2005 and 2004. The Medicare Act provides a subsidy for sponsors of retiree medical plans who offer drug benefits equivalent to those provided under Medicare. As a result of the Medicare Act,

our 2005 and 2004 retiree medical costs were $11 million and $7 million lower, respectively, and our 2005 and 2004 lia- bilities were reduced by $136 million and $80 million, respectively. We expect our 2006 retiree medical costs to be approxi- mately $18 million lower than they other- wise would have been as a result of the Medicare Act.

For additional unaudited information on our pension and retiree medical plans and related accounting policies and assump- tions, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis.

Pension Retiree Medical 2005 2004 2003 2005 2004 2003 2005 2004 2003

U.S. International Weighted-average assumptions Liability discount rate ........................................................ 5.7% 6.1% 6.1% 5.1% 6.1% 6.1% 5.7% 6.1% 6.1% Expense discount rate........................................................ 6.1% 6.1% 6.7% 6.1% 6.1% 6.4% 6.1% 6.1% 6.7% Expected return on plan assets ......................................... 7.8% 7.8% 8.3% 8.0% 8.0% 8.0% – – – Rate of compensation increases........................................ 4.4% 4.5% 4.5% 4.1% 3.9% 3.8% – – –

Components of benefit expense Service cost....................................................................... $ 213 $ 193 $ 153 $ 32 $ 27 $ 24 $ 40 $ 38 $ 33 Interest cost...................................................................... 296 271 245 55 47 39 78 72 73 Expected return on plan assets ........................................ (344) (325) (305) (69) (65) (54) – – – Amortization of prior service cost/(benefit)....................... 3 6 6 1 1 – (11) (8) (3) Amortization of experience loss......................................... 106 81 44 15 9 5 26 19 13 Benefit expense................................................................. 274 226 143 34 19 14 133 121 116 Settlement/curtailment loss ............................................. – 4 – – 1 – – – – Special termination benefits............................................. 21 19 4 – 1 – 2 4 – Total .................................................................................. $ 295 $ 249 $ 147 $ 34 $ 21 $ 14 $135 $125 $116

Note 7 — Pension, Retiree Medical and Savings Plans

A18 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Pension Retiree Medical 2005 2004 2005 2004 2005 2004

U.S. International Change in projected benefit liability Liability at beginning of year $ 4,968 $4,456 $ 952 $758 $1,319 $1,264 Service cost 213 193 32 27 40 38 Interest cost 296 271 55 47 78 72 Plan amendments – (17) 3 1 (8) (41) Participant contributions – – 10 9 – – Experience loss/(gain) 517 261 203 73 (45) 58 Benefit payments (241) (205) (28) (29) (74) (76) Settlement/curtailment loss – (9) – (2) – – Special termination benefits 21 18 – 1 2 4 Foreign currency adjustment – – (68) 67 – – Other (3) – 104 – – – Liability at end of year $ 5,771 $4,968 $1,263 $952 $1,312 $1,319

Liability at end of year for service to date $ 4,783 $4,164 $1,047 $779

Change in fair value of plan assets Fair value at beginning of year $ 4,152 $3,558 $ 838 $687 $ – $ – Actual return on plan assets 477 392 142 77 – – Employer contributions/funding 699 416 104 37 74 76 Participant contributions – – 10 9 – – Benefit payments (241) (205) (28) (29) (74) (76) Settlement/curtailment loss – (9) – (2) – – Foreign currency adjustment – – (61) 59 – – Other (1) – 94 – – – Fair value at end of year $ 5,086 $4,152 $1,099 $838 $ – $ –

Funded status as recognized in our Consolidated Balance Sheet Funded status at end of year $ (685) $ (817) $ (164) $(113) $(1,312) $(1,319) Unrecognized prior service cost/(benefit) 5 9 17 13 (113) (116) Unrecognized experience loss 2,288 2,013 474 380 402 473 Fourth quarter benefit payments 5 5 4 7 19 19 Net amounts recognized $1,613 $1,210 $ 331 $ 287 $(1,004) $ (943)

Net amounts as recognized in our Consolidated Balance Sheet Other assets $2,068 $1,572 $367 $ 294 $ – $ – Intangible assets – – 1 5 – – Other liabilities (479) (387) (41) (37) (1,004) (943) Accumulated other comprehensive loss 24 25 4 25 – – Net amounts recognized $1,613 $1,210 $331 $ 287 $(1,004) $(943)

Components of increase in unrecognized experience loss Decrease in discount rate $ 365 $ – $194 $ 4 $ 61 $ – Employee-related assumption changes 57 196 2 65 – 109 Liability-related experience different from assumptions 95 65 7 4 (54) 31 Actual asset return different from expected return (133) (67) (73) (12) – – Amortization of losses (106) (81) (15) (9) (26) (19) Other, including foreign currency adjustments

and 2003 Medicare Act (3) (5) (22) 26 (52) (82) Total $ 275 $108 $ 93 $ 78 $(71) $ 39

Selected information for plans with liability for service to date in excess of plan assets Liability for service to date $ (374) $(320) $ (65) $(191) $(1,312) $(1,319) Projected benefit liability $ (815) $(685) $ (84) $(227) $(1,312) $(1,319) Fair value of plan assets $8 $11 $33 $161 $– $–

Of the total projected pension benefit liability at year-end 2005, $765 million relates to plans that we do not fund because the funding of such plans does not receive favorable tax treatment.

Financial Statements and Accompanying Notes A19

Savings Plans Our U.S. employees are eligible to partici- pate in 401(k) savings plans, which are voluntary defined contribution plans. The

plans are designed to help employees accumulate additional savings for retire- ment. We make matching contributions on a portion of eligible pay based on years of

service. In 2005 and 2004, our matching contributions were $52 million and $35 million, respectively.

Future Benefit Payments Our estimated future benefit payments are as follows:

2006 2007 2008 2009 2010 2011-15 Pension $235 $255 $275 $300 $330 $2,215 Retiree medical $85 $90 $90 $95 $100 $545

These future benefits to beneficiaries include payments from both funded and unfunded pension plans.

Pension Assets The expected return on pension plan assets is based on our historical experi- ence, our pension plan investment guide- lines, and our expectations for long-term rates of return. We use a market-related value method that recognizes each year’s asset gain or loss over a five-year period. Therefore, it takes five years for the gain or loss from any one year to be fully included in the value of pension plan assets that is used to calculate the expected return. Our

pension plan investment guidelines are established based upon an evaluation of market conditions, tolerance for risk and cash requirements for benefit payments. Our investment objective is to ensure that funds are available to meet the plans’ ben- efit obligations when they are due. Our investment strategy is to prudently invest plan assets in high-quality and diversified equity and debt securities to achieve our long-term return expectation. Our target

allocation and actual pension plan asset allocations for the plan years 2005 and 2004, are below.

Pension assets include approximately 5.5 million shares of PepsiCo common stock with a market value of $311 million in 2005, and 5.5 million shares with a market value of $267 million in 2004. Our investment policy limits the investment in PepsiCo stock at the time of investment to 10% of the fair value of plan assets.

1% Increase 1% Decrease 2005 service and interest cost components $3 $(2) 2005 benefit liability $38 $(33)

Actual Allocation Asset Category Target Allocation 2005 2004

Equity securities 60% 60% 60% Debt securities 40% 39% 39% Other, primarily cash – 1% 1% Total 100% 100% 100%

Our most significant noncontrolled bottling affiliates are PBG and PAS. Approximately 10% of our net revenue in 2005, 2004 and 2003 reflects sales to PBG.

The Pepsi Bottling Group In addition to approximately 41% and 42% of PBG’s outstanding common stock that we own at year-end 2005 and 2004, respectively, we own 100% of PBG’s class B common stock and approximately 7% of the equity of Bottling Group, LLC, PBG’s

principal operating subsidiary. This gives us economic ownership of approximately 45% and 46% of PBG’s combined opera- tions at year-end 2005 and 2004, respec- tively. In 2005, bottling equity income includes $126 million of pre-tax gains on our sales of PBG stock.

Note 8 — Noncontrolled Bottling Affiliates

Retiree Medical Cost Trend Rates An average increase of 10% in the cost of covered retiree medical benefits is assumed for 2006. This average increase is then projected to decline gradually to

5% in 2010 and thereafter. These assumed health care cost trend rates have an impact on the retiree medical plan expense and liability. However, the cap on our share of retiree medical costs limits

the impact. A 1 percentage point change in the assumed health care trend rate would have the following effects:

A20 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Such amounts are settled on terms consistent with other trade receivables and payables. See Note 9 regarding our guaran- tee of certain PBG debt.

In addition, we coordinate, on an aggre- gate basis, the negotiation and purchase of sweeteners and other raw materials

requirements for certain of our bottlers with suppliers. Once we have negotiated the contracts, the bottlers order and take delivery directly from the supplier and pay the suppliers directly. Consequently, these transactions are not reflected in our consolidated financial statements. As the

contracting party, we could be liable to these suppliers in the event of any nonpay- ment by our bottlers, but we consider this exposure to be remote.

2005 2004 2003 Net revenue $ 4,633 $ 4,170 $3,699 Selling, general and administrative expenses $143 $114 $128 Accounts and notes receivable $178 $157 Accounts payable and other current liabilities $117 $95

Our investment in PBG, which includes the related goodwill, was $400 million and $321 million higher than our ownership interest in their net assets at year-end 2005 and 2004, respectively. Based upon the quoted closing price of PBG shares at year-end 2005 and 2004, the calculated market value of our shares in PBG, exclud- ing our investment in Bottling Group, LLC, exceeded our investment balance by approximately $1.5 billion and $1.7 billion, respectively.

PepsiAmericas At year-end 2005 and 2004, we owned approximately 43% and 41% of PepsiAmericas, respectively, and their summarized financial information is as follows:

2005 2004 2003 Current assets $ 598 $ 530 Noncurrent assets 3,456 3,000

Total assets $4,054 $3,530

Current liabilities $ 722 $ 521 Noncurrent liabilities 1,763 1,386

Total liabilities $2,485 $1,907

Our investment $968 $924

Net revenue $3,726 $3,345 $3,237 Gross profit $1,562 $1,423 $1,360 Operating profit $393 $340 $316 Net income $195 $182 $158

PBG’s summarized financial information is as follows:

2005 2004 2003 Current assets $ 2,412 $ 2,183 Noncurrent assets 9,112 8,754

Total assets $11,524 $10,937 Current liabilities $2,598 $1,725 Noncurrent liabilities 6,387 6,818 Minority interest 496 445

Total liabilities $9,481 $8,988

Our investment $1,738 $1,594

Net revenue $11,885 $10,906 $10,265 Gross profit $5,632 $5,250 $5,050 Operating profit $1,023 $976 $956 Net income $466 $457 $416

Related Party Transactions Our significant related party transactions involve our noncontrolled bottling affiliates. We sell concentrate to these affiliates, which is used in the production of carbon- ated soft drinks and non-carbonated bever-

ages. We also sell certain finished goods to these affiliates and we receive royalties for the use of our trademarks for certain products. Sales of concentrate and finished goods are reported net of bottler funding. For further unaudited information

on these bottlers, see “Our Customers” in Management’s Discussion and Analysis. These transactions with our bottling affiliates are reflected in our consolidated financial statements as follows:

Our investment in PAS, which includes the related goodwill, was $292 million and $253 million higher than our owner- ship interest in their net assets at year-end 2005 and 2004, respectively. Based upon the quoted closing price of PAS shares at year-end 2005 and 2004, the calculated market value of our shares in PepsiAmericas exceeded our investment balance by approximately $364 million and $277 million, respectively.

In January 2005, PAS acquired a regional bottler, Central Investment Corporation. The table above includes the results of Central Investment Corporation from the transaction date forward.

Financial Statements and Accompanying Notes A21

Note 9 — Debt Obligations and Commitments

Short-term borrowings are reclassified to long-term when we have the intent and ability, through the existence of the unused lines of credit, to refinance these borrow- ings on a long-term basis. At year-end 2005, we maintained $2.1 billion in corporate lines of credit subject to normal banking terms and conditions. These credit facilities support short-term debt issuances and remained unused as of December 31, 2005. Of the $2.1 billion, $1.35 billion expires in May 2006 with the remaining $750 million expiring in June 2009.

In addition, $181 million of our debt was outstanding on various lines of credit maintained for our international divisions.

These lines of credit are subject to normal banking terms and conditions and are committed to the extent of our borrowings.

Interest Rate Swaps We entered into interest rate swaps in 2004 to effectively convert the interest rate of a specific debt issuance from a fixed rate of 3.2% to a variable rate. The vari- able weighted-average interest rate that we pay is linked to LIBOR and is subject to change. The notional amount of the inter- est rate swaps outstanding at December 31, 2005 and December 25, 2004 was $500 million. The terms of the interest rate swaps match the terms of the debt they modify. The swaps mature in 2007.

At December 31, 2005, approximately 78% of total debt, after the impact of the associated interest rate swaps, was exposed to variable interest rates, compared to 67% at December 25, 2004. In addition to vari- able rate long-term debt, all debt with matu- rities of less than one year is categorized as variable for purposes of this measure.

Cross Currency Interest Rate Swaps In 2004, we entered into a cross currency interest rate swap to hedge the currency exposure on U.S. dollar denominated debt of $50 million held by a foreign affiliate. The terms of this swap match the terms of the debt it modifies. The swap matures in 2008. The unrecognized gain related to this swap was less than $1 million at December 31, 2005, resulting in a U.S. dollar liability of $50 million. At December 25, 2004, the unrecognized loss related to this swap was $3 million, resulting in a U.S. dollar liability of $53 million. We have also entered into cross currency interest rate swaps to hedge the currency exposure on U.S. dollar denominated intercompany debt of $125 million. The terms of the swaps match the terms of the debt they modify. The swaps mature over the next two years. The net unrecognized gain related to these swaps was $5 million at December 31, 2005. The net unrecog- nized loss related to these swaps was less than $1 million at December 25, 2004.

2005 2004 Short-term debt obligations Current maturities of long-term debt $ 143 $ 160 Commercial paper (3.3% and 1.6%) 3,140 1,287 Other borrowings (7.4% and 6.6%) 356 357 Amounts reclassified to long-term debt (750) (750)

$2,889 $1,054

Long-term debt obligations Short-term borrowings, reclassified $ 750 $ 750 Notes due 2006-2026 (5.4% and 4.7%) 1,161 1,274 Zero coupon notes, $475 million due 2006-2012 (13.4%) 312 321 Other, due 2006-2014 (6.3% and 6.2%) 233 212

2,456 2,557 Less: current maturities of long-term debt obligations (143) (160)

$2,313 $2,397

The interest rates in the above table reflect weighted-average rates as of year-end.

Long-Term Contractual Commitments

Payments Due by Period Total 2006 2007-2008 2009-2010 2011 and beyond Long-term debt obligations(a) .......................................................... $2,313 $ – $1,052 $ 876 $ 385 Operating leases ............................................................................. 769 187 253 132 197 Purchasing commitments(b) ............................................................ 4,533 1,169 1,630 775 959 Marketing commitments.................................................................. 1,487 412 438 381 256 Other commitments ......................................................................... 99 82 10 6 1

$9,201 $1,850 $3,383 $2,170 $1,798

(a) Excludes current maturities of long-term debt of $143 million which are classified within current liabilities.

(b) Includes approximately $13 million of long-term commitments which are reflected in other liabilities in our Consolidated Balance Sheet.

The above table reflects non-cancelable commitments as of December 31, 2005 based on year-end foreign exchange rates.

A22 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Most long-term contractual commit- ments, except for our long-term debt obligations, are not recorded in our Consolidated Balance Sheet. Non-cance- lable operating leases primarily represent building leases. Non-cancelable purchasing commitments are primarily for oranges and orange juices to be used for our Tropicana brand beverages. Non-cancelable marketing commitments primarily are for sports marketing and with our fountain customers. Bottler funding is not reflected in our long-term contractual commitments as it is negotiated on an annual basis. See Note 7 regarding our pension and retiree medical

obligations and discussion below regarding our commitments to noncontrolled bottling affiliates and former restaurant operations.

Off-Balance Sheet Arrangements It is not our business practice to enter into off-balance sheet arrangements, other than in the normal course of business, nor is it our policy to issue guarantees to our bottlers, noncontrolled affiliates or third parties. However, certain guarantees were necessary to facilitate the separation of our bottling and restaurant operations from us. In connection with these transactions, we have guaranteed $2.3 billion of Bottling Group, LLC’s long-term debt through 2012 and $28 million of YUM! Brands, Inc. (YUM) outstanding obligations, primarily

property leases, through 2020. The terms of our Bottling Group, LLC debt guarantee are intended to preserve the structure of PBG’s separation from us and our payment obligation would be triggered if Bottling Group, LLC failed to perform under these debt obligations or the structure signifi- cantly changed. Our guarantees of certain obligations ensured YUM’s continued use of certain properties. These guarantees would require our cash payment if YUM failed to perform under these lease obligations.

See “Our Liquidity, Capital Resources and Financial Position” in Management’s Discussion and Analysis for further unaudited information on our borrowings.

We are exposed to the risk of loss arising from adverse changes in: • commodity prices, affecting the cost of

our raw materials and energy, • foreign exchange risks, • interest rates, • stock prices, and • discount rates affecting the measure-

ment of our pension and retiree medical liabilities. In the normal course of business, we

manage these risks through a variety of strategies, including the use of derivatives. Certain derivatives are designated as either cash flow or fair value hedges and qualify for hedge accounting treatment, while oth- ers do not qualify and are marked to market through earnings. See “Our Business Risks” in Management’s Discussion and Analysis for further unaudited information on our business risks.

For cash flow hedges, changes in fair value are deferred in accumulated other comprehensive loss within shareholders’ equity until the underlying hedged item is recognized in net income. For fair value hedges, changes in fair value are recognized immediately in earnings, consistent with the underlying hedged item. Hedging transac- tions are limited to an underlying exposure. As a result, any change in the value of our derivative instruments would be substan- tially offset by an opposite change in the value of the underlying hedged items. Hedging ineffectiveness and a net earnings

impact occur when the change in the value of the hedge does not offset the change in the value of the underlying hedged item. If the derivative instrument is terminated, we continue to defer the related gain or loss and include it as a component of the cost of the underlying hedged item. Upon determi- nation that the underlying hedged item will not be part of an actual transaction, we recognize the related gain or loss in net income in that period.

We also use derivatives that do not qualify for hedge accounting treatment. We account for such derivatives at market value with the resulting gains and losses reflected in our income statement. We do not use derivative instruments for trading or speculative purposes and we limit our exposure to individual counterparties to manage credit risk.

Commodity Prices We are subject to commodity price risk because our ability to recover increased costs through higher pricing may be limited in the competitive environment in which we operate. This risk is managed through the use of fixed-price purchase orders, pricing agreements, geographic diversity and derivatives. We use deriva- tives, with terms of no more than two years, to economically hedge price fluctua- tions related to a portion of our anticipated commodity purchases, primarily for natural gas and diesel fuel. For those derivatives that are designated as cash flow hedges,

any ineffectiveness is recorded immedi- ately. However, our commodity cash flow hedges have not had any significant inef- fectiveness for all periods presented. We classify both the earnings and cash flow impact from these derivatives consistent with the underlying hedged item. During the next 12 months, we expect to reclas- sify gains of $24 million related to cash flow hedges from accumulated other comprehensive loss into net income.

Foreign Exchange Our operations outside of the U.S. generate over a third of our net revenue of which Mexico, the United Kingdom and Canada comprise nearly 20%. As a result, we are exposed to foreign currency risks from unforeseen economic changes and political unrest. On occasion, we enter into hedges, primarily forward contracts with terms of no more than two years, to reduce the effect of foreign exchange rates. Ineffectiveness on these hedges has not been material.

Interest Rates We centrally manage our debt and invest- ment portfolios considering investment opportunities and risks, tax consequences and overall financing strategies. We may use interest rate and cross currency interest rate swaps to manage our overall interest expense and foreign exchange risk. These instruments effectively change the interest rate and currency of specific debt issuances. These swaps are entered into

Note 10 — Risk Management

Financial Statements and Accompanying Notes A23

concurrently with the issuance of the debt that they are intended to modify. The notional amount, interest payment and maturity date of the swaps match the principal, interest payment and maturity date of the related debt. These swaps are entered into only with strong creditworthy counterparties, are settled on a net basis and are of relatively short duration.

Stock Prices The portion of our deferred compensation liability that is based on certain market indices and on our stock price is subject to market risk. We hold mutual fund investments and prepaid forward contracts to manage this risk. Changes in the fair value of these investments and contracts are recognized immediately in earnings and are offset by changes in the related compensation liability.

Fair Value All derivative instruments are recognized in our Consolidated Balance Sheet at fair value. The fair value of our derivative instru- ments is generally based on quoted market prices. Book and fair values of our derivative and financial instruments are as follows:

2005 2004 Book Value Fair Value Book Value Fair Value

Assets Cash and cash equivalents(a) .................................................................................. $1,716 $1,716 $1,280 $1,280 Short-term investments(b) ........................................................................................ $3,166 $3,166 $2,165 $2,165 Forward exchange contracts(c) ................................................................................. $19 $19 $8 $8 Commodity contracts(d) ............................................................................................ $41 $41 $7 $7 Prepaid forward contract(e) ...................................................................................... $107 $107 $120 $120 Cross currency interest rate swaps(f) ....................................................................... $6 $6 $– $– Liabilities Forward exchange contracts(c) ................................................................................. $15 $15 $35 $35 Commodity contracts(d) ............................................................................................ $3 $3 $8 $8 Debt obligations....................................................................................................... $5,202 $5,378 $3,451 $3,676 Interest rate swaps(g) ............................................................................................... $9 $9 $1 $1 Cross currency interest rate swaps(f) ...................................................................... $– $– $3 $3 Included in our Consolidated Balance Sheet under the captions noted above or as indicated below. In addition, derivatives are designated as accounting hedges unless otherwise noted below.

(a) Book value approximates fair value due to the short maturity.

(b) Principally short-term time deposits and includes $124 million at December 31, 2005 and $118 million at December 25, 2004 of mutual fund investments used to manage a portion of market risk arising from our deferred compensation liability.

(c) 2005 asset includes $14 million related to derivatives not designated as accounting hedges. Assets are reported within current assets and other assets and liabilities are reported within current liabilities and other liabilities.

(d) 2005 asset includes $2 million related to derivatives not designated as accounting hedges and the liability relates entirely to derivatives not designated as accounting hedges. Assets are reported within current assets and other assets and liabilities are reported within current liabilities and other liabilities.

(e) Included in current assets and other assets.

(f ) Asset included within other assets and liability included in long-term debt.

(g) Reported in other liabilities.

This table excludes guarantees, including our guarantee of $2.3 billion of Bottling Group, LLC’s long-term debt. The guarantee had a fair value of $47 million at December 31, 2005 and $46 million at December 25, 2004 based on an external estimate of the cost to us of transferring the liability to an independent financial institution. See Note 9 for additional information on our guarantees.

Basic net income per common share is net income available to common shareholders divided by the weighted average of com- mon shares outstanding during the period. Diluted net income per common share is calculated using the weighted average of common shares outstanding adjusted to include the effect that would occur if

in-the-money employee stock options were exercised and RSUs and preferred shares were converted into common shares. Options to purchase 3.0 million shares in 2005, 7.0 million shares in 2004 and 49.0 million shares in 2003 were not included in the calculation of diluted earnings per common share because these

options were out-of-the-money. Out-of-the- money options had average exercise prices of $53.77 in 2005, $52.88 in 2004 and $48.27 in 2003.

Note 11 — Net Income per Common Share from Continuing Operations

A24 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Comprehensive income is a measure of income which includes both net income and other comprehensive income or loss. Other comprehensive loss results from items deferred on the balance sheet in shareholders’ equity. Other comprehensive (loss)/income was $(167) million in 2005, $381 million in 2004, and $405 million in 2003. The accumulated balances for each component of other comprehensive loss were as follows:

2005 2004 2003 Currency translation adjustment $ (971) $(720) $(1,121) Cash flow hedges, net of tax(a) 27 (19) (12) Minimum pension liability adjustment(b) (138) (154) (135) Unrealized gain on securities, net of tax 31 7 1 Other (2) – – Accumulated other comprehensive loss $(1,053) $(886) $(1,267)

(a) Includes net commodity gains of $55 million in 2005. Also includes no impact in 2005, $6 million gain in 2004 and $8 million gain in 2003 for our share of our equity investees’ accumulated derivative activity. Deferred gains/(losses) reclassified into earnings were $8 million in 2005, $(10) million in 2004 and no impact in 2003.

(b) Net of taxes of $72 million in 2005, $77 million in 2004 and $67 million in 2003. Also, includes $120 million in 2005, $121 million in 2004 and $110 million in 2003 for our share of our equity investees’ minimum pension liability adjustments.

As of December 31, 2005 and December 25, 2004, there were 3.6 billion shares of common stock and 3 million shares of convertible preferred stock authorized. The preferred stock was issued only for an employee stock ownership plan (ESOP) established by Quaker and these shares are redeemable for common stock by the ESOP participants. The preferred stock accrues dividends at an annual rate of $5.46 per share. At year-end 2005 and

2004, there were 803,953 preferred shares issued and 354,853 and 424,853 shares outstanding, respectively. Each share is convertible at the option of the holder into 4.9625 shares of common stock. The preferred shares may be called by us upon written notice at $78 per share plus accrued and unpaid dividends.

As of December 31, 2005, 0.3 million outstanding shares of preferred stock with a fair value of $104 million and 17 million

shares of common stock were held in the accounts of ESOP participants. As of December 25, 2004, 0.4 million outstand- ing shares of preferred stock with a fair value of $110 million and 18 million shares of common stock were held in the accounts of ESOP participants. Quaker made the final award to its ESOP plan in June 2001.

Note 12 — Preferred and Common Stock

2005 2004 2003 Income Shares(a) Income Shares(a) Income Shares(a)

Net income $4,078 $4,174 $3,568 Preferred shares:

Dividends (2) (3) (3) Redemption premium (16) (22) (12)

Net income available for common shareholders $4,060 1,669 $4,149 1,696 $3,553 1,718

Basic net income per common share $2.43 $2.45 $2.07

Net income available for common shareholders $4,060 1,669 $4,149 1,696 $3,553 1,718 Dilutive securities:

Stock options and RSUs – 35 – 31 – 17 ESOP convertible preferred stock 18 2 24 2 15 3 Unvested stock awards – – – – – 1

Diluted $4,078 1,706 $4,173 1,729 $3,568 1,739

Diluted net income per common share $2.39 $2.41 $2.05

(a) Weighted-average common shares outstanding.

2005 2004 2003 Shares Amount Shares Amount Shares Amount

Preferred stock 0.8 $41 0.8 $41 0.8 $41

Repurchased preferred stock Balance, beginning of year 0.4 $ 90 0.3 $63 0.2 $48

Redemptions 0.1 19 0.1 27 0.1 15 Balance, end of year 0.5 $110* 0.4 $90 0.3 $63

*Does not sum due to rounding.

Note 13 — Accumulated Other Comprehensive Loss

The computations of basic and diluted net income per common share from continuing operations are as follows:

Financial Statements and Accompanying Notes A25

2005 2004 2003 Accounts receivable Trade receivables ..................................................... $2,718 $2,505 Other receivables ..................................................... 618 591

3,336 3,096 Allowance, beginning of year ................................... 97 105 $116

Net amounts (credited)/charged to expense ........ (1) 18 32 Deductions(a) ........................................................ (22) (25) (43) Other(b) ................................................................. 1 (1) –

Allowance, end of year ............................................. 75 97 $105 Net receivables ........................................................ $3,261 $2,999

Inventory(c)

Raw materials.......................................................... $ 738 $ 665 Work-in-process ....................................................... 112 156 Finished goods ......................................................... 843 720

$1,693 $1,541

Accounts payable and other current liabilities Accounts payable ..................................................... $1,799 $1,731 Accrued marketplace spending ................................ 1,383 1,285 Accrued compensation and benefits ........................ 1,062 961 Dividends payable.................................................... 431 387 Insurance accruals .................................................. 136 131 Other current liabilities ............................................ 1,160 1,104

$5,971 $5,599

Other liabilities Reserves for income taxes........................................ $1,884 $1,567 Other ........................................................................ 2,439 2,532

$4,323 $4,099

Other supplemental information Rent expense............................................................ $228 $245 $231 Interest paid ............................................................ $213 $137 $147 Income taxes paid, net of refunds............................ $1,258 $1,833 $1,530 Acquisitions(d)

Fair value of assets acquired............................... $ 1,089 $ 78 $178 Cash paid and debt issued .................................. (1,096) (64) (71) SVE minority interest eliminated.......................... 216 – – Liabilities assumed.............................................. $ 209 $ 14 $107

(a) Includes accounts written off.

(b) Includes collections of previously written-off accounts and currency translation effects.

(c) Inventories are valued at the lower of cost or market. Cost is determined using the average, first-in, first-out (FIFO) or last-in, first-out (LIFO) methods. Approximately 17% in 2005 and 15% in 2004 of the inventory cost was computed using the LIFO method. The differences between LIFO and FIFO methods of valuing these inventories were not material.

(d) In 2005, these amounts include the impact of our acquisition of General Mills, Inc.’s 40.5% ownership interest in SVE for $750 million. The excess of our purchase price over the fair value of net assets acquired is $250 million and is included in goodwill. We also reacquired rights to distribute global brands for $263 million which is included in other nonamortizable intangible assets.

Note 14 — Supplemental Financial Information

A26 Appendix A Specimen Financial Statements: PepsiCo, Inc.

ADDITIONAL INFORMATION In addition to the financial statements and accompanying notes, companies are re- quired to provide a report on internal control over financial reporting and to have an auditor’s report on the financial statements. In addition, PepsiCo has provided a report indicating that financial reporting is management’s responsibility. Finally, PepsiCo also provides selected financial data it believes is useful. The two required reports are further explained below.

Management’s Report on Internal Control over Financial Reporting The Sarbanes-Oxley Act of 2002 requires managers of publicly traded companies to establish and maintain systems of internal control over the company’s financial reporting processes. In addition, management must express its responsibility for fi- nancial reporting, and it must provide certifications regarding the accuracy of the financial statements.

Auditor’s Report All publicly held corporations, as well as many other enterprises and organizations engage the services of independent certified public accountants for the purpose of obtaining an objective, expert report on their financial statements. Based on a comprehensive examination of the company’s accounting system, accounting records, and the financial statements, the outside CPA issues the auditor’s report.

The standard auditor’s report identifies who and what was audited and indi- cates the responsibilities of management and the auditor relative to the financial statements. It states that the audit was conducted in accordance with generally ac- cepted auditing standards and discusses the nature and limitations of the audit. It then expresses an informed opinion as to (1) the fairness of the financial state- ments and (2) their conformity with generally accepted accounting principles. It also expresses an opinion regarding the effectiveness of the company’s internal controls. All of this additional information for PepsiCo is provided on the follow- ing pages.

Additional Information A27

At PepsiCo, our actions — the actions of all our associates — are governed by our Worldwide Code of Conduct. This code is clearly aligned with our stated values — a commitment to sustained growth, through empowered people, operating with responsibility and building trust. Both the code and our core values enable us to operate with integrity — both within the letter and the spirit of the law. Our code of conduct is reinforced consistently at all levels and in all countries. We have maintained strong governance policies and practices for many years.

The management of PepsiCo is responsible for the objectivity and integrity of our consolidated financial statements. The Audit Committee of the Board of Directors has engaged independent registered public accounting firm, KPMG LLP, to audit our consolidated financial statements and they have expressed an unqualified opinion.

We are committed to providing timely, accurate and understand- able information to investors. Our commitment encompasses the following:

Maintaining strong controls over financial reporting. Our system of internal control is based on the control criteria framework of the Committee of Sponsoring Organizations of the Treadway Commission published in their report titled, Internal Control — Integrated Framework. The system is designed to provide reason- able assurance that transactions are executed as authorized and accurately recorded; that assets are safeguarded; and that accounting records are sufficiently reliable to permit the prepara- tion of financial statements that conform in all material respects with accounting principles generally accepted in the U.S. We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in reports under the Securities Exchange Act of 1934 is recorded, processed, summa- rized and reported within the specified time periods. We monitor these internal controls through self-assessments and an ongoing program of internal audits. Our internal controls are reinforced through our Worldwide Code of Conduct, which sets forth our commitment to conduct business with integrity, and within both the letter and the spirit of the law.

Exerting rigorous oversight of the business. We continuously review our business results and strategies. This encompasses financial discipline in our strategic and daily business decisions. Our Executive Committee is actively involved — from understanding strategies and alternatives to reviewing key initiatives and financial performance. The intent is to ensure we remain objective in our assessments, constructively challenge our approach to potential business opportunities and issues, and monitor results and controls.

Engaging strong and effective Corporate Governance from our Board of Directors. We have an active, capable and diligent Board that meets the required standards for independence, and we welcome the Board’s oversight as a representative of our shareholders. Our

Audit Committee comprises independent directors with the financial literacy, knowledge and experience to provide appropriate oversight. We review our critical accounting policies, financial reporting and internal control matters with them and encourage their direct communication with KPMG LLP, with our General Auditor, and with our General Counsel. In 2005, we named a senior compliance officer to lead and coordinate our compliance policies and practices.

Providing investors with financial results that are complete, transparent and understandable. The consolidated financial state- ments and financial information included in this report are the responsibility of management. This includes preparing the financial statements in accordance with accounting principles generally accepted in the U.S., which require estimates based on management’s best judgment.

PepsiCo has a strong history of doing what’s right. We realize that great companies are built on trust, strong ethical standards and principles. Our financial results are delivered from that culture of accountability, and we take responsibility for the quality and accuracy of our financial reporting.

Peter A. Bridgman Senior Vice President and Controller

Indra K. Nooyi President and Chief Financial Officer

Steven S Reinemund Chairman of the Board and Chief Executive Officer

Management’s Responsibility for Financial Reporting To Our Shareholders:

A28 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Exchange Act. Under the supervi- sion and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over finan- cial reporting based upon the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that evaluation, our management concluded that our internal control over financial reporting is effective as of December 31, 2005.

KPMG LLP, an independent registered public accounting firm, has audited the consolidated financial statements included in this Annual Report and, as part of their audit, has issued their report, included herein, (1) on our management’s assessment of the effec- tiveness of our internal controls over financial reporting and (2) on the effectiveness of our internal control over financial reporting.

Management’s Report on Internal Control over Financial Reporting To Our Shareholders:

Peter A. Bridgman Senior Vice President and Controller

Indra K. Nooyi President and Chief Financial Officer

Steven S Reinemund Chairman of the Board and Chief Executive Officer

Additional Information A29

Report of Independent Registered Public Accounting Firm

We have audited the accompanying Consolidated Balance Sheet of PepsiCo, Inc. and Subsidiaries as of December 31, 2005 and December 25, 2004 and the related Consolidated Statements of Income, Cash Flows and Common Shareholders’ Equity for each of the years in the three-year period ended December 31, 2005. We have also audited management’s assessment, included in Management’s Report on Internal Control over Financial Reporting, that PepsiCo, Inc. and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). PepsiCo, Inc.’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effective- ness of internal control over financial reporting. Our responsibility is to express an opinion on these consolidated financial state- ments, an opinion on management’s assessment, and an opinion on the effectiveness of PepsiCo, Inc.’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all mate- rial respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluat- ing the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluat- ing management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circum- stances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted

accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over finan- cial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PepsiCo, Inc. and Subsidiaries as of December 31, 2005 and December 25, 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with United States generally accepted accounting principles. Also, in our opinion, manage- ment’s assessment that PepsiCo, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by COSO. Furthermore, in our opinion, PepsiCo, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by COSO.

KPMG LLP New York, New York February 24, 2006

Board of Directors and Shareholders PepsiCo, Inc.:

A30 Appendix A Specimen Financial Statements: PepsiCo, Inc.

First Second Third Fourth Quarterly Quarter Quarter Quarter Quarter Net revenue 2005 $6,585 $7,697 $8,184 $10,096 2004 $6,131 $7,070 $7,257 $8,803 Gross profit(a)

2005 $3,715 $4,383 $4,669 $5,619 2004 $3,466 $4,039 $4,139 $4,943 2005 restructuring charges(b)

2005 – – – $83 2004 restructuring and

impairment charges(c)

2004 – – – $150 AJCA tax charge(d)

2005 – – $468 $(8) Net income(e)

2005 $912 $1,194 $864 $1,108 2004 $804 $1,059 $1,364 $985 Net income per common

share — basic(e)

2005 $0.54 $0.71 $0.52 $0.66 2004 $0.47 $0.62 $0.80 $0.58 Net income per common

share — diluted(e)

2005 $0.53 $0.70 $0.51 $0.65 2004 $0.46 $0.61 $0.79 $0.58 Cash dividends declared per

common share 2005 $0.23 $0.26 $0.26 $0.26 2004 $0.16 $0.23 $0.23 $0.23 2005 stock price per share(f) High $55.71 $57.20 $56.73 $60.34 Low $51.34 $51.78 $52.07 $53.55 Close $52.62 $55.52 $54.65 $59.08 2004 stock price per share(f)

High $53.00 $55.48 $55.71 $53.00 Low $45.30 $50.28 $48.41 $47.37 Close $50.93 $54.95 $50.84 $51.94 The first, second, and third quarters consist of 12 weeks and the fourth quarter consists of 16 weeks in 2004 and 17 weeks in 2005.

(a) Reflects net reclassifications in all periods from cost of sales to selling, general and administrative expenses related to the alignment of certain accounting policies in connection with our ongoing BPT initiative. See Note 1.

(b) The 2005 restructuring charges were $83 million ($55 million or $0.03 per share after-tax). See Note 3.

(c) The 2004 restructuring and impairment charges were $150 million ($96 million or $0.06 per share after-tax). See Note 3.

(d) Represents income tax expense associated with the repatriation of earnings in connection with the AJCA. See Note 5.

(e) Fourth quarter 2004 net income reflects a tax benefit from discontinued operations of $38 million or $0.02 per share. See Note 5.

(f) Represents the composite high and low sales price and quarterly closing prices for one share of PepsiCo common stock.

Five-Year Summary 2005 2004 2003 Net revenue $32,562 $29,261 $26,971 Income from continuing operations $4,078 $4,174 $3,568 Net income $4,078 $4,212 $3,568 Income per common share — basic,

continuing operations $2.43 $2.45 $2.07 Income per common share — diluted,

continuing operations $2.39 $2.41 $2.05 Cash dividends declared per common share $1.01 $0.850 $0.630 Total assets $31,727 $27,987 $25,327 Long-term debt $2,313 $2,397 $1,702 Return on invested capital(a) 22.7% 27.4% 27.5%

Five-Year Summary (Cont.) 2002 2001 Net revenue $25,112 $23,512 Net income $3,000 $2,400 Income per common share — basic $1.69 $1.35 Income per common share — diluted $1.68 $1.33 Cash dividends declared per common share $0.595 $0.575 Total assets $23,474 $21,695 Long-term debt $2,187 $2,651 Return on invested capital(a) 25.7% 22.1%

(a) Return on invested capital is defined as adjusted net income divided by the sum of average shareholders’ equity and average total debt. Adjusted net income is defined as net income plus net interest expense after tax. Net interest expense after tax was $62 million in 2005, $60 million in 2004, $72 million in 2003, $93 million in 2002, and $99 million in 2001.

• As a result of the adoption of SFAS 142, Goodwill and Other Intangible Assets, and the consolidation of SVE in 2002, the data provided above is not comparable.

• Includes restructuring and impairment charges of:

2005 2004 2003 2001

Pre-tax $83 $150 $147 $31

After-tax $55 $96 $100 $19

Per share $0.03 $0.06 $0.06 $0.01

• Includes Quaker merger-related costs of:

2003 2002 2001

Pre-tax $59 $224 $356

After-tax $42 $190 $322

Per share $0.02 $0.11 $0.18

• The 2005 fiscal year consisted of fifty-three weeks compared to fifty-two weeks in our normal fiscal

year. The 53rd week increased 2005 net revenue by an estimated $418 million and net income by an

estimated $57 million or $0.03 per share.

• Cash dividends per common share in 2001 are those of pre-merger PepsiCo prior to the effective date of the merger.

• In the fourth quarter of 2004, we reached agreement with the IRS for an open issue related to our discontinued restaurant operations which resulted in a tax benefit of $38 million or $0.02 per share.

Selected Financial Data (in millions except per share amounts, unaudited)

SPECIMEN FINANCIAL STATEMENTS:

The Coca-Cola Company

Appendix B

B1

THE COCA-COLA COMPANY AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Year Ended December 31, 2005 2004 2003 (In millions except per share data)

NET OPERATING REVENUES $ 23,104 $ 21,742 $ 20,857 Cost of goods sold 8,195 7,674 7,776

GROSS PROFIT 14,909 14,068 13,081 Selling, general and administrative expenses 8,739 7,890 7,287 Other operating charges 85 480 573

OPERATING INCOME 6,085 5,698 5,221 Interest income 235 157 176 Interest expense 240 196 178 Equity income — net 680 621 406 Other loss — net (93) (82) (138) Gains on issuances of stock by equity investees 23 24 8

INCOME BEFORE INCOME TAXES 6,690 6,222 5,495 Income taxes 1,818 1,375 1,148

NET INCOME $ 4,872 $ 4,847 $ 4,347

BASIC NET INCOME PER SHARE $ 2.04 $ 2.00 $ 1.77

DILUTED NET INCOME PER SHARE $ 2.04 $ 2.00 $ 1.77

AVERAGE SHARES OUTSTANDING 2,392 2,426 2,459 Effect of dilutive securities 1 3 3

AVERAGE SHARES OUTSTANDING ASSUMING DILUTION 2,393 2,429 2,462

Refer to Notes to Consolidated Financial Statements.

The financial information herein is reprinted with permission from The Coca-Cola Company 2005 Annual Report. The accompanying Notes are an integral part of the consolidated financial state- ments. The complete financial statements are available through a link at the book’s companion website.

B2 Appendix B Specimen Financial Statements: The Coca-Cola Company

THE COCA-COLA COMPANY AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2005 2004 (In millions except par value)

ASSETS CURRENT ASSETS

Cash and cash equivalents $ 4,701 $ 6,707 Marketable securities 66 61 Trade accounts receivable, less allowances of $72 and $69, respectively 2,281 2,244 Inventories 1,424 1,420 Prepaid expenses and other assets 1,778 1,849

TOTAL CURRENT ASSETS 10,250 12,281

INVESTMENTS Equity method investments:

Coca-Cola Enterprises Inc. 1,731 1,569 Coca-Cola Hellenic Bottling Company S.A. 1,039 1,067 Coca-Cola FEMSA, S.A. de C.V. 982 792 Coca-Cola Amatil Limited 748 736 Other, principally bottling companies 2,062 1,733

Cost method investments, principally bottling companies 360 355

TOTAL INVESTMENTS 6,922 6,252

OTHER ASSETS 2,648 2,981 PROPERTY, PLANT AND EQUIPMENT — net 5,786 6,091 TRADEMARKS WITH INDEFINITE LIVES 1,946 2,037 GOODWILL 1,047 1,097 OTHER INTANGIBLE ASSETS 828 702

TOTAL ASSETS $ 29,427 $ 31,441

LIABILITIES AND SHAREOWNERS’ EQUITY CURRENT LIABILITIES

Accounts payable and accrued expenses $ 4,493 $ 4,403 Loans and notes payable 4,518 4,531 Current maturities of long-term debt 28 1,490 Accrued income taxes 797 709

TOTAL CURRENT LIABILITIES 9,836 11,133

LONG-TERM DEBT 1,154 1,157 OTHER LIABILITIES 1,730 2,814 DEFERRED INCOME TAXES 352 402 SHAREOWNERS’ EQUITY

Common stock, $0.25 par value; Authorized — 5,600 shares; Issued — 3,507 and 3,500 shares, respectively 877 875

Capital surplus 5,492 4,928 Reinvested earnings 31,299 29,105 Accumulated other comprehensive income (loss) (1,669) (1,348) Treasury stock, at cost — 1,138 and 1,091 shares, respectively (19,644) (17,625)

TOTAL SHAREOWNERS’ EQUITY 16,355 15,935

TOTAL LIABILITIES AND SHAREOWNERS’ EQUITY $ 29,427 $ 31,441

Refer to Notes to Consolidated Financial Statements.

Specimen Financial Statements: The Coca-Cola Company B3

THE COCA-COLA COMPANY AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Year Ended December 31, 2005 2004 2003 (In millions)

OPERATING ACTIVITIES Net income $ 4,872 $ 4,847 $ 4,347 Depreciation and amortization 932 893 850 Stock-based compensation expense 324 345 422 Deferred income taxes (88) 162 (188) Equity income or loss, net of dividends (446) (476) (294) Foreign currency adjustments 47 (59) (79) Gains on issuances of stock by equity investees (23) (24) (8) Gains on sales of assets, including bottling interests (9) (20) (5) Other operating charges 85 480 330 Other items 299 437 249 Net change in operating assets and liabilities 430 (617) (168)

Net cash provided by operating activities 6,423 5,968 5,456

INVESTING ACTIVITIES Acquisitions and investments, principally trademarks and bottling companies (637) (267) (359) Purchases of investments and other assets (53) (46) (177) Proceeds from disposals of investments and other assets 33 161 147 Purchases of property, plant and equipment (899) (755) (812) Proceeds from disposals of property, plant and equipment 88 341 87 Other investing activities (28) 63 178

Net cash used in investing activities (1,496) (503) (936)

FINANCING ACTIVITIES Issuances of debt 178 3,030 1,026 Payments of debt (2,460) (1,316) (1,119) Issuances of stock 230 193 98 Purchases of stock for treasury (2,055) (1,739) (1,440) Dividends (2,678) (2,429) (2,166)

Net cash used in financing activities (6,785) (2,261) (3,601)

EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS (148) 141 183

CASH AND CASH EQUIVALENTS Net increase (decrease) during the year (2,006) 3,345 1,102 Balance at beginning of year 6,707 3,362 2,260

Balance at end of year $ 4,701 $ 6,707 $ 3,362

Refer to Notes to Consolidated Financial Statements.

B4 Appendix B Specimen Financial Statements: The Coca-Cola Company

THE COCA-COLA COMPANY AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREOWNERS’ EQUITY

Year Ended December 31, 2005 2004 2003 (In millions except per share data)

NUMBER OF COMMON SHARES OUTSTANDING Balance at beginning of year 2,409 2,442 2,471

Stock issued to employees exercising stock options 7 5 4 Purchases of stock for treasury1 (47) (38) (33)

Balance at end of year 2,369 2,409 2,442

COMMON STOCK Balance at beginning of year $ 875 $ 874 $ 873

Stock issued to employees exercising stock options 2 1 1

Balance at end of year 877 875 874

CAPITAL SURPLUS Balance at beginning of year 4,928 4,395 3,857

Stock issued to employees exercising stock options 229 175 105 Tax benefit from employees’ stock option and restricted stock plans 11 13 11 Stock-based compensation 324 345 422

Balance at end of year 5,492 4,928 4,395

REINVESTED EARNINGS Balance at beginning of year 29,105 26,687 24,506

Net income 4,872 4,847 4,347 Dividends (per share — $1.12, $1.00 and $0.88 in 2005, 2004 and 2003, respectively) (2,678) (2,429) (2,166)

Balance at end of year 31,299 29,105 26,687

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) Balance at beginning of year (1,348) (1,995) (3,047)

Net foreign currency translation adjustment (396) 665 921 Net gain (loss) on derivatives 57 (3) (33) Net change in unrealized gain on available-for-sale securities 13 39 40 Net change in minimum pension liability 5 (54) 124

Net other comprehensive income adjustments (321) 647 1,052

Balance at end of year (1,669) (1,348) (1,995)

TREASURY STOCK Balance at beginning of year (17,625) (15,871) (14,389)

Purchases of treasury stock (2,019) (1,754) (1,482)

Balance at end of year (19,644) (17,625) (15,871)

TOTAL SHAREOWNERS’ EQUITY $ 16,355 $ 15,935 $ 14,090

COMPREHENSIVE INCOME Net income $ 4,872 $ 4,847 $ 4,347 Net other comprehensive income adjustments (321) 647 1,052

TOTAL COMPREHENSIVE INCOME $ 4,551 $ 5,494 $ 5,399

1 Common stock purchased from employees exercising stock options numbered 0.5 shares, 0.4 shares and 0.4 shares for the years ended December 31, 2005, 2004 and 2003, respectively.

Refer to Notes to Consolidated Financial Statements.

Time Value of Money

Appendix C

C1

Would you rather receive $1,000 today or a year from now? You should prefer to receive the $1,000 today because you can invest the $1,000 and earn interest on it. As a result, you will have more than $1,000 a year from now. What this example illustrates is the concept of the time value of money. Everyone prefers to receive money today rather than in the future because of the interest factor.

S T U D Y O B J E C T I V E S

After studying this appendix, you should be able to: 1 Distinguish between simple and compound interest. 2 Solve for future value of a single amount. 3 Solve for future value of an annuity. 4 Identify the variables fundamental to solving present value

problems. 5 Solve for present value of a single amount. 6 Solve for present value of an annuity. 7 Compute the present value of notes and bonds. 8 Use a financial calculator to solve time value of money problems.

THE NATURE OF INTEREST Interest is payment for the use of another person’s money. It is the difference be- tween the amount borrowed or invested (called the principal) and the amount re- paid or collected. The amount of interest to be paid or collected is usually stated as a rate over a specific period of time. The rate of interest is generally stated as an annual rate.

The amount of interest involved in any financing transaction is based on three elements:

1. Principal (p): The original amount borrowed or invested. 2. Interest Rate (i): An annual percentage of the principal. 3. Time (n): The number of years that the principal is borrowed or invested.

Simple Interest Simple interest is computed on the principal amount only. It is the return on the principal for one period. Simple interest is usually expressed as shown in Illustration C-1 on the next page.

Distinguish between simple and compound interest.

S T U D Y O B J E C T I V E 1

C2 Appendix C Time Value of Money

Interest � � �

For example, if you borrowed $5,000 for 2 years at a simple interest rate of 12% annually, you would pay $1,200 in total interest computed as follows:

Interest � p � i � n � $5,000 � .12 � 2 � $1,200

Time n

Rate i

Principal p

Illustration C-1 Interest computation

Compound Interest Compound interest is computed on principal and on any interest earned that has not been paid or withdrawn. It is the return on the principal for two or more time periods. Compounding computes interest not only on the principal but also on the interest earned to date on that principal, assuming the interest is left on deposit.

To illustrate the difference between simple and compound interest, assume that you deposit $1,000 in Bank Two, where it will earn simple interest of 9% per year, and you deposit another $1,000 in Citizens Bank, where it will earn com- pound interest of 9% per year compounded annually. Also assume that in both cases you will not withdraw any interest until three years from the date of deposit. Illustration C-2 shows the computation of interest you will receive and the accu- mulated year-end balances.

Illustration C-2 Simple versus compound interest

Note in Illustration C-2 that simple interest uses the initial principal of $1,000 to compute the interest in all three years. Compound interest uses the accumu- lated balance (principal plus interest to date) at each year-end to compute inter- est in the succeeding year—which explains why your compound interest account is larger.

Obviously, if you had a choice between investing your money at simple interest or at compound interest, you would choose compound interest, all other things— especially risk—being equal. In the example, compounding provides $25.03 of ad- ditional interest income. For practical purposes, compounding assumes that unpaid interest earned becomes a part of the principal, and the accumulated balance at the

Simple Interest Calculation

Year 1

Year 2

Year 3

$1,000.00 × 9%

$1,000.00 × 9%

$1,000.00 × 9%

$

$

90.00

90.00

90.00

270.00

$1,090.00

$1,180.00

$1,270.00

$25.03 Difference

Simple Interest

Accumulated Year-end Balance

Bank Two

Compound Interest Calculation

Year 1

Year 2

Year 3

$1,000.00 × 9%

$1,090.00 × 9%

$1,188.10 × 9%

$

$

90.00

98.10

106.93

295.03

$1,090.00

$1,188.10

$1,295.03

Compound Interest

Accumulated Year-end Balance

Citizens Bank

Future Value of a Single Amount C3

SECTION 1 Future Value Concepts

FUTURE VALUE OF A SINGLE AMOUNT

Illustration C-4 Time diagram

FV � p � (1 � i )n Illustration C-3 Formula for future value

where:

FV � future value of a single amount p � principal (or present value) i � interest rate for one period

n � number of periods

The $1,295.03 is computed as follows.

FV � p � (1 � i)n

� $1,000 � (1 � i)3

� $1,000 � 1.29503 � $1,295.03

The 1.29503 is computed by multiplying (1.09 � 1.09 � 1.09). The amounts in this example can be depicted in the following time diagram.

The future value of a single amount is the value at a future date of a given amount invested assuming compound interest. For example, in Illustration C-2, $1,295.03 is the future value of the $1,000 at the end of three years. The $1,295.03 could be determined more easily by using the following formula.

end of each year becomes the new principal on which interest is earned during the next year.

Illustration C-2 indicates that you should invest your money at the bank that compounds interest annually. Most business situations use compound interest. Simple interest is generally applicable only to short-term situations of one year or less.

Present Value (p)

0 $1,000

1 2 3 $1,295.03

i = 9% Future Value

n = 3 years

Solve for future value of a single amount.

S T U D Y O B J E C T I V E 2

In Table 1, n is the number of compounding periods, the percentages are the peri- odic interest rates, and the five-digit decimal numbers in the respective columns are the future value of 1 factors. In using Table 1, the principal amount is multiplied by the future value factor for the specified number of periods and interest rate. For ex- ample, the future value factor for two periods at 9% is 1.18810. Multiplying this factor by $1,000 equals $1,188.10, which is the accumulated balance at the end of year 2 in the Citizens Bank example in Illustration C-2. The $1,295.03 accumulated balance at the end of the third year can be calculated from Table 1 by multiplying the future value factor for three periods (1.29503) by the $1,000.

The following demonstration problem illustrates how to use Table 1.

C4 Appendix C Time Value of Money

TABLE 1 Future Value of 1

(n) Periods 4% 5% 6% 8% 9% 10% 11% 12% 15%

1 1.04000 1.05000 1.06000 1.08000 1.09000 1.10000 1.11000 1.12000 1.15000 2 1.08160 1.10250 1.12360 1.16640 1.18810 1.21000 1.23210 1.25440 1.32250 3 1.12486 1.15763 1.19102 1.25971 1.29503 1.33100 1.36763 1.40493 1.52088 4 1.16986 1.21551 1.26248 1.36049 1.41158 1.46410 1.51807 1.57352 1.74901 5 1.21665 1.27628 1.33823 1.46933 1.53862 1.61051 1.68506 1.76234 2.01136

6 1.26532 1.34010 1.41852 1.58687 1.67710 1.77156 1.87041 1.97382 2.31306 7 1.31593 1.40710 1.50363 1.71382 1.82804 1.94872 2.07616 2.21068 2.66002 8 1.36857 1.47746 1.59385 1.85093 1.99256 2.14359 2.30454 2.47596 3.05902 9 1.42331 1.55133 1.68948 1.99900 2.17189 2.35795 2.55803 2.77308 3.51788

10 1.48024 1.62889 1.79085 2.15892 2.36736 2.59374 2.83942 3.10585 4.04556

11 1.53945 1.71034 1.89830 2.33164 2.58043 2.85312 3.15176 3.47855 4.65239 12 1.60103 1.79586 2.01220 2.51817 2.81267 3.13843 3.49845 3.89598 5.35025 13 1.66507 1.88565 2.13293 2.71962 3.06581 3.45227 3.88328 4.36349 6.15279 14 1.73168 1.97993 2.26090 2.93719 3.34173 3.79750 4.31044 4.88711 7.07571 15 1.80094 2.07893 2.39656 3.17217 3.64248 4.17725 4.78459 5.47357 8.13706

16 1.87298 2.18287 2.54035 3.42594 3.97031 4.59497 5.31089 6.13039 9.35762 17 1.94790 2.29202 2.69277 3.70002 4.32763 5.05447 5.89509 6.86604 10.76126 18 2.02582 2.40662 2.85434 3.99602 4.71712 5.55992 6.54355 7.68997 12.37545 19 2.10685 2.52695 3.02560 4.31570 5.14166 6.11591 7.26334 8.61276 14.23177 20 2.19112 2.65330 3.20714 4.66096 5.60441 6.72750 8.06231 9.64629 16.36654

Another method that can be used to compute the future value of a single amount involves the use of a compound interest table. This table shows the future value of 1 for n periods. Table 1, shown below, is such a table.

Future Value of an Annuity C5

FUTURE VALUE OF AN ANNUITY The preceding discussion involved the accumulation of only a single principal sum. Individuals and businesses frequently encounter situa- tions in which a series of equal dollar amounts are to be paid or received periodically, such as loans or lease (rental) contracts. Such payments or receipts of equal dollar amounts are referred to as annuities. The future value of an annuity is the sum of all the payments (receipts) plus the accumulated com- pound interest on them. In computing the future value of an annuity, it is neces- sary to know (1) the interest rate, (2) the number of compounding periods, and (3) the amount of the periodic payments or receipts.

To illustrate the computation of the future value of an annuity, assume that you invest $2,000 at the end of each year for three years at 5% interest compounded annually. This situation is depicted in the time diagram in Illustration C-6.

Solve for future value of an annuity.

S T U D Y O B J E C T I V E 3

Illustration C-5 Demonstration Problem— Using Table 1 for FV of 1

0 $20,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

i = 6% Future

Value = ?Present Value (p)

n = 18 years

John and Mary Rich invested $20,000 in a savings account paying 6% interest at the time their son, Mike, was born. The money is to be used by Mike for his college education. On his 18th birthday, Mike withdraws the money from his savings account. How much did Mike withdraw from his account?

Answer: The future value factor from Table 1 is 2.85434 (18 periods at 6%). The future value of $20,000 earning 6% per year for 18 years is $57,086.80 ($20,000 × 2.85434).

Illustration C-6 Time diagram for a three- year annuity

0 1 2 3

$2,000 Present Value $2,000 $2,000

i = 5% Future Value = ?

n = 3 years

C6 Appendix C Time Value of Money

TABLE 2 Future Value of an Annuity of 1

(n) Periods 4% 5% 6% 8% 9% 10% 11% 12% 15%

1 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 2 2.04000 2.05000 2.06000 2.08000 2.09000 2.10000 2.11000 2.12000 2.15000 3 3.12160 3.15250 3.18360 3.24640 3.27810 3.31000 3.34210 3.37440 3.47250 4 4.24646 4.31013 4.37462 4.50611 4.57313 4.64100 4.70973 4.77933 4.99338 5 5.41632 5.52563 5.63709 5.86660 5.98471 6.10510 6.22780 6.35285 6.74238

6 6.63298 6.80191 6.97532 7.33592 7.52334 7.71561 7.91286 8.11519 8.75374 7 7.89829 8.14201 8.39384 8.92280 9.20044 9.48717 9.78327 10.08901 11.06680 8 9.21423 9.54911 9.89747 10.63663 11.02847 11.43589 11.85943 12.29969 13.72682 9 10.58280 11.02656 11.49132 12.48756 13.02104 13.57948 14.16397 14.77566 16.78584

10 12.00611 12.57789 13.18079 14.48656 15.19293 15.93743 16.72201 17.54874 20.30372

11 13.48635 14.20679 14.97164 16.64549 17.56029 18.53117 19.56143 20.65458 24.34928 12 15.02581 15.91713 16.86994 18.97713 20.14072 21.38428 22.71319 24.13313 29.00167 13 16.62684 17.71298 18.88214 21.49530 22.95339 24.52271 26.21164 28.02911 34.35192 14 18.29191 19.59863 21.01507 24.21492 26.01919 27.97498 30.09492 32.39260 40.50471 15 20.02359 21.57856 23.27597 27.15211 29.36092 31.77248 34.40536 37.27972 47.58041

16 21.82453 23.65749 25.67253 30.32428 33.00340 35.94973 39.18995 42.75328 55.71747 17 23.69751 25.84037 28.21288 33.75023 36.97351 40.54470 44.50084 48.88367 65.07509 18 25.64541 28.13238 30.90565 37.45024 41.30134 45.59917 50.39593 55.74972 75.83636 19 27.67123 30.53900 33.75999 41.44626 46.01846 51.15909 56.93949 63.43968 88.21181 20 29.77808 33.06595 36.78559 45.76196 51.16012 57.27500 64.20283 72.05244 102.44358

Illustration C-7 Future value of periodic payments

Year Amount Future Value of Future Invested Invested � 1 Factor at 5% � Value

1 $2,000 � 1.10250 � $2,205 2 $2,000 � 1.05000 � 2,100 3 $2,000 � 1.00000 � 2,000

3.15250 $6,305

As can be seen in Illustration C-6, the $2,000 invested at the end of year 1 will earn interest for two years (years 2 and 3), and the $2,000 invested at the end of year 2 will earn interest for one year (year 3). However, the last $2,000 investment (made at the end of year 3) will not earn any interest. The future value of these pe- riodic payments could be computed using the future value factors from Table 1 as shown in Illustration C-7.

The first $2,000 investment is multiplied by the future value factor for two periods (1.1025) because two years’ interest will accumulate on it (in years 2 and 3). The second $2,000 investment will earn only one year’s interest (in year 3) and there- fore is multiplied by the future value factor for one year (1.0500). The final $2,000 investment is made at the end of the third year and will not earn any interest. Consequently, the future value of the last $2,000 invested is only $2,000 since it does not accumulate any interest.

This method of calculation is required when the periodic payments or receipts are not equal in each period. However, when the periodic payments (receipts) are the same in each period, the future value can be computed by using a future value of an annuity of 1 table. Table 2, shown below, is such a table.

Present Value Variables C7

Illustration C-8 Demonstration Problem— Using Table 2 for FV of an annuity of 1

0 1 2 3 4

$25,000 Present Value $25,000 $25,000 $25,000

i = 6% Future Value = ?

n = 4 years

Henning Printing Company knows that in four years it must replace one of its existing printing presses with a new one. To insure that some funds are available to replace the machine in 4 years, the company is depositing $25,000 in a savings account at the end of each of the next four years (4 deposits in total). The savings account will earn 6% interest compounded annually. How much will be in the savings account at the end of 4 years when the new printing press is to be purchased?

Answer: The future value factor from Table 2 is 4.37462 (4 periods at 6%). The future value of $25,000 invested at the end of each year for 4 years at 6% interest is $109,365.50 ($25,000 × 4.37462).

Table 2 shows the future value of 1 to be received periodically for a given number of periods. You can see from Table 2 that the future value of an annuity of 1 factor for three periods at 5% is 3.15250. The future value factor is the total of the three individual future value factors as shown in Illustration C-8. Multiplying this amount by the annual investment of $2,000 produces a future value of $6,305.

The demonstration problem in Illustration C-8 illustrates how to use Table 2.

SECTION 2 Present Value Concepts

PRESENT VALUE VARIABLES The present value is the value now of a given amount to be paid or re- ceived in the future, assuming compound interest. The present value is based on three variables: (1) the dollar amount to be received (future amount), (2) the length of time until the amount is received (number of periods), and (3) the interest rate (the discount rate). The process of determining the present value is referred to as discounting the future amount.

In this textbook, we use present value computations in measuring several items. For example, Chapter 11 computed the present value of the principal and in- terest payments to determine the market price of a bond. In addition, determining the amount to be reported for notes payable involves present value computations.

Identify the variables fundamental to solving present value problems.

S T U D Y O B J E C T I V E 4

To illustrate present value, assume that you want to invest a sum of money that will yield $1,000 at the end of one year. What amount would you need to invest today to have $1,000 one year from now? Illustration C-9 shows the formula for calculating present value.

C8 Appendix C Time Value of Money

PRESENT VALUE OF A SINGLE AMOUNT

Present Value � Future Value � (1 � i )n Illustration C-9 Formula for present value

Thus, if you want a 10% rate of return, you would compute the present value of $1,000 for one year as follows:

PV � FV � (1 � i)n

� $1,000 � (1 � .10)1

PV � $1,000 � 1.10 PV � $909.09

We know the future amount ($1,000), the discount rate (10%), and the number of periods (one). These variables are depicted in the time diagram in Illustration C-10.

Illustration C-10 Finding present value if dis- counted for one period

i = 10%

n = 1 year

Present Value (?)

$909.09

Future Value

$1,000

If you receive the single amount of $1,000 in two years, discounted at 10% [PV � $1,000 � (1 � .10)2], the present value of your $1,000 is $826.45 [($1,000 � 1.21), depicted as shown in Illustration C-11 below.

Illustration C-11 Finding present value if discounted for two periods

You also could find the present value of your amount through tables that show the present value of 1 for n periods. In Table 3, on the next page, n (represented in

i = 10%

1

Present Value (?)

0

Future Value

2 n = 2 years$826.45 $1,000

Solve for present value of a single amount.

S T U D Y O B J E C T I V E 5

Present Value of a Single Amount C9

For example, the present value factor for one period at a discount rate of 10% is .90909, which equals the $909.09 ($1,000 � .90909) computed in Illustration C-10. For two periods at a discount rate of 10%, the present value factor is .82645, which equals the $826.45 ($1,000 � .82645) computed previously.

Note that a higher discount rate produces a smaller present value. For example, using a 15% discount rate, the present value of $1,000 due one year from now is $869.57, versus $909.09 at 10%. Also note that the further removed from the pres- ent the future value is, the smaller the present value. For example, using the same discount rate of 10%, the present value of $1,000 due in five years is $620.92, ver- sus the present value of $1,000 due in one year, which is $909.09.

The two demonstration problems on the next page (Illustrations C-12, C-13) illustrate how to use Table 3.

TABLE 3 Present Value of 1

(n) Periods 4% 5% 6% 8% 9% 10% 11% 12% 15%

1 .96154 .95238 .94340 .92593 .91743 .90909 .90090 .89286 .86957 2 .92456 .90703 .89000 .85734 .84168 .82645 .81162 .79719 .75614 3 .88900 .86384 .83962 .79383 .77218 .75132 .73119 .71178 .65752 4 .85480 .82270 .79209 .73503 .70843 .68301 .65873 .63552 .57175 5 .82193 .78353 .74726 .68058 .64993 .62092 .59345 .56743 .49718

6 .79031 .74622 .70496 .63017 .59627 .56447 .53464 .50663 .43233 7 .75992 .71068 .66506 .58349 .54703 .51316 .48166 .45235 .37594 8 .73069 .67684 .62741 .54027 .50187 .46651 .43393 .40388 .32690 9 .70259 .64461 .59190 .50025 .46043 .42410 .39092 .36061 .28426

10 .67556 .61391 .55839 .46319 .42241 .38554 .35218 .32197 .24719

11 .64958 .58468 .52679 .42888 .38753 .35049 .31728 .28748 .21494 12 .62460 .55684 .49697 .39711 .35554 .31863 .28584 .25668 .18691 13 .60057 .53032 .46884 .36770 .32618 .28966 .25751 .22917 .16253 14 .57748 .50507 .44230 .34046 .29925 .26333 .23199 .20462 .14133 15 .55526 .48102 .41727 .31524 .27454 .23939 .20900 .18270 .12289

16 .53391 .45811 .39365 .29189 .25187 .21763 .18829 .16312 .10687 17 .51337 .43630 .37136 .27027 .23107 .19785 .16963 .14564 .09293 18 .49363 .41552 .35034 .25025 .21199 .17986 .15282 .13004 .08081 19 .47464 .39573 .33051 .23171 .19449 .16351 .13768 .11611 .07027 20 .45639 .37689 .31180 .21455 .17843 .14864 .12403 .10367 .06110

the table’s rows) is the number of discounting periods involved. The percentages (represented in the table’s columns) are the periodic interest rates or discount rates. The five-digit decimal numbers in the intersections of the rows and columns are called the present value of 1 factors.

When using Table 3 to determine present value, you multiply the future value by the present value factor specified at the intersection of the number of periods and the discount rate.

C10 Appendix C Time Value of Money

Illustration C-13 Demonstration problem— Using Table 3 for PV of 1

PRESENT VALUE OF AN ANNUITY The preceding discussion involved the discounting of only a single future amount. Businesses and individuals frequently engage in transactions in which a series of equal dollar amounts are to be received or paid periodi- cally. Examples of a series of periodic receipts or payments are loan

agreements, installment sales, mortgage notes, lease (rental) contracts, and pension obligations. These periodic receipts or payments are annuities.

The present value of an annuity is the value now of a series of future receipts or payments, discounted assuming compound interest. In computing the present value of an annuity, you need to know: (1) the discount rate, (2) the number of dis- count periods, and (3) the amount of the periodic receipts or payments.

To illustrate how to compute the present value of an annuity, assume that you will receive $1,000 cash annually for three years at a time when the discount rate is 10%. Illustration C-14 depicts this situation, and Illustration C-15 shows the com- putation of its present value.

Solve for present value of an annuity.

S T U D Y O B J E C T I V E 6

Illustration C-12 Demonstration problem— Using Table 3 for PV of 1

i = 8%

2

PV = ?

Now

$10,000

3 years1

Suppose you have a winning lottery ticket and the state gives you the option of taking $10,000 three years from now or taking the present value of $10,000 now. The state uses an 8% rate in discounting. How much will you receive if you accept your winnings now?

Answer: The present value factor from Table 3 is .79383 (3 periods at 8%). The present value of $10,000 to be received in 3 years discounted at 8% is $7,938.30 ($10,000 × .79383).

n = 3

i = 9%

3

PV = ?

Now

$5,000

4 years1

Determine the amount you must deposit now in your SUPER savings account, paying 9% interest, in order to accumulate $5,000 for a down payment 4 years from now on a new Chevy Tahoe.

Answer: The present value factor from Table 3 is .70843 (4 periods at 9%). The present value of $5,000 to be received in 4 years discounted at 9% is $3,542.15 ($5,000 × .70843).

2 n = 4

This method of calculation is required when the periodic cash flows are not uniform in each period. However, when the future receipts are the same in each period, there are two other ways to compute present value. First, you can multiply the annual cash flow by the sum of the three present value factors. In the previous example, $1,000 � 2.48686 equals $2,486.86. The second method is to use annuity tables. As illustrated in Table 4 below, these tables show the present value of 1 to be received periodically for a given number of periods.

Present Value of an Annuity C11

Present Value of 1 Future Amount � Factor at 10% � Present Value

$1,000 (one year away) .90909 $ 909.09 1,000 (two years away) .82645 826.45 1,000 (three years away) . 75132 751.32

2.48686 $2,486.86

Illustration C-14 Time diagram for a three- year annuity

Illustration C-15 Present value of a series of future amounts computation

i = 10%

2Now 3 years

PV = ? $1,000 $1,000$1,000

1 n = 3

TABLE 4 Present Value of an Annuity of 1

(n) Periods 4% 5% 6% 8% 9% 10% 11% 12% 15%

1 .96154 .95238 .94340 .92593 .91743 .90909 .90090 .89286 .86957 2 1.88609 1.85941 1.83339 1.78326 1.75911 1.73554 1.71252 1.69005 1.62571 3 2.77509 2.72325 2.67301 2.57710 2.53130 2.48685 2.44371 2.40183 2.28323 4 3.62990 3.54595 3.46511 3.31213 3.23972 3.16986 3.10245 3.03735 2.85498 5 4.45182 4.32948 4.21236 3.99271 3.88965 3.79079 3.69590 3.60478 3.35216

6 5.24214 5.07569 4.91732 4.62288 4.48592 4.35526 4.23054 4.11141 3.78448 7 6.00205 5.78637 5.58238 5.20637 5.03295 4.86842 4.71220 4.56376 4.16042 8 6.73274 6.46321 6.20979 5.74664 5.53482 5.33493 5.14612 4.96764 4.48732 9 7.43533 7.10782 6.80169 6.24689 5.99525 5.75902 5.53705 5.32825 4.77158

10 8.11090 7.72173 7.36009 6.71008 6.41766 6.14457 5.88923 5.65022 5.01877

11 8.76048 8.30641 7.88687 7.13896 6.80519 6.49506 6.20652 5.93770 5.23371 12 9.38507 8.86325 8.38384 7.53608 7.16073 6.81369 6.49236 6.19437 5.42062 13 9.98565 9.39357 8.85268 7.90378 7.48690 7.10336 6.74987 6.42355 5.58315 14 10.56312 9.89864 9.29498 8.24424 7.78615 7.36669 6.98187 6.62817 5.72448 15 11.11839 10.37966 9.71225 8.55948 8.06069 7.60608 7.19087 6.81086 5.84737

16 11.65230 10.83777 10.10590 8.85137 8.31256 7.82371 7.37916 6.97399 5.95424 17 12.16567 11.27407 10.47726 9.12164 8.54363 8.02155 7.54879 7.11963 6.04716 18 12.65930 11.68959 10.82760 9.37189 8.75563 8.20141 7.70162 7.24967 6.12797 19 13.13394 12.08532 11.15812 9.60360 8.95012 8.36492 7.83929 7.36578 6.19823 20 13.59033 12.46221 11.46992 9.81815 9.12855 8.51356 7.96333 7.46944 6.25933

Table 4 shows that the present value of an annuity of 1 factor for three periods at 10% is 2.48685.1 (This present value factor is the total of the three individual present value factors, as shown in Illustration C-15.) Applying this amount to the annual cash flow of $1,000 produces a present value of $2,486.85.

The following demonstration problem (Illustration C-16) illustrates how to use Table 4.

C12 Appendix C Time Value of Money

1 The difference of .00001 between 2.48686 and 2.48685 is due to rounding.

Illustration C-16 Demonstration problem— Using Table 4 for PV of an annuity of 1

TIME PERIODS AND DISCOUNTING In the preceding calculations, the discounting was done on an annual basis using an annual interest rate. Discounting may also be done over shorter periods of time such as monthly, quarterly, or semiannually.

When the time frame is less than one year, you need to convert the annual interest rate to the applicable time frame. Assume, for example, that the investor in Illustration C-14 received $500 semiannually for three years instead of $1,000 an- nually. In this case, the number of periods becomes six (3 � 2), the discount rate is 5% (10% � 2), the present value factor from Table 4 is 5.07569, and the present value of the future cash flows is $2,537.85 (5.07569 � $500). This amount is slightly higher than the $2,486.86 computed in Illustration C-15 because interest is paid twice during the same year; therefore interest is earned on the first half year’s interest.

i = 12%

4

PV = ?

Now

$6,000

5 years1

Kildare Company has just signed a capitalizable lease contract for equip- ment that requires rental payments of $6,000 each, to be paid at the end of each of the next 5 years. The appropriate discount rate is 12%. What is the present value of the rental payments—that is, the amount used to capitalize the leased equipment?

Answer: The present value factor from Table 4 is 3.60478 (5 periods at 12%). The present value of 5 payments of $6,000 each discounted at 12% is $21,628.68 ($6,000 × 3.60478).

$6,000 $6,000

2 3

$6,000 $6,000

n = 5

COMPUTING THE PRESENT VALUE OF A LONG-TERM NOTE OR BOND

The present value (or market price) of a long-term note or bond is a func- tion of three variables: (1) the payment amounts, (2) the length of time un- til the amounts are paid, and (3) the discount rate. Our illustration uses a five-year bond issue.

Compute the present value of notes and bonds.

S T U D Y O B J E C T I V E 7

Computing the Present Value of a Long-Term Note or Bond C13

The first variable—dollars to be paid—is made up of two elements: (1) a series of interest payments (an annuity), and (2) the principal amount (a single sum). To compute the present value of the bond, we must discount both the interest pay- ments and the principal amount—two different computations. The time diagrams for a bond due in five years are shown in Illustration C-17.

When the investor’s market interest rate is equal to the bond’s contractual in- terest rate, the present value of the bonds will equal the face value of the bonds. To illustrate, assume a bond issue of 10%, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. If the discount rate is the same as the contractual rate, the bonds will sell at face value. In this case, the investor will receive the following: (1) $100,000 at maturity, and (2) a series of ten $5,000 interest payments [($100,000 � 10%) � 2] over the term of the bonds. The length of time is expressed in terms of interest periods—in this case—10, and the discount rate per interest period, 5%. The following time diagram (Illustration C-18) depicts the variables involved in this discounting situation.

Illustration C-17 Present value of a bond time diagram

Illustration C-18 Time diagram for present value of a 10%, five-year bond paying interest semiannually

Interest Rate (i)

1 yr.

Present Value (?)

Now

Principal Amount

5 yr.

Diagram for

Principal 2 yr. 3 yr. 4 yr.

Interest

1 yr.

Present Value (?)

Now 5 yr.

Diagram for

Interest 2 yr. 3 yr. 4 yr.

Interest Rate (i) Interest Interest Interest Interest

n = 5

n = 5

i = 5%

1

Present Value (?)

Now

Principal Amount $100,000

10

Diagram for

Principal 5 6

1

Present Value (?)

Now 10

Diagram for

Interest 5 6

i = 5% $5,000

2

2

3

3

4

4

7

7

8

8

9

9

$5,000 $5,000 $5,000 $5,000$5,000 $5,000 $5,000 $5,000

n = 10

n = 10

$5,000

Interest Payments

Illustration C-19 shows the computation of the present value of these bonds.

C14 Appendix C Time Value of Money

10% Contractual Rate—10% Discount Rate

Present value of principal to be received at maturity $100,000 � PV of 1 due in 10 periods at 5% $100,000 � .61391 (Table 3) $ 61,391

Present value of interest to be received periodically over the term of the bonds

$5,000 � PV of 1 due periodically for 10 periods at 5% $5,000 � 7.72173 (Table 4) 38,609*

Present value of bonds $100,000

*Rounded

10% Contractual Rate—12% Discount Rate

Present value of principal to be received at maturity $100,000 � .55839 (Table 3) $55,839

Present value of interest to be received periodically over the term of the bonds

$5,000 � 7.36009 (Table 4) 36,800

Present value of bonds $92,639

10% Contractual Rate—8% Discount Rate

Present value of principal to be received at maturity $100,000 � .67556 (Table 3) $ 67,556

Present value of interest to be received periodically over the term of the bonds

$5,000 � 8.11090 (Table 4) 40,555

Present value of bonds $108,111

Now assume that the investor’s required rate of return is 12%, not 10%. The fu- ture amounts are again $100,000 and $5,000, respectively, but now a discount rate of 6% (12% � 2) must be used. The present value of the bonds is $92,639, as com- puted in Illustration C-20.

Conversely, if the discount rate is 8% and the contractual rate is 10%, the pres- ent value of the bonds is $108,111, computed as shown in Illustration C-21.

The above discussion relies on present value tables in solving present value problems. Many people use spreadsheets such as Excel or Financial calculators (some even on websites) to compute present values, without the use of tables. Many calculators, especially financial calculators, have present value (PV) functions that allow you to calculate present values by merely inputting the proper amount, discount rate, and periods, and pressing the PV key. The next section illustrates how to use a financial calculator in various business situations.

Illustration C-19 Present value of principal and interest—face value

Illustration C-20 Present value of principal and interest—discount

Illustration C-21 Present value of principal and interest—premium

Using Financial Calculators—Present Value of a Single Sum C15

SECTION 3 Using Financial Calculators

Business professionals, once they have mastered the underlying concepts in sections 1 and 2, often use a financial (business) calculator to solve time value of money problems. In many cases, they must use calculators if in- terest rates or time periods do not correspond with the information pro- vided in the compound interest tables.

To use financial calculators, you enter the time value of money variables into the calculator. Illustration C-22 shows the five most common keys used to solve time value of money problems.2

Use a financial calculator to solve time value of money problems.

S T U D Y O B J E C T I V E 8

Illustration C-22 Financial calculator keys

N I PV PMT FV

where

N � number of periods

I � interest rate per period (some calculators use I/YR or i)

PV � present value (occurs at the beginning of the first period)

PMT � payment (all payments are equal, and none are skipped)

FV � future value (occurs at the end of the last period)

In solving time value of money problems in this appendix, you will generally be given three of four variables and will have to solve for the remaining variable. The fifth key (the key not used) is given a value of zero to ensure that this variable is not used in the computation.

PRESENT VALUE OF A SINGLE SUM To illustrate how to solve a present value problem using a financial calculator, assume that you want to know the present value of $84,253 to be received in five years, dis- counted at 11% compounded annually. Illustration C-23 pictures this problem.

2 On many calculators, these keys are actual buttons on the face of the calculator; on others they

appear on the display after the user accesses a present value menu.

Illustration C-23 Calculator solution for present value of a single sum

? 0 84,253

–50,000

N

Inputs: 5

Answer:

11

I PV PMT FV

The diagram shows you the information (inputs) to enter into the calculator: N � 5, I � 11, PMT � 0, and FV � 84,253. You then press PV for the answer: �$50,000. As indicated, the PMT key was given a value of zero because a series of payments did not occur in this problem.

Plus and Minus The use of plus and minus signs in time value of money problems with a financial calculator can be confusing. Most financial calculators are programmed so that the positive and negative cash flows in any problem offset each other. In the present value problem, we identified the $84,253 future value initial investment as a positive (inflow); the answer �$50,000 was shown as a negative amount, reflecting a cash outflow. If the 84,253 were entered as a negative, then the final answer would have been reported as a positive 50,000.

Hopefully, the sign convention will not cause confusion. If you understand what is required in a problem, you should be able to interpret a positive or negative amount in determining the solution to a problem.

Compounding Periods In the problem on page C15, we assumed that compounding occurs once a year. Some financial calculators have a default setting, which assumes that compounding occurs 12 times a year. You must determine what default period has been pro- grammed into your calculator and change it as necessary to arrive at the proper compounding period.

Rounding Most financial calculators store and calculate using 12 decimal places. As a result, because compound interest tables generally have factors only up to 5 decimal places, a slight difference in the final answer can result. In most time value of money problems, the final answer will not include more than two decimal points.

C16 Appendix C Time Value of Money

PRESENT VALUE OF AN ANNUITY To illustrate how to solve a present value of an annuity problem using a financial calculator, assume that you are asked to determine the present value of rental re- ceipts of $6,000 each to be received at the end of each of the next five years, when discounted at 12%, as pictured in Illustration C-24.

Illustration C-24 Calculator solution for present value of an annuity

N

Inputs: 5 12 ? 6,000 0

Answer: –21,628.66

I PV PMT FV

In this case, you enter N � 5, I � 12, PMT � 6,000, FV � 0, and then press PV to arrive at the answer of $21, 628.66.

USEFUL APPLICATIONS OF THE FINANCIAL CALCULATOR

With a financial calculator you can solve for any interest rate or for any number of periods in a time value of money problem. Here are some examples of these applications.

Auto Loan Assume you are financing a car with a three-year loan. The loan has a 9.5% nomi- nal annual interest rate, compounded monthly. The price of the car is $6,000, and you want to determine the monthly payments, assuming that the payments start one month after the purchase. This problem is pictured in Illustration C-25.

Summary of Study Objectives C17

To solve this problem, you enter N � 36 (12 � 3), I � 9.5, PV � 6,000, FV � 0, and then press PMT. You will find that the monthly payments will be $192.20. Note that the payment key is usually programmed for 12 payments per year. Thus, you must change the default (compounding period) if the payments are other than monthly.

Mortgage Loan Amount Let’s say you are evaluating financing options for a loan on a house. You decide that the maximum mortgage payment you can afford is $700 per month. The annual interest rate is 8.4%. If you get a mortgage that requires you to make monthly pay- ments over a 15-year period, what is the maximum purchase price you can afford? Illustration C-26 depicts this problem.

Illustration C-25 Calculator solution for auto loan payments

Illustration C-26 Calculator solution for mortgage amount

N

Inputs: 36 9.5 6,000 ? 0

Answer: –192.20

I PV PMT FV

N

Inputs: 180 8.4 ? –700 0

Answer: 71,509.81

I PV PMT FV

You enter N � 180 (12 � 15 years), I � 8.4, PMT � �700, FV � 0, and press PV. With the payment-per-year key set at 12, you find a present value of $71,509.81— the maximum house price you can afford, given that you want to keep your mort- gage payments at $700. Note that by changing any of the variables, you can quickly conduct “what-if” analyses for different situations.

SUMMARY OF STUDY OBJECTIVES 1. Distinguish between simple and compound interest.

Simple interest is computed on the principal only, whereas compound interest is computed on the principal and any interest earned that has not been withdrawn.

2. Solve for future value of a single amount. Prepare a time diagram of the problem. Identify the principal amount, the number of compounding periods, and the in-

terest rate. Using the future value of 1 table, multiply the principal amount by the future value factor specified at the intersection of the number of periods and the interest rate.

3. Solve for future value of an annuity. Prepare a time di- agram of the problem. Identify the amount of the periodic payments, the number of compounding periods, and the

C18 Appendix C Time Value of Money

GLOSSARY Annuity A series of equal dollar amounts to be paid or

received periodically. (p. C5, C10)

Compound interest The interest computed on the principal and any interest earned that has not been paid or received. (p. C2)

Discounting the future amount(s) The process of determin- ing present value. (p. C7)

Future value of a single amount The value at a future date of a given amount invested assuming compound interest. (p. C3)

Future value of an annuity The sum of all the payments or receipts plus the accumulated compound interest on them. (p. C5)

Interest Payment for the use of another’s money. (p. C1)

Present value The value now of a given amount to be invested or received in the future assuming compound interest. (p. C7)

Present value of an annuity A series of future receipts or payments discounted to their value now assuming com- pound interest. (p. C10)

Principal The amount borrowed or invested. (p. C1)

Simple interest The interest computed on the principal only. (p. C1)

interest rate. Using the future value of an annuity of 1 table, multiply the amount of the payments by the future value factor specified at the intersection of the number of periods and the interest rate.

4. Identify the variables fundamental to solving present value problems. The following three variables are funda- mental to solving present value problems: (1) the future amount, (2) the number of periods, and (3) the interest rate (the discount rate).

5. Solve for present value of a single amount. Prepare a time diagram of the problem. Identify the future amount, the number of discounting periods, and the discount (inter- est) rate. Using the present value of 1 table, multiply the fu- ture amount by the present value factor specified at the in- tersection of the number of periods and the discount rate.

6. Solve for present value of an annuity. Prepare a time diagram of the problem. Identify the future amounts (an- nuities), the number of discounting periods, and the dis- count (interest) rate. Using the present value of an annuity of 1 table, multiply the amount of the annuity by the pres- ent value factor specified at the intersection of the number of periods and the interest rate.

7. Compute the present value of notes and bonds. To determine the present value of the principal amount: Multiply the principal amount (a single future amount) by the present value factor (from the present value of 1 table) intersecting at the number of periods (number of interest payments) and the discount rate. To determine the present value of the series of interest payments: Multiply the amount of the interest payment by the present value factor (from the present value of an annuity of 1 table) intersect- ing at the number of periods (number of interest pay- ments) and the discount rate. Add the present value of the principal amount to the present value of the interest pay- ments to arrive at the present value of the note or bond.

8. Use a financial calculator to solve time value of money problems. Financial calculators can be used to solve the same and additional problems as those solved with time value of money tables. One enters into the financial calcu- lator the amounts for all of the known elements of a time value of money problem (periods, interest rate, payments, future or present value) and solves for the unknown element. Particularly useful situations involve interest rates and compounding periods not presented in the tables.

BRIEF EXERCISES Use tables to solve Brief Exercises 1-23.

BEC-1 Russ Holub invested $4,000 at 5% annual interest, and left the money invested without withdrawing any of the interest for 10 years. At the end of the 10 years, Russ withdrew the accu- mulated amount of money.

(a) What amount did Russ withdraw assuming the investment earns simple interest? (b) What amount did Russ withdraw assuming the investment earns interest compound annually?

BEC-2 For each of the following cases, indicate (1) to what interest rate columns and (2) to what number of periods you would refer in looking up the future value factor.

1. In Table 1 (future value of 1):

Annual Number of Rate Years Invested Compounded

(a) 8% 5 Annually (b) 5% 3 Semiannually

Compute the future value of a single amount.

(SO 2)

Use future value tables.

(SO 2, 3)

2. In Table 2 (future value of an annuity of 1):

Brief Exercises C19

Annual Number of Rate Years Invested Compounded

(a) 5% 10 Annually (b) 4% 6 Semiannually

BEC-3 Racine Company signed a lease for an office building for a period of 10 years. Under the lease agreement, a security deposit of $10,000 is made. The deposit will be returned at the expi- ration of the lease with interest compounded at 4% per year. What amount will Racine receive at the time the lease expires?

BEC-4 Chaffee Company issued $1,000,000, 10-year bonds and agreed to make annual sinking fund deposits of $75,000. The deposits are made at the end of each year into an account paying 6% annual interest. What amount will be in the sinking fund at the end of 10 years?

BEC-5 Wayne and Brenda Anderson invested $5,000 in a savings account paying 5% com- pound annual interest when their daughter, Sue, was born. They also deposited $1,000 on each of her birthdays until she was 18 (including her 18th birthday). How much will be in the savings ac- count on her 18th birthday (after the last deposit)?

BEC-6 Ty Ngu borrowed $20,000 on July 1, 2002. This amount plus accrued interest at 6% com- pounded annually is to be repaid on July 1, 2008. How much will Ty have to repay on July 1, 2008?

BEC-7 For each of the following cases, indicate (a) to what interest rate columns and (b) to what number of periods you would refer in looking up the discount rate.

1. In Table 3 (present value of 1):

Number of Discounts Annual Rate Years Involved Per Year

(a) 12% 6 Annually (b) 10% 15 Annually (c) 8% 10 Semiannually

2. In Table 4 (present value of an annuity of 1):

Number of Number of Frequency of Annual Rate Years Involved Payments Involved Payments

(a) 8% 20 20 Annually (b) 10% 5 5 Annually (c) 12% 4 8 Semiannually

BEC-8 (a) What is the present value of $20,000 due 8 periods from now, discounted at 8%? (b) What is the present value of $20,000 to be received at the end of each of 6 periods, discounted at 9%?

BEC-9 Gonzalez Company is considering an investment that will return a lump sum of $500,000 5 years from now. What amount should Gonzalez Company pay for this investment in order to earn a 10% return?

BEC-10 Lasorda Company earns 9% on an investment that will return $875,000 8 years from now. What is the amount Lasorda should invest now in order to earn this rate of return?

BEC-11 Bosco Company is considering investing in an annuity contract that will return $30,000 annually at the end of each year for 15 years. What amount should Bosco Company pay for this investment if it earns a 6% return?

BEC-12 Modine Enterprises earns 11% on an investment that pays back $120,000 at the end of each of the next 4 years. What is the amount Modine Enterprises invested to earn the 11% rate of return?

BEC-13 Midwest Railroad Co. is about to issue $100,000 of 10-year bonds paying a 10% inter- est rate, with interest payable semiannually. The discount rate for such securities is 8%. How much can Midwest expect to receive from the sale of these bonds?

Compute the future value of a single amount.

(SO 2)

Compute the future value of an annuity.

(SO 3)

Compute the future value of a single amount and of an annuity.

(SO 2, 3)

Compute the future value of a single amount.

(SO 2) Use present value tables.

(SO 5, 6)

Determine present values.

(SO 5, 6)

Compute the present value of a single-sum investment.

(SO 5)

Compute the present value of a single-sum investment.

(SO 5)

Compute the present value of an annuity investment.

(SO 6)

Compute the present value of an annuity investment.

(SO 6)

Compute the present value of bonds.

(SO 5, 6, 7)

BEC-14 Assume the same information as in BEC-13 except that the discount rate is 10% in- stead of 8%. In this case, how much can Midwest expect to receive from the sale of these bonds?

BEC-15 Lounsbury Company receives a $50,000, 6-year note bearing interest of 8% (paid an- nually) from a customer at a time when the discount rate is 9%. What is the present value of the note received by Lounsbury Company?

BEC-16 Hartzler Enterprises issued 8%, 8-year, $2,000,000 par value bonds that pay interest semiannually on October 1 and April 1. The bonds are dated April 1, 2008, and are issued on that date. The discount rate of interest for such bonds on April 1, 2008, is 10%. What cash proceeds did Hartzler receive from issuance of the bonds?

BEC-17 Vinny Carpino owns a garage and is contemplating purchasing a tire retreading ma- chine for $16,280. After estimating costs and revenues, Vinny projects a net cash flow from the re- treading machine of $3,000 annually for 8 years. Vinny hopes to earn a return of 11% on such in- vestments. What is the present value of the retreading operation? Should Vinny Carpino purchase the retreading machine?

BEC-18 Rodriguez Company issues a 10%, 6-year mortgage note on January 1, 2008, to obtain financing for new equipment. Land is used as collateral for the note. The terms provide for semi- annual installment payments of $56,413. What were the cash proceeds received from the issuance of the note?

BEC-19 Goltra Company is considering purchasing equipment. The equipment will produce the following cash flows: Year 1, $30,000; Year 2, $40,000; Year 3, $50,000. Goltra requires a min- imum rate of return of 12%. What is the maximum price Goltra should pay for this equipment?

BEC-20 If Maria Sanchez invests $3,152 now, she will receive $10,000 at the end of 15 years. What annual rate of interest will Maria earn on her investment? (Hint: Use Table 3.)

BEC-21 Lori Burke has been offered the opportunity of investing $42,410 now. The investment will earn 10% per year and at the end of that time will return Lori $100,000. How many years must Lori wait to receive $100,000? (Hint: Use Table 3.)

BEC-22 Nancy Burns purchased an investment for $12,462.21. From this investment, she will receive $1,000 annually for the next 20 years, starting one year from now. What rate of interest will Nancy’s investment be earning for her? (Hint: Use Table 4.)

BEC-23 Betty Estes invests $7,536.08 now for a series of $1,000 annual returns, beginning one year from now. Betty will earn a return of 8% on the initial investment. How many annual pay- ments of $1,000 will Betty receive? (Hint: Use Table 4.)

BEC-24 Reba McEntire wishes to invest $19,000 on July 1, 2008, and have it accumulate to $49,000 by July 1, 2018.

Instructions Use a financial calculator to determine at what exact annual rate of interest Reba must invest the $19,000.

BEC-25 On July 17, 2008, Tim McGraw borrowed $42,000 from his grandfather to open a clothing store. Starting July 17, 2009, Tim has to make 10 equal annual payments of $6,500 each to repay the loan.

Instructions Use a financial calculator to determine what interest rate Tim is paying.

BEC-26 As the purchaser of a new house, Patty Loveless has signed a mortgage note to pay the Memphis National Bank and Trust Co. $14,000 every 6 months for 20 years, at the end of which time she will own the house. At the date the mortgage is signed the purchase price was $198,000, and Loveless made a down payment of $20,000. The first payment will be made 6 months after the date the mortgage is signed.

Instructions Using a financial calculator, compute the exact rate of interest earned on the mortgage by the bank.

C20 Appendix C Time Value of Money

Compute the present value of a note.

(SO 5, 6, 7)

Compute the present value of bonds.

(SO 5, 6, 7)

Compute the maximum price to pay for the equipment.

(SO 7)

Compute the interest rate on a single sum.

(SO 5) Compute the number of periods of a single sum.

(SO 5)

Compute the interest rate on an annuity.

(SO 6)

Compute the number of periods of an annuity.

(SO 6)

Compute the value of a machine for purposes of making a purchase decision.

(SO 7)

Compute the present value of a note.

(SO 5, 6)

Compute the present value of bonds.

(SO 5, 6, 7)

Determine interest rate.

(SO 8)

Determine interest rate.

(SO 8)

Determine interest rate.

(SO 8)

BEC-27 Using a financial calculator, solve for the unknowns in each of the following situations.

(a) On June 1, 2008, Shelley Long purchases lakefront property from her neighbor, Joey Brenner, and agrees to pay the purchase price in seven payments of $16,000 each, the first payment to be payable June 1, 2009. (Assume that interest compounded at an annual rate of 7.35% is implicit in the payments.) What is the purchase price of the property?

(b) On January 1, 2008, Cooke Corporation purchased 200 of the $1,000 face value, 8% coupon, 10-year bonds of Howe Inc. The bonds mature on January 1, 2018, and pay interest annually beginning January 1, 2009. Cooke purchased the bonds to yield 10.65%. How much did Cooke pay for the bonds?

BEC-28 Using a financial calculator, provide a solution to each of the following situations.

(a) Bill Schroeder owes a debt of $35,000 from the purchase of his new sport utility vehicle. The debt bears annual interest of 9.1% compounded monthly. Bill wishes to pay the debt and in- terest in equal monthly payments over 8 years, beginning one month hence. What equal monthly payments will pay off the debt and interest?

(b) On January 1, 2008, Sammy Sosa offers to buy Mark Grace’s used snowmobile for $8,000, payable in five equal annual installments, which are to include 8.25% interest on the unpaid balance and a portion of the principal. If the first payment is to be made on December 31, 2008, how much will each payment be?

Brief Exercises C21

Various time value of money situations.

(SO 8)

Various time value of money situations.

(SO 8)

D1

Payroll Accounting

Appendix D

Payroll and related fringe benefits often make up a large percentage of current lia- bilities. Employee compensation is often the most significant expense that a com- pany incurs. For example, Costco recently reported total employees of 103,000 and labor and fringe benefits costs that approximated 70% of the company’s total cost of operations.

Payroll accounting involves more than paying employees’ wages. Companies are required by law to maintain payroll records for each employee, to file and pay payroll taxes, and to comply with numerous state and federal tax laws related to employee compensation. Accounting for payroll has become much more complex due to these regulations.

After studying this appendix, you should be able to: 1. Discuss the objectives of internal control for payroll. 2. Compute and record the payroll for a pay period. 3. Describe and record employer payroll taxes.

S T U D Y O B J E C T I V E

PAYROLL DEFINED The term “payroll” pertains to both salaries and wages. Managerial, administrative, and sales personnel are generally paid salaries. Salaries are often expressed in terms of a specified amount per month or per year rather than an hourly rate. Store clerks, factory employees, and manual laborers are normally paid wages. Wages are based on a rate per hour or on a piecework basis (such as per unit of product). Frequently, people use the terms “salaries” and “wages” interchangeably.

The term “payroll” does not apply to payments made for services of profes- sionals such as certified public accountants, attorneys, and architects. Such profes- sionals are independent contractors rather than salaried employees. Payments to them are called fees. This distinction is important because government regulations relating to the payment and reporting of payroll taxes apply only to employees.

INTERNAL CONTROL OF PAYROLL Chapter 8 introduced internal control. As applied to payrolls, the objec- tives of internal control are (1) to safeguard company assets against unau- thorized payments of payroll and (2) to ensure the accuracy and reliability of the accounting records pertaining to payrolls.

Irregularities often result if internal control is lax. Methods of theft involving payroll include overstating hours, using unauthorized pay rates, adding fictitious employees to the payroll, continuing terminated employees on the payroll, and dis- tributing duplicate payroll checks. Moreover, inaccurate records will result in in- correct paychecks, financial statements, and payroll tax returns.

Discuss the objectives of internal control for payroll.

S T U D Y O B J E C T I V E 1

Payroll activities involve four functions: hiring employees, timekeeping, preparing the payroll, and paying the payroll. For effective internal control, the company should assign these four functions to different departments or individuals. To illustrate these functions, we will examine the case of Academy Company and one of its employees, Michael Jordan.

Hiring Employees The human resources (personnel) department is responsible for posting job open- ings, screening and interviewing applicants, and hiring employees. From a control standpoint, this department provides significant documentation and authorization. When an employee is hired, the human resources department prepares an author- ization form. The one used by Academy Company for Michael Jordan is shown in Illustration D-1.

D2 Appendix D Payroll Accounting

Illustration D-1 Authorization form prepared by the human resources department

Human Resources

Human Resources department documents and

authorizes employment.

Hiring Employees

ACADEMY COMPANY

Employee Name

Classification

Department

LAST MI Jordan,

Skilled-Level 10

Shipping

NEW HIRE

RATE CHANGE

SEPARATION

APPROVALS

FIRST Michael Starting Date

Social Security No.

Division

9/01/06

329-36-9547

Entertainment

Classification

Rate $

Clerk

10.00 per hour Bonus N/A

Salary Grade Level 10

Non-exempt x Exempt

Trans. from Temp.

New Rate $

Present Rate $

12.00 9/1/07

10.00

Other

Effective Date

Merit x Promotion Decrease

Amount $ per TypePrevious Increase Date None

ReasonResignation Discharge Retirement

FromLeave of absence to Type

Last Day Worked

BRANCH OR DEPT. MANAGER DATE DIVISION V.P. DATE

PERSONNEL DEPARTMENT

The human resources department sends the authorization form to the payroll department, where it is used to place the new employee on the payroll. A chief con- cern of the human resources department is ensuring the accuracy of this form. The reason is quite simple: One of the most common types of payroll frauds is adding fictitious employees to the payroll.

The human resources department is also responsible for authorizing changes in employment status. Specifically, they must authorize (1) changes in pay rates and (2) terminations of employment. Every authorization should be in writing, and a copy of the change in status should be sent to the payroll department. Notice in Illustration D-1 that Jordan received a pay increase of $2 per hour.

Timekeeping Another area in which internal control is important is timekeeping. Hourly em- ployees are usually required to record time worked by “punching” a time clock. The employee inserts a time card into the clock, which automatically records the employee’s arrival and departure times. Illustration D-2 shows Michael Jordan’s time card.

Internal Control of Payroll D3

In large companies, time clock procedures are often monitored by a supervisor or security guard to make sure an employee punches only his or her own card. At the end of the pay period, each employee’s supervisor approves the hours shown by sign- ing the time card. When overtime hours are involved, approval by a supervisor is usu- ally mandatory. This guards against unauthorized overtime. The approved time cards are then sent to the payroll department. For salaried employees, a manually prepared weekly or monthly time report kept by a supervisor may be used to record time worked.

Preparing the Payroll The payroll department prepares the payroll on the basis of two inputs: (1) human resources department authorizations and (2) approved time cards. Numerous cal- culations are involved in determining gross wages and payroll deductions. Therefore, a second payroll department employee, working independently, verifies all calculated amounts, and a payroll department supervisor then approves the payroll.The payroll department is also responsible for preparing (but not signing) pay- roll checks, maintaining payroll records, and preparing payroll tax returns.

Illustration D-2 Time card

Supervisors monitor hours worked through time cards

and time reports.

Timekeeping

EXTRA TIME NAME Michael Jordan

No. 17 1/14/08

PAY PERIOD ENDING

REGULAR TIME A.M. 8:58

12:00 1:00 5:01 9:00

11:59 12:59

5:00 8:59

12:01 1:01 5:00 9:00

12:00 1:00 5:00 8:57

11:58 1:00 5:01 8:00 1:00

IN OUT

IN O

U T

P.M.

N O

O N

7th D ay

6th D ay

5th D ay

4th D ay

3rd D ay

2nd D ay

1st D ay

5:00 9:00

TT HH

IISS SS

II DD

EE O

U O

U TT

TOTAL 4 TOTAL 40

IN OUT

IN OUT

IN OUT

IN OUT

IN OUT

IN OUT

IN OUT

IN OUT

IN OUT

IN OUT

IN OUT

IN OUT

A.M.

P.M.

N O

O N

A.M.

P.M.

N O

O N

A.M.

P.M. N

O O

N

A.M.

P.M.

N O

O N

A.M.

P.M.

N O

O N

A.M.

P.M.

N O

O N

Two (or more) employees verify payroll amounts; supervisor approves.

Preparing the Payroll

Paying the Payroll The treasurer’s department pays the payroll. Payment by check minimizes the risk of loss from theft, and the endorsed check provides proof of payment. For good internal control, payroll checks should be prenumbered, and all checks should be accounted for. All checks must be signed by the treasurer (or a designated agent). Distribution of the payroll checks to employees should be controlled by the trea- surer’s department. Many employees have their pay credited electronically to their bank accounts. To control these disbursements, the company provides to employ- ees receipts detailing gross pay deductions and net pay.

Occasionally companies pay the payroll in currency. In such cases it is custom- ary to have a second person count the cash in each pay envelope. The paymaster should obtain a signed receipt from the employee upon payment.

D4 Appendix D Payroll Accounting

Treasurer signs and distributes checks.

Paying the Payroll

Type of Pay Hours � Rate � Gross Earnings Regular 40 � $12 � $480 Overtime 4 � 18 � 72

Total wages $552

Illustration D-3 Computation of total wages

This computation assumes that Jordan receives 11⁄2 times his regular hourly rate ($12 � 1.5) for his overtime hours. Union contracts often re- quire that overtime rates be as much as twice the regular rates.

An employee’s salary is generally based on a monthly or yearly rate. The company then prorates these rates to its payroll periods (e.g., bi- weekly or monthly). Most executive and administrative positions are salaried. Federal law does not require overtime pay for employees in such positions.

Many companies have bonus agreements for employees. One survey found that over 94% of the largest U.S. manufacturing companies offer an-

nual bonuses to key executives. Bonus arrangements may be based on such factors as increased sales or net income. Companies may pay bonuses in cash and/or by granting employees the opportunity to acquire shares of company stock at favor- able prices (called stock option plans).

E T H I C S N O T E

Bonuses often reward out- standing individual per-

formance, but successful corpo- rations also need considerable teamwork. A challenge is to motivate individuals while pre- venting an unethical employee from taking another’s idea for his or her own advantage.

DETERMINING THE PAYROLL Determining the payroll involves computing three amounts: (1) gross earnings, (2) payroll deductions, and (3) net pay.

Gross Earnings Gross earnings is the total compensation earned by an employee. It consists of wages or salaries, plus any bonuses and commissions.

Companies determine total wages for an employee by multiplying the hours worked by the hourly rate of pay. In addition to the hourly pay rate, most compa- nies are required by law to pay hourly workers a minimum of 11⁄2 times the regular hourly rate for overtime work in excess of eight hours per day or 40 hours per week. In addition, many employers pay overtime rates for work done at night, on weekends, and on holidays.

For example, assume that Michael Jordan, an employee of Academy Company, worked 44 hours for the weekly pay period ending January 14. His regular wage is $12 per hour. For any hours in excess of 40, the company pays at one-and-a-half times the regular rate. Academy computes Jordan’s gross earnings (total wages) as follows.

Compute and record the payroll for a pay period.

S T U D Y O B J E C T I V E 2

Payroll Deductions As anyone who has received a paycheck knows, gross earnings are usually very different from the amount actually received. The difference is due to payroll deductions.

Payroll deductions may be mandatory or voluntary. Mandatory deductions are required by law and consist of FICA taxes and income taxes. Voluntary deductions are at the option of the employee. Illustration D-4 summarizes common types of payroll deductions. Such deductions do not result in payroll tax expense to the employer. The employer is merely a collection agent, and subsequently transfers the deducted amounts to the government and designated recipients.

Determining the Payroll D5

Illustration D-4 Payroll deductions

Gross Pay Net Pay

Federal Income Tax

FICA Taxes State and City Income Taxes

Insurance, Pensions, and/or Union Dues

Charity

1 The Medicare provision also includes a tax of 1.45% on gross earnings in excess of $97,500. In

the interest of simplification, we ignore this 1.45% charge in our end-of-chapter assignment mate- rial. We assume zero FICA withholdings on gross earnings above $97,500.

FICA TAXES In 1937 Congress enacted the Federal Insurance Contribution Act (FICA). FICA taxes are designed to provide workers with supplemental retirement, employment dis- ability, and medical benefits. In 1965, Congress extended benefits to include Medicare for individuals over 65 years of age. The benefits are financed by a tax levied on employees’ earnings. FICA taxes are commonly referred to as Social Security taxes.

Congress sets the tax rate and the tax base for FICA taxes. When FICA taxes were first imposed, the rate was 1% on the first $3,000 of gross earnings, or a max- imum of $30 per year. The rate and base have changed dramatically since that time! In 2007, the rate was 7.65% (6.2% Social Security plus 1.45% Medicare) on the first $97,500 of gross earnings for each employee.1 For purpose of illustration in this chapter, we will assume a rate of 8% on the first $97,500 of gross earnings, or a maximum of $7,800. Using the 8% rate, the FICA withholding for Jordan for the weekly pay period ending January 14 is $44.16 ($552 � 8%).

INCOME TAXES Under the U.S. pay-as-you-go system of federal income taxes, employers are required to withhold income taxes from employees each pay period. Three variables determine the amount to be withheld: (1) the employee’s gross earnings; (2) the number of allowances claimed by the employee; and (3) the length of the pay period.

The number of allowances claimed typically includes the employee, his or her spouse, and other dependents. To indicate to the Internal Revenue Service the number of allowances claimed, the employee must complete an Employee’s Withholding Allowance Certificate (Form W-4). As shown in Illustration D-5, Michael Jordan claims two allowances on his W-4.

D6 Appendix D Payroll Accounting

Illustration D-5 W-4 form

W-4Form Department of the Treasury Internal Revenue Service For Privacy Act and Paperwork Reduction Act Notice, see page 2.

Employee's Withholding Allowance Certificate OMB No. 1545-0010

1 Type or print your first name and middle initial Last name Michael Jordan

2 Your social security number 329-36-9547

Home address (number and street or rural route) 2345 Mifflin Ave.

City or town, State, and ZIP code Hampton, MI 48292

3

4

Single Marriedx Note: If married, but legally separated, or spouse is a nonresident alien, check the Single box.

If your last name differs from that on your social security card, check here and call 1-800-772-1213 for a new card . . . . .

Married, but withhold at higher Single rate.

5 Total number of allowances you are claiming (from line H above or from the worksheet on page 2 if they apply) 6 Additional amount, if any, you want withheld from each paycheck 7 I claim exemption from withholding for 2006, and I certify that I meet BOTH of the following conditions for exemption:

• Last year I had a right to a refund of ALL Federal income tax withheld because I had NO tax liability AND • This year I expect a refund of ALL Federal income tax withheld because I expect to have NO tax liability.

8 Employer’s name and address (Employer: Complete 8 and 10 only if sending to the IRS) 9 Office code (optional)

10 Employer identification number

5 6

7If you meet both conditions, enter “Exempt” here

$ 2

Under penalties of perjury, I certify that I am entitled to the number of withholding allowances claimed on this certificate or entitled to claim exempt status.

Employee's signature Date

Cat. No. 102200

, 20 08September 1

Withholding tables furnished by the Internal Revenue Service indicate the amount of income tax to be withheld. Withholding amounts are based on gross wages and the number of allowances claimed. Separate tables are provided for weekly, biweekly, semimonthly, and monthly pay periods. Illustration D-6 (next page) shows the withholding tax table for Michael Jordan (assuming he earns $552 per week and claims two allowances). For a weekly salary of $552 with two allowances, the income tax to be withheld is $49.

In addition, most states (and some cities) require employers to withhold income taxes from employees’ earnings. As a rule, the amounts withheld are a per- centage (specified in the state revenue code) of the amount withheld for the fed- eral income tax. Or they may be a specified percentage of the employee’s earnings. For the sake of simplicity, we have assumed that Jordan’s wages are subject to state income taxes of 2%, or $11.04 (2% � $552) per week.

There is no limit on the amount of gross earnings subject to income tax with- holdings. In fact, under our progressive system of taxation, the higher the earnings, the higher the percentage of income withheld for taxes.

OTHER DEDUCTIONS Employees may voluntarily authorize withholdings for charitable, retirement, and other purposes. All voluntary deductions from gross earnings should be authorized in writing by the employee. The authorization(s) may be made individually or as part of a group plan. Deductions for charitable organizations, such as the United Way, or for financial arrangements, such as U.S. savings bonds and repayment of

loans from company credit unions, are made individually. Deductions for union dues, health and life insurance, and pension plans are often made on a group basis. We will assume that Jordan has weekly voluntary deductions of $10 for the United Way and $5 for union dues.

Net Pay Academy Company determines net pay by subtracting payroll deductions from gross earnings. Illustration D-7 shows the computation of Jordan’s net pay for the pay period.

Determining the Payroll D7

Illustration D-6 Withholding tax table

MARRIED Persons –– WEEKLY Payroll Period (For Wages Paid in 2008)

If the wages are —

At least But less than

And the number of withholding allowances claimed is —

The amount of income tax to be withheld is —

0 1 2 3 4 5 6 7 8 9 10

0 0 0 0 0

0 0 0 0 0

0 0 0 0 0

0 2 3 5 6

0 0 0 0 0

0 0 0 0 0

1 2 4 5 7

8 10 11 13 14

0 0 0 0 0

1 2 4 5 7

8 10 11 13 14

16 17 19 20 22

1 3 4 6 7

9 10 12 13 15

16 18 19 21 22

24 25 27 28 30

9 10 12 13 15

16 18 19 21 22

24 25 27 28 30

31 33 34 36 37

17 18 20 21 23

24 26 27 29 30

32 33 35 36 38

39 41 42 44 45

24 26 27 29 30

32 33 35 36 38

39 41 42 44 45

47 48 50 51 53

32 34 35 37 38

40 41 43 44 46

47 49 50 52 53

55 56 58 59 61

40 42 43 45 46

48 49 51 52 54

55 57 58 60 61

63 64 66 67 69

48 49 51 52 54

55 57 58 60 61

63 64 66 67 69

70 72 73 75 76

56 57 59 60 62

63 65 66 68 69

71 72 74 75 77

78 80 81 83 84

500 510 520 530 540

550 560 570 580 590

600 610 620 630 640

650 660 670 680 690

490 500 510 520 530

540 550 560 570 580

590 600 610 620 630

640 650 660 670 680

A L T E R N A T I V E T E R M I N O L O G Y

Net pay is also called take-home pay.

Gross earnings $552.00 Payroll deductions:

FICA taxes $44.16 Federal income taxes 49.00 State income taxes 11.04 United Way 10.00 Union dues 5.00 119.20

Net pay $432.80

Illustration D-7 Computation of net pay

Assuming that Michael Jordan’s wages for each week during the year are $552, total wages for the year are $28,704 (52 � $552). Thus, all of Jordan’s wages are sub- ject to FICA tax during the year. In comparison, let’s assume that Jordan’s depart- ment head earns $2,000 per week, or $104,000 for the year. Since only the first $97,500 is subject to FICA taxes, the maximum FICA withholdings on the depart- ment head’s earnings would be $7,800 ($97,500 � 8%).

Recording the payroll involves maintaining payroll department records, recogniz- ing payroll expenses and liabilities, and recording payment of the payroll.

Maintaining Payroll Department Records To comply with state and federal laws, an employer must keep a cumulative record of each employee’s gross earnings, deductions, and net pay during the year. The record that provides this information is the employee earnings record. Illustration D-8 shows Michael Jordan’s employee earnings record.

D8 Appendix D Payroll Accounting

Illustration D-8 Employee earnings record

File Edit View Insert Format Tools Data Window Help

A DB C FE G H I J K L M N

ACADEMY COMPANY Employee Earnings Record

For the Year 2008

8 7 6 5 4 3 2 1

9 10 11 12

13 14 15 16 17 18 19 20

22

23 24

21

Name

Social Security Number

Date of Birth

Date Employed

Sex

Single

Michael Jordan

329-36-9547

December 24, 1962

September 1, 2003

Male

x

Address

Telephone

Date Employment Ended

Exemptions

2345 Mifflin Ave.

Hampton, Michigan 48292

555-238-9051

2

Married

1,920.00 1,665.202,118.00 169.44 181.00 452.8042.36 40.00 20.00198.00

480.00

480.00 480.00

480.00 36.00

54.00 36.00

72.00 41.28

42.72 41.28

44.16 43.00

46.00 43.00

49.00 10.32

10.68 10.32

11.04 10.00

10.00 10.00

10.00 5.00

5.00 5.00

5.00 109.60

114.40 109.60

119.20 406.40

419.60 406.40

432.80 974

1077 1133

1028 516.00

534.00 516.00

552.00 516.00

1,602.00 2,118.00

1,068.00 1/7 1/14 1/21 1/28 Jan. Total

42 44 43 42

2008 Period Ending

Gross Earnings Deductions Payment Total Hours Regular Overtime Total Cumulative FICA

Fed. Inc. Tax

State Inc. Tax

United Way

Union Dues Total

Net Amount

Check No.

RECORDING THE PAYROLL

Companies keep a separate earnings record for each employee, and update these records after each pay period. The employer uses the cumulative payroll data on the earnings record to: (1) determine when an employee has earned the maximum earn- ings subject to FICA taxes, (2) file state and federal payroll tax returns (as explained later), and (3) provide each employee with a statement of gross earnings and tax withholdings for the year. (Illustration D-12 on page D13 shows this statement.)

In addition to employee earnings records, many companies find it useful to prepare a payroll register. This record accumulates the gross earnings, deductions, and net pay by employee for each pay period. It provides the documentation for preparing a paycheck for each employee. Illustration D-9 (next page) presents Academy Company’s payroll register. It shows the data for Michael Jordan in the wages section. In this example, Academy Company’s total weekly payroll is $17,210, as shown in the gross earnings column.

Note that this record is a listing of each employee’s payroll data for the pay pe- riod. In some companies, a payroll register is a journal or book of original entry;

postings are made from the payroll register directly to ledger accounts. In other companies, the payroll register is a memorandum record that provides the data for a general journal entry and subsequent posting to the ledger accounts. At Academy Company, the latter procedure is followed.

Recognizing Payroll Expenses and Liabilities From the payroll register in Illustration D-9, Academy Company makes a journal entry to record the payroll. For the week ending January 14 the entry is:

Jan. 14 Office Salaries Expense 5,200.00 Wages Expense 12,010.00

FICA Taxes Payable 1,376.80 Federal Income Taxes Payable 3,490.00 State Income Taxes Payable 344.20 United Way Payable 421.50 Union Dues Payable 115.00 Salaries and Wages Payable 11,462.50

(To record payroll for the week ending January 14)

The company credits specific liability accounts for the mandatory and voluntary deductions made during the pay period. In the example, Academy debits Office Salaries Expense for the gross earnings of salaried office workers, and it debits Wages Expense for the gross earnings of employees who are paid at an hourly rate. Other companies may debit other accounts such as Store Salaries or Sales Salaries. The amount credited to Salaries and Wages Payable is the sum of the individual checks the employees will receive.

Recording the Payroll D9

Illustration D-9 Payroll register

File Edit View Insert Format Tools Data Window Help

A B C D E F G H I J K L M N O

ACADEMY COMPANY Payroll Register

For the Week Ending January 14, 2008

8 7 6 5 4 3 2 1

9 10

12 13

11

14 15 16 17 18 19 20 21 22 23 24 25

40 40

40

42 44 72.00

43

580.00 590.00

530.00 5,200.00

480.00 480.00

480.00 11,000.00 16,200.00

580.00 590.00

530.00 5,200.00

516.00 552.00

534.00 12,010.00 17,210.00

46.40 47.20

42.40 416.00

41.28 44.16

42.72 960.80

1,376.80

61.00 63.00

54.00 1,090.00

43.00 49.00

46.00 2,400.00 3,490.00

11.60 11.80

10.60 104.00

10.32 11.04

10.68 240.20 344.20

15.00 20.00

11.00 120.00

18.00 10.00

10.00 301.50 421.50

134.00 142.00

118.00 1,730.00

117.60 119.20

114.40 4,017.50 5,747.50

580.00 590.00

530.00 5,200.00

5,200.00

446.00 448.00

412.00 3,470.00

398.40 432.80

419.60 7,992.50

11,462.50

516.00 552.00

534.00 12,010.00 12,010.00

998 999

1000

1025 1028

1029

5.00 5.00

5.00 115.00 115.00

54.00 1,010.00 1,010.00

36.00

Office Salaries Arnold, Patricia

Mueller, William Subtotal

Wages Bennett, Robin Jordan, Michael

Subtotal Milroy, Lee

Total

Canton, Matthew

Regular Gross FICA Total Net Pay Total HoursEmployee

Over- time

United Way

Union Dues

Check No.

Wages Expense

Federal Income

Tax

State Income

Tax

Office Salaries Expense

Earningsg Deductions Paid Accounts Debited

Cash Flows no effect

A � L � SE �5,200.00 Exp

�12,010.00 Exp �1,376.80 �3,490.00

�344.20 �421.50 �115.00

�11,462.50

D10 Appendix D Payroll Accounting

REVIEW IT 1. Identify two internal control procedures that apply to each payroll function. 2. What are the primary sources of gross earnings? 3. What payroll deductions are (a) mandatory and (b) voluntary? 4. What account titles do companies use in recording a payroll, assuming only

mandatory payroll deductions are involved?

Before You Go On...

Illustration D-10 Paycheck and statement of earnings

H E L P F U L H I N T Do any of the income tax liabilities result in payroll tax expense for the employer?

Answer: No. The employer is acting only as a collection agent for the government.

AC ACADEMY COMPANY19 Center St. Hampton, MI 48291

Pay to the order of

No. 1028

20

$

Dollars

City Bank & Trust P.O. Box 3000 Hampton, MI 48291

For

62—1113

610

DETACH AND RETAIN THIS PORTION FOR YOUR RECORDS

NAME SOC. SEC. NO. EMPL. NUMBER NO. EXEMP PAY PERIOD ENDING

OTH. EARNINGS (2) GROSS

NET PAY

OTH. EARNINGS (1)REG. EARNINGSOTH. HRS. (2)OTH. HRS. (1)O.T. HRS.REG. HRS. O.T. EARNINGS

LOCAL TAXSTATE TAXFICAFED. W/H TAX OTHER DEDUCTIONS (1) (2) (3) (4)

Michael Jordan 329-36-9547 2 1/14/08

480.00 72.00440

44.1649.00 11.04 10.00 5.00

$552.00

432.80

NET PAYLOCAL TAXSTATE TAXFICAFED. W/H TAX OTHER DEDUCTIONS (1) (2) (3) (4)

85.4492.00 21.36 20.00 10.00 $839.20

YEAR TO DATE

A � L � OE �11,462.50

�11,462.50

Cash Flows �11,462.50

Recording Payment of the Payroll A company makes payments by check (or electronic funds transfer) either from its regular bank account or a payroll bank account. Each paycheck is usually accompa- nied by a detachable statement of earnings document.This shows the employee’s gross earnings, payroll deductions, and net pay, both for the period and for the year-to-date. Academy Company uses its regular bank account for payroll checks. Illustration D-10 shows the paycheck and statement of earnings for Michael Jordan.

Following payment of the payroll, the company enters the check numbers in the payroll register. Academy Company records payment of the payroll as follows.

Jan. 14 Salaries and Wages Payable 11,462.50 Cash 11,462.50

(To record payment of payroll)

When a company uses currency in payment, it prepares one check for the pay- roll’s total amount of net pay. The company cashes this check, and inserts the coins and currency in individual pay envelopes for disbursement to individual employees.

Payroll tax expense for businesses results from three taxes that govern- mental agencies levy on employers. These taxes are: (1) FICA, (2) federal unemployment tax, and (3) state unemployment tax. These taxes plus such items as paid vacations and pensions (discussed in the appendix to this chapter) are collectively referred to as fringe benefits. As indicated earlier, the cost of fringe benefits in many companies is substantial. The pie chart in the margin shows the pieces of the benefits “pie.”

FICA Taxes Each employee must pay FICA taxes. In addition, employers must match each employee’s FICA contribution. The matching contribution results in payroll tax expense to the employer. The employer’s tax is subject to the same rate and maxi- mum earnings as the employee’s. The company uses the same account, FICA Taxes Payable, to record both the employee’s and the employer’s FICA contributions. For the January 14 payroll, Academy Company’s FICA tax contribution is $1,376.80 ($17,210.00 � 8%).

Federal Unemployment Taxes The Federal Unemployment Tax Act (FUTA) is another feature of the federal Social Security program. Federal unemployment taxes provide benefits for a lim- ited period of time to employees who lose their jobs through no fault of their own. The FUTA tax rate is 6.2% of taxable wages. The taxable wage base is the first $7,000 of wages paid to each employee in a calendar year. Employers who

Employer Payroll Taxes D11

DO IT Your cousin Stan is establishing a house-cleaning business and will have a num- ber of employees working for him. He is aware that documentation procedures are an important part of internal control. But he is unsure about the difference between an employee earnings record and a payroll register. He asks you to explain the principal differences, because he wants to be sure that he sets up the proper payroll procedures.

Action Plan ■ Determine the earnings and deductions data that must be recorded and re-

ported for each employee. ■ Design a record that will accumulate earnings and deductions data and will

serve as a basis for journal entries to be prepared and posted to the general ledger accounts.

■ Explain the difference between the employee earnings record and the payroll register.

Solution An employee earnings record is kept for each employee. It shows gross earnings, payroll deductions, and net pay for each pay period, as well as cumulative payroll data for that employee. In contrast, a payroll register is a listing of all employees’ gross earnings, payroll deductions, and net pay for each pay period. It is the documentation for preparing paychecks and for recording the payroll. Of course, Stan will need to keep both documents.

Related exercise material: BED-1, BED-3, and ED-1.

Describe and record employer payroll taxes.

S T U D Y O B J E C T I V E 3

EMPLOYER PAYROLL TAXES

BENEFITS 3% Disability and life insurance

23% Legally required benefits such as Social Security

24% Medical benefits

37% Vacation and other benefits such as parental and sick leaves, child care

13% Retirement income such as pensions

H E L P F U L H I N T Both the employer and employee pay FICA taxes. Federal unem- ployment taxes and (in most states) the state unemployment taxes are borne entirely by the employer.

pay the state unemployment tax on a timely basis will receive an offset credit of up to 5.4%. Therefore, the net federal tax rate is generally 0.8% (6.2%–5.4%). This rate would equate to a maximum of $56 of federal tax per employee per year (.008 � $7,000). State tax rates are based on state law.

The employer bears the entire federal unemployment tax. There is no deduction or withholding from employees. Companies use the account Federal Unemployment Taxes Payable to recognize this liability. The federal unemployment tax for Academy Company for the January 14 payroll is $137.68 ($17,210.00 � 0.8%).

State Unemployment Taxes All states have unemployment compensation programs under state unemployment tax acts (SUTA). Like federal unemployment taxes, state unemployment taxes pro- vide benefits to employees who lose their jobs. These taxes are levied on employers.2

The basic rate is usually 5.4% on the first $7,000 of wages paid to an employee during the year.The state adjusts the basic rate according to the employer’s experience rating: Companies with a history of stable employment may pay less than 5.4%. Companies with a history of unstable employment may pay more than the basic rate. Regardless of the rate paid, the company’s credit on the federal unemployment tax is still 5.4%.

Companies use the account State Unemployment Taxes Payable for this liabil- ity. The state unemployment tax for Academy Company for the January 14 payroll is $929.34 ($17,210.00 � 5.4%). Illustration D-11 summarizes the types of em- ployer payroll taxes.

D12 Appendix D Payroll Accounting

2 In a few states, the employee is also required to make a contribution. In this textbook, including

the homework, we will assume that the tax is only on the employer.

Illustration D-11 Employer payroll taxes

Federal Unemployment Taxes

FICA Taxes

State Unemployment Taxes

Computation Based

on Wages

Recording Employer Payroll Taxes Companies usually record employer payroll taxes at the same time they record the payroll. The entire amount of gross pay ($17,210.00) shown in the payroll register in Illustration D-9 is subject to each of the three taxes mentioned above. Accordingly, Academy records the payroll tax expense associated with the January 14 payroll with the entry shown on page D13.

Jan. 14 Payroll Tax Expense 2,443.82 FICA Taxes Payable 1,376.80 Federal Unemployment Taxes Payable 137.68 State Unemployment Taxes Payable 929.34

(To record employer’s payroll taxes on January 14 payroll)

Note that Academy uses separate liability accounts instead of a single credit to Payroll Taxes Payable. Why? Because these liabilities are payable to different tax- ing authorities at different dates. Companies classify the liability accounts in the balance sheet as current liabilities since they will be paid within the next year. They classify Payroll Tax Expense on the income statement as an operating expense.

Filing and Remitting Payroll Taxes D13

A � L � SE �2,443.82 Exp

�1,376.80 �137.68 �929.34

Cash Flows no effect

FILING AND REMITTING PAYROLL TAXES Preparation of payroll tax returns is the responsibility of the payroll department. The treasurer’s department makes the tax payment. Much of the information for the returns is obtained from employee earnings records.

For purposes of reporting and remitting to the IRS, the Company combines the FICA taxes and federal income taxes that it withheld. Companies must report the taxes quarterly, no later than one month following the close of each quarter. The remitting requirements depend on the amount of taxes withheld and the length of the pay period. Companies remit funds through deposits in either a Federal Reserve bank or an authorized commercial bank.

Companies generally file and remit federal unemployment taxes annually on or before January 31 of the subsequent year. Earlier payments are required when the tax exceeds a specified amount. Companies usually must file and pay state unemployment taxes by the end of the month following each quarter. When payroll taxes are paid, companies debit payroll liability accounts, and credit Cash.

Employers also must provide each employee with a Wage and Tax Statement (Form W-2) by January 31 following the end of a calendar year. This statement shows gross earnings, FICA taxes withheld, and income taxes withheld for the year. The required W-2 form for Michael Jordan, using assumed annual data, is shown in Illustration D-12. The employer must send a copy of each employee’s

Illustration D-12 W-2 form

Form W-2 Wage and Tax Statement Calendar Year 2008 1 Control number

2 Employer's name, address and ZIP code

8 Employee's social security number 9 Federal income tax withheld

12 Employee's name, address, and ZIP code

3 Employer's identification number 4 Employer's State number

6 Allocated tips 7 Advance EIC payment

10 Wages, tips, other compensation 11 Social security tax withheld

13 Social security wages 14 Social security tips

16

17 State income tax

20 Local income tax

18 State wages, tips, etc.

21 Local wages, tips, etc.

19 Name of State

22 Name of locality

5 Stat. employee

Deceased Legal rep.

942 emp.

Subtotal Void

OMB No. 1545-0008

329-36-9547 $2,248.00

Michael Jordan 2345 Mifflin Ave. Hampton, MI 48292

Academy Company 19 Center St. Hampton, MI 48291

36-2167852

$26,300.00

$26,300.00

$2,104.00

$526.00 Michigan

H E L P F U L H I N T Employers generally transmit their W-2s to the government elec- tronically. The taxing agencies store the infor- mation in their com- puter systems for subsequent comparison against earnings and taxes withheld reported on employees’ income tax returns.

Wage and Tax Statement (Form W-2) to the Social Security Administration. This agency subsequently furnishes the Internal Revenue Service with the income data required.

D14 Appendix D Payroll Accounting

REVIEW IT 1. What payroll taxes do governments levy on employers? 2. What accounts are involved in accruing employer payroll taxes?

DO IT In January, the payroll supervisor determines that gross earnings for Halo Company are $70,000. All earnings are subject to 8% FICA taxes, 5.4% state unemployment taxes, and 0.8% federal unemployment taxes. Halo asks you to record the employer’s payroll taxes.

Action Plan ■ Compute the employer’s payroll taxes on the period’s gross earnings. ■ Identify the expense account(s) to be debited. ■ Identify the liability account(s) to be credited.

Solution The entry to record the employer’s payroll taxes is:

Payroll Tax Expense 9,940 FICA Taxes Payable ($70,000 � 8%) 5,600 Federal Unemployment Taxes Payable ($70,000 � 0.8%) 560 State Unemployment Taxes Payable ($70,000 � 5.4%) 3,780

(To record employer’s payroll taxes on January payroll)

Related exercise material: BED-2, BED-3, BED-4, ED-1, ED-2, ED-3, ED-4, and ED-5.

Before You Go On...

Demonstration Problem

Indiana Jones Company had the following selected transactions. Feb. 1 Signs a $50,000, 6-month, 9%-interest-bearing note payable to

CitiBank and receives $50,000 in cash. 10 Cash register sales total $43,200, which includes an 8% sales tax. 28 The payroll for the month consists of Sales Salaries $32,000 and Office

Salaries $18,000. All wages are subject to 8% FICA taxes. A total of $8,900 federal income taxes are withheld. The salaries are paid on March 1.

28 The following adjustment data are developed. 1. Interest expense of $375 has been incurred on the note. 2. Employer payroll taxes include 8% FICA taxes, a 5.4% state

unemployment tax, and a 0.8% federal unemployment tax.

Instructions (a) Journalize the February transactions. (b) Journalize the adjusting entries at February 28.

Glossary D15

Solution (a) Feb. 1 Cash 50,000

Notes Payable 50,000 (Issued 6-month, 9%-interest-bearing note to CitiBank)

10 Cash 43,200 Sales ($43,200 � 1.08) 40,000 Sales Taxes Payable ($40,000 � 8%) 3,200

(To record sales and sales taxes payable) 28 Sales Salaries Expense 32,000

Office Salaries Expense 18,000 FICA Taxes Payable (8% � $50,000) 4,000 Federal Income Taxes Payable 8,900 Salaries Payable 37,100

(To record February salaries) (b) Feb. 28 Interest Expense 375

Interest Payable 375 (To record accrued interest for February)

28 Payroll Tax Expense 7,100 FICA Taxes Payable 4,000 Federal Unemployment Taxes Payable 400 (0.8% � $50,000) State Unemployment Taxes Payable 2,700 (5.4% � $50,000)

(To record employer’s payroll taxes on February payroll)

1 Discuss the objectives of internal control for payroll. The objectives of internal control for payroll are (1) to safeguard company assets against unauthorized payments of payrolls, and (2) to ensure the accuracy and reliability of the accounting records pertaining to payrolls.

2 Compute and record the payroll for a pay period. The computation of the payroll involves gross earnings, payroll deductions, and net pay. In recording the payroll, Salaries (or Wages) Expense is debited for gross earnings, individ- ual tax and other liability accounts are credited for payroll

deductions, and Salaries (Wages) Payable is credited for net pay. When the payroll is paid, Salaries and Wages Payable is debited, and Cash is credited.

3 Describe and record employer payroll taxes. Employer payroll taxes consist of FICA, federal unemployment taxes, and state unemployment taxes. The taxes are usually accrued at the time the payroll is recorded by debiting Payroll Tax Expense and crediting separate liability accounts for each type of tax.

SUMMARY OF STUDY OBJECTIVES

GLOSSARY Bonus Compensation to management personnel and other

employees, based on factors such as increased sales or the amount of net income. (p. D4).

Employee earnings record A cumulative record of each employee’s gross earnings, deductions, and net pay during the year. (p. D8).

Employee’s Withholding Allowance Certificate (Form W-4) An Internal Revenue Service form on which the employee indicates the number of allowances claimed for withhold- ing federal income taxes. (p. D6).

Federal unemployment taxes Taxes imposed on the employer that provide benefits for a limited time period to employees who lose their jobs through no fault of their own. (p. D11).

Fees Payments made for the services of professionals. (p. D1). FICA taxes Taxes designed to provide workers with supple-

mental retirement, employment disability, and medical benefits. (p. D5).

Gross earnings Total compensation earned by an em- ployee. (p. D4).

action plan ✔ To determine sales, divide the cash register total by 100% plus the sales tax percentage. ✔ Base payroll taxes on gross earnings.

Net pay Gross earnings less payroll deductions. (p. D7).

Payroll deductions Deductions from gross earnings to determine the amount of a paycheck. (p. D5).

Payroll register A payroll record that accumulates the gross earnings, deductions, and net pay by employee for each pay period. (p. D8).

Salaries Specified amount per month or per year paid to managerial, administrative, and sales personnel. (p. D1).

Statement of earnings A document attached to a paycheck that indicates the employee’s gross earnings, payroll de- ductions, and net pay. (p. D10).

State unemployment taxes Taxes imposed on the em- ployer that provide benefits to employees who lose their jobs. (p. D12).

Wage and Tax Statement (Form W-2) A form showing gross earnings, FICA taxes withheld, and income taxes withheld which is prepared annually by an employer for each employee. (p. D13).

Wages Amounts paid to employees based on a rate per hour or on a piece-work basis. (p. D1).

D16 Appendix D Payroll Accounting

SELF-STUDY QUESTIONS Answers are at the end of the appendix.

1. The department that should pay the payroll is the: a. timekeeping department. b. human resources department. c. payroll department. d. treasurer’s department.

2. J. Barr earns $14 per hour for a 40-hour week and $21 per hour for any overtime work. If Barr works 45 hours in a week, gross earnings are: a. $560. b. $630.

c. $650. d. $665.

3. Employer payroll taxes do not include: a. federal unemployment taxes. b. state unemployment taxes. c. federal income taxes. d. FICA taxes.

Go to the book’s website, www.wiley.com/college/weygandt, for Additional Self-Study questions.

QUESTIONS 1. You are a newly hired accountant with Schindlebeck

Company. On your first day, the controller asks you to identify the main internal control objectives related to payroll accounting. How would you respond?

2. What are the four functions associated with payroll activ- ities?

3. What is the difference between gross pay and net pay? Which amount should a company record as wages or salaries expense?

4. Which payroll tax is levied on both employers and em- ployees?

5. Are the federal and state income taxes withheld from employee paychecks a payroll tax expense for the em- ployer? Explain your answer.

6. What do the following acronyms stand for: FICA, FUTA, and SUTA?

7. What information is shown on a W-4 statement? On a W-2 statement?

8. Distinguish between the two types of payroll deduc- tions and give examples of each.

9. What are the primary uses of the employee earnings record?

10. (a) Identify the three types of employer payroll taxes. (b) How are tax liability accounts and Payroll Tax Expense classified in the financial statements?

BRIEF EXERCISES BED-1 Hernandez Company has the following payroll procedures.

(a) Supervisor approves overtime work. (b) The human resources department prepares hiring authorization forms for new hires. (c) A second payroll department employee verifies payroll calculations. (d) The treasurer’s department pays employees.

Identify the payroll function to which each procedure pertains.

Identify payroll functions.

(SO 1)

(SO 1)

(SO 2)

(SO 3)

BED-2 Sandy Teter’s regular hourly wage rate is $16, and she receives an hourly rate of $24 for work in excess of 40 hours. During a January pay period, Sandy works 45 hours. Sandy’s federal income tax withholding is $95, and she has no voluntary deductions. Compute Sandy Teter’s gross earnings and net pay for the pay period.

BED-3 Data for Sandy Teter are presented in BED-2. Prepare the journal entries to record (a) Sandy’s pay for the period and (b) the payment of Sandy’s wages. Use January 15 for the end of the pay period and the payment date.

BED-4 In January, gross earnings in Yoon Company totaled $90,000. All earnings are subject to 8% FICA taxes, 5.4% state unemployment taxes, and 0.8% federal unemployment taxes. Prepare the entry to record January payroll tax expense.

Exercises D17

Compute gross earnings and net pay.

(SO 2)

Record a payroll and the payment of wages.

(SO 2)

Record employer payroll taxes.

(SO 3)

EXERCISES ED-1 Betty Williams’ regular hourly wage rate is $14, and she receives a wage of 11⁄2 times the regular hourly rate for work in excess of 40 hours. During a March weekly pay period Betty worked 42 hours. Her gross earnings prior to the current week were $6,000. Betty is married and claims three withholding allowances. Her only voluntary deduction is for group hospitalization insurance at $15 per week.

Instructions (a) Compute the following amounts for Betty’s wages for the current week.

(1) Gross earnings. (2) FICA taxes. (Assume an 8% rate on maximum of $97,500.) (3) Federal income taxes withheld. (Use the withholding table in the text, page D7.) (4) State income taxes withheld. (Assume a 2.0% rate.) (5) Net pay.

(b) Record Betty’s pay, assuming she is an office computer operator.

ED-2 Employee earnings records for Brantley Company reveal the following gross earnings for four employees through the pay period of December 15.

C. Mays $83,500 D. Delgado $95,700 L. Jeter $95,200 T. Rolen $97,500

For the pay period ending December 31, each employee’s gross earnings is $3,000. Employees are required to pay a FICA tax rate of 8% gross earnings of $97,500.

Instructions Compute the FICA withholdings that should be made for each employee for the December 31 pay period. (Show computations.)

ED-3 Piniella Company has the following data for the weekly payroll ending January 31.

Hours Federal Hourly Income Tax Health

Employee M T W T F S Rate Withholding Insurance

M. Hindi 8 8 9 8 10 3 $11 $34 $10 E. Benson 8 8 8 8 8 2 13 37 15 K. Estes 9 10 8 8 9 0 14 58 15

Employees are paid 11⁄2 times the regular hourly rate for all hours worked in excess of 40 hours per week. FICA taxes are 8% on the first $97,500 of gross earnings. Piniella Company is subject to 5.4% state unemployment taxes on the first $9,800 and 0.8% federal unemployment taxes on the first $7,000 of gross earnings.

Instructions (a) Prepare the payroll register for the weekly payroll. (b) Prepare the journal entries to record the payroll and Piniella’s payroll tax expense.

Compute net pay and record pay for one employee.

(SO 2)

Compute maximum FICA deductions.

(SO 2)

Prepare payroll register and record payroll and payroll tax expense.

(SO 2, 3)

ED-4 Selected data from a February payroll register for Landmark Company are presented below. Some amounts are intentionally omitted.

Gross earnings: Regular $8,900 State income taxes $ (3) Overtime (1) Union dues 100

Total (2) Total deductions (4) Deductions: Net pay $7,215

FICA taxes $ 760 Accounts debited: Federal income taxes 1,140 Warehouse wages (5)

Store wages $4,000

FICA taxes are 8%. State income taxes are 3% of gross earnings.

Instructions (a) Fill in the missing amounts. (b) Journalize the February payroll and the payment of the payroll.

ED-5 According to a payroll register summary of Cruz Company, the amount of employees’ gross pay in December was $850,000, of which $70,000 was not subject to FICA tax and $760,000 was not subject to state and federal unemployment taxes.

Instructions (a) Determine the employer’s payroll tax expense for the month, using the following rates:

FICA 8%, state unemployment 5.4%, federal unemployment 0.8%. (b) Prepare the journal entry to record December payroll tax expense.

D18 Appendix D Payroll Accounting

Compute missing payroll amounts and record payroll.

(SO 2)

Determine employer’s payroll taxes; record payroll tax expense.

(SO 3)

EXERCISES: SET B Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Exercise Set B.

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PROBLEMS: SET A PD-1A The payroll procedures used by three different companies are described below.

1. In Brewer Company each employee is required to mark on a clock card the hours worked. At the end of each pay period, the employee must have this clock card approved by the department manager. The approved card is then given to the payroll department by the employee. Subsequently, the treasurer’s department pays the employee by check.

2. In Hilyard Computer Company clock cards and time clocks are used. At the end of each pay period, the department manager initials the cards, indicates the rates of pay, and sends them to payroll. A payroll register is prepared from the cards by the payroll department. Cash equal to the total net pay in each department is given to the department manager, who pays the employees in cash.

3. In Hyun-chan Company employees are required to record hours worked by “punching” clock cards in a time clock. At the end of each pay period, the clock cards are collected by the department manager. The manager prepares a payroll register in duplicate and forwards the original to payroll. In payroll, the summaries are checked for mathematical accuracy, and a payroll supervisor pays each employee by check.

Instructions (a) Indicate the weakness(es) in internal control in each company. (b) For each weakness, describe the control procedure(s) that will provide effective internal

control. Use the following format for your answer:

(a) Weaknesses (b) Recommended Procedures

Identify internal control weaknesses and make recommendations for improvement.

(SO 1)

PD-2A Graves Drug Store has four employees who are paid on an hourly basis plus time-and- a-half for all hours worked in excess of 40 a week. Payroll data for the week ended February 15, 2008, are presented below.

Federal Hours Hourly Income Tax United

Employees Worked Rate Withholdings Way

L. Leiss 39 $14.00 $ ? $–0– S. Bjork 42 $12.00 ? 5.00 M. Cape 44 $12.00 61 7.50 L. Wild 48 $12.00 52 5.00

Leiss and Bjork are married. They claim 2 and 4 withholding allowances, respectively. The fol- lowing tax rates are applicable: FICA 8%, state income taxes 3%, state unemployment taxes 5.4%, and federal unemployment 0.8%. The first three employees are sales clerks (store wages expense). The fourth employee performs administrative duties (office wages expense).

Instructions (a) Prepare a payroll register for the weekly payroll. (Use the wage-bracket withholding table

in the text for federal income tax withholdings.) (b) Journalize the payroll on February 15, 2008, and the accrual of employer payroll taxes. (c) Journalize the payment of the payroll on February 16, 2008. (d) Journalize the deposit in a Federal Reserve bank on February 28, 2008, of the FICA and

federal income taxes payable to the government.

PD-3A The following payroll liability accounts are included in the ledger of Eikleberry Com- pany on January 1, 2008.

FICA Taxes Payable $ 662.20 Federal Income Taxes Payable 1,254.60 State Income Taxes Payable 102.15 Federal Unemployment Taxes Payable 312.00 State Unemployment Taxes Payable 1,954.40 Union Dues Payable 250.00 U.S. Savings Bonds Payable 350.00

In January, the following transactions occurred.

Jan. 10 Sent check for $250.00 to union treasurer for union dues. 12 Deposited check for $1,916.80 in Federal Reserve bank for FICA taxes and federal

income taxes withheld. 15 Purchased U.S. Savings Bonds for employees by writing check for $350.00. 17 Paid state income taxes withheld from employees. 20 Paid federal and state unemployment taxes. 31 Completed monthly payroll register, which shows office salaries $17,600, store wages

$27,400, FICA taxes withheld $3,600, federal income taxes payable $1,770, state income taxes payable $360, union dues payable $400, United Fund contributions payable $1,800, and net pay $37,070.

31 Prepared payroll checks for the net pay and distributed checks to employees.

At January 31, the company also makes the following accrual for employer payroll taxes: FICA taxes 8%, state unemployment taxes 5.4%, and federal unemployment taxes 0.8%.

Instructions (a) Journalize the January transactions. (b) Journalize the adjustments pertaining to employee compensation at January 31.

Problems: Set A D19

Prepare payroll register and payroll entries.

(SO 2, 3)

(a) Net pay $1,786.32; Store wages expense $1,614.00

(b) Payroll tax expense $317.79

Journalize payroll transactions and adjusting entries.

(SO 2, 3)

(b) Payroll tax expense $6,390.00

PD-4A For the year ended December 31, 2008, R. Visnak Company reports the following summary payroll data.

Gross earnings: Administrative salaries $180,000 Electricians’ wages 320,000

Total $500,000

Deductions: FICA taxes $ 35,200 Federal income taxes withheld 153,000 State income taxes withheld (2.6%) 13,000 United Way contributions payable 25,000

*Hospital insurance premiums 15,800

Total $242,000

R. Visnak Company’s payroll taxes are: FICA 8%, state unemployment 2.5% (due to a stable employment record), and 0.8% federal unemployment. Gross earnings subject to FICA taxes total $440,000, and unemployment taxes total $110,000.

Instructions (a) Prepare a summary journal entry at December 31 for the full year’s payroll. (b) Journalize the adjusting entry at December 31 to record the employer’s payroll taxes. (c) The W-2 Wage and Tax Statement requires the following dollar data.

Wages, Tips, Federal Income State Income FICA FICA Tax Other Compensation Tax Withheld Tax Withheld Wages Withheld

Complete the required data for the following employees.

Employee Gross Earnings Federal Income Tax Withheld R. Lopez $60,000 $27,500 K. Kirk 27,000 11,000

D20 Appendix D Payroll Accounting

Prepare entries for payroll and payroll taxes; prepare W-2 data.

(SO 2, 3)

PROBLEMS: SET B PD-1B Selected payroll procedures of Wallace Company are described below.

1. Department managers interview applicants and on the basis of the interview either hire or reject the applicants. When an applicant is hired, the applicant fills out a W-4 form (Employee’s Withholding Allowance Certificate). One copy of the form is sent to the human resources department, and one copy is sent to the payroll department as notice that the individual has been hired. On the copy of the W-4 sent to payroll, the managers manually indicate the hourly pay rate for the new hire.

2. The payroll checks are manually signed by the chief accountant and given to the department managers for distribution to employees in their department. The managers are responsible for seeing that any absent employees receive their checks.

3. There are two clerks in the payroll department. The payroll is divided alphabetically; one clerk has employees A to L and the other has employees M to Z. Each clerk computes the gross earnings, deductions, and net pay for employees in the section and posts the data to the employee earnings records.

Instructions (a) Indicate the weaknesses in internal control. (b) For each weakness, describe the control procedures that will provide effective internal con-

trol. Use the following format for your answer:

(a) Weaknesses (b) Recommended Procedures

Identify internal control weaknesses and make recommendations for improvement.

(SO 1)

(a) Wages Payable $258,000 (b) Payroll tax expense

$38,830

PD-2B Lee Hardware has four employees who are paid on an hourly basis plus time-and-a half for all hours worked in excess of 40 a week. Payroll data for the week ended March 15, 2008, are presented below.

Federal Hours Hourly Income Tax United

Employee Worked Rate Withholdings Way

Joe Coomer 40 $15.00 $? $5.00 Mary Walker 42 13.00 ? 5.00 Andy Dye 44 13.00 60 8.00 Kim Shen 48 13.00 67 5.00

Coomer and Walker are married. They claim 0 and 4 withholding allowances, respectively. The following tax rates are applicable: FICA 8%, state income taxes 3%, state unemployment taxes 5.4%, and federal unemployment 0.8%. The first three employees are sales clerks (store wages expense). The fourth employee performs administrative duties (office wages expense).

Instructions (a) Prepare a payroll register for the weekly payroll. (Use the wage-bracket withholding table in

the text for federal income tax withholdings.) (b) Journalize the payroll on March 15, 2008, and the accrual of employer payroll taxes. (c) Journalize the payment of the payroll on March 16, 2008. (d) Journalize the deposit in a Federal Reserve bank on March 31, 2008, of the FICA and federal

income taxes payable to the government.

PD-3B The following payroll liability accounts are included in the ledger of Nordlund Company on January 1, 2008.

FICA Taxes Payable $ 760.00 Federal Income Taxes Payable 1,204.60 State Income Taxes Payable 108.95 Federal Unemployment Taxes Payable 288.95 State Unemployment Taxes Payable 1,954.40 Union Dues Payable 870.00 U.S. Savings Bonds Payable 360.00

In January, the following transactions occurred.

Jan. 10 Sent check for $870.00 to union treasurer for union dues. 12 Deposited check for $1,964.60 in Federal Reserve bank for FICA taxes and federal in-

come taxes withheld. 15 Purchased U.S. Savings Bonds for employees by writing check for $360.00. 17 Paid state income taxes withheld from employees. 20 Paid federal and state unemployment taxes. 31 Completed monthly payroll register, which shows office salaries $21,600, store wages

$28,400, FICA taxes withheld $4,000, federal income taxes payable $1,958, state income taxes payable $414, union dues payable $400, United Fund contributions payable $1,888, and net pay $41,340.

31 Prepared payroll checks for the net pay and distributed checks to employees.

At January 31, the company also makes the following accrued adjustment for employer pay- roll taxes: FICA taxes 8%, federal unemployment taxes 0.8%, and state unemployment taxes 5.4%.

Instructions (a) Journalize the January transactions. (b) Journalize the adjustments pertaining to employee compensation at January 31.

Problems: Set B D21

(a) Net pay $1,910.37; Store wages expense $1,757

(b) Payroll tax expense $345.48

Prepare payroll register and payroll entries.

(SO 2, 3)

Journalize payroll transactions and adjusting entries.

(SO 2, 3)

(b) Payroll tax expense $7,100

PD-4B For the year ended December 31, 2008, Niehaus Electrical Repair Company reports the following summary payroll data.

Gross earnings: Administrative salaries $180,000 Electricians’ wages 370,000

Total $550,000

Deductions: FICA taxes $ 38,000 Federal income taxes withheld 168,000 State income taxes withheld (2.6%) 14,300 United Way contributions payable 27,500 *Hospital insurance premiums 17,200

Total $265,000

Niehaus Company’s payroll taxes are: FICA 8%, state unemployment 2.5% (due to a stable em- ployment record), and 0.8% federal unemployment. Gross earnings subject to FICA taxes total $475,000, and unemployment taxes total $125,000.

Instructions (a) Prepare a summary journal entry at December 31 for the full year’s payroll. (b) Journalize the adjusting entry at December 31 to record the employer’s payroll taxes. (c) The W-2 Wage and Tax Statement requires the following dollar data.

Wages, Tips, Federal Income State Income FICA FICA Other Compensation Tax Withheld Tax Withheld Wages Tax Withheld

Complete the required data for the following employees.

Employee Gross Earnings Federal Income Tax Withheld

Anna Hashmi $59,000 $28,500 Sharon Bishop 26,000 10,200

D22 Appendix D Payroll Accounting

Prepare entries for payroll and payroll taxes; prepare W-2 data.

(SO 2, 3)

(a) Wages payable $285,000 (b) Payroll tax expense

$42,125

PROBLEMS: SET C Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Problem Set C.

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Exploring the Web BYPD-1 The Internal Revenue Service provides considerable information over the Internet. The following demonstrates how useful one of its sites is in answering payroll tax questions faced by employers.

Address: www.irs.ustreas.gov/formspubs/index.html, or go to www.wiley.com/college/weygandt

Steps 1. Go to the site shown above. 2. Choose View Online, Tax Publications. 3. Choose Publication 15, Circular E, Employer’s Tax Guide.

B R O A D E N I N G Y O U R P E R S P E C T I V E FINANCIAL REPORTING AND ANALYSIS

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Instructions Answer each of the following questions.

(a) How does the government define “employees”? (b) What are the special rules for Social Security and Medicare regarding children who are em-

ployed by their parents? (c) How can an employee obtain a Social Security card if he or she doesn’t have one? (d) Must employees report to their employer tips received from customers? If so, what is the

process? (e) Where should the employer deposit Social Security taxes withheld or contributed?

Broadening Your Perspective D23

CRITICAL THINKING Decision Making Across the Organization BYPD-2 Summerville Processing Company provides word-processing services for business clients and students in a university community. The work for business clients is fairly steady throughout the year. The work for students peaks significantly in December and May as a re- sult of term papers, research project reports, and dissertations.

Two years ago, the company attempted to meet the peak demand by hiring part-time help. However, this led to numerous errors and considerable customer dissatisfaction. A year ago, the company hired four experienced employees on a permanent basis instead of using part-time help. This proved to be much better in terms of productivity and customer satisfaction. But, it has caused an increase in annual payroll costs and a significant decline in annual net income.

Recently, Valarie Flynn, a sales representative of Davidson Services Inc., has made a pro- posal to the company. Under her plan, Davidson Services will provide up to four experienced workers at a daily rate of $80 per person for an 8-hour workday. Davidson workers are not avail- able on an hourly basis. Summerville Processing would have to pay only the daily rate for the workers used.

The owner of Summerville Processing, Nancy Bell, asks you, as the company’s accountant, to prepare a report on the expenses that are pertinent to the decision. If the Davidson plan is adopted, Nancy will terminate the employment of two permanent employees and will keep two permanent employees. At the moment, each employee earns an annual income of $22,000. Summerville Processing pays 8% FICA taxes, 0.8% federal unemployment taxes, and 5.4% state unemployment taxes. The unemployment taxes apply to only the first $7,000 of gross earnings. In addition, Summerville Processing pays $40 per month for each employee for medical and dental insurance.

Nancy indicates that if the Davidson Services plan is accepted, her needs for workers will be as follows.

Working Months Number Days per Month

January–March 2 20 April–May 3 25 June–October 2 18 November–December 3 23

Instructions With the class divided into groups, answer the following.

(a) Prepare a report showing the comparative payroll expense of continuing to employ per- manent workers compared to adopting the Davidson Services Inc. plan.

(b) What other factors should Nancy consider before finalizing her decision?

Communication Activity BYPD-3 Ivan Blanco, president of the Blue Sky Company, has recently hired a number of additional employees. He recognizes that additional payroll taxes will be due as a result of this hiring, and that the company will serve as the collection agent for other taxes.

Instructions In a memorandum to Ivan Blanco, explain each of the taxes, and identify the taxes that result in payroll tax expense to Blue Sky Company.

Ethics Case BYPD-4 Johnny Fuller owns and manages Johnny’s Restaurant, a 24-hour restaurant near the city’s medical complex. Johnny employs 9 full-time employees and 16 part-time employees. He pays all of the full-time employees by check, the amounts of which are determined by Johnny’s public accountant, Mary Lake. Johnny pays all of his part-time employees in cash. He computes their wages and withdraws the cash directly from his cash register.

Mary has repeatedly urged Johnny to pay all employees by check. But as Johnny has told his competitor and friend, Steve Hill, who owns the Greasy Diner, “First of all, my part-time em- ployees prefer the cash over a check, and secondly I don’t withhold or pay any taxes or work- men’s compensation insurance on those wages because they go totally unrecorded and unnoticed.”

Instructions (a) Who are the stakeholders in this situation? (b) What are the legal and ethical considerations regarding Johnny’s handling of his payroll? (c) Mary Lake is aware of Johnny’s payment of the part-time payroll in cash. What are her

ethical responsibilities in this case? (d) What internal control principle is violated in this payroll process?

Answers to Self-Study Questions 1. d 2. d 3. c

D24 Appendix D Payroll Accounting

E1

Subsidiary Ledgers and Special Journals

Appendix E

SECTION 1 Expanding the Ledger— Subsidiary Ledgers

After studying this appendix, you should be able to: 1. Describe the nature and purpose of a subsidiary ledger. 2. Explain how companies use special journals in journalizing. 3. Indicate how companies post a multi-column journal.

S T U D Y O B J E C T I V E S

NATURE AND PURPOSE OF SUBSIDIARY LEDGERS

Imagine a business that has several thousand charge (credit) customers and shows the transactions with these customers in only one general ledger account—Accounts Receivable. It would be nearly impossible to determine the balance owed by an individual customer at any specific time. Similarly, the amount payable to one creditor would be difficult to locate quickly from a single Accounts Payable account in the general ledger.

Instead, companies use subsidiary ledgers to keep track of individual balances. A subsidiary ledger is a group of accounts with a common characteristic (for example, all accounts receivable). It is an addition to, and an expansion of, the general ledger. The subsidiary ledger frees the general ledger from the details of individual balances.

Two common subsidiary ledgers are:

1. The accounts receivable (or customers’) subsidiary ledger, which collects trans- action data of individual customers.

2. The accounts payable (or creditors’) subsidiary ledger, which collects transac- tion data of individual creditors.

In each of these subsidiary ledgers, companies usually arrange individual accounts in alphabetical order.

A general ledger account summarizes the detailed data from a subsidiary ledger. For example, the detailed data from the accounts receivable subsidiary ledger are summarized in Accounts Receivable in the general ledger. The gen- eral ledger account that summarizes subsidiary ledger data is called a control account. Illustration E-1 (page E2) presents an overview of the relationship of sub- sidiary ledgers to the general ledger. There, the general ledger control accounts and subsidiary ledger accounts are in green. Note that cash and owner’s capital in this

Describe the nature and purpose of a subsidiary ledger.

S T U D Y O B J E C T I V E 1

illustration are not control accounts because there are no subsidiary ledger accounts related to these accounts.

At the end of an accounting period, each general ledger control account bal- ance must equal the composite balance of the individual accounts in the related subsidiary ledger. For example, the balance in Accounts Payable in Illustration E-1 must equal the total of the subsidiary balances of Creditors X � Y � Z.

E2 Appendix E Subsidiary Ledgers and Special Journals

CashGeneral Ledger

Control accounts

Subsidiary Ledgers

Accounts Receivable

Customer B

Customer C

Customer A

Accounts Payable

Common Stock

Creditor Y

Creditor Z

Creditor X

Illustration E-1 Relationship of general ledger and subsidiary ledgers Subsidiary Ledger Example

Illustration E-2 provides an example of a control account and subsidiary ledger for Pujols Enterprises. (Due to space considerations, the explanation column in these accounts is not shown in this and subsequent illustrations.) Illustration E-2 is based on the transactions listed in Illustration E-3 (next page).Illustration E-2

Relationship between gen- eral and subsidiary ledgers

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General Ledger General Jrnl Sales Jrnl Cash Receipts Jrnl Purchases Jrnl

Date Ref. Debit Credit Balance

2008 Jan 12

21

Branden Inc.

3,000 3,000

3,000 ------

Date Ref. Debit Credit Balance

2008 Jan 31

31

Accounts Receivable No. 112

12,000 8,000

12,000 4,000

The subsidiary ledger is separate from the general ledger.

Accounts Receivable is a control account.

Date Ref. Debit Credit Balance

2008 Jan 20

29

Caron Co.

3,000 1,000

3,000 2,000

Date Ref. Debit Credit Balance

2008 Jan 10

19

Aaron Co.

6,000 4,000

6,000 2,000

Pujols can reconcile the total debits ($12,000) and credits ($8,000) in Accounts Receivable in the general ledger to the detailed debits and credits in the subsidiary accounts. Also, the balance of $4,000 in the control account agrees with the total of the balances in the individual accounts (Aaron Co. $2,000 � Branden Inc. $0 � Caron Co. $2,000) in the subsidiary ledger.

As Illustration E-2 shows, companies make monthly postings to the control ac- counts in the general ledger. This practice allows them to prepare monthly financial statements. Companies post to the individual accounts in the subsidiary ledger daily. Daily posting ensures that account information is current. This enables the company to monitor credit limits, bill customers, and answer inquiries from cus- tomers about their account balances.

Advantages of Subsidiary Ledgers Subsidiary ledgers have several advantages:

1. They show in a single account transactions affecting one customer or one cred- itor, thus providing up-to-date information on specific account balances.

2. They free the general ledger of excessive details. As a result, a trial balance of the general ledger does not contain vast numbers of individual account balances.

3. They help locate errors in individual accounts by reducing the number of ac- counts in one ledger and by using control accounts.

4. They make possible a division of labor in posting. One employee can post to the general ledger while someone else posts to the subsidiary ledgers.

Nature and Purpose of Subsidiary Ledgers E3

Illustration E-3 Sales and collection transactions

Credit Sales Collections on Account

Jan. 10 Aaron Co. $ 6,000 Jan. 19 Aaron Co. $ 4,000 12 Branden Inc. 3,000 21 Branden Inc. 3,000 20 Caron Co. 3,000 29 Caron Co. 1,000

$12,000 $ 8,000

REVIEW IT 1. What is a subsidiary ledger, and what purpose does it serve? 2. What is a control account, and what purpose does it serve? 3. Name two general ledger accounts that may act as control accounts for a

subsidiary ledger. Can you think of a third control account?

DO IT Presented below is information related to Sims Company for its first month of operations. Determine the balances that appear in the accounts payable subsidiary ledger. What Accounts Payable balance appears in the general ledger at the end of January?

Action Plan ■ Subtract cash paid from credit purchases to determine the balances in the

accounts payable subsidiary ledger. ■ Sum the individual balances to determine the Accounts Payable balance.

Before You Go On...

Credit Purchases Cash Paid Jan. 5 Devon Co. $11,000 Jan. 9 Devon Co. $7,000

11 Shelby Co. 7,000 14 Shelby Co. 2,000 22 Taylor Co. 14,000 27 Taylor Co. 9,000

E4 Appendix E Subsidiary Ledgers and Special Journals

Solution Subsidiary ledger balances: Devon Co. $4,000 ($11,000 � $7,000) Shelby Co. $5,000 ($7,000 � $2,000) Taylor Co. $5,000 ($14,000 � $9,000). General ledger Accounts Payable balance: $14,000 ($4,000 � $5,000 � $5,000).

Related exercise material: BEE-4, BEE-5, EE-1, EE-2, EE-4, and EE-5.

SECTION 2 Expanding the Journal— Special Journals

So far you have learned to journalize transactions in a two-column general journal and post each entry to the general ledger. This procedure is satisfac- tory in only the very smallest companies. To expedite journalizing and post- ing, most companies use special journals in addition to the general journal.

Companies use special journals to record similar types of transactions. Examples are all sales of merchandise on account, or all cash receipts. The types of transactions that occur frequently in a company determine what special journals the company uses. Most merchandising enterprises record daily transactions using the journals shown in Illustration E-4.

Explain how companies use special journals in journalizing.

S T U D Y O B J E C T I V E 2

Illustration E-4 Use of special journals and the general journal

Sales Journal

All sales of merchandise on account

Used for:

Cash Receipts Journal

All cash received (including cash sales)

Used for:

Purchases Journal

All purchases of merchandise on account

Used for:

Cash Payments Journal

All cash paid (including cash purchases)

Used for:

General Journal

Transactions that cannot be entered in a special journal, including correcting, adjusting, and closing entries

Used for:

If a transaction cannot be recorded in a special journal, the company records it in the general journal. For example, if a company had special journals for only the four types of transactions listed above, it would record purchase returns and allowances in the general journal. Similarly, correcting, adjusting, and closing entries are recorded in the general journal. In some situations, companies might use special journals other than those listed above. For example, when sales returns and allowances are fre- quent, a company might use a special journal to record these transactions.

Special journals permit greater division of labor because several people can record entries in different journals at the same time. For example, one employee may journalize all cash receipts, and another may journalize all credit sales. Also, the use of special journals reduces the time needed to complete the posting process. With special journals, companies may post some accounts monthly, instead of daily, as we will illustrate later in the chapter. On the following pages, we discuss the four special journals shown in Illustration E-4.

In the sales journal, companies record sales of merchandise on account. Cash sales of merchandise go in the cash receipts journal. Credit sales of assets other than merchandise go in the general journal.

Journalizing Credit Sales To demonstrate use of a sales journal, we will use data for Karns Wholesale Supply, which uses a perpetual inventory system. Under this system, each entry in the sales journal results in one entry at selling price and another entry at cost. The entry at selling price is a debit to Accounts Receivable (a control account) and a credit of equal amount to Sales. The entry at cost is a debit to Cost of Goods Sold and a credit of equal amount to Merchandise Inventory (a control account). Using a sales journal with two amount columns, the company can show on only one line a sales transaction at both selling price and cost. Illustration E-5 shows this two-column sales journal of Karns Wholesale Supply, using assumed credit sales transactions (for sales invoices 101–107).

Sales Journal E5

SALES JOURNAL

H E L P F U L H I N T Postings are also made daily to individual ledger accounts in the inventory subsidiary ledger to maintain a perpetual inventory.

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General Ledger General Jrnl Sales Jrnl Cash Receipts Jrnl Purchases Jrnl

Date Account Debited Invoice

No. Accts. Receivable Dr.

Sales Cr. Cost of Goods Sold Dr.

Merchandise Inventory Cr.Ref.

Abbot Sisters Babson Co. Carson Bros. Deli Co. Abbot Sisters Deli Co. Babson Co.

2008 May 3

7 14 19 21 24 27

101 102 103 104 105 106 107

10,600 11,350 7,800 9,300

15,400 21,210 14,570 90,230

6,360 7,370 5,070 6,510

10,780 15,900 10,200 62,190

, ,

, ,

Illustration E-5 Journalizing the sales journal—perpetual inventory system

Note several points: Unlike the general journal, an explanation is not required for each entry in a special journal. Also, use of prenumbered invoices ensures that all invoices are journalized. Finally, the reference (Ref.) column is not used in jour- nalizing. It is used in posting the sales journal, as explained next.

Posting the Sales Journal Companies make daily postings from the sales journal to the individual accounts receivable in the subsidiary ledger. Posting to the general ledger is done monthly. Illustration E-6 (page E6) shows both the daily and monthly postings.

A check mark (✓) is inserted in the reference posting column to indicate that the daily posting to the customer’s account has been made. If the subsidiary ledger accounts were numbered, the account number would be entered in place of the check mark. At the end of the month, Karns posts the column totals of the sales

journal to the general ledger. Here, the column totals are as follows: From the selling- price column, a debit of $90,230 to Accounts Receivable (account No. 112), and a credit of $90,230 to Sales (account No. 401). From the cost column, a debit of $62,190 to Cost of Goods Sold (account No. 505), and a credit of $62,190 to Merchandise Inventory (account No. 120). Karns inserts the account numbers

E6 Appendix E Subsidiary Ledgers and Special Journals

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General Ledger General Jrnl Sales Jrnl Cash Receipts Jrnl Purchases Jrnl

Date Account Debited Invoice

No. Accts. Receivable Dr.

Sales Cr. Cost of Goods Sold Dr.

Merchandise Inventory Cr.Ref.

Abbot Sisters Babson Co. Carson Bros. Deli Co. Abbot Sisters Deli Co. Babson Co.

2008 May 3

7 14 19 21 24 27

101 102 103 104 105 106 107

10,600 11,350 7,800 9,300

15,400 21,210 14,570 90,230

6,360 7,370 5,070 6,510

10,780 15,900 10,200 62,190

, ,

, ,

(112) / (401) (505) / (120)

Date Ref. Debit Credit Balance 2008 May 3y

21

Abbot Sisters

10,600 15,400

10,600 26,000

Date Ref. Debit Credit Balance 2008 May 7

27

Babson Co.

11,350 14,570

11,350 25,920

Date Ref. Debit Credit Balance 2008 May 14

Carson Bros.

7,800 7,800

Date Ref. Debit Credit Balance 2008 May 31y

Accounts Receivable

90,230 90,230

Date Ref. Debit Credit Balance 2008 May 19

24

Deli Co.

9,300 21,210

9,300 30,510

Date Ref. Debit Credit Balance 2008 May 31

Sales

90,230 90,230

The company posts individual amounts to the subsidiary ledger daily.

At the end of the accounting period, the company posts totals to the general ledger.

S1 S1

S1 S1

S1

S1 S1

S1

S1

No. 112

Date Ref. Debit Credit Balance 2008 May 31

Merchandise Inventory

62,190162,190S1

No. 120

No. 401

Date Ref. Debit Credit Balance 2008 May 31

Cost of Goods Sold

62,190 62,190S1

No. 505

The subsidiary ledger is separate from the general ledger.

Accounts Receivable is a control account.

1The normal balance for Merchandise Inventory is a debit. But, because of the sequence in which we have posted the special journals, with the sales journals first, the credits to Merchandise Inventory are posted before the debits. This posting sequence explains the credit balance in Merchandise Inventory, which exists only until the other journals are posted.

Illustration E-6 Posting the sales journal

below the column totals to indicate that the postings have been made. In both the general ledger and subsidiary ledger accounts, the reference S1 indicates that the posting came from page 1 of the sales journal.

Proving the Ledgers The next step is to “prove” the ledgers. To do so, Karns must determine two things: (1) The total of the general ledger debit balances must equal the total of the gen- eral ledger credit balances. (2) The sum of the subsidiary ledger balances must equal the balance in the control account. Illustration E-7 shows the proof of the postings from the sales journal to the general and subsidiary ledger.

Cash Receipts Journal E7

Advantages of the Sales Journal Use of a special journal to record sales on account has several advantages. First, the one-line entry for each sales transaction saves time. In the sales journal, it is not nec- essary to write out the four account titles for each transaction. Second, only totals, rather than individual entries, are posted to the general ledger. This saves posting time and reduces the possibilities of posting errors. Finally, a division of labor re- sults, because one individual can take responsibility for the sales journal.

Illustration E-7 Proving the equality of the postings from the sales journal

Postings to General Ledger

General Ledger

Credits

Debits

Debit Postings to the Accounts Receivable Subsidiary Ledger

Subsidiary Ledger

$26,000 25,920 7,800

30,510 $90,230

Abbot Sisters Babson Co. Carson Bros. Deli Co.

$62,190 90,230

$152,420

$90,230 62,190

$152,420

Merchandise Inventory Sales

Accounts Receivable Cost of Goods Sold

CASH RECEIPTS JOURNAL In the cash receipts journal, companies record all receipts of cash. The most com- mon types of cash receipts are cash sales of merchandise and collections of accounts receivable. Many other possibilities exist, such as receipt of money from bank loans and cash proceeds from disposal of equipment. A one- or two-column cash receipts journal would not have space enough for all possible cash receipt trans- actions. Therefore, companies use a multiple-column cash receipts journal.

Generally, a cash receipts journal includes the following columns: debit columns for Cash and Sales Discounts, and credit columns for Accounts Receivable, Sales, and “Other” accounts. Companies use the “Other Accounts” category when the cash re- ceipt does not involve a cash sale or a collection of accounts receivable. Under a per- petual inventory system, each sales entry also is accompanied by an entry that debits Cost of Goods Sold and credits Merchandise Inventory for the cost of the merchan- dise sold. Illustration E-8 (page E8) shows a six-column cash receipts journal.

E8 Appendix E Subsidiary Ledgers and Special Journals

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General Ledger General Jrnl Sales Jrnl Cash Receipts Jrnl Purchases Jrnl

Date Ref. Debit Credit Balance 2008 May 3y

10 21

Abbot Sisters

10,600

15,400

10,600 -------- 15,400

Date Ref. Debit Credit Balance 2008 May 7

17 27

Babson Co.

11,350

14,570

11,350 -------- 14,570

Date Ref. Debit Credit Balance 2008 May 14

23

Carson Bros.

7,800 7,800 -------

The subsidiary ledger is separate from the general ledger.

Date Ref. Debit Credit Balance 2008 May 19

24 28

Deli Co.

9,300 21,210

9,300 30,510 21,210

S1 CR1

S1

S1 CR1

S1

S1 CR1

S1 S1

CR1

Accounts Receivable

Cr.

Sales Discounts

Dr. Cash Dr.

Sales Cr.

Other Accounts

Cr.

Cost of Goods Sold Dr.

Mdse. Inv. Cr.Ref. Account CreditedDate

Common Stock 2008 Mayy 1

7 10 12 17 22 23 28

5,000 1,900

10,388 2,600

11,123 6,000 7,644 9,114,

200

311

53,769,

1,900

2,600

4,500

5,000

6,000

11,000, (101) (414) (112) (401)

1,240

1,690

2,930 (505)/(120)(x(( )x

10,600

11,350

7,800

9,300

Date Ref. Debit Credit Balance 2008 May 31y

Cash

53,769

Date Ref. Debit Credit Balance 2008 May 31y

31

Accounts Receivable

90,230 90,230 51,180

Date Ref. Debit Credit Balance 2008 May 22y

Notes Payable

6,000

Date Ref. Debit Credit Balance 2008 May 1y

Common Stock

5,000

CR1

S1 CR1

CR1

CR1

39,050

6,000

5,000

53,769

Date Ref. Debit Credit Balance 2008 May 31

31

Sales

90,230 94,730

S1 CR1

90,230 4,500

Date Ref. Debit Credit Balance 2008 May 31

31 62,190 65,120

S1 CR1

62,190 2,930

Sales Discounts

No. 101

No. 112

No. 200

No. 311

No. 401

No. 414

Date Ref. Debit Credit Balance 2008 May 31y

31

Merchandise Inventory

62,190 65,120

S1 CR1

62,190 2,930

No. 120

Date Ref. Debit Credit Balance 2008 May 31y 781 781CR1

Cost of Goods Sold No. 505

Accounts Receivable is a control account.

Abbot Sisters

Babson Co. Notes Payabley Carson Bros. Deli Co.

212

227

156 186 781

10,600

11,350

7,800 9,300,

39,050,

The company posts individual amounts to the subsidiary ledger daily.

At the end of the accounting period, the company posts totals to the general ledger.

Illustration E-8 Journalizing and posting the cash receipts journal

Companies may use additional credit columns if these columns significantly reduce postings to a specific account. For example, a loan company, such as Household International, receives thousands of cash collections from customers. Using separate credit columns for Loans Receivable and Interest Revenue, rather than the Other Accounts credit column, would reduce postings.

Journalizing Cash Receipts Transactions To illustrate the journalizing of cash receipts transactions, we will continue with the May transactions of Karns Wholesale Supply. Collections from customers relate to the entries recorded in the sales journal in Illustration E-5. The entries in the cash receipts journal are based on the following cash receipts.

May 1 Stockholders invested $5,000 in the business. 7 Cash sales of merchandise total $1,900 (cost, $1,240).

10 Received a check for $10,388 from Abbot Sisters in payment of invoice No. 101 for $10,600 less a 2% discount.

12 Cash sales of merchandise total $2,600 (cost, $1,690). 17 Received a check for $11,123 from Babson Co. in payment of invoice No. 102 for

$11,350 less a 2% discount. 22 Received cash by signing a note for $6,000. 23 Received a check for $7,644 from Carson Bros. in full for invoice No. 103 for $7,800

less a 2% discount. 28 Received a check for $9,114 from Deli Co. in full for invoice No. 104 for $9,300 less a

2% discount.

Further information about the columns in the cash receipts journal is listed below.

Debit Columns: 1. Cash. Karns enters in this column the amount of cash actually received in each

transaction. The column total indicates the total cash receipts for the month. 2. Sales Discounts. Karns includes a Sales Discounts column in its cash receipts

journal. By doing so, it does not need to enter sales discount items in the gen- eral journal. As a result, the cash receipts journal shows on one line the collec- tion of an account receivable within the discount period.

Credit Columns: 3. Accounts Receivable. Karns uses the Accounts Receivable column to record

cash collections on account. The amount entered here is the amount to be credited to the individual customer’s account.

4. Sales. The Sales column records all cash sales of merchandise. Cash sales of other assets (plant assets, for example) are not reported in this column.

5. Other Accounts. Karns uses the Other Accounts column whenever the credit is other than to Accounts Receivable or Sales. For example, in the first entry, Karns enters $5,000 as a credit to Common Stock. This column is often referred to as the sundry accounts column.

Debit and Credit Column: 6. Cost of Goods Sold and Merchandise Inventory. This column records debits to

Cost of Goods Sold and credits to Merchandise Inventory.

In a multi-column journal, generally only one line is needed for each entry. Debit and credit amounts for each line must be equal. When Karns journalizes the collection from Abbot Sisters on May 10, for example, three amounts are indicated. Note also that the Account Credited column identifies both general ledger and subsidiary ledger account titles. General ledger accounts are illustrated in the May 1

Cash Receipts Journal E9

H E L P F U L H I N T When is an account title entered in the “Account Credited” column of the cash receipts journal? Answer: A subsidiary ledger account is entered when the entry involves a collection of accounts receivable. A general ledger account is entered when the account is not shown in a special column (and an amount must be entered in the Other Accounts column). Otherwise, no account is shown in the “Account Credited” column.

and May 22 entries. A subsidiary account is illustrated in the May 10 entry for the collection from Abbot Sisters.

When Karns has finished journalizing a multi-column journal, it totals the amount columns and compares the totals to prove the equality of debits and credits. Illustration E-9 shows the proof of the equality of Karns’s cash receipts journal.

E10 Appendix E Subsidiary Ledgers and Special Journals

Illustration E-9 Proving the equality of the cash receipts journal Debits Credits

$39,050 4,500

11,000 2,930

$57,480

Accounts Receivable Sales Other Accounts Merchandise Inventory

$53,769 781

2,930 $57,480

Cash Sales Discounts Cost of Goods Sold

Totaling the columns of a journal and proving the equality of the totals is called footing and cross-footing a journal.

Posting the Cash Receipts Journal Posting a multi-column journal involves the following steps.

1. At the end of the month, the company posts all column totals, except for the Other Accounts total, to the account title(s) specified in the column heading (such as Cash or Accounts Receivable). The company then enters account numbers below the column totals to show that

they have been posted. For example, Karns has posted cash to account No. 101, accounts receivable to account No. 112, merchandise inventory to account No. 120, sales to account No. 401, sales discounts to account No. 414, and cost of goods sold to account No. 505.

2. The company separately posts the individual amounts comprising the Other Accounts total to the general ledger accounts specified in the Account Credited column. See, for example, the credit posting to Common Stock: The total amount of this column has not been posted. The symbol (X) is inserted below the total to this column to indicate that the amount has not been posted.

3. The individual amounts in a column, posted in total to a control account (Accounts Receivable, in this case), are posted daily to the subsidiary ledger account specified in the Account Credited column. See, for example, the credit posting of $10,600 to Abbot Sisters.

The symbol CR, used in both the subsidiary and general ledgers, identifies postings from the cash receipts journal.

Proving the Ledgers After posting of the cash receipts journal is completed, Karns proves the ledgers. As shown in Illustration E-10 (next page), the general ledger totals agree. Also, the sum of the subsidiary ledger balances equals the control account balance.

Indicate how companies post a multi-column journal.

S T U D Y O B J E C T I V E 3

In the purchases journal, companies record all purchases of merchandise on ac- count. Each entry in this journal results in a debit to Merchandise Inventory and a credit to Accounts Payable. Illustration E-11 (page E12) shows the purchases jour- nal for Karns Wholesale Supply.

When using a one-column purchases journal (as in Illustration E-11), a com- pany cannot journalize other types of purchases on account or cash purchases in it. For example, using the purchases journal shown in Illustration E-11, Karns would have to record credit purchases of equipment or supplies in the general journal. Likewise, all cash purchases would be entered in the cash payments journal. As il- lustrated later, companies that make numerous credit purchases for items other than merchandise often expand the purchases journal to a multi-column format. (See Illustration E-14 on page E13.)

Journalizing Credit Purchases of Merchandise The journalizing procedure is similar to that for a sales journal. Companies make entries in the purchases journal from purchase invoices. In contrast to the sales journal, the purchases journal may not have an invoice number column, because invoices received from different suppliers will not be in numerical sequence. To en- sure that they record all purchase invoices, some companies consecutively number each invoice upon receipt and then use an internal document number column in the purchases journal. The entries for Karns Wholesale Supply are based on the assumed credit purchases listed in Illustration E-12 (page E12).

Posting the Purchases Journal The procedures for posting the purchases journal are similar to those for the sales journal. In this case, Karns makes daily postings to the accounts payable ledger; it makes monthly postings to Merchandise Inventory and Accounts Payable in the general ledger. In both ledgers, Karns uses P1 in the reference column to show that the postings are from page 1 of the purchases journal.

Proof of the equality of the postings from the purchases journal to both ledgers is shown in Illustration E-13 (page E13).

Purchases Journal E11

PURCHASES JOURNAL

Illustration E-10 Proving the ledgers after posting the sales and the cash receipts journals

$53,769 51,180

781 65,120

$170,850

Cash Accounts Receivable Sales Discounts Cost of Goods Sold

$15,400 14,570 21,210

$51,180

Abbot Sisters Babson Co. Deli Co.

Accounts Receivable Subsidiary Ledger General Ledger

$ 6,000 5,000

94,730 65,120

$170,850

Notes Payable Common Stock Sales Merchandise Inventory

Credits

Debits

H E L P F U L H I N T Postings to subsidiary ledger accounts are done daily because it is often necessary to know a current balance for the subsidiary accounts.

E12 Appendix E Subsidiary Ledgers and Special Journals

The company posts individual amounts to the subsidiary ledger daily.

Date Ref. Debit Credit Balance

2008 May 10

29

Eaton and Howe Inc.

7,200 12,600

7,200 19,800

Date Ref. Debit Credit Balance

2008 May 14

26

Fabor and Son

6,900 8,700

6,900 15,600

Date Ref. Debit Credit Balance

2008 May 6

19

Jasper Manufacturing Inc.

11,000 28,500

P1 P1

P1 P1

P1 P1

11,000 17,500

At the end of the accounting period, the company posts totals to the general ledger.

Date Ref. Debit Credit Balance

2008

Accounts Payable

63,900 63,900

Date Ref. Debit Credit Balance

2008 May 31

31 31

Merchandise Inventory

63,900

62,190 65,120 1,220

62,190 2,930

Date Account Credited

Merchandise Inventory Dr.

Accounts Payable Cr.Ref. 2008

6 10 14 19 26 29

2/10, n/30 3/10, n/30 1/10, n/30 2/10, n/30 1/10, n/30 3/10, n/30

11,000 7,200 6,900

17,500 8,700

12,600 63,900

P1

S1 CR1

P1

No. 201

No. 120

Terms

(120)/(201)

The subsidiary ledger is separate from the general ledger.

Accounts Payable is a control account.

Jasper Manufacturing Inc.J p g Eaton and Howe Inc. Fabor and Son Jasper Manufacturing Inc.J p g Fabor and Son Eaton and Howe Inc.

Mayy

,

May 31y

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General Ledger General Jrnl Sales Jrnl Cash Receipts Jrnl Purchases Jrnl

Illustration E-11 Journalizing and posting the purchases journal

Illustration E-12 Credit purchases transactions

Date Supplier Amount 5/6 Jasper Manufacturing Inc. $11,000

5/10 Eaton and Howe Inc. 7,200 5/14 Fabor and Son 6,900 5/19 Jasper Manufacturing Inc. 17,500 5/26 Fabor and Son 8,700 5/29 Eaton and Howe Inc. 12,600

Illustration E-13 Proving the equality of the purchases journal

Postings to General Ledger

Credit Postings to Accounts Payable Ledger

$19,800 15,600 28,500

$63,900

Eaton and Howe Inc. Fabor and Son Jasper Manufacturing Inc.

$63,900

$63,900

Merchandise Inventory (debit)

Accounts Payable (credit)

In a cash payments (cash disbursements) journal, companies record all disburse- ments of cash. Entries are made from prenumbered checks. Because companies make cash payments for various purposes, the cash payments journal has multiple columns. Illustration E-15 (page E14) shows a four-column journal.

Journalizing Cash Payments Transactions The procedures for journalizing transactions in this journal are similar to those for the cash receipts journal. Karns records each transaction on one line, and for each line there must be equal debit and credit amounts. The entries in the cash payments

Cash Payments Journal E13

Expanding the Purchases Journal As noted earlier, some companies expand the purchases journal to include all types of purchases on account. Instead of one column for merchandise inventory and accounts payable, they use a multiple-column format. This format usually includes a credit column for Accounts Payable and debit columns for purchases of Merchandise Inventory, Office Supplies, Store Supplies, and Other Accounts. Illustration E-14 shows a multi-column purchases journal for Hanover Co. The posting procedures are similar to those shown earlier for posting the cash receipts journal.

CASH PAYMENTS JOURNAL

H E L P F U L H I N T A single-column purchases journal needs only to be footed to prove the equality of debits and credits.

Illustration E-14 Multi-column purchases journal

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General Ledger General Jrnl Sales Jrnl Cash Receipts Jrnl Purchases Jrnl

Date Account Credited

Accounts Payable

Cr.

2008 June 1

3 5

30

2,000 1,500 2,600

800 56,600

800 1,200 4,900

2,000

Merchandise Inventory

Dr.

Office Supplies

Dr.

Store Supplies

Dr.

Other Accounts Dr.

Account Ref. Amount

Equipment 157 2,600 1,500

Ref.

Signe Audiog Wight Co.g Orange Tree Co.

Sue's Business Forms 7,50043,000

E14 Appendix E Subsidiary Ledgers and Special Journals

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General Ledger General Jrnl Sales Jrnl Cash Receipts Jrnl Purchases Jrnl

At the end of the accounting period, the company posts totals to the general ledger.

The subsidiary ledger is separate from the general ledger.

Accounts Receivable is a control account.

The company posts individual amounts to the subsidiary ledger daily.

Date Ref. Debit Credit Balance

2008 May 10

19 29

Eaton and Howe Inc.

7,200

12,600

7,200 -------

12,600

Date Ref. Debit Credit Balance

2008 May 14

23 26

Fabor and Son

6,900

8,700

6,900 ------- 8,700

Date Ref. Debit Credit Balance

2008 May 6

10 19 28

Jasper Manufacturing Inc.

11,000 -------- 17,500 --------

Date Ref. Debit Credit Balance

2008 May 31

31

Accounts Payable

42,600 63,900 21,300

101 102 103 104 105 106 107 108

2008 May 1

3 8

10 19 23 28 30

130 120 120

332

1,200 100

4,400 10,780 6,984 6,831

17,150 500

47,945

P1 CP1

P1

P1 CP1

P1

P1 CP1

P1 CP1

P1 CP1

Date Ref. Debit Credit Balance

2008 May 31

31

Cash

47,945 53,769 5,824

CR1 CP1

No. 101

No. 201

11,000

17,500

(x(( )x

Date Ck. No. Account Debited Ref.

Other Accounts Dr.

Accounts Payable Dr.

Merchandise Inventory Cr.

Cash Cr.

1,200 100

4,400

500 6,200

11,000 7,200 6,900

17,500

42,600

220 216 69

350

855

(201) (120) (101)

7,200

6,900

11,000

17,500

Date Ref. Debit Credit Balance

2008 May 3

8 31 31 31 31

Merchandise Inventory

62,190 2,930

855

100 4,500

57,690 60,620 3,280 2,425

CPI CPI

SI CRI

Pl CPI

100 4,400

63,900

No. 120

Date Ref. Debit Credit Balance

2008 May 1

Prepaid Insurance

1,200 1,200CP1

No. 130

Date Ref. Debit Credit Balance

2008 May 30

Dividends

500 500CP1

No. 332

53,769

63,900

Prepaid Insurancep Mdse. Inventoryy Mdse. Inventoryy Jasper Manuf. Inc. Eaton & Howe Inc. Fabor and Son Jasper Manuf. Inc.J p Dividends

Illustration E-15 Journalizing and posting the cash payments journal

journal in Illustration E-15 are based on the following transactions for Karns Wholesale Supply.

May 1 Issued check No. 101 for $1,200 for the annual premium on a fire insurance policy. 3 Issued check No. 102 for $100 in payment of freight when terms were FOB shipping

point. 8 Issued check No. 103 for $4,400 for the purchase of merchandise.

10 Sent check No. 104 for $10,780 to Jasper Manufacturing Inc. in payment of May 6 in- voice for $11,000 less a 2% discount.

19 Mailed check No. 105 for $6,984 to Eaton and Howe Inc. in payment of May 10 invoice for $7,200 less a 3% discount.

23 Sent check No. 106 for $6,831 to Fabor and Son in payment of May 14 invoice for $6,900 less a 1% discount.

28 Sent check No. 107 for $17,150 to Jasper Manufacturing Inc. in payment of May 19 invoice for $17,500 less a 2% discount.

30 Issued check No. 108 for $500 to stockholders as a dividend.

Note that whenever Karns enters an amount in the Other Accounts column, it must identify a specific general ledger account in the Account Debited column. The entries for checks No. 101, 102, 103, and 108 illustrate this situation. Similarly, Karns must identify a subsidiary account in the Account Debited column whenever it enters an amount in the Accounts Payable column. See, for example, the entry for check No. 104.

After Karns journalizes the cash payments journal, it totals the columns. The totals are then balanced to prove the equality of debits and credits.

Posting the Cash Payments Journal The procedures for posting the cash payments journal are similar to those for the cash receipts journal. Karns posts the amounts recorded in the Accounts Payable col- umn individually to the subsidiary ledger and in total to the control account. It posts Merchandise Inventory and Cash only in total at the end of the month. Transactions in the Other Accounts column are posted individually to the appropriate account(s) affected. The company does not post totals for the Other Accounts column.

Illustration E-15 shows the posting of the cash payments journal. Note that Karns uses the symbol CP as the posting reference. After postings are completed, the com- pany proves the equality of the debit and credit balances in the general ledger. In ad- dition, the control account balances should agree with the subsidiary ledger total bal- ance. Illustration E-16 shows the agreement of these balances.

Cash Payments Journal E15

5,824 51,180 2,425 1,200

500 781

65,120 $127,030

Cash Accounts Receivable Merchandise Inventory Prepaid Insurance Dividends Sales Discounts Cost of Goods Sold

$12,600 8,700

$21,300

Eaton and Howe Inc. Fabor and Son

Accounts Payable Subsidiary Ledger General Ledger Debits

6,000 21,300 5,000

94,730 $127,030

Notes Payable Accounts Payable Common Stock Sales

Credits

$

$

Illustration E-16 Proving the ledgers after postings from the sales, cash receipts, purchases, and cash payments journals

Special journals for sales, purchases, and cash substantially reduce the number of entries that companies make in the general journal. Only transactions that cannot be entered in a special journal are recorded in the general journal. For example, a company may use the general journal to record such transactions as granting of credit to a customer for a sales return or allowance, granting of credit from a sup- plier for purchases returned, acceptance of a note receivable from a customer, and purchase of equipment by issuing a note payable. Also, correcting, adjusting, and closing entries are made in the general journal.

The general journal has columns for date, account title and explanation, refer- ence, and debit and credit amounts. When control and subsidiary accounts are not involved, the procedures for journalizing and posting of transactions are the same as those described in earlier chapters. When control and subsidiary accounts are in- volved, companies make two changes from the earlier procedures:

1. In journalizing, they identify both the control and the subsidiary accounts. 2. In posting, there must be a dual posting: once to the control account and once

to the subsidiary account.

E16 Appendix E Subsidiary Ledgers and Special Journals

EFFECTS OF SPECIAL JOURNALS ON THE GENERAL JOURNAL

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General Ledger General Jrnl Sales Jrnl Cash Receipts Jrnl Purchases Jrnl

Date Ref. Debit Credit Balance

2008 May 14

23 26 31

Fabor and Son

6,900

8,700

6,900 ------- 8,700 8,200

Date Ref. Debit Credit Balance

2008 May 31

31 31

Accounts Payable

63,900 63,900 21,300

20,800

Date Ref. Debit Credit Balance

2008 May 31

Merchandise Inventory

500 500

Date Account Title and Explanation Ref.

Accounts Payable–Fabor and Son Merchandise Inventory (Received credit for returned goods)

2008 May 31 500

P1 CP1

P1 G1

P1 CP1 G1

G1

No. 201

No. 120

CreditDebit

500 201/ 120

6,900

500

42,600 500

,

Illustration E-17 Journalizing and posting the general journal

To illustrate, assume that on May 31, Karns Wholesale Supply returns $500 of merchandise for credit to Fabor and Son. Illustration E-17 shows the entry in the general journal and the posting of the entry. Note that if Karns receives cash instead of credit on this return, then it would record the transaction in the cash receipts journal.

Note that the general journal indicates two accounts (Accounts Payable, and Fabor and Son) for the debit, and two postings (“201/✓”) in the reference column. One debit is posted to the control account and another debit to the creditor’s account in the subsidiary ledger.

Effects of Special Journals on the General Journal E17

REVIEW IT 1. What types of special journals do companies frequently use to record trans-

actions? Why do they use special journals? 2. Explain how companies post transactions recorded in the sales journal and

the cash receipts journal. 3. Indicate the types of transactions that companies record in the general jour-

nal when they use special journals.

Before You Go On...

Demonstration Problem

Cassandra Wilson Company uses a six-column cash receipts journal with the following columns:

July 3 Cash sales total $5,800 (cost, $3,480). 5 Received a check for $6,370 from Jeltz Company in payment of an invoice dated

June 26 for $6,500, terms 2/10, n/30. 9 Stockholders made an additional investment of $5,000 cash in the business.

10 Cash sales total $12,519 (cost, $7,511). 12 Received a check for $7,275 from R. Eliot & Co. in payment of a $7,500 invoice

dated July 3, terms 3/10, n/30. 15 Received a customer advance of $700 cash for future sales. 20 Cash sales total $15,472 (cost, $9,283). 22 Received a check for $5,880 from Beck Company in payment of $6,000 invoice

dated July 13, terms 2/10, n/30. 29 Cash sales total $17,660 (cost, $10,596). 31 Received cash of $200 on interest earned for July.

Instructions (a) Journalize the transactions in the cash receipts journal. (b) Contrast the posting of the Accounts Receivable and Other Accounts columns.

Cash (Dr.) Sales Discounts (Dr.) Accounts Receivable (Cr.) Sales (Cr.)

Cash receipts transactions for the month of July 2008 are as follows.

Other Accounts (Cr.) Cost of Goods Sold (Dr.) and

Merchandise Inventory (Cr.)

action plan ✔ Record all cash receipts in the cash receipts journal.

✔ The “account credited” indicates items posted indi- vidually to the subsidiary ledger or general ledger.

✔ Record cash sales in the cash receipts journal—not in the sales journal.

✔ The total debits must equal the total credits.

1 Describe the nature and purpose of a subsidiary ledger. A subsidiary ledger is a group of accounts with a common characteristic. It facilitates the recording process by freeing the general ledger from details of individual balances.

2 Explain how companies use special journals in journal- izing. Companies use special journals to group similar types of transactions. In a special journal, generally only one line is used to record a complete transaction.

3 Indicate how companies post a multi-column journal. In posting a multi-column journal: (a) Companies post all column totals except for the Other

Accounts column once at the end of the month to the account title specified in the column heading.

(b) Companies do not post the total of the Other Accounts column. Instead, the individual amounts comprising the total are posted separately to the general ledger accounts specified in the Account Credited (Debited) column.

(c) The individual amounts in a column posted in total to a control account are posted daily to the subsidiary ledger accounts specified in the Account Credited (Debited) column.

Accounts payable (creditors’) subsidiary ledger A sub- sidiary ledger that collects transaction data of individual creditors. (p. E1).

Accounts receivable (customers’) subsidiary ledger A subsidiary ledger that collects transaction data of individual customers. (p. E1).

Cash payments (disbursements) journal A special journal that records all cash paid. (p. E13).

Cash receipts journal A special journal that records all cash received. (p. E7).

Control account An account in the general ledger that sum- marizes subsidiary ledger. (p. E1).

E18 Appendix E Subsidiary Ledgers and Special Journals

Solution (a) CASSANDRA WILSON COMPANY

Cash Receipts Journal CR1

(b) The Accounts Receivable column is posted as a credit to Accounts Receivable. The individual amounts are credited to the customers’ accounts identified in the Account Credited column, which are maintained in the accounts receivable subsidiary ledger.

The amounts in the Other Accounts column are posted individually. They are cred- ited to the account titles identified in the Account Credited column.

Sales Accounts Other Cost of Goods Cash Discounts Receivable Sales Accounts Sold Dr.

Date Account Credited Ref. Dr. Dr. Cr. Cr. Cr. Mdse. Inv. Cr.

2008 7/3 5,800 5,800 3,480

5 Jeltz Company 6,370 130 6,500 9 Common Stock 5,000 5,000

10 12,519 12,519 7,511 12 R. Eliot & Co. 7,275 225 7,500 15 Unearned Revenue 700 700 20 15,472 15,472 9,283 22 Beck Company 5,880 120 6,000 29 17,660 17,660 10,596 31 Interest Revenue 200 200

76,876 475 20,000 51,451 5,900 30,870

SUMMARY OF STUDY OBJECTIVES

GLOSSARY

Questions E19

Purchases journal A special journal that records all pur- chases of merchandise on account. (p. E11).

Sales journal A special journal that records all sales of mer- chandise on account. (p. E5).

Special journal A journal that records similar types of transactions, such as all credit sales. (p. E4).

Subsidiary ledger A group of accounts with a common characteristic. (p. E1).

1. What are the advantages of using subsidiary ledgers? 2. (a) When do companies normally post to (1) the sub-

sidiary accounts and (2) the general ledger control ac- counts? (b) Describe the relationship between a control account and a subsidiary ledger.

3. Identify and explain the four special journals discussed in the chapter. List an advantage of using each of these jour- nals rather than using only a general journal.

4. Thogmartin Company uses special journals. It recorded in a sales journal a sale made on account to R. Peters for $435. A few days later, R. Peters returns $70 worth of mer- chandise for credit. Where should Thogmartin Company record the sales return? Why?

5. A $500 purchase of merchandise on account from Lore Company was properly recorded in the purchases journal. When posted, however, the amount recorded in the

Answers are at the end of the chapter.

1. Which of the following is incorrect concerning subsidiary ledgers? a. The purchases ledger is a common subsidiary ledger for

creditor accounts. b. The accounts receivable ledger is a subsidiary ledger. c. A subsidiary ledger is a group of accounts with a com-

mon characteristic. d. An advantage of the subsidiary ledger is that it permits

a division of labor in posting. 2. A sales journal will be used for:

Credit Cash Sales Sales Sales Discounts

a. no yes yes b. yes no yes c. yes no no d. yes yes no

3. Which of the following statements is correct? a. The sales discount column is included in the cash re-

ceipts journal. b. The purchases journal records all purchases of mer-

chandise whether for cash or on account. c. The cash receipts journal records sales on account. d. Merchandise returned by the buyer is recorded by the

seller in the purchases journal. 4. Which of the following is incorrect concerning the posting

of the cash receipts journal? a. The total of the Other Accounts column is not posted. b. All column totals except the total for the Other

Accounts column are posted once at the end of the month to the account title(s) specified in the column heading.

c. The totals of all columns are posted daily to the accounts specified in the column heading.

d. The individual amounts in a column posted in total to a control account are posted daily to the subsidiary

ledger account specified in the Account Credited column.

5. Postings from the purchases journal to the subsidiary ledger are generally made: a. yearly. b. monthly. c. weekly. d. daily.

6. Which statement is incorrect regarding the general journal? a. Only transactions that cannot be entered in a special

journal are recorded in the general journal. b. Dual postings are always required in the general journal. c. The general journal may be used to record accept-

ance of a note receivable in payment of an account receivable.

d. Correcting, adjusting, and closing entries are made in the general journal.

7. When companies use special journals: a. they record all purchase transactions in the purchases

journal. b. they record all cash received, except from cash sales, in

the cash receipts journal. c. they record all cash disbursements in the cash pay-

ments journal. d. a general journal is not necessary.

8. If a customer returns goods for credit, the selling company normally makes an entry in the: a. cash payments journal. b. sales journal. c. general journal. d. cash receipts journal.

Go to the book’s website, www.wiley.com/college/weygandt, for Additional Self-Study questions.

SELF-STUDY QUESTIONS

(SO 1)

(SO 2)

(SO 2, 3)

(SO 3)

(SO 3)

(SO 2)

(SO 2)

(SO 2)

QUESTIONS

E20 Appendix E Subsidiary Ledgers and Special Journals

subsidiary ledger was $50. How might this error be discovered?

6. Why would special journals used in different businesses not be identical in format? What type of business would maintain a cash receipts journal but not include a column for accounts receivable?

7. The cash and the accounts receivable columns in the cash receipts journal were mistakenly overadded by $4,000 at the end of the month. (a) Will the customers’ ledger agree with the Accounts Receivable control account? (b) Assuming no other errors, will the trial balance totals be equal?

8. One column total of a special journal is posted at month- end to only two general ledger accounts. One of these two accounts is Accounts Receivable. What is the name of this special journal? What is the other general ledger account to which that same month-end total is posted?

9. In what journal would the following transactions be recorded? (Assume that a two-column sales journal and a single-column purchases journal are used.) (a) Recording of depreciation expense for the year. (b) Credit given to a customer for merchandise purchased

on credit and returned. (c) Sales of merchandise for cash.

(d) Sales of merchandise on account. (e) Collection of cash on account from a customer. (f) Purchase of office supplies on account.

10. In what journal would the following transactions be recorded? (Assume that a two-column sales journal and a single-column purchases journal are used.) (a) Cash received from signing a note payable. (b) Investment of cash by stockholders. (c) Closing of the expense accounts at the end of the year. (d) Purchase of merchandise on account. (e) Credit received for merchandise purchased and

returned to supplier. (f) Payment of cash on account due a supplier.

11. What transactions might be included in a multiple-column purchases journal that would not be included in a single- column purchases journal?

12. Give an example of a transaction in the general journal that causes an entry to be posted twice (i.e., to two ac- counts), one in the general ledger, the other in the sub- sidiary ledger. Does this affect the debit/credit equality of the general ledger?

13. Give some examples of appropriate general journal trans- actions for an organization using special journals.

BEE-1 Presented below is information related to Kienholz Company for its first month of op- erations. Identify the balances that appear in the accounts receivable subsidiary ledger and the accounts receivable balance that appears in the general ledger at the end of January.

BRIEF EXERCISES

BEE-2 Identify in what ledger (general or subsidiary) each of the following accounts is shown.

1. Rent Expense 3. Notes Payable 2. Accounts Receivable—Char 4. Accounts Payable—Thebeau

BEE-3 Identify the journal in which each of the following transactions is recorded.

1. Cash sales 4. Credit sales 2. Payment of dividends 5. Purchase of merchandise on account 3. Cash purchase of land 6. Receipt of cash for services performed

BEE-4 Indicate whether each of the following debits and credits is included in the cash receipts journal. (Use “Yes” or “No” to answer this question.)

1. Debit to Sales 3. Credit to Accounts Receivable 2. Credit to Merchandise Inventory 4. Debit to Accounts Payable

BEE-5 Galindo Co. uses special journals and a general journal. Identify the journal in which each of the following transactions is recorded.

(a) Purchased equipment on account. (b) Purchased merchandise on account. (c) Paid utility expense in cash. (d) Sold merchandise on account.

Credit Sales Cash Collections Jan. 7 Agler Co. $10,000 Jan. 17 Agler Co. $7,000

15 Barto Co. 6,000 24 Barto Co. 4,000 23 Maris Co. 9,000 29 Maris Co. 9,000

Identify subsidiary ledger balances.

(SO 1)

Identify subsidiary ledger accounts.

(SO 1)

Identify special journals.

(SO 2)

Identify entries to cash receipts journal.

(SO 2)

Identify transactions for special journals.

(SO 2)

BEE-6 Identify the special journal(s) in which the following column headings appear.

1. Sales Discounts Dr. 4. Sales Cr. 2. Accounts Receivable Cr. 5. Merchandise Inventory Dr. 3. Cash Dr.

BEE-7 Kidwell Computer Components Inc. uses a multi-column cash receipts journal. Indicate which column(s) is/are posted only in total, only daily, or both in total and daily.

1. Accounts Receivable 3. Cash 2. Sales Discounts 4. Other Accounts

Exercises E21

Indicate postings to cash receipts journal.

(SO 3)

Identify transactions for special journals.

(SO 2)

EXERCISES EE-1 Donahue Company uses both special journals and a general journal as described in this chapter. On June 30, after all monthly postings had been completed, the Accounts Receivable control account in the general ledger had a debit balance of $320,000; the Accounts Payable con- trol account had a credit balance of $77,000.

The July transactions recorded in the special journals are summarized below. No entries af- fecting accounts receivable and accounts payable were recorded in the general journal for July.

Sales journal Total sales $161,400 Purchases journal Total purchases $56,400 Cash receipts journal Accounts receivable column total $131,000 Cash payments journal Accounts payable column total $47,500

Instructions (a) What is the balance of the Accounts Receivable control account after the monthly postings

on July 31? (b) What is the balance of the Accounts Payable control account after the monthly postings on

July 31? (c) To what account(s) is the column total of $161,400 in the sales journal posted? (d) To what account(s) is the accounts receivable column total of $131,000 in the cash receipts

journal posted?

EE-2 Presented below is the subsidiary accounts receivable account of Jeremy Dody.

Date Ref. Debit Credit Balance 2008 Sept. 2 S31 61,000 61,000

9 G4 14,000 47,000 27 CR8 47,000 —

Instructions Write a memo to Andrea Barden, chief financial officer, that explains each transaction.

EE-3 On September 1 the balance of the Accounts Receivable control account in the general ledger of Seaver Company was $10,960. The customers’ subsidiary ledger contained account bal- ances as follows: Ruiz $1,440, Kingston $2,640, Bannister $2,060, Crampton $4,820. At the end of September the various journals contained the following information.

Sales journal: Sales to Crampton $800; to Ruiz $1,260; to Iman $1,330; to Bannister $1,100. Cash receipts journal: Cash received from Bannister $1,310; from Crampton $2,300; from Iman $380; from Kingston $1,800; from Ruiz $1,240. General journal: An allowance is granted to Crampton $220.

Instructions (a) Set up control and subsidiary accounts and enter the beginning balances. Do not construct

the journals. (b) Post the various journals. Post the items as individual items or as totals, whichever would be

the appropriate procedure. (No sales discounts given.)

Determine control account balances, and explain posting of special journals.

(SO 1, 3)

Explain postings to subsidiary ledger.

(SO 1)

Post various journals to control and subsidiary accounts.

(SO 1, 3)

(c) Prepare a list of customers and prove the agreement of the controlling account with the subsidiary ledger at September 30, 2008.

EE-4 Yu Suzuki Company has a balance in its Accounts Receivable control account of $11,000 on January 1, 2008. The subsidiary ledger contains three accounts: Smith Company, balance $4,000; Green Company, balance $2,500; and Koyan Company. During January, the following receivable-related transactions occurred.

Credit Sales Collections Returns Smith Company $9,000 $8,000 $ -0- Green Company 7,000 2,500 3,000 Koyan Company 8,500 9,000 -0-

Instructions (a) What is the January 1 balance in the Koyan Company subsidiary account? (b) What is the January 31 balance in the control account? (c) Compute the balances in the subsidiary accounts at the end of the month. (d) Which January transaction would not be recorded in a special journal?

EE-5 Nobo Uematsu Company has a balance in its Accounts Payable control account of $8,250 on January 1, 2008. The subsidiary ledger contains three accounts: Jones Company, bal- ance $3,000; Brown Company, balance $1,875; and Aatski Company. During January, the follow- ing receivable-related transactions occurred.

Purchases Payments Returns Jones Company $6,750 $6,000 $ -0- Brown Company 5,250 1,875 2,250 Aatski Company 6,375 6,750 -0-

Instructions (a) What is the January 1 balance in the Aatski Company subsidiary account? (b) What is the January 31 balance in the control account? (c) Compute the balances in the subsidiary accounts at the end of the month. (d) Which January transaction would not be recorded in a special journal?

EE-6 Montalvo Company uses special journals and a general journal. The following transac- tions occurred during September 2008.

Sept. 2 Sold merchandise on account to T. Hossfeld, invoice no. 101, $720, terms n/30. The cost of the merchandise sold was $420.

10 Purchased merchandise on account from L. Rincon $600, terms 2/10, n/30. 12 Purchased office equipment on account from R. Press $6,500. 21 Sold merchandise on account to P. Lowther, invoice no. 102 for $800, terms 2/10, n/30.

The cost of the merchandise sold was $480. 25 Purchased merchandise on account from W. Barone $860, terms n/30. 27 Sold merchandise to S. Miller for $700 cash. The cost of the merchandise sold was

$400.

Instructions (a) Prepare a sales journal (see Illustration E-6) and a single-column purchase journal (see

Illustration E-11). (Use page 1 for each journal.) (b) Record the transaction(s) for September that should be journalized in the sales journal and

the purchases journal.

EE-7 Pherigo Co. uses special journals and a general journal. The following transactions oc- curred during May 2008.

May 1 I. Pherigo invested $50,000 cash in the business in exchange for common stock. 2 Sold merchandise to B. Sherrick for $6,300 cash. The cost of the merchandise sold was

$4,200. 3 Purchased merchandise for $7,200 from J. DeLeon using check no. 101.

14 Paid salary to H. Potter $700 by issuing check no. 102.

E22 Appendix E Subsidiary Ledgers and Special Journals

Determine control and subsidiary ledger balances for accounts receivable.

(SO 1)

Determine control and subsidiary ledger balances for accounts payable.

(SO 1)

Record transactions in sales and purchases journal.

(SO 1, 2)

Record transactions in cash receipts and cash payments journal.

(SO 1, 2)

16 Sold merchandise on account to K. Kimbell for $900, terms n/30. The cost of the mer- chandise sold was $630.

22 A check of $9,000 is received from M. Moody in full for invoice 101; no discount given.

Instructions (a) Prepare a multiple-column cash receipts journal (see Illustration E-8) and a multiple-

column cash payments journal (see Illustration E-15). (Use page 1 for each journal.) (b) Record the transaction(s) for May that should be journalized in the cash receipts journal

and cash payments journal.

EE-8 Wick Company uses the columnar cash journals illustrated in the textbook. In April, the following selected cash transactions occurred.

1. Made a refund to a customer for the return of damaged goods. 2. Received collection from customer within the 3% discount period. 3. Purchased merchandise for cash. 4. Paid a creditor within the 3% discount period. 5. Received collection from customer after the 3% discount period had expired. 6. Paid freight on merchandise purchased. 7. Paid cash for office equipment. 8. Received cash refund from supplier for merchandise returned. 9. Paid cash dividend to stockholders.

10. Made cash sales.

Instructions Indicate (a) the journal, and (b) the columns in the journal that should be used in recording each transaction.

EE-9 Velasquez Company has the following selected transactions during March.

Mar. 2 Purchased equipment costing $9,400 from Chang Company on account. 5 Received credit of $410 from Lyden Company for merchandise damaged in ship-

ment to Velasquez. 7 Issued credit of $400 to Higley Company for merchandise the customer returned.

The returned merchandise had a cost of $260.

Velasquez Company uses a one-column purchases journal, a sales journal, the columnar cash journals used in the text, and a general journal.

Instructions (a) Journalize the transactions in the general journal. (b) In a brief memo to the president of Velasquez Company, explain the postings to

the control and subsidiary accounts from each type of journal.

EE-10 Below are some typical transactions incurred by Kwun Company.

1. Payment of creditors on account. 2. Return of merchandise sold for credit. 3. Collection on account from customers. 4. Sale of land for cash. 5. Sale of merchandise on account. 6. Sale of merchandise for cash. 7. Received credit for merchandise purchased on credit. 8. Sales discount taken on goods sold. 9. Payment of employee wages.

10. Payment of cash dividend to stockholders. 11. Depreciation on building. 12. Purchase of office supplies for cash. 13. Purchase of merchandise on account.

Instructions For each transaction, indicate whether it would normally be recorded in a cash receipts journal, cash payments journal, sales journal, single-column purchases journal, or general journal.

Exercises E23

Explain journalizing in cash journals.

(SO 2)

Journalize transactions in general journal and post.

(SO 1, 3)

Indicate journalizing in special journals.

(SO 2)

EE-11 The general ledger of Sanchez Company contained the following Accounts Payable control account (in T-account form). Also shown is the related subsidiary ledger.

E24 Appendix E Subsidiary Ledgers and Special Journals

GENERAL LEDGER

Accounts Payable Feb. 15 General journal 1,400 Feb. 1 Balance 26,025

28 ? ? 5 General journal 265 11 General journal 550 28 Purchases 13,400

Feb. 28 Balance 9,500

ACCOUNTS PAYABLE LEDGER

Perez Tebbetts Feb. 28 Bal. 4,600 Feb. 28 Bal. ?

Zerbe Feb. 28 Bal. 2,300

Instructions (a) Indicate the missing posting reference and amount in the control account, and the missing

ending balance in the subsidiary ledger. (b) Indicate the amounts in the control account that were dual-posted (i.e., posted to the

control account and the subsidiary accounts).

EE-12 Selected accounts from the ledgers of Lockhart Company at July 31 showed the following.

Store Equipment No. 153 Date Explanation Ref. Debit Credit Balance

July 1 G1 3,900 3,900

Accounts Payable No. 201 Date Explanation Ref. Debit Credit Balance

July 1 G1 3,900 3,900 15 G1 400 4,300 18 G1 100 4,200 25 G1 200 4,000 31 P1 8,300 12,300

Merchandise Inventory No. 120 Date Explanation Ref. Debit Credit Balance

July 15 G1 400 400 18 G1 100 300 25 G1 200 100 31 P1 8,300 8,400

GENERAL LEDGER

Drago Co. Date Explanation Ref. Debit Credit Balance

July 14 P1 1,100 1,100 25 G1 200 900

Erik Co. Date Explanation Ref. Debit Credit Balance

July 12 P1 500 500 21 P1 600 1,100

Heinen Inc. Date Explanation Ref. Debit Credit Balance

July 15 G1 400 400

Albin Equipment Co. Date Explanation Ref. Debit Credit Balance

July 1 G1 3,900 3,900

Brian Co. Date Explanation Ref. Debit Credit Balance

July 3 P1 2,400 2,400 20 P1 700 3,100

Chacon Corp Date Explanation Ref. Debit Credit Balance

July 17 P1 1,400 1,400 18 G1 100 1,300 29 P1 1,600 2,900

ACCOUNTS PAYABLE LEDGER

Explain posting to control account and subsidiary ledger.

(SO 1, 3)

Prepare purchases and general journals.

(SO 1, 2)

Instructions From the data prepare: (a) the single-column purchases journal for July. (b) the general journal entries for July.

EE-13 Kansas Products uses both special journals and a general journal as described in this chapter. Kansas also posts customers’ accounts in the accounts receivable subsidiary ledger. The postings for the most recent month are included in the subsidiary T accounts below.

Problems: Set A E25

Instructions Determine the correct amount of the end-of-month posting from the sales journal to the Accounts Receivable control account.

EE-14 Selected account balances for Matisyahu Company at January 1, 2008, are presented below.

Accounts Payable $14,000 Accounts Receivable 22,000 Cash 17,000 Inventory 13,500

Matisyahu’s sales journal for January shows a total of $100,000 in the selling price column, and its one-column purchases journal for January shows a total of $72,000.

The column totals in Matisyahu’s cash receipts journal are: Cash Dr. $61,000; Sales Discounts Dr. $1,100; Accounts Receivable Cr. $45,000; Sales Cr. $6,000; and Other Accounts Cr. $11,100.

The column totals in Matisyahu’s cash payments journal for January are: Cash Cr. $55,000; Inventory Cr. $1,000; Accounts Payable Dr. $46,000; and Other Accounts Dr. $10,000. Matisyahu’s total cost of goods sold for January is $63,600.

Accounts Payable, Accounts Receivable, Cash, Inventory, and Sales are not involved in the “Other Accounts” column in either the cash receipts or cash payments journal, and are not in- volved in any general journal entries.

Instructions Compute the January 31 balance for Matisyahu in the following accounts. (a) Accounts Payable. (b) Accounts Receivable. (c) Cash. (d) Inventory. (e) Sales.

Bargo Leary Bal. 340 250 Bal. 150 150

200 240

Carol Paul Bal. –0– 145 Bal. 120 120

145 190 150

Determine correct posting amount to control account.

(SO 3)

Compute balances in various accounts.

(SO 3)

EXERCISES: SET B

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Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Exercise Set B.

PROBLEMS: SET A PE-1A Grider Company’s chart of accounts includes the following selected accounts.

101 Cash 401 Sales 112 Accounts Receivable 414 Sales Discounts 120 Merchandise Inventory 505 Cost of Goods Sold 311 Common Stock

Journalize transactions in cash receipts journal; post to control account and subsidiary ledger.

(SO 1, 2, 3)

On April 1 the accounts receivable ledger of Grider Company showed the following balances: Ogden $1,550, Chelsea $1,200, Eggleston Co. $2,900, and Baez $1,800. The April transactions in- volving the receipt of cash were as follows.

Apr. 1 Stockholders invested $7,200 additional cash in the business, in exchange for common stock.

4 Received check for payment of account from Baez less 2% cash discount. 5 Received check for $920 in payment of invoice no. 307 from Eggleston Co. 8 Made cash sales of merchandise totaling $7,245. The cost of the merchandise sold was

$4,347. 10 Received check for $600 in payment of invoice no. 309 from Ogden. 11 Received cash refund from a supplier for damaged merchandise $740. 23 Received check for $1,500 in payment of invoice no. 310 from Eggleston Co. 29 Received check for payment of account from Chelsea.

Instructions (a) Journalize the transactions above in a six-column cash receipts journal with columns for

Cash Dr., Sales Discounts Dr., Accounts Receivable Cr., Sales Cr., Other Accounts Cr., and Cost of Goods Sold Dr./Merchandise Inventory Cr. Foot and crossfoot the journal.

(b) Insert the beginning balances in the Accounts Receivable control and subsidiary accounts, and post the April transactions to these accounts.

(c) Prove the agreement of the control account and subsidiary account balances.

PE-2A Ming Company’s chart of accounts includes the following selected accounts.

101 Cash 201 Accounts Payable 120 Merchandise Inventory 332 Dividends 130 Prepaid Insurance 505 Cost of Goods Sold 157 Equipment

On October 1 the accounts payable ledger of Ming Company showed the following balances: Bovary Company $2,700, Nyman Co. $2,500, Pyron Co. $1,800, and Sims Company $3,700. The October transactions involving the payment of cash were as follows.

Oct. 1 Purchased merchandise, check no. 63, $300. 3 Purchased equipment, check no. 64, $800. 5 Paid Bovary Company balance due of $2,700, less 2% discount, check no. 65, $2,646.

10 Purchased merchandise, check no. 66, $2,250. 15 Paid Pyron Co. balance due of $1,800, check no. 67. 16 Paid cash dividend of $400, check no. 68. 19 Paid Nyman Co. in full for invoice no. 610, $1,600 less 2% cash discount, check no. 69,

$1,568. 29 Paid Sims Company in full for invoice no. 264, $2,500, check no. 70.

Instructions (a) Journalize the transactions above in a four-column cash payments journal with columns for

Other Accounts Dr., Accounts Payable Dr., Merchandise Inventory Cr., and Cash Cr. Foot and crossfoot the journal.

(b) Insert the beginning balances in the Accounts Payable control and subsidiary accounts, and post the October transactions to these accounts.

(c) Prove the agreement of the control account and the subsidiary account balances.

PE-3A The chart of accounts of Lopez Company includes the following selected accounts.

112 Accounts Receivable 401 Sales 120 Merchandise Inventory 412 Sales Returns and Allowances 126 Supplies 505 Cost of Goods Sold 157 Equipment 610 Advertising Expense 201 Accounts Payable

In July the following selected transactions were completed. All purchases and sales were on ac- count. The cost of all merchandise sold was 70% of the sales price.

July 1 Purchased merchandise from Fritz Company $8,000. 2 Received freight bill from Wayward Shipping on Fritz purchase $400. 3 Made sales to Pinick Company $1,300, and to Wayne Bros. $1,500.

E26 Appendix E Subsidiary Ledgers and Special Journals

(a) Balancing totals $21,205

(c) Accounts Receivable $1,430

Journalize transactions in cash payments journal; post to con- trol account and subsidiary ledgers.

(SO 1, 2, 3)

(a) Balancing totals $12,350

(c) Accounts Payable $2,100

Journalize transactions in multi-column purchases journal; post to the general and subsidiary ledgers.

(SO 1, 2, 3)

5 Purchased merchandise from Moon Company $3,200. 8 Received credit on merchandise returned to Moon Company $300.

13 Purchased store supplies from Cress Supply $720. 15 Purchased merchandise from Fritz Company $3,600 and from Anton Company $3,300. 16 Made sales to Sager Company $3,450 and to Wayne Bros. $1,570. 18 Received bill for advertising from Lynda Advertisements $600. 21 Made sales to Pinick Company $310 and to Haddad Company $2,800. 22 Granted allowance to Pinick Company for merchandise damaged in shipment $40. 24 Purchased merchandise from Moon Company $3,000. 26 Purchased equipment from Cress Supply $900. 28 Received freight bill from Wayward Shipping on Moon purchase of July 24, $380. 30 Made sales to Sager Company $5,600.

Instructions (a) Journalize the transactions above in a purchases journal, a sales journal, and a general

journal. The purchases journal should have the following column headings: Date, Account Credited (Debited), Ref., Accounts Payable Cr., Merchandise Inventory Dr., and Other Accounts Dr.

(b) Post to both the general and subsidiary ledger accounts. (Assume that all accounts have zero beginning balances.)

(c) Prove the agreement of the control and subsidiary accounts.

PE-4A Selected accounts from the chart of accounts of Boyden Company are shown below.

101 Cash 401 Sales 112 Accounts Receivable 412 Sales Returns and Allowances 120 Merchandise Inventory 414 Sales Discounts 126 Supplies 505 Cost of Goods Sold 157 Equipment 726 Salaries Expense 201 Accounts Payable

The cost of all merchandise sold was 60% of the sales price. During January, Boyden completed the following transactions.

Jan. 3 Purchased merchandise on account from Wortham Co. $10,000. 4 Purchased supplies for cash $80. 4 Sold merchandise on account to Milam $5,250, invoice no. 371, terms 1/10, n/30. 5 Returned $300 worth of damaged goods purchased on account from Wortham Co. on

January 3. 6 Made cash sales for the week totaling $3,150. 8 Purchased merchandise on account from Noyes Co. $4,500. 9 Sold merchandise on account to Connor Corp. $6,400, invoice no. 372, terms 1/10, n/30.

11 Purchased merchandise on account from Betz Co. $3,700. 13 Paid in full Wortham Co. on account less a 2% discount. 13 Made cash sales for the week totaling $6,260. 15 Received payment from Connor Corp. for invoice no. 372. 15 Paid semi-monthly salaries of $14,300 to employees. 17 Received payment from Milam for invoice no. 371. 17 Sold merchandise on account to Bullock Co. $1,200, invoice no. 373, terms 1/10, n/30. 19 Purchased equipment on account from Murphy Corp. $5,500. 20 Cash sales for the week totaled $3,200. 20 Paid in full Noyes Co. on account less a 2% discount. 23 Purchased merchandise on account from Wortham Co. $7,800. 24 Purchased merchandise on account from Forgetta Corp. $5,100. 27 Made cash sales for the week totaling $4,230. 30 Received payment from Bullock Co. for invoice no. 373. 31 Paid semi-monthly salaries of $13,200 to employees. 31 Sold merchandise on account to Milam $9,330, invoice no. 374, terms 1/10, n/30.

Boyden Company uses the following journals.

1. Sales journal. 2. Single-column purchases journal.

Problems: Set A E27

(a) Purchases journal— Accounts Payable $24,100 Sales column total $16,530

(c) Accounts Receivable $16,490 Accounts Payable $23,800

Journalize transactions in special journals.

(SO 1, 2, 3)

3. Cash receipts journal with columns for Cash Dr., Sales Discounts Dr., Accounts Receivable Cr., Sales Cr., Other Accounts Cr., and Cost of Goods Sold Dr./Merchandise Inventory Cr.

4. Cash payments journal with columns for Other Accounts Dr., Accounts Payable Dr., Merchandise Inventory Cr., and Cash Cr.

5. General journal.

Instructions Using the selected accounts provided: (a) Record the January transactions in the appropriate journal noted. (b) Foot and crossfoot all special journals. (c) Show how postings would be made by placing ledger account numbers and checkmarks as

needed in the journals. (Actual posting to ledger accounts is not required.)

PE-5A Presented below are the purchases and cash payments journals for Reyes Co. for its first month of operations.

E28 Appendix E Subsidiary Ledgers and Special Journals

(a) Sales journal $22,180 Purchases journal $31,100 Cash receipts journal

balancing total $29,690 Cash payments journal

balancing total $41,780

Journalize in sales and cash receipts journals; post; prepare a trial balance; prove control to subsidiary; prepare adjusting entries; prepare an adjusted trial balance.

(SO 1, 2, 3)

PURCHASES JOURNAL P1

Merchandise Inventory Dr. Date Account Credited Ref. Accounts Payable Cr.

July 4 G. Clemens 6,800 5 A. Ernst 8,100

11 J. Happy 5,920 13 C. Tabor 15,300 20 M. Sneezy 7,900

44,020

CASH PAYMENTS JOURNAL CP1

Other Accounts Merchandise Account Accounts Payable Inventory Cash

Date Debited Ref. Dr. Dr. Cr. Cr. July 4 Store Supplies 600 600

10 A. Ernst 8,100 81 8,019 11 Prepaid Rent 6,000 6,000 15 G. Clemens 6,800 6,800 19 Dividends 2,500 2,500 21 C. Tabor 15,300 153 15,147

9,100 30,200 234 39,066

In addition, the following transactions have not been journalized for July. The cost of all mer- chandise sold was 65% of the sales price.

July 1 D. Reyes invested $80,000 in cash in exchange for common stock. 6 Sold merchandise on account to Ewing Co. $6,200 terms 1/10, n/30. 7 Made cash sales totaling $6,000. 8 Sold merchandise on account to S. Beauty $3,600, terms 1/10, n/30.

10 Sold merchandise on account to W. Pitts $4,900, terms 1/10, n/30. 13 Received payment in full from S. Beauty. 16 Received payment in full from W. Pitts. 20 Received payment in full from Ewing Co. 21 Sold merchandise on account to H. Prince $5,000, terms 1/10, n/30. 29 Returned damaged goods to G. Clemens and received cash refund of $420.

Instructions (a) Open the following accounts in the general ledger.

101 Cash 127 Store Supplies 112 Accounts Receivable 131 Prepaid Rent 120 Merchandise Inventory 201 Accounts Payable

311 Common Stock 505 Cost of Goods Sold 332 Dividends 631 Supplies Expense 401 Sales 729 Rent Expense 414 Sales Discounts

(b) Journalize the transactions that have not been journalized in the sales journal, the cash re- ceipts journal (see Illustration E-8), and the general journal.

(c) Post to the accounts receivable and accounts payable subsidiary ledgers. Follow the sequence of transactions as shown in the problem.

(d) Post the individual entries and totals to the general ledger. (e) Prepare a trial balance at July 31, 2008. (f ) Determine whether the subsidiary ledgers agree with the control accounts in the general

ledger. (g) The following adjustments at the end of July are necessary.

(1) A count of supplies indicates that $140 is still on hand. (2) Recognize rent expense for July, $500. Prepare the necessary entries in the general journal. Post the entries to the general ledger.

(h) Prepare an adjusted trial balance at July 31, 2008.

PE-6A The post-closing trial balance for Cortez Co. is as follows.

Problems: Set A E29

(b) Sales journal total $19,700 Cash receipts journal balancing totals $101,120

(e) Totals $119,520 (f) Accounts Receivable

$5,000 Accounts Payable $13,820

(h) Totals $119,520

Journalize in special journals; post; prepare a trial balance.

(SO 1, 2, 3)CORTEZ CO. Post-Closing Trial Balance

December 31, 2008

Debit Credit Cash $ 41,500 Accounts Receivable 15,000 Notes Receivable 45,000 Merchandise Inventory 23,000 Equipment 6,450 Accumulated Depreciation—Equipment $ 1,500 Accounts Payable 43,000 Common Stock 86,450

$130,950 $130,950

The subsidiary ledgers contain the following information: (1) accounts receivable—J. Anders $2,500, F. Cone $7,500, T. Dudley $5,000; (2) accounts payable—J. Feeney $10,000, D. Goodman $18,000, and K. Inwood $15,000. The cost of all merchandise sold was 60% of the sales price.

The transactions for January 2009 are as follows.

Jan. 3 Sell merchandise to M. Rensing $5,000, terms 2/10, n/30. 5 Purchase merchandise from E. Vietti $2,000, terms 2/10, n/30. 7 Receive a check from T. Dudley $3,500.

11 Pay freight on merchandise purchased $300. 12 Pay rent of $1,000 for January. 13 Receive payment in full from M. Rensing. 14 Post all entries to the subsidiary ledgers. Issued credit of $300 to J. Aders for returned

merchandise. 15 Send K. Inwood a check for $14,850 in full payment of account, discount $150. 17 Purchase merchandise from G. Marley $1,600, terms 2/10, n/30. 18 Pay sales salaries of $2,800 and office salaries $2,000. 20 Give D. Goodman a 60-day note for $18,000 in full payment of account payable. 23 Total cash sales amount to $9,100. 24 Post all entries to the subsidiary ledgers. Sell merchandise on account to F. Cone $7,400,

terms 1/10, n/30. 27 Send E. Vietti a check for $950. 29 Receive payment on a note of $40,000 from B. Lemke. 30 Post all entries to the subsidiary ledgers. Return merchandise of $300 to G. Marley for

credit.

Instructions (a) Open general and subsidiary ledger accounts for the following.

101 Cash 311 Common Stock 112 Accounts Receivable 401 Sales 115 Notes Receivable 412 Sales Returns and Allowances 120 Merchandise Inventory 414 Sales Discounts 157 Equipment 505 Cost of Goods Sold 158 Accumulated Depreciation—Equipment 726 Sales Salaries Expense 200 Notes Payable 727 Office Salaries Expense 201 Accounts Payable 729 Rent Expense

(b) Record the January transactions in a sales journal, a single-column purchases journal, a cash receipts journal (see Illustration E-8), a cash payments journal (see Illustration E-15), and a general journal.

(c) Post the appropriate amounts to the general ledger. (d) Prepare a trial balance at January 31, 2009. (e) Determine whether the subsidiary ledgers agree with controlling accounts in the general ledger.

E30 Appendix E Subsidiary Ledgers and Special Journals

(b) Sales journal $12,400 Purchases journal $3,600 Cash receipts journal (balancing) $57,600 Cash payments journal (balancing) $22,050

(d) Totals $139,800 (e) Accounts Receivable

$18,600 Accounts Payable $12,350

PROBLEMS: SET B PE-1B Darby Company’s chart of accounts includes the following selected accounts.

101 Cash 401 Sales 112 Accounts Receivable 414 Sales Discounts 120 Merchandise Inventory 505 Cost of Goods Sold 311 Common Stock

On June 1 the accounts receivable ledger of Darby Company showed the following balances: Deering & Son $2,500, Farley Co. $1,900, Grinnell Bros. $1,600, and Lenninger Co. $1,300. The June transactions involving the receipt of cash were as follows.

June 1 Stockholders invested $10,000 additional cash in the business, in exchange for common stock.

3 Received check in full from Lenninger Co. less 2% cash discount. 6 Received check in full from Farley Co. less 2% cash discount. 7 Made cash sales of merchandise totaling $6,135. The cost of the merchandise sold was

$4,090. 9 Received check in full from Deering & Son less 2% cash discount.

11 Received cash refund from a supplier for damaged merchandise $320. 15 Made cash sales of merchandise totaling $4,500. The cost of the merchandise sold was

$3,000. 20 Received check in full from Grinnell Bros. $1,600.

Instructions (a) Journalize the transactions above in a six-column cash receipts journal with columns for

Cash Dr., Sales Discounts Dr., Accounts Receivable Cr., Sales Cr., Other Accounts Cr., and Cost of Goods Sold Dr./Merchandise Inventory Cr. Foot and crossfoot the journal.

(b) Insert the beginning balances in the Accounts Receivable control and subsidiary accounts, and post the June transactions to these accounts.

(c) Prove the agreement of the control account and subsidiary account balances.

PE-2B Gonya Company’s chart of accounts includes the following selected accounts.

101 Cash 157 Equipment 120 Merchandise Inventory 201 Accounts Payable 130 Prepaid Insurance 332 Dividends

On November 1 the accounts payable ledger of Gonya Company showed the following balances: A. Hess & Co. $4,500, C. Kimberlin $2,350, G. Ruttan $1,000, and Wex Bros. $1,500. The November transactions involving the payment of cash were as follows.

Nov. 1 Purchased merchandise, check no. 11, $1,140. 3 Purchased store equipment, check no. 12, $1,700.

Journalize transactions in cash receipts journal; post to control account and subsidiary ledger.

(SO 1, 2, 3)

(a) Balancing totals $28,255

(c) Accounts Receivable $0

Journalize transactions in cash payments journal; post to the general and subsidiary ledgers.

(SO 1, 2, 3)

5 Paid Wex Bros. balance due of $1,500, less 1% discount, check no. 13, $1,485. 11 Purchased merchandise, check no. 14, $2,000. 15 Paid G. Ruttan balance due of $1,000, less 3% discount, check no. 15, $970. 16 Paid cash dividend of $500, check no. 16. 19 Paid C. Kimberlin in full for invoice no. 1245, $1,150 less 2% discount, check no. 17,

$1,127. 25 Paid premium due on one-year insurance policy, check no. 18, $3,000. 30 Paid A. Hess & Co. in full for invoice no. 832, $3,500, check no. 19.

Instructions (a) Journalize the transactions above in a four-column cash payments journal with columns for

Other Accounts Dr., Accounts Payable Dr., Merchandise Inventory Cr., and Cash Cr. Foot and crossfoot the journal.

(b) Insert the beginning balances in the Accounts Payable control and subsidiary accounts, and post the November transactions to these accounts.

(c) Prove the agreement of the control account and the subsidiary account balances.

PE-3B The chart of accounts of Emley Company includes the following selected accounts.

112 Accounts Receivable 401 Sales 120 Merchandise Inventory 412 Sales Returns and Allowances 126 Supplies 505 Cost of Goods Sold 157 Equipment 610 Advertising Expense 201 Accounts Payable

In May the following selected transactions were completed. All purchases and sales were on ac- count except as indicated. The cost of all merchandise sold was 65% of the sales price.

May 2 Purchased merchandise from Younger Company $7,500. 3 Received freight bill from Ruden Freight on Younger purchase $360. 5 Made sales to Ellie Company $1,980, DeShazer Bros. $2,700, and Liu Company $1,500. 8 Purchased merchandise from Utley Company $8,000 and Zeider Company $8,700.

10 Received credit on merchandise returned to Zeider Company $500. 15 Purchased supplies from Rodriquez Supply $900. 16 Purchased merchandise from Younger Company $4,500, and Utley Company $7,200. 17 Returned supplies to Rodriquez Supply, receiving credit $100. (Hint: Credit Supplies.) 18 Received freight bills on May 16 purchases from Ruden Freight $500. 20 Returned merchandise to Younger Company receiving credit $300. 23 Made sales to DeShazer Bros. $2,400 and to Liu Company $3,600. 25 Received bill for advertising from Amster Advertising $900. 26 Granted allowance to Liu Company for merchandise damaged in shipment $200. 28 Purchased equipment from Rodriquez Supply $500.

Instructions (a) Journalize the transactions above in a purchases journal, a sales journal, and a general

journal. The purchases journal should have the following column headings: Date, Account Credited (Debited), Ref., Accounts Payable Cr., Merchandise Inventory Dr., and Other Accounts Dr.

(b) Post to both the general and subsidiary ledger accounts. (Assume that all accounts have zero beginning balances.)

(c) Prove the agreement of the control and subsidiary accounts.

PE-4B Selected accounts from the chart of accounts of Litke Company are shown below.

101 Cash 201 Accounts Payable 112 Accounts Receivable 401 Sales 120 Merchandise Inventory 414 Sales Discounts 126 Supplies 505 Cost of Goods Sold 140 Land 610 Advertising Expense 145 Buildings

The cost of all merchandise sold was 70% of the sales price. During October, Litke Company completed the following transactions.

Problems: Set B E31

(a) Balancing totals $15,490

(c) Accounts Payable $2,200

Journalize transactions in multi-column purchases journal; post to the general and subsidiary ledgers.

(SO 1, 2, 3)

(a) Purchases journal— Accounts Payable, Cr. $39,060 Sales column total $12,180

(c) Accounts Receivable $11,980 Accounts Payable $38,160

Journalize transactions in special journals.

(SO 1, 2, 3)

Oct. 2 Purchased merchandise on account from Camacho Company $16,500. 4 Sold merchandise on account to Enos Co. $7,700. Invoice no. 204, terms 2/10, n/30. 5 Purchased supplies for cash $80. 7 Made cash sales for the week totaling $9,160. 9 Paid in full the amount owed Camacho Company less a 2% discount.

10 Purchased merchandise on account from Finn Corp. $3,500. 12 Received payment from Enos Co. for invoice no. 204. 13 Returned $210 worth of damaged goods purchased on account from Finn Corp. on

October 10. 14 Made cash sales for the week totaling $8,180. 16 Sold a parcel of land for $27,000 cash, the land’s original cost. 17 Sold merchandise on account to G. Richter & Co. $5,350, invoice no. 205, terms 2/10, n/30. 18 Purchased merchandise for cash $2,125. 21 Made cash sales for the week totaling $8,200. 23 Paid in full the amount owed Finn Corp. for the goods kept (no discount). 25 Purchased supplies on account from Robinson Co. $260. 25 Sold merchandise on account to Hunt Corp. $5,220, invoice no. 206, terms 2/10, n/30. 25 Received payment from G. Richter & Co. for invoice no. 205. 26 Purchased for cash a small parcel of land and a building on the land to use as a storage fa-

cility.The total cost of $35,000 was allocated $21,000 to the land and $14,000 to the building. 27 Purchased merchandise on account from Kudro Co. $8,500. 28 Made cash sales for the week totaling $7,540. 30 Purchased merchandise on account from Camacho Company $14,000. 30 Paid advertising bill for the month from the Gazette, $400. 30 Sold merchandise on account to G. Richter & Co. $4,600, invoice no. 207, terms 2/10, n/30.

Litke Company uses the following journals.

1. Sales journal. 2. Single-column purchases journal. 3. Cash receipts journal with columns for Cash Dr., Sales Discounts Dr., Accounts

Receivable Cr., Sales Cr., Other Accounts Cr., and Cost of Goods Sold Dr./Merchandise Inventory Cr.

4. Cash payments journal with columns for Other Accounts Dr., Accounts Payable Dr., Merchandise Inventory Cr., and Cash Cr.

5. General journal.

Instructions Using the selected accounts provided: (a) Record the October transactions in the appropriate journals. (b) Foot and crossfoot all special journals. (c) Show how postings would be made by placing ledger account numbers and check marks as

needed in the journals. (Actual posting to ledger accounts is not required.)

PE-5B Presented below are the sales and cash receipts journals for Wyrick Co. for its first month of operations.

E32 Appendix E Subsidiary Ledgers and Special Journals

SALES JOURNAL S1 Accounts Receivable Dr. Cost of Goods Sold Dr.

Date Account Debited Ref. Sales Cr. Merchandise Inventory Cr. Feb. 3 S. Arndt 5,500 3,630

9 C. Boyd 6,500 4,290 12 F. Catt 8,000 5,280 26 M. Didde 7,000 4,620

27,000 17,820

(b) Sales journal $22,870 Purchases journal $42,500 Cash receipts journal—

Cash, Dr. $72,869 Cash payments journal,

Cash, Cr. $57,065

Journalize in purchases and cash payments journals; post; prepare a trial balance; prove control to subsidiary; prepare adjusting entries; prepare an adjusted trial balance.

(SO 1, 2, 3)

In addition, the following transactions have not been journalized for February 2008.

Feb. 2 Purchased merchandise on account from J. Vopat for $4,600, terms 2/10, n/30. 7 Purchased merchandise on account from P. Kneiser for $30,000, terms 1/10, n/30. 9 Paid cash of $1,250 for purchase of supplies.

12 Paid $4,508 to J. Vopat in payment for $4,600 invoice, less 2% discount. 15 Purchased equipment for $7,000 cash. 16 Purchased merchandise on account from J. Nunez $2,400, terms 2/10, n/30. 17 Paid $29,700 to P. Kneiser in payment of $30,000 invoice, less 1% discount. 20 Paid cash dividend of $1,100. 21 Purchased merchandise on account from G. Reedy for $7,800, terms 1/10, n/30. 28 Paid $2,400 to J. Nunez in payment of $2,400 invoice.

Instructions (a) Open the following accounts in the general ledger.

101 Cash 311 Common Stock 112 Accounts Receivable 332 Dividends 120 Merchandise Inventory 401 Sales 126 Supplies 414 Sales Discounts 157 Equipment 505 Cost of Goods Sold 158 Accumulated Depreciation—Equipment 631 Supplies Expense 201 Accounts Payable 711 Depreciation Expense

(b) Journalize the transactions that have not been journalized in a one-column purchases jour- nal and the cash payments journal (see Illustration E-15).

(c) Post to the accounts receivable and accounts payable subsidiary ledgers. Follow the sequence of transactions as shown in the problem.

(d) Post the individual entries and totals to the general ledger. (e) Prepare a trial balance at February 29, 2008. (f) Determine that the subsidiary ledgers agree with the control accounts in the general ledger. (g) The following adjustments at the end of February are necessary.

(1) A count of supplies indicates that $300 is still on hand. (2) Depreciation on equipment for February is $200. Prepare the adjusting entries and then post the adjusting entries to the general ledger.

(h) Prepare an adjusted trial balance at February 29, 2008.

Comprehensive Problem: Chapters 3 to 6 and Appendix E E33

CASH RECEIPTS JOURNAL CR1 Sales Accounts Other

Cash Discounts Receivable Sales Accounts Cost of Goods Sold Dr. Date Account Credited Ref. Dr. Dr. Cr. Cr. Cr. Merchandise Inventory Cr.

Feb. 1 Common Stock 30,000 30,000 2 6,500 6,500 4,290

13 S. Arndt 5,445 55 5,500 18 Merchandise Inventory 150 150 26 C. Boyd 6,500 6,500

48,595 55 12,000 6,500 30,150 4,290

PROBLEMS: SET C

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COMPREHENSIVE PROBLEM: CHAPTERS 3 TO 6 AND APPENDIX E

Packard Company has the following opening account balances in its general and subsidiary ledgers on January 1 and uses the periodic inventory system.All accounts have normal debit and credit balances.

(b) Purchases journal total $44,800 Cash payments journal— Cash, Cr. $45,958

(e) Totals $71,300 (f) Accounts Receivable

$15,000 Accounts Payable $7,800

(h) Totals $71,500

Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Problem Set C.

Jan. 3 Sell merchandise on account to B. Remy $3,100, invoice no. 510, and J. Fine $1,800, invoice no. 511.

5 Purchase merchandise on account from S. Yost $3,000 and D. Laux $2,700. 7 Receive checks for $4,000 from S. Ingles and $2,000 from B. Hachinski. 8 Pay freight on merchandise purchased $180. 9 Send checks to S. Kosko for $9,000 and D. Moreno for $11,000. 9 Issue credit of $300 to J. Fine for merchandise returned.

10 Summary cash sales total $15,500. 11 Sell merchandise on account to R. Draves for $1,900, invoice no. 512, and to S. Ingles

$900, invoice no. 513. Post all entries to the subsidiary ledgers.

12 Pay rent of $1,000 for January. 13 Receive payment in full from B. Remy and J. Fine. 15 Pay cash dividend of $800. 16 Purchase merchandise on account from D. Moreno for $15,000, from S. Kosko for

$13,900, and from S. Yost for $1,500. 17 Pay $400 cash for office supplies. 18 Return $200 of merchandise to S. Kosko and receive credit. 20 Summary cash sales total $17,500. 21 Issue $15,000 note to R. Mikush in payment of balance due. 21 Receive payment in full from S. Ingles.

Post all entries to the subsidiary ledgers. 22 Sell merchandise on account to B. Remy for $3,700, invoice no. 514, and to R. Draves for

$800, invoice no. 515. 23 Send checks to D. Moreno and S. Kosko in full payment. 25 Sell merchandise on account to B. Hachinski for $3,500, invoice no. 516, and to J. Fine

for $6,100, invoice no. 517. 27 Purchase merchandise on account from D. Moreno for $12,500, from D. Laux for $1,200,

and from S. Yost for $2,800. 28 Pay $200 cash for office supplies. 31 Summary cash sales total $22,920. 31 Pay sales salaries of $4,300 and office salaries of $3,600.

E34 Appendix E Subsidiary Ledgers and Special Journals

General Ledger Account January 1 Number Account Title Opening Balance

101 Cash $33,750 112 Accounts Receivable 13,000 115 Notes Receivable 39,000 120 Merchandise Inventory 20,000 125 Office Supplies 1,000 130 Prepaid Insurance 2,000 157 Equipment 6,450 158 Accumulated Depreciation 1,500 201 Accounts Payable 35,000 311 Common Stock 70,000 320 Retained Earnings 8,700

Accounts Payable Subsidiary Ledger January 1 Opening

Creditor Balance S. Kosko $ 9,000 R. Mikush 15,000 D. Moreno 11,000

Accounts Receivable Subsidiary Ledger January 1 Opening

Customer Balance R. Draves $1,500 B. Hachinski 7,500 S. Ingles 4,000

Instructions (a) Record the January transactions in the appropriate journal—sales, purchases, cash receipts,

cash payments, and general. (b) Post the journals to the general and subsidiary ledgers. Add and number new accounts in an

orderly fashion as needed. (c) Prepare a trial balance at January 31, 2008, using a worksheet. Complete the worksheet using

the following additional information. (1) Office supplies at January 31 total $700. (2) Insurance coverage expires on October 31, 2008. (3) Annual depreciation on the equipment is $1,500. (4) Interest of $30 has accrued on the note payable. (5) Merchandise inventory at January 31 is $15,000.

(d) Prepare a multiple-step income statement and a retained earnings statement for January and a classified balance sheet at the end of January.

(e) Prepare and post the adjusting and closing entries. (f) Prepare a post-closing trial balance, and determine whether the subsidiary ledgers agree with

the control accounts in the general ledger.

Broadening Your Perspective E35

(c) Trial balance totals $196,820; Adj. T/B totals $196,975

(d) Net income $9,685 Total assets $126,315

(f) Post-closing T/B totals $127,940

B R O A D E N I N G Y O U R P E R S P E C T I V E FINANCIAL REPORTING AND ANALYSIS

Financial Reporting Problem—Mini Practice Set BYPE-1 (You will need the working papers that accompany this textbook in order to work this mini practice set.) Bluma Co. uses a perpetual inventory system and both an accounts receivable and an accounts payable subsidiary ledger. Balances related to both the general ledger and the subsidiary ledger for Bluma are indicated in the working papers. Presented below are a series of transactions for Bluma Co. for the month of January. Credit sales terms are 2/10, n/30. The cost of all merchan- dise sold was 60% of the sales price.

Jan. 3 Sell merchandise on account to B. Richey $3,100, invoice no. 510, and to J. Forbes $1,800, invoice no. 511.

5 Purchase merchandise from S. Vogel $5,000 and D. Lynch $2,200, terms n/30. 7 Receive checks from S. LaDew $4,000 and B. Garcia $2,000 after discount period has lapsed. 8 Pay freight on merchandise purchased $235. 9 Send checks to S. Hoyt for $9,000 less 2% cash discount, and to D. Omara for $11,000

less 1% cash discount. 9 Issue credit of $300 to J. Forbes for merchandise returned.

10 Summary daily cash sales total $15,500. 11 Sell merchandise on account to R. Dvorak $1,600, invoice no. 512, and to S. LaDew

$900, invoice no. 513. 12 Pay rent of $1,000 for January. 13 Receive payment in full from B. Richey and J. Forbes less cash discounts. 14 Pay an $800 cash dividend. 15 Post all entries to the subsidiary ledgers. 16 Purchase merchandise from D. Omara $18,000, terms 1/10, n/30; S. Hoyt $14,200, terms

2/10, n/30; and S. Vogel $1,500, terms n/30. 17 Pay $400 cash for office supplies. 18 Return $200 of merchandise to S. Hoyt and receive credit. 20 Summary daily cash sales total $20,100. 21 Issue $15,000 note, maturing in 90 days, to R. Moses in payment of balance due. 21 Receive payment in full from S. LaDew less cash discount. 22 Sell merchandise on account to B. Richey $2,700, invoice no. 514, and to R. Dvorak

$1,300, invoice no. 515. 22 Post all entries to the subsidiary ledgers.

23 Send checks to D. Omara and S. Hoyt in full payment less cash discounts. 25 Sell merchandise on account to B. Garcia $3,500, invoice no. 516, and to J. Forbes $6,100,

invoice no. 517. 27 Purchase merchandise from D. Omara $14,500, terms 1/10, n/30; D. Lynch $1,200, terms

n/30; and S. Vogel $5,400, terms n/30. 27 Post all entries to the subsidiary ledgers. 28 Pay $200 cash for office supplies. 31 Summary daily cash sales total $21,300. 31 Pay sales salaries $4,300 and office salaries $3,800.

Instructions (a) Record the January transactions in a sales journal, a single-column purchases journal, a cash

receipts journal as shown on page E8, a cash payments journal as shown on page E14, and a two-column general journal.

(b) Post the journals to the general ledger. (c) Prepare a trial balance at January 31, 2008, in the trial balance columns of the worksheet.

Complete the worksheet using the following additional information. (1) Office supplies at January 31 total $900. (2) Insurance coverage expires on October 31, 2008. (3) Annual depreciation on the equipment is $1,500. (4) Interest of $50 has accrued on the note payable.

(d) Prepare a multiple-step income statement and a retained earnings statement for January and a classified balance sheet at the end of January.

(e) Prepare and post adjusting and closing entries. (f) Prepare a post-closing trial balance, and determine whether the subsidiary ledgers agree with

the control accounts in the general ledger.

Exploring the Web BYPE-2 Great Plains’ Accounting is one of the leading accounting software packages. Infor- mation related to this package is found at its website.

Address: www.microsoft.com/dynamics/gp/product/demos.mspx, or go to www.wiley.com/college/weygandt

Steps 1. Go to the site shown above. 2. Choose General Ledger. Perform instruction (a). 3. Choose Accounts Payable. Perform instruction (b).

Instructions (a) What are three key features of the general ledger module highlighted by the company? (b) What are three key features of the payables management module highlighted by the company?

E36 Appendix E Subsidiary Ledgers and Special Journals

CRITICAL THINKING Decision Making Across the Organization BYPE-3 Hughey & Payne is a wholesaler of small appliances and parts. Hughey & Payne is operated by two owners, Rich Hughey and Kristen Payne. In addition, the company has one employee, a repair specialist, who is on a fixed salary. Revenues are earned through the sale of appliances to retailers (approximately 75% of total revenues), appliance parts to do-it-yourselfers (10%), and the repair of appliances brought to the store (15%). Appliance sales are made on both a credit and cash basis. Customers are billed on prenumbered sales invoices. Credit terms are always net/30 days. All parts sales and repair work are cash only.

Merchandise is purchased on account from the manufacturers of both the appliances and the parts. Practically all suppliers offer cash discounts for prompt payments, and it is company policy to take all discounts. Most cash payments are made by check. Checks are most fre- quently issued to suppliers, to trucking companies for freight on merchandise purchases, and to newspapers, radio, and TV stations for advertising. All advertising bills are paid as received.

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Rich and Kristen each make a monthly drawing in cash for personal living expenses. The salaried repairman is paid twice monthly. Hughey & Payne currently has a manual account- ing system.

Instructions With the class divided into groups, answer the following.

(a) Identify the special journals that Hughey & Payne should have in its manual system. List the column headings appropriate for each of the special journals.

(b) What control and subsidiary accounts should be included in Hughey & Payne manual system? Why?

Communication Activity BYPE-4 Barb Doane, a classmate, has a part-time bookkeeping job. She is concerned about the inefficiencies in journalizing and posting transactions. Jim Houser is the owner of the com- pany where Barb works. In response to numerous complaints from Barb and others, Jim hired two additional bookkeepers a month ago. However, the inefficiencies have continued at an even higher rate. The accounting information system for the company has only a general journal and a general ledger. Jim refuses to install an electronic accounting system.

Instructions Now that Barb is an expert in manual accounting information systems, she decides to send a letter to Jim Houser explaining (1) why the additional personnel did not help and (2) what changes should be made to improve the efficiency of the accounting department. Write the let- ter that you think Barb should send.

Ethics Case BYPE-5 Roniger Products Company operates three divisions, each with its own manufactur- ing plant and marketing/sales force. The corporate headquarters and central accounting office are in Roniger, and the plants are in Freeport, Rockport, and Bayport, all within 50 miles of Roniger. Corporate management treats each division as an independent profit center and en- courages competition among them. They each have similar but different product lines. As a com- petitive incentive, bonuses are awarded each year to the employees of the fastest growing and most profitable division.

Jose Molina is the manager of Roniger’s centralized computer accounting operation that enters the sales transactions and maintains the accounts receivable for all three divisions. Jose came up in the accounting ranks from the Bayport division where his wife, several relatives, and many friends still work.

As sales documents are entered into the computer, the originating division is identified by code. Most sales documents (95%) are coded, but some (5%) are not coded or are coded incorrectly. As the manager, Jose has instructed the data-entry personnel to assign the Bayport code to all uncoded and incorrectly coded sales documents. This is done he says, “in order to expedite processing and to keep the computer files current since they are updated daily.” All receivables and cash collections for all three divisions are handled by Roniger as one subsidiary accounts receivable ledger.

Instructions (a) Who are the stakeholders in this situation? (b) What are the ethical issues in this case? (c) How might the system be improved to prevent this situation?

Answers to Self-Study Questions 1. a 2. c 3. a 4. c 5. d 6. b 7. c 8. c

Broadening Your Perspective E37

F1

Other Significant Liabilities

Appendix F

In addition to the current and long-term liabilities discussed in Chapter 11, several more types of liabilities may exist that could have a significant impact on a com- pany’s financial position and future cash flows. These other significant liabilities will be discussed in this appendix. They are: (a) contingent liabilities, (b) lease lia- bilities, and (c) additional liabilities for employee fringe benefits (paid absences and postretirement benefits).

After studying this appendix, you should be able to: 1. Describe the accounting and disclosure requirements for

contingent liabilities. 2. Contrast the accounting for operating and capital leases. 3. Identify additional fringe benefits associated with employee

compensation.

S T U D Y O B J E C T I V E

CONTINGENT LIABILITIES With notes payable, interest payable, accounts payable, and sales taxes payable, we know that an obligation to make a payment exists. But sup- pose that your company is involved in a dispute with the Internal Revenue Service (IRS) over the amount of its income tax liability. Should you re- port the disputed amount as a liability on the balance sheet? Or suppose your company is involved in a lawsuit which, if you lose, might result in bankruptcy. How should you report this major contingency? The answers to these questions are difficult, because these liabilities are dependent—contingent—upon some future event. In other words, a contingent liability is a potential liability that may become an actual liability in the future.

How should companies report contingent liabilities? They use the following guidelines:

1. If the contingency is probable (if it is likely to occur) and the amount can be reasonably estimated, the liability should be recorded in the accounts.

2. If the contingency is only reasonably possible (if it could happen), then it needs to be disclosed only in the notes that accompany the financial statements.

3. If the contingency is remote (if it is unlikely to occur), it need not be recorded or disclosed.

Recording a Contingent Liability Product warranties are an example of a contingent liability that companies should record in the accounts. Warranty contracts result in future costs that companies may incur in replacing defective units or repairing malfunctioning units. Generally,

Describe the accounting and disclosure requirements for contingent liabilities.

S T U D Y O B J E C T I V E 1

a manufacturer, such as Black & Decker, knows that it will incur some warranty costs. From prior experience with the product, the company usually can reasonably estimate the anticipated cost of servicing (honoring) the warranty.

The accounting for warranty costs is based on the matching principle. The esti- mated cost of honoring product warranty contracts should be recognized as an ex- pense in the period in which the sale occurs. To illustrate, assume that in 2008 Denson Manufacturing Company sells 10,000 washers and dryers at an average price of $600 each. The selling price includes a one-year warranty on parts. Denson expects that 500 units (5%) will be defective and that warranty repair costs will av- erage $80 per unit. In 2008, the company honors warranty contracts on 300 units, at a total cost of $24,000.

At December 31, it is necessary to accrue the estimated warranty costs on the 2008 sales. Denson computes the estimated warranty liability as follows.

F2 Appendix F Other Significant Liabilities

Number of units sold 10,000 Estimated rate of defective units � 5%

Total estimated defective units 500 Average warranty repair cost � $80

Estimated product warranty liability $40,000

Illustration F-1 Computation of estimated product warranty liability

The company makes the following adjusting entry.

Dec. 31 Warranty Expense 40,000 Estimated Warranty Liability 40,000

(To accrue estimated warranty costs)

Denson records those repair costs incurred in 2008 to honor warranty contracts on 2008 sales as shown below.

Jan. 1� Estimated Warranty Liability 24,000 Dec. 31 Repair Parts 24,000

(To record honoring of 300 warranty contracts on 2008 sales)

The company reports warranty expense of $40,000 under selling expenses in the income statement. It classifies estimated warranty liability of $16,000 ($40,000 � $24,000) as a current liability on the balance sheet.

In the following year, Denson should debit to Estimated Warranty Liability all expenses incurred in honoring warranty contracts on 2008 sales. To illustrate, assume that the company replaces 20 defective units in January 2009, at an aver- age cost of $80 in parts and labor. The summary entry for the month of January 2009 is:

Jan. 31 Estimated Warranty Liability 1,600 Repair Parts 1,600

(To record honoring of 20 warranty contracts on 2008 sales)

Disclosure of Contingent Liabilities When it is probable that a company will incur a contingent liability but it cannot reasonably estimate the amount, or when the contingent liability is only reasonably possible, only disclosure of the contingency is required. Examples of contingencies

Cash Flows no effect

A � L � SE �40,000 Exp

�40,000

Cash Flows no effect

A � L � SE �24,000

�24,000

Cash Flows no effect

A � L � SE �1,600

�1,600

that may require disclosure are pending or threatened lawsuits and assessment of additional income taxes pending an IRS audit of the tax return.

The disclosure should identify the nature of the item and, if known, the amount of the contingency and the expected outcome of the future event. Disclosure is usu- ally accomplished through a note to the financial statements, as illustrated by the following.

Lease Liabilities F3

The required disclosure for contingencies is a good example of the use of the full-disclosure principle. The full-disclosure principle requires that companies dis- close all circumstances and events that would make a difference to financial state- ment users. Some important financial information, such as contingencies, is not eas- ily reported in the financial statements. Reporting information on contingencies in the notes to the financial statements will help investors be aware of events that can affect the financial health of a company.

YAHOO! INC. Notes to the Financial Statements

Contingencies. From time to time, third parties assert patent infringement claims against the company. Currently the company is engaged in several lawsuits regarding patent issues and has been notified of a number of other potential patent disputes. In addition, from time to time the company is subject to other legal proceedings and claims in the ordinary course of business, including claims for infringement of trademarks, copyrights and other intellectual property rights.... The Company does not believe, based on current knowledge, that any of the foregoing legal proceedings or claims are likely to have a material adverse effect on the financial position, results of operations or cash flows.

Illustration F-2 Disclosure of contingent liability

LEASE LIABILITIES A lease is a contractual arrangement between a lessor (owner of a property) and a lessee (renter of the property). It grants the right to use specific property for a period of time in return for cash payments. Leasing is big business. U.S. companies leased an estimated $125 billion of capital equip- ment in a recent year. This represents approximately one-third of equipment financed that year. The two most common types of leases are operating leases and capital leases.

Operating Leases The renting of an apartment and the rental of a car at an airport are examples of operating leases. In an operating lease the intent is temporary use of the property by the lessee, while the lessor continues to own the property.

In an operating lease, the lessee records the lease (or rental) payments as an expense. The lessor records the payments as revenue. For example, assume that a sales representative for Western Inc. leases a car from Hertz Car Rental at the Los Angeles airport and that Hertz charges a total of $275. Western, the lessee, records the rental as follows:

Car Rental Expense 275 Cash 275

(To record payment of lease rental charge)

Contrast the accounting for operating and capital leases.

S T U D Y O B J E C T I V E 2

A � L � SE �275 Exp

�275

Cash Flows �275

The lessee may incur other costs during the lease period. For example, in the case above, Western will generally incur costs for gas. Western would report these costs as an expense.

Capital Leases In most lease contracts, the lessee makes a periodic payment and records that payment in the income statement as rent expense. In some cases, however, the lease contract transfers to the lessee substantially all the benefits and risks of ownership. Such a lease is in effect a purchase of the property. This type of lease is a capital lease. Its name comes from the fact that the company capitalizes the present value of the cash payments for the lease and records that amount as an asset. Illustration F-3 indicates the major difference between operating and capital leases.

F4 Appendix F Other Significant Liabilities

If any one of the following conditions exists, the lessee must record a lease as an asset—that is, as a capital lease:

1. The lease transfers ownership of the property to the lessee. Rationale: If during the lease term the lessee receives ownership of the asset, the lessee should re- port the leased asset as an asset on its books.

2. The lease contains a bargain purchase option. Rationale: If during the term of the lease the lessee can purchase the asset at a price substantially below its fair market value, the lessee will exercise this option. Thus, the lessee should report the lease as a leased asset on its books.

3. The lease term is equal to 75% or more of the economic life of the leased prop- erty. Rationale: If the lease term is for much of the asset’s useful life, the lessee should report the asset as a leased asset on its books.

4. The present value of the lease payments equals or exceeds 90% of the fair mar- ket value of the leased property. Rationale: If the present value of the lease payments is equal to or almost equal to the fair market value of the asset, the lessee has essentially purchased the asset. As a result, the lessee should report the leased asset as an asset on its books.

H E L P F U L H I N T A capital lease situation is one that, although legally a rental case, is in substance an installment purchase by the lessee. Accounting standards re- quire that substance over form be used in such a situation.

Illustration F-3 Types of leases

Operating lease

Lessee has substantially all of the benefits and risks of ownership

Capital lease

“Have it back by 6:00 Sunday.”

“OK!”

Lessor has substantially all of the benefits and risks of ownership

“Only 3 more payments and this baby

is ours!”

To illustrate, assume that Gonzalez Company decides to lease new equipment. The lease period is four years; the economic life of the leased equipment is esti- mated to be five years. The present value of the lease payments is $190,000, which is equal to the fair market value of the equipment. There is no transfer of owner- ship during the lease term, nor is there any bargain purchase option.

In this example, Gonzalez has essentially purchased the equipment. Conditions 3 and 4 have been met. First, the lease term is 75% or more of the economic life of the asset. Second, the present value of cash payments is equal to the equipment’s fair market value. Gonzalez records the transaction as follows.

Leased Asset—Equipment 190,000 Lease Liability 190,000

(To record leased asset and lease liability)

The lessee reports a leased asset on the balance sheet under plant assets. It re- ports the lease liability on the balance sheet as a liability. The portion of the lease liability expected to be paid in the next year is a current liability. The remainder is classified as a long-term liability.

Most lessees do not like to report leases on their balance sheets. Why? Because the lease liability increases the company’s total liabilities. This, in turn, may make it more difficult for the company to obtain needed funds from lenders. As a result, companies attempt to keep leased assets and lease liabilities off the balance sheet by structuring leases so as not to meet any of the four conditions mentioned on page F4. The practice of keeping liabilities off the balance sheet is referred to as off-balance-sheet financing.

Additional Liabilities for Employee Fringe Benefits F5

E T H I C S N O T E

Accounting standard setters are attempting to rewrite

rules on lease accounting because of concerns that abuse of the cur- rent standards is reducing the usefulness of financial statements.

A � L � SE �190,000

�190,000

Cash Flows no effect

ADDITIONAL LIABILITIES FOR EMPLOYEE FRINGE BENEFITS

In addition to the three payroll tax fringe benefits discussed in Appendix D (FICA taxes and state and federal unemployment taxes), employers in- cur other substantial fringe benefit costs. Indeed, fringe benefits have been growing faster than pay. In a recent year, benefits equaled 38 percent of wages and salaries. While vacations and other forms of paid leave still take the biggest bite out of the benefits pie, as shown in Illustration F-4, medical costs are the fastest-growing item.

Illustration F-4 The fringe benefits pieBENEFITS

3% Disability and life insurance

23% Legally required benefits such as Social Security

24% Medical benefits

37% Vacation and other benefits such as parental and sick leaves, child care

13% Retirement income such as pensions

We discuss two of the most important fringe benefits—paid absences and postretirement benefits—in this section.

Identify additional fringe benefits associated with employee compensation.

S T U D Y O B J E C T I V E 3

Paid Absences Employees often are given rights to receive compensation for absences when cer- tain conditions of employment are met. The compensation may be for paid vaca- tions, sick pay benefits, and paid holidays. When the payment for such absences is probable and the amount can be reasonably estimated, a liability should be ac- crued for paid future absences. When the amount cannot be reasonably estimated, companies should instead disclose the potential liability. Ordinarily, vacation pay is the only paid absence that is accrued. The other types of paid absences are only disclosed.1

To illustrate, assume that Academy Company employees are entitled to one day’s vacation for each month worked. If 30 employees earn an average of $110 per day in a given month, the accrual for vacation benefits in one month is $3,300. The liability is recognized at the end of the month by the following adjusting entry.

Jan. 31 Vacation Benefits Expense 3,300 Vacation Benefits Payable 3,300

(To accrue vacation benefits expense)

This accrual is required by the matching principle. Academy would report Vacation Benefits Expense as an operating expense in the income statement, and Vacation Benefits Payable as a current liability in the balance sheet.

Later, when Academy pays vacation benefits, it debits Vacation Benefits Payable and credits Cash. For example, if the above benefits for 10 employees are paid in July, the entry is:

July 31 Vacation Benefits Payable 1,100 Cash 1,100

(To record payment of vacation benefits)

The magnitude of unpaid absences has gained employers’ attention. Consider the case of an assistant superintendent of schools who worked for 20 years and rarely took a vacation or sick day. A month or so before she retired, the school dis- trict discovered that she was due nearly $30,000 in accrued benefits. Yet the school district had never accrued the liability.

Postretirement Benefits Postretirement benefits are benefits provided by employers to retired employees for (1) health care and life insurance and (2) pensions. For many years the accounting for postretirement benefits was on a cash basis. Companies now ac- count for both types of postretirement benefits on the accrual basis. The cost of postretirement benefits is getting steep. For example, General Motor’s pension and health-care costs for retirees in a recent year totaled $6.2 billion, or approximately $1,784 per vehicle produced.

The average American has debt of approximately $10,000 (not counting the mortgage on their home) and has little in the way of savings. What will happen at retirement for these people? The picture is not pretty—people are living longer, the future of Social Security is unclear, and companies are cutting back on post- retirement benefits. This situation may lead to one of the great social and moral dilemmas this country faces in the next 40 years. The more you know about post-

F6 Appendix F Other Significant Liabilities

A � L � SE �3,300 Exp

�3,300

A � L � SE �1,100

�1,100

Cash Flows �1,100

Cash Flows no effect

1 The typical U.S. company provides an average of 12 days of paid vacation for its employees, at an

average cost of 5% of gross earnings.

retirement benefits, the better you will understand the issues involved in this dilemma.

POSTRETIREMENT HEALTH-CARE AND LIFE INSURANCE BENEFITS Providing medical and related health-care benefits for retirees was at one time an inexpensive and highly effective way of generating employee goodwill. This prac- tice has now turned into one of corporate America’s most worrisome financial problems. Runaway medical costs, early retirement, and increased longevity are sending the liability for retiree health plans through the roof.

Many companies began offering retiree health-care coverage in the form of Medicare supplements in the 1960s. Almost all plans operated on a pay-as-you-go basis. The companies simply paid for the bills as they came in, rather than setting aside funds to meet the cost of future benefits. These plans were accounted for on the cash basis. But, the FASB concluded that shareholders and creditors should know the amount of the employer’s obligations. As a result, employers must now use the accrual basis in accounting for postretirement health-care and life insur- ance benefits.

PENSION PLANS A pension plan is an agreement whereby an employer provides benefits (pay- ments) to employees after they retire. Over 50 million workers currently partici- pate in pension plans in the United States. The need for good accounting for pen- sion plans becomes apparent when one appreciates the size of existing pension funds. Most pension plans are subject to the provisions of ERISA (Employee Retirement Income Security Act), a law enacted to curb abuses in the administra- tion and funding of such plans.

Three parties are generally involved in a pension plan. The employer (com- pany) sponsors the pension plan. The plan administrator receives the contributions from the employer, invests the pension assets, and makes the benefit payments to the pension recipients (retired employees). Illustration F-5 indicates the flow of cash among the three parties involved in a pension plan.

Additional Liabilities for Employee Fringe Benefits F7

Illustration F-5 Parties in a pension plan

Contributions Benefits

Fund Assets: Investments and Earnings

Employer Plan Administrator Pension Recipients

Kear Trust Co.

An employer-financed pension is part of the employees’ compensation. ERISA establishes the minimum contribution that a company must make each year toward employee pensions. The most popular type of pension plan used is the 401(k) plan. A 401(k) plan works as follows: As an employee, you can contribute up to a certain percentage of your pay into a 401(k) plan, and your employer will match a percentage of your contribution. These contributions are then generally invested in stocks and bonds through mutual funds. These funds will grow without being taxed and can be withdrawn beginning at age 59-1/2. If you must access the funds earlier, you may be able to do so, but a penalty usually occurs along with a payment of tax

on the proceeds. Any time you have the opportunity to be involved in a 401(k) plan, you should avail yourself of this benefit!

Companies record pension costs as an expense while the employees are work- ing because that is when the company receives benefits from the employees’ serv- ices. Generally the pension expense is reported as an operating expense in the company’s income statement. Frequently, the amount contributed by the company to the pension plan is different from the amount of the pension expense. A liability is recognized when the pension expense to date is more than the company’s con- tributions to date. An asset is recognized when the pension expense to date is less than the company’s contributions to date. Further consideration of the accounting for pension plans is left for more advanced courses.

The two most common types of pension arrangements for providing benefits to employees after they retire are defined-contribution plans and defined-benefit plans.

Defined-Contribution Plan. In a defined-contribution plan, the plan defines the employer’s contribution but not the benefit that the employee will receive at re- tirement. That is, the employer agrees to contribute a certain sum each period based on a formula. A 401(k) plan is typically a defined-contribution plan.

The accounting for a defined-contribution plan is straightforward: The em- ployer simply makes a contribution each year based on the formula established in the plan. As a result, the employer’s obligation is easily determined. It follows that the company reports the amount of the contribution required each period as pen- sion expense. The employer reports a liability only if it has not made the contribu- tion in full.

To illustrate, assume that Alba Office Interiors Corp. has a defined-contribution plan in which it contributes $200,000 each year to the pension fund for its employees. The entry to record this transaction is:

Pension Expense 200,000 Cash 200,000

(To record pension expense and contribution to pension fund)

To the extent that Alba did not contribute the $200,000 defined contribution, it would record a liability. Pension payments to retired employees are made from the pension fund by the plan administrator.

Defined-Benefit Plan. In a defined-benefit plan, the benefits that the employee will receive at the time of retirement are defined by the terms of the plan. Benefits are typically calculated using a formula that considers an employee’s compensation level when he or she nears retirement and the employee’s years of service. Because the benefits in this plan are defined in terms of uncertain future variables, an ap- propriate funding pattern is established to ensure that enough funds are available at retirement to meet the benefits promised. This funding level depends on a num- ber of factors such as employee turnover, length of service, mortality, compensation levels, and investment earnings. The proper accounting for these plans is complex and is considered in more advanced accounting courses.

POSTRETIREMENT BENEFITS AS LONG-TERM LIABILITIES While part of the liability associated with (1) postretirement health-care and life in- surance benefits and (2) pension plans is generally a current liability, the greater portion of these liabilities extends many years into the future. Therefore, many companies are required to report significant amounts as long-term liabilities for postretirement benefits.

F8 Appendix F Other Significant Liabilities

A � L � SE �200,000

�200,000

Cash Flows �200,000

1 Describe the accounting and disclosure requirements for contingent liabilities. If it is probable that the contin- gency will happen (if it is likely to occur) and the amount can be reasonably estimated, the liability should be recorded in the accounts. If the contingency is only reason- ably possible (it could occur), then it should be disclosed only in the notes to the financial statements. If the possibil- ity that the contingency will happen is remote (unlikely to occur), it need not be recorded or disclosed.

2 Contrast the accounting for operating and capital leases. For an operating lease, lease (or rental) payments

Self-Study Questions F9

REVIEW IT 1. What is a contingent liability? 2. How are contingent liabilities reported in financial statements? 3. What accounts are involved in accruing and paying vacation benefits? 4. What basis should be used in accounting for postretirement benefits?

Before You Go On...

SUMMARY OF STUDY OBJECTIVES are recorded as an expense by the lessee (renter). For a capital lease, the lessee records the asset and related obli- gation at the present value of the future lease payments.

3 Identify additional fringe benefits associated with em- ployee compensation. Additional fringe benefits associ- ated with wages are paid absences (paid vacations, sick pay benefits, and paid holidays), postretirement health care and life insurance, and pensions. The two most common types of pension arrangements are a defined-contribution plan and a defined-benefit plan.

GLOSSARY Capital lease A contractual arrangement that transfers

substantially all the benefits and risks of ownership to the lessee so that the lease is in effect a purchase of the prop- erty. (p. F4).

Contingent liability A potential liability that may become an actual liability in the future. (p. F1).

Defined-benefit plan A pension plan in which the bene- fits that the employee will receive at retirement are defined by the terms of the plan. (p. F8).

Defined-contribution plan A pension plan in which the employer’s contribution to the plan is defined by the terms of the plan. (p. F8).

Lease A contractual arrangement between a lessor (owner of a property) and a lessee (renter of the property). (p. F3).

Operating lease A contractual arrangement giving the les- see temporary use of the property, with continued owner- ship of the property by the lessor. (p. F3).

Pension plan An agreement whereby an employer provides benefits to employees after they retire. (p. F7).

Postretirement benefits Payments by employers to retired employees for health care, life insurance, and pensions. (p. F6).

SELF-STUDY QUESTIONS Answers are at the end of the appendix.

1. A contingency should be recorded in the accounts when: a. It is probable the contingency will happen but the

amount cannot be reasonably estimated. b. It is reasonably possible the contingency will happen

and the amount can be reasonably estimated. c. It is reasonably possible the contingency will happen

but the amount cannot be reasonably estimated. d. It is probable the contingency will happen and the

amount can be reasonably estimated.

2. At December 31, Anthony Company prepares an adjust- ing entry for a product warranty contract. Which of the following accounts are included in the entry? a. Warranty Expense. b. Estimated Warranty Liability. c. Repair Parts/Wages Payable. d. Both (a) and (b).

3. Lease A does not contain a bargain purchase option, but the lease term is equal to 90 percent of the estimated economic life of the leased property. Lease B does not

(SO 1)

(SO 1)

(SO 2)

transfer ownership of the property to the lessee by the end of the lease term, but the lease term is equal to 75 percent of the estimated economic life of the lease property. How should the lessee classify these leases?

Lease A Lease B

a. Operating lease Capital lease b. Operating lease Operating lease c. Capital lease Capital lease d. Capital lease Operating lease

4. Which of the following is not an additional fringe benefit? a. Salaries. b. Paid absences. c. Paid vacations. d. Postretirement pensions.

F10 Appendix F Other Significant Liabilities

(SO 3)

QUESTIONS 1. What is a contingent liability? Give an example of a con-

tingent liability that is usually recorded in the accounts. 2. Under what circumstances is a contingent liability dis-

closed only in the notes to the financial statements? Under what circumstances is a contingent liability not recorded in the accounts nor disclosed in the notes to the financial statements?

3. (a) What is a lease agreement? (b) What are the two most common types of leases? (c) Distinguish between the two types of leases.

4. Orbison Company rents a warehouse on a month-to- month basis for the storage of its excess inventory. The company periodically must rent space when its production greatly exceeds actual sales. What is the nature of this type of lease agreement, and what accounting treatment should be accorded it?

5. Costello Company entered into an agreement to lease 12 computers from Estes Electronics Inc. The present value of the lease payments is $186,300. Assuming that this is a capital lease, what entry would Costello Company make on the date of the lease agreement?

6. Identify three additional types of fringe benefits associ- ated with employees’ compensation.

7. Often during job interviews, the candidate asks the poten- tial employer about the firm’s paid absences policy. What are paid absences? How are they accounted for?

8. What are the two types of postretirement benefits? During what years does the FASB advocate expensing the employer’s costs of these postretirement benefits?

9. What basis of accounting for the employer’s cost of postretirement health-care and life insurance benefits has been used by most companies, and what basis does the FASB advocate in the future? Explain the basic difference between these methods in recognizing postretirement benefit costs.

10. Identify the three parties in a pension plan. What role does each party have in the plan?

11. Brenna Ottare and Caitlin Wilkes are reviewing pension plans. They ask your help in distinguishing between a defined-contribution plan and a defined-benefit plan. Explain the principal difference to Brenna and Caitlin.

Go to the book’s website, www.wiley.com/college/weygandt, for Additional Self-Study questions.

BRIEF EXERCISES BEF-1 On December 1, Vina Company introduces a new product that includes a 1-year war- ranty on parts. In December 1,000 units are sold. Management believes that 5% of the units will be defective and that the average warranty costs will be $60 per unit. Prepare the adjusting entry at December 31 to accrue the estimated warranty cost.

BEF-2 Prepare the journal entries that the lessee should make to record the following transactions.

1. The lessee makes a lease payment of $80,000 to the lessor in an operating lease transaction. 2. Zander Company leases a new building from Joel Construction, Inc. The present value of the

lease payments is $900,000. The lease qualifies as a capital lease.

BEF-3 In Alomar Company, employees are entitled to 1 day’s vacation for each month worked. In January, 50 employees worked the full month. Record the vacation pay liability for January assuming the average daily pay for each employee is $120.

Record estimated vacation benefits.

(SO 3)

Prepare entries for operating and capital leases.

(SO 2)

Prepare adjusting entry for warranty costs.

(SO 1)

Exercises: Set B F11

EXERCISES EF-1 Boone Company sells automatic can openers under a 75-day warranty for defective mer- chandise. Based on past experience, Boone Company estimates that 3% of the units sold will become defective during the warranty period. Management estimates that the average cost of replacing or repairing a defective unit is $15. The units sold and units defective that occurred during the last 2 months of 2006 are as follows.

Units Units Defective Month Sold Prior to December 31

November 30,000 600 December 32,000 400

Instructions (a) Determine the estimated warranty liability at December 31 for the units sold in November

and December. (b) Prepare the journal entries to record the estimated liability for warranties and the costs (assume

actual costs of $15,000) incurred in honoring 1,000 warranty claims. (c) Give the entry to record the honoring of 500 warranty contracts in January at an average cost

of $15.

EF-2 Larkin Online Company has the following liability accounts after posting adjusting entries: Accounts Payable $63,000, Unearned Ticket Revenue $24,000, Estimated Warranty Liability $18,000, Interest Payable $8,000, Mortgage Payable $120,000, Notes Payable $80,000, and Sales Taxes Payable $10,000. Assume the company’s operating cycle is less than 1 year, ticket revenue will be earned within 1 year, warranty costs are expected to be incurred within 1 year, and the notes mature in 3 years.

Instructions (a) Prepare the current liabilities section of the balance sheet, assuming $40,000 of the mortgage

is payable next year. (b) Comment on Larkin Online Company’s liquidity, assuming total current assets are

$300,000.

EF-3 Presented below are two independent situations.

1. Speedy Car Rental leased a car to Rundgren Company for 1 year. Terms of the operating lease agreement call for monthly payments of $500.

2. On January 1, 2008, Miles Inc. entered into an agreement to lease 20 computers from Halo Electronics. The terms of the lease agreement require three annual rental payments of $40,000 (including 10% interest) beginning December 31, 2008. The present value of the three rental payments is $99,474. Miles considers this a capital lease.

Instructions (a) Prepare the appropriate journal entry to be made by Rundgren Company for the first lease

payment. (b) Prepare the journal entry to record the lease agreement on the books of Miles Inc. on

January 1, 2008.

EF-4 Bunill Company has two fringe benefit plans for its employees: 1. It grants employees 2 days’ vacation for each month worked. Ten employees worked the

entire month of March at an average daily wage of $80 per employee. 2. It has a defined contribution pension plan in which the company contributes 10% of

gross earnings. Gross earnings in March were $30,000. The payment to the pension fund has not been made.

Instructions Prepare the adjusting entries at March 31.

Record estimated liability and expense for warranties.

(SO 1)

Prepare the current liabilities section of the balance sheet.

(SO 1)

Prepare journal entries for op- erating lease and capital lease.

(SO 2)

Prepare adjusting entries for fringe benefits.

(SO 3)

EXERCISES: SET B Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Exercise Set B.

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PF-1A On January 1, 2008, the ledger of Shumway Software Company contains the following liability accounts.

Accounts Payable $42,500 Sales Taxes Payable 5,800 Unearned Service Revenue 15,000

During January the following selected transactions occurred.

Jan. 1 Borrowed $15,000 in cash from Amsterdam Bank on a 4-month, 8%, $15,000 note. 5 Sold merchandise for cash totaling $10,400 which includes 4% sales taxes.

12 Provided services for customers who had made advance payments of $9,000. (Credit Service Revenue.)

14 Paid state treasurer’s department for sales taxes collected in December 2007 ($5,800). 20 Sold 700 units of a new product on credit at $52 per unit, plus 4% sales tax. This new

product is subject to a 1-year warranty. 25 Sold merchandise for cash totaling $12,480, which includes 4% sales taxes.

Instructions (a) Journalize the January transactions. (b) Journalize the adjusting entries at January 31 for (1) the outstanding notes payable, and (2)

estimated warranty liability, assuming warranty costs are expected to equal 5% of sales of the new product.

(c) Prepare the current liabilities section of the balance sheet at January 31, 2008. Assume no change in accounts payable.

PF-2A Presented below are three different lease transactions in which Ortiz Enterprises engaged in 2008. Assume that all lease transactions start on January 1, 2008. In no case does Ortiz receive title to the properties leased during or at the end of the lease term.

Lessor

Schoen Inc. Casey Co. Lester Inc. Type of property Bulldozer Truck Furniture Bargain purchase option None None None Lease term 4 years 6 years 3 years Estimated economic life 8 years 7 years 5 years Yearly rental $13,000 $15,000 $4,000 Fair market value of leased

asset $80,000 $72,000 $27,500 Present value of the lease

rental payments $48,000 $62,000 $12,000

Instructions (a) Identify the leases above as operating or capital leases. Explain. (b) How should the lease transaction with Casey Co. be recorded on January 1, 2008? (c) How should the lease transactions for Lester Inc. be recorded in 2008?

F12 Appendix F Other Significant Liabilities

PROBLEMS: SET A Prepare current liability entries, adjusting entries, and current liabilities section.

(SO 1)

Analyze three different lease situations and prepare journal entries.

(SO 2)

PROBLEMS: SET B PF-1B On January 1, 2008, the ledger of Zaur Company contains the following liability accounts.

Accounts Payable $52,000 Sales Taxes Payable 7,700 Unearned Service Revenue 16,000

During January the following selected transactions occurred.

Jan. 5 Sold merchandise for cash totaling $17,280, which includes 8% sales taxes. 12 Provided services for customers who had made advance payments of $10,000.

(Credit Service Revenue.)

Prepare current liability entries, adjusting entries, and current liabilities section.

(SO 1)

14 Paid state revenue department for sales taxes collected in December 2007 ($7,700). 20 Sold 600 units of a new product on credit at $50 per unit, plus 8% sales tax. This new

product is subject to a 1-year warranty. 21 Borrowed $18,000 from UCLA Bank on a 3-month, 9%, $18,000 note. 25 Sold merchandise for cash totaling $12,420, which includes 8% sales taxes.

Instructions (a) Journalize the January transactions. (b) Journalize the adjusting entries at January 31 for (1) the outstanding notes payable, and (2)

estimated warranty liability, assuming warranty costs are expected to equal 7% of sales of the new product. (Hint: Use one-third of a month for the UCLA Bank note.)

(c) Prepare the current liabilities section of the balance sheet at January 31, 2008. Assume no change in accounts payable.

PF-2B Presented below are three different lease transactions that occurred for Milo Inc. in 2008. Assume that all lease contracts start on January 1, 2008. In no case does Milo receive title to the properties leased during or at the end of the lease term.

Lessor

Gibson Delivery Eller Co. Louis Auto

Type of property Computer Delivery equipment Automobile Yearly rental $ 8,000 $ 4,200 $ 3,700 Lease term 6 years 4 years 2 years Estimated economic life 7 years 7 years 5 years Fair market value of leased asset $44,000 $19,000 $11,000 Present value of the lease rental

payments $41,000 $13,000 $6,400 Bargain purchase option None None None

Instructions (a) Which of the leases above are operating leases and which are capital leases? Explain. (b) How should the lease transaction with Eller Co. be recorded in 2008? (c) How should the lease transaction for Gibson Delivery be recorded on January 1, 2008?

Broadening Your Perspective F13

Analyze three different lease situations and prepare journal entries.

(SO 2)

PROBLEMS: SET C Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Problem Set C.

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B R O A D E N I N G Y O U R P E R S P E C T I V E FINANCIAL REPORTING AND ANALYSIS

Financial Reporting Problems BYPF-1 Refer to the financial statements of PepsiCo and the Notes to Consolidated Financial Statements in Appendix A to answer the following questions about contingent liabilities, lease liabilities, and pension costs.

(a) Where does PepsiCo report its contingent liabilities? (b) What is management’s opinion as to the ultimate effect of the “various claims and legal pro-

ceedings” pending against the company? (c) Where did PepsiCo report the details of its lease obligations? What amount of rent expense

from operating leases did PepsiCo incur in 2005? What was PepsiCo’s total future minimum annual rental commitment under noncancelable operating leases as of December 31, 2005?

(d) What type of employee pension plan does PepsiCo have? (e) What is the amount of postretirement benefit expense (other than pensions) for 2005?

BYPF-2 Presented below is the lease portion of the notes to the financial statements of CF In- dustries, Inc.

CF INDUSTRIES, INC. Notes to the Financial Statements

Leases The present value of future minimum capital lease payments and the future minimum lease payments under noncancelable operating leases at December 31, 2006, are:

(in millions) Capital Lease Operating Lease

Payments Payments

2007 $ 7,733 $3,067 2008 6,791 2,052 2009 6,730 1,056 2010 6,788 918 2011 6,785 86 Thereafter 13,441 6

Future minimum lease payments 48,268 $7,185 Less: Equivalent interest 11,391

Present value 36,877 Less: Current portion 5,570

$31,307

Rent expense for operating leases was $7.0 million for the year ended December 31, 2006, $5.3 million for 2005, and $5.6 million for 2004.

Instructions What type of leases does CF Industries, Inc. use? What is the amount of the current portion of the capital lease obligation?

F14 Appendix F Other Significant Liabilities

CRITICAL THINKING Decision Making Across the Organization BYPF-3 Presented below is the condensed balance sheet for Express, Inc. as of December 31, 2008.

EXPRESS, INC. Balance Sheet

December 31, 2008

Current assets $ 800,000 Current liabilities $1,200,000 Plant assets 1,600,000 Long-term liabilities 700,000

Common stock 400,000 Retained earnings 100,000

Total $2,400,000 Total $2,400,000

Express has decided that it needs to purchase a new crane for its operations. The new crane costs $900,000 and has a useful life of 15 years. However, Express’s bank has refused to provide any help in financing the purchase of the new equipment, even though Express is willing to pay an above-market interest rate for the financing.

The chief financial officer for Express, Lisa Colder, has discussed with the manufacturer of the crane the possibility of a lease agreement. After some negotiation, the crane manufacturer agrees to lease the crane to Express under the following terms: length of the lease 7 years; pay- ments $100,000 per year. The present value of the lease payments is $548,732.

The board of directors at Express is delighted with this new lease. They reason they have the use of the crane for the next 7 years. In addition, Lisa Colder notes that this type of fi- nancing is a good deal because it will keep debt off the balance sheet.

Instructions With the class divided into groups, answer the following.

(a) Why do you think the bank decided not to lend money to Express, Inc.? (b) How should this lease transaction be reported in the financial statements? (c) What did Lisa Colder mean when she said “leasing will keep debt off the balance sheet”?

Answers to Self-Study Questions 1. d 2. d 3. c 4. a

Broadening Your Perspective F15

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Chapter 10 Page 425: David Trood/Getty Images, Inc. Page 429: iStockphoto. Page 438: AFP/Getty Images. Page 445: Andy Lions/Photonica/Getty Images, Inc.

Chapter 11 Page 473: Cary Westfall/iStockphoto. Page 478: Catherine dee Auvil/iStockphoto. Page 486: iStockphoto. Page 494: Greg Nicholas/iStockphoto. Page 495: Corbis Stock Market.

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PC-1

P H O T O C R E D I T S

A ABC, 445 Ace Hardware, 271 Adelphia, 10 Advanced Micro, 540 AIG, 8 Alcatel-Alsthom, 298 Alliance Atlantis Communications Inc., 676 Altria Group, 470, 603, 634 Aluminum Company of America

(Alcoa), 581 Amazon.com, 560, 696 America Bank, 412 American Airlines, 102, 479 American Cancer Society, 534 American Eagle Outfitters, 350 American Express, 396, 473 American Standard, 707 America Online (AOL), 470, 595, 597 Anaheim Angels, 604 AOL Time Warner, 597 Apple Computer, 6, 115, 298, 443, 715 Arthur Andersen, 537 AT&T, 4, 603 Avis, 425, 431, 604

B Babies “R” Us, 604 BankAmerica, 314 Bank of America, 11 Bank One Corporation, 70 Batten Ltd., 325–326 Baylor University, 514 Berkshire Hathaway, 470 Best Buy, 9, 104, 140 Bill and Melinda Gates Foundation, 29, 534 Black & Decker Manufacturing

Company, 255 Boeing Capital Corporation, 429 Boeing Company, 440, 470, 485, 552, 710 Boise Cascade, 434 Book-of-the-Month Club, 595 Breyer, 470 Bristol-Myers Squibb, 215, 255, 722 Budget, 425

C Cadbury-Schweppes, 10 Campbell Soup Company, 255, 433, 707 Capital Cities/ABC, Inc., 604 Cargill Inc., 535 Caterpillar Inc., 244–246, 257, 480, 481, 535 Caterpillar Logistics Services, Inc., 245 Cendant Corp., 314, 604 Century 21, 604 Chase, 70 Chevron, 434 Cisco Systems, 155, 193, 289, 404, 470, 722 Citibank, 409 Citigroup, 11 CNN, 595 Coca-Cola Amatil Limited, B2 The Coca-Cola Company, 3, 5, 10, 11, 42, 43,

87, 100, 137, 163, 191, 215, 240, 243, 289, 333, 381, 421, 468, 470, 480, 528, 589, 618, 632, 692, 744, B1–B4

Coca-Cola Enterprises Inc., B2 Coca-Cola FEMSA, S.A. de C.V., B2 Coca-Cola Hellenic Bottling Company

S.A., B2 Coldwell Banker, 604

Columbia Sportswear Company, 676 Computer Associates International, 106 ConAgra Foods, 212 Consolidated Edison, 711 Continental Bank, 429 Costco Wholesale Corp., 641, D1 Craig Consumer Electronics, 249 Crane Company, 551 Cypress Semiconductor Corporation, 676

D DaimlerChrysler Corporation, 296, 491 Dairy Queen, 470 DeKalb Genetics Corporation, 626 Dell Computer, 60, 247, 298, 605 Dell Financial Services, 429 Delta Air Lines, 23, 45, 95, 102, 440 Discover, 395 Disney Company, see The Walt Disney

Company Disneyland, 604 DisneyWorld, 604 Dun & Bradstreet, 309, 699 Dunkin’ Donuts, 23, 45 DuPont, 484, 485 Dynegy, Inc., 644, 694

E EarthLink, 552 Eastman Kodak Company, 346, 363, 606, 638 eBay, 357 Enron, 8, 29, 213, 301, 314, 340, 537, 591,

722, 746 ESPN, 445, 470, 604 Estée Lauder Companies, Inc., 724–725 ExxonMobil, 11, 296, 298, 470, 547

F Fannie Mae, 70, 108 Fidelity Investments, 47, 48 First National Bank, 12 Florida Citrus Company, 718 Ford Motor Company, 4, 11, 198, 258, 296,

532–536, 547 Frito-Lay, 315, A9, A10, A12, A13

G GE, see General Electric General Dynamics, 745 General Electric (GE), 7, 10, 204, 213, 298, 301,

341, 470, 535, 597 General Mills, 433 General Motors (GM), 6–7, 11, 194, 296, 302,

410, 538, 650, 695, 721, 728 Global Crossing, 301, 340 GM, see General Motors Goldman Sachs, 11 Google, 29, 534, 540 Gulf Oil, 538

H Harley-Davidson, 215 Harold’s Club, 301, 335 HBO, 595 HealthSouth, 8 Hershey Foods Corp., 552 Hertz, 425, F3 Hewlett-Packard, 298 Hilton, 429 Home Depot, 4, 247, 271, 428 Howard Johnson, 604

I IBM, 71, 213, 242, 298, 535, 539n.2 Imaginarium, 604 Intel Corporation, 325, 535, 555, 560 InterContinental, 429 International Harvester, 3 IT&T, 2

J J. Crew, 350 J.C. Penney Company, Inc., 349, 387, 412–413,

641, 698–700, 704–715 John Deere Capital Corporation, 429 Johnson & Johnson, 310, 325 J.P. Morgan Leasing, 429

K Kellogg Company, 12, 29, 495, 560, 565, 566 Kids “R” Us, 604 Kmart, 196, 310, 699, 710, 717 Kodak, see Eastman Kodak Company Kohl’s Corporation, 641 KPMG LLP, A27, A29 Kraft Foods, Inc., 597, 603, 634 Krispy Kreme Doughnuts, 215 Kroger Stores, 198, 255, 310, 710, 711 K2, Inc., 164

L Leslie Fay Cos., 248, 290 The Limited, 296 Limited Brands, 100 Little, Brown & Co., 595 L.L. Bean, 296 Lockheed Martin Corporation, 155, 440, 561 Long Beach City College, 334 Lotus, 71 Lucent Technologies, 314

M McDonald’s Corporation, 11, 443, 455, 470,

493, 534 McKesson Corporation, 196, 290 Major League Baseball Players Association, 7 Marriott, 429, 433 Marshall Farms, 626 Massachusetts General Hospital, 11 MasterCard, 395–397, 412, 416 Merck, 310 Merrill Lynch, 11 Microsoft Corporation, 6, 11, 56, 89, 204, 295,

302, 443, 470, 547, 555, 636–637, 655, 728 Mighty Ducks, 604 Minnesota Mining and Manufacturing Company,

see 3M Mitsubishi Motors, 402, 423 Moody’s, 529, 699 Morgan Stanley, 608 Morrow Snowboards, Inc., 199 Motorola, 255, 325, 720

N NationsBank, 314 NBC, 470 New York Stock Exchange, 609 Nike, Inc., 4, 100, 542, 552, 553, 558, 705–706 Nordstrom, Inc., 166, 397, 423, 732–733 Nortel Networks, 394, 715 North American Van Lines, 542 Northern Virginia Community College, 11 Northwest Airlines, 94, 166

C O M PA N Y I N D E X

I-1

O Office Depot, 196 Oracle Corporation, 655 Owens-Illinois, 446, 447

P PACE Membership Warehouse, 717 PayLess Drug Stores Northwest, 717 PayPal, 357 PepsiAmericas, A20 Pepsi Bottling Group, A19–A20, A22, A23 PepsiCo, Inc., 3–6, 10, 13, 42–43, 45, 53, 86–87,

90, 95, 100, 104, 137, 140, 168, 190–191, 193, 213, 214, 239–240, 243, 257, 258, 288–289, 291, 298, 315, 333, 336, 365, 380–381, 383, 394, 421, 423, 430, 468, 471, 480, 481, 492, 528, 531, 534, 541, 546, 550, 551, 559, 565, 588–589, 592, 604, 632, 635, 642, 692, 695, 743–744, 747, A1–A30, F13

PepsiCo Beverages North America, A9, A10, A12, A13

PepsiCo International, A9, A10, A12, A13 Pfizer, 310 P&G, see Procter & Gamble Company Philip Morris, 470, 597, 603 Pizza Hut, 470 Planet Hollywood, 514 PNC Financial Services Group Inc., 567 Policy Management Systems, 292 Procter & Gamble Company (P&G), 11, 446,

447, 470, 542, 720 Prudential Real Estate, 11

Q Quaker, A24 Quaker Foods, 257, A9, A10, A12, A13, A30 Qualcomm, 538 Qwest, 310

R Radio Shack, 71, 90 Ramada Inn, 604 Red Cross, 29 Reebok International Ltd., 255, 541, 548

Regions Financial Corp., 567 Rent-A-Wreck, 425–428, 431, 433, 443, 445,

448, 470 Rent-Way Inc., 293 Republic Carloading, 160 Reynolds Company, 653–654 Rhino Foods, Inc., 142–144 Robert Half and Co., 30 Royal Dutch/Shell Group, 442, 445

S Safeway, 310, 710 Salvation Army, 534 SAM’S CLUB, 261 Samsung Electronics Co., 262, 291 Sears, Roebuck, and Company, 195, 349, 387 Sears Holdings, 296 Shell, see Royal Dutch/Shell Group Snack Ventures Europe, A5 Southern Company, 325 Sports Illustrated, 479 Springfield ReManufacturing Corporation, 2–4 Standard & Poor’s, 699 Starbucks, 29, 255, 695 Stephanie’s Gourmet Coffee and More,

338–341, 344, 345 Sunbeam Corporation, 243, 292–293 Sunset Books, 595 SunTrust Banks Inc., 346

T Taco Bell, 445, 470 Target Corporation, 196, 247, 355, 641, 739 Tektronix Inc., 561 Texaco Oil Company, 409 3M Company, 411, 518 Tiffany & Co., 710 Time-Life Books, 595 Time Warner, Inc., 7, 164, 298, 470, 547,

594–597, 601, 603 TNT, 595 Toys “R” Us, Inc., 325, 346, 604 Trek, 11 True Value Hardware, 247

Turner Broadcasting, 597, 601, 603 Twentieth Century Fox, 96 Tyco, 340

U U.S. Olympic Committee, 71 United Airlines, 7, 102, 479, 638 United Stationers, 196 USAir, 491 US Bancorp Equipment Finance, 429 USX Corp., 491

V Veritas Software, 71 Verizon Communications, 310 Visa, 395–397, 406, 409, 411, 413, 419

W Walgreen Drugs, 196, 255 Wall Street Journal, 8, 537, 541 Wal-Mart Stores, Inc., 11, 58, 90, 194–196, 199,

200, 204, 247, 248, 261–262, 271, 291, 310, 349, 355, 555, 641, 710, 739, A11

The Walt Disney Company, 7, 23, 45, 95, 295, 470, 560, 603, 604

Warner Bros., 595 Waste Management Company, 70 Wells Fargo Bank, 340 Wendy’s International, 255, 470 Weyerhaeuser Co., 718 Whirlpool, 707 Whitehall-Robins, 384–385, 393 WorldCom, Inc., 8, 29, 93, 301, 314, 340, 438,

470, 644, 694, 722

X Xerox, 93

Y Yahoo! Inc., 163, 696, F3 Yale Express, 160, 193 YUM! Brands, 470, A22

I-2 Company Index

A Absences, paid, F6 Accelerated-depreciation method, 435 Account(s), 48–53

chart of, 60–61 control, E1–E2 T, 48 three-column form of, 58

Accounting: basic activities of, 4–5 career opportunities in, 29–30

Accounting cycle: optional steps in, 162–164 required steps in, 161–162

Accounting cycle tutorial adjusting entries, 97 preparing financial statements and closing

the books, 148 recording process, 61

Accounting data, users of, 6–7 Accounting principle, changes in, 720 Accounts payable subsidiary ledger, E1 Accounts receivable, 386–398

defined, 386 disposing of, 395–398 recognizing, 387 types of, 386 valuing, 388–395

Accounts receivable subsidiary ledger, E1 Accounts receivable turnover ratio,

403–404. See also Receivables turnover Accruals, adjusting entries for, 97, 105–110

expenses, accrued, 106–109 revenues, accrued, 105–106

Accrual-basis accounting, cash-basis vs., 95 Accrued expenses, 106–109 Accrued interest, 107–108 Accrued revenues, 105–106 Acid-test (quick) ratio, 707–708 Additional paid-in capital, 564 Additions and improvements, 438 Adjustable-rate mortgages, 493 Adjusted trial balance:

preparation of, 112 preparing financial statements from,

113–114, 116 Adjusting entries, 97–111

for accruals, 105–110 expenses, accrued, 106–109 revenues, accrued, 105–106

classes of, 97–98 for deferrals, 98–105

prepaid expenses, 98–102 unearned revenues, 102–103

example of journalizing/posting, 110–111 for merchandising operations, 207 preparing, from worksheets, 148, 150, 152, 154 purpose of, 97

Administrative expenses, 211 Affiliated (subsidiary) company, 602 Agents:

collection, 476 of corporations, 535

Aging schedule, 393 Aging the accounts receivable, 393 Allowance for Doubtful Accounts, 390, 393 Allowance method, 389–394 Alternative accounting methods, 721–722 Amortization, 443

of bonds, 506–513 straight-line method, 509–513

Annual report(s), 71, A1 Annuity(-ies):

defined, C5, C10 future value of an, C5–C7 present value of an, 502–503, C10–C12, C16

Assets, 12 depreciable, 431 in double-entry system, 49 return on, 311, 711

Asset turnover ratio, 446–447, 710–711 Assumptions, accounting, 9–11, 298–299 Auditing, as area of public accounting, 29 Auditors, internal, 345–346 Authorized stock, 540 Auto loans, calculating, C17 Available-for-sale securities, 605, 607–608 Averages, industry, 699 Average collection period, 404 Average-cost method, 254–255, 267–268

B Bad Debts Expense, 388, 391 Balance sheet, 21–23. See also Classified

balance sheet consolidated, 615–618 effects of cost flow methods on, 257 effects of inventory errors on, 260–261 horizontal analysis of, 700–701 investments on, 608–609 stockholders’ equity section of, 564–565 vertical analysis of, 703

Bank(s), 355–362 deposits to, 355 and writing checks, 355–357

Bank accounts, reconciling, 359–362 Banking, investment, 540 Bank reconciliation, 355, 359–362

entries from, 361–362 example of, 360–361 procedure for, 359–360

Bank service charges, 357 Bank statements, 357–358 Basic accounting equation, 11–13

expansion of, 52–53 using, 14–20

Bearer (coupon) bonds, 484 Best-efforts contracts, 540n.3 Blank, Arthur, 4 Bond(s), 482–492, 500–513

amortization of, 506–513 effective-interest method, 506–509 straight-line method, 509–513

bearer, 484 callable, 484 conversion of, to common stock, 491–492 defined, 482 determining market value of, 486 discounting of, 487–488, 503–504 issuance of:

accounting for, 487–490 at discount, 488–489 at face value, 487 at premium, 489–490 procedures for, 484

premiums on, 487–488 present value of, 504–505 and present value of annuity, 502–503 present value of face value of, 500–502 pricing of, 500–505 recording acquisition of, 598 recording interest from, 598

recording sale of, 598–599 redemption of:

at maturity, 491 before maturity, 491

registered, 484 retirement of, 489–492 secured, 483 trading of, 484–485

Bond discount, 488–489 amortization of, 506–508, 510–511 defined, 488

Bonding, 346 Bond premium, 489–490

amortization of, 508–509, 511–513 defined, 488

Bonuses, D4 Bookkeeping, 5 Book value, 102, 431 Book value per share, 571–572 Buildings, 428 Business documents, 54, 203 By-laws, 538

C Calculator, using a, C16–C17 Calendar year, 95 Callable bonds, 484 Canceled checks, 357 Capital, 305

ability of corporations to acquire, 535 corporate, 542 paid-in, 542 working, 309–310, 481, 707

Capital expenditures, 438 Capital leases, F4–F5 Capital stock, 564 Careers, accounting, 29–30 Carrying (book) value:

of convertible bonds, 491–492 defined, 489

Carrying (book) value method, 492 Cash:

defined, 348 net change in:

direct method, 671 indirect method, 652–654

reporting, 363, 365–366 restricted, 363

Cash-basis accounting, accrual-basis vs., 95 Cash controls, 347–355

disbursements, 351–355 receipts, 348–351

Cash disbursements journal, see Cash payments journal

Cash dividends, 51, 552–555 Cash equivalents, 363 Cash flow(s):

classification of, 639–640 free, 654–655 statement of, see Statement of cash flows

Cash payments journal, E13–E15 Cash (net) realizable value, 389, 400 Cash receipts journal, E7–E11 Cash register tapes, 203 Cash sales, credit card sales as, 396–397 Castle, Ted, 142–143 CEO (chief executive officer), 536 Certified public accountants (CPAs), 29 Changes in accounting principle, 720 Channel stuffing, 215, 722 Charter, 538

S U B J E C T I N D E X

I-3

Chart of accounts, 60–61 Check(s):

canceled, 357 outstanding, 359 paying payroll via, D4 writing, 355–357

Check register, 352 Chief executive officer (CEO), 536 Classified balance sheet, 161–166, 168–170,

305–306 current assets on, 162–163 current liabilities on, 165–166 examples of, 168–170 intangible assets on, 164 long-term investments on, 163 long-term liabilities on, 166 for merchandising operations, 213, 214 property, plant, and equipment on, 164 stockholders’ equity on, 166 valuing/reporting of investments on, 610–611

Classified financial statements, 305–308 Classified income statement, 306–308 Closing entries:

for merchandising operations, 207 posting of, 153–154, 157–158 preparation of, 151–153, 155–157

Closing the books, 154–161 defined, 154 and posting of closing entries, 157–158 and preparation of closing entries, 155–157 and preparation of post-closing trial balance,

159–161 Collection agents, 476 Collection period, average, 404 Collusion, 347 Common stock, 50, 538–546

cash dividend allocation, 554, 555 issuance of, 540–546 and owners’ equity, 542–543 and ownership rights of stockholders, 538–539 par-value vs. no-par-value, 544–546 for services or noncash assets, 545–546

Common stockholders’ equity, return on, 311, 566, 711–712

Comparability of accounting information, 296 Comparative analysis, 698–699 Compensating balances, 363 Compound entries, 55–56 Compound interest, C2–C3 Comprehensive income, 610, 720 Computer controls, 344 Conceptual framework, 295 Conservatism, 258, 304 Consigned goods, 249 Consistency, of accounting information, 296 Consistency principle, 257–258 Consolidated balance sheet, 615–618 Consolidated income statement, 618 Constraints, accounting, 303–304 Consumerism, 194, 195 Consumption, 194–195 Contingent liabilities, F1–F3 Continuous life (of corporation), 536 Contra asset accounts, 101, 488 Contracts, best-efforts, 540n.3 Contractual interest rate, 484, 488 Contra-revenue accounts, 204 Contra stockholders’ equity account, 547–548 Controls, internal, see Internal control(s) Control accounts, E1–E2 Controller, 536 Controlling interest, 603 Convertible bonds, 484, 491–492 Copyrights, 444 Corporate capital, 542 Corporation(s), 532–543

book value per share of, 571–572

characteristics of, 535–537 classification of, 534–535 defined, 10, 534 formation of, 538 issuance of stock by, 540–542 owners’ equity in, 542–543 ownership of, 538–539

Correcting entries, 158–160 Cost(s):

depreciable, 432 expired/unexpired, 300 organization, 538 of plant assets, 427–430 research and development, 446

Cost flow assumptions, 251–255, 266–269 Cost method:

and stock investments, 600 for valuation of treasury stock, 547

Cost of goods sold: defined, 196 determining, under periodic system, 216–218 and matching principle, 300

Cost principle, 302, 598 Coupon (bearer) bonds, 484 CPAs (certified public accountants), 29 Credit, 49 Credit cards:

sales via, 396–397 using, 405

Credit memoranda, 358 Creditors, long- vs. short-term, 698 Creditors’ subsidiary ledger, E1 Credit sales, journalizing, E5 Credit terms, 201–202 Cumulative dividend, 551–552 Current assets:

on classified balance sheet, 162–163 and current liabilities, 474

Current liabilities, 474–482 changes in, 649 on classified balance sheet, 165–166 and current assets, 474 defined, 474 long-term debt, current maturities of, 479–480 notes payable, 475–476 payroll and payroll taxes payable, 476–478 sales taxes payable, 476 statement presentation/analysis of, 480–482 unearned revenues, 479

Current maturities of long-term debt, 479–480 Current ratio, 309, 706–707 Current replacement cost, 258 Customers’ subsidiary ledger, E1

D Days in inventory, 262 Debenture bonds, 484 Debit, 49 Debit memoranda, 357 Debt investments, 597–598 Debt to total assets ratio, 311–312, 495, 714–715 Declaration date, 553 Declining-balance method, 434–435 Deferrals, adjusting entries for, 97–105

prepaid expenses, 98–102 unearned revenues, 102–103

Deficits, 560 Defined-benefit plans, F8 Defined-contribution plans, F8 Depletion, 442 Deposits, bank, 355 Deposits in transit, 359 Depreciable assets, 431 Depreciable cost, 432 Depreciation:

declining-balance method of, 434–435 defined, 101, 430

of plant assets, 430–438 computation, 431–432 and income taxes, 436 methods, 432–436 revisions in estimate of, 436–437

as prepaid expense, 101 straight-line method of, 432–433 units-of-activity method of, 433–434

Depreciation expense, 646–647 Direct method (of preparing statement of cash

flows), 644, 665–671 investing/financing activities, 670–671 net change in cash, 671 operating activities, cash provided/used by,

666–670 Direct write-off method, 388–389 Disbursements, cash, 351–355

and EFT system, 352–353 and petty cash fund, 353–355 and voucher system, 351–352

Discontinued operations, 717–718 Discount(s):

bonds issued at, 488–489, 506–508, 510–511 purchase, 201–202 sales, 205

Discounting the future amount, C7, C12 Discount period, 202 Dishonored notes, 401–402 Disposal:

of accounts receivable, 395–398 of notes receivable, 401–402 of plant assets, 439–441

retirement, 439–440 sale, 440–441

of treasury stock, 548–550 Dividend(s), 51, 558

cash, 552–555 cumulative, 551–552 defined, 13, 552 preferred, 712 stock, 556–558 stock splits, 558–559

Dividends in arrears, 551–552 Documentation procedures, 344 Double-declining-balance method, 435 Double-entry system, 49 Dunlap, “Chainsaw” Al, 292–293 Duties, segregation of, 342–343

E Earnings:

gross, D4 statement of, D10

Earning power, 717 Earnings management, 300 Earnings per share (EPS), 307–308, 712–713 Economic entity assumption, 10 Effective-interest amortization method,

506–509 EFT, see Electronic funds transfers Egypt, ancient, 343 Electronic controls, 344, 345 Electronic funds transfers (EFT), 352–353 Employee earnings record, D8 Employee fringe benefits, liabilities for, F5–F8 Employee Retirement Income Security Act

(ERISA), F7 Employees:

bonding of, 346 hiring of, D2

Employee’s Withholding Allowance Certificate (W-4), D6

The End of Work (Jeremy Rifkin), 194 Endorsements, restrictive, 350 Environmental liabilities, 115 EPS, see Earnings per share Equipment, 428–429, 647

I-4 Subject Index

Equity: stockholders’, 12–13 trading on the, 712

Equity method, 601–602 ERISA (Employee Retirement Income

Security Act), F7 Errors:

on bank statements, 359–360 in inventory, 259–261

balance sheet effects, 260–261 income statement effects, 259–260

Ethics: in financial reporting, 8–9 in personal financial reporting, 25

Exchange of intangible assets, 452–454 gain treatment, 453–454 loss treatment, 452–453

Expense(s), 51 accrued, 106–109 administrative, 211 defined, 13 operating, 210–211 prepaid, 98–102, 118–119 selling, 211

Expired costs, 300 External transactions, 14 External users of accounting data, 6 Extraordinary operations, 718–720

F Face value, 488

of bonds, 484, 487 of notes receivable, 400 present value of, 500–502

Factors, 395–396 FAFSA form, 25 Fair value, 605–607 FASB, see Financial Accounting Standards

Board Federal Bureau of Investigation (FBI), 4 Federal Insurance Contribution Act (FICA), D5 Federal unemployment taxes, D11–D12 Federal Unemployment Tax Act (FUTA), D11 FICA (Federal Insurance Contribution

Act), D5 FICA taxes:

employer contribution for, D11 payroll deduction for, D5–D6

FIFO method, see First-in, first-out method Financial accounting, database concept of, 302 Financial Accounting Standards Board

(FASB), 9, 294–295, 297, 313 Financial calculator, using a, C16–C17 Financial statement presentation and analysis:

of intangible assets, 446–447 Financial statements, 5, 21–24, 294

analysis of, 308–312, 698–726 classified, 305–308 for Coca-Cola Company, B1–B4 current liabilities on, 480–482 and determination of earning power, 717 elements of, 297 and global economy, 312–313 horizontal analysis of, 699–703 inventories on:

cost flow methods, 255–257 presentation and analysis, 261–262, 264

irregular items on, 717–720 long-term liabilities on, 494–495, 497–498 for merchandising operations, 209–214

classified balance sheet, 213, 214 multiple-step income statement, 209–213 single-step income statement, 213, 214

operating guidelines for preparation of, 297 for PepsiCo, Inc., A1–A30 preparing, from adjusted trial balance,

113–114, 116

preparing, from worksheets, 148, 152, 153 and quality of earnings, 721–722, 724–726 ratio analysis of, 705–717 receivables on, 403–404 retained earnings on, 564–566 retained earnings statement, 562–563 tools for, 699 vertical analysis of, 703–705

Financing activities, cash inflow/outflow from, 639, 640

direct method, 670–671 indirect method, 651–652

Finished goods inventory, 246 First-in, first-out (FIFO) method, 252–253, 266 Fiscal year, 95 Fixed assets, 426. See also Plant assets Fixed-rate mortgages, 493 FOB (free on board), 200, 248 FOB destination, 200, 248, 249 FOB shipping point, 200, 248, 249 Ford, Henry, 533–534 “For Deposit Only,” 350 Forensic accounting, 30 Form W-2 (Wage and Tax Statement), D13–D14 Form W-4 (Employee’s Withholding Allowance

Certificate), D6 Franchises, 445 Free Application for Federal Student Aid

(FAFSA) form, 25 Free cash flow, 654–655 Free on board (FOB), 200, 248 Freight costs, 200–201 Fringe benefits, liabilities for, F5–F8 Full disclosure principle, 301, F3 FUTA (Federal Unemployment Tax Act), D11 Future value, C3–C7

of an annuity, C5–C7 of a single amount, C3–C5

G GAAP, see Generally accepted accounting

principles Geneen, Harold, 2 General journal, 54, E16–E17 General ledger (ledger), 57–61 Generally accepted accounting principles

(GAAP), 9, 294 and allowance method, 389 and alternative accounting methods,

721, 722 and cash-basis accounting, 95 and materiality, 303

Global economy, and financial statement presentation, 312–313

Going concern assumption, 298–299, 431 Goods in transit, 248–249 Goodwill, 445–446 Government, accounting career opportunities

in, 30 Government regulation, of corporations, 537 Gross earnings, D4 Gross profit, 210 Gross profit method (for estimating

inventories), 270–271 Gross profit rate, 210

H Health insurance, cost of, 496 Held-to-maturity securities, 605 Hiring employees, D2 Home-equity loans, 567 Honor (of notes receivable), 401 Horizontal analysis, 699–703

of balance sheet, 700–701 of income statement, 701–702 of retained earnings statement, 702–703

Human resources (HR), 344, D2

I IASB, see International Accounting Standards

Board Identity theft, 364 Imprest system, 353 Improper recognition, 722 Improvements:

additions and, 438 land, 427–428

Income: comprehensive, 610, 720 pro forma, 722

Income statement, 21, 22 classified, 306–308 consolidated, 618 effects of cost flow methods on, 255–257 effects of inventory errors on, 259–260 horizontal analysis of, 701–702 for merchandising operations, 209–214

multiple-step income statement, 209–213 single-step income statement, 213, 214

vertical analysis of, 703–705 Income taxes (income taxation):

on classified income statement, 306–307 of corporations, 537 and depreciation of plant assets, 436 effects of cost flow methods on, 257 payroll deduction for, D6 remitting, D13

Independent internal verification, 344–346 Indirect method (of preparing statement of

cash flows), 643–654 investing/financing activities, 651–652 net change in cash, 652–654 operating activities, cash provided/used by,

646–650 worksheets, using, 659–664

Industry averages (norms), 699 Information, accounting, 295–297 Insurance, as prepaid expense, 100 Intangible assets, 443–447

accounting for, 443–446 amortization of, 443 on classified balance sheet, 164 copyrights, 444 exchange of, 452–454

gain treatment, 453–454 loss treatment, 452–453

franchises and licenses, 445 goodwill, 445–446 patents, 444 research and development costs, 446 statement presentation/analyis of, 446–447 trademarks and trade names, 444

Intercompany comparisons, 699 Intercompany eliminations, 615, 616, 618 Intercompany transactions, 615, 618 Interest, C1–C3

accrued, 107–108 on checking accounts, 358 compound, C2–C3 defined, C1 on notes receivable, 400 simple, C1–C2

Interest rate, C1 Interim periods, 95 Internal auditors, 345–346 Internal control(s), 340–347

defined, 340 and documentation procedures, 344 and establishment of responsibility, 341, 342 and independent internal verification, 344–346 limitations of, 346–347 for payroll, D1–D4 physical/mechanical/electronic controls, 344, 345 and Sarbanes-Oxley Act, 341 and segregation of duties, 342–343

Subject Index I-5

Internal Revenue Service (IRS), 436 Internal transactions, 14 Internal users of accounting data, 6 International Accounting Standards Board

(IASB), 9, 313 Intracompany comparisons, 699 Inventory(-ies), 244–272

classification of, 246–247 costing of:

average-cost method for, 254–255, 267–268 balance sheet effects, 257 and consistency principle, 257 and cost flow assumption, 251–252 FIFO method for, 252–253, 266 financial statement effects, 255–257 LIFO method for, 253–254, 267 lower-of-cost-or-market method for, 258 and quality of earnings, 721 specific identification method for, 250–251 tax effects, 257

days in, 262 determining quantities of, 247–249

and ownership of goods, 248–249 physical inventory, 247–248

errors in, 259–261 balance sheet effects, 260–261 income statement effects, 259–260

estimating, 269–272 gross profit method for, 270–271 retail inventory method for, 271–272

finished goods, 246 just-in-time, 247 in merchandising operations, 197–199,

219–222 periodic inventory system, 198 perpetual inventory systems, 197–198,

219–222, 266–269 statement presentation and analysis of,

261–262, 264 taking, 247–248 theft of, 263

Inventory turnover, 261–262, 709–710 Investee, 600 Investing activities, cash inflow/outflow from,

639, 640 direct method, 670–671 indirect method, 651–652

Investments, 594–614 debt, 598–599 purchase of, by corporations, 596–597 short- vs. long-term, 608–609 stock, 600–605

between 20% and 50%, holdings, 601–602 less than 20%, holdings of, 600–601 more than 50%, holdings of, 602–603

valuing/reporting of, 605–611, 613 available-for-sale securities, 607–608 on balance sheet, 608–609 on classified balance sheet, 610–611 realized/unrealized gain/loss presentation,

609–610, 613 trading securities, 605–607

Investment banking, 540 Investment portfolio, 600 Investments, long-term, see Long-term

investments Invoice(s):

purchase, 199, 200 sales, 203

Irregular items, 717–720 changes in accounting principle, 720 comprehensive income, 720 discontinued operations, 717–718 extraordinary operations, 718–720

IRS (Internal Revenue Service), 436

J JIT (just-in-time) inventory, 247 Johnson, Matthew, 715 Journal, 54–57 Journalizing, 54–55, 67–68, 110–111 Just-in-time (JIT) inventory, 247

K Knight, Phil, 4

L Land, 427 Land improvements, 427–428 Large stock dividend, 556 Last-in, first-out (LIFO) method, 253–254, 267 LCM (lower-of-cost-or-market), 258 Leases, F3–F5

capital, F4–F5 operating, F3–F4

Lease liabilities, F3–F5 Ledger, see General ledger Legal capital, 541 Letter to the stockholders, A2–A3 Leverage, 712 Leveraging, 712 Liabilities, 12, 472–499

contingent, F1–F3 current, 474–482

long-term debt, current maturities of, 479–480 notes payable, 475–476 payroll and payroll taxes payable, 476–478 sales taxes payable, 476 statement presentation/analysis of, 480–482 unearned revenues, 479

in double-entry system, 49 for employee fringe benefits, F5–F8 environmental, 115 lease, F3–F5 long-term, 482–495, 497–498

bonds, 482–492, 500–513 notes payable, long-term, 492–493 statement presentation/analysis of, 494–495, 497–498

Licenses, 445 LIFO conformity rule, 257 LIFO method, see Last-in, first-out method Limited liability, of corporate stockholders, 535 Liquidating dividend, 553 Liquidation preference, 552 Liquidity, 309–310, 481 Liquidity ratios, 706–710

acid-test ratio, 707–708 current ratio, 706–707 inventory turnover, 709–710 receivables turnover, 708–709

Long-term debt, current maturities of, 479–480 Long-term debt due within one year, 480 Long-term investments, 163, 608, 609 Long-term liabilities, 482–495, 497–498

bonds, 482–492, 500–513 on classified balance sheet, 166 notes payable, long-term, 492–493 postretirement benefits as, F8 present value of, C12–C15 statement presentation/analysis of, 494–495,

497–498 Long-term notes payable, 492–493 Lower-of-cost-or-market (LCM), 258 Lucas, George, 96

M MACRS (Modified Accelerated Cost

Recovery System), 436 Mail receipts, 350–351 Maker, 398 Management (of corporation), 536

Management consulting, as area of public accounting, 29

Management’s discussion and analysis (MD&A), A3

Managerial accounting, 6, 29 Market interest rate, 486, 488 Market value:

book value vs., 102, 572 of stock, 541

Marshall, John, 534 Matching principle, 95–96, 300 Materiality (materiality principle), 303, 438 Maturity date (of promissory note), 399 MD&A (management’s discussion and

analysis), A3 Mechanical controls, 344, 345 Medicare, D5n.1 Merchandising operations, 194–224

completing the accounting cycle for, 206–208 adjusting entries, 207 closing entries, 207

cost of goods sold in, 216–218 financial statements for, 209–214

classified balance sheet, 213, 214 multiple-step income statement, 209–213 single-step income statement, 213, 214

inventory systems in, 197–199 periodic system, 198 perpetual system, 197–198, 219–222

operating cycles in, 196–197 recording purchases of merchandise in,

199–203 freight costs, 200–201 purchase discounts, 201–202 purchase returns and allowances, 201

recording sales of merchandise in, 203–205 sales discounts, 205 sales returns and allowances, 204–205

Merchandising profit, 210 Mintenko, Stephanie, 338–339 MNCs (multinational corporations), 312 Modified Accelerated Cost Recovery System

(MACRS), 436 Monetary unit assumption, 10, 298 Mortgage bonds, 483 Mortgage loans, calculating, C17 Mortgage notes payable, 493 Multinational corporations (MNCs), 312 Multiple-step income statement, 209–213

N Natural resources, 442–443 Net change in cash:

direct method, 671 indirect method, 652–654

Net pay, D7 Net (cash) realizable value, 389, 400 Net sales, 209–210 Net worth, 167 Noncash activities, significant, 640–641 Noncash current assets, changes in, 647–648 Nonoperating activities, 211–213 No-par-value stock, 542, 544–545 Norms, industry, 699 Normal balance, 50 Notes payable, 475–476 Notes receivable, 398–403

computing interest for, 400 defined, 386 disposing of, 401–402 maturity date of, 399 recognizing, 400 valuing, 400–401

Not-for-profit corporations, 534 NSF (not sufficient funds), 358

I-6 Subject Index

O Obsolescence, 431 Off-balance-sheet financing, F5 “Open-book management,” 3 Operating activities, cash inflow/outflow from,

639, 640 direct method, 666–670 indirect method, 646–650

Operating cycles, in merchandising operations, 196–197

Operating expenses, 210–211, 300 Operating leases, F3–F4 Ordinary repairs, 438 Organization costs, 538 “Other expenses and losses,” 211 Other receivables, 386 “Other revenues and gains,” 211 Outstanding checks, 359 Outstanding stock, 548 Over-the counter receipts, 349–350

P Paid absences, F6 Paid-in capital, 542, 564 Paper (phantom) profit, 256 Parent company, 602–603 Partnerships, 10 Par-value stock, 541, 544, 546 Passwords, computer, 344 Patents, 444 Payee, 398 Payment date (dividends), 554 Payout ratio, 713–714 Payroll, D1–D15

defined, D1 determining, D4–D7 internal control of, D1–D4 recording, D8–D10

Payroll and payroll taxes payable, 476–478 Payroll deductions, D5–D7

for FICA taxes, D5 for income taxes, D6

Payroll register, D8–D9 Payroll taxes, 476, D11–D15

federal unemployment taxes, D11–D12 FICA, D11 filing/remitting, D13–D15 recording, D12–D13 state unemployment taxes, D12

PCAOB (Public Company Accounting Oversight Board), 341

Pension plans, F7–F8 P-E ratio, see Price-earnings ratio Percentage-of-receivables basis, 393–394 Percentage-of-sales basis, 392–393 Periodic inventory system, 198, 219–222

merchandise purchases in, 220–221 merchandise sales in, 221–222

Permanent accounts, 150–151, 154–155 Perpetual inventory system(s), 197–198

inventory cost flow methods in, 266–269 periodic vs., 219–222

Personal annual report, 71 Personal financial reporting, ethics in, 25 Petty cash fund, 353–355

establishment of, 353 making payments from, 353–354 replenishment of, 354–355

Phantom (paper) profit, 256 Physical controls, 344, 345 Pickard, Thomas, 4 Plan administrator (pensions), F7 Plant and equipment, see Plant assets Plant assets, 426–441

buildings, 428 defined, 426 depreciation of, 430–438

computation, 431–432 and income taxes, 436 methods, 432–436 revisions in estimate of, 436–437

determining cost of, 427–430 disposal of, 439–441

retirement, 439–440 sale, 440–441

equipment, 428–429 exchange of, 452–454

gain treatment, 453–454 loss treatment, 452–453

expenditures during useful life of, 438 land, 427 land improvements, 427–428 loss on sale of, 647

Post-closing trial balance, 155–157, 159–161 Posting, 59–60, 67–68, 110–111 Postretirement benefits, F6–F8 Preferred dividend, 712 Preferred stock, 550–552, 554–555 Premium, bonds issued at, 488–490 Prepaid expenses (prepayments), 98–102,

118–119 Present value, C7–C16

of an annuity, 502–503, C10–C12, C16 and bond pricing, 500–505 defined, C7 of a long-term note or bond, C12–C15 and market value of bonds, 486 of a single amount, C8–C10, C15–16 variables affecting, C7

Present value of 1 factors, C9 Price-earnings (P-E) ratio, 307n.4, 713 Principal, C1 Principle(s) of accounting, 294–295,

299–303 cost principle as, 302 full disclosure as, 301 matching as, 300 revenue recognition as, 299–300

Prior period adjustments, 562 Private accounting, 29. See also Managerial

accounting Privately held corporations, 535 Profit:

gross, 210 as purpose of corporation, 534

Profitability, 310 Profitability ratios, 710–714

asset turnover, 710–711 earnings per share, 712–713 payout ratio, 713–714 price-earnings ratio, 713 profit margin, 710 return on assets, 711 return on common stockholders’ equity,

711–712 Profit margin (profit margin percentage),

310, 710 Pro forma income, 722 Promissory notes, 398 Property, plant, and equipment, 164. See also

Plant assets Proprietorships, 10 Public accounting, 29 Public Company Accounting Oversight Board

(PCAOB), 341 Publicly held corporations, 534–535 Purchase allowances, 201 Purchase discounts, 201–202 Purchase invoices, 199, 200 Purchase returns, 201 Purchases, recording, 199–203

discounts, 201–202 freight costs, 200–201 returns and allowances, 201

Purchases journal, E11–E13 Purchasing activities, and segregation of

duties, 342

Q Quality of earnings, 721–722, 724–726

and alternative accounting methods, 721–722 and improper recognition, 722 and pro forma income, 722

Quick (acid-test) ratio, 707–708

R Ratio analysis, 699, 705–717

liquidity ratios, 706–710 profitability ratios, 710–714 solvency ratios, 714–715 summary of ratios, 716

Raw materials, 246 R&D (research and development) costs, 446 Receipts, cash, 348–351

mail receipts, 350–351 over-the counter receipts, 349–350

Receivables, 384–408 accounts receivable, 386–398

disposing of, 395–398 recognizing, 387 types of, 386 valuing, 388–395

defined, 386 notes receivable, 398–403

computing interest for, 400 disposing of, 401–402 maturity date of, 399 recognizing, 400 valuing, 400–401

statement presentation/analysis for, 403–404 trade, 386

Receivables turnover, 708–709. See also Accounts receivable turnover ratio

Recessions, inventory fraud during, 260 Recognition, improper, 722 Reconciliation, see Bank reconciliation Record date (dividends), 554 Recording process, 46–74

and accounts, 48–53 illustrated example of, 61–68 for payroll, D8–D10 for payroll taxes, D12–D13 steps in, 53–61

journalizing, 54–57 ledger, transfer to, 57–61 transaction analysis, 15–20

and trial balance, 68–70, 72–73 Registered bonds, 484 Relevance, of accounting information, 296 Reliability, of accounting information, 296 Reporting:

of cash, 363, 365–366 ethics in, 8–9

Research and development (R&D) costs, 446 Responsibility, establishment of, 341, 342 Restricted cash, 363 Restrictive endorsements, 350 Retailers, 196 Retail inventory method, 271–272 Retained earnings, 51, 542–543, 560–565

defined, 560 and prior period adjustments, 562 restrictions on, 560–561 statement of, 562–563 statement presentation/analysis of, 564–566

Retained earnings restrictions, 561 Retained earnings statement, 21–23, 562–563

horizontal analysis of, 702–703 statement presentation/analysis of, 564–565, 568

Retirement, of plant assets, 439–440

Subject Index I-7

Return on assets, 311, 711 Return on common stockholders’ equity, 311,

566, 711–712 Returns and allowances:

merchandise purchases, 201 for merchandise sales, 204–205

Revenue(s), 51 accrued, 105–106 defined, 13 sales, 196 unearned, 102–103, 119–120, 479

Revenue expenditures, 438 Revenue recognition principle, 95, 299–300 Reversing entries, 158, 171–173 Rifkin, Jeremy, 194 Rowling, J. K., 443 Rubino, Carlos, 696–697

S Salaries, 108–109, D1, D4 Sale(s):

of bonds, 598–599 credit card, 396–397 net, 209–210 of plant assets, 440–441, 647 of receivables, 395–396 recording, 203–205

discounts, 205 returns and allowances, 204–205

Sales activities, and segregation of duties, 342–343

Sales invoices, 203 Sales journal, E5–E7 Sales revenue, 196 Sales taxes payable, 476 Salvage value, 431, 432 Sarbanes-Oxley Act of 2002 (SOX; Sarbox),

8, 29, 341 and human resources, 344 and identity theft, 364 and restatements, 159

Saving, personal, 612 SEC, see Securities and Exchange

Commission Secured bonds, 483 Securities and Exchange Commission (SEC),

9, 294, 537 Segregation of duties, 342–343 Selling expenses, 211 Semiannually payable interest, C12, C13 Serial bonds, 484 Service charges, bank, 357 Short-term investments, 608–609 Short-term paper, 609n.4 Significant noncash activities, 640–641 Simple entries, 55 Simple interest, C1–C2 Single-step income statement, 213, 214 Sinking fund bond, 483 Small stock dividend, 556 Social Security taxes, see FICA taxes Solvency, 311 Solvency ratios, 714–715

debt to total assets ratio, 714–715 times interest earned, 715

SOX, see Sarbanes-Oxley Act of 2002 Special journals, E4–E18

cash payments journal, E13–E15 cash receipts journal, E7–E11 effects of, on general journal, E16–E17 purchases journal, E11–E13 sales journal, E5–E7 usefulness of, E4

Specific identification method, 250–251 Stack, Jack, 2 Star Wars, 96 Stated value, 542, 544–545

State income taxes, D6 Statement of cash flows, 21, 22, 24, 638–671

classification of cash flows on, 639–640 direct method of preparing, 644, 665–671

investing/financing activities, 670–671 net change in cash, 671 operating activities, 666–670

evaluating a company using, 654–655, 657–658

format of, 641 indirect method of preparing, 643–654

investing/financing activities, 651–652 net change in cash, 652–654 operating activities, 646–650 worksheets, using, 659–664

preparation of, 642–643 preparing, from worksheets, 659–664 and significant noncash activities,

640–641 usefulness of, 638–639

Statement of earnings, D10 State unemployment taxes, D12 State unemployment tax acts (SUTA), D12 Stock:

authorized, 540 book value of, 571–572 deciding to invest in, 723 issuance of, 540–546 market value of, 541, 572 par vs. no-par-value, 541–542, 544–546 preferred, 550–552 treasury, 546–550

disposal of, 548–550 purchase of, 547–548

Stock certificate, 538 Stock dividends, 556–558 Stockholders:

financial statement analysis by, 698 letter to the, A2–A3 limited liability of, 535 ownership rights of, 538–539

Stockholders’ equity, 12–13 on classified balance sheet, 166 return on common stockholders’ equity,

311, 566, 711–712 Stockholders’ equity account, 557 Stockholders’ equity statement, 565,

570–571 Stock investments, 600–605

between 20% and 50%, holdings, 601–602 less than 20%, holdings of, 600–601 more than 50%, holdings of, 602–603

Stock splits, 558–559 Straight-line method, 432–433, 509–513 Su, Vivi, 384–385 Subsidiary (affiliated) company, 602 Subsidiary ledger(s), E1–E4

advantages of, E3 defined, E1 example, E1–E2

Supplies, as prepaid expense, 99 SUTA (state unemployment tax acts), D12

T T account, 48 Taking inventory, 247–248 Taxes and taxation. See also Income taxes

(income taxation); Payroll taxes as area of public accounting, 29 burden of, 478 corporate, 537 sales taxes payable, 476

Temporary accounts, 150, 154 Term bonds, 484 Theft, inventory, 263 Three-column form of account, 58 Time cards, D3

Timekeeping, D3 Time periods, and discounting of bonds,

503–504 Time period assumption, 94, 298 Times interest earned ratio, 495, 715 Time value of money, C1–C18

and discounting, C12 future value, C3–C7 and interest, C1–C3 and market value of bonds, 486 present value, C7–C16 and use of financial calculator, C16–C17

Timing issue(s), 94–96 accrual- vs. cash-basis accounting as, 95 fiscal/calendar years as, 95 recognizing revenues/expenses as, 95–96 selection of accounting time period as, 94

Trademarks and trade names, 444 Trade receivables, 386 Trading on the equity, 712 Trading securities, 605–607 Transactions, 14 Transaction analysis, 15–20 Transfer, of corporate ownership rights, 535 Transit, goods in, 248–249 Transposition errors, 70 Treasurer, 536 Treasury stock, 546–550

disposal of, 548–550 purchase of, 547–548

Trend analysis, see Horizontal analysis Trial balance, 68–70, 72–73

defined, 68 limitations of, 69 locating errors in, 69–70 post-closing, 155–157, 159–161 steps in preparation of, 69 use of dollar signs in, 70

Trustee (of bond), 484 Turnover:

asset, 446–447, 710–711 inventory, 261–262, 709–710 receivables, 403–404, 708–709

U Uncollectible accounts:

allowance method for, 389–394 direct write-off method for, 388–389

Underwriting, of stock issues, 540 Unearned revenues, 102–103, 119–120, 479 Unemployment taxes:

federal, D11–D12 state, D12

Unexpired costs, 300 Units-of-activity method, 433–434, 442 Unsecured bonds, 484 Useful life, 101, 431, 432, 438

V Valuation:

of accounts receivable, 388–395 of notes receivable, 400–401

Vertical analysis, 699, 703–705 of balance sheet, 703 of income statement, 703–705

Virtual close, 155 Vouchers, 351, 352 Voucher register, 352 Voucher systems, 351–352

W W-2 (Wage and Tax Statement), D13–D14 W-4 (Employee’s Withholding Allowance

Certificate), D6 Wages, D1 Wages and salaries payable, 476 Wage and Tax Statement (Form W-2), D13–D14

I-8 Subject Index

Wear and tear, 431 Weighted-average unit cost, 254 Wholesalers, 196 Withholding taxes, 476. See also Payroll taxes Working capital, 309–310, 481, 707 Working capital ratio, 707 Work in process, 246

Worksheet(s), 144–154 defined, 144 for merchandising company, 222–224 preparing adjusting entries from, 148, 150,

152, 154 preparing consolidated balance sheets from,

616–617

preparing financial statements from, 148, 152, 153

preparing statement of cash flows from, 659–664 steps in preparation of, 144–152

Z Zero-interest bonds, 486

Subject Index I-9

RAPID REVIEW Chapter Content

BASIC ACCOUNTING EQUATION (Chapter 2) INVENTORY (Chapters 5 and 6)

Ownership

ADJUSTING ENTRIES (Chapter 3)

7

Prepare financial statements:

Income statement Retained earnings statement

Balance sheet

5

Journalize and post adjusting entries:

Prepayments/Accruals 6

Prepare an adjusted trial balance

Optional steps: If a worksheet is prepared, steps 4, 5, and 6 are incorporated in the worksheet. If reversing entries are prepared, they occur between steps 9 and 1 as discussed below.

4

Prepare a trial balance

3

Post to ledger accounts

2

Journalize the transactions

1

Analyze business transactions

9

Prepare a post-closing trial balance

8

Journalize and post closing entries

Type Adjusting Entry

Deferrals 1. Prepaid expenses Dr. Expenses Cr. Assets 2. Unearned revenues Dr. Liabilities Cr. Revenues

Accruals 1. Accrued revenues Dr. Assets Cr. Revenues 2. Accrued expenses Dr. Expenses Cr. Liabilities

Note: Each adjusting entry will affect one or more income statement accounts and one or more balance sheet accounts.

Interest Computation

Interest � Face value of note � Annual interest rate � Time in terms of one year

CLOSING ENTRIES (Chapter 4)

Purpose: (1) Update the Retained Earnings account in the ledger by transferring net income (loss) and dividends to retained earnings. (2) Prepare the temporary accounts (revenue, expense, dividends) for the next period’s postings by reducing their balances to zero.

Process

1. Debit each revenue account for its balance (assuming normal balances), and credit Income Summary for total revenues.

2. Debit Income Summary for total expenses, and credit each expense account for its balance (assuming normal balances).

STOP AND CHECK: Does the balance in your Income Summary Account equal the net income (loss) reported in the income statement?

3. Debit (credit) Income Summary, and credit (debit) Retained Earnings for the amount of net income (loss).

4. Debit Retained Earnings for the balance in the Dividends account and credit Dividends for the same amount.

STOP AND CHECK: Does the balance in your Retained Earnings account equal the ending balance reported in the balance sheet and the retained earnings statement? Are all of your temporary account balances zero?

ACCOUNTING CYCLE (Chapter 4)

Freight Terms Ownership of goods on public carrier resides with:

FOB Shipping point Buyer

FOB Destination Seller

Perpetual vs. Periodic Journal Entries

Event Perpetual Periodic*

Purchase of goods Inventory Purchases Cash (A/P) Cash (A/P)

Freight (shipping point) Inventory Freight-In Cash Cash

Return of goods Cash (or A/P) Cash (or A/P) Inventory Purchase Returns and Allowances

Sale of goods Cash (or A/R) Cash (or A/R) Sales Sales

Cost of Goods Sold No entry Inventory

End of period No entry Closing or adjusting entry required

Cost Flow Methods

• Specific identification • Weighted average • First-in, first-out (FIFO) • Last-in, first-out (LIFO)

CONCEPTUAL FRAMEWORK OF ACCOUNTING (Chapter 7)

Bank Books

Balance per bank statement Balance per books Add: Deposit in transit Add: Unrecorded credit memoranda from bank

statement Deduct: Outstanding checks Deduct: Unrecorded debit memoranda from

bank statement Adjusted cash balance Adjusted cash balance

Note: 1. Errors should be offset (added or deducted) on the side that made the error. 2. Adjusting journal entries should only be made on the books.

STOP AND CHECK: Does the adjusted cash balance in the Cash account equal the reconciled balance?

Characteristics Assumptions Principles Constraints

Relevance Monetary unit Revenue recognition Materiality Comparability Economic entity Matching Conservatism Reliability Time period Full disclosure

Going concern Cost

EP-1

INTERNAL CONTROL AND CASH (Chapter 8)

Principles of Internal Control

• Establishment of responsibility • Physical, mechanical, and electronic controls • Segregation of duties • Independent internal verification • Documentation procedures • Other controls

Bank Reconciliation

Assets Stockholders’ Equity+Basic Equation

Expanded Basic Equation = + – ++ –

Debit /Credit Effects

Liabilities=

Dr. +

Assets

Cr. –

Dr. –

Liabilities

Cr. +

Dr. –

Common Stock

Cr. +

Dr. –

Retained Earnings

Cr. +

Dr. +

Dividends

Cr. –

Dr. –

Revenues

Cr. +

Dr. +

Expenses

Cr. –

⎧ ⎪ ⎪ ⎪ ⎪

⎪ ⎪ ⎪

⎪

⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪

⎪ ⎪ ⎪

⎪ ⎪ ⎪

⎪ ⎪ ⎪ ⎪ ⎪ ⎩

*Items with an asterisk are covered in a chapter-end appendix.

EP-2

PLANT ASSETS (Chapter 10)

Presentation

INVESTMENTS (Chapter 13)

Comparison of Long-Term Bond Investment and Liability Journal Entries

Tangible Assets Intangible Assets

Property, plant, and equipment Intangible assets (Patents, copyrights, trademarks, franchises, goodwill)

Natural resources

Computation of Annual Depreciation Expense

Straight-line

Units-of-activity � Units of activity during year

Declining-balance Book value at beginning of year � Declining balance rate* *Declining-balance rate � 1 � Useful life (in years)

Depreciable cost ��� Useful life (in units)

Cost � Salvage value ��� Useful life (in years)

Straight-line amortization

Bond interest expense Bond interest paid

Carrying value of bonds Face amount of bonds � at beginning of period � Contractual interest rate Effective interest rate

Bond discount (premium) Number of interest periods

Note: If depreciation is calculated for partial periods, the straight-line and declining- balance methods must be adjusted for the relevant proportion of the year. Multiply the annual depreciation expense by the number of months expired in the year divided by 12 months.

Retained Earnings

Debits (Decreases) Credits (Increases) 1. Net loss 1. Net income 2. Prior period adjustments for 2. Prior period adjustments for

overstatement of net income Understatement of net income 3. Cash dividends and stock dividends 4. Some disposals of treasury stock

No-Par Value Par Value

Cash Cash Common Stock Common Stock (par value)

Paid-in Capital in Excess of Par Value

Cash Common Stock Retained Earnings

Cash dividend ↓ No effect ↓

Stock dividend No effect ↑ ↓

Stock split No effect No effect No effect

BONDS (Chapter 11)

Premium Market interest rate � Contractual interest rate

Face Value Market interest rate � Contractual interest rate

Discount Market interest rate Contractual interest rate

Event Investor Investee

Purchase / issue of bonds Debt Investments Cash Cash Bonds Payable

Interest receipt / payment Cash Interest Expense Interest Revenue Cash

Comparison of Cost and Equity Methods of Accounting for Long-Term Stock Investments

Event Cost Equity

Acquisition Stock Investments Stock Investments Cash Cash

Investee reports No entry Stock Investments earnings Investment Revenue

Investee pays Cash Cash dividends Dividend Revenue Stock Investments

RAPID REVIEW Chapter Content

RECEIVABLES (Chapter 9) Methods to Account for Uncollectible Accounts

Direct write-off method Record bad debts expense when the company determines a particular account to be uncollectible.

Allowance methods: At the end of each period estimate the amount of Percentage-of-sales credit sales uncollectible. Debit Bad Debts Expense

and credit Allowance for Doubtful Accounts for this amount. As specific accounts become uncollectible, debit Allowance for Doubtful Accounts and credit Accounts Receivable.

Percentage-of-receivables At the end of each period estimate the amount of uncollectible receivables. Debit Bad Debts Expense and credit Allowance for Doubtful Accounts in an amount that results in a balance in the allowance account equal to the estimate of uncollectibles. As specific accounts become uncollectible, debit Allowance for Doubtful Accounts and credit Accounts Receivable.

STOCKHOLDERS’ EQUITY (Chapter 12)

No-Par Value vs. Par Value Stock Journal Entries

Comparison of Dividend Effects

Computation of Annual Bond Interest Expense

Interest expense � Interest paid (payable) � Amortization of discount (OR � Amortization of premium)

Effective-interest amortization (preferred method)

Debits and Credits to Retained Earnings

Trading Report at fair value with changes reported in net income.

Available-for- Report at fair value with changes reported in the stockholders’ sale equity section.

Trading and Available-for-Sale Securities

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RAPID REVIEW Chapter Content

Prior period adjustments Statement of retained earnings (adjustment of (Chapter 12) beginning retained earnings)

Discontinued operations Income statement (presented separately after “Income from continuing operations”)

Extraordinary items Income statement (presented separately after “Income before extraordinary items”)

Changes in accounting principle In most instances, use the new method in current period and restate previous years results using new method. For changes in depreciation and amortization methods, use the new method in the current period, but do not restate previous periods.

PRESENTATION OF NON-TYPICAL ITEMS (Chapter 15)

STATEMENT OF CASH FLOWS (Chapter 14)

Cash flows from operating activities (indirect method) Net income Add: Losses on disposals of assets $ X

Amortization and depreciation X Decreases in noncash current assets X Increases in current liabilities X

Deduct: Gains on disposals of assets (X) Increases in noncash current assets (X) Decreases in current liabilities (X)

Net cash provided (used) by operating activities $ X

Cash flows from operating activities (direct method) Cash receipts

(Examples: from sales of goods and services to customers, from receipts of interest and dividends on loans and investments) $ X

Cash payments (Examples: to suppliers, for operating expenses, for interest, for taxes) (X)

Cash provided (used) by operating activities $ X

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RAPID REVIEW Financial Statements

Order of Preparation

Statement Type Date

1. Income statement For the period ended

2. Retained earnings statement For the period ended

3. Balance sheet As of the end of the period

4. Statement of cash flows For the period ended

Income Statement (perpetual inventory system)

Name of Company Income Statement

For the Period Ended

Sales revenues Sales $ X Less: Sales returns and allowances X

Sales discounts X Net sales $ X

Cost of goods sold X Gross profit X Operating expenses

(Examples: store salaries, advertising, delivery, rent, depreciation, utilities, insurance) X

Income from operations X Other revenues and gains

(Examples: interest, gains) X Other expenses and losses

(Examples: interest, losses) X X Income before income taxes X Income tax expense X Net income $ X

Income Statement (periodic inventory system)

Name of Company Income Statement

For the Period Ended

Sales revenues Sales $ X Less: Sales returns and allowances X

Sales discounts X Net sales $ X

Cost of goods sold Beginning inventory X Purchases $ X Less: Purchase returns and allowances X Net purchases X Add: Freight in X Cost of goods purchased X Cost of goods available for sale X Less: Ending inventory X

Cost of goods sold X Gross profit X Operating expenses

(Examples: store salaries, advertising, delivery, rent, depreciation, utilities, insurance) X

Income from operations X Other revenues and gains

(Examples: interest, gains) X Other expenses and losses

(Examples: interest, losses) X X Income before income taxes X Income tax expense X Net income $ X

Retained Earnings Statement

Name of Company Retained Earnings Statement

For the Period Ended

Retained earnings, beginning of period $ X Add: Net income (or deduct net loss) X

X Deduct: Dividends X Retained earnings, end of period $ X

STOP AND CHECK: Net income (loss) presented on the retained earnings statement must equal the net income (loss) presented on the income statement.

Balance Sheet

Name of Company Balance Sheet

As of the End of the Period

Assets

Current assets (Examples: cash, short-term investments, accounts receivable, merchandise inventory, prepaid expenses) $ X

Long-term investments (Examples: investments in bonds, investments in stocks) X

Property, plant, and equipment Land $ X Buildings and equipment $ X Less: Accumulated depreciation X X X

Intangible assets X Total assets $ X

Liabilities and Stockholders’ Equity

Liabilities Current liabilities

(Examples: notes payable, accounts payable, accruals, unearned revenues, current portion of notes payable) $ X

Long-term liabilities (Examples: notes payable, bonds payable) X Total liabilities X

Stockholders’ equity Common stock X Retained earnings X

Total liabilities and stockholders’ equity $ X

STOP AND CHECK: Total assets on the balance sheet must equal total liabilities and stockholders’ equity; and, ending retained earnings on the balance sheet must equal ending retained earnings on the retained earnings statement.

Statement of Cash Flows

Name of Company Statement of Cash Flows

For the Period Ended

Cash flows from operating activities Note: May be prepared using the direct or indirect method Cash provided (used) by operating activities $ X

Cash flows from investing activities (Examples: purchase / sale of long-term assets) Cash provided (used) by investing activities X

Cash flows from financing activities (Examples: issue / repayment of long-term liabilities, issue of stock, payment of dividends) Net cash provided (used) by financing activities X

Net increase (decrease) in cash X Cash, beginning of the period X

Cash, end of the period $ X

STOP AND CHECK: Cash, end of the period, on the statement of cash flows must equal cash presented on the balance sheet.

Ratio Formula Purpose or Use

Liquidity Ratios

1. Current ratio Measures short-term debt-paying ability.

2. Acid-test (quick) ratio Measures immediate short-term liquidity.

3. Receivables turnover Measures liquidity of receivables.

4. Inventory turnover Measures liquidity of inventory.

Profitability Ratios

5. Profit margin � N

N et

et in

s c a o le m s e

� Measures net income generated by each dollar of sales.

6. Asset turnover �Av N er

e a t g

s e a a le s s sets�

Measures how efficiently assets are used to generate sales.

7. Return on assets Measures overall profitability of assets.

8. Return on common stockholders’ equity

Measures profitability of stockholders’ investment.

9. Earnings per share (EPS) Measures net income earned on each share of common stock.

10. Price-earnings (P-E) ratio Measures the ratio of the market price per share to earnings per share.

11. Payout ratio Measures percentage of earnings distributed in the form of cash dividends.

Solvency Ratios

12. Debt to total assets ratio Measures percentage of total assets provided by creditors.

13. Times interest earned Measures ability to meet interest payments as they come due.

14. Free cash flow Cash provided by operating activities � Measures the amount of cash generated Capital expenditures � Cash dividends during the current year that is available for

the payment of additional dividends or for expansion.

Income before income taxes and interest expense ������

Interest expense

Total debt �� Total assets

Cash dividends ��

Net income

Market price per share of stock ����

Earnings per share

Net income ������ Weighted average common shares outstanding

Net income ������ Average common stockholders’ equity

Net income ��� Average total assets

Cost of goods sold ��� Average inventory

Net credit sales ��� Average net receivables

Cash � Short-term investments � Receivables (net) ������

Current liabilities

Current assets ��� Current liabilities

RAPID REVIEW Using the Information in the Financial Statements

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