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Accounting Principles:
A Business Perspective
First Global Text Edition, Volume 1
Financial Accounting

Roger H
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W
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H
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M
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Maher PhD, CPA
Graduate School of Management
University of California at Davis
Special con
to managerial chapters:
Kathleen M
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Acknowledgments for the Global Text First Edition:
Revision Editor: Donald J
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0 License

Table of Contents
Accounting principles:A business perspective
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18
Accounting defined
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23
Development of financial accounting standards
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26

1
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30
Forms of business organizations
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32
Financial statements of business organizations
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37
Analyzing and using the financial results—the equity ratio
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Recording business transactions
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66
The accounting cycle
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73
The ledger
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76

3
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116
Cash versus accrual basis accounting
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120
Adjustments for deferred items
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129

4
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150
The accounting cycle summarized
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151
Preparing financial statements from the work sheet
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158
The closing process
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164
A classified balance sheet
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175

5
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198
Traditional accounting theory
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201
The measurement process in accounting
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203
Modifying conventions (or constraints)
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212
Objectives of financial reporting
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214
Recognition and measurement in financial statements
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Merchandising transactions
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236
Two income statements compared— Service company and merchandising company
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238
Cost of goods sold
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252
Analyzing and using the financial results—Gross margin percentage
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Measuring and reporting inventories
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280
Determining inventory cost
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303
Analyzing and using financial results—inventory turnover ratio
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Control of cash
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333
Controlling cash
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343
Bank reconciliation
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352
Analyzing and using the financial results—The quick ratio
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Receivables and payables
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372
Current liabilities
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387
Short-term financing through notes payable
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394

10
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410
Nature of plant assets
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412
Depreciation of plant assets
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428
Subsidiary records used to control plant assets
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433

11
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449
Disposal of plant assets
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461
Analyzing and using the financial results—Total assets turnover
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Stockholders' equity: Classes of capital stock
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487
Documents, books, and records relating to capital stock
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492
Other values commonly associated with capital stock
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493
Classes of capital stock
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495
Balance sheet presentation of stock
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498
Capital stock issued for property or services
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500
Analyzing and using the financial results—Return on average common stockholders' equity
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Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
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522
Retained earnings
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523
Retained earnings appropriations
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532
Statement of stockholders' equity
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533
Net income inclusions and exclusions
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540
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Stock investments
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560
Consolidated balance sheet at time of acquisition
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572
Consolidated financial statements at a date after acquisition
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576
Analyzing and using the financial results—Dividend yield on common stock and payout ratios
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Long-term financing: Bonds
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594
Bond prices and interest rates
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611

16
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630
Purposes of the statement of cash flows
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631
Information in the statement of cash flows
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634
Steps in preparing statement of cash flows
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641
Analyzing and using the financial results—Cash flow per share of common stock, cash flow margin, and cash
flow liquidity ratios
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649

17
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675
Objectives of financial statement analysis
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678
Horizontal analysis and vertical analysis: An illustration
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682
Ratio analysis
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Managerial accounting concepts/job costing
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729
Merchandiser and manufacturer accounting: Differences in cost concepts
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733
The general cost accumulation model
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738
Predetermined overhead rates
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Process: Cost systems
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765
Process costing illustration
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775
Spoilage
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Using accounting for quality and cost management
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795
Quality and customer satisfaction measures
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805
Activity-based costing and management
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811
Impact of new production environment on cost drivers
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816
Strategic use of activity-based management
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817
Opportunities to improve activity-based costing in practice
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Cost-volume-profit analysis
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832
Methods for analyzing costs
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837
Finding the break-even point
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841
Assumptions made in cost-volume-profit analysis
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844
Effect of automation on cost-volume-profit analysis
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Short-term decision making: Differential analysis
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859
Differential analysis
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863
Applying differential analysis to quality
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Budgeting for planning and control
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882
The master budget illustrated
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899
Budgeting in service companies
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900

24
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916
Uses of standard costs
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918
Computing variances
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930
Investigating variances from standard
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931
Nonfinancial performance measures
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933

25
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945
Responsibility accounting
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947
Responsibility centers
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952
Use of segmental analysis
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953
Investment center analysis
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960
Segmental reporting in external financial statements
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Capital budgeting:Long-range planning
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978
Profitability index
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990
The postaudit
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992
Capital budgeting in not-for-profit organizations
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992

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Hermanson, PhD, CPA (Georgia State University, USA)
James D
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H
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, CPA (The University of Georgia, USA)
Michael W
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Hermanson, PhD, CPA
Regents Professor Emeritus of Accounting and Ernst & Young-J
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Holloway Memorial Professor Emeritus at
Georgia State University
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Professor Hermanson taught and later served as chairperson of the Division of Accounting at the University of
Maryland
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He also has
served on the editorial boards of the Journal of Accounting Education, New Accountant, Accounting Horizons, and
Management Accounting
...
He has held the office of vice president of the American Accounting
Association and served on its Executive Committee
...

Professor Hermanson has been awarded two excellence in teaching awards, a doctoral fellow's award, and a
Distinguished Alumni Professor award; and he was selected as the Outstanding Faculty Member for 1985 by the
Federation of Schools of Accountancy
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In
1990, Professor Hermanson was named Accounting Educator of the Year by the Georgia Society of CPAs
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Professor James D
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M
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He is a
graduate of Louisiana State University and has been inducted into the Louisiana State University Alumni
Federation's Hall of Distinction
...
He has served as a professor and chairman of the
Department of Accounting and Financial Administration at Michigan State University, a professor and dean of the
Graduate School of Business Administration at the University of Minnesota, and a Visiting Scholar at Oxford
University in Oxford, England
...
He has served on the board of
directors of the American Institute of Certified Public Accountants and as chairman of the Georgia State Board of
Accountancy
...

He has published in The Accounting Review, The Journal of Accountancy, The Journal of Accounting
Research, Management Accounting, and The Harvard Business History Review
...
He has served on various American Institute of Certified Public
Accountants committees and boards, including the Objectives of Financial Statements Committee, Standards of
Professional Conduct Committee, and the CPA Board of Examiners
...

In 1974, Beta Alpha Psi, the National Accounting Fraternity, selected Professor Edwards for its first annual
Outstanding Accountant of the Year award
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In 1975, he was selected by the American Accounting Association as its Outstanding Educator
...
He was on the Education
Standards Committee of the International Federation of Accountants and the Committee on Planning for the
Institute of Management Accountants
...
He is also a member of the Financial Executives Institute
...
A Doctor Honoris
Causa (Honorary Doctorate) from the University of Paris was awarded to him in 1994
...
The Academy of Accounting Historians awarded him the 1994 Hourglass Award
which is the highest international honor in the field of Accounting History
...
His wife's name is Clara, and he has one son, Jim
...
Maher, PhD, CPA
Professor of management at the University of California at Davis
...
Before going to the University of California at Davis, he taught at
the University of Michigan and the University of Chicago
...
and was a self-employed financial consultant for small businesses while attending graduate school
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He has
coauthored several additional books and monographs, including Internal Controls in US Corporations (Financial
Executives Research Foundation, 1980); and Management Incentive Compensation Plans (National Association of
Accountants, 1986)
...

For his research on internal controls, Professor Maher was awarded the American Accounting Association
Competitive Manuscript Award and the AICPA Notable Contribution in Literature Award
...
From the students at the Graduate School of
Management, University of California, Davis, he has received the Annual Outstanding Teacher Award three times
and twice received a special award for outstanding service
...


Preface
Philosophy and purpose
Imagine that you have graduated from college without taking an accounting course
...
While attending a sales
managers' meeting, financial results are reviewed by the Vice President of Sales and terms such as gross margin
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The Vice
President eventually asks you to discuss these topics as they relate to your territory
...

Accounting principles courses teach you the "language of business" so you understand terms and concepts used
in business decisions
...

The importance of transactions analysis and proper recording of transactions has clearly been demonstrated in
some of the recent business failures that have been reported in the press
...
The debits and
credits are important not only to accounting majors but also to those entering or engaged in a business career to
become managers because the ultimate effects of these journal entries are reflected in the financial statements
...
The
financial statements are only useful and meaningful if they are fair and clearly represent the business events of the
company
...
The text takes a business perspective
...
You are familiar with many of the companies we use, such
as The Limited, The Home Depot, and Coca-Cola Company
...
You also need to be able to find information on the Internet, analyze various business situations, work
effectively as a member of a team, and communicate your ideas clearly
...


Curriculum concerns
Significant changes have been recommended for accounting education
...
The
typical accounting graduate seems unable to successfully deal with complex and unstructured "real world"
accounting problems and generally lacks communication and interpersonal skills
...
The traditional lecture and
structured problem solving method approach would be supplemented or replaced with a more informal classroom
setting dealing with cases, simulations, and group projects
...
Study groups would be
formed so that students could tutor other students
...

One of the most important benefits you can obtain from a college education is that you "learn how to learn"
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Change is occurring at an increasingly rapid pace
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Much of the information you learn in college will

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Accounting principles:A business perspective
be obsolete in just a few years
...
Memorizing is much
less important than learning how to think critically
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The section at the end of each chapter titled, "Beyond the
numbers—Critical thinking", provides the opportunity for you to address unstructured case situations, the analysis
of real companies' financial situations, ethics cases, and team projects
...
For many of these items,
you will use written and oral communication skills in presenting your results
...
As a result, significant changes have taken place in
that course at many universities
...
These individuals will be
better prepared for their responsibilities if they understand the role of accounting information in
decision-making by managers, investors, government regulators, and others
...
1
One of the purposes of the first course should be to recruit accounting majors
...

We retained a solid coverage of accounting that serves business students well regardless of the majors they
select
...


Approach and organization
Business emphasis
Without actual business experience, business students sometimes lack a frame of reference in attempting to
apply accounting concepts to business transactions
...

• "An accounting perspective: Business insight" boxes throughout the text provide examples of how

companies featured in text examples use accounting information every day, or they provide other useful
information
...

• Some chapters contain "A broader perspective"
...
Two, “The First Course in Account”
(Torrance, CA, June 1992), pp
...

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These real
world examples demonstrate the business relevance of accounting
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• The annual report appendix included with this text contains significant portions of the annual report of The

Limited, Inc
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• Numerous illustrations adapted from Accounting Trends & Techniques show the frequency of use in

business of various accounting techniques
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• Throughout the text we have included numerous references to the annual reports of many companies
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This section discusses

and illustrates a ratio or other analysis technique that pertains to the content of the chapter
...

• Some of the chapters contain end-of-chapter questions, exercises, or business decision cases that require

the student to refer to the Annual report appendix and answer certain questions
...

• Each chapter contains a section entitled, "Beyond the numbers—Critical thinking"
...

Pedagogy
Students often come into accounting principles courses feeling anxious about learning the subject matter
...

• Improvements in the text's content reflect feedback from adopters, suggestions by reviewers, and a serious

study of the learning process itself by the authors and editors
...
These paragraphs provide students with
the reasons for proceeding to the new material and explain the progression of topics within the chapter
...

• Each chapter has an "Understanding the learning objectives" section
...
We were the first authors (1974) to
ever include Learning objectives in an accounting text
...
The objectives are also
indicated for each exercise and problem
...
These demonstration problems help students to assess their own progress by
showing them how problems that focus on the topic(s) covered in the chapter are worked before students do
assigned homework problems
...
End-of-chapter glossaries contain the definition
...
The answers and

explanations appear at the end of the chapter
...

• In the margin beside each exercise and problem, we have included a description of the requirements and

the related Learning objective(s)
...

• Throughout the text we use examples taken from everyday life to relate an accounting concept being

introduced or discussed to students' experiences
...
This text includes many items
throughout the text entitled, "An ethical perspective"
...
They range from resisting pressure by a superior or a client to do the
wrong thing to deciding between alternative corporate behaviors that have environmental and profit consequences
...
should place a priority on their interaction with
students and on interaction among students
...
" 2 A section entitled "Beyond the numbers—Critical thinking" at the end of every
chapter is designed to implement these recommendations
...
The Annual report analysis section requires analyzing annual
reports and interpreting the results in writing
...
These cases do not necessarily have one right answer
...
The Internet projects teach students how to retrieve
useful information from the Internet
...

Teams can be assigned the task of presenting their solutions to exercises or problems to the rest of the class
...
(Two additional group projects are described in the Instructor's resource
guide
...
)
We have included a vast amount of other resource materials for each chapter within the text from which the
instructor may draw: (1) one of the largest selections of end-of-chapter questions, exercises, and problems
available; (2) several comprehensive review problems that allow students to review all major concepts covered to
that point; and (3) from one to three business decision cases per chapter
...

• A uniform chart of accounts appears in a separate file you can download
...
We believe students will benefit from using the same chart
of accounts for all homework problems in those chapters
...
2
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• A comprehensive review problem at the end of Chapter 4 serves as a mini practice set to test all material

covered to that point
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Two comprehensive budgeting problems are also included as business decision cases at
the end of Chapter 23
...
Each exercise
and problem is identified with the learning objective(s) to which it relates
...
This feature was a strength of previous editions, ensuring
that instructors could confidently assign problems without having to check for applicability
...


Acknowledgments
The development of all eight editions of Accounting: A Business Perspective was an evolving and challenging
process
...
We are
grateful to the following individuals for their valuable contributions and suggestions which we have incorporated in
the various editions of this text
...

Survey Participants
Diane Adcox (University of North Florida-Jacksonville, USA)
Sue Atkinson (Tarleton State University, USA)
Ed Bader (Holy Family College, USA)
Keith Baker (Oglethorpe University, USA)
C
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Michael Erwin (University of Tennessee, USA)
Ali Fekrat (Georgetown University, USA)
Bill Felty (Lindenwood College, USA)
Clyde J
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Garr (Wayne State University, USA)
John Gercio (Loyola College, USA)
Martin Ginsberg (Rockland Community College, USA)
Earl Godfrey (Gardner-Webb College, USA)
Thomas Grant (Kutztown University, USA)
Paul W
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R
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Harris (Indiana State University, USA)
Dennis Hart (Manchester Community College, USA)
Brenda Hartman (Tomball College, USA)
Mary Hatch (Thomas College, USA)
Margaret Hicks (Howard University, USA)
Patricia H
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Johnson, Sr
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Johnson (Washington State University, USA)
Richard W
...
Kranowski (Radford University, USA)
Michael Kulper (Santa Barbara Community College, USA)
Michael R
...
McClure (University of Maine, USA)
T
...
McCoy (Middlesex Community College, USA)
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Harrison McCraw (West Georgia College, USA)
James E
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J
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Mitchum (Virginia State University, USA)
Susan Moncada (Indiana State University, USA)
Susan Mulhern (Rivier College, USA)
Lee H
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Palmer (Longwood College, USA)
Lynn M
...
Wisconsin Tech Institute, USA)
Doug Pfister (Lansing Community College, USA)
Sharyll A
...
Polk (University of Southern Mississippi, USA)
Harry Purcell (Ulster Community College, USA)
T
...
Regan (Middlesex County College, USA)
Ruthie G
...
Barry Rice (Loyola College in Maryland, USA)
Cheryl Rumler (Monroe County Community College, USA)
Francis Sake (Mercer County Community College, USA)
Jackie Sanders (Mercer County Community College, USA)
Alex J
...
Smith (Cedarville College, USA)
John Snyder (Mohawk Valley Community College, USA)
Leonard E
...
Sullivan (Assumption College, USA)
Norman A
...
Swanson (Southern Oregon State College, USA)
Norman Swanson (Greenville College, USA)
Audrey G
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Weiner (University of San Francisco, USA)
L
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Williams (Morehead State University, USA)
Marge Zolldi (Husson College, USA)
Reviewers
Lucille Berry (Webster University, USA)
Elizabeth L
...
Bremser (Villanova University, USA)
Fred Dial (Stephen F
...
Hartgraves (Emory University, USA)
Martin G
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King (Tyler Junior College, USA)
Jane Konditi (Northwood University, USA)
Charles Konkol (University of Wisconsin-Milwaukee, USA)
William Lawler (Tomball College, USA)
Keith R
...
Nicholas (University of Northern Iowa, USA)
Douglas R
...
Polk (University of Southern Mississippi, USA)
Richard Rand (Tennessee Technical University, USA)
Ruthie G
...
Berry Rice (Loyola College in Maryland, USA)
William Richardson (University of Phoenix, USA)
Douglas Sharp (Wichita State University, USA)
Janet Stoudemire (Midlands Technical College-Airport Campus, USA)
Marilyn Young (Tulsa Junior College-Southeast, USA)

Annotations authors
Diane Adcox (University of North Florida-Jacksonville, USA)
C
...
Cryzewski (Indiana State University, USA)

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Holmes (Des Moines Area Community College, USA)
Donald W
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(Siena College, USA)
Linda Lessing (SUNY at Farmingdale, USA)
Cheryl E
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Nicholas (University of Northern Iowa, USA)
Lynn Mazzola Paluska (Nassau Community College, USA)
Benjamin Shlaes (Des Moines Area Community College, USA)
Margaret Skinner (SUNY at New Paltz, USA)
Leonard F
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Tam (Tulsa Junior College, USA)
Other Contributors
Donald R
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Sellers (Fort Lewis College, USA)
Wayne B
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Sterling Wetzel (Oklahoma State University-Stillwater, USA)

Former co-author
R
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Salmonson (Deceased) (Michigan State University, USA)

The accounting environment
Learning objectives
After studying this introduction, you should be able to:
• Define accounting
...

• Describe employment opportunities in accounting
...

• Identify several organizations that have a role in the development of financial accounting standards
...

History indicates that all developed societies require certain accounting records
...
For example, ancient governments also kept records of receipts and disbursements and
used procedures to check on the honesty and reliability of employees
...
Also, economic progress has affected the development of accounting processes
...

The emergence of double-entry bookkeeping was a crucial event in accounting history
...
Many consider
Pacioli's Summa to be a reworked version of a manuscript that circulated among teachers and pupils of the
Venetian school of commerce and arithmetic
...
As professionals, accountants have a responsibility for placing public service above their
commitment to personal economic gain
...
The special abilities of accountants,
their independence, and their high ethical standards permit them to make significant and unique contributions to
business and areas of public interest
...
Your financial and economic decisions as a student and consumer involve accounting
information
...

Understanding the discipline of accounting also can influence many of your future professional decisions
...

Every profit-seeking business organization that has economic resources, such as money, machinery, and
buildings, uses accounting information
...
Accounting
also serves as the language providing financial information about not-for-profit organizations such as governments,
churches, charities, fraternities, and hospitals
...

The accounting system of a profit-seeking business is an information system designed to provide relevant
financial information on the resources of a business and the effects of their use
...
Companies present this relevant information in their financial
statements
...

As a background for studying accounting, this Introduction defines accounting and lists the functions
accountants perform
...
Because accounting information must conform to certain standards, we
discuss several prominent organizations contributing to these standards
...
You will realize that you are
constantly exposed to accounting information in your everyday life
...
3 This information is primarily financial—stated
in money terms
...
As a measurement and communication
process for business, accounting supplies information that permits informed judgments and decisions by users of
the data
...
Bank officials, for example, may study a company's financial statements to evaluate the company's
ability to repay a loan
...
, 1966), p
...

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Accounting also supplies management with significant financial data
useful for decision making
...
Accounting information is valuable because decision makers can use it to evaluate the financial
consequences of various alternatives
...
They
can reduce uncertainty by using professional judgment to quantify the future financial impact of taking action or
delaying action
...
This information tells how management has discharged its
responsibility for protecting and managing the company's resources
...
In fulfilling this obligation, accountants prepare financial statements such as
an income statement, a statement of retained earnings, a balance sheet, and a statement of cash flows
...

Accounting is often confused with bookkeeping
...
Accounting includes bookkeeping but goes well beyond it in scope
...

Specifically the accounting process consists of the following groups of functions (see Exhibit 1 below):
• Accountants observe many events (or activities) and identify and measure in financial terms (dollars) those

events considered evidence of economic activity
...
) The purchase and sale of goods and services are economic events
...

• Accountants report on economic events (or business activity) by preparing financial statements and special

reports
...
Interpretation may involve determining how the business is performing compared to
prior years and other similar businesses
...
Today, the accountants in the United States number well over a million
...
Typically, accountants provide services in various branches of accounting
...
The demand for accountants will likely increase dramatically in the future
...
You may want to consider accounting as a career
...
An accountant may become a Certified Public Accountant (CPA) by passing an
examination prepared and graded by the American Institute of Certified Public Accountants (AICPA)
...
In addition to passing the exam, CPA candidates must meet other requirements, which
include obtaining a state license
...
A number of states require a CPA candidate to
have completed specific accounting courses and earned a certain number of college credits (five years of study in

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Accounting principles:A business perspective
many states); worked a certain number of years in public accounting, industry, or government; and lived in that
state a certain length of time before taking the CPA examination
...

After a candidate passes the CPA examination, some states (called one-tier states) insist that the candidate meet
all requirements before the state grants the CPA certificate and license to practice
...
However, these states issue the
license to practice only after all other requirements have been met
...
No one can claim to be a CPA and offer the services normally provided by a CPA unless that person holds
an active license to practice
...

The public accounting profession in the United States consists of the Big-Four international CPA firms, several
national firms, many regional firms, and numerous local firms
...
At all levels, these public accounting firms provide auditing,
tax, and, for nonaudit clients, management advisory (or consulting) services
...
Users of a company's financial statements are more confident
that the company is presenting its statements fairly when a CPA has audited the statements
...
Independent auditors of the CPA firm check some of the company's records by contacting external
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...
For example, the accountant may contact a bank to verify the cash balances of the client
...
(For an example of
an auditor's opinion, see The Limited, Inc
...
) This
report states whether the company's financial statements fairly (equitably) report the economic performance and
financial condition of the business
...
Currently auditing standards are established by the Public Company
Accounting Oversight Board
...
The Act was passed as one result of the large losses to the
employees and investors from accounting fraud situations involving companies such as Enron and WorldCom
...
The Board consists of five members appointed and
overseen by the Securities and Exchange Commission
...
The
Chief Executive Officer and Chief Financial Officer of a public company must now certify the company's financial
statements
...

Tax services CPAs often provide expert advice on tax planning and preparing federal, state, and local tax
returns
...
Almost every major
business decision has a tax impact
...

Management advisory (or consulting) services Before Sarbanes-Oxley management advisory services
were the fastest growing service area for most large and many smaller CPA firms
...
However, the Sarbanes-Oxley Act specifically prohibits
providing certain types of consulting services to a publicly-held company by its external auditor
...
Accounting firms can perform many of these services for publicly
held companies they do not audit
...

In contrast to public accountants, who provide accounting services for many clients, management accountants
provide accounting services for a single business
...

Management accountants may or may not be CPAs
...
The ICMA is an affiliate of the Institute of
Management Accountants, an organization primarily consisting of management accountants employed in private
industry
...
Many management accountants
specialize in one particular area of accounting
...
Many management accountants become specialists in the design and installation of computerized
accounting systems
...
They
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Accounting principles:A business perspective
ensure that the company's divisions and departments follow the policies and procedures of management
...
The Institute
of Internal Auditors (IIA) grants the CIA certificate to accountants after they have successfully completed the IIA
examination and met certain other requirements
...
They
have essentially the same educational background and training as accountants in public accounting and
management accounting
...
Often the duties
of these accountants relate to tax revenues and expenditures
...
Government agencies that
regulate business activity, such as a state public service commission that regulates public utilities (e
...
telephone
company, electric company), usually employ governmental accountants
...
Also, FBI
agents trained as accountants find their accounting backgrounds useful in investigating criminals involved in illegal
business activities, such as drugs or gambling
...
Even though these agencies do not have a profit motive, they
should operate efficiently and use resources effectively
...
The activities of these academic
accountants include teaching accounting courses, conducting scholarly and applied research and publishing the
results, and performing service for the institution and the community
...
A significant shortage of accounting faculty has
developed due to the retirement beginning in the late 1990s of many faculty members
...
You may want to talk with some of your professors about the
advantages and disadvantages of pursuing an accounting career in higher education
...
You
might find one that you would like to pursue
...

Decision makers outside the business are affected in some way by the performance of the business
...
For this reason, accounting is divided into
two categories: financial accounting for those outside and managerial accounting for those inside
...
Stockholders and creditors are two of the
outside parties who need financial accounting information
...
Consequently, financial accounting information relates to the company as a whole, while managerial
accounting focuses on the parts or segments of the company
...
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Management accountants in a company prepare the financial statements
...
The financial statements are the representations
of management, not the CPA firm that performs the audit
...
The groups and some of their possible questions are:
• Owners and prospective owners
...
Should a loan be granted to the company? Will the company be able to pay its

debts as they become due?
• Employees and their unions
...
Does the company offer useful products at fair prices? Will the company survive long enough

to honor its product warranties?
• Governmental units
...
Is the company providing useful products and gainful employment for citizens without

causing serious environmental problems?
General-purpose financial statements provide much of the information needed by external users of financial
accounting
...
Many companies publish these statements in
annual reports
...
, annual report in the Annual report appendix
...

Financial accounting information is historical in nature, reporting on what has happened in the past
...
These generally accepted accounting
principles for businesses or governmental organizations have developed through accounting practice or been
established by an authoritative organization
...

Managerial accounting information is for internal use and provides special information for the managers of a
company
...
Managerial accounting information should:
• Relate to the part of the company for which the manager is responsible
...

• Involve planning for the future
...

• Meet two tests: the accounting information must be useful (relevant) and must not cost more to gather and

process than it is worth
...
The four major
types of internal management decisions are:

Accounting Principles: A Business Perspective

24

A Global Text

Accounting principles:A business perspective
• Financial decisions—deciding what amounts of capital (funds) are needed to run the business and

whether to secure these funds from owners (stockholders) or creditors
...

• Resource allocation decisions—deciding how the total capital of a company is to be invested, such as

the amount to be invested in machinery
...

• Marketing decisions—setting selling prices and advertising budgets; determining the location of a

company's markets and how to reach them
...
These are the American Institute of Certified Public Accountants, the
Financial Accounting Standards Board, the Governmental Accounting Standards Board, the Securities and
Exchange Commission, the American Accounting Association, the Financial Executives Institute, and the Institute
of Management Accountants
...

The American Institute of Certified Public Accountants (AICPA) is a professional organization of CPAs
...
Until recent years, the AICPA was the dominant organization in the
development of accounting standards
...
From 1959
through 1973, the committee's successor, the Accounting Principles Board (APB), issued 31 numbered
Opinions that CPAs generally are required to follow
...
Two of its committees—the Accounting Standards Committee and the Auditing
Standards Committee—are particularly influential in providing input to the Financial Accounting Standards Board
(the current rule-making body) and to the Securities and Exchange Commission and other regulatory agencies
...
The FASB has issued numerous Statements of Financial Accounting
Standards
...
The FASB is the private
sector organization now responsible for the development of new financial accounting standards
...
The conclusions of this task force must also be followed in filings with the Securities and
Exchange Commission
...
The GASB issues statements on accounting and financial reporting in the
governmental area
...
The GASB also has the authority to issue interpretations of
these standards
...
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Created under the Securities and Exchange Act of 1934, the Securities and Exchange Commission (SEC)
is a government agency that administers important acts dealing with the interstate sale of securities (stocks and
bonds)
...
This includes virtually every major US business corporation
...
The SEC indicates to the FASB the accounting topics it believes the FASB should address
...
One
of its quarterly magazines, The Accounting Review, carries many articles reporting on scholarly accounting
research
...
A third journal, Issues in Accounting Education, contains articles relating to accounting
education matters
...

The Financial Executives Institute is an organization established in 1931 whose members are primarily
financial policy-making executives
...
The role of the CFO has evolved in recent years from number cruncher to strategic planner
...
Slightly more than 14,000
financial officers, representing approximately 7,000 companies in the United States and Canada, are members of
the FEI
...

The Institute of Management Accountants (formerly the National Association of Accountants) is an
organization with approximately 70,000 members, consisting of management accountants in private industry,
CPAs, and academics
...
However, management accountants prepare the financial statements for external
users
...

Many other organizations such as the Financial Analysts Federation (composed of investment advisers and
investors), the Securities Industry Associates (composed of investment bankers), and CPA firms have committees
or task forces that respond to Exposure Drafts of proposed FASB Statements
...
Many individuals also make their
reactions known to the FASB
...
For instance,
both the American Institute of Certified Public Accountants and the Institute of Management Accountants have
formulated such codes
...

Ethical behavior involves more than merely making sure you are not violating a code of ethics
...
Yet get-rich-quick opportunities can tempt many of us
...
Greed won out over their sense
of right and wrong
...
More appropriate slogans might
be: "If it seems too good to be true, it usually is"; "There are no free lunches"; and the golden rule, "Do unto others
as you would have them do unto you"
...
Those who take the high road of ethical behavior
receive praise and honor; they are sought out for their advice and services
...
Occasionally, accountants do take the low road and suffer the consequences
...
Some of these individuals are removed from the profession
...

Many chapters in the text include an ethics case entitled, "An ethical perspective"
...
Often you will not have much difficulty in determining
"right and wrong"
...

Critical thinking and communication skills
Accountants in practice and business executives have generally been dissatisfied with accounting graduates'
ability to think critically and to communicate their ideas effectively
...

To address these concerns, we have included a section at the end of each chapter entitled, "Beyond the numbers
—Critical thinking"
...

Most of the other end-of-chapter materials also involve analysis and written communication of ideas
...
In writing such a memorandum, identify your role (auditor, consultant), the audience
(management, stockholders, and creditors), and the task (the specific assignment)
...

The purpose of the group projects is to assist you in learning to listen to and work with others
...
Team players listen to the views of others and work cohesively with
them to achieve group goals
...
It is important for accountants and students to be able to use the Internet to find
relevant information
...
Your
instructor might assign some of these, or you could pursue them on your own
...

• Read "Understanding the learning objectives" at the end of the chapter for a preview of the chapter content
...
0 License
• Read the chapter content
...
If you learn best by reading about a concept and then working a short exercise that illustrates
that concept, work the exercises as you read the chapter
...

• Study the Key terms to see if you understand each term
...

• Take the Self-test and then check your answers with those at the end of the chapter
...
Then,

compare your solution to the correct solution that follows immediately
...
If you cannot answer

a particular question, refer back into the chapter for the needed information
...

• Work the Problems assigned by your instructor, using the forms available
...
freeloadpress
...

• Study the items in the "Beyond the numbers—Critical thinking" section and the "Using the Internet—A view

of the real world" section at the end of each chapter to relate what you have learned to real-world situations
...
The Study guide is a supplement that contains (for each chapter)

Learning objectives; Demonstration problem and solution (different from the one in the text); Matching,
Completion, True-false, and Multiple-choice questions; and Solutions to all questions and exercises in the
study guide
...
freeloadpress
...

If you perform each of these steps for each chapter, you should do well in the course
...


International accounting standards
In recent years, there has been a movement to develop a single set of global accounting standards
for use around the world
...
The International Accounting
Standards Committee (IASC) Foundation was established as an independent, not-for profit, private
sector organisation to work towards this goal
...
The AICPA (as well as the other entities mentioned above)
supports this effort and, as of early 2010, states on its website that:
“The growing acceptance of International Financial Reporting Standards (IFRS) as a basis for U
...

financial reporting represents a fundamental change for the U
...
accounting profession
...
In the United States, the Securities and Exchange
Commission (SEC) has been taking steps to set a date to allow U
...
public companies to use IFRS,
and perhaps make its adoption mandatory
...
Clearly, many new issues can emerge between now and 2014, but the direction
seems to be clear
...


You might like to check it out from time to time at

http://www
...
com/Backgrounder_Get_Ready
...
There is also a wealth of information on the
IFRS website at http://ifrs
...

Students from countries other than the US should check the website of the professional accounting
organization in your country for an update on the current status
...
org and search on IFRS you
will find a number of links to documents covering the planned migration to IFRS in India
...
0 License

1
...

• Distinguish among the three types of activities performed by business organizations
...

• State the basic accounting equation and describe its relationship to the balance sheet
...

• Prepare an income statement, a statement of retained earnings, and a balance sheet
...


A career as an entrepreneur
When today’s college students are polled about their long-term career choice, a surprisingly large number
respond that they wish to someday own and manage their own business
...
It is widely acknowledged that a degree in accounting offers many
advantages to a would-be entrepreneur
...
No matter what the business may be, the owner
and/or manager must be able to understand the accounting and financial consequences of business decisions
...
There are many steps involved before an idea becomes a successful and
rewarding business
...
Once a business
has been launched, the entrepreneur must be a manager—a manager of people, inventory, facilities, customer
relationships, and relationships with the very banks and investors that provided the capital
...
An accounting education is ideal for providing this versatile background
...
For example, a large percentage of public accountants work as sole
proprietors—building and managing their own professional practice
...
One advantage of this career is that you can establish your practice in
virtually any location ranging from large cities to rural settings
...
Expertise such as
this, which may be in a field outside of traditional accounting practice, can generate billing rates well in the excess
of USD 100 an hour
...
Accounting and its use in business decisions
The introduction to this text provided a background for your study of accounting
...
This chapter presents
the financial statements used by businesses
...
Investors, creditors, and managers use these statements in evaluating management’s past decisions
and as a basis for making future decisions
...
This accounting process uses financial data such as the records of sales made to
customers and purchases made from suppliers
...
As you study this chapter, you
will begin to understand the unique, systematic nature of accounting—the language of business
...
A
business entity is any business organization, such as a hardware store or grocery store, that exists as an economic
unit
...
4 This separate existence of the business organization is
known as the business entity concept
...

Assume, for example, that you own two businesses, a physical fitness center and a horse stable
...
Thus, you would
normally keep separate accounting records for each business
...
You can determine this
fact because you are treating your physical fitness center and horse stable as two separate business entities
...
Therefore, you cannot include
the car you drive only for personal use as a business activity of your physical fitness center or your horse stable
...

As you will see shortly, the business entity concept applies to the three forms of businesses—single
proprietorships, partnerships, and corporations
...
Since most large businesses are corporations, we use
the corporate approach in this text and include only a brief discussion of single proprietorships and partnerships
...
Single proprietors include physicians, lawyers, electricians, and other people in business for
themselves
...
No legal
formalities are necessary to organize such businesses, and usually business operations can begin with only a limited
investment
...
For accounting purposes,
however, the business is a separate entity from the owner
...
Usually these terms are set in bold
...

31

This book is licensed under a Creative Commons Attribution 3
...
For example, owners of single proprietorships should not enter the cost of personal houses or car
payments in the financial records of their businesses
...
Often the
same persons who own the business also manage the business
...

A partnership begins with a verbal or written agreement
...
These terms include the initial investment of each partner, the
duties of each partner, the means of dividing profits or losses between the partners each year, and the settlement
after the death or withdrawal of a partner
...
However, as with the single proprietorship, for
accounting purposes, the partnership is a separate business entity
...
Almost all large businesses and many small businesses are incorporated
...
The owners of the corporation are
stockholders, or shareholders
...

Should the corporation fail, the owners would only lose the amount they paid for their stock
...
5
Stockholders do not directly manage the corporation
...

The board of directors selects the officers of the corporation, such as the president and vice presidents, who manage
the corporation for the stockholders
...
Since corporations have such an important impact on our economy, we use
them in this text to illustrate basic accounting principles and concepts
...
Single proprietorships constitute about 75 per cent of all
business organizations but account for less than 10 per cent of sales volume
...
Business entities can also be grouped by the type of business activities they perform—service
5 When individuals seek a bank loan to finance the formation of a small corporation, the bank often requires those
individuals to sign documents making them personally responsible for repaying the loan if the corporation
cannot pay
...

Accounting Principles: A Business Perspective

32

A Global Text

1
...
Any of these activities can be performed by
companies using any of the three forms of business organizations
...
This group includes accounting firms, law firms, and dry

cleaning establishments
...

• Merchandising companies purchase goods that are ready for sale and then sell them to customers
...
We begin the
description of accounting for merchandising companies in Chapter 6
...
Manufacturing companies include steel mills, auto
manufacturers, and clothing manufacturers
...
These
financial statements provide relevant financial information both to those inside the company—management—and
to those outside the company—creditors, stockholders, and other interested parties
...


Financial statements of business organizations
Business entities may have many objectives and goals
...
However, the two primary objectives of every business are
profitability and solvency
...
Solvency is the ability to pay debts as
they become due
...

There are four basic financial statements
...
The
financial statement that reflects a company’s profitability is the income statement
...
g
...
The balance sheet reflects a company’s solvency and financial position
...
The headings and elements of each
statement are similar from company to company
...

The income statement, sometimes called an earnings statement, reports the profitability of a business
organization for a stated period of time
...
Revenues are the
inflows of assets (such as cash) resulting from the sale of products or the rendering of services to customers
...

Expenses are the costs incurred to produce revenues
...
If the revenues of a period exceed the expenses of the same period, net income
results
...
When expenses exceed revenues, the business has a net
loss, and it has operated unprofitably
...
0 License
In Exhibit 3, Part A shows the income statement of Metro Courier, Inc
...
This corporation
performs courier delivery services of documents and packages in San Diego in the state of California, USA
...
Expenses for the month amounted to USD 3,600
...
To determine its net income, the
company subtracts its expenses of USD 3,600 from its revenues of USD 5,700
...

One purpose of the statement of retained earnings is to connect the income statement and the balance sheet
...

These changes usually consist of the addition of net income (or deduction of net loss) and the deduction of
dividends
...
A dividend is a payment (usually of cash) to the owners of the business; it is a distribution of
income to owners rather than an expense of doing business
...

The effect of a dividend is to reduce cash and retained earnings by the amount paid out
...
Receiving dividends is, of course,
one of the primary reasons people invest in corporations
...
, for July 2010 is relatively simple (see Part B of
Exhibit 3)
...
So Metro’s
beginning retained earnings balance on July 1 is zero
...
Since
Metro paid no dividends in July, the USD 2,100 would be the ending balance of retained earnings
...

A
...
Statement of Retained
Earnings
METRO COURIER , INC
...
Accounting and its use in business decisions

Retained
earnings, July 1
Add: Net
income for July
Retained
earnings, July
31

-0(A)2,100
$
2,100
(B)

C
...

Balance Sheet
2010 July 31
Assets
Cash

Liabilities and Stockholder's Equity
$

Account receivables
Trucks
Office equipment

15,500 Liabilities:
700 Accounts payable
20,000 Notes payable
2,500 Total liabilities

$

600
6,000
6,600

$

Stockholders equity:
Capital stock

$

Retained earnings
Total stockholders' equity
Total assets

$

38,700 Total liabilities and stockholders' equity

30,000
(B)2,100

$

32,100

$

38,700

Exhibit 2:
Next, Metro carries this USD 2,100 ending balance in retained earnings to the balance sheet (Part C)
...
For instance, if during the next month (August) there is a net loss of USD 500, the loss would be deducted
from the beginning balance in retained earnings of USD 2,100
...

Dividends could also have affected the Retained Earnings balance
...
’s net income for August was actually USD 1,500 (revenues of USD 5,600 less expenses
of USD 4,100) and (2) the company declared and paid dividends of USD 1,000
...

Statement of Retained Earnings
For the Month Ended 2010 August 31
Retained earnings, August 1
...

Total
...

Retained earnings, August 31
...
That specific moment is the
close of business on the date of the balance sheet
...
A balance sheet is like a photograph; it
captures the financial position of a company at a particular point in time
...
As you study about the assets, liabilities, and stockholders’ equity contained in a balance sheet, you will
understand why this financial statement provides information about the solvency of the business
...
They are also called the resources of the business
...
Assets have value because a business can use or exchange them to produce
35

This book is licensed under a Creative Commons Attribution 3
...
In Part C of Exhibit 3 the assets of Metro Courier, Inc
...
Metro’s assets consist of cash, accounts receivable (amounts due from customers for services previously
rendered), trucks, and office equipment
...
Typically, a business must pay its debts by certain dates
...
Metro’s liabilities consist of accounts
payable (amounts owed to suppliers for previous purchases) and notes payable (written promises to pay a
specific sum of money) totaling USD 6,600
...
, is a corporation
...
Metro’s stockholders’ equity consists of (1) USD 30,000 paid for shares of capital stock and (2) retained
earnings of USD 2,100
...
Retained
earnings generally consists of the accumulated net income of the corporation minus dividends distributed to
stockholders
...
At this point, simply note that the balance sheet heading
includes the name of the organization and the title and date of the statement
...
The balance sheet shows these claims under
the heading “Liabilities and Stockholders’ Equity”
...
The statement of cash flows shows
the cash inflows and cash outflows from operating, investing, and financing activities
...

Investing activities generally include business transactions involving the acquisition or disposal of long-term assets
such as land, buildings, and equipment
...

Chapter 16 describes the statement of cash flows in detail
...
Normally, a firm prepares a statement of cash flows for the same time period as the
income statement
...
,
since it was formed on 2010 June 1
...

METRO COURIER, INC
...


$2
...

Increase in accounts payable
...


(700)
600
$2,000

Cash flows from investing activities:
Purchase of trucks
...


(2,500)

Net cash used by investing activities
...


$6,000

Proceeds from sale of capital stock
...
Interest is an amount
paid by the borrower to the lender (in addition to the amount of the loan) for use of the money over time
...
Accounting and its use in business decisions
Net cash provided by financing activities
...


36,000
$15,500

At this point in the course, you need to understand what a statement of cash flows is rather than how to prepare
it
...

The income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows of
Metro Courier, Inc
...
They are the end products of the accounting
process, which we explain in the next section
...
The accounting process details how this picture was made
...
Management is the first to know the financial
results; then, it publishes the financial statements to inform other users
...


The financial accounting process
In this section, we explain the accounting equation—the framework for the entire accounting process
...
Next you learn how to analyze and record business transactions
...
, were equal to its total
liabilities and stockholders’ equity
...
Equities are all claims to, or interests in, assets
...
Your equity in the automobile is USD 10,000, and the bank’s equity is
USD 5,000
...
If you are a
corporation, you can describe your USD 10,000 equity as stockholders’ equity or interest in the asset
...
Therefore, this
equation must always be in balance
...
The liabilities and stockholders’ equity
show the sources of an existing group of assets
...

Together, creditors and owners provide all the assets in a corporation
...
However, companies can sometimes improve their profitability
by borrowing from creditors and using the funds effectively
...
0 License
amounts and composition of its assets, liabilities, and stockholders’ equity change
...

An accounting transaction is a business activity or event that causes a measurable change in the accounting
equation, Assets = Liabilities + Stockholders’ equity
...
The
exchange takes place at an agreed price that provides an objective measure of economic activity
...
These two factors—evidence and measurement—make
possible the recording of a transaction
...

A source document usually supports the evidence of the transaction
...
Examples of source
documents are receipts for cash paid or received, checks written or received, bills sent to customers for services
performed or bills received from suppliers for items purchased, cash register tapes, sales tickets, and notes given or
received
...
Each source document initiates the process
of recording a transaction
...
Both
preparers and users of financial statements must understand these assumptions:
• Business entity concept (or accounting entity concept)
...
The business entity concept assumes that each business has an
existence separate from its owners, creditors, employees, customers, other interested parties, and other
businesses
...
Economic activity is initially recorded and reported in a common

monetary unit of measure—the dollar in the United States
...

• Exchange-price (or cost) concept (principle)
...
As a result, we record most assets at their
acquisition cost
...

• Going-concern (continuity) concept
...
Accountants call this
assumption the going-concern or continuity concept
...
Market values of these assets would be relevant only if they were for sale
...

• Periodicity (time periods) concept
...


Accounting Principles: A Business Perspective

38

A Global Text

1
...
To begin, we divide Metro’s transactions into two groups: (1)
transactions affecting only the balance sheet in June, and (2) transactions affecting the income statement and/or
the balance sheet in July
...


Transactions affecting only the balance sheet
Since each transaction affecting a business entity must be recorded in the accounting records, analyzing a
transaction before actually recording it is an important part of financial accounting
...

To illustrate the analysis of transactions and their effects on the basic accounting equation, the activities of
Metro Courier, Inc
...
The first set of transactions (for June), 1a, 2a, and
so on, are repeated in the summary of transactions, Exhibit 2 (Part A)
...


1a
...
, was organized as a corporation on 2010 June 1, the company issued shares of capital
stock for USD 30,000 cash to Ron Chaney, his wife, and their son
...

Consequently, the transaction yields the following basic accounting equation:
Transaction

Explanation
Beginning
balances
Stockholder
s invested
cash
Balance
after
transaction

1a

Assets
Accounts
Receivable

Cash

$ -030,000

Trucks

$ -0-

$ -0-

=Liabilities +
Notes
Payable
+

Office
Equipment

Stockholders' Equity

Accounts
Payable

$ -0-

= $ -0-

Capital
Stock
$ -030,000

$ -0-

$ 30,000

$ 30,000

Increased
by
$30,000

Increased by
$30,000

2a
...
Chaney signed the note for the company
...
After including the effects of this transaction, the basic accounting equation is:
Assets
Transaction

2a

Explanation
Balances
before
transaction
Borrowed
money
Balance
after
transaction

Cash
$ 30,000

= Liabilities +

Stockholder's Equity

Accounts
Receivable

Trucks

Office
Equipment

Accounts
Payable

Notes
Payable

$ -0-

$ -0-

$ -0-

= $ -0-

$ -0-

6,000

Capital
+ Stock
$ 30,000

6,000

$ 36,000

=

Increased by
$6,000

$ 6,000
Increased by
$6,000

39

+ $ 30,000

This book is licensed under a Creative Commons Attribution 3
...
Purchased trucks and office equipment for cash
Metro paid USD 20,000 cash for two used delivery trucks and USD 1,500 for office equipment
...
Note that this transaction does
not change the total amount of assets in the basic equation but only changes the composition of the assets
...
Metro received two assets and gave up one asset of equal value
...
The
accounting equation now is:
Assets
Cash
$ 36,000

=

Accounts
Receivable
$ -0-

Office
Equipment

Accounts
Payable

$ -0- =

Trucks

$ -0-

$ -0-

(21,500)
$

20,000
$ 20,000

Notes
Payable

Capital
+ Stock

$ 6,000

$ 6,000

$ 1,500 =

+ $ 30,000

+ $ 30,000

1,500

14,500

Stockholders'
Equity

Liabilities +

Decreased
by
$21,500

Increased
Increased by
by
$1,500
$20,000

4a
...
(To purchase an item on account means to buy it on credit
...
As stated earlier, accounts payable are amounts
owed to suppliers for items purchased on credit
...
Paid an account payable
Eight days after receiving the bill, Metro paid USD 1,000 for the office equipment purchased on account
(transaction 4a)
...
Thus,
the assets and liabilities both are reduced by USD 1,000, and the equation again balances as follows:
Assets
Transaction

5a

Explanatio
n
Balances
before
transaction
Paid an
account
payable
Balance
after
transaction

Cash
$ 14,500

Accounts
Receivable
$ -0-

Trucks
$ 20,000

= Liabilities +
Office
Equipment

Accounts
Payable

$ 2,500 =

$

(1,000)
$ 13,500

1,000

Notes
Payable

Stockholders equity
+ Capital Stock

$ 6,000

+ $30,000

$ 6,000

+$30,000

(1,000)
$ -0-

$ 20,000

Decreased
by
$1,000

$ 2,500

$ -0-

Decreased
by
$1,000

A
...
Accounting and its use in business decisions
METRO COURIER, INC
...
Balance Sheet
METRO COURIER, INC
...
A summary of
transactions is a teaching tool used to show the effects of transactions on the accounting equation
...
This amount changes as the business begins to earn revenues or
incur expenses
...
The date on the balance sheet is 2010 June 30
...

Thus far, all transactions have consisted of exchanges or acquisitions of assets either by borrowing or by owner
investment
...

However, people do not form a business only to hold existing assets
...
Thus, a business increases its assets by providing goods or services to
customers
...
The section that follows shows more of
Metro’s transactions as it began earning revenues and incurring expenses
...
This means that the revenues earned by providing goods and services
to customers must exceed the expenses incurred
...
, began selling services and incurring expenses
...


1b
...

This transaction increased an asset (cash) by USD 4,800
...

41

This book is licensed under a Creative Commons Attribution 3
...
Likewise, if the corporation
sustains a loss, the loss would reduce retained earnings
...
(In this first
chapter, we show all of these items as immediately affecting retained earnings
...
) The effects of this USD 4,800 transaction on the financial position of Metro are:
Metro would record the increase in stockholders’ equity brought about by the revenue transaction as a separate
account, retained earnings
...
The expectation is that revenue transactions will exceed expenses and
yield net income
...
Later chapters show that
because of complexities in handling large numbers of transactions, revenues and expenses affect retained earnings
only at the end of an accounting period
...

Assets
Transac
tion

1b

Explanation
Beginning balances
(Exhibit 2)
Earned service revenue
and received cash
Balances after transaction

Accounts
Receivable

Cash
$

13,500

$

$ -0-

18,300

=Liabilities +
Office
Equipment

Trucks
$ 20,000

$ 2,500 =

$ 20,000

Accounts
Payable

Stockholders' Equity

Notes
Payable

$ -0-

$ 2,500 =

Capital +
Stock

Retained
Earnings

$

6,000

$ 30,000

$

6,000

+ $ 30,000

$ -0-

4,800

4,800
$

4,800

Increased
by
$4,800

Increased by
$4,800

2b
...
The
company granted credit rather than requiring the customer to pay cash immediately
...
The transaction consists of exchanging services for the customer’s promise to pay later
...
However, the transaction differs because the company has not received cash
...
As noted earlier, an account receivable is
the amount due from a customer for goods or services already provided
...
Accounting recognizes such claims as assets
...
Accounting and its use in business decisions

3b
...
The customer will pay the remaining
USD 700 later
...
The transaction increases cash by USD 200 and decreases accounts receivable by USD 200
...
When the company performed the
services, it recorded the revenue
...

Assets
Transact Explanation
ion

Cash

Balances before
transaction
3b

Accounts
Receivable

$

18,300

$

=Liabilities +
Trucks

900 $

Collected cash
on account

$

200

$

18,500

$700

Accounts
Payable

Notes Payable

+ Capital
Stock

20,000

$ 2,500
=

$ 6,000

$ 30,000

20,000

$ 2,500
=

$ 6,000

+ $ 30,000

(200)

Balances after
transaction

Office
Equipment

Stockholders' +Equity

Increased by
$200

Decreased by
$200

4b
...
This transaction is an exchange of cash for employee services
...
Salaries (or wages) are costs
companies incur to produce revenues, and companies consider them an expense
...
Expense transactions reduce net income
...

Assets
Cash
$

Accounts
Receivable

Trucks

18,500
(2,600)

$

$

700

$ 20,000

15,900

$

700

= Liabilities +
Stockholders' Equity
Accounts
Notes
Capital Stock Retained Earnings
Payable Payable +
$ 5,700
$ 2,500 =
$6,000
$ 30,000
(2,600)

Office
Equipment

$ 20,000

$ 2,500 =

$6,000 +

Decreased by
$2,600

$ 30,000

$

3,100

Decreased by
$2,600

5b
...
This transaction causes a decrease in cash of USD 400
and a decrease in retained earnings of USD 400 because of the incurrence of rent expense
...
Received bill for gas and oil used
At the end of the month, Metro received a USD 600 bill for gas and oil consumed during the month
...
Metro’s accounting equation now reads:
43

This book is licensed under a Creative Commons Attribution 3
...
, in July
...
The summary shows subtotals after each transaction; these subtotals are optional and may be omitted
...

The ending balances in each of the columns in Part A of Exhibit 4 are the dollar amounts in Part B and those
reported earlier in the balance sheet in Part C of Exhibit 3
...
The beginning balance in the Retained Earnings column (USD 0) plus net income for the month (USD
2,100) is equal to the ending balance in retained earnings (USD 2,100) shown earlier in Part B of Exhibit 3
...
Throughout the text we show how people use accounting information in
decision making
...
The payment of cash or other assets to
stockholders in the form of dividends also reduces stockholders’ equity
...


An ethical perspective:
State university
James Stevens was taking an accounting course at State University
...
He advised one of his clients to
acquire a software computer package that could record the business transactions and prepare the
financial statements
...

James was pleased that his recommendation to acquire the software was followed
...
A member of management
stated, “The software company will never know the difference and, besides, everyone else seems to
be pirating software
...
Our expenses are high

Accounting Principles: A Business Perspective

44

A Global Text

1
...
” James believed he might lose this client if he did
not do as management instructed
...
By making on-screen choices you can discover all kinds of interesting
information about almost anything
...
We have included some Internet Projects at the end of the chapters to give you some
experience at “surfing the net” for accounting applications
...
Summary of Transactions
METRO COURIER, INC
...
2)
Earned service revenue and
received cash

-Liabilities
Accounts
Receiv- Trucks
able

$
13,500

$ -0-

Paid salaries

$ 900

200

Paid rent

$ 30,000

$ 4,800

$ 700

900(B)
$ 20,000 $ 2,500 =

$ 6,000 +

$ 30,000

$ 20,000 $ 2,500 =

$ 6,000 +

$ 30,000

$ 5,700

$ 5,700
(2,600)(C)

$ 700

$ 20,000 $ 2,500 =

$ 6,000 +

$ 30,000

$ 3,100
(400)(D)

$ 700

$ 20,000 $ 2,500 =

$ 6,000 +

Received bill for gas and oil used

$38,700

$ 2,500
=(I)

$ 2,700

$

600(J)

(600)(E)
$ 6,000 +(K)

$6,600

METRO COURIER, INC
...
Balance Sheet

Cash

$ 6,000 +

(400)

End-of-month balances

Assets

$ -0-

(2,600)

$
15,500
6b

$ 30,000

(200)

$
15,900
5b

$ 6,000 +

Retained
Earnings

900

$
18,500
4b

$ -0-

$ 20,000 $ 2,500 =

Earned service revenue on account

Collected cash on account

Stockholders' Equity

4,800(A)

$
18,300
3b

$ 20,000 $ 2,500 =

+

Notes Payable Capital
+
Stock

4,800
$
18,300

2b

Office
Accounts
Equipment Payable

Accounts payable
(J)$600
Notes payable
(K)6,000
Total liabilities Stockholders' equity $6,600

45

$ 30,000(L)

$ 2,100(M)

$32,100

This book is licensed under a Creative Commons Attribution 3
...
Income Statement
METRO COURIER, INC
...
To find the equity ratio, divide stockholders’ equity by total equities or total assets, since total
equities equals total assets
...

However, a high portion of debt may indicate higher profitability because quite often the interest rate on debt is
lower than the rate of earnings realized from using the proceeds of the debt
...
$100,000 Liabilities
...
$80,000
Case 2
Assets
...
$80,000
Stockholders' equity
...
In Case 1, the assets would have to shrink by 80
per cent before the liabilities would equal the assets
...
When the liabilities exceed the assets, the company is said to be
insolvent
...

However, if funds borrowed at 10 per cent are used to produce earnings at a 20 per cent rate, Case 2 is
preferable in terms of profitability
...

Next, we examine the recent equity ratios of some actual companies:
Stockholders'
Equity ($ millions)
Johnson & Johnson
$ 23,734
3M Corporation
6,166
General Electric Company 53,597
Name of Company

Total Equities ($ millions) Equity Ratio
$ 37,053
15,205
460,097

Accounting Principles: A Business Perspective

64
...
6
11
...
Accounting and its use in business decisions
As you can see from the preceding data, the equity ratios of actual companies vary widely
...
GE employs a greater proportion of
debt, possibly in an attempt to increase profitability
...
The correct balance between proportions of stockholder and creditor
equities depends on the industry, general business conditions, and management philosophy
...
In Chapter 2, you learn about debits and credits and how accountants use them in
recording transactions
...


An accounting perspective:
Uses of technology
When you apply for your first job after graduation, prospective employers will expect you to know
how to use a PC to perform many tasks
...
You should be able to use the Internet to find
useful information
...
If
your school does not offer credit courses, take noncredit courses or attend a training center
...

• A partnership is an unincorporated business owned by two or more persons associated as partners and

is often managed by them
...

• Service companies perform services for a fee
...

• Manufacturing companies buy materials, convert them into products, and then sell the products to

other companies or to final customers
...

• The statement of retained earnings shows the change in retained earnings between the beginning of

the period (e
...
a month) and its end
...

• The statement of cash flows shows the cash inflows and cash outflows for a company for a stated

period of time
...
0 License
• The accounting equation is Assets = Liabilities + Stockholders’ equity
...

• The right side of the equation represents the right side of the balance sheet and shows who provided

the funds to acquire the things of value (assets)
...
Other transactions affect both balance sheet items and income statement items (revenues,
expenses, and eventually retained earnings)
...

• The income statement appears in Exhibit 3 (Part A) and Exhibit 4 (Part C)
...

• The balance sheet appears in Exhibit 3 (Part C) and Exhibit 4 (Part B)
...

• The equity ratio shows the percentage that assets would have to shrink before a company would become

insolvent (liabilities exceed assets)
...
In a survey of users and nonusers of our text, we learned that the majority
preferred the corporate approach because most students will probably work for or invest in corporations
...

This appendix briefly describes the differences in accounting for these three forms of business ownership
...

As you learned in this chapter, the stockholders’ equity section of the balance sheet for a corporation consists of
capital stock and retained earnings
...
The owner’s equity section of a partnership is similar to that of a single
proprietorship except that it shows a capital account and its balance for each partner
...
$100,000

Sole Proprietorship
Owner's equity:
John Smith,
Capital
...
$75,000

Retained

Sam Jones,

earnings
...
75,000

Total
...
However, the items in the owner’s equity section of the balance sheets of a sole proprietorship and a
partnership always remain as just shown
...
Thus, all of the amounts in the various stockholders’ equity accounts for a
corporation are in the owner’s capital account in a single proprietorship
...
Accounting and its use in business decisions
account balance consists of that partner’s investments in the business, plus that partner’s cumulative share of net
income since that partner became a partner, less any amounts withdrawn by that partner
...

These accounts both show amounts taken out of the business by the owners
...
Accountants treat asset, liability, revenue, and expense accounts similarly in all three forms of
organization
...
The following transactions occurred
during June:
June 1 Shares of capital stock were issued for USD 10,000 cash
...

8 Horse feed for the month was purchased on credit, USD 800
...
(Fee is due
on July 10
...

29 Land was purchased from a savings and loan association by borrowing USD 40,000 on a note from that
association
...
Interest payments are due at the end of each month beginning
July 31
...

30 Riding and lesson fees were billed to customers in the amount of USD 2,800
...
)
Prepare a summary of the preceding transactions
...
Determine balances after each transaction
to show that the basic accounting equation is in balance
...

Prepare a statement of retained earnings for June 2010
...

Solution to demonstration problem
GREEN HILLS RIDING STABLE, INCORPORATED
Summary of Transactions
Month of June 2010

a
...
0 License
30

Salaries paid

30

(700)

(700)

Riding and lesson
fees billed

$ 7,500

$

3,000

$ 40,000 =

$

800

$ 40,000

+ $ 10,000

2,800
$ 7,500

$

$

(300)

2,800

5,800

$ 40,000

$

800

$ 40,000

+ $ 10,000

$

2,500

b)
GREEN HILLS RIDING STABLE, INCORPORATE
Income Statement
For the Month Ended 2010 June 30
Revenues:
Horse boarding fees revenue

$

3,000

Riding and lesson fee revenue

2,800

Total revenues

$

5,800

Expenses:
Rent expense

$

Feed expense

800

Salaries expense

700

Miscellaneous expense

1,200

600

Total expenses
Net income

3,300
$

2,500

c)
GREEN HILLS RIDING STABLE, INCORPORATED
Statement of Retained Earnings
For the Month Ended 2010 June 30
Retained earnings, June 1
$ -0Add: Net income for June
2,500
Total
$ 2,500
Less: Dividends
-0Retained earnings, June 30
$ 2,500

d)
GREEN HILLS RIDING STABLE, INCORPORATE
Balance Sheet
2010 June 30
Assets
Cash

$

7,500

Accounts receivable

5,800

Land

40,000

Total assets

$

53,300

Liabilities and Stockholders' Equity
Liabilities:
Accounts payable

$

Noted payable

800
40,000

Total liabilities

$

40,800

Stockholders' equity:
Capital stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity

$ 10,000
2,500
$

12,500

$53,300
...

Accounts payable Amounts owed to suppliers for goods or services purchased on credit
...


Accounting Principles: A Business Perspective

50

A Global Text

1
...
Examples include cash, machines, and buildings
...

Balance sheet Financial statement that lists a company’s assets, liabilities, and stockholders’ equity
(including dollar amounts) as of a specific moment in time
...

Business entity concept (or accounting entity concept) The separate existence of the business
organization
...

Continuity See going-concern concept
...

Cost Sacrifice made or the resources given up, measured in money terms, to acquire some desired thing,
such as a new truck (asset)
...

Entity A business unit that is deemed to have an existence separate and apart from its owners, creditors,
employees, customers, other interested parties, and other businesses, and for which accounting records are
maintained
...

Equity ratio A ratio found by dividing stockholders’ equity by total equities (or total assets)
...

Expenses Costs incurred to produce revenues, measured by the assets surrendered or consumed in serving
customers
...

Income statement Financial statement that shows the revenues and expenses and reports the profitability
of a business organization for a stated period of time
...

Liabilities Debts owed by a business—or creditors’ equity
...

Manufacturing companies Companies that buy materials, convert them into products, and then sell the
products to other companies or to final customers
...

Money measurement concept Recording and reporting economic activity in a common monetary unit of
measure such as the dollar
...

Net loss Amount by which the expenses of a period exceed the revenues of the same period
...

Partnership An unincorporated business owned by two or more persons associated as partners
...

Profitability Ability to generate income
...

Retained earnings Accumulated net income less dividend distributions to stockholders
...

Service companies Companies (such as accounting firms, law firms, or dry cleaning establishments) that
perform services for a fee
...

Solvency Ability to pay debts as they become due
...

Source document Any written or printed evidence of a business transaction that describes the essential
facts of that transaction, such as receipts for cash paid or received
...
0 License
Statement of cash flows Financial statement showing cash inflows and outflows for a company over a
period of time
...

Stockholders’ equity The owners’ interest in a corporation
...

Summary of transactions Teaching tool used in Chapter 1 to show the effects of transactions on the
accounting equation
...

Self-test
True-False
Indicate whether each of the following statements is true or false
...

The three types of business activity are service, merchandising, and manufacturing
...

The statement of retained earnings shows both the net income for the period and the beginning and ending
balances of retained earnings
...

Multiple-choice
Select the best answer for each of the following questions
...
Income statement
...
Statement of retained earnings
...
Balance sheet
...
Both (b) and (c)
...
Assets = Equities
...
Assets = Liabilities + Stockholders’ equity
...
Assets – Liabilities = Stockholders’ equity
...
Assets + Stockholders’ equity = Liabilities
...
Exchange-price concept
...
Inflation accounting concept
...
Business entity concept
...
Going-concern concept
...
Liabilities increase and stockholders’ equity increases
...
Both assets and liabilities increase
...
Both assets and stockholders’ equity increase
...
Accounting and its use in business decisions
d
...

When services are performed on account, what is the effect?
a
...

b
...

c
...

d
...

Now turn to “Answers to self-test” at the end of your chapter to check your answers
...
In what respects would you agree with
this description? How might you argue that this description is deficient?

➢

Define asset, liability, and stockholders’ equity
...
How are revenues measured?

➢

Define expenses
...


➢

What is a transaction? What use does the accountant make of transactions? Why?

➢

What is the accounting equation? Why must it always balance?

➢

Give an example from your personal life that illustrates your use of accounting information in
reaching a decision
...
At the first meeting you attend,
mention is made of building a new church
...
The vendor stated that the equipment was
worth USD 2,400
...


➢

Increase both an asset and a liability
...
0 License
➢

Increase one asset and decrease another asset
...


➢

Increase both an asset and retained earnings
...


➢

Increase a liability and decrease retained earnings
...


➢

Identify the causes of increases and decreases in stockholders’ equity

➢

Real world question: Refer to the 2000 financial statements of The Limited in the Annual Report
Appendix at the back of the text
...


➢

Real world question: Refer to the financial statements of The Limited in the Annual Report
Appendix
...


Exercises
Exercise A Match the descriptions in Column B with the appropriate terms in Column A
...

2
...

4
...

Merchandising company
...

Manufacturing company
...


Service company
...


Single proprietorship
...

b
...

d
...

The form of organization used by most large businesses
...

Buys goods in their finished form and sells them to
customers in that same form
...


An unincorporated business with more than one owner
...


Performs services for a fee
...
A cash
dividend of USD 300 was declared and paid during the year
...
Compute the net income for the year
...
Assume expenses for the year were USD 9,000
...

Exercise C On 2010 December 31, Perez Company had assets of USD 150,000, liabilities of USD 97,500, and
capital stock of USD 30,000
...
Dividends declared and paid amounted to USD 3,000
...
Compute the company’s retained earnings on 2010 December 31
...
Compute the company’s retained earnings on 2011 December 31
...

At the end of the year, retained earnings amounted to USD 135,000
...
Compute retained earnings and total assets at the beginning of
the year
...
For the events that do have an effect, present an analysis of the transaction showing its
two sides or dual nature
...
Purchased equipment for cash, USD 12,000
...
Purchased a truck for USD 40,000, signed a note (with no interest) promising payment in 10 days
...
Paid USD 1,600 for the current month’s utilities
...
Accounting and its use in business decisions
d
...

e
...
She is to start work next week
...
Signed an agreement with a bank in which the bank agreed to lend the company up to USD 200,000 any time
within the next two years
...
Purchased office equipment on account
...
Paid an account payable
...
Earned service revenue on account
...
Borrowed money by signing a note at the bank
...
Paid salaries for month to employees
...
Received cash on account from a charge customer
...
Received gas and oil bill for month
...
Purchased delivery truck for cash
...
Declared and paid a cash dividend
...
No dollar amounts are needed, and you need not fill in the
Explanation column
...
The stockholders invested USD 100,000 cash in the business by purchasing capital stock
...
Land costing USD 40,000 was purchased by paying cash
...
The company performed services for a customer who agreed to pay USD 18,000 in one month
...
Paid salaries for the month, USD 12,000
...
Paid USD 14,000 on an account payable
...
Increase cash; decrease some other asset
...
Decrease cash; increase some other asset
...
Increase an asset; increase a liability
...
Decrease retained earnings; decrease an asset
...
Increase an asset other than cash; increase retained earnings
...
Decrease an asset; decrease a liability
...
Employees were paid USD 20,000 for services received during the month
...
USD 175,000 was paid to acquire land
...
Paid an USD 18,000 note payable
...

d
...

Exercise J Assume that the following items were included in the Retained Earnings column in the summary of
transactions for Cinck Company for July 2010:
55

This book is licensed under a Creative Commons Attribution 3
...

Exercise K Given the following facts, prepare a statement of retained earnings for Brindle Company, a tanning
salon, for August 2010:
Balance in retained earnings at end of July, USD 188,000
...

Net income for August, USD 72,000
...
, as of 2010 December 31, were as
follows:
Accounts payable
Accounts receivable
Capital stock
Cash
Land
Building
Equipment
Notes payable
Retained earnings

$60,000
90,000
100,000
40,000
80,000
50,000
30,000
20,000
?

Prepare a balance sheet
...

Exercise M Merck & Co
...
is a world leader in the discovery, development, manufacture and marketing of a
broad range of human and animal health products
...
As of the end of 2, its 2
...
Given the following data for Merck, calculate the equity ratios for
2003 and 2002
...

2003

2002

Stockholders' equity

USD 14,832,400,000

USD 13,241,600,000

Total equities

USD 39,910,400,000

USD 35,634,900,000

Problems
Problem A Lakewood Personal Finance Company, which provides financial advisory services, engaged in the
following transactions during May 2010:
May 1Received USD 300,000 cash for shares of capital stock issued when company was organized
...

7 The company bought USD 182,400 of computer equipment for cash
...

14 Services performed for a customer who agreed to pay within a month were USD 10,000
...

19 The company paid USD 14,000 on the note to the bank
...
(Interest is an expense, which reduces retained earnings
...


Accounting Principles: A Business Perspective

56

A Global Text

1
...

Prepare a summary of transactions (see Part A of Exhibit 4)
...
Determine balances after each
transaction to show that the accounting equation balances
...
, a company that takes care of lawns and shrubbery of personal
residences, engaged in the following transactions in April 2010:
Apr
...

4 The company bought equipment for cash, USD 101,760
...

15 Cash received for services performed to date was USD 3,840
...

30 Of the receivable (see April 16), USD 3,072 was collected in cash
...

30 An order was placed for miscellaneous equipment costing USD 28,800
...
Prepare a summary of transactions (see Part A of Exhibit 4)
...
Determine balances after each
transaction to show that the basic accounting equation balances
...
Prepare a balance sheet as of April 30
...
0 License
Capital stock

114000

Retained earnings as of 2010 June 1

84900

a
...

b
...

c
...

d
...
, was formed by a group of parents to meet a need for a place for kids to
play baseball
...
Issued additional capital stock for cash, USD 200,000
...
Collected USD 80,000 on accounts receivable
...
Paid USD 64,000 on accounts payable
...
Received membership fees from parents (nonrefundable): in cash, USD 260,000; and on account, USD
120,000
...
Incurred operating expenses: for cash, USD 60,000; and on account, USD 160,000
...
Paid dividends of USD 16,000
...
Purchased more land for cash, USD 96,000
...
Placed an order for new equipment expected to cost USD 120,000
...
Prepare a summary of transactions (see Part A of Exhibit 4) using column headings as given in the balance
sheet
...

b
...

c
...

d
...

The balance sheets for 2010 May 31, and 2010 April 30, and the income statement for May of the Target-Line
Golf Driving Range follow
...
)
TARGET-LINE GOLF DRIVING RANGE
Comparative Balance Sheet
May 31, April 30,

Accounting Principles: A Business Perspective

58

A Global Text

1
...

State the probable cause(s) of the change in each of the balance sheet accounts from April 30 to 2010 May 31
...
1 The company was organized and received USD 100,000 cash from the issuance of capital stock
...

7 The company painted the auto fleet of a customer who agreed to pay USD 8,000 in one week
...

14 The company received the USD 8,000 from the transaction of September 7
...

28 USD 2,400 was paid on the liability incurred on September 20
...

30 Placed an order for additional painting equipment advertised at USD 20,000
...
Use money
columns headed Cash, Accounts Receivable, Equipment, Accounts Payable, Capital Stock, and Retained Earnings
...

Alternate problem B Quick-Start Home Repair Company completed the following transactions in June 2010:
June 1 The company was organized and received USD 200,000 cash from the issuance of capital stock
...

7 The company borrowed USD 10,000 from its bank on a note
...

12 Expenses of operating the business so far this month were paid in cash, USD 3,400
...

25 The company paid USD 4,065 on its loan from the bank, including USD 4,050 of principal and USD 15 of
interest
...
Interest is an expense, which reduces retained earnings
...
0 License
30 Miscellaneous expenses incurred in operating the business from June 13 to date were USD 3,825 and were
paid in cash
...

a
...
Include money columns for Cash, Accounts
Receivable, Trucks, Notes Payable, Capital Stock, and Retained Earnings
...

b
...

Alternate problem C Following are summarized transaction data for Luxury Apartments, Inc
...
The company owns and operates an apartment building
...

Prepare an income statement for the year ended 2010 June 30
...
1 The accounts payable owed as of September 30 (USD 94,000) were paid
...
Accounting and its use in business decisions
1 The company paid rent for the premises for October, USD 19,200
...

10 The company collected USD 14,400 of the accounts receivable in the balance sheet at September 30
...

15 Parking revenue earned but not yet collected from fleet customers was USD 6,000
...

19 The company paid advertising expenses of USD 1,200 for October
...

24 The company incurred miscellaneous expenses of USD 840
...

31 Cash receipts for the last 10 days of the month from daily customers were USD 8,400
...

31 Billings to monthly customers totaled USD 21,600 for October
...

a
...
Determine balances after each transaction
...
Prepare an income statement for October 2010
...
Prepare a statement of retained earnings for October 2010
...
Prepare a balance sheet as of 2010 October 31
...
(Common practice is to show the most recent period
first
...
,
Income Statement For the Month Ended 2010 June

18,000 $
60,000
34,000
112,000 $

24,000
60,000
12,000
96,000

3

Revenues:
Service revenue

$

100,000

$

28,000

Expenses:
Salaries expense
Supplies bought and used

$

48,000
24,000

Net income

72,000

A cash dividend of USD 6,000 was declared and paid in June
...


61

This book is licensed under a Creative Commons Attribution 3
...
During the next six years, Crane earned a reputation as an excellent employee—
hardworking, dedicated, and dependable—in the light construction industry
...

Crane then decided to go into business for himself under the name Jim’s Fix-It Shop, Inc
...
He completed many repair and remodeling jobs for
homeowners and apartment owners
...
He operated out of his garage, which he had converted into a shop, adding several new pieces of power
woodworking equipment
...
He has been offered an annual salary of USD
50,000 and a package of fringe benefits (medical and hospitalization insurance, pension contribution, vacation and
sick pay, and life insurance) worth approximately USD 8,000 per year
...
But he
dislikes giving up his business since he has thoroughly enjoyed being his own boss, even though it has led to an
average workweek well in excess of the standard 40 hours
Suppose Crane comes to you for assistance in gathering the information needed to help him make a decision
...

Using logic and your own life experiences, indicate the nature of the information Jim needs if he is to make an
informed decision
...

Does the accounting information available enter directly into the decision? Write a memorandum to Jim describing
the information he will need to make an informed decision
...
(See the format in Group Project E below
...
Another format for analyzing solvency is to divide total debt
by total equities
...
These two ratios are complements and must add to 100 per cent
...

Using the following historical data from Gateway, calculate the “total-debt-to total-capital” ratio for each year
...
Accounting and its use in business decisions
Study these amounts and comment on the solvency of the company
...
Could Gateway have grown this much without increasing liabilities?
Annual report analysis C Look at The Limited, Inc
...
In that
report you will find a letter outlining Management’s responsibilities concerning the financial statements, as well as
the report of the independent auditors
...
Write a short essay
discussing the alternatives James Stevens could pursue and the likely outcomes of those alternatives
...
Ask how
that person uses accounting information in making business decisions and obtain specific examples
...
Information contained in
the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of
the interview, examples of the use of accounting information for decision making,

and

any

other

pertinent

information
...
Then describe approximately 15–20 transactions that the business might undertake in
its first month of operations
...
Identify each asset, liability, and stockholders’ equity item in your summary of transactions
...

Group project G With a team of one or two other students and using library sources, write a paper on the
American Institute of Certified Public Accountants, their services to members, and their activities
...
Direct quotes should be labeled as such and should be single-spaced and indented if
relatively long or in quote marks and not indented if relatively short
...

63

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...
nokia
...

Visit the following website for Ford Motor Company:
http://www
...
com
When the web page appears, search for Investor Information and then locate the Ford Motor Company Annual
Report
...

Answers to self-test
True-False

False
...

True
...

False
...

True
...

True
...

Multiple-choice

d
...

d
...

b
...
The other two were the money
measurement concept and the periodicity concept
...
When the stockholders invest cash, assets and stockholders’ equity increase
...
The performance of services on account increases both accounts receivable and retained earnings
...
0 License

2
...

• Express the effects of business transactions in terms of debits and credits to different types of accounts
...

• Record the effects of business transactions in a journal
...

• Prepare a trial balance to test the equality of debits and credits in the journalizing and posting process
...


Salary potential of accountants
Selecting a major represents much more than the choice of courses a student takes in college
...
Few professionals would recommend a specific career choice based solely on salaries
...
Outlined below is information on selected salaries
for many accounting-related careers
...

Salaries at all levels can vary significantly between locations
...

Salaries for Public Accounting, Non-Partners
Position
Large CPA Firms:
Starting Salaries
Salary between 1-3 years
Manager/Director
Small CPA Firms:

Salary Range
$35,750 - $42,500
$41,000 - $51,250
$77,750 - $119,000

Starting Salaries
Salary between 1-3 years
Manager/Director

$29,500 - $36,250
$33,750 - $42,500
$62,750 - $84,500

Position
Chief Financial Officer/Treasurer
Vice President, Finance
Director of Finance
Director of Accounting
Controller
Assistant Controller
Tax Director
Tax Manager
Audit Director
General Accounting - Manager
General Accounting - 1-3 years experience
General Accounting - starting salary

Salary Range
$244,500 - $347,000
$189,000 - $293,500
$121,500 - $178,250
$115,250 - $157,500
$105,750 - $147,250
$89,750 - $114,750
$117,000 - $209,750
$78,000 - $113,750
$127,750 - $200,750
$61,250 - $83,250
$37,500 - $48,750
$31,750 - $39,750

Salaries for Corporate Accounting

- Large Corporations

Accounting Principles: A Business Perspective

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2
...
roberthalf
...
Also, accounting professors are generally familiar
with starting salaries and job opportunities for accounting graduates, so you may want to address more specific
questions about potential careers and salaries with them
...
These statements are the end products of the financial accounting process, which is based on the
accounting equation
...
The results of these
decisions are communicated to users—management, creditors, and investors—and serve as a basis for making
future decisions
...
We recorded the transactions in Chapter 1 as increases
or decreases in the assets, liabilities, and stockholders' equity items of the accounting equation
...
When working through these sample
transactions, you probably suspected that listing all transactions as increases or decreases in the transactions
summary columns would be too cumbersome in practice
...
Chapter 2 teaches you how to actually record business transactions in the accounting
process
...
Using these tools, you can follow a company through its
various business transactions
...
This is the double-entry accounting system that the Franciscan monk, Luca Pacioli, described
centuries ago
...


The account and rules of debit and credit
A business may engage in thousands of transactions during a year
...

Steps in recording business transactions
Look at Exhibit 9 to see the steps in recording and posting the effects of a business transaction
...
These source documents include such items
as bills received from suppliers for goods or services received, bills sent to customers for goods sold or services
performed, and cash register tapes
...
Then a firm posts (transfers) that information to accounts in the ledger
...

However, before you can record the journal entry, you must understand the rules of debit and credit
...

Fortunately, most business transactions are repetitive
...
For example, a company may
have thousands of receipts or payments of cash during a year
...


66

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...
Firms set up accounts
for each different business element, such as cash, accounts receivable, and accounts payable
...

Accountants may differ on the account title (or name) they give the same item
...
Both account titles refer to the
amounts borrowed by the company
...
Once you give an account a title, you must use that same title throughout the
accounting records
...
The main requirement is that each account provides information useful in making decisions
...
The amount of cash is useful information; the form of cash often is not
...
The name of the account, such as Cash, appears across the top of the T
...
A T-account appears as follows:

An accounting perspective:
Business insight
Have you ever considered starting your own business? If so, you will need to understand
accounting to successfully run your business
...
Accounting information also tells you why you are
performing as reported
...


Accounting Principles: A Business Perspective

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2
...
For example, if you—an owner—
invest cash in your business, the company's assets increase and its stockholders' equity increases
...
3
...

Accountants use the term debit instead of saying, "Place an entry on the left side of the T-account"
...
Debit (abbreviated Dr
...
) means right side
...

Any Account
Left, or
debit, side

Right, or
credit, side

After recognizing a business event as a business transaction, we analyze it to determine its increase or decrease
effects on the assets, liabilities, stockholders' equity items, dividends, revenues, or expenses of the business
...

In each business transaction we record, the total dollar amount of debits must equal the total dollar amount of
credits
...
The accounting requirement that each transaction be recorded by an entry that has equal debits
and credits is called double-entry procedure, or duality
...

The dual recording process produces two sets of accounts—those with debit balances and those with credit
balances
...
Then, some assurance exists that the arithmetic
part of the transaction recording process has been properly carried out
...


Recording changes in assets, liabilities, and stockholders' equity
While recording business transactions, remember that the foundation of the accounting process is the following
basic accounting equation:
Assets= LiabilitiesStockholders ' Equity

7 The abbreviations “Dr
...
” are based on the Latin words “debere” and “credere”
...

68

This book is licensed under a Creative Commons Attribution 3
...
Assets, which are on the left of the equal sign, increase on the left side of the T-accounts
...
You already know
that the left side of the T-account is the debit side and the right side is the credit side
...

• Liabilities and stockholders' equity decrease by debits (left side) to the T-account and increase by credits

(right side) to the T-account
...
Now we apply the debit and credit rules for
assets, liabilities, and stockholders' equity to business transactions
...
(Note the figure in
parentheses is the number of the transaction and ties the two sides of the transaction together
...
)
(1)

Cash
10,000

(Cr)

(Dr
...
Then, the
transaction increases stockholders' equity, which is recorded on the right side of the Capital Stock account
...
A note is an unconditional
written promise to pay to another party (the bank) the amount owed either when demanded or at a specified date,
usually with interest at a specified rate
...
)

Cash

(Cr)

(Dr
...

Recording changes in revenues and expenses In Chapter 1, we recorded the revenues and expenses
directly in the Retained Earnings account
...
Instead, businesses treat the expense accounts as if they were subclassifications of the
debit side of the Retained Earnings account, and the revenue accounts as if they were subclassifications of the credit
side
...
The recording rules for revenues and expenses are:
• Record increases in revenues on the right (credit) side of the T-account and decreases on the left (debit)

side
...

• Record increases in expenses on the left (debit) side of the T-account and decreases on the right (credit)

side
...

Accounting Principles: A Business Perspective

69

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2
...
The Cash account, an asset, increases on the left (debit) side of the T-account; and the
Service Revenue account, an increase in retained earnings, increases on the right (credit) side
...
)

Cash

(1)

10,000

(2)

5,000

(3)

(Cr)

(Dr
...
The Cash account, an asset,
decreases on the right (credit) side of the T-account; and the Salaries Expense account, a decrease in retained
earnings, increases on the left (debit) side
...
)
(4)

Salaries Expense
600

(Cr)

Recording changes in dividends Since dividends decrease retained earnings, increases appear on the left
side of the Dividends account and decreases on the right side
...
)
(5)

(2)

5,000

(5)

2,000

(3)

1,000

Dividends3
2,000

(Cr)

9

At the end of the accounting period, the accountant transfers any balances in the expense, revenue, and
Dividends accounts to the Retained Earnings account
...
We discuss and illustrate this step in
Chapter 4
...
If the sum of the debits exceeds the sum of the credits, the account has a
debit balance
...
The
account has a debit balance of USD 13,400, computed as total debits of USD 16,000 less total credits of USD 2,600
...
)
(1)
(2)
(3)

Cash
10,000
5,000
1,000
16,000

Dr
...
Those deductions are ignored here
...

70

This book is licensed under a Creative Commons Attribution 3
...

For instance, assume that a company has an Accounts Payable account with a total of USD 10,000 in debits and
USD 13,000 in credits
...
)
10,000

Accounts Payable
7,000
6,000

10,000

(Cr)

13,000
Cr
...
Conversely, because credits increase liability, capital stock, retained earnings, and revenue
accounts, they normally have credit (or right-side) balances
...
Later, as you proceed in your study of
accounting, the rules will become automatic
...
When the account balances are totaled, they conform to the following independent equations:
Assets = Liabilities + Stockholders' Equity
Debits = Credits
The arrangement of these two formulas gives the first three rules of debit and credit:
• Increases in asset accounts are debits; decreases are credits
...

• Decreases in stockholders' equity accounts are debits; increases are credits
...
Recording business transactions
Assets

Liabilities

+

Stockholder's Equity

Stockholders' Equity Account(s)
Asset Accounts
Debit*
Credit

=

Liability Accounts
Debit
Credit*

+
Debit

(Capital Stock and Retained Earnings)
Credit*

+

-

-

+

+

Debit

Credit

Debit

Credit

Debit

Credit

for

for

for

for

for

for

increase

decrease

decrease

increase

decrease

increase

Expense Accounts
Debits

Credits

and Dividends Account

Revenue Accounts

Debit*

Credit

Debit

Credit*

1
...


1
...


2
...


2

Increase liabilities
...
Decrease

3
...


Debit

Credit

Debit

Credit

stockholders' equity
...
Decrease revenues
...


Increase revenues
...
Increase expenses
...


Decrease expenses
...
Increase dividends
...


Decrease dividends
...
Since stockholders' equity accounts decrease on the debit side, expense and Dividend accounts
increase on the debit side
...
The last three debit and credit rules are:
• Decreases in revenue accounts are debits; increases are credits
...

• Increases in Dividends accounts are debits; decreases are credits
...
Note first the treatment of expense and Dividends
accounts as if they were subclassifications of the debit side of the Retained Earnings account
...
Next, we discuss the accounting cycle and indicate where steps in the accounting cycle are discussed in
Chapters 2 through 4
...
Before you can visualize the eight steps in the accounting cycle, you must
be able to recognize a business transaction
...
For example, assume that the owner of a business spilled a pot of coffee in her office or
broke her leg while skiing
...
However, they are
not measurable in terms that affect the solvency and profitability of the business
...
These events have one fundamental criterion:
They must have caused a measurable change in the amounts in the accounting equation, Assets = Liabilities +

72

This book is licensed under a Creative Commons Attribution 3
...
The evidence that a business event has occurred is a source document such as a sales ticket,
check, and so on
...
10
After you have determined that an event is a measurable business transaction and have adequate proof of this
transaction, mentally analyze the transaction's effects on the accounting equation
...
This chapter and Chapters 3 and 4 describe the other steps in the accounting cycle
...

• Journalize transactions in the journal (Chapter 2)
...

• Prepare a trial balance of the accounts (Chapter 2) and complete the work sheet (Chapter 4)
...
)
• Prepare financial statements (Chapter 4)
...

• Journalize and post closing entries (Chapter 4)
...


This listing serves as a preview of what you will study in Chapters 2-4
...
Step 5 precedes steps 6 and 7 because management needs the financial
statements at the earliest possible date
...
In Exhibit 7, we diagram the eight steps in the accounting cycle
...
However, you must
understand a manual accounting system and all of the steps in the accounting cycle to understand what the
computer is doing
...


The journal
In explaining the rules of debit and credit, we recorded transactions directly in the accounts
...
Thus, all the effects of a single
business transaction would not appear in any one account
...
To have a permanent record of
an entire transaction, the accountant uses a book or record known as a journal
...
A journal entry is the
recording of a business transaction in the journal
...
A transaction is entered in a
journal before it is entered in ledger accounts
...


10 Many companies send and receive source documents electronically, rather than on paper
...

Accounting Principles: A Business Perspective

73

A Global Text

2
...
Chapter 4 briefly describes several special journals
...
As shown in Exhibit 8, a general journal contains the
following columns:

Exhibit 7: Steps in the accounting cycle
MICROTRAIN COMPANY General Journal
Date

Account Titles and Explanation

Post
...

100

2010 Nov
...


Exhibit 8: Journal entry
• Date column
...
For the first journal entry on a page,

this column contains the year, month, and day (number)
...

• Account titles and explanation column
...
The

second line shows the account credited
...
For
instance, in Exhibit 8 we show the debit to the Cash account and then the credit to the Capital Stock
74

This book is licensed under a Creative Commons Attribution 3
...
Any necessary explanation of a transaction appears on the line(s) below the credit entry and is
indented halfway between the accounts debited and credited
...
When a journal
entry is self-explanatory, we omit the explanation
...
This column shows the account number of the debited or credited account
...
No
number appears in this column until the information has been posted to the appropriate ledger account
...

• Debit column
...

• Credit column
...


An account perspective:
Uses of technology
Preparing journal entries in a computerized system is different than in a manual system
...
After you type the account
number, the computer shows the account title in its proper position
...
Then it asks if there are more
debits
...
After you type the
account number, the computer supplies the account name of the credit and enters the same
amount debited as the credit
...
Then you would enter the other credit in the same way
...
You can
supply an explanation for the entry from a standard list or type it in
...
At any time, you can have
the computer print a trial balance
...

• Shows the analysis of each transaction in debits and credits
...

• Serves as a source for future reference to accounting transactions
...

• Makes possible posting to the ledger at convenient times
...


Accounting Principles: A Business Perspective

75

A Global Text

2
...


The ledger
A ledger (general ledger) is the complete collection of all the accounts of a company
...

Accounts fall into two general groups: (1) balance sheet accounts (assets, liabilities, and stockholders' equity)
and (2) income statement accounts (revenues and expenses)
...
Balance sheet accounts are real accounts because they are not subclassifications
or subdivisions of any other account
...
Income statement accounts and the Dividends
account are nominal accounts because they are merely subclassifications of the stockholders' equity accounts
...
Nominal accounts are also called temporary accounts because they
temporarily contain revenue, expense, and dividend information that is transferred (or closed) to the Retained
Earnings account at the end of the accounting period
...
The
chart of accounts can be compared to a table of contents
...

Individual accounts are in sequence in the ledger
...
For example, a company might number asset accounts, 100-199;
liability accounts, 200-299; stockholders' equity accounts and Dividends account, 300-399; revenue accounts, 400499; and expense accounts, 500-599
...
The uniform chart of accounts
used in the first 11 chapters appears in a separate file at the end of the text
...
Companies may use other numbering systems
...
The important idea is that
companies use some numbering system
...


The accounting process in operation
MicroTrain Company is a small corporation that provides on-site personal computer software training using the
clients' equipment
...
A small
fleet of trucks transports personnel and teaching supplies to the clients' sites
...

We illustrate the capital stock transaction that occurred to form the company (in November) and the first month
of operations (December)
...

The ledger accounts used by MicroTrain Company are:
Acct
...

100

Cash

Bank deposits and cash on hand
...


107
Assets

Description

Supplies on Hand

Items such as paper, envelopes, writing materials, and other
materials used in performing training services for customers or
in doing administrative
and clerical office work
...
0 License
108

Prepaid Insurance

Insurance policy premiums paid in advance of the periods for
which the insurance coverage applies
...

Trucks used to transport personnel and training supplies to
clients' locations
...

Amounts received from customers before the training services
have been performed for them
...
The earnings
retained in the business
...

Amounts earned by performing training services for customers
...


506

Gas and Oil Expense

The cost of gas and oil used in trucks in the

507

Salaries Expense

The amount of salaries incurred in the current period
...


Expenses

]

current period
...
These gaps allow the firm to later add new
accounts between the existing accounts
...
Journalizing is the process of entering the effects of a transaction
in a journal
...
Posting is the
process of recording in the ledger accounts the information contained in the journal
...

In the following example, notice that each business transaction affects two or more accounts in the ledger
...
In the ledger
accounts, the date used is the date that the transaction was recorded in the general journal, even if the entry is not
posted until several days later
...
In practice, firms post
journal entries to ledger accounts, as we show later in the chapter
...
Under the accrual basis of accounting, they recognize
revenues when the company makes a sale or performs a service, regardless of when the company receives the cash
...
Chapter 3 discusses the
accrual basis of accounting in more detail
...
First, MicroTrain records the transaction in the general journal; second, it posts the
entry to the accounts in the general ledger
...
28 Stockholders invested $50,000 and formed MicroTrain Company
...
Debit
Ref
...
28 Cash (+A)
100
5 0 0 0 0
Capital Stock (+SE)

300

Credit

5 0 0 0 0

Stockholders invested $50,000 cash in business
...
)
2010

Acct
...
100

Nov
...
)

(Dr
...
No
...
28

77

(Cr
...
Recording business transactions
No other transactions occurred in November
...
Exhibit 5 shows the company's balance sheet at 2010 November 30
...
These
closing balances are the beginning balances on 2010 December 1
...
bal
...
We show the
proper recording of each transaction in the journal and then in the ledger accounts (in T-account form), and
describe the effects of each transaction
...
1 Paid cash for four small trucks, $40,000
...

Ref
...


Account Titles and Explanation

Debit

Credit

100

4 0 0 0 0 (A)
4 0 0 0 0 (B)

To record the purchase of four trucks
...
)
2010 Dec
...
No
...
)

Cash

(Dr
...
1 Beg
...


Acct
...
100
50,000
2010 Dec
...
)
(B)40,0

00
Transaction 3: Dec
...

General Journal
Date
2010 Dec
...

Ref
...


78

Debit

Credit
2 4 0 0
2 4 0 0

This book is licensed under a Creative Commons Attribution 3
...
1

(Cr)

Acct
...
108
2,400
Cash

(Dr)
2010
Dec
...
Bal

(Cr
...
No
...
1 Dec
...
The debit
is to Prepaid Insurance rather than Insurance Expense because the policy covers more than the current accounting
period of December (insurance policies are usually paid one year in advance)
...
If this insurance policy was only written for December, the entire USD 2,400
debit would have been to Insurance Expense
...
1 Rented a building and paid $1,200 to cover a three-month period from this date
...

Ref
...


Account Titles and Explanation

Debit

Credit

100

1 2 0 0
1 2 0 0

Paid three months' rent on a building
...
)
2010

Acct
...
112

Dec
...
)
2010

Cash
Acct
...
100
2010

Dec
...
Bal
...
)

Dec
...
1

40,000
2,400

Dec
...
The
debit is to Prepaid Rent rather than Rent Expense because the payment covers more than the current month
...

Transaction 5: Dec
...

General Journal
Date
Account Titles and Explanation
Post
...

Supplies on Hand (+A)
107
1 4 0 0
2010 Dec
...


General Ledger

Accounting Principles: A Business Perspective

79

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2
...
)
2010

Acct
...
107

(Cr)

Dec
...
)

Accounts Payable
Acct
...
200
2010
Dec
...
)
1,400

Effects of transaction
An asset, supplies on hand, increases (debited); and a liability, accounts payable, increases (credited) by USD
1,400
...

In each of the three preceding entries, we debited an asset rather than an expense
...
Whenever a company will not
fully use up an item such as insurance, rent, or supplies in the period when purchased, it usually debits an asset
...

Companies sometimes buy items that they fully use up within the current accounting period
...

If the company fully consumes the supplies during the period of purchase, the best practice is to debit Supplies
Expense at the time of purchase rather than Supplies on Hand
...
If a
company purchases insurance that it fully consumes during the current period, the company should debit
Insurance Expense at the time of purchase rather than Prepaid Insurance
...
As
illustrated in Chapter 3, following this advice simplifies the procedures at the end of the accounting period
...
7 Received $4,500 from a customer in payment for future training services
...
Debit
Ref
...
7
Unearned Service Fees (+L)

216

To record the receipt of cash from a customer in payment

for future training services
...
)
2010
Dec
...
7

General Ledger
Cash
Acct
...
100

(Cr)
2010

Beg Bal 50,000
4,500

Dec
...
1
Dec
...
)

(Cr
...
No
...
7

4,500

Effects of transaction
80

Credit

4 5 0 0

This book is licensed under a Creative Commons Attribution 3
...

The credit is to Unearned Service Fees rather than Service Revenue because the USD 4,500 applies to more than
just the current accounting period
...
If the payment had been for services to be provided in December, the
credit would have been to Service Revenue
...
15 Performed training services for a customer for cash, $5,000
...


15

Post
...

100

Debit

Credit

400

5 0 0 0
5 0 0 0

To record the receipt of cash for performing training

services for a customer
...
)
2010

(Cr)

Acct
...
100
2010

Dec
...
50,000
Dec
...
15
5,000
Service Revenue

(Dr
...
1
Dec
...
1

40,000
2,400
1,200

(Cr
...
No
...
15

5,000

Effects of transaction
An asset, cash, increases (debited); and a revenue, service revenue, increases (credited) by USD 5,000
...
17 Paid the $1,400 account payable resulting from the transaction of December 4
...
Debit
Ref
...
17 Accounts Payable (-L)
Cash (-A)

100

Credit

1 4 0 0

Paid the account payable arising from the purchase of
Supplies on December 4
...
)
2010
Dec
...
)
2010
Dec
...

Dec
...
No
...
4

(Cr
...
No
...
50,000
7
4,500
15
5,000

1,400

2010
Dec
...
1
Dec
...
Recording business transactions
A liability, accounts payable, decreases (debited); and an asset, cash, decreases (credited) by USD 1,400
...
20 Billed a customer for training services performed, $5,700
...
20

Accounts Receivable (+A)

Post
...

103

Service Revenue (+SE)

Debit

Credit

400

5 7 0 0
5 7 0 0

To record the performance of training services on account

for which a customer was billed
...
)
2010

Acct
...
103

Dec
...
No
...
)

(Cr)

(Cr
...
15

5,000

Dec
...

Transaction 10: Dec
...

General Journal

Date

Account Titles and Explanation
24

Advertising Expense (-SE)
Accounts Payable (+L)

2010 Dec
...

Ref
...


General Ledger
Advertising Expense

(Dr
...
No
...

(Dr
...


24

17

50
Accounts Payable
Acct
...
200
2010
1,400
Dec
...
24

(Cr
...
The reason for debiting an expense rather than an asset is because all the cost pertains to the current
accounting period, the month of December
...

Transaction 11: Dec
...

General Journal

82

This book is licensed under a Creative Commons Attribution 3
...

Ref
...


Account Titles and Explanation

Debit

Credit

103

5 0 0
5 0 0

Received $500 from a customer on accounts receivable

General Ledger Cash
(Dr
...
No
...
1 Beg Bal
...
1
40,000
Dec
...
1
2,400
Dec
...
1
1,200
Dec
...
17
1,400
Accounts
Receivable
(Dr
...
N
o
...
)
2010
2010
Dec
...
26
500

Effects of transaction
One asset, cash, increases (debited); and another asset, accounts receivable, decreases (credited) by USD 500
...
28 Paid salaries of $3,600 to training personnel for the first four weeks of December
...
)
General Journal

Date

Account Titles and Explanation

2010 Dec
...

Ref
...


General Ledger
Salaries Expense

(Dr
...
No
...

28

(Cr)

3,600
Cash

(Dr
...
No
...
)

Dec
...

7
Dec
...

26

50,000

Dec
...
1

2,400

5,000

Dec
...
17

1,400

Dec
...

Transaction 13: Dec
...

General Journal
Date
29

Utilities Expense (-SE)

Post
...

511

Cash (+A)

2010 Dec
...
Recording business transactions
Paid the utilities bill for December
...
)
2010

Acct
...
511

Dec
...
)
2010

Acct
...
100

Dec
...

7
Dec
...

26

50,000

(Cr
...

1
Dec
...

1
Dec
...

28
Dec
...

Transaction 14: Dec
...

General Journal
Date
30

Gas and Oil Expense (-SE)

Post
...

506

Accounts Payable (+L)

2010 Dec
...


General Ledger
Gas and Oil Expense

(Dr
...
No
...

30

(Cr)

680

Dec
...
No
...
)

1,400

Dec
...
24

50

Dec
...
)
2010

680

Effects of transaction
An expense, gas and oil expense, increases (debited); and a liability, accounts payable, increases (credited) by
USD 680
...
0 License
Transaction 15: Dec
...

General Journal
Date

Account Titles and Explanation
31

Dividends (-SE)
Cash (-A)

2010 Dec
...

Ref
...


General Ledger
Dividends

(Dr
...
No
...
31

(Cr)

3,000
Cash

(Dr
...

Dec
...

Dec
...
)

Acct
...
100
2010
1 Beg Bal
...

Dec
...

Dec
...


1
1
1
17
28

40,000
2,400
1,200
1,400
3,600

Dec
...
31

3,000

Effects of transaction
The Dividends account increases (debited); and an asset, cash, decreases (credited) by USD 3,000
...
The next section discusses and
illustrates posting to ledger accounts and cross-indexing
...

Then universities and scientific institutions connected to the network to meet their research and
communication needs
...
Today
many companies seek customers and employees over the Internet
...
Accountants in practice are heavy users of the Internet to locate company data, tax
regulations, and almost any other information they need
...


Accounting Principles: A Business Perspective

85

A Global Text

2
...
The carrying out of these instructions is known as posting
...
A journal entry directs
the entry of a certain dollar amount as a debit in a specific ledger account and directs the entry of a certain dollar
amount as a credit in a specific ledger account
...
In practice, however, companies post these journal entries to ledger accounts
...
Later, we show you how to post
the MicroTrain Company journal entries to ledger accounts
...
We post the debit in the general ledger Cash
account by using the following procedure: Enter in the Cash account the date, a short explanation, the journal
designation ("G" for general journal) and the journal page number from which the debit is posted, and the USD
10,000 in the Debit column
...
Post the credit in a similar manner but as a credit to Account No
...
The
arrows in Exhibit 10 show how these amounts were posted to the correct accounts
...
In contrast to the two-sided T-account format shown so far, the threecolumn format has columns for debit, credit, and balance
...
In addition, in this chapter, we indicate whether each
balance is a debit or a credit
...
Also, notice that we give an explanation for each item in the ledger accounts
...

Posting is always from the journal to the ledger accounts
...
The choice is a matter of
personal taste
...

Frequently, accountants must check and trace the origin of their transactions, so they provide cross-indexing
...
As shown in Exhibit 10, the account number of the ledger
account to which the posting was made is in the Posting Reference column of the general journal
...
100 in the ledger to the 100 in the Posting Reference column beside the first debit in the general
journal
...
Note the arrow from page 1 in Exhibit 10 the general journal to G1 in the
Posting Reference column of the Cash account in the general ledger
...
The date of the transaction also appears in the general ledger
...


86

This book is licensed under a Creative Commons Attribution 3
...


Account Titles and Explanation

Post
...

(C)100
1 0 0 0 0 (A)

1(B) Cash (+A)
Capital Stock (+SE)

300

Credit

1 0 0 0 0 (D)

Stockholders invested $10,000 cash in the business
...


:-

Account No 100(C)

General Ledger Cash

Explanation

Post
Ref
...
(B)1 Stockholders investment
5

Bank loan

Debt

Credit

(A) 1 0 0 0 0

1 0 0 0 0 Dr

5 0 0 0

1 5 0 0 0 Dr

G1

Account No
...


Explanation
5

Post
Ref
...

G1

Borrowed cash

Debt

Credit

Explanation

Debt

(B)1 Cash from stockholders

Balance

5 0 0 0

Capital Stock

2010 "
Jan
...
300
Balance
1 0 0 0 0 Cr

Exhibit 10: General journal and general ledger; posting and cross-indexing
Cross-indexing aids the tracing of any recorded transaction, either from general journal to general ledger or
from general ledger to general journal
...
If this practice is followed, the cross-reference numbers
indicate that the entry has been posted
...
Debit
Ref
...
28

Cash (+A)

100*

Capital Stock (+SE)

300

Credit

5 0 0 0 0
5 0 0 0 0

Stockholders invested $50,000 cash in the business
...
Recording business transactions
Dec

1

Truck (+A)

150

Cash (-A)

100

4 0 0 0 0
4 0 0 0 0

To record the purchase of four trucks
...


1

Prepaid Rent (+A)

112

Cash (-A)

1 2 0 0

100

1 2 0 0

Paid three months' rent on a building
...


7

Cash (+A)

100

Unearned Service Fees (+L)

216

4 5 0 0
4 5 0 0

To record the receipt of cash from a customer in payment
for future training services
...


17

Accounts Payable (-L)

200

Cash (-A)

100

Paid the account payable arising from the purchase of
supplies on December 4
...
0 License
General Journal
Page 2

Date

Account Titles and Explanation

Post
...
20

Accounts Receivable (+A)

Ref
...


24

Advertising Expense (-SE)

505

Accounts Payable (+L)

5 0

200

5 0

Received a bill for advertising for the month of December
...


28

Salaries Expense (-SE)

507

Cash (-A)

100

3 6 0 0
3 6 0 0

Paid training personnel salaries for the first four weeks
of December
...


30

Gas and Oil Expense (-SE)

506

Accounts Payable (-A)

200

6 8 0
6 8 0

Received a bill for gas and oil used in the trucks for
December
...


Exhibit 11: General journal (after posting)
To understand the posting and cross-indexing process, trace the entries from the general journal to the general
ledger
...

Look at Exhibit 11 to see how all the November and December transactions of MicroTrain Company would be
journalized
...
This procedure is standard practice among accountants
...
When amounts are in even dollar amounts, accountants leave the cents column blank or use
zeros or a dash
...
When they use unlined paper, they add both commas and decimal points
...
Recording business transactions
Next, observe Exhibit 12, the three-column general ledger accounts of MicroTrain Company after the journal
entries have been posted
...
Trace the postings
from the general journal to the general ledger to make sure you know how to post journal entries
...
Many business transactions, however, affect more than two accounts
...
Such journal entries are called compound
journal entries
...
See below
...
1

Post
Ref
...
100

Debit

Credit

Balance

Beginning balance*

5 0 0 0 0 Dr

1

Trucks

G1

4 0 0 0 0

1 0 0 0 0 Dr

1

Prepaid insurance

G1

2 4 0 0

7 6 0 0 Dr

1

Prepaid rent

G1

7

Unearned service fees

G1

4 5 0 0

15

Service revenue

G1

5 0 0 0

17

Paid account payable

G1

26

Collected account receivable

G2

28

Salaries

G2

3 6 0 0

1 1 4 0 0 Dr

29

Utilities

G2

1 5 0

1 1 2 5 0 Dr

31

Dividends

G2

3 0 0 0

8 2 5 0 Dr

1 2 0 0

Explanation

2010 Dec
...

G2

Collections

1 5 0 0 0 Dr

G2

Debit

Explanation

2010 Dec
...
1

One-year policy on trucks

Debit

2010 Dec
...
108
Post
Ref
...

G1

Credit
2 4 0 0

General Ledger
Prepaid Rent
Date

5 7 0 0 Dr
5 0 0

Prepaid Insurance
Explanation

Balance

Account No
...

G1

Date

Credit
5 7 0 0

Supplies on Hand
Date

1 4 5 0 0 Dr

Account No
...
112
Credit
1 2 0 0

Account No
...
0 License

Date

Explanation

2010 Dec
...

G1

Paid cash

Debit

Credit

Balance

4 0 0 0 0

4 0 0 0 0 Dr

Account No
...
4

Supplies

Post
Ref
...
7

Received cash

2010 Dec
...
300

Beginning balance

Accounting Principles: A Business Perspective

- 0 -

Account No
...

G1

Explanation

1 4 0 0 Cr

1 4 0 0

Capital Stock
Date

Balance
1 4 0 0

Unearned Service Fees
Date

Credit

Post
Ref
...
Recording business transactions
General Ledger
Dividends
Date
2010 Dec
...

G2

Cash

Debt

15

Cash

Post
Ref
...


Explanation
30

Debt

2010 Dec
...


Explanation
29

Cash paid

5 0 Dr

Credit

Balance

6 8 0

Debt

6 8 0 Dr

Credit
3 6 0 0

Balance
3 6 0 0 Dr

Account No
...
507
Post
Ref
...
506
Post
Ref
...
505
Post
Ref
...


3 0 0 0 Dr

Account No
...


Explanation

Balance

3 0 0 0

Service Revenue
Date

Page 3
Account No
...

G2

Debt

Credit
1 5 0

Exhibit 12: General ledger - Extended illustration

92

Balance
1 5 0 Dr

This book is licensed under a Creative Commons Attribution 3
...

No
...
The general journal entry for
MicroTrain Company is:
Debit

Credit

2011
Jan
...


Note that the firm credits two accounts, Cash and Accounts Payable, in this one entry
...

Periodically, accountants use a trial balance to test the equality of their debits and credits
...
The accounts appear in this order: assets, liabilities, stockholders' equity, dividends, revenues,
and expenses
...
Within the liabilities, those liabilities with the shortest maturities appear first
...
Note the listing of the account numbers and account titles on
the left, the column for debit balances, the column for credit balances, and the equality of the two totals
...
If this step does not locate the error,
divide the difference in the totals by 2 and then by 9
...
When the difference
is divisible by 2, look for an amount in the trial balance that is equal to one-half of the difference
...

If the difference is divisible by 9, you may have made a transposition error in transferring a balance to the trial
balance or a slide error
...
g
...
Recording business transactions
573 or 110 as 101)
...
g
...
00)
...


An ethical perspective:
Financial Deals, Inc
...
Later, he earned a master's
degree in business administration with a concentration in accounting
...
, in the accounting and
finance division
...
He was tall, good looking, and had an
outgoing personality
...
However, Larry was
somewhat bothered when the president started asking him to do some things that were slightly
unethical
...
You have great potential if you don't let things like this get in your way
...
When he resisted, the president appealed to his loyalty and asked him to be
a team player
...
Finally,
when he was told to falsify some financial statements by making improper entries and to sign some
documents containing material errors, the president supported his request by stating: "You are in
too deep now to refuse to cooperate
...
" Through various
company schemes, Larry had convinced some friends and relatives to invest about USD 10 million
...

Larry could not sleep at night and began each day with a pain in his stomach and by becoming
physically ill
...
He also heard that
the president had a shady past and could become violent in retaliating against his enemies
...
(Note: This scenario is
based on an actual situation with some facts changed to protect the guilty
...

• Posting a debit as a credit, or vice versa
...

• Recording the balance of an account incorrectly in the trial balance
...

• Making a transposition or slide error in the accounts or the journal
...
Assuming you have
already re-totaled the columns and traced the amounts appearing in the trial balance back to the general ledger
account balances, use the following steps: Verify the balance of each general ledger account, verify postings to the
general ledger, verify general journal entries, and then review the transactions and possibly the source documents
...
0 License
The equality of the two totals in the trial balance does not necessarily mean that the accounting process has been
error-free
...
For instance, if a transaction involving payment of a USD 100 account payable is never
recorded, the trial balance totals still balance, but at an amount that is USD 100 too high
...

You can prepare a trial balance at any time—at the end of a day, a week, a month, a quarter, or a year
...


An accounting perspective:
Uses of technology
The computers of persons in a given department or building are frequently connected in a Local
Area Network (LAN)
...
A more
advanced type of computer network is called Client/Server Computing
...

For example, accounting information stored in one computer could be updated by authorized
persons from a number of other computers in the system
...


Analyzing and using the financial results— Horizontal and vertical analyses
The calculation of dollar and/or percentage changes from one year to the next in an item on financial statements
is horizontal analysis
...
This
amount represented a 17 per cent increase
...
To find the percentage change, divide the increase or decrease by the 1999 amount
...
By analyzing the data, we can see that cash and cash equivalents declined
in 2000
...
We can also see
that the company invested in property, plant and equipment
...
At this point, all we want you to understand is the nature of
horizontal and vertical analyses
...
For instance, in the Hewlett-Packard data we can see that cash and cash equivalents were
15
...
0 per cent of total assets by 2000 October
31
...
3 per cent of total assets to 68
...
Long-term investments and other non-current
assets accounted for 18
...

Increase or

Accounting Principles: A Business Perspective

95

Percent of

A Global Text

2
...
0%
1
...
8%
6
...
8%
14
...
3%

15
...
5%
16
...
4%
13
...
5%
61
...
2%

12
...
4%
100
...
4%
100
...
Other data would have to be examined before decisions
could be made regarding the assets shown
...
We illustrate horizontal and vertical
analyses to a much greater extent later in the text
...
General Motors, AT&T, IBM, and numerous other companies have
taken this action
...
In previous years it was common to see the following statement in the annual reports
of companies: "Our employees are our most valuable asset"
...
Do you think they should be allowed to do so?
What you have learned in this chapter is basic to your study of accounting
...
Chapter 3 explains that adjustments bring the accounts to their proper balances
before accurate financial statements are prepared
...

• A firm sets up an account whenever it needs to provide useful information about a particular business item

to some party having a valid interest in the business
...

• Debits are entries on the left side of a T-account
...


96

This book is licensed under a Creative Commons Attribution 3
...

• Credits increase liability, stockholders' equity, and revenue accounts
...

• Journalize transactions in the journal
...

• Prepare a trial balance of the accounts and complete the work sheet
...

• Journalize and post adjusting entries
...
Prepare a post-closing trial balance
...
An example of a general journal

is shown in Exhibit 11
...

• Posting is the process of transferring information recorded in the journal to the proper places in the ledger
...

• An example of cross-indexing appears in Exhibit 10
...

• If the trial balance does not balance, an accountant works backward to discover the error
...

• Horizontal analysis involves calculating the dollar and/or percentage changes in an item from one year to

the next
...


Demonstration problem
Green Hills Riding Stable, Incorporated, had the following balance sheet on 2010 June 30:
GREEN HILLS RIDING STABLE, INCORPORATED
Balance Sheet
2010 June 30
Assets
Cash

$ 7,500

Accounts receivable

5,400

Land

40,000

Total assets
Liabilities:

$ 52,900
Liabilities and Stockholders' Equity

Accounts payable

$ 800

Notes payable

40,000

Total liabilities

$ 40,800

Stockholders' equity:
Capital stock
Retained earnings

$ 10,000
2,100

Total stockholders' equity

12,100

Total liabilities and stockholders' equity

$52,900

a
...

b
...
Insert
cross-indexing references in the journal and ledger
...
Recording business transactions
100
103
130
140
200
201
300
310

Cash
Accounts Receivable
Land
Buildings
Accounts Payable
Notes Payable
Capital Stock
Retained Earnings

320
402
404
507
513
540
568

Dividends
Horse Boarding Fees Revenue
Riding and Lesson Fees Revenue
Salaries Expense
Feed Expense
Interest Expense
Miscellaneous Expense

c
...

Solution to demonstration problem
a
...
Debit
Ref
...


1

Buildings (+A)

140

Cash (-A)

2 4 0 0 0

100

2 4 0 0 0

Paid for building
...


10

Cash (+A)

100

Accounts Receivable (-A)

103

5 4 0 0
5 4 0 0

Collected accounts receivable
...


24

Miscellaneous Expense (-SE)

568

Cash (-A)

100

8 0 0
8 0 0

Paid miscellaneous expenses for July
...


98

1 4 0 0
1 4 0 0

This book is licensed under a Creative Commons Attribution 3
...


31

Dividends (-SE)

320

Cash (-A)

100

1 0 0 0
1 0 0 0

Paid a dividend to stockholders
...


GREEN HILLS RIDING STABLE, INCORPORATED
General Ledger
Account No
...


Debt

Credit

Balance

2010 June 30

Balance

July

1

Stockholders' investment

G1

1

Buildings

G1

8

Accounts payable

G1

10

Accounts receivable

G1

24

Miscellaneous expense

G1

8 0 0

1 2 3 0 0 Dr

31

Interest expense

G1

2 0 0

1 2 1 0 0 Dr

31

Salaries expense

G1

1 4 0 0

1 0 7 0 0 Dr

31

Dividends

G1

1 0 0 0

9 7 0 0 Dr

7 5 0 0 0 Dr
2 5 0 0 0

3 2 5 0 0 Dr
2 4 0 0 0
8 0 0

5 4 0 0

8 5 0 0 Dr
7 7 0 0 Dr
1 3 1 0 0 Dr

Account No
...


Debt

2010 June 30

Balance

July

10

Cash

G1

15

Horse boarding fees

G1

4 5 0 0

4 5 0 0 Dr

31

Riding and lessons fees

G1

3 6 0 0

8 1 0 0 Dr

5 4 0 0

Balance

Post
Ref
...

G1

Cash

Debt

Explanation

Credit

Balance

2 4 0 0 0

2 4 0 0 0 Dr

Account No
...
140

Explanation
1

Credit

4 0 0 0 0 Dr

Buildings
Date

- 0 -

Account No
...


2010 June 30
8

Cash

G1

12

Feed expense

Credit

G1

Balance

Balance

July

Debt

8 0 0 Cr

Notes Payable

8 0 0
1 1 0 0

General Ledger (continued)

Accounting Principles: A Business Perspective

- 0 -

99

1 1 0 0 Cr

Account No
...
Recording business transactions
Date
2010 June

Explanation
30

Post
Ref
...
300

Capital Stock
Date

Balance

Explanation

2010 June

30
1

Cash

Debt

Credit

Balance

Balance

July

Post
Ref
...
310

Retained Earnings
Date
2010 June

Explanation
30

Post
Ref
...
320
Post
Ref
...

G1

Cash

Debt

2010 July

Explanation
12

Debt

2010 July

Explanation
31

Debt

2010 July

c
...
568

Miscellaneous Expense
Date

Credit

Account No
...

G1

Cash

Balance
1 4 0 0 Dr

1 1 0 0

Interest Expense
Date

3 6 0 0 Cr

Account No
...

G1

Accounts payable

Account No
...
404
Post
Ref
...
402
Post
Ref
...

G1

Debt

Credit
8 0 0

GREEN HILLS RIDING STABLE, INCORPORATED

100

Balance
8 0 0 Dr

This book is licensed under a Creative Commons Attribution 3
...

No
...
The three-column
account is normally used
...

Accounting cycle A series of steps performed during the accounting period (some throughout the period
and some at the end) to analyze, record, classify, summarize, and report useful financial information for the
purpose of preparing financial statements
...
Recognizes expenses as incurred, whether or not cash has been paid out
...

Chart of accounts The complete listing of the account titles and account numbers of all of the accounts in
the ledger; somewhat comparable to a table of contents
...

Credit The right side of any account; when used as a verb, to enter a dollar amount on the right side of an
account; credits increase liability, stockholders' equity, and revenue accounts and decrease asset, expense,
and Dividends accounts
...

Cross-indexing The placing of (1) the account number of the ledger account in the general journal and (2)
the general journal page number in the ledger account
...

Debit balance The balance in an account when the sum of the debits to the account exceeds the sum of the
credits to that account
...

Horizontal analysis The calculation of dollar and/or percentage changes in an item on the financial
statements from one year to the next
...


Accounting Principles: A Business Perspective

101

A Global Text

2
...

Journalizing A step in the accounting recording process that consists of entering the effects of a transaction
in a journal
...

Nominal accounts See temporary accounts
...

Permanent accounts (real accounts) Balance sheet accounts; their balances are not transferred (or
closed) to any other account at the end of the accounting period
...

Real accounts See permanent accounts
...

T-account An account resembling the letter T, which is used for illustrative purposes only
...

Temporary accounts (nominal accounts) They temporarily contain the revenue, expense, and dividend
information that is transferred (or closed) to a stockholders' equity account (Retained Earnings) at the end of
the accounting period
...

Vertical analysis Shows the percentage that each item in a financial statement is of some significant total
such as total assets or sales
...

All of the steps in the accounting cycle are performed only at the end of the accounting period
...

The left side of any account is the credit side
...

The dividends account is increased by debits
...

Multiple-choice
Select the best answer for each of the following questions
...
Capital Stock is debited and Cash is credited
...
Cash is debited and Dividends is credited
...
Cash is debited and Capital Stock is credited
...
None of the above
...
The recommended debit and credit are:
a
...

b
...

c
...

d
...

A company received cash from a customer in payment for future delivery services
...
0 License
a
...

b
...

c
...

d
...

A company performed delivery services for a customer for cash
...
Debit Cash, credit Unearned Delivery Fees
...
Debit Cash, credit Delivery Fee Revenue
...
Debit Accounts Receivable, credit Delivery Fee Revenue
...
None of the above
...
The correct journal entry is:
a
...
Cash
Dividends
c
...
Cash
Capital stock

500
500
500
500

500
500
500
500

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...


➢

Give some examples of source documents
...
What are the two basic forms (styles) of accounts illustrated in the chapter?

➢

What is meant by the term double-entry procedure, or duality?

➢

Describe how you would determine the balance of a T-account
...
Name the types of accounts that are:
➢
➢

Decreased by a debit
...


➢
➢

Increased by a debit
...


Do you think this system makes sense? Can you conceive of other possible methods for recording
changes in accounts?

➢

Which of the steps in the accounting cycle are performed throughout the accounting period?

➢

Which of the steps in the accounting cycle are performed only at the end of the accounting period?

➢

Why are expense and revenue accounts used when all revenues and expenses could be shown directly
in the Retained Earnings account?

➢

What is the purpose of the Dividends account and how is it increased?

➢

Are the following possibilities conceivable in an entry involving only one debit and one credit? Why?
➢

Increase a liability and increase an expense
...


➢

Increase a revenue and decrease an expense
...


Accounting Principles: A Business Perspective

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...


➢
➢

Decrease an asset and increase a liability
...


Describe the nature and purposes of the general journal
...


➢

Describe a ledger and a chart of accounts
...
What difficulties could arise if no cross-indexing existed between the
general journal and the ledger accounts?

➢

Which of the following cash payments would involve the immediate recording of an expense? Why?
➢
➢

Paid an automobile dealer for a new company auto
...


➢
➢

Paid vendors for office supplies previously purchased on account
...


What types of accounts appear in the unadjusted trial balance? What are the purposes of this trial
balance?

➢

You have found that the total of the Debits column of the trial balance of Burns Company is USD
200,000, while the total of the Credits column is USD 180,000
...
Instead of debiting the Store Equipment account,
the debit was made to Delivery Equipment
...
The student took an examination in a room where the windows were on the other side of the
room and became confused and consistently reversed debits and credits
...
Show where pluses (+) or minuses (-) should be
inserted to indicate the effect debits and credits have on each account
...
Cash was received for services performed for customers, USD 1,200
...
Services were performed for customers on account, USD 4,200
...
0 License
Exercise C Prepare the journal entry required for each of the following transactions:
a
...

b
...

Exercise D Prepare the journal entry required for each of the following transactions:
a
...

b
...
The bank increased the company's checking account by USD
30,000 after management of the company signed a written promise to return the USD 30,000 in 30 days
...
Cash was received for services performed for customers, USD 700
...
Services were performed for customers on account, USD 1,200
...

Then show how the journal entry would be posted to T-accounts
...

a
...

b
...

c
...

Exercise F Explain each of the sets of debits and credits in these accounts for Tuxedos, Inc
...
There are 10 transactions to be explained
...
For example, the first transaction is the issuance of capital stock for cash and
is denoted by the letter (a)
...


'

(e)

1,000

18,200

Accounts Receivable

(c)

1,800

(J)

Service Revenue

12,000

Bal
...

on Hand

1,800

(J)

13,80C

Rent Expense

30,000

Bal
...
, as they
appear at 2010 December 31
...

Exercise H Prepare journal entries to record each of the following transactions for Sanchez Company
...
Include an explanation for each entry
...
Recording business transactions
a
...

b
...

c
...

d
...

e
...

f
...

g
...

h
...

i
...

j
...

Exercise I Using the data in the previous problem, post the entries to T-accounts
...
Determine a balance for each account
...
Assume the date of the trial
balance is 2010 March 31
...
He also maintains his own
accounting records and was about to prepare financial statements for the year 2010
...
What are the possible reasons why the totals of the debits and credits are out of balance?
How would you normally proceed to find an error if the two trial balance columns do not agree?
Exercise L Refer to the Consolidated Balance Sheets of The Limited in the Annual Report Appendix located in
the back of this text
...
comment on the results
...

Problems
Problem A The transactions of Lightning Package Delivery Company for March 2010 follow:
Mar
...

2 Paid USD 6,000 as the rent for March on a completely furnished building
...

6 Paid USD 4,000 as the rent for March on two forklift trucks
...

12 Performed delivery services for customers who promised to pay USD 27,000 at a later date
...

21 Received a bill for USD 1,200 for advertising in the local newspaper in March
...

31 Paid USD 2,400 salaries to employees for March
...
The services will be performed in April
...

Prepare the journal entries required to record these transactions in the general journal of the company
...
0 License
Aug
...

3 Borrowed USD 40,000 from the bank on a note
...

6 Performed services for customers who promised to pay later, USD 16,000
...

10 Collections were made for the services performed on August 6, USD 3,200
...

17 A bill for USD 400 was received for utilities for this month
...

31 Paid employee salaries, USD 6,000
...

a
...

b
...
Enter the account number in the Posting Reference column of the
journal as you post each amount
...

No
...
Prepare a trial balance as of 2010 August 31
...
, a company providing janitorial services, was organized 2010 July 1
...

100
103
150
160
170
200
201
300
310
320
400
506
507
511
512
515
518

Acct
...

5 Office space was rented for July, and USD 5,000 was paid for the rental
...


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...

15 Purchased trucks for USD 150,000, paying USD 120,000 cash and giving a 60-day note to the dealer for USD
30,000
...

23 Received USD 17,280 cash as service revenue
...

30 Paid for gasoline and oil used by the truck in July, USD 576
...

31 Paid salaries for July, USD 51,840
...

31 Paid cash dividends, USD 9,600
...
Prepare general ledger accounts for all of these accounts except Retained Earnings
...

b
...

c
...

d
...

Problem D Trim Lawn, Inc
...
Thus, the company earns its revenue from sending its
trucks to customers' residences and certain commercial establishments to care for lawns and shrubbery
...

Trial Balance
2010 November 30
Acct
...

100

Account Title
Cash

Debits
$ 63,740

103

Accounts Receivable

88,600

150

Trucks

102,900

160

Office Furniture

8,400

200

Accounts Payable

$ 33,600

300

Capital Stock

30,000

310

Retained Earnings, 2010 January 1

30,540

400

Service Revenue

371,010

505

Advertising Expense

18,300

506

Gas an d Oil Expense

21,900

507

Salaries Expense

65,850

511

Utilities Expense

2,310

515

Rent Expense

15,000

518

Supplies Expense

75,600

531

Entertainment Expense

2,550
$465,150

Dec
...

5 Paid the accounts payable of USD 33,600
...

10 Purchased a new office desk on account, USD 1,050
...
0 License
13 Purchased USD 240 of supplies on account for use in December
...

20 Paid for customer entertainment, USD 450
...

26 Paid for gasoline used in the trucks in December, USD 270
...

30 Paid for more December supplies, USD 12,000
...

31 Paid a USD 4,000 cash dividend
...
320
...
Open three-column general ledger accounts for each of the accounts in the trial balance under the date of
2010 December 1
...
Also open an account for
Dividends, No
...

b
...

c
...

d
...

Problem E Marc Miller prepared the following trial balance from the ledger of the Quick-Fix TV Repair
Company
...

QUICK-FIX REPAIR COMPANY
Trial Balance
2010 December 31
Acct
...

100

Account Title
Cash

Debits
$ 69,200

Credits

103

Accounts Receivable

60,800

160

Office Furniture

120,000

172

Office Equipment

48,000

200

Accounts Payable

$ 32,400

300

Capital Stock

180,000

310

Retained Earnings

80,000

320

Dividends

400

Service Revenue

507

Salaries Expense

280,000

515

Rent Expense

40,000

568

Miscellaneous Expense

7,200

28,800
360,000

$654,000

$652,400

The difference in totals in the trial balance caused Miller to carefully examine the company's accounting records
...

• In computing the balance of the Accounts Payable account, a credit of USD 3,200 was omitted from the

computation
...
The

ledger account has the balance at its correct amount of USD 83,200
...
Recording business transactions
• One debit of USD 2,400 to the Dividends account was posted as a credit to that account
...


Prepare a corrected trial balance for the Quick-Fix TV Repair Company as of 2010 December 31
...

Alternate problems
Alternate problem A Speedy Laundry Company, Inc
...
1 Received cash for capital stock issued to owners, USD 400,000
...

6 Performed laundry services for USD 2,000 cash
...
The services are to be performed next
month
...

15 Received and paid a bill for USD 430 for supplies used in operations
...

31 Paid USD 2,400 salaries to employees for August
...

31 Paid cash dividend, USD 1,000
...

Alternate problem B The transactions listed below are those of Reliable Computer Repair, Inc
...
1 Cash of USD 500,000 was received for capital stock issued to the owners
...

6 Trucks were purchased for USD 56,000 cash
...

14 Salaries for first two weeks were paid, USD 12,000
...

18 An invoice was received from Roger's Gas Station for USD 400 for gas and oil used during April
...
The cash was received, and a note promising to return
the USD 80,000 on 2010 May 30, was signed
...

30 Salaries for the remainder of April were paid, USD 14,400
...
Prepare journal entries for these transactions
...
Post the journal entries to T-accounts
...
Use the following account numbers:
Acct
...

100
150
172
200
201
300
400

Account Title
Cash
Trucks
Office equipment
Accounts payable
Notes payable
Capital stock
Service revenue

110

This book is licensed under a Creative Commons Attribution 3
...
Prepare a trial balance as of 2010 April 30
...
, was organized 2010 January 1
...

No
...
1 The company received USD 560,000 cash and USD 240,000 of office furniture in exchange for USD
800,000 of capital stock
...

4 Purchased computers on account, USD 13,200
...

Jan 12 Purchased insurance for January on the delivery trucks
...

15 Received and paid January utilities bills, USD 960
...

17 Cash received for delivery services to date amounted to USD 1,800
...

23 Purchased delivery trucks for cash, USD 108,000
...

27 Purchased a copy machine on account, USD 3,600
...

31 Sales of delivery services on account amounted to USD 11,400
...

a
...
The Retained Earnings
account has a beginning balance of zero and maintains this balance throughout the period
...
Journalize the transactions given for 2010 January in the general journal
...
Post the journal entries to ledger accounts
...
Prepare a trial balance as of 2010 January 31
...
Recording business transactions
Alternate problem 4 The trial balance of California Tennis Center, Inc
...

Trial Balance
2010 November 30
Acct
...

100

Account Title
Cash

Debits
$71,180

Credits

103

Accounts Receivable

81,750

130

Land

60,000

200

Accounts Payable

$18,750

201

Notes Payable

15,000

300

Capital Stock

50,000

310

Retained Earnings, 2010 January 1

53,700

413

Membership and Lesson Revenue

505

Advertising Expense

21,000

507

Salaries Expense

66,000

511

Utilities Expense

2,100

515

Rent Expense

33,000

518

Supplies Expense

2,250

530

Repairs Expense

1,500

531

Entertainment Expense

870

540

Interest Expense

300

202,500

$339,950

$339,950

Dec
...

2 Paid vendors on account, USD 18,000
...

7 Sold memberships on account for December, USD 27,000
...

13 Cash collections from customers on account, USD 36,000
...

24 Paid the December utilities bill, USD 180
...

29 Paid the equipment repair bill received on the 19th, USD 225
...

30 Paid salaries, USD 6,000
...

30 Costs paid in entertaining customers in December, USD 350
...
(The Dividends account is No
...
)
a
...
Place the word
Balance in the explanation space and enter the date 2010 December 1, on this same line
...
320
...
Prepare entries in the general journal for the transactions during December 2010
...
Post the journal entries to ledger accounts
...
0 License
d
...

Alternate problem E Bill Baxter prepared a trial balance for Special Party Rentals, Inc
...
The trial balance did not balance
...

Trial Balance
2010 December 31
Acct
...


Account Title

Debits

Credits

100

Cash

$ 74,000

103

Accounts Receivable

50,800

170

Equipment

160,000

200

Accounts Payable

$ 34,000

300

Capital Stock

130,000

310

Retained Earnings

320

Dividends

400

Service Revenue

505

Advertising Expense

1,200

507

Salaries Expense

176,000

511

Utilities Expense

44,800

515

Rent Expense

64,000

44,000
16,000
432,000

$ 586,800

$ 640,000

In trying to f ind out why the trial balance did not balance, Baxter discovered the following errors:
Equipment was understated (too low) by USD 12,000 because of an error in addition in determining the balance
of that account in the ledger
...

A debit of USD 16,000 for a semiannual dividend was posted as a credit to the Capital Stock account
...

Miscellaneous Expense (Account No
...

Prepare a corrected trial balance as of 2010 December 31
...

Beyond the numbers—Critical thinking
Business decision case A John Jacobs lost his job as a carpenter with a contractor when a recession hit the
construction industry
...
He decided to form his own company, Jacobs
Corporation, and do home repairs
...
15 Stockholders invested USD 40,000 in the business
...
25 Received payment of USD 4,400 for remodeling a basement into a recreation room
...

Mar
...

Apr
...
The
professor purchased all of the materials for the job
...

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...

15 Paid dividends of USD 2,000
...
Prepare journal entries for these transactions
...
Post the journal entries to T-accounts
...
How profitable is this new venture? Should Jacobs stay in this business?
Annual report analysis B Refer to the Annual Report of The Limited, Inc
...

Perform horizontal and vertical analyses of the liabilities and stockholder's equity sections of the balance sheets for
the two most recent years shown
...
Vertical analysis involves showing the percentage of
total liabilities and stockholder's equity that each account represents as of the balance sheet dates
...

Annual report analysis C In The Home Depot's recent Annual Report, the following passages appear:
The primary key to our success is our 39,000 employees who wear those orange aprons you see in our stores
...
Indeed, one
need look no further than the business section of the morning newspaper to read of how yet another "blue chip"
American business, entrenched in and isolated by its own bureaucracy, has lost the support of its employees and
customers
...


...
Many of our best ideas come from the people who work on the sales floor
...


...
Certainly,
people can often perceive great risk acting this way
...
We do everything we can to
make people feel challenged and inspired at work instead of being threatened and made to feel insecure
...

Write answers to the following questions:
a
...

b
...

c
...
Could its philosophy regarding its employees be the major factor in its outstanding financial performance?
Explain
...
Write out the
answers to the following questions:
a
...

b
...


114

This book is licensed under a Creative Commons Attribution 3
...
What would you do if you were Larry? Describe in detail
...
What do you think the real Larry did? Describe in detail
...
Seek information on the advantages and
disadvantages of working for a CPA firm
...
As a team, write a memorandum to the instructor summarizing the results of
the interview
...

Group project F With one or two other students and using library resources, write a report on the life of Luca
Pacioli, sometimes referred to as the father of accounting
...
Be careful to cite sources and treat direct quotes properly
...
)
Using the Internet—A view of the real world
Visit the following website:
http://www
...
com
Click on Job Seekers
...

Visit the following website:
http://www
...
gov
Investigate this site for anything of interest
...

Answers to self-test
True-false
False
...
The first three steps are performed
throughout the accounting period
...
The journal is the book of original entry
...

False
...

False
...

True
...

False
...

Multiple-choice
c
...

b
...

The credit is to Cash
...
The receipt of cash before services are performed creates a liability, Unearned Delivery Fees
...
Cash is debited to increase its balance
...
Cash is increased by the debit, and Delivery Service Revenue is increased by the credit
...
Dividends is increased by the debit, and Cash is decreased by the credit
...
0 License

3
...

• Identify the reasons why adjusting entries must be made
...

• Prepare adjusting entries
...

• Analyze and use the financial results and trend percentages
...
Nearly
all public accounting firms, ranging from the “Big 4” international firms to the sole practitioner, generate a
significant portion of their fees through tax compliance, planning and consulting
...
This complexity also provides tremendous tax
planning opportunities
...
For your business clients, careful planning and structuring of business investments
and transactions can save millions of dollars in taxes
...

A career in taxation is by no means limited to public accounting
...
For example,
many companies offer deferred compensation or stock bonus plans to their executives
...

Significant tax savings can be generated for both the company and their employees if these benefits are structured
correctly
...
Such a degree is not required to specialize in tax, but does offer students a significant advantage if they want to
pursue a career in taxation
...
These responses reflect the
indisputable fact that as the US demographic includes more wealthy, and older, Americans than ever before,
professional tax guidance will be in ever-increasing demand
...
Adjustments for financial reporting
The career paths outlined above do not nearly cover all of the many professional options available to tax
specialists
...
Are you interested in law? Accounting offers an ideal undergraduate degree for aspiring
business and tax attorneys
...

Chapters 1 and 2 introduced the accounting process of analyzing, classifying, and summarizing business
transactions into accounts
...
You also know how to use the trial balance to test the equality of debits and credits in the journalizing and
posting process
...
At this point in your study of accounting, you are concentrating on three
financial statements—the income statement, the statement of retained earnings, and the balance sheet
...

When you began to analyze business transactions in Chapter 1, you saw that the evidence of the transaction is
usually a source document
...
Examples are receipts for cash paid or received, checks written or received, bills sent to customers, or
bills received from suppliers
...

The journal entries we discuss in this chapter are adjusting entries
...
Accountants use adjusting entries to bring accounts to their proper balances
before preparing financial statements
...
Then you learn about the classes and types of adjusting entries and how to prepare them
...
The cash basis of accounting recognizes revenues when cash is received
and recognizes expenses when cash is paid out
...
Similarly, under the
cash basis, a company would treat expenses incurred in 2010 for which the company disbursed cash in 2011 as 2011
expenses
...
However,
under the “modified” cash basis, the purchase of long-lived assets (such as a building) would be debited to an asset
and depreciated (gradually charged to expense) over its useful life
...


Cash Basis
Revenues are recognized

Accrual Basis

As cash is received

As earned (goods are
delivered or services are
performed)

Expenses are recognized

As cash is paid

Exhibit 14: Cash basis and accrual basis of accounting compared

117

As incurred to produce
revenues

This book is licensed under a Creative Commons Attribution 3
...
The cash basis is acceptable in practice only under those circumstances
when it approximates the results that a company could obtain under the accrual basis of accounting
...
Under certain circumstances, companies may use the cash basis
for income tax purposes
...
The accrual basis of accounting recognizes revenues
when sales are made or services are performed, regardless of when cash is received
...
For instance, assume a company performs services for a customer
on account
...
Later, when the company receives the cash, no revenue is recorded because the company has already
recorded the revenue
...
In Exhibit 14, shown below, we show when revenues and
expenses are recognized under the cash basis and under the accrual basis
...
An income statement that does not report all revenues and expenses is incomplete,
inaccurate, and possibly misleading
...
Each adjusting entry has a dual purpose:
(1) to make the income statement report the proper revenue or expense and (2) to make the balance sheet report
the proper asset or liability
...

January
February
March
April
May
June
July
August
September
October
November
Subtotal
December
Total Companies

30
9
16
8
18
49
8
14
42
17
13
224
376
600

Source' American Institute of Certified Public Accountants

Accounting Trends & Techniques (New York' AICPA, 2004) p39

Exhibit 15: Summary-fiscal year ending by month
Since those interested in the activities of a business need timely information, companies must prepare financial
statements periodically
...
These
time periods are usually equal in length and are called accounting periods
...
An accounting year, or fiscal year, is an accounting period of one year
...
The fiscal year may or may not coincide with the calendar year, which ends
on December 31
...
In 2008, the comparable figure for publicly-traded companies in the US was 65 per
cent
...
For instance many
Accounting Principles: A Business Perspective

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...
Other
companies select a fiscal year ending at a time when inventories and business activity are lowest
...
Adjusting
entries are journal entries made at the end of an accounting period or at any time financial statements are to be
prepared to bring about a proper matching of revenues and expenses
...
The matching principle is one of the underlying principles of accounting
...

Adjusting entries reflect unrecorded economic activity that has taken place but has not yet been recorded
...
A second reason is that no source document
concerning that activity has yet come to the accountant’s attention
...
That is, adjusting entries convert the amounts that are actually in the general
ledger accounts to the amounts that should be in the general ledger accounts for proper financial reporting
...
For example,
assume a company purchased a three-year insurance policy costing USD 600 at the beginning of the year and
debited USD 600 to Prepaid Insurance
...
Failure to do so misstates assets and net income on the financial statements
...
g
...
Thus, an entry could be made daily to record the expense incurred
...
Therefore, if monthly financial statements are prepared,
monthly adjusting entries are required
...
Accordingly, adjusting entries are required at least once a year
...

119

This book is licensed under a Creative Commons Attribution 3
...
Computers
will be fed the facts concerning activities that would normally result in adjusting entries and
instructed to seek any necessary information from their own databases or those of other computers
to continually adjust the accounts
...
Deferred items consist of adjusting entries involving data previously
recorded in accounts
...
Accrued items consist of adjusting entries relating to activity on
which no data have been previously recorded in the accounts
...

Deferred items consist of two types of adjusting entries: asset/expense adjustments and liability/revenue
adjustments
...
Also, unearned revenue is a liability until the company renders the service; then the unearned revenue
becomes earned revenue
...
For example, assume a company performs a service for a customer but has not yet billed the customer
...
Also, assume a company owes its employees salaries not yet paid
...


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...

No
...
Look at Exhibit 17, the trial balance of the MicroTrain Company at 2010
December 31
...
The adjustments for these accounts involve data already recorded in the company’s accounts
...
These new accounts are:
Type of Account
Asset
Contra asset*
Liability Revenue
Expenses

Acct
...

121
151
206
418
512
515
518
521

Account Title
Interest Receivable
Accumulated
Deprecation—Trucks
Salaries Payable
Interest Revenue
Insurance Expense
Rent Expense
Supplies Expense
Depreciation Expense—
Trucks

*Accountants deduct the balance of a contra asset from the balance of the related reasons for using a
contra asset account later in the chapter
...
The total depreciation
expense taken on trucks since the
acquisition date
...

The amount of salaries earned
by employees but not yet paid
by the company
...

The cost of insurance incurred
in the current period
...

The cost of supplies used in
the current period
...

asset account on the balance sheet
...
If you find the
process confusing, review the beginning of this chapter so you clearly understand the purpose of adjusting entries
...
0 License

An accounting perspective:
Uses of technology
It is difficult to name a publicly owned company that does not provide an extensive website
...
Most websites
will have a link titled investor relations or merely company information which provides a wealth of
financial information ranging from audited financial statements to charts of the company's stock
prices
...
gapinc
...


Adjustments for deferred items
This section discusses the two types of adjustments for deferred items: asset/expense adjustments and
liability/revenue adjustments
...
In the liability/revenue group, you learn how to prepare adjusting entries for unearned
revenues
...
A prepaid expense
is an asset awaiting assignment to expense, such as prepaid insurance, prepaid rent, and supplies on hand
...

Prepaid insurance When a company pays an insurance policy premium in advance, the purchase creates the
asset, prepaid insurance
...
With the passage of time, however, the asset gradually expires
...
To illustrate this point, recall that in Chapter 2, MicroTrain Company purchased for cash an insurance
policy on its trucks for the period 2010 December 1, to 2011 November 30
...


1

Prepaid Insurance

2,400

Cash

2400

Purchased truck insurance to cover a one-year period
...

After posting this entry, the Prepaid Insurance account has a USD 2,400 debit balance on 2010 December 1
...

(Dr
...
1
Bal
...
)
2010

Insurance Expense

(Cr)

Dec
...


Accounting Principles: A Business Perspective

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...
Therefore, part of the service
potential (or benefit obtained from the asset) has expired
...
We recognize this reduction by treating the cost of the services received from
the asset as an expense
...
Since the policy provides the same services for every month of its one-year life, we assign an equal
amount (USD 200) of cost to each month
...
The adjusting journal entry is:
2010
Dec
...


After posting these two journal entries, the accounts in T-account format appear as follows:
(Dr
...
1 Purchased
on account 2,400

2010
Dec
...
After adjustment

(Dr
...
)

200

In practice, accountants do not use T-accounts
...
After posting the preceding two entries, the three-column
ledger accounts appear as follows:
Prepaid Insurance
Date

Post Ref
...
2010

Explanation

Adjustment

G3*

Credit

Balance
2400 Dr
...


Credit

Balance

Insurance Expense
Date
Dec
...


Debit

Adjustment

G3*

200

200 Dr
...
So on 2010 December 31, one month of protection had passed, and
an adjusting entry transferred USD 200 of the USD 2,400 (USD 2,400/12 = USD 200) to Insurance Expense
...
It reports the remaining amount of
the prepaid expense, USD 2,200, as an asset on the balance sheet
...

Prepaid rent Prepaid rent is another example of the gradual consumption of a previously recorded asset
...
On the date it pays the rent, the

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...
The company has not yet received
benefits resulting from this expenditure
...

We measure rent expense similarly to insurance expense
...
If the prepayment covers a three-month rental, we charge one-third of this rental to each
month
...

For example, MicroTrain Company paid USD 1,200 rent in advance on 2010 December 28, to cover a threemonth period beginning on that date
...


1

Prepaid Rent

1,200

Cash

1,200

Paid three months' rent on a building
...
After this entry is posted, the
Prepaid Rent account has a USD 1,200 balance and the Rent Expense account has a zero balance because no part of
the rent period has yet elapsed
...
)
2010

(Cr)

Prepaid Rent

Dec
...
Cash Paid

(Dr
...
1
1,200

Bal
...
Since one third of the period covered by the
prepaid rent has elapsed, it charges one-third of the USD 1,200 of prepaid rent to expense
...

Adjustment

31 Rent Expense

2—Rent

400

Prepaid Rent To record rent expense for December

400

After posting this adjusting entry, the T-accounts appear as follows:
(Dr
...
1 Cash Paid
Bal
...
)
Increased by
$400

Prepaid Rent

Rent Expense

2010
Dec
...
31
Adjustment 2

Decreased

400

800

by $400

(Cr)

The USD 400 rent expense appears in the income statement for the year ended 2010 December 31
...
Thus, the
adjusting entries have accomplished their purpose of maintaining the accuracy of the financial statements
...
It may classify supplies simply as
supplies (to include all types of supplies), or more specifically as office supplies (paper, stationery, floppy diskettes,
pencils), selling supplies (gummed tape, string, paper bags, cartons, wrapping paper), or training supplies
(transparencies, training manuals)
...
These supplies are an asset until

Accounting Principles: A Business Perspective

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...
This asset may be called supplies on hand or supplies inventory
...

On 2010 December 4, MicroTrain Company purchased supplies for USD 1,400 and recorded the transaction as
follows:
2010
Dec
...


1,400
1,400

MicroTrain’s two accounts relating to supplies are Supplies on Hand (an asset) and Supplies Expense
...
)
2010
Dec
...
Cash Paid

On Hand

(Cr
...
)
2010
Dec
...


Supplies

Expense

(Cr
...
Thus, the company must have used USD 500 of supplies in December
...
The adjusting entry recognizes the
reduction in the asset (Supplies on Hand) and the recording of an expense (Supplies Expense) by transferring USD
500 from the asset to the expense
...
So MicroTrain makes the following adjusting entry:
2010
Dec
...


500

3—Supplies

After posting this adjusting entry, the T-accounts appear as follows:
(Dr
...
)
Increased by
$500

(Cr)

Supplies on Hand

2010
Dec
...
after
adjustment
900
Supplies Expense

2010
Dec 31 Adjustment 3

2010
Dec
...
)
500

The entry to record the use of supplies could be made when the supplies are issued from the storeroom
...

Accountants make adjusting entries for supplies on hand, like for any other prepaid expense, before preparing
financial statements
...
Supplies on hand is an asset in the balance
sheet
...
If so, an expense account is
usually debited at the time of purchase rather than debiting an asset account
...
Sometimes, too, a company debits an expense even though
the asset will benefit more than the current period
...
For instance, assume that on January 1, a company
paid USD 1,200 rent to cover a three-year period and debited the USD 1,200 to Rent Expense
...
0 License
year, it transfers USD 800 from Rent Expense to Prepaid Rent
...

Depreciation Just as prepaid insurance and prepaid rent indicate a gradual using up of a previously recorded
asset, so does depreciation
...
Also, a prepaid expense generally involves a fairly small
amount of money
...

A depreciable asset is a manufactured asset such as a building, machine, vehicle, or piece of equipment that
provides service to a business
...
Since companies gradually use up these assets over time, they record
depreciation expense on them
...
The process of recording depreciation expense is called depreciation accounting
...
The asset cost is the amount that a company paid to purchase the depreciable asset
...
The estimated residual value (scrap value) is the amount that the

company can probably sell the asset for at the end of its estimated useful life
...
The estimated useful life of an asset is the estimated time that a company can

use the asset
...

However, sometimes the useful life is determined by company policy (e
...
keep a fleet of automobiles for three
years)
...
The method illustrated here is the straight-line
method
...
Straight-line depreciation assigns the same amount
of depreciation expense to each accounting period over the life of the asset
...
The journal entry was:
2010
Dec
...


The estimated residual value for each truck was USD 1,000, so MicroTrain estimated the total residual value for
all four trucks at USD 4,000
...
Using the
straight-line depreciation formula, MicroTrain calculated the annual depreciation on the trucks as follows:
Annual deprecation =

USD 40,000 – USD 4,000
= USD 9,000
4 years

The amount of depreciation expense for one month would be 1/12 of the annual amount
...

The difference between an asset’s cost and its estimated residual value is an asset’s depreciable amount
...
It does this by debiting the amount of depreciation for a period to a depreciation expense
Accounting Principles: A Business Perspective

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...
MicroTrain’s depreciation on its
delivery trucks for December is USD 750
...


31 Depreciation Expense – Trucks

750

Accumulated Depreciation - Trucks

750

Adjusted 4Depreciation

To record depreciation expense for December
...
)

Depreciation Expense—Trucks

Increased by
$750

2010
Dec 31 Adjustment 4

(Dr
...
)

Increased by $750
(book value of asset
decreased)

2010
Dec
...
And it reports accumulated depreciation in
the balance sheet as a deduction from the related asset
...
A contra asset account is a
deduction from the asset to which it relates in the balance sheet
...
The accumulated
depreciation account does not represent cash that is being set aside to replace the worn out asset
...
Accountants also refer to an asset’s cost less accumulated
depreciation as the book value (or net book value) of the asset
...
In the previous example, the book value of the equipment after the first month is:
Cost
Less: Accumulated depreciation
Book value (or cost not yet allocated to as an expense)

USD 40,000
750
39,250

MicroTrain credits the depreciation amount to an accumulated depreciation account, which is a contra asset,
rather than directly to the asset account
...
For instance, for the asset Trucks, it is useful
to know both the original cost of the asset and the total accumulated depreciation amount recorded on the asset
...
The contra account, Accumulated Depreciation—Trucks,
shows the total amount of recorded depreciation from the date of acquisition
...
For instance, assume the accumulated depreciation amount is about threefourths the cost of the asset
...

Thus, to provide more complete balance sheet information to users of financial statements, companies show
both the original acquisition cost and accumulated depreciation
...
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Assets
Trucks
Less: Accumulated deprecation

USD 40,000
750
USD 39,250

As you may expect, the accumulated depreciation account balance increases each period by the amount of
depreciation expense recorded until the remaining book value of the asset equals the estimated residual value
...
Receiving
assets before they are earned creates a liability called unearned revenue
...
The liability account credited may be Unearned Fees, Revenue
Received in Advance, Advances by Customers, or some similar title
...
By performing the services, the company earns revenue and cancels the liability
...
Although we illustrate and discuss only advanced receipt of training fees,
firms treat the other items similarly
...
The firm recorded the following journal entry:
2010
Dec
...


4,500
4,500

The two T-accounts relating to training fees are Unearned Service Fees (a liability) and Service Revenue
...
)

(Dr
...
)
2010
Dec
...
)
2010
Bal
...


The balance in the Unearned Service Fees liability account established when MicroTrain received the cash will
be converted into revenue as the company performs the training services
...
If we assume that MicroTrain earned one-third of the USD 4,500 in the
Unearned Service Fees account by December 31, then the company transfers USD 1,500 to the Service Revenue
account as follows:
2010
Dec
...


1,500
1,500

After posting the adjusting entry, the T-accounts would appear as follows:
Decreased by
$1,500

(Dr
...
)

Unearned Service Fees

2010

Accounting Principles: A Business Perspective

2010

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...
31

Adjustment 5 1,500

Dec
...
after adjustment

(Dr
...
)

Service Revenue
2010
Bal
...
31
Adjustment 5
Bal
...
The company reports the USD 3,000
balance in the Unearned Service Fees account as a liability in the balance sheet
...

If MicroTrain does not perform the training services, the company would have to refund the money to the
training service customers
...
Then, the company would make the following entry:
Unearned Service Fees

3,000

Cash

3,000

To record the refund of unearned training fees
...
This fact should strengthen your
understanding that unearned service fees and similar items are liabilities
...
They also make adjusting entries for accrued items, which we discuss in the next section, for
business data not yet recorded in the accounting records
...
According to recent
surveys, the market for accounting graduates remains brisk
...
As a result of the low unemployment rate,
employers—especially small accounting firms with limited recruiting budgets—are doing whatever
they can to grab qualified candidates
...
The first group—asset/revenue adjustments—involves accrued assets; the second group—
liability/expense adjustments—involves accrued liabilities
...
These assets represent rights to receive future payments that are not due at the
balance sheet date
...
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recognize these rights at the end of an accounting period by preparing an adjusting entry to correct the account
balances
...

We also call these adjustments accrued revenues because the revenues must be recorded
...
Rarely is payment of the
interest made on the last day of the accounting period
...
The adjusting entry at the end of the accounting period debits a receivable
account (an asset) and credits a revenue account to record the interest earned and the asset owned
...
On 2010 December 31, the
money on deposit has earned one month’s interest of USD 600, although the company has not received the interest
...
The entry to record the accrual of revenue is:
2010
Adjustment

Dec
...


600

The T-accounts relating to interest would appear as follows:
(Dr
...
)

Interest Receivable

2010
Dec 31

Adjustment 6

600

(Dr
...
)
2010
Dec
...


Increased by $600

MicroTrain reports the USD 600 debit balance in Interest Receivable as an asset in the 2010 December 31,
balance sheet
...
The USD 600 credit balance in Interest
Revenue is the interest earned during the month
...
It reports the interest revenue
earned during the accounting period in the income statement
...

MicroTrain Company performed USD 1,000 of training services on account for a client at the end of December
...
The necessary
adjusting journal entry at 2010 December 31, is:
Adjustment 7—Unbilled

2010
Dec
...


After posting the adjusting entry, the T-accounts appear as follows:
(Dr
...
)

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...


5,200*

Dec
...
after adjustment

6,200

*This previous balance came from transactions discussed in Chapter 2
...
)
Service
Revenue
2010

(Cr
...
before adjustment

10,700

Dec
...


1,500

Dec
...
after both adjustments

13200

The service revenue appears in the income statement; the asset, accounts receivable, appears in the balance
sheet
...
They represent
obligations to make payments not legally due at the balance sheet date, such as employee salaries
...
For this reason, we also call these obligations accrued expenses
...
Unless a company pays salaries on the last day of the accounting period for a pay period ending on
that date, it must make an adjusting entry to record any salaries incurred but not yet paid
...
The entry made at that time was:
2010
Dec
...


Assuming that the last day of December 2010 falls on a Monday, this expense account does not show salaries
earned by employees for the last day of the month
...
The T-accounts pertaining to salaries appear as follows before adjustment:
(Dr
...

28

(Cr)

Salaries Expense
3,600

(Dr
...
28 Bal
...
For a five-day workweek, daily salaries are
USD 180
...


31 Salaries Expense

180

Salaries Payable

180

To accrue one day's salaries that were earned but not paid
...
)

(Cr)

Salaries Expense

2010
Dec
...

Dec
...
0 License
Bal
...
)

3,780

(Cr
...
31 Adjustment 8
Failure to Recognize

1
...


Consumption of the benefits of an asset
(prepaid expense)
Earning of previously unearned revenues

Understates net income

3
...


Accrual of liabilities

Overstates net income

Overstates liabilities Understates retained
earnings
Understates assets Understates retained
earnings
Understates liabilities Overstates retained
earnings

Exhibit 18: Effects of failure to recognize adjustments
The debit in the adjusting journal entry brings the month’s salaries expense up to its correct USD 3,780 amount
for income statement purposes
...

The balance sheet shows salaries payable as a liability
...
The
debit would be to Interest Expense, and the credit would be to Interest Payable
...


Effects of failing to prepare adjusting entries
Failure to prepare proper adjusting entries causes net income and the balance sheet to be in error
...

Using MicroTrain Company as an example, this chapter has discussed and illustrated many of the typical entries
that companies must make at the end of an accounting period
...


Analyzing and using the financial results—trend percentages
It is sometimes more informative to express all the dollar amounts as a percentage of one of the amounts in the
base year rather than to look only at the dollar amount of the item in the financial statements
...
The last column expresses these dollar amounts as a percentage of
the 2001 amount
...
609
1,995
2,333
2,681
2,740
3,056

100 %
125
155
181
208
212
237

Accounting Principles: A Business Perspective

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...
The 2010 net income is over 4 times as much as the 2001 amount
...

In the first three chapters of this text, you have learned most of the steps of the accounting process
...


An accounting perspective:
Uses of technology
The Internet sites of the Big-4 accounting firms are as follows:
Ernst & Young

http://www
...
com

Deloitte Touche Tohmatsu

http://www
...
com

KPMG

http://www
...
com

PricewaterhouseCoopers

http://www
...
com

You might want to visit these sites to learn more about a possible career in accounting
...

• The accrual basis of accounting recognizes revenues when sales are made or services are performed,

regardless of when cash is received; expenses are recognized as incurred, whether or not cash has been paid
out
...

• Adjusting entries convert the amounts that are actually in the accounts to the amounts that should be in the

accounts for proper periodic financial reporting
...

• Deferred items consist of adjusting entries involving data previously recorded in accounts
...

The two types of adjustments within this deferred items class are asset/expense adjustments and
liability/revenue adjustments
...
These entries involve the initial recording of assets and liabilities and the related revenues
and expenses
...

• This chapter illustrates entries for deferred items and accrued items
...


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...

Demonstration problem
Among other items, the trial balance of Korman Company for 2010 December 31, includes the following account
balances:
Debits

Supplies on Hand

$ 6,000

Prepaid Rent

25,200

Buildings

Credits

200,000

Accumulated Depreciation—Buildings
Salaries Expense

$33,250
124,000

Unearned Delivery Fees

4,000

Some of the supplies represented by the USD 6,000 balance of the Supplies on Hand account have been
consumed
...

On May 1 of the current year, a rental payment of USD 25,200 was made for 12 months’ rent; it was debited to
Prepaid Rent
...
The estimated useful lives of the buildings are 40 years each
...

The company has earned one-fourth of the unearned delivery fees by December 31
...

a
...

b
...
31

Post
...


Supplies Expense

Debit

Credit
3 6 0 0

Supplies on Hand

3 6 0 0

To record supplies expense ($6,000 - $2,400)
...


31

Depreciation Expense—Buildings

4 7 5 0

Accumulated Deprecation—Buildings

4 7 5 0

To record depreciation ($200,000 - $10,000 / 40 years)
...
Adjustments for financial reporting
To record accrued salaries
...


31

Accounts Receivable

6 0 0

Service Revenue

6 0 0

To record delivery fees earned
...

Accounting year An accounting period of one year
...

Accrual basis of accounting Recognizes revenues when sales are made or services are performed,
regardless of when cash is received
...

Accrued assets and liabilities Assets and liabilities that exist at the end of an accounting period but have
not yet been recorded; they represent rights to receive, or obligations to make, payments that are not legally
due at the balance sheet date
...

Accrued items Adjusting entries relating to activity on which no data have been previously recorded in the
accounts
...

Accrued revenues and expenses Other names for accrued assets and liabilities
...

Adjusting entries Journal entries made at the end of an accounting period to bring about a proper
matching of revenues and expenses; they reflect economic activity that has taken place but has not yet been
recorded
...

Book value For depreciable assets, book value equals cost less accumulated depreciation
...

Cash basis of accounting Recognizes revenues when cash is received and recognizes expenses when cash
is paid out
...

Deferred items Adjusting entries involving data previously recorded in the accounts
...
Examples are prepaid expenses,
depreciation, and unearned revenues
...

Depreciable asset A manufactured asset such as a building, machine, vehicle, or equipment on which
depreciation expense is recorded
...

Depreciation expense The amount of asset cost assigned as an expense to a particular time period
...

Estimated useful life The estimated time periods that a company can make use of the asset
...
0 License
Fiscal year An accounting year of any 12 consecutive months that may or may not coincide with the
calendar year
...

Matching principle An accounting principle requiring that expenses incurred in producing revenues be
deducted from the revenues they generated during the accounting period
...
An example is prepaid insurance
...

Service potential The benefits that can be obtained from assets
...

Trend percentages Calculated by dividing the amount of an item for each year by the amount of that item
for the base year
...
Since the
revenue has not been earned, it is a liability, often called revenue received in advance or advances by
customers
...

All calendar years are also fiscal years, but not all fiscal years are calendar years
...

The Unearned Delivery Fees account is a revenue account
...

Multiple-choice
Select the best answer for each of the following questions
...
An asset was debited on that date
...
The necessary
adjusting entry at the company’s year-end, 2010 December 31, is:
a
...
Insurance expense
Prepaid insurance
c
...
Insurance expense
Prepaid insurance

400
800
800
400

400
800
800
400

The Supplies on Hand account has a balance of USD 1,500 at year-end
...
The necessary adjusting entry is:
a
...
Supplies expense
Supplies on hand
c
...
Supplies on hand
Supplies expense

1,100
400
1,100
400

1,100
400
1,100
400

A company purchased a truck for USD 20,000 on 2010 January 1
...
Adjusting entries are prepared only at year-end
...
Adjustments for financial reporting
a
...
0 License
Accumulated
b
...
Deprecation expense – Trucks
Accumulated deprecation – Trucks
d
...
A liability account was credited when the cash was received
...
The company prepares adjusting entries at the end of each month because
it prepares financial statements each month
...
Unearned subscription fees

6,000

Subscription fee revenue
b
...
Unearned subscription feeds

2,000

18,000
18,000

Subscription fee revenue
d
...

b
...

d
...
Debit an expense and credit a liability
...
Debit an expense and credit an asset
...
Debit a liability and credit an asset
...
Debit a liability and credit an expense
...


Questions
➢

Which events during an accounting period trigger the recording of normal journal entries? Which
event triggers the making of adjusting entries?

➢

Describe the difference between the cash basis and accrual basis of accounting
...
Under the cash
basis, receipts that are of a revenue nature are considered revenue when received, and expenditures
that are of an expense nature are considered expenses when paid
...
Adjustments for financial reporting
accounting, where an effort is made to match expenses incurred against the revenues they create,
that makes adjusting entries necessary
...


➢

Give an example of a journal entry for each of the following:
➢
➢

Earning of revenue that was previously recorded as unearned revenue
...


➢
➢

Equal growth of an expense and a liability
...


A fellow student makes the following statement: “You can easily tell whether a company is using the
cash or accrual basis of accounting
...
” Is the student correct?

➢

You notice that the Supplies on Hand account has a debit balance of USD 2,700 at the end of the
accounting period
...
Give examples of asset and liability accounts for which this statement is true
...


➢

Give the depreciation formula to compute straight-line depreciation for a one-year period
...
Do you think the effort is worthwhile?

➢

Real world question Refer to the financial statements of The Limited, Inc
...
Approximately what percentage of the depreciable assets under property, plant, and
equipment has been depreciated as of the end of the most recent year shown?

Exercises
Exercise A Select the correct response for each of the following multiple-choice questions:
The cash basis of accounting:
(a) Recognizes revenues when sales are made or services are rendered
...

(c) Is typically used by some relatively small businesses and professional persons
...


139

This book is licensed under a Creative Commons Attribution 3
...

(b) Is used by almost all companies
...

(d)Recognizes revenues when sales are made or services are performed and recognizes expenses only
when cash is paid out
...

(b) Two months
...

(d)Twelve months
...

(b) Source documents
...

(d)Activity that has already been recorded in the proper accounts
...

(b) Liability/expense adjustments
...

(d)Asset/liability adjustments
...

(b) Liability/revenue adjustments
...

(d)Liability/expense adjustments
...

Exercise E Assume that rent of USD 12,000 was paid on 2010 September 1, to cover a one-year period from
that date
...
If financial statements are prepared only on December 31 of each year, what
adjusting entry is necessary on 2010 December 31, to bring the accounts involved to their proper balances?
Exercise F At 2010 December 31, an adjusting entry was made as follows:
Rent Expense

Accounting Principles: A Business Perspective

1,500

140

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3
...
Determine:
a
...

b
...

Exercise G Supplies were purchased for cash on 2010 May 2, for USD 8,000
...
Then show the adjusting entry that would be necessary, assuming that USD 2,500 of the supplies
remained at the end of the year
...
The
building has an estimated useful life of 40 years and an estimated residual value of USD 200,000
...
, received a total of USD 120,000 as payment
in advance for one-year subscriptions to a monthly magazine
...
By the end of the year, one-third of the magazines paid for in advance had been delivered
...

Exercise J On 2010 April 15, Rialto Theater sold USD 90,000 in tickets for the summer musicals to be
performed (one per month) during June, July, and August
...
It was too late to find another group
qualified to perform the musicals
...
Show the appropriate journal entries to be made on April 15, June 30,
and July 20
...

Exercise K Guilty & Innocent, a law firm, performed legal services in late December 2010 for clients
...
Give the adjusting entry that is necessary on 2010
December 31, if financial statements are prepared at the end of each month
...
By December 31, USD 300 of interest had been
incurred
...

Exercise M Convenient Mailing Services, Inc
...
The last payday
in January is Friday, January 27
...
Financial statements are prepared monthly
...

Exercise N State the effect that each of the following independent situations would have on the amount of
annual net income reported for 2010 and 2011
...

b
...
The services are performed in 2011
...

Effect on Balance Sheet Items
Effect on
Failure to Recognize
1
...
0 License
2
...


The earning of ticket revenue
received in advance

4
...


Salaries incurred by unpaid

Exercise P The following data regarding net income (loss) are for Perkins Parts, a medium-sized automotive
supplier, for the period 2004–2009
...


...


...


...


...


...


...


...


...


...


...


...


...

Problems
Problem A Among other items, the trial balance of Filmblaster, Inc
...
Of the prepaid insurance in the trial balance, USD 4,000 is for coverage during the months after December 31
of the current year
...
The balance in the Prepaid Rent account is for a 12-month period that started October 1 of the current year
...
USD 300 of interest has been earned but not received
...
Supplies used during the year amount to USD 1,800
...

Problem B Marathon Magazine, Inc
...


$3,720

Prepaid Rent
...


$15,000

Subscriptions Revenue
...


123,000

• The inventory of supplies on hand at December 31 amounts to USD 720
...

• One-third of the USD 15,000 balance in Unearned Subscription Fees has been earned
...
Adjustments for financial reporting
• Since the last payday, the employees of the company have earned additional salaries in the amount of USD

5,430
...
Prepare the year-end adjusting journal entries at December 31
...
Open ledger accounts for each of the accounts involved, enter the balances as shown in the trial balance, post
the adjusting journal entries, and calculate year-end balances
...
, adjusts and closes its books each December 31
...
Following are some of the company’s account balances prior
to adjustment on 2010 December 31:
HILLSIDE APARTMENTS, INC
...

The physical inventory of the office supply stockroom indicates that the supplies on hand cost USD 3,000
...

Salaries earned since the last payday but unpaid at December 31 amount to USD 5,000
...

The Unearned Rent account arose through the prepayment of rent by a tenant in the building for 12 months
beginning 2010 October 1
...

Problem D The reported net income amounts for Gulf Coast Magazine, Inc
...
No annual adjusting entries were made at either year-end for
any of the following transactions:
A fire insurance policy to cover a three-year period from the date of payment was purchased on 2010 March 1 for
USD 3,600
...

Subscriptions for magazines in the amount of USD 72,000 to cover an 18-month period from 2010 May 1, were
received on 2010 April 15
...

A building costing USD 180,000 and having an estimated useful life of 50 years and a residual value of USD
30,000 was purchased and put into service on 2010 January 1
...
The account debited was Salaries Expense
...

Calculate the correct net income for 2010 and 2011
...
Then
show the effects of each correction (adjustment), using a plus or a minus to indicate whether reported income
should be increased or decreased as a result of the correction
...
0 License
the reported net income amounts, the result should be the correct net income amounts
...
The company’s bookkeeper
intended to use the cash basis of accounting
...
No adjusting entries were made
prior to preparing the financial statements for December
...
1 Issued capital stock for USD 300,000 cash
...
The magazine is
published monthly on the 23rd
...
The cost was
USD 36,000
...

12 Paid the annual rent on the building, USD 36,000, effective through 2011 November 30
...

15 Salaries for the period December 1–15 amounted to USD 48,000
...

20 Salaries for the period December 1–15 were paid
...
(Only USD 1,800 of these were subsequently used in 2010
...

31 Cash sales of the December issue, USD 84,000
...

31 Sales on account of December issue, USD 14,000
...
Prepare journal entries for the transactions as the bookkeeper prepared them
...
Prepare journal entries as they would have been prepared under the accrual basis
...
Where possible, record the original transaction so that no
adjusting entry would be necessary at the end of the month
...

Alternate problems
Alternate problem A The trial balance of Caribbean Vacation Tours, Inc
...


$24,000

Prepaid Rent
...


Credits

188,000

Accumulated Depreciation—Buildings
...


$31,600
200,000

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...

The buildings are expected to last 25 years, with an expected residual value of USD 30,000
...

The balance in Prepaid Rent is for a one-year period that started March 1 of the current year
...

Alternate problem B Among the account balances shown in the trial balance of Dunwoody Mail Station, Inc
...

The balance in the Prepaid Insurance account is for a two-year policy taken out June 1 of the current year
...
When acquired, the lives of the buildings were estimated at 50 years each
...
Prepare the year-end adjusting journal entries at December 31
...
Open ledger accounts for each of the accounts involved, enter the balances as shown in the trial balance, post
the adjusting journal entries, and calculate year-end balances
...
To get this location, the company rented a store larger than needed and subleased (rented) a
portion of the area to Max’s Restaurant
...
Salaries of employees amount to USD 300 per day and were last paid through Wednesday, December 27
...
The store is closed Sundays
...
An analysis of the Camping Equipment account disclosed:
Balance, 2010 January 1
Addition, 2010 July 1
Balance, 2010 December 31, per trial balance

$128,000
48,000
$176,000

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...

c
...
The
premium on the policy now in force amounts to USD 7,200 per year
...
Unused supplies on hand at 2010 December 31, have a cost of USD 9,200
...
December’s rent from Max’s Restaurant has not yet been received, USD 800
...
Interest accrued on the note payable is USD 700
...

Alternate problem D The reported net income amounts for Safety Waste Control Company were 2010, USD
200,000; and 2011, USD 230,000
...
A building was rented on 2010 April 1
...

Prepaid Rent was debited
...
The balance in the Office Supplies on Hand account on 2010 December 31, was USD 6,000
...
No new
supplies were purchased during 2011
...

c
...

d
...
The USD 24,000 bill for these services was not
sent until January 2011
...

Calculate the correct net income for 2010 and 2011
...

Then show the effects of each correction (adjustment) using a plus or a minus to indicate whether reported income
should be increased or decreased as a result of the correction
...
The answer format should
be as follows:
Explanation of Corrections

2010

2011

Reported net income
To correct error in accounting for:

$200,000

$230,000

Prepaid rent:
Correct expense in 2010
Correct expense in 2011

-5,400
-7,200

Alternate problem E On 2010 June 1, Richard Cross opened a swimming pool cleaning and maintenance
service, Cross Pool Company
...
At the end of June, he prepared an
income statement for the month of June, but he had the feeling that he had not proceeded correctly
...
John immediately noted that
his brother had kept his records on a cash basis
...

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...
The payment covered the entire period
...

10 Received an advance of USD 9,000 from a Florida building contractor in exchange for an agreement to help
service pools in his housing development during October through May
...

17 Paid USD 900 for advertising to be run in a local newspaper for two weeks in June and four weeks in July
...

26 Purchased USD 5,400 of supplies for cash
...
)
29 Billed various customers for services rendered, USD 16,000
...

30 Received a bill for USD 600 for gas and oil used in June
...
Prepare the entries for the transactions as Richard must have recorded them under the cash basis of
accounting
...
Prepare journal entries as they would have been prepared under the accrual basis
...
Where possible, record the original transaction so that no
adjusting entry would be necessary at the end of the month
...

Beyond the numbers—Critical thinking
Business decision case A You have just been hired by Top Executive Employment Agency, Inc
...
It becomes obvious to you that management does not
seem to have much of an understanding about the necessity or adjusting entries or which accounts might possibly
need adjustment
...
Only those ledger accounts that had end-of-year balances are included in the trial balance
...
0 License
a
...

b
...

Business decision case B A friend of yours, Jack Andrews, is quite excited over the opportunity he has to
purchase the land and several miscellaneous assets of Drake Bowling Lanes Company for USD 400,000
...

The annual rent on the building and equipment is USD 54,000
...
Andrews believes an annual
profit of USD 100,000 on an investment of USD 400,000 is a really good deal
...
You agree and discover the following:
Drake has computed his annual profit for 2010 as the sum of his cash dividends plus the increase in the Cash
account: Dividends of USD 60,000 + Increase in Cash account of USD 40,000 = USD 100,000 profit
...
The land was acquired at a cost of USD 624,000 seven years ago
...

a
...
Comment on Drake’s method of computing the annual profit of the business
...
Include in your report an approximate income statement for 2010
...
Identify the name of the company and the major products or services offered, as well as gross
revenues, major expenses, and the trend of profits over the last three years
...
Each team should write a memorandum to
management summarizing the data and commenting on the trend percentages
...

Group project D With one or two other students and using library and internet sources, write a paper on
Statement of Accounting Standards No
...
This
standard resulted in some of the largest adjusting entries ever made
...
In the past they typically had recorded this expense on a cash
basis, recognizing the expense only when cash was paid to retirees
...

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...
Generally accepted accounting principles do not allow “human assets” to be included among assets on
the balance sheet
...

Using the Internet—A view of the real world
Visit the website:
http://www
...
com
Click on the Sarbanes-Oxley Act
...

Answers to self-test
True-false
True
...

True
...
A calendar year,
however, must end on December 31, so it does not include fiscal years that end on any date other than December 31
(such as June 30)
...
The accumulated depreciation account is a contra asset that shows the total of all depreciation recorded
on an asset from its acquisition date up through the balance sheet date
...
The Unearned Delivery Fees account is a liability
...

True
...

Multiple-choice
d
...
Therefore, USD 400 must be moved from the asset (credit) to an
expense (debit)
...
USD 1,100 of the supplies have been used, so that amount must be moved from the asset (credit) to an
expense (debit)
...
The amount of annual depreciation is determined as (USD 20,000 – USD 5,000) divided by 5 = USD 3,000
...

b
...

b
...

a
...


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...
Completing the accounting
cycle
Learning objectives
After studying this chapter, you should be able to:
• Summarize the steps in the accounting cycle
...

• Prepare an income statement, statement of retained earnings, and balance sheet using information contained

in the work sheet
...

• Prepare a post-closing trial balance
...

• Prepare a classified balance sheet
...


A career in information systems
Have you ever heard the sayings "knowledge is power" or "information is money"? When people talk about
accounting, what they are really talking about is information
...
Very often, the success of a business depends on effective creation, management, and use of information
...
Improved technology has the potential to dramatically
improve business organizations and practices, reduce costs and exploit new business and investment opportunities
...

Because of their high value and inherent complexity, the development, support, and auditing of information
systems has become one of the fastest growing specialties in accounting
...
In
addition to traditional accounting and auditing functions, MIS professionals perform evaluations of technologies
and communications protocols involving electronic data interchange, client servers, local and wide area networks,
data communications, telecommunications, and integrated voice/data/video systems
...

With management consulting practices growing and information systems becoming a larger percentage of public
accounting revenue, MIS professionals are in high demand
...
Completing the accounting cycle
working closely with businesses and consulting firms
...

This chapter explains two new steps in the accounting cycle—the preparation of the work sheet and closing
entries
...

This balance sheet format more closely resembles actual company balance sheets
...


The accounting cycle summarized
In Chapter 1, you learned that when an event is a measurable business transaction, you need adequate proof of
this transaction
...
In Chapters 2 and 3, you performed other steps in the accounting cycle
...
As a review, study the
diagram of the eight steps in the accounting cycle in Exhibit 19
...
The next section explains how to use the work sheet to
facilitate the completion of the accounting cycle
...
Usually, they
save these work sheets to document the end-of-period entries
...
Therefore, work sheets may vary in format; some are prepared in pencil so that
errors can be corrected easily
...

Accountants prepare work sheets each time financial statements are needed—monthly, quarterly, or at the end of
the accounting year
...
Each set
has a debit and a credit column
...
)
Accountants use these initial steps in preparing the work sheet
...

• Enter the titles and balances of ledger accounts in the Trial Balance columns
...

• Enter adjusted account balances in the Adjusted Trial Balance columns
...

• Extend any balances in the Retained Earnings and Dividends accounts to the Statement of Retained

Earnings columns
...

Instead of preparing a separate trial balance as we did in Chapter 2, accountants use the Trial Balance columns
on a work sheet
...
0 License
Company are on the left portion of the work sheet
...
(Some accountants do list the entire chart of accounts, even those with zero balances
...
You list the Retained Earnings account in the trial balance even though it
has a zero balance to (1) show its relative position among the accounts and (2) indicate that December 2010 is the
first month of operations for this company
...
The accounts are in the order in which they appear in the general ledger: assets, liabilities, stockholders'
equity, dividends, revenues, and expenses
...
If the debit and credit column totals are not
equal, an error exists that must be corrected before you proceed with the work sheet
...
You enter these adjustments in
the Adjustments columns of the work sheet
...
This key number facilitates the actual journalizing of the
adjusting entries later because you do not have to rethink the adjustments to record them
...
Note in the Account
Titles column that the Insurance Expense account title is below the trial balance totals because the Insurance
Expense account did not have a balance before the adjustment and, therefore, did not appear in the trial balance
...

Although these explanations are optional, they provide valuable information for those who review the work sheet
later
...
Completing the accounting cycle

Exhibit 19: Steps in the accounting cycle
• Entry (1) records the expiration of USD 200 of prepaid insurance in December
...

• Entry (3) records the using up of USD 500 of supplies during the month
...
MicroTrain acquired the

trucks at the beginning of December
...

• Entry (6) records USD 600 of interest earned in December
...

• Entry (8) records the USD 180 accrual of salaries expense at the end of the month
...
The following steps are helpful:
• Examine adjusting entries made at the end of the preceding accounting period
...

• Examine the account titles in the trial balance
...

• Examine various business documents (such as bills for services received or rendered) to discover other

assets, liabilities, revenues, and expenses that have not yet been recorded
...
For

example: "Were any services performed during the month that have not yet been billed?"

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...


Statement of
Retained
Earnings

Trial Balance

Adjustments

Adjusted Trail
Balance

Income
Statement

No
...

(2) To record rent expenses for December
...

(4) To record depreciation expenses for December
...

(6) To record one month's interest revenue
...
Completing the accounting cycle
(7) To record unbilled training services performed in December
...

After all the adjusting entries are entered in the Adjustments columns, total the two columns
...

After MicroTrain's adjustments, compute the adjusted balance of each account and enter these in the Adjusted
Trial Balance columns
...
107) had an unadjusted balance of USD 1,400
...
This amount is a debit in
the Adjusted Trial Balance columns
...
Note carefully how the rules of
debit and credit apply in determining whether an adjustment increases or decreases the account balance
...
507) has a USD 3,600 debit balance in the Trial Balance columns
...

Some account balances remain the same because no adjustments have affected them
...
200) does not change and is simply extended to the Adjusted Trial Balance
columns
...
The totals must be equal before taking the next
step in completing the work sheet
...
The Adjusted Trial
Balance columns make the next step of sorting the amounts to the Income Statement, the Statement of Retained
Earnings, and the Balance Sheet columns much easier
...
Since revenues carry credit balances, extend them to the credit column
...
MicroTrain's total expenses are USD 6,510 and
total revenues are USD 13,800
...
Enter this
USD 7,290 income in the debit column to make the two column totals balance
...

Next, complete the Statement of Retained Earnings columns
...
Thus, this net income amount is the balancing
figure for the Income Statement columns and is also in the credit Statement of Retained Earnings column
...
Add the USD 7,290 net income to the beginning retained earnings balance of USD 0, and deduct the
dividends of USD 3,000
...

Now extend the assets, liabilities, and capital stock accounts in the Adjusted Trial Balance columns to the
Balance Sheet columns
...

Note that the ending retained earnings amount determined in the Statement of Retained Earnings columns
appears again as a credit in the Balance Sheet columns
...
The ending
retained earnings is a credit in the Balance Sheet columns because it increases stockholders' equity, and increases
155

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...
(Retained earnings would have a debit ending balance only if cumulative losses
and dividends exceed cumulative earnings
...

When the Balance Sheet column totals do not agree on the first attempt, work backward through the process
used in preparing the work sheet
...
If the column totals do not

agree, check to see if you did not extend a balance sheet item or if you made an incorrect extension from the
Adjusted Trial Balance columns
...

• Re-total the Income Statement columns and determine whether you entered the correct amount of net

income or net loss for the period in the appropriate Income Statement and Statement of Retained Earnings
columns
...
An electronic spreadsheet is
simply a large blank page that contains rows and columns on the computer screen
...
Spreadsheets are ideal for creating large work
sheets, trial balances, and other schedules, and for performing large volumes of calculations such

Accounting Principles: A Business Perspective

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...
The most popular spreadsheet program is Microsoft Excel®
...


Preparing financial statements from the work sheet
When the work sheet is completed, all the necessary information to prepare the income statement, statement of
retained earnings, and balance sheet is readily available
...

The information you need to prepare the income statement in Exhibit 21 is in the work sheet's Income
Statement columns in Exhibit 20
...
Look at Exhibit 22, MicroTrain Company's statement of retained earnings for
the month ended 2010 December 31
...
310), add the net income (or deduct the net loss), and then subtract the Dividends (Account
No
...
Carry the ending Retained Earnings balance forward to the balance sheet
...
It does this by
indicating how net income on the income statement relates to retained earnings on the balance sheet
...
0 License
The information needed to prepare a balance sheet comes from the Balance Sheet columns of MicroTrain's work
sheet (Exhibit 20)
...
See the completed balance sheet for MicroTrain in Exhibit 23
...
You would prepare these adjusting entries
as you learned in Chapter 3, except that the work sheet is now your source for making the entries
...

The numerical notations in the Adjustments columns and the adjustments explanations at the bottom of the
work sheet identify each adjusting entry
...
MicroTrain's adjusting entries as they would appear in the general journal after posting are:
MICROTRAIN COMPANY
General Journal
Date

Account Titles and Explanation

2010
Dec
...
Debit
Ref
...


31

Rent Expense (-SE)

515

Prepaid Rent (-A)

4 0 0

112

4 0 0

To record rent expense for December
...


31

Depreciation Expense—Trucks (-SE)

521

Accumulated Depredation—Trucks (-A)

7 5 0

151

7 5 0

To record depreciation expense for December
...


31

Interest Receivable (+A)

121

Interest Revenue (+SE)

6 0 0

418

6 0 0

To record one month's interest revenue
...


Accounting Principles: A Business Perspective

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...


The closing process
In Chapter 2, you learned that revenue, expense, and dividends accounts are nominal (temporary) accounts that
are merely subclassifications of a real (permanent) account, Retained Earnings
...
The closing process transfers (1) the balances in the revenue
and expense accounts to a clearing account called Income Summary and then to Retained Earnings and (2) the
balance in the Dividends account to the Retained Earnings account
...

Accountants may perform the closing process monthly or annually
...
After transferring all revenue and expense account balances to
Income Summary, the balance in the Income Summary account represents the net income or net loss for the
period
...

Also closed at the end of the accounting period is the Dividends account containing the dividends declared by
the board of directors to the stockholders
...

In accounting, we often refer to the process of closing as closing the books
...
The
four basic steps in the closing process are:
• Closing the revenue accounts—transferring the balances in the revenue accounts to a clearing account

called Income Summary
...

• Closing the Income Summary account—transferring the balance of the Income Summary account to

the Retained Earnings account
...

Revenues appear in the Income Statement credit column of the work sheet
...
Because revenue accounts have credit balances, you must debit them for an amount equal
to their balance to bring them to a zero balance
...
600)
...
Do this for all other closing journal entries
...


31

Post
...


Service Revenue

400

159

1 3 2 0 0

Credit

This book is licensed under a Creative Commons Attribution 3
...


After the closing entries have been posted, the Service Revenue and Interest Revenue accounts (in T-account
format) of MicroTrain appear as follows
...

(Dr)
2010

Decreased
by $13,200

Dec
...
31

Service Revenue
Account No
...
before
closing
To close to
Income
Summary13,20
0
Bal
...
418
Bal
...
after closing

(Cr
...
)
600

—0—

As a result of the previous entry, you would credit the Income Summary account for USD 13,800
...

Expenses appear in the Income Statement debit column of the work sheet
...
As shown by the column subtotal, these expenses add up to USD
6,510
...
Then, make the
debit in the closing entry to the Income Summary account for USD 6,510
...


Account Titles and Explanation

31 Income Summary

Post
...

600

Page 4
Debit

Credit

6 5 1 0

Advertising Expense

505

5 0

Gas and Oil Expense

506

6 8 0

Salaries Expense

507

3 7 8 0

Utilities Expense

511

1 5 0

Insurance Expense

512

2 0 0

Rent Expense

515

4 0 0

Supplies Expense

518

5 0 0

Depreciation Expense—Trucks

521

7 5 0

To close the expense accounts appearing in the Income

The debit of USD 6,510 to the Income Summary account agrees with the Income Statement debit column
subtotal in the work sheet
...
If the debit in the preceding entry was made for a different amount than the
column subtotal, the company would have an error in the closing entry for expenses
...
Completing the accounting cycle
After they have been closed, MicroTrain's expense accounts appear as follows
...

(Dr)

Bal
...
505

■ 50

Summary
Bal
...
)

Bal
...
)

2010 ■ ■
Dec
...
506

680

(Cr
...
31 To close to
Income
Summary
680

Bal
...
)

Bal
...
507

3,780

(Dr
...
before
closing

(Cr
...
31 To close to
Income

Summary
Bal
...
511

150

(Cr
...
31 To close to
Income
Summary
150

Bal
...
)

Bal
...
512

200

(Cr
...
31 To close to
Income
Summary
200

Bal
...
)

Bal
...
515

400

(Cr
...
0 License
Dec
...
after
closing

—0—
Supplies Expense
Account No
...
)

Bal
...
)

2010
Dec
...
after
closing

—0—

Depreciation Expense-Trucks
(Dr
...
521

Bal
...
)

2010 "
Dec
...
after
closing

Decreased
by $750

—0—

The expense accounts could be closed before the revenue accounts; the end result is the same
...

If total expenses exceed
total revenues,
the account has a debit
balance, which is the net
loss for the period

Income Summary
Total expenses
Total revenues
w

If total revenues exceed
total expenses,
the account has a credit
balance, which is the net
income for the period
...

Income Summary
2010
From closing
6,510
Dec
...
)

2010
Dec
...
before closing this
account (net income)

13,800

7,290

Next, close MicroTrain's Income Summary account to its Retained Earnings account
...


Account Titles and Explanation
31 Income Summary
Retained Earnings

Page 4

Post
...
Debt
600
7 2 9 0
310

Credit
7 2 9 0

To close the Income Summary account to the Retained
Earnings account
...
Completing the accounting cycle
Income Summary
(Dr
...
600

2010
Dec
...
31 To close this
account to Retain ed
Earnings

(Cr
...
31 From
closing
The revenue
accounts
Bal
...
after closing

—0—

Retained Earnings
(Dr)

Account No
...
)

Bal
...
31 From Income
Summary

7,290

Decreased by
$7,290

The last closing entry closes MicroTrain's Dividends account
...
To
close the account, credit the Dividends account and debit the Retained Earnings account
...
The
journal entry to close MicroTrain's Dividends account is:
MICROTRAIN COMPANY
General Journal

Date
2010 Dec
...
Ref
...


After this closing entry is posted, the company's Dividends and Retained Earnings accounts appear as follows:
Dividends
(Dr
...
320 (Cr
...
before closing 3,000

2010
Dec
...
after closing

—0—
Retained Earnings

(Dr
...
310 (Cr
...
31 From dividends 3,000

Bal
...
31 From Income
Summary 7,290
Bal
...
Because these accounts contain the opening balances for the coming
accounting period, debit balance totals must equal credit balance totals
...
The post-closing trial balance differs from the adjusted trial balance in only two

163

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...

A post-closing trial balance is a trial balance taken after the closing entries have been posted
...
List all the
account balances in the debit and credit columns and total them to make sure debits and credits are equal
...
The amounts
in the post-closing trial balance are from the ledger after the closing entries have been posted
...
Then, we discuss the role of an accounting system
...
aicpa
...
You can also learn such things as the states that have approved limited liability
companies (LLCs) and limited liability partnerships (LLPs)
...
You can also find the phone numbers and mailing addresses
of State Boards of accountancy and State Societies of CPAs
...
Similar sites are available in other countries as well
...
Gradually, some manual systems evolved to
include multiple journals and ledgers for increased efficiency
...
Still recorded in the general journal are adjusting and closing entries and any other entries that do not fit
in one of the special journals
...
The general ledger shows the total amount of accounts receivable and accounts payable, but the details in
the subsidiary ledgers allow companies to send bills to customers and pay bills to suppliers
...
By creating one document and
aligning other records under it on a pegboard, companies could record transactions more efficiently
...
Even
though some of these systems are still in use today, computers make them obsolete
...
Completing the accounting cycle
During the 1950s, companies also used bookkeeping machines to supplement manual systems
...
They posted transactions to the general ledger and
subsidiary ledger accounts and computed new balances
...
They were quite expensive, and computers easily outperformed them
...
Early accounting applications were in payroll, accounts
receivable, accounts payable, and inventory
...

Until the 1980s, small and medium-sized companies either continued with a manual system, rented time on
another company's computer, or hired a service bureau to perform at least some accounting functions
...

No
...
How would this company know to whom to send bills and in what amounts? Also, how
would employees know for which suppliers to write checks and in what amounts? Such subsidiary
records are necessary either on paper or in a computer file
...
0 License
200

1

900

100

SYLVIA SMITH
300

1

GRANGER CORPORATION
ACCOUNTS PAYABLE

600

1,000
JAMES WELLS
400

WONG CORPORATION
300

1

When a sale on account is made to John Jones, the debit is posted to both the control account,
Accounts Receivable, in the General Ledger and the subsidiary account, John Jones, in the
Subsidiary Accounts Receivable Ledger
...

At the end of the accounting period, the balances in each of the control accounts in the General
Ledger must agree with the totals of the accounts in their respective subsidiary ledgers as shown
above
...


A broader perspective:
Skills for the long haul
The decision has been made: You [Tracy] have opted to start your career by joining an
international accounting firm
...

Most students understand that accounting knowledge, organizational ability and interpersonal
skills are critical to success in public accounting
...

Let us examine the duties and skills needed at each level—Staff Accountant (years 1-2), Senior
Accountant (years 3-4), Manager/ Senior Manager (years 5-11) and Partner (years 11+)
...
At the outset, she works directly
under a senior accountant on each of her audits and is responsible for completing audits and
administrative tasks assigned to her
...
Tracy
will work on different audit engagements during her first year and learn the firm's audit approach
...

The two most important traits to be demonstrated at the staff level are (1) a positive attitude and
(2) the ability to learn quickly while adapting to unfamiliar situations
...
Completing the accounting cycle

As a senior accountant, Tracy will be responsible for the day-to-day management of several audit
engagements during the year
...
She will also perform much of the final wrap-up work, such
as preparing checklists, writing the management letter and reviewing or drafting the financial
statements
...

The two most critical skills needed at the senior level are (1) the ability to organize and control an
audit and (2) the ability to teach staff accountants how to audit
...
She
will manage several audits at one time and become active in billing clients as well as negotiating
audit fees
...
Tracy will also
become more involved in the firm's administrative tasks
...

The two skills most emphasized at the manager level are (1) general management ability and (2)
sales and communication skills
...
She will engage in high-level
client service activities, business development, recruiting, strategic planning, office administration
and counseling
...
Although a certain
industry or administrative function will become her specialty, she will often be called upon to
perform a wide variety of audit and administrative duties when other partners have scheduling
conflicts
...

At the partnership level, what is looked for is leadership ability plus the ability to become an expert
in a specific industry or administrative function
...
To
develop the needed skills, a broad education background in business and nonbusiness courses is
required

plus

participation

in

extracurricular

activities

that

promote

leadership

and

communication skills
...

Source: Dana R
...
Hermanson, New Accountant, January 1990, pp
...

The development of the personal computer (PC) in 1976 and its widespread use a decade later drastically
changed the accounting systems of small and medium-sized businesses
...
Soon small and medium-sized businesses could

167

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...
By the 1990s, the cost of PCs and accounting software packages had
decreased significantly, accounting software packages had become more user-friendly, and computer literacy had
increased so much that many very small businesses converted from manual to computerized systems
...

Your knowledge of the basic manual accounting system described in these first four chapters enables you to
better understand a computerized accounting system
...
However, if you understand all of the steps in the accounting cycle, you will better understand
how to use the resulting data in decision making
...

With the rise of integrated accounting and information systems, technical expertise will go hand in
hand with general business knowledge
...
Manual systems consist of journals and ledgers on paper
...

Regardless of the system, the functions of accountants include: (1) observing, identifying, and measuring
economic events; (2) recording, classifying, and summarizing measurements; and (3) reporting economic events
and interpreting financial statements
...

The accounting system enables a company's accounting staff to supply relevant accounting information to meet
those needs
...

The primary focus of the first four chapters has been on how you can use an accounting system to prepare
financial statements
...
Later chapters
also show how to prepare information and how that information helps users to make informed decisions
...
These users understand not only the limitations of the information
but also its relevance for decision making
...
One example of this analysis is the current ratio and its use in analyzing the short-term debtpaying ability of a company
...
Completing the accounting cycle

Exhibit 25: The role of an accounting system

An accounting perspective
Uses of technology
Accounting software packages are typically menu driven and organized into modules such as
general ledger, accounts payable, accounts receivable, invoicing, inventory, payroll, fixed assets,
job cost, and purchase order
...
The accounts payable module
records all transactions involving credit purchases from suppliers and payments made to those
suppliers
...


A classified balance sheet
The balance sheets we presented so far have been unclassified balance sheets
...
A classified
balance sheet contains the same three major categories and subdivides them to provide useful information for
interpretation and analysis by users of financial statements
...
, and subsidiaries
...
The two formats are equally acceptable
...
The company has more than 1,000 full-service warehouse stores
...

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...
The Home Depot
subdivides its assets into current assets, property and equipment, long-term investments, long-term notes
receivable, intangible assets (cost in excess of the fair value of net assets acquired), and other assets
...
A later
chapter describes minority interest
...
Later chapters describe further subdivisions of the stockholders' equity section
...
Our only purpose here is to
briefly describe the items that can be listed under each category
...


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...
AND SUBSIDIARIES
Consolidated Balance Sheet
2001 January 28
(amounts in millions, except share data)

January 28,
2001
Assets
Current Assets:
Cash and Cash Equivalents

$

167

Short-Term Investments, including current maturities of long-term investments

10

Receivables, net

835

Merchandise Inventories

6,556

Other Current Assets

209

Total Current Assets

$

7,777

Property and Equipment, at cost:
Land

$

4,230

Buildings

6,167

Furniture, Fixtures and Equipment

2,877

Leasehold Improvements

665

Construction in Progress

1,032

Capital Leases

261
$

Less: Accumulated Depreciation and Amortization

15,232
2,164

Net Property and Equipment

$

13,068

Long-Term Investments

15

Notes Receivable

77

Cost in Excess of Fair Value of Net Assets Acquired, net of accumulated amortization
of $41 at January 25, 2001 and $33 at January 30, 2000

314

Other

134

Total assets

13,608
$

21,385

Liabilities and Stockholders' Equity
Current Liabilities:
Accounts Payable

$

1,976

Accrued Salaries and Related Expenses

627

Sales Taxes Payable

298

Other Accrued Expenses

1,402

Income Taxes Payable

78

Current Installments of Long-Term Debt

4

Total Current Liabilities

$4,385

Long-Term Debt, excluding current installments

$

1,545

Other Long-Term Liabilities

245

Deferred Income Taxes

195

Minority Interest

1,985
11

Stockholders' equity:
Common Stock, par value $0
...
Authorized: 10,000,000,000 shares; issued and
outstanding2,323,747,000 shares at 2001 January 28 and 2,304,317,000 shares at 2000 January 30

116

Paid-In Capital

4,810

Retained Earnings

10,151

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...
An operating cycle is the time it takes to start with
cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or finished goods), sell
services or goods, and receive cash by collecting the resulting receivables
...
Companies in some manufacturing
industries, such as distilling and lumber, have operating cycles longer than one year
...
Common current assets in a service business include cash, marketable securities, accounts receivable,
notes receivable, interest receivable, and prepaid expenses
...

Cash includes deposits in banks available for current operations at the balance sheet date plus cash on hand
consisting of currency, undeposited checks, drafts, and money orders
...
The term cash normally includes cash equivalents
...
Examples are Treasury bills, short-term notes maturing within 90 days,
certificates of deposit, and money market funds
...
Such investments do not qualify as cash equivalents
...

Accounts receivable (also called trade accounts receivable) are amounts owed to a business by customers
...
Customers normally
provide no written evidence of indebtedness on sales invoices or delivery tickets except their signatures
...
This term indicates the possibility that the company
may not collect some of its accounts receivable
...

Merchandise inventories are goods held for sale
...

A note is an unconditional written promise to pay another party the amount owed either when demanded or at
a certain specified date, usually with interest (a charge made for use of the money) at a specified rate
...
A note receivable arises (1) when
a company makes a sale and receives a note from the customer, (2) when a customer gives a note for an amount due
on an account receivable, or (3) when a company loans money and receives a note in return
...


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...
Interest receivable arises when
a company has earned but not collected interest by the balance sheet date
...
Prepaid expenses include rent, insurance, and supplies that have been paid for but all the benefits have not
yet been realized (or consumed) from these expenses
...
Furthermore, prepaid expenses are considered assets because they
have service potential
...
Examples include
property, plant, and equipment; long-term investments; and intangible assets
...
(These assets are called property and equipment in The Home
Depot's balance sheet
...
To
agree with the order in the heading, balance sheets generally list property first, plant next, and equipment last
...
We describe several types of
property, plant, and equipment next
...
Land owned for investment is not a
plant asset because it is a long-term investment
...
Again, the buildings that a company owns
as investments are not plant assets
...

Office equipment includes computers, copiers, FAX machines, and phone answering machines
...
An example is when the lessee builds room
partitions in a leased building
...
)
Construction in progress represents the partially completed stores or other buildings that a company such
as The Home Depot plans to occupy when completed
...
This account shows the total depreciation taken for the depreciable assets
...

Long-term investments A long-term investment usually consists of securities of another company held
with the intention of (1) obtaining control of another company, (2) securing a permanent source of income for the
investor, or (3) establishing friendly business relations
...
For most businesses, long-term investments
may be stocks or bonds of other corporations
...

Intangible assets Intangible assets consist of the noncurrent, nonmonetary, nonphysical assets of a
business
...
Among the
intangible assets are rights granted by governmental bodies, such as patents and copyrights
...


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A copyright granted by the federal government gives the owner the exclusive privilege of publishing written
material for a specified time
...

Goodwill is an intangible value attached to a business, evidenced by the ability to earn larger net income per
dollar of investment than that earned by competitors in the same industry
...
Normally, companies record goodwill only at the time of purchase and then only
at the price paid for it
...

Accumulated amortization is a contra asset account to intangible assets
...

Current liabilities are debts due within one year or one operating cycle, whichever is longer
...
Balance sheets list current liabilities in the order they
must be paid; the sooner a liability must be paid, the earlier it is listed
...

Accounts payable are amounts owed to suppliers for goods or services purchased on credit
...
In the balance sheet, the accounts payable amount is
the sum of the individual accounts payable to suppliers shown in a subsidiary ledger or file
...
The notes may arise from borrowing money from a bank, from the purchase of assets, or from the
giving of a note in settlement of an account payable
...

Salaries payable are amounts owed to employees for services rendered
...

Sales taxes payable are the taxes a company has collected from customers but not yet remitted to the taxing
authority, usually the state
...
Taxes withheld from employees include federal income taxes, state income taxes, and social security
taxes withheld from employees' paychecks
...
Income taxes payable are the taxes paid to the state and federal governments by
a corporation on its income
...

Dividends payable, or amounts the company has declared payable to stockholders, represent a distribution of
income
...

Unearned revenues (revenues received in advance) result when a company receives payment for goods or
services before earning the revenue, such as payments for subscriptions to a magazine
...

Companies report any current installment on long-term debt due within one year under current liabilities
...

Accounting Principles: A Business Perspective

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...
Companies should show maturity dates in the balance sheet for all long-term liabilities
...

Notes payable with maturity dates at least one year beyond the balance sheet date are long-term liabilities
...
Maturity dates should appear on the balance sheet for all major longterm liabilities
...

Stockholders' equity shows the owners' interest in the business
...

The items under stockholders' equity in The Home Depot's balance sheet are paid-in capital (including common
stock) and retained earnings
...

Retained earnings shows the cumulative income of the company less the amounts distributed to the owners in
the form of dividends
...
The unrealized loss on investments is discussed in
Chapter 14
...
Together they
help reveal a company's short-term debt-paying ability
...
To find the current ratio, we
divide current assets by current liabilities
...
Thus, its current
ratio was:

Current ratio=

Current assets
Current liabilities

USD 7,777,000,000
=1
...
77:1 for The Home Depot means that it has almost twice as many current assets as current
liabilities
...

In evaluating a company's short-term debt-paying ability, you should also examine the quality of the current
assets
...
The Home Depot
undoubtedly does not have such a problem
...

Hewlett-Packard Company
3M Corporation
General Electric Company
Johnson & Johnson

Current
Assets
$ 32,620,000,000
15,782,000,000
6,556,000,000
313,050,000,000
19,079,000,000

Current
Liabilities
$ 32,869,000,000
13,950,000,000
5,006,000,000
168,788,000,000
7,504,000,000

We described each of these companies earlier in the text
...
99:1
1
...
31:1
1
...
54:1

This book is licensed under a Creative Commons Attribution 3
...
An old rule of thumb is that the
current ratio should be at least 2:1
...

For instance, companies in the airline industry are able to generate huge amounts of cash on a daily basis and may
be able to pay their current liabilities even if their current ratio is less than 1:1
...
A company with the lowest current ratio in its industry may be unable to pay its short-term
obligations on a timely basis, unless it can borrow funds from a bank on a line of credit
...

The next chapter describes the assumptions, concepts, and principles that constitute the accounting theory
underlying financial accounting
...

Understanding the learning objectives
• Analyze transactions by examining source documents
...

• Post journal entries to the accounts in the ledger
...

• Prepare financial statements
...

• Journalize and post closing entries
...

• The work sheet is a columnar sheet of paper on which accountants summarize information needed to make

the adjusting and closing entries and to prepare the financial statements
...
The work sheet illustrated in the chapter has 12 columns—two each for

trial balance, adjustments, adjusted trial balance, income statement, statement of retained earnings, and
balance sheet
...
Net income for the period is the amount needed to balance the two Income Statement columns in the
work sheet
...
The ending Retained Earnings balance is carried forward to the
balance sheet
...

• As explained in Chapter 3, adjusting entries are necessary to bring the accounts to their proper balances

before preparing the financial statements
...

• Revenue accounts are closed by debiting them and crediting the Income Summary account
...


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...

• To close the Income Summary account, the balance is transferred to the Retained Earnings account
...

• Only the balance sheet accounts have balances and appear on the post-closing trial balance
...

• Manual systems and computerized systems perform the same accounting functions
...

• A classified balance sheet subdivides the major categories on the balance sheet
...
It subdivides liabilities into current liabilities and long-term liabilities
...

• The current ratio gives some indication of the short-term debt-paying ability of a company
...


Demonstration problem
This problem involves using a work sheet for Green Hills Riding Stable, Incorporated, for the month ended 2010
July 31, and performing the closing process
...

No
...
Accrued salaries on July 31 are USD 300
...
Prepare a 12-column work sheet for the month ended 2010 July 31
...
Journalize the adjusting entries
...
Journalize the closing entries
...
0 License
Solution to demonstration problem
a
...

GREEN HILLS RIDING STABLE, INCORPORATE
Work Sheet
For the Month Ended 2010 July 31
Acct Account Titles

...


Debit

Debit Credit

Debit

Debit

100
103
130
140
200
201
300
310

Cash
Accounts Receivable
Land
Buildings
Accounts Payable
Notes Payable
Capital Stock
Retained Earnings
2010 July 1
Dividends
Horse Boarding Fees
Revenue
Riding and Lesson
Fees Revenue
Salaries Expense

10,700
S,100
40,000
24,000

513
540
563

Feed Expense
Interest Expense
Miscellaneous
Expense

1,100
200
300

520

Credit

Depreciation
Expense—Buildings
Accumulated
DepreciationBuildings

320
402
404
507

141

206

1,000

10,700
3,100
40,000
24,000

1,100
40,000
35,000
3,100

Credit

1,100
40,0 0 0
35,000
3,100

Debit

Credit

1,100
40,000
35,000

3,100
1,000

4,500

4,500

3,600

3,500

Balance Sheet

10,700
8,100
40,000
24,000

1,000

4,500

1,400

Credit

Statement of
Retained
Earnings
Debit
Credit

3,600

(2)
300

1,700

1,700

1,100
200
SOO

1,100
200
SOO

(1)
200

200

200

87,300 37,300

Salaries Payable
EOO

(1)
200
(2)
300
5oo

200
300
87,500

200
300

37,300
4,000
4,100
8,100

Net Income

8,100
8,100

Retained Earnings,
2010 July 31

1,000
6,200
7,200

4,100
7,200
7,200

82,300 76,600
6,200
S2,S00 32,800

Adjustments:
(i)
To record depreciation of
building for July
...


b
...

Ref
...


3 Salaries Expense (-SE)
1
Salaries Payable (+L)

507
206

Page 4
Credit

2 0 0
2 0 0

3 0 0
3 0 0

To record accrued salaries
...

GREEN HILLS RIDING STABLE, INCORPORATED
General Journal

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...
Debt

Credit

Ref
...

31 Income Summary

600

4 0 0 0

Salaries Expense

507

1 7 0 0

Feed Expense

513

1 1 0 0

Interest Expense

540

2 0 0

Miscellaneous Expense

568

8 0 0

Depreciation Expense—Buildings

520

2 0 0

To close expense accounts
...

31 Retained Earnings

310

Dividends

320

1 0 0 0
1 0 0 0

To close dividends account
...
The
steps include analyzing transactions, journalizing transactions, posting journal entries, taking a trial balance
and completing the work sheet, preparing financial statements, journalizing and posting adjusting entries,
journalizing and posting closing entries, and taking a post-closing trial balance
...

Accounts payable Amounts owed to suppliers for goods or services purchased on credit
...

Accumulated amortization A contra account to intangible assets
...

Bonds payable Written promises to pay a definite sum at a certain date as evidenced by formal printed
certificates that are sometimes secured by liens on property, such as mortgages
...

Cash Includes deposits in banks available for current operations at the balance sheet date plus cash on hand
consisting of currency, undeposited checks, drafts, and money orders
...

Classified balance sheet Subdivides the three major balance sheet categories (assets, liabilities, and
stockholders' equity) to provide more information for users of financial statements
...
Liabilities
may be divided into current liabilities and long-term liabilities
...
The balance in the Dividends
account is also transferred to the Retained Earnings account
...

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...

Current assets Cash and other assets that a business can convert into cash or use up in one year or one
operating cycle, whichever is longer
...
The payment of
current liabilities normally requires the use of current assets
...

Dividends payable Amounts declared payable to stockholders and that represent a distribution of income
...

Income Summary account A clearing account used only at the end of an accounting period to summarize
revenues and expenses for the period
...

Intangible assets Noncurrent, nonmonetary, nonphysical assets of a business
...
This accrued interest has
not been paid at the balance sheet date because it is not due until later
...

Land Ground the company uses for business operations
...

Leasehold improvements Are any physical alterations made by the lessee to the leased property when
these benefits are expected to last beyond the current accounting period
...

Long-term assets Assets that are on hand or used by a business for a relatively long time
...

Long-term investment Usually securities of another company held with the intention of (1) obtaining
control of another company, (2) securing a permanent source of income for the investor, or (3) establishing
friendly business relations
...

Marketable securities Temporary investments that a company makes to earn a return on idle cash
...

Note An unconditional written promise to pay to another party the amount owed either when demanded or
at a certain date
...

Office equipment Includes computers, copiers, FAX machines, and phone answering machines
...

Operating cycle The time it takes to start with cash, buy necessary items to produce revenues (such as
materials, supplies, labor, and/or inventories), sell services or goods, and receive cash by collecting the
resulting receivables
...

Patent A right granted by the federal government authorizing the owner of an invention to manufacture a
product or to use a process for a specific time
...

Prepaid expenses Assets awaiting assignment to expense
...
Prepaid
expenses are classified as current assets
...

Retained earnings Shows the cumulative income of the company less the amounts distributed to the
owners in the form of dividends
...

Accounting Principles: A Business Perspective

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...

Stockholders' equity Shows the owners' interest (equity) in the business
...

Unclassified balance sheet A balance sheet showing only three major categories: assets, liabilities, and
stockholders' equity
...

Work sheet A columnar sheet of paper on which accountants have summarized information needed to
make the adjusting and closing entries and to prepare the financial statements
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

The amounts in the Adjustments columns are always added to the amounts in the Trial Balance columns to
determine the amounts in the Adjusted Trial Balance columns
...

After the closing process is complete, no balance can exist in any revenue, expense, Dividends, or Income
Summary account
...

All accounting systems currently in use are computerized
...

Which of the following accounts is least likely to be adjusted on the work sheet?
a
...

b
...

c
...

d
...

If the Balance Sheet columns do not balance, the error is most likely to exist in the:
a
...

b
...

c
...

d
...

Net income for a period appears in all but which one of the following?
a
...

b
...

c
...

d
...

Which of the following statements is false regarding the closing process?

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...
The Dividends account is closed to Income Summary
...
The closing of expense accounts results in a debit to Income Summary
...
The closing of revenues results in a credit to Income Summary
...
The Income Summary account is closed to the Retained Earnings account
...
Current assets include cash, accounts receivable, and equipment
...
Plant, property, and equipment is one category of long-term assets
...
Current liabilities include accounts payable, salaries payable, and notes receivable
...
Stockholders' equity is subdivided into current and long-term categories
...


Questions
➢

At which stage of the accounting cycle is a work sheet usually prepared?

➢

Why are the financial statements prepared before the adjusting and closing entries are journalized
and posted?

➢

Describe the purposes for which the work sheet is prepared
...
At the end of
the first accounting period, you have partially completed the work sheet by entering the proper
ledger accounts and balances in the Trial Balance columns
...
(In all the text problems you have done, you have always been given
this information
...
The following four
adjustments were ignored:
➢
➢

Depreciation of equipment, USD 4,000
...


➢
➢

Subscriptions Fees earned, USD 1,200
...
What is the correct net income?

After the Adjusted Trial Balance columns of a work sheet have been totaled, which account balances
are extended to the Income Statement columns, which account balances are extended to the
Statement of Retained Earnings columns, and which account balances are extended to the Balance
Sheet columns?

➢

How is the statement of retained earnings prepared?

➢

What is the purpose of closing entries? What accounts are not affected by closing entries?

➢

A company has net income of USD 50,000 for the year
...
Completing the accounting cycle
➢

What is the purpose of a post-closing trial balance?

➢

Describe some of the ways in which the manual accounting system has evolved
...


➢

How is a classified balance sheet different than an unclassified balance sheet?

➢

Real world question Refer to "A broader perspective: Skills for the long haul" to answer the
following true-false questions:
➢

The same skills are needed at each level in a CPA firm
...


➢

The senior accountant needs management skills in addition to technical skills
...


➢

Real world question Referring to the Annual report appendix in your text, identify the
classifications (or categories) of assets used by The Limited in its balance sheet
...


Exercises
Exercise A List the steps in the accounting cycle
...
Determine under which major column headings each of the following items would appear and
whether it would be a debit or credit
...
)

a
...

c
...

e
...

g
...


Account Titles
Accounts Receivable
Accounts Payable
Interest Revenue
Advertising Expense
Capital Stock
Retained Earnings (Beg
...
Illustrate how these would appear in the Statement of Retained Earnings columns and Balance Sheet
columns in the work sheet
...

Exercise E Damon Davis was preparing the work sheet for Drano Plumbing Company
...
When he totaled the Balance Sheet columns, the column totals were debit, USD

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...
What was the probable cause of this difference? If this was not the cause, what
should he do to find the error?
Exercise F The Trial Balance of the Printer Repair Company at 2010 December 31, contains the following
account balances listed in alphabetical order to increase your skill in sorting amounts to the proper work sheet
columns
...
Arrange the accounts in their approximate usual order
...

• The balance in the Prepaid Insurance account represents the cost of a two-year insurance policy covering

the period from 2010 January 1, through 2011 December 31
...
No salvage

values are anticipated
...
For the year 2010, net income was USD 50,000 and dividends declared and paid were USD 24,000
...

Exercise H Rubino Company reported net income of USD 100,000 for the current year
...

• Depreciation on equipment acquired on July 1 amounted to USD 4,000
...
Prepare the adjusting and
closing journal entries
...
In T-account format, show how the postings to the Income Summary
account would appear as a result of the closing process
...

Exercise K After adjustment, these selected account balances of Cold Stream Campground are:
Debits

Credits

Retained earnings

$540,000
...
00

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4
...
(You do not
need to show the closing journal entries
...
Key the postings
from the first closing entry with the number (1), the second with the number (2), and so on
...

Exercise M Which of the following accounts are likely to appear in the post-closing trial balance for the Blake
Company?
• Accounts Receivable
• Cash
• Service Revenue
• Buildings
• Salaries Expense
• Capital Stock
• Dividends
• Accounts Payable
• Income Summary
• Unearned Subscription Fees

Exercise N Using the legend at the right, determine the category (number) into which you would place each of
these items
...

b
...

d
...

f
...


Land
...

Notes payable, due in three years
...

Patents
...

Unearned subscription fees
...

2
...

4
...

6
...


Current assets
...

Property, plant, and equipment
...

Current liabilities
...

Stockholders' equity
...
0 License
h
...


Bonds of another corporation (a 20-year
investment)
...


j
...


Exercise O The following data are from the 2001 annual report of The Procter & Gamble Company and its
subsidiaries
...
Leading brands include Ariel, Crest, Pampers,
Pantene, Crisco, Vicks, and Max Factor
...

June 30
2001

2000

$10,889
9,846

Current assets
Current liabilities

$10,146
10,141

Calculate the current rations for the two years
...

Problems
Problem A The following adjusted trial balance is for Jasper Appliance Repair Company:
JASPER APPLIANCE REPAIR COMPANY
Adjusted Trial Balance
2010 June 30
Debits

Cash

$ 63,000

Accounts Receivable

42,000

Trucks

Credits

110,000

Accumulated Depreciation—Trucks

$ 30,000

Accounts Payable

10,800

Notes Payable

20,000

Capital Stock

50,000

Retained Earnings, 2009 July 1
Dividends

5,500
10,000

Service Revenue

230,000

Rent Expense

12,000

Advertising Expense

5,000

Salaries Expense

90,000

Supplies Expense

1,500

Insurance Expense

1,200

Depreciation Expense—Trucks

10,000

Interest Expense

1,000

Miscellaneous Expense

600
$346,300

$346,300

Prepare the closing journal entries at the end of the fiscal year, 2010 June 30
...
, follows:
DENVER ARCHITECTS, INC
...
Completing the accounting cycle
Notes Receivable

4,000

Prepaid Insurance

960

Prepaid Rent

2,400

Supplies on Hand

600

Equipment

60,000

Accumulated Depreciation—Equipment
Buildings

$ 12,500
140,000

Accumulated Depreciation—Buildings
Land

15,000
56,240

Accounts Payable

60,000

Notes Payable

10,000

Interest Payable

750

Salaries Payable

7,000

Capital Stock

100,000

Retained Earnings, 2010 January 1
Dividends

20,200
40,000

Service Revenue

360,000

Insurance Expense

1,920

Rent Expense

9,600

Advertising Expense

1,200

Depreciation Expense—Equipment

2,500

Depreciation Expense—Buildings

3,000

Supplies Expense

2,280

Salaries Expense

150,000

Interest Expense

750

Interest Revenue

200
$ 585,650

$ 585,650

a
...

b
...

c
...

d
...

e
...

Problem C The following trial balance and additional data are for Sure Sale Reality Company
SURE SALE REALTY COMPANY
Trial Balance
2010 December 31
Debits

Cash

$ 62,800

Accounts Receivable

117,120

Prepaid Rent

46,080

Equipment

Credits

173,760

Accumulated Depreciation—Equipment

$ 21,120

Accounts Payable

62,400

Capital Stock

96,000

Retained Earnings, 2010 January 1

49,920

Dividends

46,080

Commissions Revenue

653,200

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...

The equipment has an expected life of 10 years with no salvage value
...

Travel expenses accrued but unreimbursed to sales staff at December 31 were USD 17,280
a
...
You need not include account numbers
or explanations of adjustments
...
Prepare adjusting journal entries
...
Prepare closing journal entries
...
:
SOUTH SEA TOURS, INC
...

The buildings have an expected life of 50 years with no salvage value
...

Accrued interest on notes receivable is USD 450
...

Accrued salaries are USD 2,100
...

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...

a
...
You need not include account
numbers
...

b
...

Problem E The following trial balance and additional data are for Florida Time-Share Property Management
Company:
FLORIDA TIME-SHARE PROPERTY MANAGEMENT COMPANY
Trial Balance
2010 December 31
Debits

Cash
Prepaid Rent

28,800

Prepaid Insurance

7,680

Supplies on Hand

2,400

Office Equipment

Credits

$ 424,000

24,000

Accumulated Depreciation—Office Equipment
Automobiles

$ 5,760
64,000

Accumulated Depreciation—Automobiles

16,000

Accounts Payable

2,880

Unearned Management Fees

12,480

Capital Stock

360,000

Retained Earnings, 2010 January 1
Dividends

120,640
28,000

Commissions Revenue

260,000

Management Fee Revenue

19,200

Salaries Expense

199,840

Advertising Expense

2,400

Gas and Oil Expense

14,240

Miscellaneous Expense

1,600
$ 796,960

$ 796,960

Insurance expense for the year, USD 3,840
...

Depreciation expense: office equipment, USD 2,880; and automobiles, USD 12,800
...

Supplies on hand at December 31, USD 1,000
...
The advance payment
covered six months' management of an apartment building
...
Prepare a 12-column work sheet for the year ended 2010 December 31
...

b
...

c
...

d
...

e
...


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...

Alternate problem B The adjusted trial balance for Penrod Insurance Consultants, Inc
...

Adjusted Trial Balance
2010 December 31

Debits

Cash
Accounts Receivable

68,000

Interest Receivable

400

Notes Receivable

20,000

Prepaid Insurance

2,400

Supplies on Hand

1,800

Land

32,000

Buildings

Credits

$ 107,200

190,000

Accumulated Depreciation—Buildings
Office Equipment

$ 40,000
28,000

Accumulated Depreciation—Office Equipment

8,000

Accounts Payable

48,000

Salaries Payable

8,500

Interest Payable

900

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...
Prepare an income statement for the year ended 2010 December 31
...
Prepare a statement of retained earnings
...
Prepare a classified balance sheet
...
Prepare the closing journal entries
...
Show the post-closing trial balance assuming you had posted the closing entries to the general ledger
...

The equipment is expected to last 10 years with no salvage value
...
0 License
The prepaid insurance was for the period 2010 April 1, to 2011 March 31
...

a
...
You need not include account numbers
or explanations of adjustments
...
Prepare the adjusting journal entries
...
Prepare the closing journal entries
...

BEST-FRIEND PET HOSPITAL, INC
...

Prepaid fire insurance is USD 600 as of the end of the year
...

Prepaid rent is USD 2,625 as of the end of the year
...

Accrued salaries are USD 2,625
...
Prepare a 12-column work sheet for the year ended 2010 December 31
...
Briefly explain the entries in the Adjustments columns at the bottom of the work sheet, as was done in
Exhibit 20
...
Prepare the 2010 December 31, closing entries
...
:
ROSWELL INTERIOR DECORATORS, INC
Trial Balance
2010 December 31

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...

Rent expense for 2010 is USD 10,000
...

Insurance expense for 2010 is USD 2,400
...

Accrued interest on notes payable is USD 150
...

a
...
You need not include account numbers
or explanations of adjustments
...
Prepare an income statement
...
Prepare a statement of retained earnings
...
Prepare a classified balance sheet
...
Prepare adjusting and closing entries
...
After their marriage, they decided to earn some extra income by
doing small jobs involving canvas, vinyl, and upholstered products
...
To do this, they invested USD 120,000 cash in their business
...
They undertook only custom work, with the customers purchasing the required materials, to avoid
stocking any inventory other than supplies
...


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...
But they felt
something was wrong
...
Yet there seemed to be barely enough
cash available from the business to cover immediate personal needs
...
Their combined income from the auto manufacturer had
been USD 45,000
...
They turned to you for advice
...

Work completed in 2010 and billed to customers for which cash had not yet been received by year-end
amounted to USD 40,000
...

(Hint: Prepare an income statement for 2010 and include it in your report
...
Write a summary of the results of your calculations
...
For instance, look at the net income for the last three years
...

Write a description of a career in public accounting broader perspective at each level within the firm
...

Group project D In teams of two or three students, interview a management accountant
...
Seek information on the advantages and disadvantages of working as a management accountant
...
As a team, write a
memorandum to the instructor summarizing the results of the interview
...

Group project E With a small group of students, obtain an annual report of a company in which you have
some interest
...

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...
You may have to do library research on some of the
items
...
Write a report to your instructor
summarizing the results of the project
...
Give the strengths and weaknesses of
each
...

Using the Internet—A view of the real world
Visit the following Internet site:
http://www
...
com
Pursue choices you are offered on the screen under Investor Relations until you locate the most recent
consolidated balance sheet
...
For instance, the first such heading is Assets
...

Visit the following Internet site:
http://www
...
com
Type in "Annual report" in the search box to locate the most recent annual report and then find the consolidated
statement of financial position
...
Write a memo to your instructor summarizing your findings
...
The three trial balances are the unadjusted trial balance, the adjusted trial balance, and the post-closing
trial balance
...

False
...

True
...

Then the loss appears in the Statement of Retained Earnings debit column because it reduces Retained Earnings
...
All of these accounts are closed, or reduced to zero balances, as a result of the closing process
...
All revenue and expense accounts have zero balances after closing
...
Some manual accounting systems are still in use
...
The other accounts are very likely to be adjusted
...

c
...
Therefore, if the Balance Sheet columns do not
balance, the error is likely to exist in the last six columns of the work sheet
...
The net income for the period does not appear in the balance sheet
...


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...
The Dividends account is closed to the Retained Earnings account rather than to the Income Summary
account
...
Plant, property, and equipment is one of the long-term asset categories
...
Response (c) should not include notes receivable
...

Comprehensive review problem
Lopez Delivery Service Company has the following chart of accounts:
Acct
...

100
103
107
108
112
140
141
150
151
200
206
300

Acct
...

310
320
400
507
511
512
515
518
520
521
568
600

Account Title
Retained Earnings
Dividends
Service Revenue
Salaries Expense
Utilities Expense
Insurance Expense
Rent Expense
Supplies Expense
Depreciation Expense—Buildings
Depreciation Expense—Trucks
Miscellaneous Expense
Income Summary

The post-closing trial balance as of 2010 May 31, was as follows:
LOPEZ DELIVERY SERVICE COMPANY
Post-Closing Trial Balance
2010 May 31
Acct
...

100

Account Title
Cash

Debits
$ 80,000

Credits

103

Accounts Receivable

30,000

107

Supplies on Hand

14,000

108

Prepaid Insurance

4,800

112

Prepaid Rent

12,000

140

Buildings

320,000

141

Accumulated Depreciation —Buildings

150

Trucks

151

Accumulated Depreciation—Trucks

30,000

200

Accounts Payable

24,000

300

Capital Stock

300,000

310

Retained Earnings

150,800

$ 36,000
80,000

$ 540,800

$ 540,800

The transactions for June 2010 were as follows:
June 1 Performed delivery services for customers on account, USD 60,000
...

4 Purchased a USD 20,000 truck on account
...

8 Paid USD 16,000 of the accounts payable
...
The asset account for supplies was debited
...

20 Paid the utilities bills for June, USD 1,200
...
Completing the accounting cycle
23 Paid miscellaneous expenses for June, USD 600
...

• Depreciation expense on the buildings for June is USD 800
...

• Accrued salaries at June 30 are USD 4,000
...

• The prepaid insurance balance of USD 4,800 applies to a two-year period beginning 2010 June 1
...

• Performed USD 12,000 of delivery services for customers as of June 30 that will not be billed to those

customers until July
...
Open three-column ledger accounts for the accounts listed in the chart of accounts
...
Enter the 2010 May 31, account balances in the accounts
...
Journalize the transactions for June 2010
...
Post the June journal entries and include cross-references (assume all journal entries appear on page 10 of the
journal)
...
Prepare a 12-column work sheet as of 2010 June 30
...
Prepare an income statement, a statement of retained earnings, and a classified balance sheet
...
Prepare and post the adjusting entries (assume they appear on page 11 of the general journal)
...
Prepare and post the closing entries (assume they appear on page 12 of the general journal)
...
Prepare a post-closing trial balance
...
0 License

5
...

• Identify and discuss the major principles of accounting
...

• Describe the conceptual framework project of the Financial Accounting Standards Board
...


A career as an accounting professor
Do you enjoy college life? Do you enjoy teaching others? If so, you might want to consider a career as a college
professor
...
A college professor can make a real difference in the lives of hundreds,
even thousands, of students over a career
...
The work of a college professor is a valuable investment in our nation's most
valuable resource—people
...
This is
because most college faculty have at least two additional important responsibilities: research and service
...
It represents
arriving at new knowledge by discovering things that previously were unknown
...
This illustrates the importance of accounting numbers and has resulted in a large stream of discovery
called Capital Markets research
...
Accounting faculty are involved in service to the university, the accounting profession, and to the general
public
...

The demand for college professors varies greatly by discipline
...
However, in applied fields such as accounting and engineering, there
is a shortage of candidates with advanced degrees
...

Chapter 1 briefly introduced the body of theory underlying accounting procedures
...
Now that you have learned some accounting procedures, you are better able to
relate these theoretical concepts to accounting practice
...
Accounting theory
assumptions and related principles that explain and guide the accountant's actions in identifying, measuring, and
communicating economic information"
...
Understanding the theory behind
the accounting process, however, helps one make decisions in diverse accounting situations
...

The first part of the chapter describes underlying accounting assumptions or concepts, the measurement
process, the major principles, and modifying conventions or constraints
...
The next part of the chapter describes
the development of the Financial Accounting Standards Board's (FASB) conceptual framework for accounting
...
Presenting the traditional body of theory first and the conceptual framework second gives
you a sense of the historical development of accounting theory
...
The final
part of the chapter discusses significant accounting policies contained in annual reports issued by companies and
illustrates them with an actual example from an annual report of the Walt Disney Company
...
The following sections describe these aspects of accounting theory that
greatly influence accounting practice
...
This section discusses the effects of
these assumptions on the accounting process
...
The business entity
concept assumes that each business has an existence separate from its owners, creditors, employees, customers,
interested parties, and other businesses
...
Therefore, financial statements are identified as belonging to a
particular business entity
...

A business entity may be made up of several different legal entities
...

For reporting purposes, however, the corporations may be considered as one business entity because they have a
common ownership
...

When accountants record business transactions for an entity, they assume it is a going concern
...
The termination of an entity occurs when a company ceases business
operations and sells its assets
...
If liquidation appears likely, the
going-concern assumption is no longer valid
...
, 1966), pp
...

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...
Market values are of less significance to an entity using its assets rather than selling them
...

The economic activity of a business is normally recorded and reported in money terms
...
Using a particular
monetary unit provides accountants with a common unit of measurement to report economic activity
...

Financial statements identify their unit of measure (such as the dollar in the United States) so the statement
user can make valid comparisons of amounts
...

In the United States, accountants make another assumption regarding money measurement—the stable dollar
assumption
...
Thus, accountants make no adjustments for the changing value of the dollar in the primary financial
statements
...
Assume, for example, that a
company acquired a building in 1975 and computed the 30-year straight-line depreciation on the building without
adjusting for any changes in the value of the dollar
...
The company makes no adjustments for the difference between the values of the
1975 dollar and the 2008 dollar
...
Accountants and business executives have expressed concern
over this inflation problem, especially during periods of high inflation
...
Then, accountants attempt to prepare accurate reports on the entity's
activities for these periods
...

Accounting reports cover relatively short periods
...
The length of the
accounting period must be stated in the financial statements
...
Companies that publish their financial statements, such as publicly held
corporations, generally prepare monthly statements for internal management and publish financial statements
quarterly and annually for external statement users
...
Under the cash basis, we record revenues when cash is received and expenses when cash is paid
...

The periodicity assumption requires preparing adjusting entries under the accrual basis
...
Then, the
concepts of cash basis and accrual basis accounting would be irrelevant because all revenues and all expenses would
Accounting Principles: A Business Perspective

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...

Approximation and judgment because of periodicity To provide periodic financial information,
accountants must often estimate expected uncollectible accounts (see Chapter 9) and the useful lives of depreciable
assets
...
Fortunately, these estimates are often reasonably accurate
...
We discuss these basic accounting
concepts next
...
In contrast, accountants can gather specialpurpose financial information for a specific decision, usually on a one-time basis
...
Since special-purpose financial
information must be specific, this information is best obtained from the detailed accounting records rather than
from the financial statements
...
For
example, a contract that is legally a lease may, in fact, be equivalent to a purchase
...
At the end of the lease period, the
company receives title to the auto after paying a nominal sum (say, USD 1)
...
Thus, under the substance-over-form concept, the auto is
an asset on the balance sheet and is depreciated instead of showing rent expense on the income statement
...

Consistency generally requires that a company use the same accounting principles and reporting practices
through time
...
However, consistency does not prohibit a change in accounting principles
if the information needs of financial statement users are better served by the change
...

Chapter 2 introduced the basic accounting concept of the double-entry method of recording transactions
...

Thus, to record a transaction, each party debits at least one account and credits at least one account
...

When learning how to prepare work sheets in Chapter 4, you learned that financial statements are
fundamentally related and articulate (interact) with each other
...
Then we carry the ending balance on the
statement of retained earnings to the balance sheet to bring total assets and total equities into balance
...
0 License
In Exhibit 27 we summarize the underlying assumptions or concepts
...


The measurement process in accounting
Earlier, we defined accounting as "the process of identifying, measuring, and communicating economic
information to permit informed judgments and decisions by the users of the information"
...

Accountants measure a business entity's assets, liabilities, and stockholders' equity and any changes that occur
in them
...

Accountants measure the various assets of a business in different ways
...
Chapter 9 explains how they measure claims to cash, such as accounts receivable, at their expected cash
inflows, taking into consideration possible uncollectibles
...
After the acquisition date, they carry some items,
such as inventory, at the lower-of-cost-or-market value
...
They measure liabilities at the amount of
cash that will be paid or the value of services that will be performed to satisfy the liabilities
...
Other changes in assets and liabilities, such as those recorded in adjusting
entries, are more difficult to measure because they often involve estimates and/or calculations
...
These decisions involve matching
revenues and expenses and are guided by the principles discussed next
...
, p
...

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...

Going concern (continuity) An entity will continue to operate indefinitely
unless strong evidence exists that the entity
will terminate
...

Stable dollar

The dollar is accepted as a reasonably
stable unit of measure
...


General-purpose financial
statements

One set of financial statements serves the
needs of all users
...


Consistency

Generally requires that a company use the
same accounting principles and reporting
practices every accounting period
...


Articulation

Financial statements are fundamentally
related and articulate (interact) with each
other
...
Identifies which
transactions should be recorded on the company's
books
...

Provides accountants with a common unit of
measure to report economic activity
...

Permits us to make no adjustments in the financial
statements for the changing value of the dollar
...

Permits us to prepare financial statements that
cover periods shorter than the entire life of a
business
...
The
need for adjusting entries arises because of this
concept and the use of accrual accounting
...

The financial statements should be free of bias so
they do not favor the interests of any one type of
user
...
This approach is the accounting equivalent
of "tell it like it is
...

Prevents a company from changing accounting
methods whenever it likes to present a better
picture or to manipulate income
...

Uses a system of checks and balances to help
identify whether or not errors have been made in
recording transactions
...

Changes in account balances during an accounting
period are reflected in financial statements that are
related to one another
...
The statement of
retained earnings ties the income statement and
balance sheet together
...
A standardized presentation format enables users to compare the financial information of
different companies more easily
...
Organizations that have contributed to the
development of the principles are the American Institute of Certified Public Accountants (AICPA), the Financial
Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), the American Accounting
Association (AAA), the Financial Executives Institute (FEI), and the Institute of Management Accounting (IMA)
...

• Revenue recognition principle
...


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...

• Full disclosure principle
...
The exchange-price
(or cost) principle requires an accountant to record transfers of resources at prices agreed on by the parties to
the exchange at the time of exchange
...

As applied to most assets, this principle is often called the cost principle
...
Historical cost is the amount paid, or the fair market
value of the liability incurred or other resources surrendered, to acquire an asset and place it in a condition and
position for its intended use
...
Accountants prefer the term exchange-price principle to cost principle because it
seems inappropriate to refer to liabilities, stockholders' equity, and such assets as cash and accounts receivable as
being measured in terms of cost
...

SFAS 157 defines “fair value” as “the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date”
...

“The fair value accounting standard SFAS 157 applies to financial assets of all publicly-traded companies in the
US as of 2007 Nov
...
It also applies to non-financial assets and liabilities that are recognized, or disclosed, at fair
value on a recurring basis
...
SFAS 157
applies to items for which other accounting pronouncements require or permit fair value measurements except
share-based payment transactions, such as stock option compensation
...

This hierarchy ranks the quality and reliability of information used to determine fair values, with level 1 inputs
being the most reliable and level 3 inputs being the least reliable
...

• Level 2 is observable information for similar items in active or inactive markets, such as two similarly

situated buildings in a downtown real estate market
...
At this point fair market valuation becomes highly subjective
...

Those prices declined severely with the collapse of credit markets as mortgage defaults escalated in the financial
crisis of 2008-2009
...
Accounting theory
Financial Reporting Standards utilize this approach much more than the Generally Accepted Accounting Principles
of the United States
...
aicpa
...
htm), the source used for the explanation of this topic
...
These secret reserves arise
from a company not reporting all of its profits when it has a very good year
...
By holding back some profits, not only
are the creditors more protected but the company is also more solvent and has more resources to invest
in productive assets
...
However, the crucial question for the
accountant is when to record a revenue
...

Earning of revenue All economic activities undertaken by a company to create revenues are part of the
earning process
...
For these activities, the company incurs costs
...
This
requirement is the earning principle
...
The seller acquires this right from the
buyer at the time of sale for merchandise transactions or when services have been performed in service
transactions
...
The time at which
title passes normally depends on the shipping terms—FOB shipping point or FOB destination (as we discuss in
Chapter 6)
...

The advantages of recognizing revenue at the time of sale are (1) the actual transaction—delivery of goods—is an
observable event; (2) revenue is easily measured; (3) risk of loss due to price decline or destruction of the goods has
passed to the buyer; (4) revenue has been earned, or substantially so; and (5) because the revenue has been earned,
expenses and net income can be determined
...

Exceptions to the realization principle The following examples are instances when practical
considerations may cause accountants to vary the point of revenue recognition from the time of sale
...
0 License
examples illustrate the effect that the business environment has on the development of accounting principles and
standards
...
This procedure is the cash basis of
accounting
...

Installment basis of revenue recognition When collecting the selling price of goods sold in monthly or
annual installments and considerable doubt exists as to collectibility, the company may use the installment basis of
accounting
...
Under the installment basis, the
percentage of total gross margin (selling price of a good minus its cost) recognized in a period is equal to the
percentage of total cash from a sale that is received in that period
...
The formula to
recognize gross profit on cash collections made on installment sales of a certain year is:
Cash collections x Gross margin percentage=Gross margin recognized
To be more precise, we expand the descriptions in the formula as follows:
Cash collections this year resulting X
from installment sales made in a
certain year

Gross margin percentage = Gross margin recognized
for the year of sale
this year on cash collections
this year from installment sales
made in a certain year

To illustrate, assume a company sold a stereo set
...
1

USD 500

USD 300

(500-300) – 200

(200/500) = 40 per cent

The buyer makes 10 equal monthly installment payments of USD 50 to pay for the set (10 X USD 50 = USD
500)
...
The gross margin to recognize in 2010 is:
2010 cash collections from
2010 installment sales

X

USD 150

X

Gross margin percentage = 2010 gross margin
on 2010 installment sales recognized on 2010 cash
collections from 2010
installment sales
40 per cent
= USD 60

The company collects the other installments when due so it receives a total of USD 350 in 2011 from 2010
installment sales
...
350 70%
$500 100%

$ 60 30%
140 70%
$200 100%

Because the installment basis delays some revenue recognition beyond the time of sale, it is acceptable for
accounting purposes only when considerable doubt exists as to collectibility of the installments
...
Accounting theory
Revenue recognition on long-term construction projects Companies recognize revenue from a longterm construction project under two different methods: (1) the completed-contract method or (2) the percentageof-completion method
...
In that period, they recognize all revenue even though the contract may have required three years to
complete
...
Companies carry costs incurred on the project forward in an inventory account (Construction in
Process) and charge them to expense in the period in which the revenue is recognized
...
They believe that
because revenue-producing activities have been performed during each year of construction, revenue should be
recognized in each year of construction even if estimates are needed
...
To measure the stage of
completion, firms compare actual costs incurred in a period with the total estimated costs to be incurred on the
project
...
The estimated
construction cost is USD 40 million
...
The formula to recognize revenue is:
Actual construction costs incurred during the period
x Total sales price=Revenue recognized for period
Total estimated construction costs for the entire project

Suppose that by the end of the first year (2010), the company had incurred actual construction costs of USD 30
million
...
Under the percentage-of-completion method, the firm would use the 75 per cent figure to assign revenue
to the first year
...
In 2012, it incurs the final USD 4
million of construction costs
...
6 million

X

$44 million =

$4
...
0 million
6
...
4
$44
...
0 million
- 6
...
0
$40
...
0 million
= 0
...
4
$4
...
0 License

Number of Companies
2003 2002 2001 2000
Percentage of completion 78
Units of delivery
32
Completed contract
9

82
26
5

80 71
21 19
35

Source: American Institute of Certified Public Accountants,
Accounting Trends & Techniques (New York: AICPA, 2004), p
...
For instance, assuming general and administrative expenses
were USD 100,000 in 2010, net income would be (USD 3,000,000 - USD 100,000) = USD 2,900,000
...

The matching principle states that expenses should be recognized (recorded) as they are incurred to produce
revenues
...
Firms voluntarily incur
expense to produce revenue
...
Similarly, the cost of services such as labor are
voluntarily incurred to produce revenue
...
Therefore, they measure a depreciation expense resulting from the consumption of those assets by
the historical costs of those assets
...

The timing of expense recognition The matching principle implies that a relationship exists between
expenses and revenues
...
However, when a direct relationship cannot be seen, we charge the costs of assets with
limited lives to expense in the periods benefited on a systematic and rational allocation basis
...

Product costs are costs incurred in the acquisition or manufacture of goods
...
For
manufacturing companies, product costs include all costs of materials, labor, and factory operations necessary to
produce the goods
...
We charge product costs to expense when the goods are sold
...

Period costs are costs not traceable to specific products and expensed in the period incurred
...

The gain and loss recognition principle states that we record gains only when realized, but losses when
they first become evident
...
This principle is related to the
conservatism concept
...
Firms should not
recognize gains until they are realized through sale or exchange
...


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...
However, unlike expenses, they do not produce revenues
...
A loss on the sale of
a building may be voluntary when management decides to sell the building even though incurring a loss
...
Depending on its nature, companies should disclose
this information either in the financial statements, in notes to the financial statements, or in supplemental
statements
...
Many lawsuits against CPAs and their clients have resulted from inadequate or misleading
disclosure of the underlying facts
...


An accounting perspective:
Business insight
The accounting model involves reporting revenues earned and expenses incurred by the company
...
Suppose, for instance, that a company is dumping toxic waste into a river and this action
causes cancer among the citizens downstream
...
Modifying conventions are customs emerging from accounting practice that alter the results
obtained from a strict application of accounting principles
...

Cost-benefit The cost-benefit consideration involves deciding whether the benefits of including optional
information in financial statements exceed the costs of providing the information
...
Preparers realize that providing
information is costly
...
The measurement of
benefits is inexact, which makes application of this modifying convention difficult in practice
...
The fundamental question accountants
must ask in judging the materiality of an item is whether a knowledgeable user's decisions would be different if the
information were presented in the theoretically correct manner
...
For instance, because inexpensive items such as calculators often
do not make a difference in a statement user's decision to invest in the company, they are immaterial (unimportant)
and may be expensed when purchased
...
Accountants should record all material items in a theoretically correct manner
...
0 License
immaterial items in a theoretically incorrect manner simply because it is more convenient and less expensive to do
so
...
It simply is not worth the cost of recording
depreciation expense on such a small item over its life
...
14 The term magnitude in
this definition suggests that the materiality of an item may be assessed by looking at its relative size
...
The same error in a company earning
USD 30,000,000 may not be material
...
Often the nature of the item makes it material
...

Conservatism Conservatism means being cautious or prudent and making sure that assets and net income
are not overstated
...
We apply conservatism when the lower-of-cost-or-market rule is used for inventory (see Chapter
7)
...

See Exhibit 30 for a summary of the modifying conventions and their importance
...
The FASB designed the conceptual framework project to resolve some disagreements about the
proper theoretical foundation for accounting
...


14 FASB, Statement of Financial Accounting Concepts No
...
, 1980), p
...
Copyright © by the Financial Accounting Standards Board, High
Ridge Park, Stamford, Connecticut 06905, U
...
A
...
Copies of the
complete documents are available from the FASB
...
Accounting theory
Principle
Exchange-price (or
cost)

Description
Requires transfers of resources to be

Importance
Tells the accountant to record a transfer of

recorded at prices agreed on by the parties
to the exchange at the time of the
exchange
...
Also, self-constructed
assets are recorded at their actual cost rather than
at some estimate of what they would have cost if
they had been purchased
...
Exceptions are made for items such
as installment sales and long-term construction
projects
...

Tells the accountant to be conservative when

Revenue recognition

Revenues should be earned and realized
before they are recognized (recorded)
...


Gain and loss
recognition

Gains may be recorded only when realized,
but losses should be recorded when they
first become evident
...


recognizing gains and losses
...
Losses should be recognized as
soon as they become evident
...

Requires the accountant to disclose everything that
is important
...
Another good rule is—if you are not
consistent, disclose all the facts and the effect on
income
...
Accounting theory
Modifying
Convention
Cost-benefit

Materiality

Conservatism

Description

Importance

Optional information should be
included
financial statements only if the
benefits
providing it exceed its costs
...
An example may be
companies going to the expense of providing
information on the effects of inflation when the
inflation rate is low and/or users do not seem to
benefit significantly from the information
...
For instance, a
reported in a theoretically correct way
...

Transactions should be recorded so
Warns accountants that assets and net income are
that assets and net income are not
not to be overstated
...

possible losses and do not anticipate (or record)
any possible gains" is common advice under this
constraint
...


Exhibit 30: Modifying conventions

The financial accounting standards board's conceptual framework project
Experts have debated the exact nature of the basic concepts and related principles composing accounting theory
for years
...
To date, all attempts to present a concise statement of GAAP have received only limited acceptance
...
The belief is that if a person (1)
carefully studies the environment, (2) knows what objectives are sought, (3) can identify certain qualitative traits of
accounting information, and (4) can define the basic elements of financial statements, that person can discover the
principles and standards leading to the stated objectives
...
15 Addressing the fourth goal are concepts statements entitled "Elements of Financial Statements of
Business Enterprises" and "Elements of Financial Statements"
...
According to the FASB, the first objective of financial reporting is to:

15 FASB, Statement of Financial Accounting Concepts No
...
, 1978); and Statement of Financial Accounting Concepts No
...
, 1980)
...
S
...
Quoted (or excerpted) with
permission
...

16 FASB, Statement of Financial Accounting Concepts No
...
, 1980); and Statement of Financial Accounting Concepts No
...
, 1985)
...
S
...
Quoted (or excerpted) with permission
...

212

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...
The information should be comprehensible
to those who have a reasonable understanding of business and economic activities and are willing to
study the information with reasonable diligence
...
Financial
reporting should provide information to all who are willing to learn to use it properly
...
Since investors' and creditors' cash flows are related to enterprise cash flows, financial
reporting should provide information to help investors, creditors, and others assess the amounts,
timing, and uncertainty of prospective net cash inflows to the related enterprise
...
Enterprise cash inflows are the source of cash for dividends, interest, and the
redemption of maturing debt
...
19
We can draw some conclusions from these three objectives and from a study of the environment in which
financial reporting is carried out
...

• Focus on earnings and its components, despite the emphasis in the objectives on cash flows
...
)
On the other hand, financial reporting does not seek to:
• Measure the value of an enterprise but to provide information useful in determining its value
...

These conclusions are some of those reached in Statement of Financial Accounting Concepts No
...
As the Board
stated, these statements "are intended to establish the objectives and concepts that the Financial Accounting
Standards Board will use in developing standards of financial accounting and reporting"
...

17 FASB, Statement of Financial Accounting Concepts No
...
viii
...

19 Ibid
...
, p
...

Accounting Principles: A Business Perspective

213

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5
...
This
criterion is difficult to apply
...

Accountants cannot specify who the decision makers are, their characteristics, the decisions to be made, or the
methods chosen to make the decisions
...
Note the FASB's graphic summarization of the qualities accountants consider in Exhibit 2821
To have relevance, information must be pertinent to or affect a decision
...
Relevant information makes a difference in a decision either by
affecting users' predictions of outcomes of past, present, or future events or by confirming or correcting
expectations
...
Expectations are commonly based on the present or past
...
Although information
that merely confirms prior expectations may be less useful, it is still relevant because it reduces uncertainty
...
For example, some argue that a
cost of USD 1 million paid for a tract of land 40 years ago and reported in the current balance sheet at that amount
is irrelevant (except for possible tax implications) to users for decision making today
...
Some suggest using a different valuation basis,
such as current cost, in reporting such assets
...

Information that reveals the relative success of users in predicting outcomes possesses feedback value
...
For example, a
report on the first quarter's earnings of a company reduces the uncertainty surrounding the amount of such
earnings, confirms or refutes the predicted amount of such earnings, and provides a possible basis on which to
predict earnings for the full year
...
Making predictions is a function performed by the decision maker
...
Utility of information decreases with age
...
If information is to be of any
value in decision making, it must be available before the decision is made
...

In determining what constitutes timely information, accountants consider the other qualitative characteristics and
the cost of gathering information
...
Timeliness alone cannot make information relevant, but potentially relevant
information can be rendered irrelevant by a lack of timeliness
...
2, p
...

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...
Information has reliability when it
faithfully depicts for users what it purports to represent
...
The reliability of information depends
on its representational faithfulness, verifiability, and neutrality
...

Representational faithfulness To gain insight into this quality, consider a map
...
A
correspondence exists between what is on the map and what is present physically
...

Where there is no correspondence, the cause may be (1) bias or (2) lack of completeness
...
Accounting measurements contain bias if they are consistently too high or too low
...

• Completeness
...
Completeness means disclosing all significant information in a
way that aids understanding and does not mislead
...
Currently, full disclosure requires presentation of a balance
sheet, an income statement, a statement of cash flows, and necessary notes to the financial statements and
supporting schedules
...
Such statements
must be complete, with items properly classified and segregated (such as reporting sales revenue separately
from other revenues)
...
Accounting theory
notes to such statements, (3) special communications, and/or (4) the president's letter or other management
reports in the annual report
...
22
Disclosure should include unusual activities (loans to officers), changes in expectations (losses on inventory),
depreciation expense for the period, long-term obligations entered into that are not recorded by the accountant (a
20-year lease on a building), new arrangements with certain groups (pension and profit-sharing plans for
employees), and significant events that occur after the date of the statements (loss of a major customer)
...
23 Because of its emphasis on disclosure, we often call this aspect of reliability the full
disclosure principle
...
Verifiability eliminates measurer bias
...
Unbiased information is especially necessary when parties with opposing interests (credit
seekers and credit grantors) rely on the same information
...

Financial information is never completely free of subjective opinion and judgment; it always possesses varying
degrees of verifiability
...
Accountants can never verify
other measurements, such as periodic depreciation charges, because of their very nature
...

Neutrality Neutrality means that the accounting information should be free of measurement method bias
...
Non-neutral accounting information
favors one set of interested parties over others
...
"To be neutral, accounting information must report economic activity as
faithfully as possible, without coloring the image it communicates for the purpose of influencing behavior in some
particular direction
...
Verifiability seeks to eliminate measurer bias; neutrality seeks to eliminate measurement method
bias
...
Comparable information reveals relative strengths and weaknesses in a
single company through time and between two or more companies at the same time
...

Consistency leads to comparability of financial information for a single company through time
...
For
example, Company B may use one method of depreciation, while Company C accounts for an identical asset in
22 APB, APB Opinion No
...

23 APB, APB Opinion No
...

24 FASB, Statement of Financial Accounting Concepts No
...
100
...
0 License
similar circumstances using another method
...

As we show in Exhibit 28, accountants must consider one pervasive constraint and one threshold for recognition
in providing useful information
...
Second, only material items need be disclosed and accounted for strictly in accordance
with generally accepted accounting principles (GAAP)
...


An accounting perspective:
Use of technology
You may want to visit the home page of the Financial Accounting Standards Board at:
http://www
...
org
You can check out the latest developments at the FASB to see how the rules of accounting might be
changing
...


The basic elements of financial statements
Thus far we have discussed objectives of financial reporting and qualitative characteristics of accounting
information
...
The FASB identified and defined the basic elements of financial statements in Concepts
Statement No
...
Later, Concepts Statement No
...
We defined most of the terms
earlier in this text in a less technical way; the more technical definitions follow
...
)
Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events
...

Equity or net assets is the residual interest in the assets of an entity that remains after deducting its
liabilities
...
In a not-for-profit organization, which has
no ownership interest in the same sense as a business enterprise, net assets is divided into three classes based on
the presence or absence of donor-imposed restrictions—permanently restricted, temporarily restricted, and
unrestricted net assets
...
It includes all changes in equity during a period
except those resulting from investments by owners and distributions to owners
...
Accounting theory
Revenues are inflows or other enhancements of assets of any entity or settlements of its liabilities (or a
combination of both) from delivering or producing goods, rendering services, or other activities that constitute the
entity's ongoing major or central operations
...

Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all
other transactions and other events and circumstances affecting the entity except those that result from revenues or
investments by owners
...

Investments by owners are increases in equity of a particular business enterprise resulting from transfers to
it from other entities of something valuable to obtain or increase ownership interests (or equity) in it
...

Distributions to owners are decreases in equity of a particular business enterprise resulting from
transferring assets, rendering services, or incurring liabilities by the enterprise to owners
...
25

An accounting perspective:
Business insight
Accountants record expenditures on physical resources such as land, buildings, and equipment
that benefit future periods as assets
...
Also, when a computer is dropped and destroyed,
accountants record a loss
...

Should the accounting model be changed regarding the accounting for human resources?

Recognition and measurement in financial statements
In December 1984, the FASB issued Statement of Financial Accounting Concepts No
...
26 The recognition criteria
25 FASB, Statement of Financial Accounting Concepts No
...

26 FASB, Statement of Financial Accounting Concepts No
...
, 1984)
...
S
...
Copies of the complete document are
available from the FASB
...
4, it pertains to accounting for not-for-profit organizations and is, therefore, not relevant to this
218

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...
The Statement indicates,
however, that when information more useful than currently reported information is available at a reasonable cost, it
should be included in financial statements
...
These policies
assist users in interpreting the financial statements
...
Companies must follow generally accepted accounting principles in preparing their financial
statements
...
After each, the chapter of this text where we discuss that particular
policy is in parentheses
...


An ethical perspective:
Maplehurst company
Maplehurst Company manufactures large spinning machines for the textile industry
...
The company's accountant
recorded the tools in an asset account and was going to write them off over 20 years
...
Management's goal was to smooth out
income rather than showing sharp increases and decreases
...
Since amounts under USD 20,000 are considered immaterial for this company, all of the
tools could then be charged to expense this year
...
She doubts that she could successfully defend
management's position if the auditors challenge the expensing of these items
...

Investments in affiliated companies are accounted for using the equity method
...
These changes had no cash
impact
...
(Chapters 13 and 14)
text
...
Accounting theory

Revenue recognition
Revenues from the theatrical distribution of motion pictures are recognized when motion pictures are exhibited
...
Revenues from video sales are recognized on the date that video units
are made widely available for sale by retailers
...
(Chapter 5)

Cash, cash equivalents and investments
Cash and cash equivalents consist of cash on hand and marketable securities with original maturities of three
months or less
...

Debt securities that the Company has the positive intent and ability to hold to maturity are classified as "held-tomaturity" and reported at amortized cost
...
(Chapter 14)

Merchandise inventories
Carrying amounts of merchandise, materials and supplies inventories are generally determined on a moving
average cost basis and are stated at the lower of cost or market
...
Estimates of
total gross revenues are reviewed periodically and amortization is adjusted accordingly
...
(Chapter 11)

Theme parks, resorts and other property
Theme parks, resorts and other property are carried at cost
...
(Chapter 3)

Other assets
Rights to the name, likeness and portrait of Walt Disney, goodwill and other intangible assets are amortized over
periods ranging from two to forty years
...
The
company designates interest rate and cross-currency swaps as hedges of investments and debt, and accrues the
differential to be paid or received under the agreements as interest rates change over the lives of the contracts
...
Gains
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...
Gains and losses arising from interest rate futures,
forwards and option contracts, and foreign currency forward and option contracts are recognized in income or
expense as offsets of gains and losses resulting from the underlying hedged transactions
...
(Chapter 16)
The Company classifies its derivative financial instruments as held or issued for purposes other than trading
...
Common equivalent shares are excluded from the computation in periods in
which they have an antidilutive effect
...
In Chapter 6, for instance, we discuss why sales revenue is recognized and recorded only after goods
have been delivered to the customer
...

Chapter 6 introduces merchandising operations
...

Understanding the learning objectives
• The major underlying assumptions or concepts of accounting are (1) business entity, (2) going concern

(continuity), (3) money measurement, (4) stable dollar, (5) periodicity, and (6) accrual basis and periodicity
...

• The major principles include exchange-price (or cost), revenue recognition, matching, gain and loss

recognition, and full disclosure
...

• Modifying conventions include cost-benefit, materiality, and conservatism
...

• Financial reporting objectives are the broad overriding goals sought by accountants engaging in financial

reporting
...
The two primary qualitative characteristics are relevance and reliability
...

• Pervasive constraints include cost-benefit analysis and materiality
...

• The FASB has also described revenue recognition criteria and provided guidance as to the timing and

nature of information to be included in financial statements
...


Accounting Principles: A Business Perspective

221

A Global Text

5
...


Demonstration problem
For each of the following transactions or circumstances and the entries made, state which, if any, of the
assumptions, concepts, principles, or modifying conventions of accounting have been violated
...

During the year, Dorsey Company did the following:
• Had its buildings appraised
...
The accountant debited the Buildings and Accumulated Depreciation—Buildings
accounts for USD 15,000 each and credited Paid-in Capital—From Appreciation
...

• Purchased new electric pencil sharpeners for its offices at a total cost of USD 60
...

Solution to demonstration problem
• The cost principle and the modifying convention of conservatism may have been violated
...
To correct the situation, the entry made needs to be
reversed:
Paid-in Capital

30,000

Building

15,000

Accumulated Depreciation—Building

15,000

• Theoretically, no violations occurred, but the cost of compiling insignificant information could be

considered a violation of acceptable accounting practice
...


Key terms
Accounting theory "A set of basic concepts and assumptions and related principles that explain and guide
the accountant's actions in identifying, measuring, and communicating economic information"
...

Business entity concept The specific unit for which accounting information is gathered
...

Comparability A qualitative characteristic of accounting information; when information is comparable, it
reveals differences and similarities that are real and are not the result of differing accounting treatments
...

Completeness A qualitative characteristic of accounting information; requires disclosure of all significant
information in a way that aids understanding and does not mislead; sometimes called the full disclosure
principle
...

Consistency Requires a company to use the same accounting principles and reporting practices through
time
...

Cost principle See Exchange-price principle
...

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...

Feedback value A qualitative characteristic that information has when it reveals the relative success of
users in predicting outcomes
...

Full disclosure principle Information important enough to influence the decisions of an informed user of
the financial statements should be disclosed
...

Gains Typically result from the sale of long-term assets for more than their book value
...

Historical cost The amount paid, or the fair market value of a liability incurred or other resources
surrendered, to acquire an asset and place it in a condition and position for its intended use
...

Liquidation Terminating a business by ceasing business operations and selling off its assets
...

Matching principle Expenses should be recognized as they are incurred to produce revenues
...

Modifying conventions Customs emerging from accounting practice that alter the results obtained from a
strict application of accounting principles; conservatism is an example
...

Neutrality A qualitative characteristic that requires accounting information to be free of measurement
method bias
...
The stage of completion is measured by comparing actual costs incurred
in a period with total estimated costs to be incurred in all periods
...

Periodicity (time periods) assumption An assumption of the accountant that an entity's life can be
divided into time periods for reporting its economic activities
...

Product costs Costs incurred in the acquisition or manufacture of goods
...

Qualitative characteristics Characteristics that accounting information should possess to be useful in
decision making
...

Relevance A qualitative characteristic requiring that information be pertinent to or affect a decision
...

Representational faithfulness A qualitative characteristic requiring that accounting statements on
economic activity correspond to the actual underlying activity
...

Stable dollar assumption An assumption that the dollar is a reasonably stable unit of measurement
...
Accounting theory
Timeliness A qualitative characteristic requiring that accounting information be provided at a time when it
may be considered before making a decision
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

When the substance of a transaction differs from its legal form, the accountant should record the economic
substance
...

Exceptions to the realization principle include the installment basis of revenue recognition for sales revenue and
the completed-contract method for long-term construction projects
...

The conceptual framework project resulted in identifying two primary qualitative characteristics that accounting
information should possess—relevance and reliability
...

The underlying assumptions of accounting includes all the following except:
a
...

b
...

c
...

d
...

The concept that requires companies to use the same accounting practices and reporting practices through time
is:
a
...

b
...

c
...

d
...

Which of the following statements is false regarding the revenue recognition principle?
a
...

b
...

c
...

d
...

Assume the following facts regarding the construction of a bridge:
Construction costs this period
...
10,000,000
Total sales price
...
0 License
The revenue that should be recognized this period is:
a
...

b
...

c
...

d
...

Modifying conventions include all of the following except:
a
...

b
...

c
...

d
...

Which of the following is not part of the conceptual framework project?
a
...

b
...

c
...

d
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
Comment on the
validity of the stable unit of measurement assumption during periods of high inflation
...
What principles guide the recognition of expense?

➢

How does an expense differ from a loss?

➢

What is the full disclosure principle?

➢

What role does cost-benefit play in financial reporting?

➢

What is meant by the accounting term conservatism? How does it affect the amounts reported in the
financial statements?

➢

Does materiality relate only to the relative size of dollar amounts?

➢

Identify the three major parts of the conceptual framework project
...
Accounting theory
Revenues, costs, and profits applicable to construction and conversion contracts are included in the
consolidated statements of operations using the
...
The
completed contract method was used for income tax reporting in the years this method was allowed
...
Expenditures that relate to an existing condition caused by past operations, and do not
contribute to current or future revenue generation, are expensed
...

Column A

Column B

Going concern (continuity)
...
An assumption relied on in the preparation of the
primary financial statements that would be
unreasonable when the inflation rate is high
...


b
...


Disclosure
...
The usual basis for the recording of assets
...


d
...


Conservatism
...
An assumption that would be unreasonable to use
in reporting on a firm that had become insolvent
...


f
...


Matching
...
Requires a company to use the same accounting
procedures and practices through time
...


h
...


Exchange-price (cost)
...
Discourages undue optimism in measuring and
reporting net assets and net income
...


j
...


Exercise B Parker Clothing Company sells its products on an installment sales basis
...
0 License
2010

Installment sales
...

Other expenses
...

Cash collected from 2011 sales
...
Compute the net income for 2011, assuming use of the accrual (sales) basis of revenue recognition
...
Compute the net income for 2011, assuming use of the installment basis of recognizing gross margin
...
Costs of USD 100 million were incurred
...
In 2010, the company charged to expense the USD 6,000 premium paid on a three-year policy covering the
period 2010 July 1, to 2010 June 30
...

a
...

b
...

c
...

Exercise E Match the descriptions in Column B with the accounting qualities in Column A
...

Column A: Accounting qualities

Column B: Descriptions

Relevance
...
Users of accounting information
...


b
...


Decision makers
...
User-specific qualities
...


d
...


Reliability
...
Ingredients of primary qualities
...


f
...


Benefits exceed costs
...
Threshold for recognition
...

Timeliness
...

Verifiability
...

Neutrality
...


Accounting Principles: A Business Perspective

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5
...
Going-concern assumption
...
Business entity concept
...
Separate entity concept
...
Corporation concept
...
There are changes in the value of the dollar
...
The periodicity assumption is applied
...
The company is not a going concern and will be dissolved
...
The accrual basis of accounting is not used
...
The company chose to
report the item as prepaid advertising and includes it among the assets on the balance sheet
...
This practice is a violation of:
a
...

b
...

c
...

d
...

Recording revenue only after the seller has obtained the right to receive payment from the buyer for
merchandise sold or services performed is called the:
a
...

b
...

c
...

d
...

Problem B Ramirez Video, Inc
...
Following are data for the first three years of the company's operations:
2008
Gross margin rate 30%
Cash collected in 2010:
From sales in
...

From sales in
...

a
...

b
...

Problem C The following data relate to Merit Construction Company's long-term construction projects for the
year 2010:
Contract price
...

Costs incurred in 2010
...


Completed
Projects
$20,000,000

...
11,100,000

Incomplete
Projects
$100,000,000
16,000,000
32,000,000

- 0-

32,000,000

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...

a
...

b
...

Problem D For each of the following numbered items, state the letter or letters of the principle(s),
assumption(s), or concept(s) used to justify the accounting procedure followed
...

a
...

b
...

c
...

d
...

e
...

f
...

g
...

h
...

i
...

Inventory is recorded at the lower of cost or market value
...

The collection of USD 40,000 of cash for services to be performed next year was reported as a current liability
...

No entry was made to record the company's receipt of an offer of USD 800,000 for land carried in its accounts
at USD 435,000
...

A tract of land acquired for USD 180,000 was recorded at that price even though it was appraised at USD
230,000, and the company would have been willing to pay that amount
...

Craig Nelson is the sole stockholder of the company
...

1
...

3
...

5
...

7
...

9
...

11
...

13
...

Qualitative
characteristics
...

Predictive value
...

Timeliness
...

Representational
faithfulness
...

Neutrality
...

Consistency
...


a
...

c
...

e
...

g
...

i
...

k
...

m
...

The benefits exceed the costs
...

The information can be substantially duplicated by independent measurers
using the same measurement methods
...

Broad overriding goals sought by accountants engaging in financial reporting
...

The characteristics that accounting information should possess to be useful
in decision making
...

When accounting statements on economic activity correspond to the actual
underlying activity
...

When information faithfully depicts for users what it purports to represent
...
Accounting theory
14
...


n
...

When reported differences and similarities in information are real and not
the result of differing accounting treatments
...
Accounting theory
...
Accounting rules
...
Accrual basis
...
Matching concept
...
Several separate legal entities properly may be considered to be one accounting entity
...
The stable dollar assumption is used only when the dollar is absolutely stable
...
Publicly held corporations generally prepare monthly financial statements for internal management and
publish quarterly and annual financial statements for users outside the company
...
Without the periodicity assumption, a business would have only one time period running from the inception
of the business to its termination
...
When the substance of a transaction conflicts with the legal form of the transaction, the accountant should be
guided by the legal form in recording the transaction
...
The consistency concept prohibits a change in accounting principle even when such a change would better
meet the information needs of financial statement users
...
Under the double-entry approach, each transaction must be recorded with one debit and one credit of equal
dollar amounts
...
Special-purpose financial information for a specific decision, such as whether or not to purchase a new
machine, is best obtained from the detailed accounting records rather than from the financial statements
...
All assets are carried indefinitely at their original costs in the financial statements
...
Liabilities are measured in the cash to be paid or the value of services to be performed to satisfy the liabilities
...
Accounting principles are derived by merely summarizing accounting practices used to date
...
Accountants can easily measure all changes in assets and liabilities since they never involve estimates or
calculations
...
The exchange-price principle is also called the cost principle
...
The matching principle is closely related to the revenue recognition principle
...
The installment sales method recognizes revenue sooner than it would normally be recognized
...
The percentage-of-completion method recognizes revenue sooner than the completed- contract method
...

Following are data on the company's operations for its first three years:
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This book is licensed under a Creative Commons Attribution 3
...

Cash collected in 2010 from
sales of lots made in
...
45%

2009
48%

2010
50%


...

a
...

b
...

Alternate problem C The following contract prices and costs relate to all of Orlando Construction Company's
long-term construction projects (in millions of dollars):
Costs Incurred

On projects completed in 2010
On incomplete projects

Contract
Price
$46
144

Prior to
2010
$4
24

Cost to Be
Incurred in
Future Years
$0
48

In
2010
$36
48

General and administrative expenses for 2010 amounted to USD 1,200,000
...

a
...

b
...

Alternate problem D In each of these circumstances, the accounting practices may be questioned
...

The salaries paid to the top officers of the company were charged to expense in the period in which they were
incurred even though the officers spent over half of their time planning next year's activities
...

The acquisition of a tract of land was recorded at the price paid for it of USD 400,000, even though the company
would have been willing to pay USD 600,000
...

Alternate problem E Select the best answer to each of the following questions:
In the conceptual framework project, how many financial reporting objectives were identified by the FASB?
a
...

b
...

c
...

d
...

The two primary qualitative characteristics are:
a
...

b
...

c
...

d
...

A pervasive constraint of accounting information is that:
a
...


Accounting Principles: A Business Perspective

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5
...
The information must be timely
...
The information must be neutral
...
The information must be verifiable
...
Be verifiable
...
Be timely
...
Have representational faithfulness
...
Be neutral
...
Terms and their definitions
...
The objectives of financial reporting
...
The qualitative characteristics
...
The new income statement format
...
After he had been with the firm for about six months, he was sent to the Ling
Clothing Company to work on the audit
...

He noticed, however, that some of the company's transactions and events were recorded in a way that might be in
violation of accounting theory and generally accepted accounting principles
...
Write your decisions and the reasoning behind your conclusions
...
Some of the following situations relate to material you have already
covered, and some situations relate to material to be covered in future chapters
...
You may research future chapters to find the correct
answer
...
Realize, however, that some generally
accepted accounting practices were based on compromise and seem to differ with accounting theory as described in
this chapter
...

He said that the cash in the Accumulated Depreciation account would be used to pay for the furniture
...
3)
The company held the books open at the end of 2010 so they could record some early 2011 sales as 2010
revenue
...
(Ch
...
The appraised values were USD 10,000,000
higher than the book value
...
(Ch
...

(Ch
...
The goods were not
included in ending inventory because the goods had not yet arrived
...
5, 6)
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This book is licensed under a Creative Commons Attribution 3
...
The person
taking the inventory said he had forgotten to include some items in last year's physical inventory, and counting
some items twice would make up for the items missed last year so that net income this year would be about correct
...
7)
The company switched from FIFO to LIFO in accounting for inventories
...
The reason given for the most recent change was that federal income
taxes would be lower
...
(Ch
...
His
reason was that the bank probably had not made any errors
...
(Ch
...
The amount of accounts written off in this manner was huge
...
9)
A completely depreciated machine was still being used
...
(Ch
...
This year USD 200,000 of these costs were
charged to expense
...
11)
An old truck was traded for a new truck
...
(Ch
...
The accountant is amortizing the asset over 60 years
...
11)
The company leases a building and has a nonrenewable lease that expires in 15 years
...
Since the improvements will last 30 years, they are being written off over 30 years
...
11)
Annual report analysis B Refer to the "Summary of significant accounting policies" in the annual report of
The Limited, Inc
...
For each of the policies, explain in writing what the company is trying
to communicate
...
Write out
the answers to the following questions:
Is management being ethical in this situation? Explain
...

What would you do if you were the accountant? Describe in detail
...
(As an alternative, annual reports can be downloaded from the SEC's EDGAR site at
www
...
gov/edgar
...
As a team, write a memorandum to the
instructor detailing the significant accounting policies of the company
...


Accounting Principles: A Business Perspective

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5
...
This board is responsible for establishing the
accounting standards and principles for financial accounting in the private sector
...
Be sure to cite sources used and to treat direct quotes properly
...
Your library might have a copy
...
019303, Order Department, AICPA, Harborside Financial
Center, 201 Plaza Three, Jersey City, NJ 07311- 3881] [Toll free number 1-800-862-4272; FAX 1-800-362-5066]
...
Be sure to cite sources used and treat
direct quotes properly
...
ge
...
Print a copy of
the summary of Significant Accounting Policies
...

Visit the following Internet site for Oracle
...
oracle
...
Examine the notes on the
financial statements for the latest quarter
...

Answers to self-test
True-false
False
...

True
...

True
...

False
...

False
...
g
...

True
...

Multiple-choice
c
...

b
...

b
...

b
...

USD 10,000,000

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...
Periodicity is an underlying assumption rather than a modifying convention
...
The category, quantitative characteristics, is not part of the conceptual framework project
...
0 License

6
...

• Describe briefly cost of goods sold and the distinction between perpetual and periodic inventory procedures
...

• Describe the freight terms and record transportation costs
...

• Prepare a classified income statement
...

• Prepare a work sheet and closing entries for a merchandising company (Appendix)
...
The accounting field greatly values
individuals with leadership potential
...
Recruiters in public accounting (i
...

auditing, tax, consulting) and private accounting (i
...
financial reporting, cost accounting, financial analysis,
internal auditing) alike demonstrate a strong preference for students with leadership potential
...
Some
examples of leadership potential that would look good on a resume include organizing a successful fund-raiser,
participating effectively as an officer in a student club, or taking the lead in a group project
...
Many
students at your level already have a resume, and it takes time to refine and develop an effective one
...

Did you know that the chief executive officers (CEO) of many of the largest manufacturing, merchandising, and
service organizations in the United States have degrees in accounting? James Dimon of JPMorgan Chase, Gary C
...
Mulva of ConocoPhillips, and Indra K
...
It is really not that surprising that accounting majors are so successful, as
accounting provides an excellent foundation in business
...


Accounting Principles: A Business Perspective

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6
...
You are now ready to apply the accounting process to a more complex business—a merchandising
company
...

The normal flow of goods from manufacturer to final customer is as follows:

Manufacturers produce goods from raw materials and normally sell them to wholesalers
...
Retailers sell the goods
to final customers
...
These companies buy
goods in finished form for resale
...
Then, we describe (1) how to record merchandise-related transactions (2) a classified income statement
and (3) the gross margin percentage
...

SERVICE COMPANY

MERCHANDISING COMPANY

Income Statement

Income Statement

For the Year Ended 2010 December 31

Service revenues

$13,200

For the Year Ended 2010 December 31

Sales revenues

$262,000

Cost of goods sold

159,000

Gross Margin

$103,000

Expenses

6,510

Expenses

74,900

Net income

$ 6,690

Net income

$ 28,100

Exhibit 32: Condensed income statements of a service company and a merchandising company compared

Two income statements compared— Service company and merchandising company
In Exhibit 32 we compare the main divisions of an income statement for a service company with those for a
merchandising company
...
A merchandising company is a more complex business and, therefore, has a more
complex income statement
...
Then, they deduct other expenses
...

In the next two sections we discuss the first two main divisions of the income statement of a merchandising
company
...
As you study these sections, keep in mind how the divisions of the merchandising income
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...


Sales revenues
The sale of goods occurs between two parties
...
This exchange is a relatively simple business transaction
...

In Exhibit 32, we show a condensed income statement to emphasize its major divisions
...
The merchandising company that we use to
illustrate the income statement is Hanlon Retail Food Store
...
Then, we explain how to record two deductions from sales revenues—sales
discounts and sales returns and allowances (Exhibit 33)
...
The formula for
determining net sales is:
Net sales = Gross sales - (Sales discounts + Sales returns and allowances)
HANLON RETAIL FOOD STORE
Partial income Statement
For the Year Ended 2010 December 31

Operating revenues:
Gross sales
Less: Sales discounts

$ 5,000

Sales returns and allowances 15,000
Net sales

$282,000
20,000
$262,000

Exhibit 33: Partial income statement of merchandising company
BRYAN WHOLESALE CO
...
: 1258 Date: 2010 Dec
...
: 218
Sold to:

Baier Company

Address:

2255 Hannon Street

Big Rapids, Michigan 48106

Date Shipped: 2010 Dec
...


Net 30, FOB Destination

Description

Item Number

Quantity

Price per Unit

Total Amount

True-tone stereo radio

Model No
...
Usually, the
physical delivery of the goods occurs at the same time as the sale of the goods
...

An invoice is a document prepared by the seller of merchandise and sent to the buyer
...
A retail company prepares the invoice at the point of sale
...
Merchandising transactions
the goods to the retailer
...

Using the invoice as the source document, a wholesale company records the revenue from the sale at the time of
the sale for the following reasons:
• The seller has passed legal title of the goods to the buyer, and the goods are now the responsibility and

property of the buyer
...

• The seller has completed its obligation
...

• The seller can determine the costs incurred in selling the goods
...
This revenue increases a revenue account called
Sales
...
Therefore, the firm credits the Sales account for the
amount of the sale
...
When a sale is for cash, the company credits the Sales account and
debits Cash
...


When a sale is on account, it credits the Sales account and debits Accounts Receivable
...


Usually, a seller quotes the gross selling price, also called the invoice price, of goods to the buyer
...
In this latter situation, the buyer
must calculate the gross selling price
...

Merchandising companies that sell goods use the gross selling price as the credit to sales
...
Once you have defined
this information to the database management system, you can use commands to answer such
questions as: Which products have been sold to which customers? What are the amounts of sales
by individual salespersons? You could also print a customer list sorted by ZIP code, the alphabet,
or salesperson
...
Companies use trade discounts to:
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...
A seller can use a catalog for a longer time by printing list prices in

the catalog and giving separate discount sheets to salespersons whenever prices change
...

• Allow quotation of different prices to various customers, such as retailers and wholesalers
...
However, sellers do not record trade discounts in their
accounting records because the discounts are used only to calculate the gross selling price
...
To illustrate, assume an invoice contains the following data:
List price, 200 swimsuits at $24
Less: Trade discount, 30%
Gross selling price (invoice price)

$4,800
1,440
$3,360

The seller records a sale of USD 3,360
...
Thus, neither the seller
nor the purchaser enters list prices and trade discounts on their books
...
Chain discounts exist, for example, when a wholesaler receives two trade discounts for services
performed, such as packaging and distributing
...
If a product has a list price of USD 100 and is subject to trade
discounts of 20 per cent and 10 per cent, the gross selling price (invoice price) would be USD 100 - 0
...
1(USD 80) = USD 72, computed as follows:
List price
Less 20%

$100
$

20
80

$

■
8
72

Less 10%
Gross selling price (invoice price)

You could obtain the same results by multiplying the list price by the complements of the trade discounts
allowed
...
The
complement of 10 per cent is 90 per cent because 10 per cent + 90 per cent = 100 per cent
...
8 X 0
...

Two common deductions from gross sales are (1) sales discounts and (2) sales returns and allowances
...
Contra accounts have normal balances
that are opposite to the balance of the account they reduce
...
We
explain the methods of recording these contra revenue accounts next
...
For example, the invoice in Exhibit 34 states the terms of payment as "net 30"
...
Either way, this term means that the buyer may not take a discount and
must pay the entire amount of the invoice (USD 20,000) on or before 30 days after 2010 December 19 (invoice
date)—or 2011 January 18
...
Credit terms vary from industry to industry
...
A cash discount is a deduction from the invoice price that can be taken only if the invoice is paid
within a specified time
...
Merchandising transactions
gross selling price for the prompt payment of an invoice
...
Sellers call a cash discount a sales discount and
buyers call it a purchase discount
...
If payment is not made within the discount period, the entire invoice price is due
30 days from the invoice date
...
If payment is not made within the discount period, the entire invoice price is
due 60 days from the invoice date
...
If payment is not made within the discount period,
the entire invoice price is due 60 days from the invoice date
...
A cash discount taken by the buyer reduces the cash that the seller actually collects from the
sale of the goods, so the seller must indicate this fact in its accounting records
...

Assume that on July 12, a business sold merchandise for USD 2,000 on account; terms are 2/10, n/30
...
The required
journal entries for the seller are:
July

12 Accounts Receivable (+A)

2,000

Sales (+SE)

2,000

To record sale on account; terms 2/10, n/30
21 Cash (+A)
Sales Discounts (-SE; Contra-Revenue Account)

1,960
40

Accounts Receivable (-A)

2,000

To record collection on account, less a discount
...
In the income statement, the
seller deducts this contra revenue account from gross sales
...
Note that the Sales Discounts account is not an expense incurred in generating
revenue
...

Sales returns and allowances Merchandising companies usually allow customers to return goods that are
defective or unsatisfactory for a variety of reasons, such as wrong color, wrong size, wrong style, wrong amounts, or
inferior quality
...
A sales return is merchandise returned by a buyer
...
Alternatively, some customers keep unsatisfactory
goods, and the seller gives them an allowance off the original price
...
When a seller agrees to the sales
return or sales allowance, the seller sends the buyer a credit memorandum indicating a reduction (crediting) of the
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...
A credit memorandum is a document that provides space for the name and address of
the concerned parties, followed by a space for the reason for the credit and the amount to be credited
...

In theory, sellers could record both sales returns and sales allowances as debits to the Sales account because
they cancel part of the recorded selling price
...
The amount of returns and allowances in relation to goods sold can indicate the quality
of the goods (high-return percentage, equals low quality) or of pressure applied by salespersons (high-return
percentage, equals high-pressure sales)
...
The Sales Returns and Allowances account is a contra revenue account (to
Sales) that records the selling price of merchandise returned by buyers or reductions in selling prices granted
...
)
Following are two examples illustrating the recording of sales returns in the Sales Returns and Allowances
account:
• Assume that a customer returns USD 300 of goods sold on account
...


• Assume that the customer has already paid the account and the seller gives the customer a cash refund
...
If the customer has taken a 2 per cent discount
when paying the account, the company would return to the customer the sales price less the sales discount
amount
...


The debit to the Sales Returns and Allowances account is for the full selling price of the purchase
...

Next, we illustrate the recording of a sales allowance in the Sales Returns and Allowances account
...

If the customer has not yet paid the account, the required entry would be:
Sales Returns and Allowances (-SE)

400

Accounts Receivable (-A)

400

To record a sales allowance granted for damaged
merchandise
...
If the
customer took a 2 per cent discount when paying the account, the company would refund only the net amount
(USD 392)
...
The entry would be:
Accounting Principles: A Business Perspective

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...


HANLON RETAIL FOOD STORE
Partial income Statement
For the Year Ended 2010 December 31,

Operating revenues:
Gross sales
Less: Sales discounts

$ 5,000

Sales returns and allowances 15,000
Net sales

$282,000
20,000
$262,000

*This illustration is the same as Exhibit 33, repeated here for your convenience
...
More often, the income statement in a company's annual report begins with "Net sales" because
sales details are not important to external financial statement users
...
A national retailer of personal computers
and related products and services, for example, should include wording similar to that in the
following paragraph in its Annual Report describing seasonality
...
Excluding
the effects of new store openings, net sales and earnings are generally lower during the first and
fourth fiscal quarters than in the second and third fiscal quarters
...
They attempt to stock just the right amount of goods to meet demand
...
The only way they can unload these goods is to offer huge
discounts during the following period
...
0 License

Cost of goods sold
The second main division of an income statement for a merchandising business is cost of goods sold
...
For a merchandising company, the cost of goods
sold can be relatively large
...
Merchandise inventory (or inventory) is the quantity of goods available for sale
at any given time
...

Look at the cost of goods sold section of Hanlon Retail Food Store's income statement in Exhibit 36
...
The net cost of purchases for the year was USD
166,000
...
On 2010 December 31, the
merchandise inventory was USD 31,000, meaning that this amount was left unsold
...
Understanding this relationship shown on
Hanlon Retail Food Store's partial income statement gives you the necessary background to determine the cost of
goods sold as presented in this section
...

Accountants use two basic methods for determining the amount of merchandise inventory—perpetual inventory
procedure and periodic inventory procedure
...
In the
next chapter, we emphasize perpetual inventory procedure and further compare it with periodic inventory
procedure
...
The difference
between perpetual and periodic inventory procedures is the frequency with which the Merchandise Inventory
account is updated to reflect what is physically on hand
...
For example, your supermarket
uses a scanner to ring up your purchases
...


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6
...
Usually, the physical count takes place immediately before the preparation of
financial statements
...
Historically, companies that sold merchandise with a high individual unit value, such as automobiles,
furniture, and appliances, used perpetual inventory procedure
...

Computerization makes it economical for many retail stores to use perpetual inventory procedure even for goods of
low unit value, such as groceries
...
Companies debit the Merchandise
Inventory account for each purchase and credit it for each sale so that the current balance is shown in the account
at all times
...
Company personnel also take a physical inventory by actually counting the units of inventory on
hand
...
Chapter 7
describes perpetual inventory procedure in more detail
...
These
merchandising companies often use periodic inventory procedure
...
Instead, a company corrects the balance in the Merchandise Inventory account
as the result of a physical inventory count at the end of the accounting period
...
Although periodic inventory
procedure reduces record-keeping, it also reduces control over inventory items
...
Thus, these companies have no up-to-date balance against
which to compare the physical inventory count at the end of the period
...
Instead, they calculate the cost of all the goods sold during
the accounting period at the end of the period
...

• Net cost of purchases during the period
...


The company would show this information as follows:
Beginning inventory
Add: Net cost of purchases during the period
Cost of goods available for sale during the period
Deduct: Ending inventory
Cost of goods sold during the period

$ 34,000
140,000
$174,000
20,000
$154,000

In this schedule, notice that the company began the accounting period with USD 34,000 of merchandise and
purchased an additional USD 140,000, making a total of USD 174,000 of goods that could have been sold during
the period
...
0 License
was the cost of goods sold during the period
...
Periodic inventory procedure
basically assumes that everything not on hand at the end of the period has been sold
...

Under periodic inventory procedure, a merchandising company uses the Purchases account to record the cost
of merchandise bought for resale during the current accounting period
...

To illustrate entries affecting the Purchases account, assume that Hanlon Retail Food Store made two purchases
of merchandise from Smith Wholesale Company
...
The required journal entries for
Hanlon are:
May

4

Purchases (+A)
Accounts Payable (+L)
To record purchases of merchandise on account
...


30,000
30,000
20,000

20,000

The buyer deducts purchase discounts and purchase returns and allowances from purchases to arrive at net
purchases
...

Purchase discounts Often companies purchase merchandise under credit terms that permit them to deduct a
stated cash discount if they pay invoices within a specified time
...
If Hanlon pays for the merchandise by May 14, the store may take a 2 per cent discount
...
The entry to record the
payment of the invoice on May 14 is:
May

14 Accounts Payable (-L)

30,000

Cash (-A)

29,400

Purchase Discount (+SE)

600

To record payment on account within the
discount period
...
The Purchase Discounts account is a contra account to Purchases that reduces the recorded
invoice price of the goods purchased to the price actually paid
...

Companies base purchase discounts on the invoice price of goods
...
For example, in
the previous transaction, the invoice price of goods purchased was USD 30,000
...

Interest rate implied in cash discounts To decide whether you should take advantage of discounts by using
your cash or borrowing, make this simple analysis
...
By advancing payment 20 days from
the final due date, you can secure a discount of USD 200
...
Merchandising transactions
per cent per year for 20 days is USD 65
...
12 x 20/360)
...
67
(USD 200 - USD 65
...

In terms of an annual rate of interest, the 2 per cent rate of discount for 20 days is equivalent to a 36 per cent
annual rate: (360/20) X 2 per cent
...
Thus, a company could afford to pay up to 36 per cent [(360/20) X 2 per cent] on borrowed funds to take
advantage of discount terms of 2/10, n/ 30
...

Purchase returns and allowances A purchase return occurs when a buyer returns merchandise to a seller
...
Then, the buyer
commonly uses a debit memorandum to notify the seller that the account payable with the seller is being reduced
(Accounts Payable is debited)
...

Both returns and allowances reduce the buyer's debt to the seller and decrease the cost of the goods purchased
...
For this reason, buyers record
purchase returns and allowances in a separate Purchase Returns and Allowances account
...
Only the explanation would change
...
If the company took a discount at the time it paid the account, only the net amount
would be refunded
...


Purchase returns and allowances is a contra account to the Purchases account, and the income statement shows
it as a deduction from purchases
...

Transportation costs are an important part of cost of goods sold
...
0 License
• FOB shipping point means "free on board at shipping point"
...
Thus, the buyer is
responsible for ultimately paying the freight charges
...
The seller ships the goods to their destination

without charge to the buyer
...

• Passage of title is a term that indicates the transfer of the legal ownership of goods
...
Thus, when goods are shipped FOB shipping point, title
usually passes to the buyer at the shipping point
...

• Freight prepaid means the seller must initially pay the freight at the time of shipment
...


To illustrate the use of these terms, assume that a company ships goods FOB shipping point, freight collect
...
The buyer is responsible for paying the USD 100 freight costs and does so
...


The Transportation-In account records the inward freight costs of acquiring merchandise
...
An adjunct
account is closely related to another account (Purchases, in this instance), and its balance is added to the balance
of the related account in the financial statements
...
Buyers deduct a contra account, such as accumulated depreciation, from the related fixed asset account in
the financial statements
...

Because the seller cannot bill a separate freight cost to the buyer, the buyer shows no entry for freight on its books
...
The following entry is
required on the seller's books:
Delivery Expense (or Transportation-Out Expense) (-SE)

100

Cash (-A)

100

To record freight cost on goods sold
...

FOB terms are especially important at the end of an accounting period
...
Goods shipped
FOB destination belong to the seller while in transit, and the seller includes these goods in its ending inventory
...
For example, assume that a seller ships goods on 2009
December 30, and they arrive at their destination on 2010 January 5
...
Merchandising transactions
transaction until 2010 January 5
...

Sometimes the seller prepays the freight as a convenience to the buyer, even though the buyer is ultimately
responsible for it
...
For example, assume that Wood
Company sold merchandise to Loud Company with terms of FOB shipping point, freight prepaid
...
The following entries are necessary on the books of the buyer and the seller:
Buyer—Loud Company
Transportation-In (-SE)
Accounts Payable (+L)

Seller—Wood Company
100
100

Accounts Receivable (+A)
Cash (-A)

100

100

Such entries are necessary because Wood initially paid the freight charges when not required to do so
...
If the buyer pays freight for the seller (e
...
FOB
destination, freight collect), the buyer merely deducts the freight paid from the amount owed to the seller
...
Therefore, a buyer who owes the seller for
freight charges cannot take a discount on the freight charges owed, even if the buyer makes payment within the
discount period
...

Merchandise inventory is the cost of goods on hand and available for sale at any given time
...
Management must
know its cost of goods on hand at the start of the period (beginning inventory), the net cost of purchases during the
period, and the cost of goods on hand at the close of the period (ending inventory)
...
Companies record purchases, purchase discounts, purchase returns and allowances, and
transportation-in throughout the period
...

Taking a physical inventory Under periodic inventory procedure, company personnel determine ending
inventory cost by taking a physical inventory
...
To calculate inventory cost, they multiply the number of each kind of
merchandise by its unit cost
...

In taking a physical inventory, company personnel must be careful to count all goods owned, regardless of where
they are located, and include them in the inventory
...
0 License
Shipping point: Detroit-

Destination: San Diego

Goods travel from shipping point to destination
If shipping terms are:
FOB shipping point—Buyer incurs

charges

Freight prepaid—Seller initially

charges

the freight

FOB destination—Seller incurs

the freight

Freight collect—Buyer initially

pays the freight

charge

pays the freight

charges

If the freight terms are combined as follows:
Party that
Party that
Terms

(1)
(2)
(3)
(4)

FOB
FOB
FOB
FOB

Ultimately Bears

Initially Pays

shipping point, freight collect
destination, freight prepaid
shipping point, freight prepaid
destination, freight collect

Expense

Buyer
Seller
Seller
Buyer

Buyer
Seller
Buyer
Seller

Exhibit 37: Summary of shipping terms
Explanations:
FOB shipping point, freight collect – Buyer both incurs and initially pays the freight chargers
...
The buyer debits
Transportation-In and credits Cash
...
The proper party (seller) paid the freight
...

FOB shipping point, freight prepaid – Buyer incurs the freight chargers, and seller initially pays the freight charges
...

The seller debits Accounts Receivable and credits Cash upon paying the freight
...

FOB destination, freight collect – Seller incurs freight charges, and buyer initially pays freight charges
...

The buyer debits Accounts Payable and credits Cash when paying the freight
...


Thus, companies should include goods shipped to potential customers on approval in their inventories
...
These goods remain the property of the owner (consignor) until sold by the
consignee and must be included in the owner's inventory
...

As stated above, buyers must record merchandise in transit at the end of the accounting period as a purchase if the
goods were shipped FOB shipping point and they have received title to the merchandise
...

When accounting personnel know the beginning and ending inventories and the various items making up the
net cost of purchases, they can determine the cost of goods sold
...

Dr
...

Cr
...


By taking a physical inventory, Hanlon determined the 2010 December 31, merchandise inventory to be USD
31,000
...
This computation appears in a section
of the income statement directly below the calculation of net sales
...
Merchandising transactions
Cost of goods sold:
Merchandise inventory, 2010 January 1

$ 24,000

Purchases

$167,000

Less: Purchase discounts

$3,000

Purchase returns and allowances

8,000

11,000

Net Purchases

$156,000

Add: Transportation-in

10,000

Net cost of purchases

166,000

Cost of goods available for sale

$190,000

Less: Merchandise inventory, 2010 December 31

31,000

Cost of goods sold

$159,000

This illustration is the same as Exhibit 36, repeated here for your convenience
...
The firm deducts the ending inventory cost (USD 31,000) from
cost of goods available for sale to arrive at cost of goods sold (USD 159,000)
...
Hanlon divides
the cost of goods available for sale into ending inventory (which is the cost of goods not sold) and cost of goods sold
...

As shown in Exhibit 38, ending inventory cost (merchandise inventory) appears in the income statement as a
deduction from cost of goods available for sale to compute cost of goods sold
...

Companies use periodic inventory procedure because of its simplicity and relatively low cost
...
Firms assume any items not included in the physical
count of inventory at the end of the period have been sold
...

To illustrate, suppose that the cost of goods available for sale was USD 200,000 and ending inventory was USD
60,000
...
Now suppose that USD 2,000 of goods

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...
If such goods had not been stolen, the ending inventory would have been
USD 62,000 and the cost of goods sold only USD 138,000
...


An accounting perspective:
Uses of technology
Many companies are building private networks to link their employees, customers, and suppliers
together
...
The Internet
can be likened to the entire universe, while an intranet can be likened to a solar system within the
universe
...
For instance, these
networks are designed to be secure against "hackers" and other unauthorized persons
...


Classified income statement
In preceding chapters, we illustrated the unclassified (or single-step) income statement
...
In contrast, a classified income
statement divides both revenues and expenses into operating and nonoperating items
...
A classified income statement is also called a
multiple-step income statement
...
This statement uses the
previously presented data on sales (Exhibit 35) and cost of goods sold (Exhibit 38), together with additional
assumed data on operating expenses and other expenses and revenues
...

• Cost of goods sold
...

• Nonoperating revenues and expenses (other revenues and other expenses)
...
For example, by deducting cost of goods sold from operating revenues, you can determine by what
amount sales revenues exceed the cost of items being sold
...
The classified income
statement subdivides operating expenses into selling and administrative expenses
...
Statement users
can also make comparisons with other years' data for the same business and with other businesses
...


Accounting Principles: A Business Perspective

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...
This choice may be based either on how their competitors present their
data or on the costs associated with assembling the data
...
0 License
HANLON RETAIL FOOD STORE
Income Statement
For the Year Ended 2010 December 31

Operating revenues:
Gross sales

$282,000

Less: Sales discounts

$ 5,000

Sales return and allowances

15,000

Net sales

20,000
$262,000

Cost of goods sold:
Merchandise inventory, 2010 January 1
Purchases
Less: Purchase discount
Purchase returns and allowances
Net purchases
Add: Transportation-in

$24,000
$167,00
0

$3,00
0
8,000 11,000

$156,00
0
10,000

Net cost of purchases

166,000

Cost of goods available for sale

$190,00
0
31,000

Less: Merchandise inventory, 2010
December 31
Cost of goods sold

159,000

Gross Margin

$103,000

Operating expenses:
Selling expenses:
Salaries and commissions expense
Salespersons' travel expense

$
26,000
3,000

Delivery expense

2,000

Advertising expense

4,000

Rent expense—store building

2,500

Supplies expense

1,000

Utilities expense

1,800

Depreciation expense—store equipment

700

Other selling expense

400

$41,400

Administrative expenses:
Salaries expense, executive

$29,000

Rent expense—administrative building

1,600

Insurance expense

1,500

Supplies expense

800

Depreciation expense—office equipment

1,100

Other administrative expenses

300

34,300

Total operating expenses

75,700

Income from operations

$ 27,300

Nonoperating revenues and expenses:
Nonoperating revenues:
Interest revenue
Nonoperating expenses:

1,400
$ 28,700

Interest expense

600

Net income

$ 28,100

Exhibit 39: Classified income statement for a merchandising company
Accounting Principles: A Business Perspective

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...
The terms in some of these
headings are already familiar to you
...

• Operating revenues are the revenues generated by the major activities of the business—usually the sale

of products or services or both
...
Note the cost of goods sold section

of the classified income statement in Exhibit 39
...
Merchandisers usually highlight the amount by which sales revenues exceed the
cost of goods sold in the top part of the income statement
...
To express gross margin as a percentage rate, we divide gross margin by net
sales
...
3 per cent (USD 103,000/USD 262,000)
...
Business owners watch the gross margin rate closely since a small percentage
fluctuation can cause a large dollar change in net income
...
For instance, one Southeastern sporting goods company,
SportsTown, Inc
...

• Operating expenses for a merchandising company are those expenses, other than cost of goods sold,

incurred in the normal business functions of a company
...
Selling expenses are expenses a company incurs in selling and
marketing efforts
...
Administrative expenses are expenses a company
incurs in the overall management of a business
...

Certain operating expenses may be shared by the selling and administrative functions
...
Expenses covering
both the selling and administrative functions must be analyzed and prorated between the two functions on the
income statement
...

• Nonoperating revenues (other revenues) and nonoperating expenses (other expenses) are revenues

and expenses not related to the sale of products or services regularly offered for sale by a business
...
An example of a nonoperating
expense is interest incurred on money borrowed by the company
...

• Net purchases = Purchases - (Purchase discounts + Purchase returns and allowances)
...
0 License
• Net cost of purchases = Net purchases + Transportation-in
...

• Gross margin = Net sales - Cost of goods sold
...

• Net income = Income from operations + Nonoperating revenues - Nonoperating expenses
...
For example, a company may produce a high gross margin on sales
...
The classifications in the income statement allow a user to focus on the whole picture as well as on how net
income was derived (statement relationships)
...
The company buys
approximately USD 500 million of auto parts each year from small suppliers all over the world and
resells them to auto repair shops in the United States
...
John has instructed his personnel to
pay invoices on the 30th day after the invoice date but to take the 2 per cent discount even though
they are not entitled to do so
...
When some of his own employees
questioned the practice, John responded as follows:
This practice really does no harm
...
For most of them, we are their largest customer
...
Last year our profits were USD 100 million
...
Do you really want me to change this practice and give
up USD 10 million of our profits?

Analyzing and using the financial results—Gross margin percentage
As discussed earlier, you can calculate the gross margin percentage by using the following formula:
Gross margin percentage=

Gross margin
Net sales

To demonstrate the use of this ratio, consider the following information from the 2000 Annual Report of
Abercrombie & Fitch
...
6
509
...
9
450
...
2
331
...
5/$1,238
...
13% $450
...
9 = 43
...
4/$805
...
16%

Abercrombie's gross margin held at a rather high 41-43 per cent over those three years
...
Merchandising transactions
You should now understand the distinction between accounting for a service company and a merchandising
company
...

Understanding the learning objectives
• In a sales transaction, the seller transfers the legal ownership (title) of the goods to the buyer
...

• Usually sales are for cash or on account
...
When a sale is on account, the debit is to Accounts Receivable and the credit is to Sales
...

• Two common deductions from gross sales are (1) sales discounts and (2) sales returns and allowances
...
Both the Sales Discounts
account and the Sales Returns and Allowances account normally have debit balances
...

• Sales discounts arise when the seller offers the buyer a cash discount of 1 per cent to 3 per cent to induce

early payment of an amount due
...
A sales allowance is a deduction from the original invoiced sales price
granted to a customer when the customer keeps the merchandise but is dissatisfied
...


Net cost of purchases= Purchases−Purchase discountsPurchase returns Transportation−¿
• Two methods of accounting for inventory are perpetual inventory procedure and periodic inventory

procedure
...
Under periodic inventory procedure, the inventory account is updated only periodically—
after a physical count has been made
...

• Two common deductions from purchases are (1) purchase discounts and (2) purchase returns and

allowances
...
From the buyer's side of
the transactions, cash discounts are purchase discounts, and merchandise returns and allowances are purchase
returns and allowances
...

• FOB destination means free on board at destination—the seller incurs the freight
...

• Freight prepaid is when the seller must initially pay the freight at the time of shipment
...


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Beginning inventory +

Net cost of purchases = Cost of goods available for sale
...

• A classified income statement has four major sections—operating revenues, cost of goods sold, operating

expenses, and nonoperating revenues and expenses
...

• Cost of goods sold is the major expense in merchandising companies
...
Usually, operating expenses are classified as either selling
expenses or administrative expenses
...

•

Gross margin percentage=

Gross margin
Net sales

• The gross margin rate indicates the amount of sales dollars available to cover expenses and produce

income
...

• Any revenue accounts and contra purchases accounts in the Adjusted Trial Balance credit column of the

work sheet are carried to the Income Statement credit column
...
Purchases, Transportation-In, and expense accounts in the

Adjusted Trial Balance debit column are carried to the Income Statement debit column
...

• Closing entries may be prepared directly from the work sheet
...
The second entry credits all
items appearing in the Income Statement debit column and debits Income Summary
...
The fourth entry
debits the Retained Earnings account and credits the Dividends account
...
Lyons Company is a small sporting goods firm
...
Thus, we do not show the fixed
assets (land, building, and equipment)
...
Recall that use of a work sheet assists in the
preparation of the adjusting and closing entries
...

To further simplify this illustration, assume Lyons needs no adjusting entries at month-end
...
The USD 7,000 merchandise inventory in the trial balance is the

Accounting Principles: A Business Perspective

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...
The sales and sales-related accounts and the purchases and purchases-related accounts
summarize the merchandising activity for December 2010
...
It carries beginning inventory, contra revenue accounts (Sales Discounts, Sales Returns and
Allowances), Purchases, Transportation-In, and expense accounts (Selling Expenses, Administrative Expenses) in
the Adjusted Trial Balance debit column to the Income Statement debit column
...
Lyons enters this amount in the Income Statement credit column
because it is deducted from cost of goods available for sale (beginning inventory plus net cost of purchases) in
determining cost of goods sold
...
The beginning and ending inventories are on the Income
Statement because Lyons uses both to calculate cost of goods sold in the income statement
...
The firm carries the net income to the Statement of
Retained Earnings credit column
...
Lyons Company carries the retained earnings to the Balance Sheet credit column
...
It also carries the liability (Accounts Payable) and Capital Stock account
balances to the Balance Sheet credit column
...

Once the work sheet has been completed, Lyons prepares the financial statements
...
This process clears the records for the next
accounting period
...

Income statement Exhibit 41 shows the income statement Lyons prepared from its work sheet in Exhibit 40
...

Statement of retained earnings The statement of retained earnings, as you recall, is a financial statement
that summarizes the transactions affecting the Retained Earnings account balance
...


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no
...
Merchandising transactions
LYONS COMPANY
Income Statement
For the Month Ended 2010 December 31

Operating revenues:
Gross sales

$14,600

Less: Sales discounts

$ 44

Sales return and allowances

20

Net sales

64
$14,536

Cost of goods sold:
Merchandise inventory, 2010 January 1

$ 7,000

Purchases

$ 6,000

Less: Purchase discount

$ 82

Purchase returns and allowances

100

182

Net purchases

$5,818

Add: Transportation-in

75

Net cost of purchases

5,893

Cost of goods available for sale

$12,893

Less: Merchandise inventory, 2010 December 31

8,000

Cost of goods sold

4,893

Gross Margin

$ 9,643

Operating expenses:
Miscellaneous selling expense

$2,650

Miscellaneous administrative expense

1,150

Total operating expenses

3,800

Net income

$ 5,843

Exhibit 41: Income statement for a merchandising company
LYONS COMPANY
Statement of Retained Earnings
For the Month Ended 2010 December 31

Retained earnings, 2010 December 1
Add: Net income for the month
Total
Deduct: Dividends
Retained earnings, 2010 December 31

$15,000
5,843
$20,843
2,000
$18,843

Exhibit 42: Statement of retained earnings
Assets

LYONS COMPANY
Balance Sheet 2010 December 31

Cash
Accounts receivable
Merchandise inventory
Total assets

$19,663
1,880
8,000
$29,543

Liabilities and Stockholders' Equity

Liabilities:
Accounts payable

$ 700

Stockholders' equity:
Capital stock
Retained earnings
Total stockholders' equity Total liabilities and
stockholders' equity

$ 10,000
18,843
28,843
$29,543

Exhibit 43: Balance sheet for a merchandising company

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...
Note the USD 8,000 ending inventory is a current asset
...

Recall from Chapter 4 that the closing process normally takes place after the accountant has prepared the
financial statements for the period
...
The closing process reduces
the revenue and expense account balances to zero so that information for each accounting period may be
accumulated separately
...
The closing entries for Lyons Company follow
...

2010
Dec
...


8,000
14,600
82
100
22,782

The second entry credits all items appearing in the Income Statement debit column and debits Income
Summary for the total of that column, USD 16,939
...


• 2nd entry

31 Income Summary
Merchandise Inventory (beginning)
Sales Discounts
Sales Returns and Allowance
Purchases
Transportation-In
Miscellaneous Selling Expenses
Miscellaneous Administrative Expenses
To close accounts with a debit balance in the Income
Statement columns
...

2010
Dec
...


5,843

The fourth entry closes the Dividends account balance of $2,000 to the Retained Earnings account by debiting
Retained Earnings and crediting Dividends
...


2,000
31 Retained Earnings
Dividends
To close the Dividends account to the Retained Earnings
account
...
In the first closing journal entry, the credit to the Income Summary account is equal to the total of the
Income Statement credit column
...
Merchandising transactions
subtotal of the Income Statement debit column
...

Demonstration problem
The following transactions occurred between Companies C and D in June 2010:
June 10 Company C purchased merchandise from Company D for USD 80,000; terms 2/10/EOM, n/60, FOB
destination, freight prepaid
...

14 Company C received an allowance of USD 4,000 from the gross selling price because of damaged goods
...

30 Company D received payment in full from Company C
...
Journalize the transactions for Company C
...
Journalize the transactions for Company D
...

Date
2010
June

Account Titles and Explanation
1
0

General Journal

Post
...


Debit

Credit

Company C

Purchases
Accounts Payable

8 0 0 0 0

8 0 0 0 0

Purchased merchandise from Company D; terms
2/10/EOM, n/60
1
4

Accounts Payable

4 0 0 0

Purchase Return and Allowances

4 0 0 0

Received an allowance from Company D for damaged
goods
...
02)

1 3 6 0

Cash ($68,000 - $1,360)

6 6 6 4 0

Paid the amount due to Company D
...

General Journal

Date
2010
June

Account Titles and Explanation
1
0

Company D

Accounts Receivable
Sales

Post
...


Debit
8 0 0 0 0

8 0 0 0 0

Sold merchandise to Company C; terms 2/10/EOM,
n/60
1

Credit

Delivery Expense

1 2 0 0

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...


1
4

Sales Returns and Allowances

4 0 0 0

Accounts Receivable

4 0 0 0

Granted an allowance to Company C for damaged
goods
...

3
0

Cash ($68,000 - $1,360)

6 6 6 4 0

Sales Discounts ($68,000 x 0
...


Key terms
Adjunct account Closely related to another account; its balance is added to the balance of the related
account in the financial statements
...

Cash discount A deduction from the invoice price that can be taken only if the invoice is paid within a
specified time
...

Chain discount Occurs when the list price of a product is subject to a series of trade discounts
...

The statement also separates operating expenses into selling and administrative expenses
...

Consigned goods Goods delivered to another party who attempts to sell the goods for the owner at a
commission
...

Cost of goods sold Shows the cost to the seller of the goods sold to customers; under periodic inventory
procedure, cost of goods sold is computed as Beginning inventory + Net cost of purchases - Ending inventory
...

FOB destination Means free on board at destination; goods are shipped to their destination without charge
to the buyer; the seller is responsible for paying the freight charges
...

Freight collect Terms that require the buyer to pay the freight bill on arrival of the goods
...

Gross margin or gross profit Net sales - Cost of goods sold; identifies the number of dollars available to
cover expenses other than cost of goods sold
...

Gross selling price (also called the invoice price) The list price less all trade discounts
...

Invoice A document prepared by the seller of merchandise and sent to the buyer
...
It
is a purchase invoice from the buyer's point of view and a sales invoice from the seller's point of view
...
Merchandising transactions
Manufacturers Companies that produce goods from raw materials and normally sell them to wholesalers
...

Merchandise inventory The quantity of goods available for sale at any given time
...

Net income Income from operations + Nonoperating revenues - Nonoperating expenses
...

Net sales Gross sales - (Sales discounts + Sales returns and allowances)
...

Nonoperating revenues (other revenues) Revenues not related to the sale of products or services
regularly offered for sale by a business
...

Operating revenues Those revenues generated by the major activities of a business
...

Periodic inventory procedure A method of accounting for merchandise acquired for sale to customers
wherein the cost of merchandise sold and the cost of merchandise on hand are determined only at the end of
the accounting period by taking a physical inventory
...

Physical inventory Consists of counting physical units of each type of merchandise on hand
...

Purchase Discounts account A contra account to Purchases that reduces the recorded gross invoice cost
of the purchase to the price actually paid
...

Purchases account An account used under periodic inventory procedure to record the cost of goods or
merchandise bought for resale during the current accounting period
...

Sales allowance A deduction from original invoiced sales price granted to a customer when the customer
keeps the merchandise but is dissatisfied for any of a number of reasons, including inferior quality, damage,
or deterioration in transit
...

Sales Discounts account A contra revenue account to Sales; it is shown as a deduction from gross sales in
the income statement
...

Sales Returns and Allowances account A contra revenue account to Sales used to record the selling
price of merchandise returned by buyers or reductions in selling prices granted
...

Trade discount A percentage deduction, or discount, from the specified list price or catalog price of
merchandise to arrive at the gross invoice price; granted to particular categories of customers (e
...
retailers
and wholesalers)
...

Transportation-In account An account used under periodic inventory procedure to record inward freight
costs incurred in the acquisition of merchandise; a part of cost of goods sold
...
Also called the
single-step income statement
...
0 License
Wholesalers Companies that normally sell goods to other companies (retailers) for resale
...

To compute net sales, sales discounts are added to, and sales returns and allowances are deducted from, gross
sales
...

Purchase discounts and purchase returns and allowances are recorded in contra accounts to the Purchases
account
...

A classified income statement consists of only two categories of items, revenues and expenses
...

A seller sold merchandise which has a list price of USD 4,000 on account, giving a trade discount of 20 per cent
...
Accounts Receivable
Trade Discounts

3,200
800

Sales
b
...


4,000

Accounts Receivable

3,200

Trade Discounts

800

Sales
d
...
A physical inventory showed USD 72,000 of merchandise unsold at the end of the period
...
USD 300,000
...
USD 228,000
...
USD 252,000
...
USD 168,000
...
None of the above
...
If USD 2,000 of the
merchandise was returned and the remaining amount due was paid within the discount period, the purchase
discount would be:
a
...

b
...

c
...


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...
USD 1,000
...
USD 3,600
...
Operating revenues
...
Cost of goods sold
...
Operating expenses
...
Nonoperating revenues and expenses
...
Current assets
...
A credit to Sales Discounts
...
A credit to Merchandise Inventory for the cost of ending inventory
...
A debit to Purchase Discounts
...
A credit to Transportation-In
...
A debit to Sales
...


Questions
➢

Which account titles are likely to appear in a merchandising company's ledger that do not appear in
the ledger of a service enterprise?

➢

What entry is made to record a sale of merchandise on account under periodic inventory procedure?

➢

Describe trade discounts and chain discounts
...
Why not deduct these directly from the Sales account by debiting Sales each time
a sales discount, return, or allowance occurs?

➢

What are the two basic procedures for accounting for inventory? How do these two procedures
differ?

➢

What useful purpose does the Purchases account serve?

➢

What do the letters FOB stand for? When terms are FOB destination, who incurs the cost of freight?

➢

What type of an expense is delivery expense? Where is this expense reported in the income
statement?

➢

Periodic inventory procedure is said to afford little control over inventory
...


➢

How does the accountant arrive at the total dollar amount of the inventory after taking a physical
inventory?

➢

How is cost of goods sold determined under periodic inventory procedure?

➢

If the cost of goods available for sale and the cost of the ending inventory are known, what other
amount appearing on the income statement can be calculated?

➢

What are the major sections in a classified income statement for a merchandising company, and in
what order do these sections appear?

➢

What is gross margin? Why might management be interested in the percentage of gross margin to
net sales?

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Based on the financial statements of The Limited in the Annual Report
Appendix, what were the 2000 operating expenses? For each of the three years shown, what
percentage of net sales were these expenses? Is the trend favorable or unfavorable?

➢

The Limited, Inc
...
, in the Annual Report
Appendix, what were the 2000 cost of goods sold, occupancy, and buying costs? For each of the three
years shown, what percentage of net sales were these expenses? Is the trend favorable or
unfavorable?

Exercises
Exercise A In the following table, indicate how to increase or decrease (debit or credit) each account, and
indicate its normal balance (debit or credit)
...
Silver Company purchased USD 56,000 of merchandise from Milton Company on account
...

Assuming use of periodic inventory procedure, prepare entries on both companies' books to record both the
purchase/sale and the return
...
Show how any of the required entries would change assuming that Milton Company granted an allowance of
USD 3,360 on the damaged goods instead of giving permission to return the merchandise
...

Exercise D You have purchased merchandise with a list price of USD 36,000
...
6 per cent
...
How much will you
remit if you pay the invoice by the end of the month of purchase? How much will discounts on payment you remit if
you do not pay the invoice until the following month?
Exercise E Lasky Company sold merchandise with a list price of USD 60,000 on July 1
...

Trade Discount

Credit

Date

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...
30%, 20%
b
...
30%, 10%, 5%
d
...
Discount terms
of 2/10, n/30 were available
...

Purchase
Transportation
Terms
a
...
FOB destination
c
...
FOB destination

Freight
Paid (by)

Allowance
Granted

$240 (buyer)
120 (seller)
180 (seller)
192 (buyer)

$480
240
720
120

Exercise G Stuart Company purchased goods for USD 84,000 on June 14, under the following terms: 3/10, n/
30; FOB shipping point, freight collect
...

a
...

b
...
Prepare the entry to record the payment made on that date
...
Determine the cost of goods sold for the
company assuming purchases during the period were USD 40,000, transportation-in was USD 300, purchase
returns and allowances were USD 1,000, beginning inventory was USD 25,000, purchase discounts were USD
2,000, and ending inventory was USD 13,000
...
Net sales = Gross sales - (______________________ + Sales returns and allowances)
...
Cost of goods sold = Beginning inventory + Net cost of purchases - ________ ________
...
Gross margin = ________ ________ - Cost of goods sold
...
Income from operations = __________ _________ - Operating expenses
...
Net income = Income from operations + _________ ________ - ________ ________
...
The ending inventory is USD 96
...

We purposely left out the Statement of Retained Earnings columns since they are not used
...
0 License
Merchandise
Inventory

120

Sales
Sales Discounts

S40
18

Sales Returns
and Allowances

45

Purchases

600

Purchase
Discounts

12

Purchase Returns
and Allowances
Transportation-In

24
36

Exercise L Using the data in the previous exercise prepare closing entries for the preceding accounts
...

Problems
Problem A a
...
1 Sold merchandise on account for USD 288,000; terms 2/10, n/30, FOB shipping point, freight collect
...
Payment for these goods
had not yet been received
...

10 Payment was received for the net amount due from the sale of April 1
...
High Stereo Company engaged in the following transactions in July 2010
...

15 Sold merchandise for USD 64,800, terms 2/10, n/30, FOB destination, freight prepaid
...

20 High Stereo Company was granted an allowance of USD 2,880 on the purchase of July 2 because of damaged
merchandise
...

Prepare journal entries to record the transactions
...
The terms were 3/EOM, n/60, FOB shipping point, freight collect
...

5 The buyer paid the freight bill on the purchase of July 2, USD 1,104
...

On the last day of the discount period, the buyer paid the seller for the merchandise
...

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...

4 Merchandise was purchased for cash, USD 432,000; FOB shipping point, freight collect
...

13 The company sold merchandise on account, USD 288,000; terms 2/10, n/ 30
...

16 Of the merchandise sold June 13, USD 31,680 was returned for credit
...

22 The company collected the amount due on the remaining USD 256,320 of accounts receivable arising from
the sale of June 13
...

26 The company returned USD 57,600 of the merchandise purchased June 24 to the vendor for credit
...

29 The company sold merchandise on account, USD 384,000; terms 2/10, n/30
...

30 Payment was received for the sale of June 15
...

30 Paid the amount due on the purchase of June 24
...

a
...

b
...
Use the account numbers in the chart of accounts
shown in a separate file at the end of the text
...

c
...

d
...
No adjusting entries are needed
...
The company
entered into the following transactions in May 2010:
May 1 The Western Wear Company was organized as a corporation
...

1 Paid rent on administrative offices for May, USD 25,200
...

Freight terms were FOB shipping point, freight collect
...

14 The company sold merchandise on account, USD 315,000; terms 2/10, n/30
...

16 Of the merchandise sold May 14, USD 13,860 was returned for credit
...

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...

25 The company purchased merchandise on account from Bond Company, USD 151,200; terms 2/10, n/30
...

27 Of the merchandise purchased May 25, USD 25,200 was returned to the vendor
...

29 The company sold merchandise on open account, USD 15,120; terms 2/10, n/30
...

30 Cash of USD 100,800 was received from the sale of May 14
...

The inventory on hand at the close of business on May 31 is USD 299,040
...
Prepare journal entries for the transactions
...
Post the journal entries to the proper ledger accounts
...
Assume that all postings are from page 15 of the general journal
...
)
c
...

d
...

e
...

Problem E The following data are for Leone Lumber Company:
LEONE LUMBER COMPANY
Trial Balance
2010 December 31
Acct
...


Account Title

Debits

100
103
105
107
108
112
170
171
200
300
310
410
412
418
500
502
503
505
508
509
510
511
536
540
567

Cash
Accounts Receivable
Merchandise Inventory, 2010 January 1
Supplies on Hand
Prepaid Insurance
Prepaid Rent
Equipment
Accumulated Depreciation—Equipment
Accounts Payable
Capital Stock
Retained Earnings, 2010 January 1
Sales
Sales Returns and Allowances
Interest Revenue
Purchases
Purchases Returns and Allowances
Transportation-In
Advertising Expense
Sales Salaries Expense
Office Salaries Expense
Officers' Salaries Expense
Utilities Expense
Legal and Accounting Expense
Interest Expense
Miscellaneous Administrative Expense

$ 70,640
159,520
285,200
5,360
4,800
57,600
88,000

Credits

$ 17,600
102,800
200,000
219,640
1,122,360

5,160

$ 1,000

$ 500,840

$4,040

$7,840
78,000
138,400
80,800
160,000
4,800
10,000
600
9,880
$1,667,440

$1,667,440

• A total of USD 3,400 of the prepaid insurance has expired
...


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...

• Depreciation expense on store equipment is USD 8,800
...

• Accrued office salaries are USD 3,000
...


Prepare the following:
a
...
Refer to the chart of accounts shown in a separate file at
the end of the text for any other account numbers you need
...
A classified income statement
...

c
...

d
...

e
...

Alternate problems
Alternate problem A a
...
2 Sold merchandise on account for USD 300,000; terms 2/10, n/30, FOB shipping point, freight collect
...

20 A total of USD 10,000 of the merchandise sold on August 2 was returned, and a full refund was made
because it was the wrong merchandise
...

b
...
4 Purchased merchandise on account at a cost of USD 140,000; terms 2/10, n/30, FOB shipping point,
freight collect
...

10 Sold goods for USD 100,000; terms 2/10, n/30
...

14 Paid the amount due on the purchase of August 4
...

Alternate problem B Edwardo Auto Parts Company and Spoon Company engaged in the following
transactions with each other during August 2010:
Aug
...
Trade discounts of 20 per cent and 10 per cent were allowed
...

16 The seller paid the freight charges, USD 2,400
...

20 The seller granted the allowance requested on August 17
...
0 License
The buyer paid the amount due on the last day of the discount period
...

Alternate problem C Gardner Company engaged in the following transactions in June 2010, the company's
first month of operations:
June 1 Stockholders invested USD 384,000 cash and USD 144,000 of merchandise inventory in the business in
exchange for capital stock
...

4 Paid height on the June 3 purchase, USD 5,280
...

10 Sold merchandise on account, USD 230,400; terms 2/10, n/30, FOB shipping point, freight collect
...

12 Paid the amount due on the purchase of June 3
...

14 Paid height on sale of June 13, USD 14,400
...

21 USD 48,000 of the goods sold on June 13 were returned for credit
...

25 Received the amount due on sale of June 10
...

30 Paid sales salaries of USD 57,600 for June
...

The inventory on hand on June 30 was USD 288,000
...
Prepare journal entries for the transactions
...
Post the journal entries to the proper ledger accounts
...
Assume that all postings are from page 10 of the general journal
...
Prepare a trial balance as of 2010 June 30
...
Prepare a classified income statement for the month ended 2010 June 30
...

Alternate problem D Organized on 2010 May 1, Noah Cabinet Company engaged in the following
transactions:
May 1 The stockholders invested USD 900,000 in this new business by purchasing capital stock
...

3 Sold merchandise for cash, USD 28,800
...

7 Returned USD 3,600 of merchandise to String Company due to improper size
...

14 Sold merchandise on account to Texas Company, USD 18,000; terms 2/20, n/30, FOB shipping point, freight
collect
...

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...

18 Received a bill for freight charges of USD 900 from Ball Trucking Company on the purchase from Tan
Company
...

24 Returned USD 2,880 of defective merchandise to Tan Company
...

28 Texas Company remitted balance due on sale of May 14
...

31 Paid miscellaneous selling expenses of USD 7,200
...

The May 31st inventory is USD 57,600
...
Journalize the transactions
...

b
...
Use the account numbers appearing in the chart of account
shown in a separate file at the end of the text
...

(There were no adjusting journal entries
...
Prepare a trial balance
...
Prepare a classified income statement for the month ended 2010 May 31
...


Account Title

Debits

Credits

100

Cash

$ 228,800

103

Accounts Receivable

193,200

105

Merchandise Inventory, 2010 January 1

166,400

108

Prepaid Insurance

11,600

130

Land

240,000

140

Building

440,000

141

Accumulated Depreciation – Building

174

Store Fixtures

175

Accumulated Depreciation – Store Fixtures

44,480

200

Accounts Payable

151,600

300

Capital Stock

400,000

310

Retained Earnings, 2010 January 1

480,720

410

Sales

411

Sales Discounts

14,800

412

Sales Returns and Allowances

8,000

418

Interest Revenue

500

Purchases

501

Purchases Discounts

502

Purchases Returns and Allowances

503

Transportation-In

29,200

505

Advertising Expense

48,000

508

Sales Salaries Expense

256,000

509

Office Salaries Expense

296,000

519

Delivery Expense

18,400

No
...
0 License
540

Interest Expense

8,000
$ 3,432,400

$ 3,432,400

• Depreciation expense on the store building is USD 8,800
...

• Accrued sales salaries are USD 5,600
...

• Cost of merchandise inventory on hand 2010 December 31, is USD 222,000
...
A work sheet for the year ended 2010 December 31
...

b
...
The only administrative expenses are office salaries and insurance
...

c
...

d
...

e
...

Beyond the numbers—Critical thinking
Business decision case A Candy's Shirts, Inc
...
Candy, who is not currently in business, is considering buying these shirts and
then renting a display cart from which to sell these shirts (called a kiosk) in a shopping mall
...

• Candy thinks it would take two years to sell all of the shirts
...

• Rent of the kiosk would be USD 1,500 per month in 2009 and USD 1,600 per month in 2010
...
She could sell the

counters for USD 500 at the end of the second year
...

• Candy would hire employees and pay them USD 1 per shirt sold
...

• Candy and her husband purchased USD 100,000 of capital stock in the business
...
Interest expense on this loan will be USD 52,000 in 2009 and
USD 6,500 in 2010
...
Storage

space costs USD 2,500 per year
...
Prepare estimated income statements for 2009 and 2010 for Candy's business
...
Will Candy have the cash available to pay the bank loan as she planned?

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...
Calculate the gross margin percentage and write an explanation of what the
results mean for each of the three years
...
Identify the 2000, 1999, and 1998 net sales; cost of goods sold; gross profit; selling,
administrative, and general expenses; and operating income
...

Ethics case – Writing experience D Based on the ethics case related to World Auto Parts Corporation,
respond in writing to the following questions:
a
...
Are the small suppliers probably better off going along with the practice?
c
...
sec
...
shtml) to locate one merchandising company's annual report for the most recent year
...
As a team, write a memorandum to
the instructor showing your calculations and commenting on the results
...

Group project F In a team of two or three students, contact a variety of businesses in your area and inquire as
to the types of sales discount terms they offer to credit customers and the types of purchase discount terms they are
offered by their suppliers
...
For instance, the book states that the implied annual rate of interest on terms of 2/10, n/30 is 36
per cent, assuming we use a 360-day year
...

Group project G In a team of two or three students, obtain access to several annual reports of companies in
different industries (see www
...
gov/edgar
...
) Examine their income statements and identify differences in
their formats
...

Using the Internet—A view of the real world
Visit the Fat Brains Toys website at:
http://fatbraintoys
...
What products do they sell? What journal entries would they
make to record sales of these products? Write a report to your instructor summarizing your experience at this site
...
Sales discounts, as well as sales returns and allowances, are deducted from gross sales
...
Under perpetual inventory procedure, the Merchandise Inventory account is debited for each purchase
and credited for each sale
...
Purchase Discounts and Purchase Returns and Allowances are contra accounts to the Purchases account
...


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...
Consigned goods delivered to another party for attempted sale are included in the ending inventory of
the company that sent the goods
...
An unclassified income statement, not a classified income statement, has only two categories of items
...
Trade discounts are not recorded on the books of either a buyer or a seller
...
8= USD 3,200

b
...
Purchase discounts are based on invoice prices less purchase returns and allowances, if any
...
02=USD 200

e
...
Current assets appear on a
classified balance sheet
...
Merchandise Inventory is debited for the cost of ending inventory
...
This practice
does not affect the balance of the Income Summary account or the amount of net income
...
0 License

7
...

• Indicate which costs are properly included in inventory
...

• Explain the advantages and disadvantages of the four major inventory costing methods
...

• Apply net realizable value and the lower-of-cost-or-market method of inventory
...

• Analyze and use the financial results- inventory turnover ratio
...
Similarly, one of the greatest benefits of obtaining an accounting degree is the
broad range of career choices available
...
For example, check out the list of accounting jobs at:
http://www
...
edu/stuaff/career/Majors/accounting
...

One of the primary reasons many students go into accounting is successful job placement
...
Even the relative demand for MIS majors has diminished recently,
while the demand for accounting majors remains strong
...
Another important factor to keep in mind regarding job placement is where you would
like to be three to five years from now
...

Many students pursue an accounting degree because it does not restrict their career opportunities as much as
having a different business degree
...
In fact, many recruiters in business favor accounting
graduates because they recognize an accounting degree as a more difficult business degree to obtain
...
In fact, with some additional courses in systems, an accounting major is well equipped to
pursue a career in any business field including information systems
...
Measuring and reporting inventories
Have you ever taken advantage of a pre-inventory sale at your favorite retail store? Many stores offer bargain
prices to reduce the merchandise on hand and to minimize the time and expense of taking the inventory
...
From Chapter 6 you know that companies use inventory amounts to determine the cost of goods sold; this
major expense affects a merchandising company's net income
...

This chapter discusses merchandise inventory carried by merchandising retailers and wholesalers
...

Merchandising companies determine the quantity of inventory items by a physical count
...
This chapter discusses four accepted methods of costing the items: (1) specific identification; (2) firstin, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average
...

This chapter stresses the importance of having accurate inventory figures and the serious consequences of using
inaccurate inventory figures
...


Inventories and cost of goods sold
Inventory is often the largest and most important asset owned by a merchandising business
...
As an asset, the inventory figure has a direct impact on reporting the solvency of the company in
the balance sheet
...
Thus, the importance of the
inventory figure should not be underestimated
...
On the income statement, a company using periodic
inventory procedure takes a physical inventory to determine the cost of goods sold
...
On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained
earnings
...
Because inventories are consumed or converted into cash within a year or one
operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet
...
In each accounting period, the
appropriate expenses must be matched with the revenues of that period to determine the net income
...
Because
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...
This relationship involves three items:
First, a merchandising company must be sure that it has properly valued its ending inventory
...
Also, overstatement of ending inventory causes current assets, total assets, and retained earnings to be
overstated
...

Second, when a company misstates its ending inventory in the current year, the company carries forward that
misstatement into the next year
...

Third, an error in one period's ending inventory automatically causes an error in net income in the opposite
direction in the next period
...

Exhibit 44 and Exhibit 45 prove that net income for an accounting period depends directly on the valuation of
the inventory
...

ALLEN COMPANY

Income Statement
Sales
Cost of goods available for sale
Ending inventory
Cost of goods sold
Gross margin
Other expenses
Net income
Statement of Retained Earnings
Beginning retained earnings
Net income
Ending retained earnings

For Year Ended 2009 December 31
Ending Inventory
Ending Inventory
Overstated
Correctly Stated
By $5,000
$400,000
$400,000
$300,000
$300,000
35,000
40,000
265,000
260,000
$135,000
$140,000
$85,000
85,000
$ 50,000
$55,000
$120,000
50,000
$170,000

$120,000
55,000
$175,000

Exhibit 44: Effects of an overstated ending inventory
ALLEN COMPANY

Income Statement
Sales
Beginning inventory
Purchases
Cost of goods available for sale
Ending inventory
Cost of goods sold
Gross margin
Other expenses
Net income
Statement of Retained Earnings
Beginning retained earnings
Net income
Ending retained earnings

For Year Ended 2010 December 31
Beginning
Beginning
Inventory
Inventory
Overstated
Correctly Stated
By $5,000
$425,000
$425,000
$ 35,000
$40,000
290,000
290,000
$325,000
$330,000
45,000
45,000
280,000
285,000
$145,000
$140,000
53,500
53,500
$ 91,500
$ 86,500
$170,000
91,500
$261,500

$175,000
86,500
$261,500

Exhibit 45: Effects of an overstated beginning inventory

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...
As a result, Allen has a
gross margin of USD 135,000 and net income of USD 50,000
...
When the ending
inventory is overstated by USD 5,000, as shown on the right in Exhibit 44, the gross margin is USD 140,000, and
net income is USD 55,000
...
The ending inventory overstatement of USD 5,000 causes a USD 5,000 overstatement of net income and a
USD 5,000 overstatement of retained earnings
...
Due to the error in ending inventory, both the stockholders and creditors may
overestimate the profitability of the business
...
Note that the ending inventory in Exhibit 44 now becomes the beginning inventory of Exhibit 45
...
As a result, the
gross margin in the income statement with the beginning inventory correctly stated is USD 145,000, and Allen
Company has net income of USD 91,500 and an ending retained earnings of USD 261,500
...

Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net income, an overstated
beginning inventory results in an understatement of net income
...
Consequently, gross margin and net income
are understated
...
The overstatement of net income in the first year is offset
by the understatement of net income in the second year
...
At
the end of the second year, the balance sheet contains the correct amounts for both inventory and retained
earnings
...

The costs included in inventory depend on two variables: quantity and price
...
They multiply the quantity of
inventory by the unit cost to compute the cost of ending inventory
...
The remainder of the chapter discusses departures from the cost basis of inventory measurement
...
0 License
As briefly described in Chapter 6, to take a physical inventory, a company must count, weigh, measure, or
estimate the physical quantities of the goods on hand
...
Throughout the taking of a physical
inventory, the goal should be accuracy
...
Thus, the count should be
administered as quickly and as efficiently as possible
...
Proper forms are required to record accurate
counts and determine totals
...

Inventory Tag
JMA Corp
...
281

Date

Description

Location
Quantity Counted
Counted by
Checked by
Duplicate Inventory Tag
Inventory Tag No
...
These tags are
consecutively numbered for control purposes
...

The duplicate section facilitates checking discrepancies
...
However, the tag usually
provides space for (1) a detailed description and identification of inventory items by product, class, and model; (2)
location of items; (3) quantity of items on hand; and (4) initials of the counters and checkers
...
Another
team of counters may record its count on the duplicate copy of the tag
...
Only when the inventory counts are completed and checked does management send the final
sheets to the accounting department for pricing and extensions (quantity X price)
...
Later in the chapter we explain the different methods accountants use to cost
inventory
...
Measuring and reporting inventories
Usually, inventory cost includes all the necessary outlays to obtain the goods, get the goods ready to sell, and
have the goods in the desired location for sale to customers
...

• Cost of the buyer's insurance to cover the goods while in transit
...

• Handling costs, such as the cost of pressing clothes wrinkled during shipment
...
The 1986 Tax Reform Act requires companies to assign these costs to inventory for tax
purposes
...

Practical difficulties arise in allocating some of these costs to inventory items
...
Also, assume that the
company wants to include the freight cost as part of the inventory cost of the shirt
...
In practice, allocations of freight,
insurance, and handling costs to the individual units of inventory purchased are often not worth the additional cost
...
Instead, they have expensed these costs as incurred
...
The required
allocation for tax purposes has probably resulted in many companies using the same inventory amounts in their
financial statements
...

Management must consider two other aspects of the problem:
• If goods were purchased at varying unit costs, how should the cost of goods available for sale be allocated

between the units sold and those that remain in inventory? For example, assume Hi-Fi Buys, Inc
...
One cost USD 250 and the other, USD 200
...

Generally companies should account for inventories at historical cost; that is, the cost at which the items were
purchased
...
For example, suppose a retailer has three shirts on
hand
...
If the retailer sells two shirts for USD 30 each,
what is the cost of the two shirts sold?
Accountants developed these four inventory costing methods to solve costing problems: (1) specific
identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average
...


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...
Under periodic inventory procedure, firms
debit the Purchases account when goods are acquired; they use other accounts, such as Purchase Discounts,
Purchase Returns and Allowances, and Transportation-In, for purchase-related transactions
...
They keep no records of the cost of items as they are sold, and have no information on possible inventory
shortages
...


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Item

TV-96874

26

Minimum

Location

Maximum

6

Purchased
2008
Date

Unit
Units Cost

Sold
Total
Cost

Total
Cost

10

$300

7
315

8

320

1,800

315

$2,400

300

5,400

6

300

1,800

300

1,800

10

315

3,150

8

300

315
315

2,520
2,520

320

2,560

630

3,150

22

24

$3,600

6

10

$300

2

12

12

$300

6

$3,000

Total
Cost

8

July 5

Unit
Cost

18

Beg
...


Units
8

Units

Unit
Cost

Balance

2,560

Exhibit 48: Perpetual inventory record (FIFO menthod)
The availability of inventory management software packages is causing more and more businesses to change
from periodic to perpetual inventory procedure
...
Instead, they make all entries involving merchandise purchased for sale
to customers directly in the Merchandise Inventory account
...
At the time of each sale, firms make two entries: the first debits Accounts Receivable or Cash
and credits Sales at the retail selling price
...
Therefore, at the end of the period the Merchandise Inventory account shows the cost of the inventory that
should be on hand
...
Thus, perpetual inventory procedure is an important element in providing internal
control over goods in inventory
...
Both manual and computer
processing maintain a record for each item in inventory
...
This inventory record shows the information on
one particular brand and model of television set carried in inventory
...
The number of units on hand and their cost are readily available also
...
This assumption is the first-in, first-out (FIFO) method
of inventory costing; we will discuss it later
...
Under a manual system, the cost of an up-to-date inventory for stores with high
turnover would outweigh the benefit
...
These bar codes not only provide accurate
sales prices but also record the merchandise sold so that the total cost of the store's inventory is up
to date
...
We explain these differences by using data from Exhibit 48 and making additional
assumptions
...

These entries record the purchase on July 5 under each of the methods:
Periodic Procedure
Purchases (+A)
Accounts Payable (+L)

3,000

3,000

Perpetual Procedure
Merchandise Inventory (+A) 3,000
Accounts Payable (+L)
3,000

Assuming the merchandise sold on July 7 was priced at USD 4,800, these entries record the sale:
Periodic Procedure
Accounts Receivable (+A)
Sales (+SE)

4,800

4,800

Perpetual Procedure
Accounts Receivable (+A) 4,800
Sales (+SE)
4,800
Cost of Goods Sold (-SE)
3,600
Merchandise Inventory(-A)
3,600

Several other transactions not included in Exhibit 48 could occur:
• Assume that two of the units purchased on July 5 were returned to the supplier because they were defective
...
The entries would be:
Periodic Procedure
Accounts Payable (-L)
Purchase
Returns and
Allowances (-A)

600
600

Perpetual Procedure
Accounts Payable (-L)
Merchandise
Inventory (-A)

600
600

• Assume that the company incurred and paid freight charges of USD 100 on the purchase of July 5
...
Also, when goods are sold,
the seller debits (increases) Cost of Goods Sold and credits or reduces Merchandise Inventory
...
The Purchases, Purchase Returns and Allowances, Purchase Discounts,
and Transportation-In accounts do not even exist
...
0 License
Beginning Inventory and Purchases

Sales

Unit

Total

Date

Units

Cost

Cost

Date

Units

Price

Total

Beginning
inventory

10

$8
...
00

$120

March 2

10

8
...
00

240

May 28

20

8
...
00

140

August 12

10

9
...
00

280

October 12

20

8
...
10

91

80

$690

60

$780

Ending inventory = 20 units, determined By taking a physical inventory
...
The name of the item and the price appear on a video display that you can see
...
But this is not the end of the story
...
The information is included with other information and
is used to order more merchandise from the warehouse so the items can be replenished in the
store
...
The paperwork for the purchase and payment are often handled electronically
through a process called electronic data interchange (EDI) and electronic funds transfer (EFT)
...
Except for the specific identification method, we first present all of the methods using periodic
inventory procedure and then present all of the methods using perpetual inventory procedure
...
A physical inventory determined that 20 units are on hand
at the end of the period
...
The questions to be answered are: What
is the cost of the 20 units in inventory? What is the cost of the 60 units sold?
Specific identification The specific identification method of inventory costing attaches the actual cost to
an identifiable unit of product
...
Under the specific identification method, the firm must identify each unit in inventory, unless
it is unique, with a serial number or identification tag
...
The company computes the ending
inventory as shown in Exhibit 50; it subtracts the USD 181 ending inventory cost from the USD 690 cost of goods
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...
Note that you can also determine the cost of goods sold
for the year by recording the cost of each unit sold
...

The specific identification costing method attaches cost to an identifiable unit of inventory
...
Conceptually, the
method matches the cost to the physical flow of the inventory and eliminates the emphasis on the timing of the cost
determination
...


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...
00
9
...
00

$ 80

10
20
20

8
...
40
8
...
This method assumes the first goods purchased are the first goods sold
...

Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis
...

Because a company using FIFO assumes the older units are sold first and the newer units are still on hand, the
ending inventory consists of the most recent purchases
...
If the ending inventory contains more units than acquired in the most recent purchase, it also
includes units from the next-to-the-latest purchase at the unit cost incurred, and so on
...

In Exhibit 51, you can see how to determine the cost of ending inventory under FIFO using periodic inventory
procedure
...
The total cost of ending inventory is USD 179, and the cost of goods sold is USD 511
...
The 80 units in cost of goods available for sale consists of the beginning
inventory and all of the purchases during the period
...
We assume the beginning inventory and other earlier purchases have been sold during the period,
representing the cost of goods sold of USD 511
...
Measuring and reporting inventories
Unit
Cost

Total
Cost

10
10
20

$9
...
80

$ 91
88
$179

10

8
...
50
8
...
00
8
...

In Exhibit 53, we show the use of LIFO under periodic inventory procedure
...
Therefore, when determining the cost of inventory under periodic inventory procedure, the company
lists the oldest units and their costs
...
Thus, ending inventory in Exhibit 53
consists of the 10 units from beginning inventory and the 10 units purchased on March 2
...
Exhibit 54 is a graphic
representation of the LIFO flow of costs under periodic inventory procedure
...
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Units
Ending inventory composed of:
Beginning inventory
March 2 purchase
Ending inventory
Cost of goods sold composed of purchases made on:
December 21
October 12
August 12
May 28

Unit
Cost

Total
Cost

10
10
20

$8
...
50

$ 80
85
$165

10
20
10
20

9
...
80
9
...
40

$ 91
176
90
168
$525
$690
165
$525

Cost of goods available for sale
Ending inventory
Cost of goods sold

Exhibit 53: Determining LIFO cost of ending inventory under periodic inventory procedure

Exhibit 54: LIFO flow of costs under periodic inventory procedure
Weighted-average under periodic inventory procedure The weighted-average method of inventory
costing is a means of costing ending inventory using a weighted-average unit cost
...
Since the units are alike, firms can assign the same unit cost to
them
...

The ending inventory is carried at this per unit cost
...
Note that we compute weightedaverage cost per unit by dividing the cost of units available for sale, USD 690, by the total number of units available
for sale, 80
...
625, meaning that each unit sold or remaining in
inventory is valued at USD 8
...


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...
00

Beginning inventory
Purchases
March 2
May 28
August 12
October 12
December 21
Total
Weighted-average unit cost is
$690 / 80, or $8
...
625 x 20
Cost of goods sold:
$8
...
00

8
...
40
9
...
80
9
...
00
168
...
00
176
...
00
$690
...
50
$517
...
40 168

July 14

10

8
...
40

(D)84

8
...
22

10

10

9
...
00

85

8
...
40

168

10

8
...
40

84

9
...
00

90

9
...
80

176

10

8
...
80

88

9
...
50

(B)85

9
...
7
Oct
...
50

10
Aug
...
50

10

$8
...
10

8
...
50 $85

80

20(F)

10

$8
...
2

Cost

10(B)

Beg
...


Cost

10(A)

Units

Units

20(C)

Cost Cost

Total

10

Units

Unit

10

Date

Unit

8
...


$179

Exhibit 56: Determining FIFO cost of ending inventory under perpetual inventory procedure
FIFO under perpetual inventory procedure Under perpetual inventory procedure, the ending balance in
the Merchandise Inventory account reflects the most recent purchases as a result of making the required entries
during the period
...

Exhibit 56 shows how to determine the cost of ending inventory under FIFO using perpetual inventory procedure
...
The company keeps a
record of the balance in the inventory account as it makes purchases and sells items from inventory
...
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Purchased

Sold

Date
Beg
...


Units

Unit
Cost

Total
Cost

Mar
...
50

$85

Mar
...
40

9
...
80

20
10

9
...
80

91

176

80
85

10

8
...
00
8
...
00

80

8
...
00

80
90

10

8
...
00
8
...
00

80

10
10

90

176

Nov
...
21

9
...
00
8
...
7
Oct
...
40

Total
Cost
80

10
10

85

Unit
Cost
$8
...
50

Total
Cost

168

20
10

Unit
Cost

Units

10
10
10

July 14
Aug
...
00
9
...


$171

Exhibit 57: Determining LIFO cost of ending inventory under perpectual inventory procedure
Notice in Exhibit 56 that each time a sale occurs, the company assumes the items sold are the oldest on hand
...
The balance after the December 21 purchase represents the 20 units from the most
recent purchases
...
During the accounting period, as sales occurred the firm would have debited a total of USD 511 to
Cost of Goods Sold
...
Under FIFO, using either perpetual or periodic inventory procedures results in the same
total amounts for ending inventory and for cost of goods sold
...
Under this procedure, the inventory composition and balance are updated with each purchase
and sale
...
Despite numerous purchases and sales during the year, the ending inventory still includes the 10 units
from beginning inventory in our example
...
The total cost of the 20 units in ending inventory is USD
171; the cost of goods sold is USD 519
...

Applying LIFO on a perpetual basis during the accounting period, as shown in Exhibit 57, results in different
ending inventory and cost of goods sold figures than applying LIFO only at year-end using periodic inventory
procedure
...
) For this reason, if LIFO is applied on a perpetual basis during the period, special
adjustments are sometimes necessary at year-end to take full advantage of using LIFO for tax purposes
...
Measuring and reporting inventories
Complicated applications of LIFO perpetual inventory procedures that require such adjustments are beyond the
scope of this text
...
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Purchased
Date
Beg
...


Units

Mar
...
50

$85

Mar
...
40

9
...
35

8
...
80

10

9
...
00/2
0
e
$175
...
25
...
50/30 = $8
...
c$173
...
929 * rounding difference
...
22

a

8
...
17

165
...
25

82
...
35

250
...
35

83
...
675c

173
...
675
8
...
758

87
...
75

176

Dec 21

167
...
25aA

30

90

Sept
...
12

$82
...
00

20

B

Unit
Cost
$8
...
25

Total
Cost

168

10

Unit
Cost

Units
10
20

10

July 14
Aug
...
929e

$178
...
75
c

262
...
675
...
75/30 = $8
...


A

A new unit cost is calculated after each purchase
...
C Balance
of $178
...


Exhibit 59: Determining ending inventory under weighted-average method using perpetual inventory procedure
Look at Exhibit 58 and Exhibit 54, the flow of inventory costs under LIFO using both the perpetual and periodic
inventory procedures
...

Weighted-average under perpetual inventory procedure Under perpetual inventory procedure, firms
compute a new weighted-average unit cost after each purchase by dividing total cost of goods available for sale by
total units available for sale
...
In
Exhibit 59, you can see how to compute the moving weighted-average using perpetual inventory procedure
...
The unit cost of the 20 units in ending inventory is USD 8
...
58
...
58, or USD 511
...

Advantages and disadvantages of specific identification Companies that use the specific identification
method of inventory costing state their cost of goods sold and ending inventory at the actual cost of specific units
sold and on hand
...
This statement is true for some one-of-a-kind
items, such as autos or real estate
...

One disadvantage of the specific identification method is that it permits the manipulation of income
...
One unit cost
USD 2,000, the second cost USD 2,100, and the third cost USD 2,200
...

The units are alike, so the customer does not care which of the identical units the company ships
...

Advantages and disadvantages of FIFO The FIFO method has four major advantages: (1) it is easy to
apply, (2) the assumed flow of costs corresponds with the normal physical flow of goods, (3) no manipulation of

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All the advantages of FIFO occur because when a company sells goods, the first costs it removes from
inventory are the oldest unit costs
...
Instead, the cost attached to the unit sold is always the
oldest cost
...

The disadvantages of FIFO include (1) the recognition of paper profits and (2) a heavier tax burden if used for
tax purposes in periods of inflation
...

Advantages and disadvantages of LIFO The advantages of the LIFO method are based on the fact that
prices have risen almost constantly for decades
...
Inventory, or paper, profits are equal to the current
replacement cost of a unit of inventory at the time of sale minus the unit's historical cost
...
The sales price of the unit normally rises because the unit's
replacement cost is rising
...
FIFO gross margin would be USD
18 (USD 30 – USD 12), while LIFO would show a gross margin of USD 10 (USD 30 – USD 20)
...
Thus, the profit is not real; it exists only on paper
...
LIFO shows the actual profits that
the company can distribute to the owners while still replenishing inventory
...
The larger the cost of goods sold, the smaller
the net income
...
When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in
current dollars
...

Supporters of FIFO argue that LIFO (1) matches the cost of goods not sold against revenues, (2) grossly
understates inventory, and (3) permits income manipulation
...
LIFO supporters contend that
it makes more sense to match current costs against current revenues than to worry about matching costs for the
physical flow of goods
...
A company may report LIFO inventory
at a fraction of its current replacement cost, especially if the historical costs are from several decades ago
...

The third criticism—that LIFO permits income manipulation—is also valid
...
For example, assume that management wishes to reduce income
...
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goods in the next period
...
To obtain higher income, management could delay
making the normal amount of purchases until the next period and thus include some of the older, lower costs in
cost of goods sold
...
The Internal Revenue Service allows companies to use LIFO for tax purposes only if they use
LIFO for financial reporting purposes
...
Because of high inflation during the 1970s, many companies
switched from FIFO to LIFO for tax advantages
...
Inventory is not as badly understated as under LIFO, but it is not as up-to-date as under
FIFO
...
A company can manipulate income under
the weighted-average costing method by buying or failing to buy goods near year-end
...

The four inventory costing methods, specific identification, FIFO, LIFO, and weighted-average, involve
assumptions about how costs flow through a business
...
For example, fresh meats and dairy products must flow in a FIFO manner to avoid
spoilage losses
...
Gasoline held in a tank is a good example of an inventory that has an
average physical flow
...
Thus, any amount used is a blend
of the old gas with the new
...
In fact, good reasons exist for simply ignoring physical flows and choosing an inventory method based on
other criteria
...
The
differences for the four methods occur because the company paid different prices for goods purchased
...
Since a company's purchase prices are seldom constant,
inventory costing method affects cost of goods sold, inventory cost, gross margin, and net income
...

Which is the correct method? All four methods of inventory costing are acceptable; no single method is the
only correct method
...

If a company wants to match sales revenue with current cost of goods sold, it would use LIFO
...
On the other hand, LIFO often
charges against revenues the cost of goods not actually sold
...

The FIFO and specific identification methods result in a more precise matching of historical cost with revenue
...
The
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...
Only under FIFO is the manipulation of net income
not possible
...
) to use
...
Then, it must use the selected method consistently
...
Note in the following footnote from Kellwood's financial
statements that it, like other companies, uses several costing methods within the same enterprise:
Summary of significant accounting policies
3
...
The first-in, first-out (FIFO) method is used
to determine the value of 46 per cent of the domestic inventories, and the last-in, first-out (LIFO)
method is used to value the remaining domestic inventories
...
Sales are recognized when goods are shipped
...
However, this
freedom of choice does not include changing inventory methods every year or so, especially if the goal is to report
higher income
...
Consistency of
methods in preparing financial statements enables financial statement users to compare statements of a company
from period to period and determine trends
...
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Specific
Identification
Sales
$780
...
00
Purchases
610
...
00
Ending inventory
181
...
00
Gross Margin
$271
...
00

LIFO
$780
...
00

$ 80
...
00
$690
...
00
$511
...
00

$ 80
...
00
$690
...
00
$519
...
00

$ 80
...
00
$690
...
58
$511
...
58

Exhibit 60: Effects of different inventory costing methods using perpetual inventory procedure
Specific
Identification
$780
...
00
Purchases
610
...
00
Ending inventory
181
...
00
Gross Margin
$271
...
00

LIFO
$780
...
00

$ 80
...
00
$690
...
00
$511
...
00

$ 80
...
00
$690
...
00
$525
...
00

$ 80
...
00
$690
...
50
$517
...
50

Exhibit 61: Effects of different inventory costing methods using periodic inventory procedure

An accounting perspective:
Business insight
Sometimes, companies change inventory methods in spite of the principle of consistency
...
A company
that changes its inventory method must make a full disclosure of the change
...
The footnote consists of a
complete description of the change, the reasons why the change was made, and, if possible, the
effect of the change on net income
...
M
...
, sells a diverse range of metals (aluminum, brass, copper, steel, stainless
steel, and nickel alloys) for severe corrosion conditions and high-temperature applications
...
M
...
Change in accounting method for inventory
The company changed its method of determining inventory cost from the lower of average cost
or market method to the last-in, first-out (LIFO) method for substantially all inventory
...

Now we illustrate in more detail the journal entries made when using perpetual inventory procedure
...

You would debit the Merchandise Inventory account to record the increases in the asset due to purchase costs
and transportation-in costs
...
The balance in
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...
This entry records the purchase of 10
units on March 2 in Exhibit 56:
Mar
...
50 on
account
...
Perpetual inventory
procedure requires two journal entries for each sale
...
The other entry is at cost—a debit to Cost of Goods Sold and a credit to Merchandise
Inventory
...


10 Accounts Receivable (+A)
Sales (+SE)
To record 10 units sold at $13 each on account
...


130
130
80

80

When a company sells merchandise to customers, it transfers the cost of the merchandise from an asset account
(Merchandise Inventory) to an expense account (Cost of Goods Sold)
...
Thus, the Cost of
Goods Sold account accumulates the cost of all the merchandise that the company sells during a period
...
Assume that a customer returned
merchandise that cost USD 20 and originally sold for USD 32
...


17 Sales Return and Allowances (-SE)
Accounts Receivable (-A)
To record the reduction in amount owed by a
customer upon return of goods
...


17 Merchandise Inventory (+A)
Cost of Goods Sold (+SE)
To record replacement of goods returned to
inventory
...
In contrast, sales allowances granted to customers affect only revenues because the
customers do not have to return goods
...

The balance of the Merchandise Inventory account is the cost of the inventory that should be on hand
...
The cost of inventory that should
be on hand is readily available
...
Management
may investigate any major discrepancies between the balance in the account and the cost based on the physical
count
...
When a shortage is discovered, an adjusting entry is
required
...


31 Loss from Inventory Shortage (-SE)
Merchandise Inventory (-A)
To record inventory shortage

15

15

302

This book is licensed under a Creative Commons Attribution 3
...
There are no other purchase-related accounts to be closed
...


31 Income Summary
Cost of Goods Sold
To close Cost of Goods Sold account to Income
Summary at the end of the year
...
However, some
circumstances justify departures from historical cost
...
A decline in the selling price of the goods or their replacement cost may
indicate such a loss of utility
...

Companies should not carry goods in inventory at more than their net realizable value
...
Damaged, obsolete, or shopworn goods often have a net realizable value lower than their historical
cost and must be written down to their net realizable value
...
Technological changes and increased competition have caused significant
reductions in selling prices for such products as computers, TVs, DVD players, and digital cameras
...
The dealer acquired the auto at a cost of USD 18,000
...
Since the dealer used the auto as a demonstrator and the new models are coming in, the auto now
has an estimated selling price of only USD 18,100
...
This
work and the sales commission cost USD 300
...
For inventory purposes, the required journal entry is:
Loss Due to the Decline in Market Value of Inventory (-SE)
Merchandise Inventory (-A)
To write down inventory to net realizable value ($18,000 $17,800)

200

200

This entry treats the USD 200 inventory decline as a loss in the period in which the decline in utility occurred
...
If net realizable value declines but
still exceeds cost, the dealer would continue to carry the item at cost
...
The term cost refers to historical cost of
inventory as determined under the specific identification, FIFO, LIFO, or weighted-average inventory method
...
The basic
assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or
will fall
...

Under LCM, inventory items are written down to market value when the market value is less than the cost of the
items
...
Then,
the company would record a USD 400 loss because the inventory has lost some of its revenue-generating ability
...
Measuring and reporting inventories
The company must recognize the loss in the period the loss occurred
...
To
do so would recognize revenue before the time of sale
...
To see how the company would apply the method to individual items and total
inventory, look at Exhibit 62
...
The company would deduct
the USD 5,000 ending inventory from cost of goods available for sale on the income statement and report this
inventory in the current assets section of the balance sheet
...
One class might be games; another might be toys
...
If LCM is applied on a total
inventory basis, ending inventory would be USD 5,100, since total cost of USD 5,100 is lower than total market of
USD 5,150
...
The report states that "substantially
all inventories are valued at cost as determined by the last-in, first-out (LIFO) method; in the aggregate, such
valuations are not in excess of market"
...


An accounting perspective:
Business insight
Procter & Gamble markets a broad range of laundry, cleaning, paper, beauty care, health care,
food, and beverage products around the world
...

Inventories are valued at cost, which is not in excess of current market price
...
The replacement cost of
last-in, first-out inventories exceeds carrying value by approximately USD 169 [million]
...
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Item
1
2
3

Quantity
100 units
200 units
500 units

Unit
Cost
$10
8
5

Unit
Market
$9
...
7 5
5
...
The effort of taking a physical inventory can be very expensive and disrupts normal business
operations; once a year is often enough
...

• To determine the amount recoverable from an insurance company when fire has destroyed inventory or the

inventory has been stolen
...

Gross margin method The steps in calculating ending inventory under the gross margin method are:
• Estimate gross margin (based on net sales) using the same gross margin rate experienced in prior

accounting periods
...

• Determine estimated ending inventory by deducting estimated cost of goods sold from cost of goods

available for sale
...

The gross margin method assumes that a fairly stable relationship exists between gross margin and net sales
...
If this percentage relationship has changed, the gross margin method does not yield
satisfactory results
...
The following data for 2010 are available: The January 1
inventory was USD 40,000; net cost of purchases of merchandise was USD 480,000; and net sales of merchandise
were USD 700,000
...


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...
At year-end, a
physical inventory must be taken and valued by either the specific identification, FIFO, LIFO, or weighted-average
methods
...
Taking a physical inventory during an accounting period (such as monthly
or quarterly) is too time consuming and significantly interferes with business operations
...
The advantage of this method is that companies can estimate ending inventory (at cost) without
taking a physical inventory
...
The steps for finding the ending inventory by the retail
inventory method are:
• Total the beginning inventory and the net amount of goods purchased during the period at both cost and

retail prices
...

• Deduct the retail sales from the retail price of the goods available for sale to determine ending inventory at

retail
...


306

This book is licensed under a Creative Commons Attribution 3
...
In the exhibit, the cost (USD 22,000) and retail (USD
40,000) amounts for beginning inventory are available from the preceding period's computation
...
The amounts for purchase allowances and transportation-in appear only in the cost column
...
The
difference between what was available for sale at retail prices and what was sold at retail prices (which is sales)
equals what should be on hand (March 31 inventory of USD 60,000) expressed in retail prices
...
We do this by
multiplying it times the cost/retail price ratio
...
To find the 2010 March 31, inventory at cost
(USD 36,000), we multiplied the ending inventory at retail (USD 60,000) by 60 per cent
...
We can also find the
cost of goods sold by multiplying the cost/retail price ratio of 60 per cent by sales of USD 280,000
...
We would include other quarterly data regarding purchases,
purchase returns, purchase allowances, and transportation-in to determine goods available for sale at cost and at
retail
...

At the end of each year, merchandisers usually take a physical inventory at retail prices
...
Accountants can then compare the results of the physical inventory to the calculation of
inventory at retail under the retail inventory method for the fourth quarter to determine whether a shortage exists
...
To illustrate
how you can determine inventory shortages using the retail method, assume that a physical inventory taken at year
end, showed only USD 62,000 of retail-priced goods in the store
...
After converting the USD 4,000 to USD 2,400 of cost (USD 4,000 X 0
...
Knowledge of such shortages may lead management
to reduce or prevent them, by increasing security or improving the training of employees
...
Measuring and reporting inventories

An ethical perspective:
Dorsey hardware
Terry Dorsey started Dorsey Hardware, a small hardware store, two years ago and has struggled to
make it successful
...
His initial cash investment was almost depleted because he had to
withdraw money for living expenses
...
His
customer base was growing and seemed to be loyal
...

At the end of the third year, Terry's accountant asked him for his ending inventory figure and later
told him that initial estimates indicated that net income (and taxable income) for the year would be
approximately USD 80,000
...
He told the accountant that he did not have enough cash
to pay the taxes and could not even borrow it, since he already had an outstanding loan at the bank
...
He noticed that ending inventory of USD
160,000 had been deducted from cost of goods available for sale of USD 640,000 to arrive at cost of
goods sold of USD 480,000
...
But Terry hit on a scheme to reduce his net income
...
This lower inventory amount would increase cost of goods sold by USD 40,000 and
reduce net income by that same amount
...

To justify his action in his own mind, Terry used the following arguments: (1) federal taxes are too
high, and the federal government seems to be taxing the little guy out of existence; (2) no harm is
really done because, when the business becomes more profitable, I will use correct inventory
amounts, and this loan from the government will be paid back; (3) since I am the only one who
knows the correct ending inventory I will not get caught; and (4) I bet a lot of other people do the
same thing
...
This ratio tests whether a company is generating a sufficient volume of business based
on its inventory
...
A high inventory turnover is generally a sign of efficient inventory management
and profit for the firm; the faster inventory sells, the less time funds are tied up in inventory
...
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turnover could be the result of a company carrying too much inventory or stocking inventory that is obsolete, slowmoving, or inferior
...
When making comparisons among
firms, they check the cost-flow assumption used to value inventory and cost of products sold
...

Beginning inventory
...


$728,229
75,262
120,997

Their inventory turnover is:
USD 728,229/[(USD 75,262 + USD 120,997)/2] = 7
...
In the next chapter, you will learn the general principles of internal control and how to control cash
...

Understanding the learning objectives
• Net income for an accounting period depends directly on the valuation of ending inventory
...

• When ending inventory is misstated in the current year, companies carry that misstatement forward into

the next year
...

• Inventory cost includes all necessary outlays to obtain the goods, get the goods ready to sell, and have the

goods in the desired location for sale to customers
...
Seller's gross selling price less purchase discount
...
Cost of insurance on the goods while in transit
...
Transportation charges when borne by the buyer
...
Handling costs, such as the cost of pressing clothes wrinkled during shipment
...
Specific identification creates precise matching in determining net income
...
FIFO assumes that

the costs of the first goods purchased are those charged to cost of goods sold when goods are sold
...

• LIFO (last-in, first-out): Ending inventory consists of the oldest costs
...
Net income is usually lower under
LIFO since the costs charged to cost of goods sold are higher due to inflation
...

• Weighted-average: Ending inventory is priced using a weighted-average unit cost
...
Under periodic procedure,
the average is determined at the end of the accounting period by dividing the total number of units purchased
plus those in beginning inventory into total cost of goods available for sale
...
Measuring and reporting inventories
this average unit cost is applied to each item
...

• Specific identification: Advantages: (1) States cost of goods sold and ending inventory at the actual cost

of specific units sold and on hand, and (2) provides the most precise matching of costs and revenues
...

• FIFO: Advantages: (1) FIFO is easy to apply, (2) the assumed flow of costs often corresponds with the

normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for
inventory is likely to approximate the current market value
...

• LIFO: Advantages: (1) LIFO reports both sales revenue and cost of goods sold in current dollars, and (2)

lower income taxes result if used for tax purposes when prices are rising
...

• Weighted-average: Advantages: Due to the averaging process, the effects of year-end buying or not

buying are lessened
...

• Perpetual inventory procedure requires an entry to Merchandise Inventory whenever goods are purchased,

returned, sold, or otherwise adjusted, so that inventory records reflect actual units on hand at all times
...

• Companies should not carry goods in inventory at more than their net realizable value
...
Inventory items are written down to market value when the market value is less than the cost of the
items
...
LCM may be applied to each
inventory item, each inventory class, or total inventory
...
Estimate gross margin (based on net sales) using the same gross margin rate experienced in prior
accounting periods
...
Determine estimated cost of goods sold by deducting estimated gross margin from net sales
...
Determine estimated ending inventory by deducting estimated cost of goods sold from cost of goods
available for sale
...
To find the cost/retail price ratio, divide the cost of goods available
for sale by the retail price of the goods available for sale
...
It gauges the

liquidity of the firm's inventory
...
0 License
and Purchases
Units
Beginning inventory 6,250
March 15 5,000
May 10 8,750
August 12 6,250
November 20 3,750
30,000

@
@
@
@
@

Unit
Cost
$3
...
12
3
...
48
3
...
Compute the ending inventory under each of the following methods:
Specific identification (assume ending inventory is taken equally from the August 12 and November 20
purchases)
...

(b) Assume use of periodic inventory procedure
...

(b) Assume use of periodic inventory procedure
...

(b) Assume use of periodic inventory procedure
...
)
b
...

Demonstration problem B a
...
USD 27,200
2008
...
USD 24,000
Analysis of the inventories shows that certain clerical errors were made with the following results:
Incorrect inventory amount

Correct inventory amount

2007 December 31

$4,800

$5,680

2008 December 31

5,600

4,680

What is the corrected net income for 2007, 2008, and 2009?
b
...

Compute an estimated value of the ending inventory using the gross margin method
...
The records of Draper Company show the following account balances at year-end:
Merchandise inventory, January 1
Purchases
Transportation-in
Sales

Cost

...


Accounting Principles: A Business Perspective

311

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...
The ending inventory is 5,000 units, calculated as follows:
Beginning inventory
Purchases
Goods available
Sales
Ending inventory

Units
6,250
23,750
30,000
25,000
5,000

Ending inventory under specific identification:
Purchased

Units

November 20
August 12

2,500
2,500

Unit
Cost
$3
...
48

Total
Cost
$ 9,300
8,700
$ 18,000

2
...
0 License
Date

Purchased
Unit Total
Units
Cost Cost

1,000
3,500
8,750

Aug
...
00
3
...
30 28,875
3
...
16
Oct
...
20

$3
...
12 $15,600

May 4
May 10

Sold
Unit
Cost

5,250

Beg
...

Feb
...
15 5,000

Units

3,750

3
...
12
3
...
30
3
...
48)

Total
Cost

Balance
Unit

Units

6,250
$15,750 1,000
1,000
5,000
3,000
1,500
10,920
1,500
8,750
1,500
8,750
6,250
4,680
2,250
21,450 6,250
7,425
1,250
17,400
1,250
3,750
+ (3,750 X $3
...
00
3
...
00
3
...
12

$18,750
3,000
3,000
15,600
4,680

3
...
30
3
...
30
3
...
30
3
...
48

4,680
28,875
4,680
28,875
21,750
7,425
21,750
4,350

3
...
72
$18,300

4,350
13,950

(b) Periodic:
Purchased

Units

November 20
August 12

Unit
Cost
$3
...
48

3,750
1,250
5,000

Total
Cost
$ 13,950
4,350
$ 18,300 *

*Note that the cost of ending
inventory is the same as under
perpetual
...
Ending inventory under LIFO:
(a) Perpetual:
Purchased
Date

Unit
Cost

Total
Cost

Units

Unit
Cost

Total
Cost

Beg
...

Feb
...
15

5,250
5,000

$3
...
12

14,040

Sept
...
48
3
...
9

7,000
250

3
...
12

23,100
780

May 10
Aug
...
20

8,750

3
...
48

21,750

3,750

Ending inventory
=

$3
...
00

3,000

3
...
12
3
...
12
3
...
12
3
...
00
3
...
30
3
...
00
3
...
30
3
...
12
3
...
12
3
...
12 $15,600

May 4

Units

Balanc
e
Unit

6,250

Units

Sold

3
...
00) + (250 X $3
...
72) =

(b) Periodic:

Accounting Principles: A Business Perspective

313

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...
00

Units
5,000

Total
Cost
$ 15,000

4
...
inv
...
3
Mar
...
00

4,500

3
...
12 $15,600

Balance
Unit
Units
Cost
Total Cost
6,250 $3
...
0000 3,000
6,000
3
...
30 28,875

Aug
...
48 21,750

1,500
10,250

3
...
2707

4,650
33,525

b

16,500

3
...
16
Oct
...
20

3,750

3
...
35
3
...
000

3
...
3500
3
...
6274) =
$18,137
a
$18,600 = $3
...
2707 c $55,275 = $3
...

Unit
(b) Periodic
Purchased
Units
Cost
M e r c h a n d i s e I n v e n t o r y, J a n u a r y 6 , 2 5 0
$3
...
12

May 10

8 ,7 5 0

3
...
48

November 20

3 ,7 5 0

3
...
2975
Ending inventory cost = $3
...
Journal entries under LIFO perpetual:

314

$3
...
0 License
Feb
...


15

May

4
10

Aug
...
16

Oct
...


20

Cost of Goods Sold (-SE)
Merchandise Inventory (-A)
To record cost of $3 on 5,200 units sold
Merchandise Inventory (+A)
Accounts Payable (+L)
To record purchase of 5,000 units at $3
...

Cost of Goods Sold (-SE)
Merchandise Inventory (-A)
To record cost of $3
...

Merchandise Inventory (+A)
Accounts Payable (+L)
To record purchase of 8,750 units at $3
...

Merchandise Inventory (+A)
Accounts Payable (+L)
To record purchase of 6,250 units at $3
...
48 and $3
...

Cost of Goods Sold (-SE)
Merchandise Inventory (-A)
To record costs of $3
...
12 on 7,000 units
and 250 units sold, respectively
...
72 on
account
...
Corrected net income:
Net income as reported
Adjustments
(1)
(2)

2007
$ 27,200

2008
28,400

2009
24,000

Total
$ 79,600

920
24,920

$ 79,600

880
(880)
(920)

(3)
Corrected net income
$ 28,080
26,600
(1) Ending inventory understated ($ 5,680 - $ 4,800 = $ 880)
(2) Beginning inventory understated (5,680 – 4,800 = 880)
Ending inventory overstated (5,600 – 4,680 = 920)
(3) Beginning inventory overstated (5,600 – 4,680 = 920)

b
...
30)
Estimated cost of goods sold
Inventory at cost, estimated by
gross margin method
...
Computation of inventory:
Merchandise Inventory, January 1
Purchases
Transportation-in
Goods available for sale
$
Cost/retail price ratio:
$87,500/$125,000 = 70%
Sales

Accounting Principles: A Business Perspective

Cost
$ 17,600

Retail
$ 25,000

68,000
1,900
$ 87,500

100,000
—
$ 125,000

101,000

315

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...


$24,000
X
70%
$ 16,800

Key terms
FIFO (first-in, first-out) A method of costing inventory that assumes the costs of the first goods
purchased are those charged to cost of goods sold when the company actually sells goods
...
The estimated gross margin is calculated using gross margin rates (in
relation to net sales) of prior periods
...

Inventory turnover ratio Cost of goods sold/Average inventory
...

Lower-of-cost-or-market (LCM) method An inventory costing method that values inventory at the
lower of its historical cost or its current market (replacement) cost
...

Net realizable value Estimated selling price of an item less the estimated costs incurred in preparing the
item for sale and selling it
...

Specific identification method An inventory costing method that attaches the actual cost to an
identifiable unit of product
...

Under perpetual inventory procedure, a new weighted-average is calculated after each purchase
...
Units in the ending inventory are
carried at this per unit cost
...

Overstated ending inventory results in an overstatement of cost of goods sold and an understatement of gross
margin and net income
...

Under LCM, inventory is written down to market value when the market value is less than the cost, and
inventory is written up to market value when the market value is greater than the cost
...

To use the retail inventory method, both cost and retail prices must be known for the goods available for sale
...

Multiple-choice
Select the best answer for each of the following questions
...
During the period,
the company purchased an additional 5,000 units at USD 36 each and sold 4,600 units
...


316

This book is licensed under a Creative Commons Attribution 3
...
USD 104,400
...
USD 122,400
...
USD 120,000
...
USD 147,600
...
None of the above
...
USD 165,600
...
USD 150,000
...
USD 147,600
...
USD 122,400
...
None of the above
...
USD 104,400
...
USD 114,750
...
USD 156,000
...
USD 122,400
...
None of the above
...
USD 155,250
...
USD 114,000
...
USD 147,600
...
USD 165,600
...
None of the above
...
USD 114,750
...
USD 157,600
...
USD 122,400
...
USD 109,650
...
None of the above
...
USD 147,200
...
USD 160,350
...
USD 155,250
...
USD 114,000
...
None of the above
...
Weighted-average
...
FIFO
...
LIFO
...
Measuring and reporting inventories
d
...

e
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
Is the same opportunity
available under FIFO? Why or why not?

➢

What are the main advantages of using FIFO and LIFO?

➢

Which inventory method is the correct one? Can a company change inventory methods?

➢

Why are ending inventory and cost of goods sold the same under FIFO perpetual and FIFO periodic?

➢

Would you agree with the following statement? Reducing the amount of taxes payable currently is a
valid objective of business management and, since LIFO results in such a reduction, all businesses
should use LIFO
...
0 License
Exercises
Exercise A Crocker Company reported annual net income as follows:
2008
2009
2010

$484,480
487,680
409,984

Analysis of its inventories revealed the following incorrect inventory amounts and these correct amounts:
Incorrect Inventory
Amount

Correct inventory
amount

2008 December 31

$ 76,800

$89,600

2009 December 31

86,400

77,600

Compute the annual net income for each of the three years assuming the correct inventories had been used
...
On
December 31, a customer ordered 5 trucks from the company, which currently has 20 trucks in its inventory
...
If Slate wished to minimize its net
income, which trucks would it ship? By how much could Slate reduce net income by selecting units from one group
versus the other group?
Exercise C Miami Discount Company inventory records show:
Units
3,000

Total
Cost
$114,000

900
2,400
1,800
1,800
600

Beginning inventory
Purchases:
February 14
March 18
July 21
September 27
November 27
Sales:
April 15
August 20
October 3

Unit
Cost
$38
...
00
40
...
30
40
...
00

35,100
96,000
72,540
73,080
24,600

2,800
2,000
1,500

The December 31 inventory was 4,200 units
...

Present a schedule showing the measurement of the ending inventory using FIFO perpetual inventory procedure
...

Exercise E London Company had a beginning inventory of 160 units at USD 24 (total = USD 3,840) and the
following inventory transactions during the year:
January 8, sold 40 units
...
00
...
00
...

Using the preceding information, price the ending inventory at its weighted-average cost, assuming perpetual
inventory procedure
...
40
7
...
60
8
...
Measuring and reporting inventories
The ending inventory that year consisted of 2,400 units
...

a
...

b
...

Exercise G The following are selected transactions and other data of the Custer Company:
Purchased 20 units at USD 360 per unit on account on 2010 September 18
...

Discovered a shortage of USD 2,640 at year-end after a physical inventory
...
Assume the beginning
inventory consists of 20 units at USD 336 per unit
...

Paid the invoice in transaction 1 within the discount period
...

Purchased 100 units at USD 360; terms 2/10, n/30
...

Sold 60 units at USD 552 each for cash
...
Assume Gamble uses FIFO perpetual inventory procedure
...

Sold 108 units at USD 90 on account
...

Sold 122 units at USD 95 on account
...

The beginning inventory consisted of 67 units purchased at a cost of USD 55
...
Do not record the entries for sales
...
80
...

February sales totaled 120 units
...
24
...

September 1, purchased 40 units at USD 33
...

September through December sales were 180 units
...
00 and 2,000 units at USD 13
...
It sold
all of these units at USD 18
...
80
...

Exercise L Clayton Company's inventory was 12,000 units with a cost of USD 160 each on 2010 January 1
...
Also during 2010, the purchase price of this product fell
320

This book is licensed under a Creative Commons Attribution 3
...
The inventory at year-end was 18,000 units
...

Exercise M Levi Motor Company owns a luxury automobile that it has used as a demonstrator for eight
months
...
At the end of the fiscal year,
the auto is on hand and has an expected selling price of USD 80,000
...
Compute the amount at which the auto should be carried in
inventory
...
It cost USD 3,600 and had an
original selling price of USD 4,800
...
The sound system had an estimated selling price of USD 2,880, but when the company performed USD 480
in repairs, it could be sold for USD 3,840
...

Exercise O Your assistant has compiled the following data:
Item
A
B
C
D

Quantity
(units)
300
300
900
500

Unit
Cost
$ 57
...
80
21
...
00

Unit
Market
$ 55
...
60
21
...
20

Total
Cost
$17,280
8,640
19,440
6,000

Total
Market
$16,560
10,080
19,440
6,600

Calculate the dollar amount of the ending inventory using the LCM method, applied on an item-by-item basis,
and the amount of the decline from cost to lower-of-cost-or-market
...

Exercise Q Tilley-Mill Company takes a physical inventory at the end of each calendar-year accounting period
to establish the ending inventory amount for financial statement purposes
...
On July 18, a fire destroyed the entire store
building and its contents
...
Through July 17, these records show:
Merchandise inventory, January 1 USD 672,000
Merchandise purchases USD 9,408,000
Purchase returns USD 134,400
Transportation-in USD 504,000
Sales USD 14,336,000
Sales returns USD 672,000
The company was fully covered by insurance and asks you to determine the amount of its claim for loss of
merchandise
...
Its
financial statements for the past few years indicate an average gross margin on net sales of 30 per cent
...
The records in a fireproof vault were
intact
...
Measuring and reporting inventories
Transportation -in
Sales

$204,000
$3,720,000

The company was fully covered by insurance and asks you to determine the amount of its claim for loss of
merchandise
...
, records show the following account balances for the year ending 2010
December 31:
Cost

Retail

Beginning inventory

USD 42,000

USD 57,500

Purchases

25000

37500

Transportation-in

500

Sales

52500

Using these data, compute the estimated cost of ending inventory using the retail method of inventory valuation
...
Recently, Kelley
corrected the inventory amounts for those dates
...

Incorrect

Correct

2009 December 31

USD 72,600

USD 86,200

2010 December 31

84000

70200

Prepare a schedule that shows: (a) the reported net income for each year, (b) the amount of correction needed
for each year, and (c) the correct net income for each year
...

2006 December 31, inventory was overstated USD 200,000
...

2081 December 31, inventory was understated USD 220,000
...

The reported net income for each year was:
2006
2007
2008
2009

$384,000
544,000
670,000
846,000

a
...

b
...

c
...


322

This book is licensed under a Creative Commons Attribution 3
...
On 2010 November 30, the company had 46 Orange III personal computers on hand that were
acquired on the following dates and at these stated costs:
July 3
September 10
November 29

Units
10
@
20
@
16
@

Unit cost
$10,080
$ 9,600
$10,700

Brett sold 36 Orange III computers at USD 12,720 each in December
...

a
...

b
...

c
...

3 Sold 5 units at USD 94 per unit
...

12 Sold 8 units at USD 96 per unit
...

25 Purchased 16 units at USD 50 per unit
...

Assume all purchases and sales are made on credit
...

Problem E The following purchases and sales for Ripple Company are for April 2010
...

Purchases
April
April
April
April

3
10
22
28

Units
3,200
1,600
2,000
1,800

@
@
@
@

Unit
Cost
$33
...
00
35
...
00

Sales
April 6
April 12
April 25

Units
1,500
1,400
2,300

a
...

b
...

Problem F Refer to the data in problem E
a
...

b
...
(Note: You may want to refer
to the Appendix in Chapter 6 for this part
...
Measuring and reporting inventories
Problem G The following data relate to the beginning inventory, purchases, and sales of Braxton Company for
the year 2010:
Units
1,400
1,000
2,000
1,200
1,400
1,800

Merchandise Inventory, January 1
Purchases:
February 2
April 5
June 15
September 30
November 28
Sales:
March 10
May 15
July 6
August 23
December 22

Unit
Cost
@ $5
...
80
3
...
00
2
...
20

900
1,800
800
600
2,500

a
...

b
...

Problem H Welch Company accounts for a product it sells using LIFO periodic inventory procedure
...
Merchandise inventory on January 1 was 3,000 units
at USD 14
...

Purchases
January 5
March 31
August 12
December 26

Units
6,000
18,000
12,000
6,000

@
@
@
@

Unit
Cost
$18
...
60
27
...
80

Sales
Units
4,000
15,000
16,000
3,000

January 10
April 2
August 22
December 24

@
@
@
@

Unit
Co st
$28
...
40
36
...
60

a
...

b
...

c
...

d
...

Problem I The accountant for Gentry Company prepared the following schedule of the company's inventory at
2009 December 31, and used the LCM method applied to total inventory in determining cost of goods sold:
Item
Q
R
S
T

Quantity
4,200
2,400
5,400
4,800

Unit
Cost
$7
...
00
4
...
20

Unit
Market
$7
...
76
4
...
32

a
...

b
...

c
...

Problem J As part of a loan agreement with a local bank, Brazos Company must present quarterly and
cumulative income statements for the year 2009
...
0 License
merchandise to sell at a price yielding a gross margin of 30 per cent
...

a
...

b
...

Cobb Company records show the following information for 2010:
Sales
Purchases
Transportation-in
Merchandise inventory,
January 1
Purchase returns

Cost
$2/0,000
26,280

Retail
$350,400
420,000
—

12,000
15,120

1/,400
18,600

Compute the estimated year-end inventory balance at cost using the retail method of estimating inventory
...
Harris used the correct 2011 December 31, inventory
amount in calculating 2011 net income
...
Measuring and reporting inventories
2009 December 31
2010 December 31

$96,000
91,200

$108,000
84,000

Prepare a schedule that shows: (a) the reported net income for each year, (b) the amount of correction needed
for each year, and (c) the correct net income for each year
...

2009 December 31, inventory was understated USD 50,000
...

2011 December 31, inventory was understated USD 30,000
...

The reported net income for each year was:
2009
2010
2011
2012

$292,500
$355,000
$382,500
$350,000

a
...

b
...

c
...

Alternate problem C High Surf Company sells the Ultra-Light model wind surfer and uses the specific
identification method to account for its inventory
...
On 2009 August 1, the company had three Ultra-Lights that cost USD 14,000 each in its inventory
...

a
...

b
...

c
...
1 Beginning inventory consists of 12 units costing USD 48 per unit
...
92 per unit
...

12 Sold 7 units @ USD108 per unit
...
16 per unit
...

30 Sold 20 units @ USD 110
...

Assume all purchases and sales are made on account
...
0 License
a
...

b
...

c
...
Is there a difference between the
amount computed using the two different procedures?
Alternate problem E Following are data for Dandy Company for the year 2010:
Units

M e r c h a n d i s e I n v e n t o r y,
January 1
Purchases:
Fe b r u a r y 2

700

@

500

April 5
June 1 5
September 30
November 28

1,000
600
700
900
4,400

@
@

Sales:
March 5
July 18
August 12
October 15

@
@
@

Unit
Cost
$20
...
00
24
...
00
30
...
20

400
1,200
800
900
3,300

a
...

b
...

Alternate problem F Refer to the data in alternate problem E
a
...

b
...
(Note: You may want to refer to the
Appendix in Chapter 6 for this part
...
60

1,500
3,000
1,800
2,100
2,700

@
@
@
@
@

12
...
20
10
...
00
10
...
Assuming use of perpetual inventory procedure, compute the ending inventory and cost of goods sold under
each of the following methods: (1) FIFO, (2) LIFO, and (3) weighted-average (carry unit cost to four decimal places
and round total cost to nearest dollar)
...
Measuring and reporting inventories
b
...

Alternate problem H Star Company accounts for its inventory using the LIFO method under periodic
inventory procedure
...

a
...

b
...

c
...

d
...

Alternate problem I Data on the ending inventory of Jannis Company on 2009 December 31, are:
Item
1
2
3
4
5
6

Quantity
8,400
16,800
5,600
14,000
11,200
2,800

Unit
Cost
$3
...
88
2
...
84
3
...
04

Unit
Market
$3
...
04
2
...
60
3
...
88

a
...

b
...

Alternate problem J The sales and cost of goods sold for Lively Company for the past five years were as
follows:
Year
2004
2005
2006
2007
2008

Sales
(net)
$ 9,984,960
10,794,240
12,346,560
11,926,080
12,747,840

Cost of
Goods Sold
$ 6,240,600
6,746,400
7,716,600
7,272,000
7,920,000

The following information is for the seven months ended 2009 July 31:
Sales
Purchases
Purchase returns
Sales returns
Merchandise inventory,
2009 January 1

$7,748,000
4,588,800
28,800
173,760
948,000

To secure a loan, Lively Company has been asked to present current financial statements
...

a
...

328

This book is licensed under a Creative Commons Attribution 3
...
From the data given, compute the estimated inventory as of 2009 July 31
...
Both heard a presentation by the manufacturer of an exercise device
and decided to become a distributor of this exerciser
...
Each owns her own business
...
The manufacturer sold the first 200 units at USD 15 each, the next 300 at USD 18 per unit, and
the next 500 at USD 19 per unit
...

During the first year, each bought 1,200 units; coincidentally, both sold exactly 950 units for USD 27 each
...
(Green's expenses were
considerably higher because on December 28 she distributed 4,000 sales brochures to households in her territory
at a cost of USD 800
...
)
At the end of the year, both had to determine their net incomes
...
She remembered the FIFO inventory method and plans to use it
...
However, her husband is acquainted with the LIFO inventory method used at the
company where he works
...

a
...

b
...

c
...

Business decision case B Connie Dalton owns and operates a sporting goods store
...
Dalton uses periodic inventory procedure
and has the following information in her accounting records, which were undamaged:

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...
Her insurance company
offered to pay USD 56,000 to settle this inventory loss unless Dalton can show that she suffered a greater loss
...

Answer these questions: Based on your analysis, should Dalton settle for USD 56,000? If not, how can she show
that she suffered a greater loss? What is your estimate of her loss?
Annual report analysis C Refer to the financial statements of The Limited in the Annual Report Appendix
...
Also, determine the inventory turnover ratio for
2000
...
Do you believe that Terry's scheme will work?
b
...
Comment on each of Terry's points of justification
...

Inquire about inventory control methods, inventory costing methods, and any other information about the
company's inventory procedures
...
The heading of the memorandum should include the date, to whom it is written, from whom, and the
subject matter
...
Investigate how the system works by
interviewing a knowledgeable person in the company
...

Group project G With a small group of students, identify and visit a retail store that uses periodic inventory
procedure and uses the retail inventory method for preparing interim (monthly or quarterly) financial reports
...
Write
a report to your instructor summarizing your findings
...
nasba
...
Also check out some of the information
provided at websites of other state boards by clicking on any sites that appear at the end of a listing for a particular
state
...

Visit the Lexis-Nexis website at:
http://www
...
com

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...
Specifically, what kinds of products and
services are available? What is the background of Lexis-Nexis? What pricing information is available for using its
services? Write a report to your instructor summarizing your findings
...
Overstated ending inventory results in an understatement of cost of goods sold and an overstatement of
gross margin and net income
...
The cost of goods sold consists of the earliest purchases at the lowest costs in a period of rising prices
...
Under LCM, inventory is adjusted to market value only when the market (replacement) value is less than
the cost
...
The first step in the gross margin method is to estimate gross margin using the gross margin rate
experienced in the past
...
The cost/retail ratio is computed by dividing the cost of goods available for sale by the retail price of the
goods available for sale
...
Under perpetual procedure, the Cost of Goods Sold account is updated as sales occur
...
The cost of ending inventory using FIFO consists of the most recent purchase:
Cost of ending inventory=3,400×USD 36= USD 122,400
c
...
The cost of ending inventory using LIFO is:
3,000×USD 30400×USD36= USD 104,400

d
...
The cost of ending inventory using weighted-average cost is computed:
Unit cost= USD 270,000−8,000=USD 33
...
75=USD 114,750
c
...
During a period of rising prices, FIFO results in the lowest cost of goods sold, thus the highest net income
...
0 License

8
...

• Define cash and list the objectives sought by management in handling a company's cash
...

• Prepare a bank reconciliation and make necessary journal entries based on that schedule
...

• Analyze and use the financial results-quick ratio
...
Unfortunately,
many smaller companies do not heed this advice
...
This is when the
services of a forensic accountant may be necessary
...
It is frequently associated with the investigation of civil or criminal white-collar crime
such as fraud, embezzlement, and general abuse of funds issues
...
The forensic accountant's responsibility is to
gather and analyze the evidence and deliver clear, accurate, and unbiased reports reflecting the results of the
investigation
...
CFEs have
extensive training and possess special expertise in investigation and interview techniques specifically designed to
detect or prevent fraud
...
You can learn more about the FBI from their homepage at www
...
gov
...
Did you know that the fastest track to becoming an FBI agent is with an accounting undergraduate
degree? There are four entry programs for becoming an FBI special agent: accounting, law, language, and
diversified
...
The only entry program requiring only an undergraduate degree is one with an
undergraduate accounting option
...

In a small corporation the president might make all the important decisions and will usually maintain a close
watch over the affairs of the business
...
Realizing that precautions are necessary to
protect the company's interests, the company establishes an internal control structure at this point
...
Control of cash
The internal control structure of a company consists of "the policies and procedures established to provide
reasonable assurance that specific entity objectives will be achieved"
...

The control environment reflects the overall attitude, awareness, and actions of the board of directors,
management, and stockholders
...
The control procedures of a company are additional policies and procedures that
management establishes to provide reasonable assurance that the company achieves its specific objectives
...

Internal control not only prevents theft and fraud but also serves many purposes:
(1) Companies must implement policies requiring compliance with federal law; (2) personnel must perform their
assigned duties to promote efficiency of operations; and (3) correct accounting records must supply accurate and
reliable information in the accounting reports
...

You will learn how to establish internal control through control of cash receipts and cash disbursements, proper
use of the bank checking account, preparation of the bank reconciliation, and protection of petty cash funds
...


Internal control
An effective internal control structure includes a company's plan of organization and all the procedures and
actions it takes to:
• Protect its assets against theft and waste
...

• Evaluate the performance of all personnel to promote efficient operations
...


As you study the basic procedures and actions of an effective internal control structure, remember that even
small companies can benefit from using some internal control measures
...

In general terms, the purpose of internal control is to ensure the efficient operations of a business, thus enabling
the business to effectively reach its goals
...


27 AICPA, Statement on Auditing Standards No
...
4
...
Previous editions referred to the "internal control
system
...
0 License

An accounting perspective:
Business insight
When performing an audit, one of an outside auditor's first duties is to examine the internal
control structure of the corporation
...
To increase understanding, the auditor inspects documents in
the accounting system, discusses external influences on the company with management, reads
accounting manuals, and observes the happenings in the company
...

Companies protect their assets by (1) segregating employee duties, (2) assigning specific duties to each
employee, (3) rotating employee job assignments, and (4) using mechanical devices
...
Also, employees share
responsibility for related transactions so that one employee's work serves as a check on the work of other
employees
...
For example, an employee could not steal cash from a company and have the
theft go undetected unless someone changes the cash records to cover the shortage
...

Assignment of specific duties to each employee When the responsibility for a particular work function is
assigned to one employee, that employee is accountable for specific tasks
...

When a company gives each employee specific duties, it can trace lost documents or determine how a particular
transaction was recorded
...

Being responsible for specific duties gives people a sense of pride and importance that usually makes them want to
perform to the best of their ability
...
Employees realize that if they steal from the company, the
next employees assigned to their positions may discover the theft
...
This policy also
discourages theft because many dishonest schemes collapse when the employee does not attend to the scheme on a
daily basis
...
Control of cash
Use of mechanical devices Companies use several mechanical devices to help protect their assets
...

Internal control policies are effective only when employees follow them
...
Thus, the execution of
effective internal control begins with the time and effort a company expends in hiring employees
...
Frequently, written job descriptions
establish the responsibilities and duties of employees
...

In publicly held corporations, the company's internal control structure must satisfy the requirements of federal
law
...
This law requires a publicly
held corporation to devise and maintain an effective internal control structure and to keep accurate accounting
records
...
The FCPA made this specific type of bribery illegal
...
Internal
auditing consists of investigating and evaluating employees' compliance with the company's policies and
procedures
...
Trained in company policies and
internal auditing duties, internal auditors periodically test the effectiveness of controls and procedures throughout
the company
...
In addition, internal auditors make recommendations for the improvement of
the company's internal control structure
...
However, internal auditing is especially necessary in large organizations because the owners
(stockholders) cannot be involved personally with all aspects of the business
...
The best method to ensure such
accounting records is to hire and train competent and honest individuals
...
Inaccurate or inadequate
accounting records serve as an invitation to theft by dishonest employees because theft can be concealed more
easily
...
These source documents are an
integral part of the internal control structure
...

(Transaction documentation and related aspects of internal control are presented throughout the text
...
0 License
PURCHASE REQUISITION
No
...
5868200
$50 per unit
24393
Reason for request:
To be filled in by purchasing department:
Customer order
Dated ordered 2 0 1 0 N o v e m b e r 2 9
Baier Company
Purchase order number N - M S
Approved R
...
T
...
For example, to review a purchase transaction, they check the documents used to
record the transaction against the proper accounting records
...

• A purchase order (Exhibit 66) is a document sent from the purchasing department to a supplier

requesting that merchandise or other items be shipped to the purchaser
...

• A receiving report is a document prepared by the receiving department showing the descriptions and

quantities of all items received from a supplier in a particular shipment
...
Then, because receiving department personnel do not
know what quantity to expect, they will count the quantity received more accurately
...
Without these documents, a company might fail to pay a legitimate invoice, pay fictitious
invoices, or pay an invoice more than once
...
In
Exhibit 68 we show the flow of documents and goods in a merchandise transaction
...

N-145
BRYAN WHOLESALE COMPANY
476 Mason Street
Detroit, Michigan 48823
To: Wilkes Radio Company
2515 West Peachtree Street
Date: 2010 November 21
Atlanta, Georgia 30303
Ship by: 2010 December 20
Ship to: Above address
FOB terms requested:
Destination
Discount terms requested: 2/10, n/30
Please send the foil owing item;
Price
Total
Description
Item Number
Quantity
Per Unit
Amount
True-tone stereo
Model No
...


Exhibit 66: Purchase order
Unfortunately, even though a company implements all of these features in its internal control structure, theft
may still occur
...
Control of cash
circumventing even the most effective internal control structure
...
This insurance reimburses the company for loss of a nonmonetary asset such as
specialized equipment
...
These bonds ensure that a company is reimbursed for losses due to theft of cash and other
monetary assets
...

According to the Committee of Sponsoring Organizations of the Treadway Commission, there are five
components of an internal control structure
...
The components are:
• Control environment
...
The control environment includes many factors such as ethical values, management's philosophy,
the integrity of the employees of the corporation, and the guidance provided by management or the board of
directors
...
After the entity sets objectives, the risks (such as theft and waste of assets) from

external and internal sources must be assessed
...

• Control activities
...
These activities include procedures that employees must follow
...

• Information and communication
...
The events that yield these data may come from internal or external sources
...
Employees must
understand what is expected of them and how their responsibilities relate to the work of others
...

• Monitoring
...
In testing components of the internal control
structure, companies base their thoroughness on the risk assigned to those components
...
However, the following three
groups have specific responsibilities regarding the internal control structure
...
0 License
INVOICE

Invoice No
...
15

WILXES RADIO COMPANY
2515 West Peachtree Street
Atlanta, Georgia 30303
Customer's Orders No
...


Address:

475 Mason Street
Detroit, Michigan 4S823

Terms: 2/10, n/30, FOB destination

Date shipped: 2010 D e c e m b e r 1 5
Shipped by:

Nagel Trucking Co
...

5868-24393

Description

200

$50

$10,000

Total

$10,000

Exhibit 67: Invoice
Management holds ultimate responsibility for establishing and maintaining an effective internal control
structure
...

The board of directors provides guidance to management
...
Often, an efficient board that has access to the company's internal auditors can
discover such fraud
...
All employees are part of a communications network
that enables an internal control structure to work effectively
...
The exact control steps depend on whether a company is using
mainframe computers and minicomputers or microcomputers
...
The size and
complexity of mainframe computers and minicomputers require specially trained persons to keep these systems
operating
...
In a mainframe or minicomputer environment, internal control
should include the following:
• Control computer access by placing the computer in an easily secured room, and allow only persons

authorized to operate the computer to enter the room
...
This policy prevents the running of unauthorized, altered programs
...
Change the

passwords as necessary
...
Also, large companies
might supply certain employees with personal computers
...
Control of cash
environment somewhat
...
Instead,
these companies use off-the-shelf programs such as accounting, spreadsheet, database management, and word
processing packages
...
g
...
Thus, controls are also important
...
Just as one person

maintains custody over a certain set of records in a manual system, in a computer system one person
maintains custody over certain information (such as the accounts receivable subsidiary ledger)
...

• Require passwords (kept secret) to gain entry into data files maintained on the hard disk
...

Computerized accounting systems do not lessen the need for internal control
...


339

This book is licensed under a Creative Commons Attribution 3
...
In accounting, cash includes coins; currency; undeposited negotiable instruments such as
checks, bank drafts, and money orders; amounts in checking and savings accounts; and demand certificates of
deposit
...
Only demand CDs that may be withdrawn at any time without
prior notice or penalty are included in cash
...

In its general ledger, a company usually maintains two cash accounts—Cash and Petty Cash
...


An accounting perspective:
Business insight
Users of financial data must look to see the real meaning behind the numbers
...
In Reader's Digest's annual report, for
example, the company defines cash and cash equivalents in this footnote:
The company considers all highly liquid debt instruments with original maturities of three months
or less to be cash equivalents
...
Of all the
company's assets, cash is the most easily mishandled either through theft or carelessness
...

• Make certain that enough cash is available to pay bills as they come due
...

• Prevent loss of cash due to theft or fraud
...
Without the proper timing of cash flows and
the protection of idle cash, a business cannot survive
...

Later in the chapter, we explain the importance of preparing a bank reconciliation for each bank checking account
and controlling the petty cash fund
...
A clerk receives the cash immediately over the counter, records it, and places it in a cash
register
...
At the end of each day, stores reconcile the cash in each cash register with
the cash register tape or computer printout for that register
...
Control of cash
of checks
...
Some merchandising
companies receive all their cash receipts on a delayed basis as payments on accounts receivable
...
)
Although businesses vary their specific procedures for controlling cash receipts, they usually observe the
following principles:
• Prepare a record of all cash receipts as soon as cash is received
...
Once a record is made, it is easier to trace a theft
...
Undeposited cash is more susceptible to misappropriation
...
This control feature follows the general principle of segregation of duties given earlier in
the chapter, as does the next principle
...
This control measure

is possible in all but the smallest companies
...
Since a company spends most of its cash by check, many
of the internal controls for cash disbursements deal with checks and authorizations for cash payments
...
Following are some basic control
procedures for cash disbursements:
• Make all disbursements by check or from petty cash
...
Many retail stores make refunds for returned merchandise
from the cash register
...

• Require all checks to be serially numbered and limit access to checks to employees authorized to write

checks
...


Exhibit 69: Cash receipts cycle for merchandise transactions

341

This book is licensed under a Creative Commons Attribution 3
...
Otherwise, the

checks could be written to friends in payment of fictitious invoices
...

• Instruct the employee authorizing cash disbursements to make certain that payment is for a legitimate

purpose and is made out for the exact amount and to the proper party
...
These procedures lessen the chance of paying the same debt more than once
...
This policy makes it more difficult for an employee to conceal a theft
...

• Void all checks incorrectly prepared
...


Exhibit 70 shows an overview of some of the internal control considerations relating to cash
...
The company deposits its cash receipts
in a bank checking account and writes checks to pay its bills
...

The company checks this statement against its records to determine if it must make any corrections or adjustments
in either the company's balance or the bank's balance
...
In the next section, we discuss the bank checking account
...


Exhibit 70: Internal control considerations regarding cash

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...
Instead of mailing
paper copies of these documents, the entire transaction is done electronically
...
One concern of such
procedures is the security of the transaction
...


The bank checking account
Banks earn income by providing a variety of services to individuals, businesses, and other entities such as
churches or libraries
...
A checking account is a money balance
maintained in the bank; it is subject to withdrawal by the depositor, or owner of the money, on demand
...
28
A bank requires a new depositor to complete a signature card, which provides the signatures of persons
authorized to sign checks drawn on an account
...
The bank does not compare every check with this signature card
...

When depositors make a bank deposit, they prepare a deposit ticket or slip
...
Often, the ticket is pre-printed to show the
depositor's name, address, and account number
...
The depositor receives a receipt showing the date of deposit
and the amount deposited
...
Thus, every check transaction involves three parties: the bank, the payee (party to whom
the check is made payable), and the drawer (depositor)
...
Often a business check has an
attached remittance advice
...
Before cashing or depositing it, the payee detaches the remittance advice from the check
(Exhibit 72)
...
All of these institutions function somewhat similarly; but,
for simplicity's sake, we discuss only banks here
...
0 License

Exhibit 71: Deposit ticket

Exhibit 72: Check with attached remittance advice
JOHH DOE'S COMPANY
P 0 BOX 216603
C0RVALLIS OR 218803

6141337
2010 September 1THRU 2010/09/29
PAGE 1

ASK US ABOUT
REAL ESTATE AHD CONSTRUCTIOH LOANS
BUSINESS BASIC ACCOUNT 614153
DESCRIPTION

DEBITS

CREDIT

BALANCE

2010/08/31

BALANCE LAST STATEMENT

DATE

3,594
...
77

2010/09/08

3,52 5
...
41

2010/09/08

3,423
...
25

DEPOSIT

7,300
...
95

2010/09/18

10,684
...
08

2010/09/20

10,668
...
50

2010/09/21

10,553
...
00

2010/09/21

3,448,33

CHECK # 1039

137
...
88

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344

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8
...
88

NEF CHECK

102
...
00

2010/09/30

4,208
...
88

SAFE DEPOSIT BOX REMT

15
...
38

2010/09/30

4,1S5
...
00 MINIMUM BALANCE

3,195
...
55 AVG AVAILABLE BALAHCE

5,236
...
41
09/08 1033*
6B
...
90

DATE
09/18
09/20
09/21

YOUR CHECKS
SEQUENCED
CHECK # AMOUNT
1036
38
...
08
1033
7,105,00

DATE CHECK # AMOUNT
03/25 1039
137,45

Exhibit 73: Bank statement
A bank statement is a statement issued (usually monthly) by a bank describing the activities in a depositor's
checking account during the period
...

• Checks paid out of the depositor's checking account by the bank during the period
...

• Other deductions from the checking account for service charges, NSF (not sufficient funds) checks, safe-

deposit box rent, and check printing fees
...
An NSF (not sufficient funds) check is Bank
Statement a customer's check returned from the customer's bank to the depositor's bank because the funds in
the customer's checking account balance were insufficient to cover the check
...
Since the customer still owes the
depositor money, the depositor restores the amount of the NSF check to the account receivable for that
customer in the company's books
...


345

This book is licensed under a Creative Commons Attribution 3
...
Such deposits are made by a third party
...

A wire transfer of funds is an interbank transfer of funds by telephone
...
These companies may set up special procedures to avoid accumulating too much idle cash in
local bank accounts
...
For example, a
company may set up transfer bank accounts so local banks automatically transfer to a central bank (by wire or
bank draft) all amounts on deposit in excess of a stated amount
...


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...
Since it is
expensive to sort, handle, and mail these items, some banks no longer return them to depositors
...
Most depositors need only a
detailed bank statement, as shown in Exhibit 73, and not the original documents to show what transactions
occurred during a given period
...

Banks may also return these memos with the bank statement
...
The terms
debit memo and credit memo may seem reversed, but remember that the depositor's checking account is a liability
—an account payable—of the bank
...
To increase the balance, it prepares a credit memo
...

Some banks no longer mail these documents to the depositor and rely instead on explanations in the bank
statements
...
After the entries have been made to record the new information, the balance in the Cash
account is the actual cash available to the company
...
In this chapter, we
assume no entries have been made for these items unless stated otherwise
...
If you have a personal checking account, you also should reconcile your bank
statement with your checkbook
...
Some small
businesses use this form
...


Bank reconciliation
A bank reconciliation is a schedule the company (depositor) prepares to reconcile, or explain, the difference
between the cash balance on the bank statement and the cash balance on the company's books
...


An accounting perspective:
Business insight
Within the internal control structure, segregation of duties is an important way to prevent fraud
...
To
prevent collusion among employees, the person who reconciles the bank account should not be
involved in the cash disbursement cycle
...
Sending the statement directly limits the
number of employees who would have an opportunity to tamper with the statement
...
0 License
Look at Exhibit 75; the bank reconciliation has two main sections
...
The bottom section begins with the balance on the company's books
...
The steps in
preparing a bank reconciliation are as follows:
Deposits
...
To
make this comparison, place check marks in the bank statement and in the company's books by the deposits that
agree
...
A deposit in transit is typically a day's cash receipts recorded in
the depositor's books in one period but recorded as a deposit by the bank in the succeeding period
...
Normally, deposits
in transit occur only near the end of the period covered by the bank statement
...
Thus,
the deposit does not appear on a bank statement for the month ended May 31
...
Immediately investigate any deposit made
during the month but missing from the bank statement (unless it involves a deposit made at the end of the period)
...
If canceled checks are returned with the bank statement, compare them to the statement to be
sure both amounts agree
...
Next, determine which checks are outstanding
...
The party
receiving the check may not have deposited it immediately
...
Determine the outstanding checks by comparing the check numbers that have cleared the bank
with the check numbers issued by the company
...
Checks issued that have not yet been returned by the bank are the
outstanding checks
...
Sometimes
checks written long ago are still outstanding
...
Most of these have cleared during the current month; list those that have not
cleared as still outstanding on the current month's reconciliation
...
Verify all debit and credit memos on the bank statement
...
Credit memos reflect additions for such items as notes collected for the depositor by the bank and
wire transfers of funds from another bank in which the company sends funds to the home office bank
...
Make journal
entries for any items not already recorded in the company's books
...
List any errors
...
For example, a USD 47 check may be recorded as USD 74
...

Deposits in transit, outstanding checks, and bank service charges usually account for the difference between the
company's Cash account balance and the bank balance
...
) Remember that all items shown on the bank
reconciliation as adjustments of the book (ledger) balance require journal entries to adjust the Cash account (items
Accounting Principles: A Business Perspective

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...
Items appearing as adjustments to the balance per bank
statement do not require entries by the depositor (items 2 and 3)
...


349

This book is licensed under a Creative Commons Attribution 3
...
L
...
9544
No
...
9546
Adjusted balance, 2010 May 31,
Balance per ledger, 2010 May 31
Add: Note collected (including interest of
$25)
Less: NSF check (R
...
L
...
On June 2, Lee received

its bank statement for the month ended May 31, which showed an ending balance of USD 3,252
...
This
deposit was in the bank's night deposit chute on May 31
...
9544
No
...
9546
Total

$322
168
223
$713

• Included with the bank statement was a credit memo for USD 1,225 (principal of USD 1,200 + interest of

USD 25) for collection of a note owed to Lee by Shipley Company
...
Johnson and

deposited by Lee
...


After reconciling the book and bank balances as shown in Exhibit 75, Lee Company finds that its actual cash
balance is USD 2,991
...
Control of cash
4

5
6

Cash
Notes Receivable—Shipley Company (-A)
Interest Receivable (-A)
To record note collected from Shipley Company
...
Johnson* (Contra Account)
Cash (-A)
To charge NSF check back to customer, R
...

Bank Service Charge Expense (-SE)
Cash (-A)
To record bank service charges
...

Johnson's account in the Accounts Receivable subsidiary ledger
...
The May 31 balance sheet would show USD 2,991 cash, the actual cash balance
...
Johnson (+A)
Note Receivable (-A)
Interest Revenue (+SE)
To correct the accounts for needed changes identified in the
bank reconciliation
...
Since these items appear on the bank balance side of the reconciliation, they require no entry in the
company's books
...

When a company maintains more than one checking account, it must reconcile each account separately with the
balance on the bank statement for that account
...

To make sure a check cannot bounce and become an NSF check, a payee may demand a certified or cashier's
check from the maker
...
As a result, payees usually accept these checks without question
...
The bank stamps certified across the face of the check and inserts the name of the bank and the
date; a bank official signs the certification
...
The bank deducts the amount of the check from the depositor's account at the time
it certifies the check
...

In this section, you learned that all cash receipts should be deposited in the bank and all cash disbursements
should be made by check
...


351

This book is licensed under a Creative Commons Attribution 3
...
This
process of transferring money by telephone, computer, or wire is called electronic fund
transferring
...
Manipulation and fraud can still occur whenever firms do not
separate duties; however, limiting access to the payroll function may eliminate some of the risk
associated with internal control weaknesses
...
To permit these cash disbursements and still maintain adequate control over cash, companies
frequently establish a petty cash fund of a round figure such as USD 100 or USD 500
...
By assigning the responsibility for the fund to one
individual, the company has internal control over the cash in the fund
...
It is payable to the petty cash
custodian
...
The following entry records this transaction as follows:
Petty Cash
Cash
To establish a petty cash fund
...

The fund is now ready to be disbursed as needed
...
Thus, using a petty cash fund avoids the need for making many entries for small amounts
...

When disbursing cash from the fund, the petty cash custodian prepares a petty cash voucher, which should be
signed by the person receiving the funds
...
The custodian should prepare a voucher for each
disbursement and staple any invoices for expenditures to the petty cash voucher
...

Companies replenish the petty cash fund at the end of the accounting period, or sooner if it becomes low
...
(Sometimes we refer to this fund as an imprest
Accounting Principles: A Business Perspective

352

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...
) The petty cash custodian presents the vouchers to the employee
having authority to order that the fund be reimbursed
...

To determine which accounts to debit, an employee summarizes the petty cash vouchers according to the
reasons for expenditure
...
The journal
entry to record replenishing the fund would debit the various accounts indicated by the summary and credit Cash
...
0 License
PETTY CASH VOUCHERS NO
...

Date 2010 June 29
EXPLANATION
Freight on parts
APPROVED B

ACCT NO
...
E
...


AMOUNT
12 57

RECEIVED B Ken Black

Exhibit 76: Petty cash voucher
For example, assume the USD 100 petty cash fund currently has a money balance of USD 7
...
A summary of
the vouchers shows payments of USD 22
...
80 for stamps, and USD 19
...
60
...
60 which, when cashed, restores the cash in the fund to its USD 100 balance
...


22
...
80
19
...
60

Note that the entry to record replenishing the fund does not credit the Petty Cash account
...

At the end of an accounting period, the firm records any petty cash disbursements for which the fund has not yet
been replenished
...

Failure to make an entry at the end of an accounting period would cause errors in both the income statement and
balance sheet
...

After a time, if the petty cash custodian finds that the petty cash fund is larger than needed, the excess petty cash
should be deposited in the company's checking account
...
On the other hand, a petty cash fund may be
too small, requiring replenishment every few days
...

To illustrate, the entry to decrease the petty cash fund by USD 50 would be:
Cash
Petty Cash
To decrease the size of the petty cash fund by $50
...


600

600

The following rules summarize how the Petty Cash account is debited and credited:
Debited to establish
Debited to increase
Credited to decrease
Credited to terminate
Sometimes, the petty cash custodian makes errors in making change from the fund
...
When the fund is restored to its
original amount, the credit to Cash is for the difference between the established amount and the actual cash in the
Accounting Principles: A Business Perspective

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...
We would debit all vouchered items
...
The Cash Short and Over account is an expense or a revenue, depending on whether it has a debit
or credit balance
...
10 instead of USD
7
...
Restoring the fund to USD 100 requires a check for USD 93
...
Since the petty cash vouchers total only USD
92
...
30
...


22
...
80
19
...
30
93
...
For example,
assume that a clerk accidentally shortchanges a customer USD 1 and that total cash sales for the day are USD
740
...
At the end of the day, actual cash is USD 1 over the sum of the sales tickets or the total of the cash register
tape
...


741
...
50
1
...
It is the ratio of quick assets (cash,
marketable securities, and net receivables) to current liabilities
...
A rule of thumb is that
the ratio of quick assets to current liabilities should be 1:1 or higher
...
Short-term creditors are interested in this ratio
since it relates the pool of cash and immediate cash inflows to immediate cash outflows
...
85 and 6
...
85
$110,147

2009
$283,913
314,872
177,300
$776,085
$113,430
$776,085 = 6
...
For 20 years, John Blue has
managed the restaurant and received only minimal salary increases
...
A few years ago he began
supplementing his income by placing phony invoices in the petty cash box, writing a petty cash
355

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...
Through this mechanism,
John increased his income by about USD 12,000 per year, an amount that he considered fair
...

Now that you have learned how to control a company's most liquid asset, cash, in the next chapter you are ready
to study receivables and payables
...
In all probability, the next
automobile you plan to buy will be financed
...
The many offers of credit we receive from various businesses are evidence of the importance
companies place on credit as a method of stimulating sales and expanding their business
...

• The purpose of internal control is to ensure the efficient operation of a business
...

• To protect their cash, companies should account for all cash transactions accurately, make certain enough

cash is available to pay bills as they come due, avoid holding too much idle cash, and prevent loss of cash due
to theft or fraud
...

• Procedures for controlling cash disbursements include, among others, making all disbursements by check

or from petty cash, using checks that are serially numbered, requiring two signatures on each check, and
having a different person authorize payment of a bill than the persons allowed to sign checks
...

• A bank reconciliation is shown in Exhibit 75
...

• Companies establish a petty cash fund to permit minor cash disbursements and still maintain adequate

control over cash
...
A journal entry is

necessary to record the replenishment
...
Control of cash
• Quick ratio equals cash, marketable securities, and net receivables divided by current liabilities
...


Demonstration problem
Demonstration problem A You are the manager of a restaurant that has an ice cream parlor as a separate
unit
...
In the current year,
you have a feeling that even though business seems good, net income is going to be lower
...
All sales are priced to yield an estimated gross margin of 40 per
cent
...
The resulting sales, cost of goods sold, and gross margins are:
March

April

Restaurant
Sales $36,300
Cost of goods sold 22,275
Gross Margin $13,025

Ice
Cream
Parlor
$53,000
31,500
$21,500

Restaurant
$39,050
23,800
$15,250

May
Ice
Cream
Parlor
$42,750
31,000
$11,750

Restaurant
$38,100
22,975
$15,125

June
Ice
Cream
Parlor
$39,000
30,750
$8,250

Restaurant
$41,250
25,500
$15,750

Ice
Cream
Parlor
$35,500
31,125
$4,375

What would you suspect after analyzing these reports? What sales control procedures would you recommend to
correct the situation? All of the points in this problem were not specifically covered in the chapter, although the
principles were
...

Demonstration problem B The following data pertains to Carr Company:
• Balance per bank statement, dated 2010 March 31, is USD 4,450
...

• The USD 1,300 deposit of March 31 was not on the bank statement
...

• Service and collection charges for the month were USD 10
...
The

check was included with the canceled checks returned with the bank statement
...

• A customer's USD 75 check marked NSF was returned with the bank statement
...
50 non interest-bearing note

of Carr Company
...

• An examination of the cash receipts and the deposit tickets revealed that the bookkeeper erroneously

recorded a customer's check of USD 148
...
00
...

a
...

b
...

Solution to demonstration problem
Solution to demonstration problem A The gross margin percentages are as follows:
March

April

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May

June

This book is licensed under a Creative Commons Attribution 3
...
88 per cent
40
...
05 per cent
27
...
70 per cent
21
...
18 per cent
12
...
Employees or outsiders may be
pocketing cash
...
Several things could be done to improve the sales control procedures:
• The manager could hire an investigator to come in and watch the employees in action
...

• The prices of ice cream cones could be changed to odd amounts so that employees would not be as able to

make change without going to the cash register
...

• The customers could be encouraged to ask for their cash register receipts by having a monthly drawing (for

some prize) by cash register receipt number
...
No customer is going to be willing to pay USD 1
...
00
...
The manager (and possibly assistant

manager) should have the only keys to the cash registers
...

• Require that all sales be rung up immediately after the sale
...


a
...
00
200
...
00
20
...
50

Less: Service and collection charges
NSF check
Carr Company noted charged against account
Adjusted balance, 2010 March 31

$4,450
...
00
75
...
50

1,500
...
00
1,050
...
00
$4,459
...
50
$5,492
...
50
$4,900
...

Mar
...
00
10
...
00
507
...
00
20
...
50

Alternatively:
Mar
...
50

Accounting Principles: A Business Perspective

1,000
...
00

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...

Bank Service Charge Expense
Accounts Receivable
Notes Payable
Cash
To record deductions from Cash account
...
50
10
...
00
507
...
50

Key terms
Accounting system Methods and records established to identify, assemble, analyze, classify, record, and
report an entity's transactions to provide complete, accurate, and timely financial information
...

Bank statement A statement issued (usually monthly) by a bank describing the activities in a depositor's
checking account during the period
...

Cashier's check A check made out to either the depositor or a third party and written, or drawn, by a bank
after deducting the amount of the check from the depositor's account or receiving cash from the depositor
...

Certified check A check written, or drawn, by a depositor and taken to the depositor's bank for
certification
...
Thus, it usually is accepted without question
...

Checking account A money balance maintained in a bank that is subject to withdrawal by the depositor, or
owner of the money, on demand
...

Control procedures Policies and procedures in addition to the control environment and the accounting
system that management has established to provide reasonable assurance that the company will achieve its
specific objectives
...

Debit memo A form used by a bank to explain a deduction from the depositor's account
...

Deposit ticket A form that shows the date and the items that make up the deposit
...

Fidelity bonds Ensure that a company is reimbursed for losses due to theft of cash and other monetary
assets
...
Internal auditing is performed by company personnel
...
These auditors are
trained in company policies and in internal auditing duties such as testing effectiveness of controls and
procedures involving cash receipts and cash disbursements
...

Invoice Statement sent by the supplier to the purchaser requesting payment for the merchandise shipped
...

Outstanding checks Checks issued by a depositor that have not yet been paid by the bank on which they
are drawn
...
0 License
Payee The party to whom a check is made payable
...
The cash in the fund plus the vouchers covering
disbursements should always equal the balance at which the fund was established and at which it is carried in
the Petty Cash account
...

Purchase order A document sent from the purchasing department to a supplier requesting that
merchandise or other items be shipped to the purchaser
...

Quick ratio The ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities
...

Receiving report A document prepared by the receiving department showing the descriptions and
quantities of all items received from a supplier in a particular shipment
...

Segregation of duties Having one employee responsible for safeguarding an asset and a second employee
responsible for maintaining the accounting records for that asset
...

Signature card Provides the signatures of persons authorized to sign checks drawn on an account
...

Wire transfer of funds Interbank transfer of funds by telephone
...

Cash includes coin, currency, postdated checks, money orders, and money on deposit with banks
...

The cash balance on the bank statement is usually equal to the cash balance in the depositor's books
...

For control purposes, a company should issue checks for every payment, regardless of its amount
...

The objectives of the internal control structure of a company include all of the following except:
a
...

b
...

c
...

d
...

e
...

Use the following information to answer the next three questions:
Balance per bank statement USD 1,951
...
60
Deposits in transit 271
...
Control of cash
Outstanding checks 427
...
20
Service charges 13
...
USD 1,794
...

b
...
60
...
USD 1,638
...

d
...
00
...
USD 1,876
...

In a bank reconciliation, deposits in transit should be:
a
...

b
...

c
...

d
...

e
...

After the bank reconciliation is prepared, the entry to record bank service charges would have a credit to:
a
...

b
...

c
...

d
...

e
...

The entry to replenish the petty cash fund for disbursements made for stamps includes:
a
...

b
...

c
...

d
...

e
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...


➢

Name several control documents used in merchandise transactions
...


➢

The bookkeeper of a given company was stealing cash received from customers in payment of their
accounts
...
What feature of internal control would have prevented
the thefts?

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...


➢

What types of items cause the balance per ledger and the balance per bank statement to disagree?

➢

"The difference between a company's Cash account balance and the balance on its bank statement is
usually a matter of timing
...


➢

Describe the operation of a petty cash fund and its advantages
...


➢

When are entries made to the Petty Cash account?

➢

The Limited, Inc
...
, in the Annual report
appendix, what was the quick ratio for each of the two years shown?

➢

The Limited, Inc
...
, in the Annual report
appendix, what was the ending cash and equivalents balance? What percentage of current assets
does the amount of cash and equivalents represent for each of the two years shown?

Exercises
Exercise A State whether each of the following statements about internal control is true or false:
a
...

b
...

c
...

d
...

e
...

f
...

g
...

h
...

Exercise B Concerning internal control, which one of the following statements is correct? Explain
...
Broadly speaking, an internal control structure is only necessary in large organizations
...
The purposes of internal control are to check the accuracy of accounting data, safeguard assets against theft,
promote efficiency of operations, and ensure that management's policies are being followed
...
Once an internal control structure has been established, it should be effective as long as the formal
organization remains unchanged
...
An example of internal control is having one employee count the day's cash receipts and compare the total
with the total of the cash register tapes
...

Checks outstanding totaled USD 3,937, and deposits in transit were USD 5,990
...

Balance per bank statement, 2010 October 31

Accounting Principles: A Business Perspective

$13,974

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...
2010 October 31
Proceeds of a note collected by bank not yet entered in
ledger (includes $500 of interest)
Bank service charges not yet entered by Reed Company
Deposit in transit
Outstanding checks:
No
...
328
No
...
331

8,088
6,000
18
1,680
654
288
390
252

Exercise E The following is a bank reconciliation for Brian company as of August 31
...

Exercise F On March 1 of the current year, Shelbey Company had outstanding checks of USD 15,000
...
As of March 31, the bank statement showed USD
48,000 of checks had cleared the bank during the month
...
On July 31, deposits of USD 410 and USD 330 were in
transit
...
What is the amount of deposits in transit at August 31?
Exercise H Holder Company deposits all cash receipts intact each day and makes all payments by check
...
The bank statement
for the month ended on October 31 showed a balance of USD 3,988
...

October 31 cash receipts of USD 838 were placed in the bank's night depository and do not appear on the bank
statement
...

Check No
...

Prepare a bank reconciliation for Holder Company as of October 31
...

Exercise I On August 31, Brighton Company's petty cash fund contained coins and currency of USD 260, an
IOU from an employee of USD 30, and vouchers showing expenditures of USD 120 for postage, USD 52 for taxi
fare, and USD 138 to entertain a customer
...
The fund is
replenished on August 31 because financial statements are to be prepared
...
What entry would have been required if the amount of coin
and currency had been USD 247
...
0 License
Exercise K Rock Company has a USD 450 petty cash fund
...
2 The petty cash fund was increased to USD 1,350
...
318 for USD 14
...
The fund was not
replenished at this time
...

Prepare any necessary journal entries for these transactions
...
724
No
...
896
No
...
898
Adjusted cash balance, June 30

Cash
Amount
$29,143
...
45
15
...
55
187
...
90

$29,143
...
31
942
...
91

443
...
36

Tiffany's July bank statement follows:
Balance, July 1
Deposits during July
Canceled checks returned:
No
...
896
No
...
898
No
...
900
No
...
904
NSF Check of Starr Company
Bank statement balance, July 31

$28,644
...
94
$ 18
...
55
187
...
90
18
...
55
946
...
01

$2,787
...
98

$34,086
...
87
$31,158
...
30
...

No
...

No
...

No
...

No
...
86
1,349
...
75
946
...
70
44
...
50
15
...
37
...

Problem B The following information pertains to Hughes Company as of 2010 May 31:
• Balance per bank statement as of 2010 May 31, was USD 59,410
...

• A late deposit on May 31 did not appear on the bank statement, USD 4,275
...


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...
Interest revenue was USD 45 of the total
...

• Comparison of the canceled checks with the check register revealed that one check in the amount as USD

1,458 had been recorded in the books as USD 1,539
...

• A review of the deposit slips with the bank statement showed that a deposit for USD 2,250 of a company

with a similar account number had been credited to the Hughes Company account in error
...
Petty, was returned with the bank statement marked NSF
...
Hughes Company had not recorded the payment of this
note
...
Parker, of USD 1,458 as USD 1,944
...

a
...

b
...

Problem C The following transactions pertain to the petty cash fund of Carrington Company:
Nov
...

Dec
...
An analysis of the fund shows:
Coins and currency
Petty cash vouchers for:
Delivery expenses
Transportation-In
Postage stamps purchased

$147
...
48
111
...
00

31 The end of the accounting period falls on this date
...
The fund's contents on this
date consist of:
Coins and currency
Petty cash vouchers for:
Delivery expenses
Postage stamps purchased
Employee's IOU

$ 352
...
65
36
...
00

Present journal entries to record these transactions
...

Problem D The following transactions relate to the petty cash fund of Jarvis Wrecking Company
Apr
...

19 Because the money in the fund is down to USD 70
...

Petty cash vouchers as follows:
Flowers for hospitalized employee (miscellaneous expense)
Postage stampls
Office supplies

$84
...
00
46
...
07
...
The petty cash vouchers are for the following:
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This book is licensed under a Creative Commons Attribution 3
...
12
92
...

Prepare the journal entries to record these transactions
...

Balance of the Cash in Bank account on the company books as of 2010 June 30, is USD 8,795
...

Bank deposit of June 30 for USD 2,735 was not included in the deposits per the bank statement
...
The bank charged the company a collection fee of USD 15 on the note
...

Bank service charges for June, exclusive of the collection fee, amounted to USD 95
...
The bookkeeper had recorded
the check at USD 920 in the company records
...
No
entry has been made to reflect the returned check on the company records
...
The check had been received as a payment on the customer's account receivable
...

Alternate problem B The bank statement of Irish Company's checking account with the 2nd National Bank
shows:
Balance, 2010 June 30
Deposits
Less: Checks deducted
Service charges
Balance, 2010 July 31

$243,001
67

$166,118
245,700
411,818
243,068
$168,750

The following additional data are available:
Balance per ledger account as of July 31 was USD 128,209
...
Proceeds were USD 13,500, of which USD 375 was interest
...

Deposits in transit as of July 31 totaled USD 33,750
...

The bank added the USD 29,025 deposit of another company to Irish's account in error
...


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...
75 and by the bank at the actual amount of USD
4,542
...
The receipts for the day were from collections on account
...

a
...

b
...

Alternate problem C Transactions involving the petty cash fund of Sonar Company are as follows:
Mar
...

31 Fund was replenished on this date
...
50
$82
...
00
32
...
00
15
...
00
15
...
Use the Cash Short and Over account for any shortage or overage
in the fund
...
Transactions involving this fund
follow:
June 4 Set up a petty cash fund of USD 225
...
35, the custodian of the fund was reimbursed for expenditures
made, including:
Transportation-in
Postage
Office supplies

$ 82
...
00
81
...
The fund had the following cash and vouchers before reimbursement:
Coins and currency
Petty cash vouchers for:
Employee's IOU
Postage
Office supplies

$174
...
00
27
...
10

July 1 The petty cash fund balance is increased to USD 300
...

Beyond the numbers—Critical thinking
Business decision case A During a national emergency, a managerial accountant was called back to active
duty with the US Army
...
He obtained a position in a small company as the only accountant
...
On one weekend, he traveled to some neighboring cities and mailed invoices made out to the company for
which he worked
...
The following weekend he returned to the neighboring cities and cashed and deposited

367

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...
After continuing this practice for several months, he withdrew all
of the funds and never was heard from again
...
Remember that this small company
had limited financial resources
...
One of the few changes in personnel made by Billings was to install a
college classmate as the office manager-bookkeeper-cashier-sales manager
...
Although his business seemed profitable, there was a
shortage of cash
...
Finally, after a year
had elapsed, Billings's father employed you, a certified public accountant, to audit the records of his business
...
More specifically, he had:
• Pocketed cash receipts from sales and understated the cash register readings at the end of the day or altered

the copies of the sales tickets retained
...

• Issued checks to fictitious suppliers and deposited them in accounts bearing these names with himself as

signer of checks drawn on these accounts; the books were kept in balance by debiting the Purchases account
...

• Prepared false sales returns vouchers indicating the return of cash sales to cover further thefts of cash

receipts
...

Business decision case C The outstanding checks of Brothers Company at 2010 November 30, were:
No
...

No
...

No
...
Checks 3678, 3679, and 3680 also cleared the bank
...
Service charges amounted to USD 20,
and two checks were returned by the bank, one marked NSF in the amount of USD 114 and the other marked “No
account" in the amount of USD 2,000
...
Hannah noted the absence of an internal control structure but was momentarily deterred from
embezzling for lack of a scheme of concealment
...
The USD 2,000 check
marked “No account" by the bank is the product of one scheme
...


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...
Hannah pocketed cash receipts in an amount equal to two unlisted
outstanding checks and prepared the following bank reconciliation:
Balance per bank statement, 2010 December 31
Add: Deposit in transit
Less: Outstanding checks
No
...
3720
Adjusted balance, December 2010
Balance per ledger, 2010 December 31
Add: Worthless check
NSF check
Service charges
Adjusted balance, 2010 December 31

$23,944
...
80
$26,781
...
00
726
...
00
114
...
00

1,689
...
80
$27,226
...
00
$25,092
...
State the nature of the second scheme hit on by Hannah
...
Prepare a correct bank reconciliation as of 2010 December 31
...
After your analysis in (a) and (b), describe several procedures that would have defeated Fred Hannah's
attempts to misappropriate funds and conceal these actions
...

Annual report analysis D In Reader's Digest's Annual Report, under Report of Management, the chairman
and chief executive officer and the executive vice president and chief financial officer stated:
The company maintains a system of internal accounting controls designed to provide reasonable
assurance, at reasonable cost, that transactions and events are recorded properly and that assets
are safeguarded
...

What is the purpose of this statement? To which basic elements of the internal control structure does the
statement refer?
Annual report analysis E Obtain an annual report for a company (your library may have some annual
reports)
...
Comment on the results
...
Describe the steps the owners could take to end John Blue's wage supplement scheme
...
Specifically, discover how it protects its assets against theft and waste, ensures compliance with
company policies and federal laws, evaluates performance of its personnel, and ensures accurate and reliable
operating data and accounting reports
...
Write a
report to your instructor summarizing your findings and be prepared to make a short presentation to the class
...
Interview the custodians of those funds to identify the controls that are used to manage those funds
...
Be prepared to make a short presentation to the class
...
0 License
Group project I "Kiting" of bank accounts has been used to conceal shortages in bank accounts
...
Write a paper to your instructor describing how this technique
works and the steps that can be taken to detect it once it occurs and to prevent it in the future
...
vfauditmall
...
Click on the visitors center, CCA Studio, Tool Box, Job
Shop, Tek Shak, Risk Depot, Contact Plaza, and Arcade
...

Visit the Securities and Exchange website and find the EDGAR database at:
http://www
...
gov/edgar
...
What is its purpose? What
kinds of information can be found at this site? Select a company of your choice and search the EDGAR database for
information on that company
...

Answers to self-test
True-false
False
...

True
...

False
...

False
...

False
...

Multiple-choice
d
...

a
...
20
271
...
80)
$1,794
...
60
(61
...
80)
$1,794
...
Deposits in transit have been recorded in the company's accounting records but have not yet been recorded in
the bank's records
...
The entry to record bank service charges on the books is:
Bank Service Charge Expense
Cash

13
...
80

d
...

Postage Expense
Cash

xxx
xxx

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...
Receivables and payables
Learning objectives
After studying this chapter, you should be able to:
• Account for uncollectible accounts receivable under the allowance method
...

• Define liabilities, current liabilities, and long-term liabilities
...

• Account for notes receivable and payable, including calculation of interest
...

• Analyze and use the financial results—accounts receivable turnover and the number of days' sales in accounts

receivable
...
It involves assisting legal counsel in
attempting to gain favorable verdicts in a court of law
...
An experienced
litigation support person can expect to earn an income well into six figures
...
The practice of litigation support involves assisting legal counsel in such things as product
liability disputes, shareholder disputes, contract breaches, and major losses reported by entities
...

The accountant can be, and often is, requested to serve as an expert witness in a court of law
...

What kind of person pursues litigation support as a career? It takes a very special individual
...
An undergraduate accounting
degree, an MBA, and a law degree would be the perfect educational background needed for such a career
...
Such a program fulfills the graduate needs of the litigation support
person
...
A career in public accounting,
industry, or with a government agency would serve as valuable experience in pursuing a career in litigation support
...
Managers of
companies have learned that by granting customers the privilege of charging their purchases, sales and profits
increase
...


Accounting Principles: A Business Perspective

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...
For a company, a receivable is any sum of money due to be
paid to that company from any party for any reason
...

Primarily, receivables arise from the sale of goods and services
...
We pay particular
attention to accounting for uncollectible accounts receivable
...
Accounts
payable normally result from the purchase of goods or services and do not carry an interest charge
...
Chapter 4 identified accounts payable and
short-term notes payable as current liabilities
...
Long-term notes payable usually result from borrowing money from a bank or other
institution to finance the acquisition of plant assets
...


Accounts receivable
In Chapter 3, you learned that most companies use the accrual basis of accounting since it better reflects the
actual results of the operations of a business
...
The company has
earned the revenue because it has completed the seller's part of the sales contract by delivering the goods
...

This promise to pay by the customer is an account receivable to the seller
...
Frequently, these receivables resulting
from credit sales of goods and services are called trade receivables
...
However, customers may sign a sales invoice to acknowledge
purchase of goods
...
Companies usually do not
charge interest on amounts owed, except on some past-due amounts
...
Companies use two methods for handling uncollectible accounts
...
The direct write-off method recognizes bad accounts as an expense
at the point when judged to be uncollectible and is the required method for federal income tax purposes
...

Even though companies carefully screen credit customers, they cannot eliminate all uncollectible accounts
...
The matching
principle requires deducting expenses incurred in producing revenues from those revenues during the accounting

372

This book is licensed under a Creative Commons Attribution 3
...
The allowance method of recording uncollectible accounts adheres to this principle by recognizing the
uncollectible accounts expense in advance of identifying specific accounts as being uncollectible
...
The purpose of the entry is to make the income statement fairly present the proper expense and the
balance sheet fairly present the asset
...
We classify
uncollectible accounts expense as a selling expense because it results from credit sales
...

To adhere to the matching principle, companies must match the uncollectible accounts expense against the
revenues it generates
...
Estimates are necessary because the company sometimes
cannot determine until 2008 or later which 2010 customer accounts will become uncollectible
...
It debits Uncollectible Accounts Expense, thus
recording the operating expense in the proper period
...

As a contra account to the Accounts Receivable account, the Allowance for Uncollectible Accounts (also
called Allowance for doubtful accounts or Allowance for bad debts) reduces accounts receivable to their net
realizable value
...

When the firm makes the uncollectible accounts adjusting entry, it does not know which specific accounts will
become uncollectible
...
If only one or the other were credited, the Accounts
Receivable control account balance would not agree with the total of the balances in the accounts receivable
subsidiary ledger
...

To illustrate the adjusting entry for uncollectible accounts, assume a company has USD 100,000 of accounts
receivable and estimates its uncollectible accounts expense for a given year at USD 4,000
...


31 Uncollectible Accounts Expense (-SE)
Allowance for Uncollectible Accounts (-A)
To record estimated uncollectible accounts
...
The credit to
Allowance for Uncollectible Accounts reduces accounts receivable to their net realizable value on the balance sheet
...
It reports the
allowance on the balance sheet as a deduction from accounts receivable as follows:
Brice Company
Balance Sheet
2010 December 31
Current assets
Cash
Accounts receivable
Less: Allowance for uncollectible accounts

$21,200
$ 100,000
4,000

Accounting Principles: A Business Perspective

96,000

373

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9
...
The first method—percentage-of-sales method—focuses on the income statement and the relationship
of uncollectible accounts to sales
...

Percentage-of-sales method The percentage-of-sales method estimates uncollectible accounts from the
credit sales of a given period
...
When cash sales are small or make up a fairly constant percentage of total
sales, firms base the calculation on total net sales
...
The formula to determine the amount of the entry is:
Amount of journal entry for uncollectible accounts – Net sales (total or credit) x Percentage estimated as
uncollectible
To illustrate, assume that Rankin Company's uncollectible accounts from 2008 sales were 1
...
A similar calculation for 2009 showed an uncollectible account percentage of 0
...
The average
for the two years is 1 per cent [(1
...
9)/2]
...

Total net sales for 2010 were USD 500,000; receivables at year-end were USD 100,000; and the Allowance for
Uncollectible Accounts had a zero balance
...


31 Uncollectible Accounts Expense (-SE)
Allowance for Uncollectible Accounts (-A)
To record estimated uncollectible accounts
($500,000 X 0
...


5,000

5,000

Using T-accounts, Rankin would show:
Uncollectible Accounts Expense
Dec
...
before
adjustment
Dec
...
after
adjustment

-05,000
5,000

Rankin reports Uncollectible Accounts Expense on the income statement
...
We would classify this expense as a selling expense since it is a normal consequence of selling on credit
...
Under the percentage-of-sales method, the company ignores any existing balance in the allowance
when calculating the amount of the year-end adjustment (except that the allowance account must have a credit
balance after adjustment)
...
The
adjusting entry would still be for USD 5,000
...
On the
income statement, Uncollectible Accounts Expense would still be 1 per cent of total net sales, or USD 5,000
...
0 License
In applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts
that resulted from the previous year's sales
...

However, if the situation has changed significantly, the company increases or decreases the percentage rate to
reflect the changed condition
...
However, if the company adopts a more
stringent credit policy, it may have to decrease the percentage rate because the company would expect fewer
uncollectible accounts
...
Rankin would multiply the
ending balance in Accounts Receivable by a rate (or rates) based on its uncollectible accounts experience
...

To calculate the amount of the entry for uncollectible accounts under the percentage-of-receivables method
using an overall rate, Rankin would use:
Amount of entry for uncollectible accounts – (Accounts receivable ending balance x percentage estimated as
uncollectible) – Existing credit balance in allowance for uncollectible accounts or existing debit balance in
allowance for uncollectible accounts
Using the same information as before, Rankin makes an estimate of uncollectible accounts at the end of 2010
...
If Rankin estimates
that 6 per cent of the receivables will be uncollectible, the adjusting entry would be:
Dec
...
06)
...
31
Adjustment 6,000

Allowance for Uncollectible Accounts
Bal
...
31
Adjustment
Bal
...
The difference in amounts arises because
management wants the allowance account to contain a credit balance equal to 6 per cent of the outstanding
receivables when presenting the two accounts on the balance sheet
...
06)-USD 300] = USD 5,700
...
Using T-accounts, Rankin
would show:
Uncollectible Accounts Expense
Dec
...
before
Adjustment
Dec
...
after
Adjustment

Accounting Principles: A Business Perspective

375

300
5,700
6,000

A Global Text

9
...
Then, a credit of USD 6,300 would be necessary to get the balance to the required USD 6,000 credit
balance
...
06) + USD 300] = USD 6,300
...
31
Adjustment 6,300

Allowance for Uncollectible Accounts
Bal
...
31
Adjustment 300
Adjustment 6,300
Bal
...
The desired USD 6,000 ending credit balance in the
Allowance for Uncollectible Accounts serves as a "target" in making the adjustment
...
However, some
companies use a different percentage for each age category of accounts receivable
...
An aging schedule classifies
accounts receivable according to how long they have been outstanding and uses a different uncollectibility
percentage rate for each age category
...
In Exhibit 77, the aging
schedule shows that the older the receivable, the less likely the company is to collect it
...
For example, based on experience, a company can expect only 1 per cent of the
accounts not yet due (sales made less than 30 days before the end of the accounting period) to be uncollectible
...
For
each age category, the firm multiplies the accounts receivable by the percentage estimated as uncollectible to find
the estimated amount uncollectible
...

Since the aging schedule approach is an alternative under the percentage-of-receivables method, the balance in
the allowance account before adjustment affects the year-end adjusting entry amount recorded for uncollectible
376

This book is licensed under a Creative Commons Attribution 3
...
For example, the schedule in Exhibit 77 shows that USD 24,400 is needed as the ending credit balance in
the allowance account
...

The information in an aging schedule also is useful to management for other purposes
...
For
example, if the age of many customer balances has increased to 61-90 days past due, collection efforts may have to
be strengthened
...
Preparation of an aging schedule may also help identify certain accounts that should be written off as
uncollectible
...
Agencies can call employers only if the
employers allow such calls
...

Write-off of receivables As time passes and a firm considers a specific customer's account to be uncollectible,
it writes that account off
...
The credit is to the Accounts
Receivable control account in the general ledger and to the customer's account in the accounts receivable subsidiary
ledger
...
The entry to write
off this account is:
Allowance for Uncollectible Accounts (-SE)
Accounts Receivable—Smith (-A)
To write off Smith's account as uncollectible
...
Debiting the allowance account and crediting Accounts
Receivable shows that the firm has identified Smith's account as uncollectible
...
The company recognized the uncollectible
accounts expense in the same accounting period as the sale
...

A write-off does not affect the net realizable value of accounts receivable
...
After posting that entry, accounts receivable are
USD 49,250, and the allowance is USD 2,250; net realizable value is still USD 47,000, as shown here:

Accounts receivable
Allowance for uncollectible accounts
Net realizable value

Before
Write-Off
$ 50,000 Dr
...

$47,000

Entry for
Write-Off
$750 Cr
...


After
Write-Off
$ 49,250 Dr
...

$ 47,000

You might wonder how the allowance account can develop a debit balance before adjustment
...
Receivables and payables
make the adjusting entry for uncollectible accounts only at year-end
...
If the company wrote off any uncollectible accounts during 2009, it would
debit Allowance for Uncollectible Accounts and cause a debit balance in that account
...
This
adjusting entry would cause the allowance account to have a credit balance
...
Even if the adjustment at the end
of 2009 was adequate to cover all accounts receivable existing at that time that would later become uncollectible,
some accounts receivable from 2010 sales may be written off before the end of 2010
...

Uncollectible accounts recovered Sometimes companies collect accounts previously considered to be
uncollectible after the accounts have been written off
...
Then the company reverses the original write-off entry and reinstates the
account by debiting Accounts Receivable and crediting Allowance for Uncollectible Accounts for the amount
received
...
The firm also records the amount received as a debit to Cash and a credit to Accounts Receivable
...

To illustrate, assume that on May 17 a company received a USD 750 check from Smith in payment of the account
previously written off
...

17 Cash (+A)
Accounts Receivable—Smith (-A)
To record collection of account
...
As a result, the company may decide to sell to him in the future
...
If a company expects full
payment, it reinstates the entire amount of the account
...
This policy relieves the company of the headaches of
collecting overdue accounts
...
The allowance for losses on small-balance
receivables reflects management's best estimate of probable losses inherent in the portfolio
determined principally on the basis of historical experience
...
0 License

management's best estimate of probable losses, including specific allowances for known troubled
accounts
...
Small-balance accounts generally are written off
when 6 to 12 months delinquent, although any such balance judged to be uncollectible, such as an
account in bankruptcy, is written down immediately to estimated realizable value
...

When collateral is repossessed in satisfaction of a loan, the receivable is written down against the
allowance for losses to estimated fair value of the asset less costs to sell, transferred to other assets
and subsequently carried at the lower of cost or estimated fair value less costs to sell
...

(In millions)
Balance at January 1
Provisions charged
To operations
Net transfers related to
companies acquired
or sold
Amounts written
off-net
Balance at December 31
Source: General Electric Company, 2000 Annual
Report
...
The expert system
reaches conclusions based on rules and information programmed into the expert system software
...
In the medical field, for instance, the rules constituting the expert system are derived
from modeling the diagnostic decision processes of the foremost experts in a given area of
medicine
...

In a similar fashion, an accountant can feed client information into the expert system and receive
an evaluation as to the appropriateness of the account balance or internal control structure
...
g
...
g
...
For some businesses, uncollectible account losses and other costs of
extending credit are a burden
...
Receivables and payables
to banks and agencies issuing national credit cards
...

Usually, banks and agencies issue credit cards to approved credit applicants for an annual fee
...

When making a credit card sale, the seller checks to see if the customer's card has been canceled and requests
approval if the sale exceeds a prescribed amount, such as USD 50
...
Also, this policy protects the credit agency from sales causing customers to
exceed their established credit limits
...
To illustrate the entries for the use of nonbank credit cards (such as American
Express), assume that a restaurant American Express invoices amounting to USD 1,400 at the end of a day
...
The restaurant uses the Credit Card
Expense account to record the credit card agency's service charge and makes the following entry:
Accounts Receivable—American Express (+A)
Credit Card Expense (-SE)
Sales (+SE)
To record credit card sales
...
Sometime later, the restaurant receives payment from
American Express and makes the following entry:
Cash (+A)
Accounts Receivable – American Express (-A)
To record remittance from American Express
...
VISA sales are treated as cash sales because the receipt of cash is certain
...
The entry to record this deposit is:
Cash (+A)
Credit Card Expense (-SE)
Sales (+SE)
To record credit Visa card sales
...
g
...
Discover Card, for example, remits a percentage of all charges back
to credit card holders
...

Just as every company must have current assets such as cash and accounts receivable to operate, every company
incurs current liabilities in conducting its operations
...
0 License
firms), and single proprietorships (corner grocery stores) all have one thing in common—they have liabilities
...


Current liabilities
Liabilities result from some past transaction and are obligations to pay cash, provide services, or deliver goods
at some future time
...
The balance sheet divides liabilities into current liabilities and long-term
liabilities
...
Long-term
liabilities are obligations that do not qualify as current liabilities
...

Note the definition of a current liability uses the term operating cycle
...
For most companies,
this period is no longer than a few months
...
Manufacturing companies generally have the longest cycle because their
cash is tied up in inventory accounts and in accounts receivable before coming back
...
Thus, as a practical matter, current liabilities are due in one
year or less, and long-term liabilities are due after one year from the balance sheet date
...
The existence of the liability and its amount are certain
...
Sales tax payable, federal excise tax payable, current portions of
long-term debt, and payroll liabilities are other examples
...
The existence of the liability is certain, but its amount only can be estimated
...

• Contingent liabilities
...

Examples include liabilities arising from lawsuits, discounted notes receivable, income tax disputes, penalties
that may be assessed because of some past action, and failure of another party to pay a debt that a company
has guaranteed
...
Receivables and payables
Estimated liabilities
Contingent liabilities

Yes
No

No
No

Clearly determinable liabilities have clearly determinable amounts
...
Later in this chapter, we discuss clearly determinable liabilities such as notes
payable
...
The company selling
the product is responsible for collecting the sales tax from customers
...
Periodically, the company pays the sales taxes collected to the
state
...

To illustrate, assume that a company sells merchandise in a state that has a 6 per cent sales tax
...


1,060
1,000
60

Now assume that sales for the entire period are USD 100,000 and that USD 6,000 is in the Sales Tax Payable
account when the company remits the funds to the state taxing agency
...
For
instance, the previous company could record sales as follows:
Accounts Receivable (+A)
Sales (+SE)

1,060
1,060

When recording sales taxes in the same account as sales revenue, the firm must separate the sales tax from sales
revenue at the end of the accounting period
...
For instance, assume that total recorded sales revenues for an
accounting period are USD 10,600, and the sales tax rate is 6 per cent
...
Sales tax is equal to the recorded sales revenue of USD 10,600
less actual sales revenue of USD 10,000, or USD 600
...
The entries a company makes when selling goods
subject to the federal excise tax are similar to those made for sales taxes payable
...
The sale is subject to a 6 per cent sales
tax and a 10 per cent federal excise tax
...
0 License
Federal Excise Tax Payable
To record the sale of a diamond ring
...

Current portions of long-term debt Accountants move any portion of long-term debt that becomes due
within the next year to the current liability section of the balance sheet
...
Beginning in the 5th year, an accountant would move a USD 10,000 note from the long-term
liability category to the current liability category on the balance sheet
...


An accounting perspective:
Uses of technology
Many companies use service bureaus to process their payrolls because these bureaus keep up to
date on rates, bases, and changes in the laws affecting payroll
...
Managers
instruct service bureaus either to print the payroll checks or to transfer data back to the company
over the Internet so it can print the checks
...
Payroll liabilities include taxes and other amounts
withheld from employees' paychecks and taxes paid by employers
...
Assume that a company had a payroll of USD 35,000 for the
month of April 2010
...
This
entry records the payroll:
2010
April

30

Salaries Expense (-SE)
35,000
Employees' Federal Income Taxes Payable (+L)
Employees' State Income Taxes Payable (+L)
FICA Taxes Payable (+L)
Employees' Medical Insurance Premiums Payable
(+L)
Salaries Payable (+L)
To record the payroll for the month ending April 30
...
When these liabilities are paid, the employer debits each one and credits
Cash
...
Receivables and payables
Employers normally record payroll taxes at the same time as the payroll to which they relate
...
The entry to record these payroll taxes would be:
2010
April

30 Payroll Taxes Expense (-SE)
FICA Taxes Payable (+L)
State Unemployment Taxes Payable (+L)
Federal Unemployment Taxes Payable (+L)
To record employer's payroll taxes
...
The credit to FICA Taxes
Payable is equal to the amount withheld from the employees' paychecks
...

When these liabilities are paid, the employer debits each of the liability accounts and credits Cash
...
As long as
companies update this module each time rates, bases, or laws change, they can calculate
withholdings, print payroll checks, and complete reporting forms for taxing agencies
...

Managers of companies that have estimated liabilities know these liabilities exist but can only estimate the
amount
...
An
example of an estimated liability is product warranty payable
...
When defects occur, the company is obligated to
reimburse the customer or repair the product
...
To provide for a proper matching of revenues and expenses, the accountant estimates the
warranty expense resulting from an accounting period's sales
...

To illustrate, assume that a company sells personal computers and warrants all parts for one year
...
The company expects 10 per
cent of the computers to develop defective parts within one year
...
The estimated
average cost of warranty repairs per defective computer is USD 150
...
Receivables and payables
Number of computers sold
Percent estimated to develop defects
Total estimated defective computers
Deduct computers returned as defective to date
Estimated additional number to become
defective during warranty period
Estimated average warranty repair cost per compute:
Estimated product warranty payable

1,000
X 10%
100
40
60
X $ 150
$9,000

The entry made at the end of the accounting period is:
Product Warranty Expense (-SE)
Estimated Product Warranty Payable (+L)
To record estimated product warranty expense
...
For instance, assume
that Evan Holman returns his computer for repairs within the warranty period
...
The company makes the following entry:
Estimated Product Warranty Payable (-L)
Repair Parts Inventory (-A)
Wages Payable (+L)
To record replacement of parts under warranty
...

One company had the following note in its recent financial statements:
In the past, the Company treated hazardous waste at its chemical facilities
...
In compliance with environmental regulations, the Company developed a
plan that will prevent further contamination, provide for remedial action to remove the present
contaminants, and establish a monitoring program to monitor ground water conditions in the
future
...

Estimated future costs of USD 2,860,000 have been accrued in the accompanying financial
statements
...

When liabilities are contingent, the company usually is not sure that the liability exists and is uncertain about
the amount
...
5 defines a contingency as "an existing condition, situation, or set of
circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved
when one or more future events occur or fail to occur"
...
5, if the liability is probable and the amount can be reasonably estimated,
companies should record contingent liabilities in the accounts
...
5, "Accounting for Contingencies" (Stamford, Conn
...
Copyright © by Financial Accounting Standards Board, High Ridge Park, Stamford, Connecticut 06905,
USA
...
0 License
occur and the amount often cannot be reasonably estimated, the accountant usually does not record them in the
accounts
...

Many contingent liabilities arise as the result of lawsuits
...
30
The following two examples from annual reports are typical of the disclosures made in notes to the financial
statements
...
One
company included the following note in its annual report to describe its contingent liability regarding various
lawsuits against the company:
Contingent liabilities:
Various lawsuits and claims, including those involving ordinary routine litigation incidental to its business, to
which the Company is a party, are pending, or have been asserted, against the Company
...
that the United States Environmental Protection Agency had determined the existence of PCBs in a
river and harbor near Sheboygan, Wisconsin,USA, and that the Company, as well as others, allegedly contributed to
that contamination
...
Although the outcome of these matters
cannot be predicted with certainty, and some of them may be disposed of unfavorably to the Company,
management has no reason to believe that their disposition will have a materially adverse effect on the consolidated
financial position of the Company
...
A jury awarded USD 5
...
The Company has appealed the judgment on the basis of errors in the judge's
instructions to the jury and insufficiency of evidence to support the amount of the jury's award
...

The Company and its subsidiaries are also involved in various other litigation arising in the ordinary course of
business
...
The resolution of the appeal of the jury award could have a
significant effect on the Company's earnings in the year that a determination is made; however, in management's
opinion, the final resolution of all legal matters will not have a material adverse effect on the Company's financial
position
...

The remainder of this chapter discusses notes receivable and notes payable
...


30 AICPA, Accounting Trends & Techniques (New York, 2000), p
...

Accounting Principles: A Business Perspective

386

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9
...
On the balance sheet of the lender
(payee), a note is a receivable; on the balance sheet of the borrower (maker), a note is a payable
...
Look at
the promissory note in Exhibit 78
...
Also, a business may give a note to a supplier in exchange for merchandise to sell or to a
bank or an individual for a loan
...

Companies usually do not establish a subsidiary ledger for notes
...

Most promissory notes have an explicit interest charge
...
To the maker of the note, or borrower, interest is an expense; to the payee of the note, or lender, interest is a
revenue
...
For convenience, bankers sometimes
calculate interest on a 360-day year; we calculate it on that basis in this text
...
)

Exhibit 78: Promissory note
The basic formula for computing interest is:
Interest=Principal× Rate×Time , or

I= P× R×T

Principal is the face value of the note
...
Time, which is the amount of time the note is to run, can be either days or
months
...
The note has a
principal (face value) of USD 20,000, an annual interest rate of 10 per cent, and a life of 90 days
...
10×

90
360

Interest = USD 500

387

This book is licensed under a Creative Commons Attribution 3
...

The maturity date is the date on which a note becomes due and must be paid
...
The wording in the note expresses the maturity date and determines when the note is to be paid
...
Examples of the maturity date wording are:
• On demand
...
" When the maturity date is on demand, it is at the option of

the holder and cannot be computed
...

• On a stated date
...
" When the maturity date is designated, computing

the maturity date is not necessary
...


(a) "One year after date, I promise to pay
...

(b) "Four months after date, I promise to pay
...
For example, one month from 2010 July 18, is 2010
August 18, and two months from 2010 July 18, is 2010 September 18
...
A one-month note dated 2010 January 31, matures on 2010
February 28
...
" When the maturity is expressed in days, the exact
number of days must be counted
...
For example, a 90-day note dated 2010 October 19, matures on 2008
January 17, as shown here:
Life of note (days)
Days remaining in October not counting date of origin of note:
Days to count in October (31 - 19)
Total days in November
Total Days in December
Maturity date in January

90 days
12
30
31

73
17 days

Sometimes a company receives a note when it sells high-priced merchandise; more often, a note results from the
conversion of an overdue account receivable
...
This action
allows the customer more time to pay the balance due, and the company earns interest on the balance until paid
...

To illustrate the conversion of an account receivable to a note, assume that Price Company (maker) had
purchased USD 18,000 of merchandise on August 1 from Cooper Company (payee) on account
...
Cooper agrees to accept Price's USD 18,000, 15 per cent, 90day note dated September 1 to settle Price's open account
...
0 License
Cooper Company, Payee
Accounts Receivable—Price Company (+A)
Aug
...

Sept
...

Nov
...
15 X /360)
...

Price Company, Maker
Purchase (+A)
Aug
...

Sept
...

Nov
...
15 X /360)
...


18,000

18,000

18,000
18,000
18,675
18,000
675

18,000
18,000

18,000
18,000

18,000
675
18,675

The USD 18,675 paid by Price to Cooper is called the maturity value of the note
...

Sometimes the maker of a note does not pay the note when it becomes due
...

A dishonored note is a note that the maker failed to pay at maturity
...

At the maturity date of a note, the maker should pay the principal plus interest
...
The payee should record the interest earned and
remove the note from its Notes Receivable account
...
After these entries have been posted, the full liability on the note—principal plus interest—is included in
the records of both parties
...
To illustrate, assume that Price did not pay the note at maturity
...
30 Accounts Receivable—Price Company (+A)
Notes Receivable (-A)
Interest Revenue (+SE)
To record dishonor of Price Company note
...
30 Interest Expense (-SE)
Interest Payable (+L)
To record interest on note payable
...
Both parties account for the new note in the
same manner as the old note
...
Receivables and payables
the payee writes off the account with a debit to Uncollectible Accounts Expense (or to an account with a title such as
Loss on Dishonored Notes) and a credit to Accounts Receivable
...

Assume that Price Company pays the interest at the maturity date and issues a new 15 per cent, 90-day note for
USD 18,000
...

(Optional entry)
18,000
Notes Receivable (+A)
Notes Receivable (-A)
To replace old 15%,
90-day note from
Price Company with
new 15%, 90-day
note
...

(Optional entry)
Notes Payable (-L)
Notes Payable (+L)
To replace old 15%,
90-day note to Cooper
Company with new
15%, 90-day note
...
Both parties substitute the new note, or a copy, for the old note in a file of
notes
...
The entries on both sets of books would be:
Cooper Company, Payee
Notes Receivable (+A) 18,675
Interest Revenue (+SE)
675
Notes Receivable (-A)
18,000
To record the
replacement of the
old Price Company
$18,000, 15%, 90day note with a
new $18,675, 15%,
90-day note
...


18,675

On an interest-bearing note, even though interest accrues, or accumulates, on a day-to-day basis, usually both
parties record it only at the note's maturity date
...
Both the payee and maker of the note must make an adjusting entry to record the
accrued interest and report the proper assets and revenues for the payee and the proper liabilities and expenses for
the maker
...

Payee's books To illustrate how to record accrued interest on the payee's books, assume that the payee, Cooper
Company, has a fiscal year ending on October 31 instead of December 31
...


3
1

Interest Receivable (+A)
Interest Revenue ($18,000 X 0
...
0 License
note
for the period September 1 through October
31
...
Interest receivable is a
current asset in the balance sheet because the interest will be collected in 30 days
...
When Price pays the note on November 30, Cooper makes the following entry to record the
collection of the note's principal and interest:
Nov
...


18,000
450
225

Note that the entry credits the Interest Receivable account for the USD 450 interest accrued from September 1
through October 31, which was debited to the account in the previous entry, and credits Interest Revenue for the
USD 225 interest earned in November
...

Price's accounting records would be incomplete unless the company makes an adjusting entry to record the liability
owed for the accrued interest on the note it gave to Cooper Company
...


3
1

Interest Expense ($18,000 X 0
...


450

The Interest Payable account, which shows the interest expense incurred but not yet paid, is a current
liability in the balance sheet because the interest will be paid in 30 days
...
When the note is paid, Price makes the following entry:
Nov
...


18,675

In this illustration, Cooper's financial position made it possible for the company to carry the Price note to the
maturity date
...
This topic is reserved for a more advanced text
...
This situation may occur when (1) the company's cash
receipts are delayed because of lenient credit terms granted customers, or (2) the company needs cash to finance
the buildup of seasonal inventories, such as before Christmas
...

Interest-bearing notes To receive short-term financing, a company may issue an interest-bearing note to a
bank
...
The company receives

Accounting Principles: A Business Perspective

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...

Accounting for an interest-bearing note is simple
...
Needham Company issued a USD 10,000, 90-day, 9 per cent note on 2009 December 1
...


2010
Mar
...

31 Interest Expense (-SE)
Interest Payable (+L)
To record accrued interest on a note payable at
year-end ($10,000 X 0
...

1 Notes Payable (-L)
60
Interest Expense ($10,000 X 0
...


10,000

10,000

75
75
10,000
150
75

10,225

Non interest-bearing notes (discounting notes payable) A company may also issue a non interestbearing note to receive short-term financing from a bank
...
Instead, the note is drawn for a maturity amount less a bank
discount; the borrower receives the proceeds
...
The cash proceeds are equal to the maturity amount of a note
less the bank discount
...
The purpose of this process is to
introduce interest into what appears to be a non interest-bearing note
...

Because interest is related to time, the bank discount is not interest on the date the loan is made; however, it
becomes interest expense to the company and interest revenue to the bank as time passes
...
The discount is USD 225 (USD 10,000 X 0
...
The entry required on the date of the note's issue is:

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...
1

Cash (+A)
Discount on Notes Payable (-L)
Notes Payable (+L)
Issued a 90-day note to bank
...
Discount on notes payable is a contra account
used to reduce Notes Payable from face value to the net amount of the debt
...

Over time, the discount becomes interest expense
...
However, if
Needham's fiscal year ended on December 31, an adjusting entry would be required as follows:
2009
Dec
...


75

75

This entry records the interest expense incurred by Needham for the 30 days the note has been outstanding
...
09 X 30/360, or 30/90 X USD 225
...
The Notes Payable account already
contains the total liability that will be paid at maturity, USD 10,000
...
Thus, the current liability section of the 2009 December 31, balance sheet would show:
Current Liabilities:
Notes payable
Less: Discount on notes payable

$ 10,000
150 $ 9,850

When the note is paid at maturity, the entry is:
2010
Mar
...


10,000
150

The T-accounts for Discount on Notes Payable and for Interest Expense appear as follows:
Discount on Notes Payable
2009
2009
Dec
...
31
Dec
...
1

75

2009
Dec
...
1

Interest Expense
2009
75
Dec
...


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...


Interest-Bearing Notes
1

Cash (+A)
Notes Payable (+L)

10,000

To record 90-day bank loan,

2010
Mar
...

1

Notes Payable (-L)
Interest Expense (-SE)
Interest Payable (-L)
Cash (-A)
To record note principal and
interest payment
...
1

Non interest-Bearing Notes
Cash (+A)
Discount on Notes Payable (-L)

Notes Payable (+L)
To record 90-day bank loan
...


75

2010
Mar
...


9,775
225
10,000
75
75

10,000
150
10,000
150

Exhibit 79: Comparison between interest-bearing notes and noninterest-bearing notes

Analyzing and using the financial results—Accounts receivable turnover and number of
days' sales in accounts receivable
Accounts receivable turnover is the number of times per year that the average amount of accounts
receivable is collected
...
Although analysts should
use net credit sales, frequently net credit sales are not known to those outside the company
...

Generally, the faster firms collect accounts receivable, the better
...
Both
the company's credit terms and collection policies affect turnover
...
Also, a company that aggressively
pursues overdue accounts receivable has a higher turnover of accounts receivable than one that does not
...


Net Sales
(millions)
$ 1,238
10,105

Accounts Receivable
Average
Net
Turnover
$ 14
88
...
00

We calculate the number of days' sales in accounts receivable (also called the average collection period
for accounts receivable) as follows:
Number of days ' sales per accounts receivable =

Number of days per a year 365
Accounts receivable turnover

This ratio measures the average liquidity of accounts receivable and gives an indication of their quality
...
The
longer accounts receivable remain outstanding, the greater the probability they never will be collected
...


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...


Accounts Receivable
Turnover
Number of
Day's Sales in
88
...
1
10
...
5

These companies have collection periods ranging from 4
...
5 days
...
If customers do not pay within 10 days and take
the discount offered, they incur an annual interest rate of 36
...
(They lose a 2 per cent
discount and get to use the funds another 20 days, which is equivalent to an annual rate of 36
...
)
Having studied receivables and payables in this chapter, you will study plant assets in the next chapter
...

Understanding the learning objectives
• Companies use two methods to account for uncollectible accounts receivable: the allowance method, which

provides in advance for uncollectible accounts; and the direct write-off method, which recognizes uncollectible
accounts as an expense when judged uncollectible
...

• The two basic methods for estimating uncollectible accounts under the allowance method are the

percentage-of-sales method and the percentage-of-receivables method
...
The debit to Uncollectible Accounts Expense is a certain per cent of credit sales
or total net sales
...
The credit to the Allowance for Uncollectible
Accounts is the amount necessary to bring that account up to a certain percentage of the Accounts Receivable
balance
...

• Credit cards are charge cards used by customers to charge purchases of goods and services
...

• The sale is recorded at the gross amount of the sale, and the cash or receivable is recorded at the net

amount the company will receive
...

• Current liabilities are obligations that (1) are payable within one year or one operating cycle, whichever is

longer, or (2) will be paid out of current assets or create other current liabilities
...

• Clearly determinable liabilities are those for which the existence of the liability and its amount are certain
...

• Estimated liabilities are those for which the existence of the liability is certain, but its amount can only be

estimated
...


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...
An example is a liability
arising from a lawsuit
...

• Interest is the fee charged for the use of money through time
...

• Companies sometimes need short-term financing
...

• An interest-bearing note specifies the interest rate that will be charged on the principal borrowed
...

• Calculate accounts receivable turnover by dividing net credit sales, or net sales, by average net accounts

receivable
...

• Together, these ratios show the liquidity of accounts receivable and give some indication of their quality
...

Demonstration problem
Demonstration problem A a
...
Sales
in 2010 were USD 1,125,000
...

On 2011 February 12, John Nunn's check for USD 750 arrived
...
Prepare the journal entries in the records of Lyle Company for the following:
On 2010 June 15, Lyle Company received a USD 22,500, 90-day, 12 per cent note dated 2010 June 15, from
Stone Company in payment of its account
...
Lyle Company decided that the note was
uncollectible
...
Prepare the entries on the books of Cromwell Company assuming the company
borrowed USD 10,000 at 7 per cent from First National Bank and signed a 60-day non interest-bearing note
payable on 2009 December 1, accrued interest on 2009 December 31, and paid the debt on the maturity date
...
Prepare the entries on the books of Cromwell Company assuming it purchased equipment from Jones
Company for USD 5,000 and signed a 30-day, 9 per cent interest-bearing note payable on 2010 February 24
...

Solution to demonstration problem
Solution to demonstration problem A
a
...
0 License
1
...


3
...

2011
Jan
...


31 Uncollectible Accounts Expense (-SE)
Allowance for Uncollectible Accounts (-A)
To record estimated Uncollectible accounts for
the year
...

12 Accounts Receivable—John Nunn (+A)
Allowance for Uncollectible Accounts (-A)
To correct the write-off of John Nunn's account
on January 15
...


11,250
11,250
750
750
750
750
750
750

b
...
2010 15 Notes Receivable (+A)
June
Accounts Receivable—Stone Company (-A)
To record receipt of a note from Stone Company
...
Sept 13 Accounts Receivable—Stone Company (+A)
Notes Receivable (-A)
Interest Revenue(+SE)
To record the default of the Stone Company note
of $22,500
...

13 Allowance for Uncollectible Accounts* (+A)
Accounts Receivable—Stone Company (-A)
To write off the Stone Company as uncollectible
...
If
not, the debit should be to Loss from Dishonored Notes Receivable
...

2009
Dec
...


30

b
...
07 X ' '/36)) (+A)
Notes Payable (+L)
Interest Expense (-SE)
Bank Discount (-A)
($10,000 X 0
...
09 X /360) = $37
...
33
116
...
00
58
...
00
58
...
00

58
...
33
10,000
...
00

5,000
...
50
5,037
...

Aging schedule A means of classifying accounts receivable according to their age; used to determine the
necessary balance in an Allowance for Uncollectible Accounts
...

Allowance for Uncollectible Accounts A contra-asset account to the Accounts Receivable account; it
reduces accounts receivable to their net realizable value
...

Bad debts expense See Uncollectible accounts expense
...


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...

Clearly determinable liabilities Liabilities whose existence and amount are certain
...

Contingent liabilities Liabilities whose existence is uncertain
...

Both their existence and amount depend on some future event that may or may not occur
...

Credit Card Expense account Used to record credit card agency's service charges for services rendered in
processing credit card sales
...
g
...
g
...

Current liabilities Obligations that (1) are payable within one year or one operating cycle, whichever is
longer, or (2) will be paid out of current assets or result in the creation of other current liabilities
...

Discounting a note payable The act of borrowing on a non interest-bearing note drawn for a maturity
amount, from which a bank discount is deducted, and the proceeds are given to the borrower
...

Estimated liabilities Liabilities whose existence is certain, but whose amount can only be estimated
...

Interest The fee charged for use of money over a period of time (I = P X R X T)
...

Interest Receivable account An account showing the interest earned but not yet collected; reported as a
current asset in the balance sheet
...

Long-term liabilities Obligations that do not qualify as current liabilities
...

Maturity date The date on which a note becomes due and must be paid
...

Net realizable value The amount the company expects to collect from accounts receivable
...

Operating cycle The time it takes to start with cash, buy necessary items to produce revenues (such as
materials, supplies, labor, and/or finished goods), sell goods or services, and receive cash by collecting the
resulting receivables
...

Payee (of a note) The party who receives a note and will be paid cash at maturity
...

Percentage-of-sales method A method of estimating the uncollectible accounts from the sales of a given
period's total net credit sales or net sales
...

Promissory note An unconditional written promise by a borrower (maker) to pay a definite sum of money
to the lender (payee) on demand or at a specific date
...

Receivable Any sum of money due to be paid to a company from any party for any reason
...


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...

Also called accounts receivable or trade accounts receivable
...

Self test
True-false
Indicate whether each of the following statements is true or false
...

Under the allowance method, uncollectible accounts expense is recognized when a specific customer's account is
written off
...

Liabilities result from some future transaction
...

A dishonored note is removed from Notes Receivable, and the total amount due is recorded in Accounts
Receivable
...

Multiple-choice
Select the best answer for each of the following questions
...
Any existing balance in the Allowance for Uncollectible Accounts is ignored in calculating the uncollectible
accounts expense under the percentage-of-sales method except that the allowance account must have a credit
balance after adjustment
...
The percentage-of-receivables method may use either an overall rate or a different rate for each age category
...
The Allowance for Uncollectible Accounts reduces accounts receivable to their net realizable value
...
A write-off of an account reduces the net amount shown for accounts receivable on the balance sheet
...
None of the above
...
The balance in Accounts Receivable is USD
200,000, and the allowance account has a USD 3,000 credit balance before adjustment at year-end
...
USD 7,000
...
USD 10,000
...
USD 13,000
...
USD 9,850
...
None of the above
...
Service company
...
Merchandising company
...
Manufacturing company
...
Receivables and payables
d
...

Maxwell Company records its sales taxes in the same account as sales revenues
...

At the end of the current period, the Sales account has a balance of USD 265,000
...
USD 12,000
...
USD 15,000
...
USD 15,900
...
USD 18,000
...
During 2010, the company sold 2,000 fax machines
...
To date, 30 machines have been repaired
...
The required amount of the
adjusting entry to record estimated product warranty payable is:
a
...

b
...

c
...

d
...

To compute interest on a promissory note, all of the following elements must be known except:
a
...

b
...

c
...

d
...

e
...

Keats Company issued its own USD 10,000, 90-day, non interest-bearing note to a bank
...
USD 10,000
...
USD 9,000
...
USD 9,750
...
USD 10,250
...
None of the above
...


Questions
➢

In view of the difficulty in estimating future events, would you recommend that accountants wait
until collections are made from customers before recording sales revenue? Should they wait until
known accounts prove to be uncollectible before charging an expense account?

➢

The credit manager of a company has established a policy of seeking to completely eliminate all
losses from uncollectible accounts
...


➢

What are the two major purposes of establishing an allowance for uncollectible accounts?

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...


➢

What is an operating cycle? Which type of company is likely to have the shortest operating cycle, and
which is likely to have the longest operating cycle? Why?

➢

Describe the differences between clearly determinable, estimated, and contingent liabilities
...


➢

In what instances might a company acquire notes receivable?

➢

How is the maturity value of a note calculated?

➢

What is a dishonored note receivable and how is it reported in the balance sheet?

➢

Under what circumstances does the account Discount on Notes Payable arise? How is it reported in
the financial statements? Explain why
...
What factors are taken into account by the General Electric Company in determining
the adjusting entry to establish the desired balance in the Allowance for Losses?

➢

Real world question Refer to "A Broader Perspective: GECS allowance for losses on financing
receivables"
...


Exercises
Exercise A The accounts of Stackhouse Company as of 2010 December 31, show Accounts Receivable, USD
190,000; Allowance for Uncollectible Accounts, USD 950 (credit balance); Sales, USD 920,000; and Sales Returns
and Allowances, USD 12,000
...
Uncollectible accounts are estimated at 1 per cent of net sales
...
The allowance is to be increased to 3 per cent of accounts receivable
...
Receivables and payables
39,000
12,000
2,250

3-6
6-9
9-12

75
35
10

Exercise C On 2009 April 1, Kelley Company, which uses the allowance method of accounting for uncollectible
accounts, wrote off Bob Dyer's USD 400 account
...
Prepare the necessary entries
...
, sold USD 80,000 of furniture in May to customers who used their
American Express credit cards
...
Prepare journal entries to record the sales and the subsequent receipt of cash from the credit card company
...
Do the same as requirement (a), but assume the credit cards used were VISA cards (a bank credit card)
...
, sells merchandise in a state that has a 5 per cent sales tax
...
At the end of the first quarter of operations, when it is time to remit the sales taxes to the
state taxing agency, the company has USD 420,000 in the Sales account
...

Exercise F Assume the following note appeared in the annual report of a company:
In 2009, two small retail customers filed separate suits against the company alleging misrepresentation,
breach of contract, conspiracy to violate federal laws, and state antitrust violations arising out of their purchase
of retail grocery stores through the company from a third party
...
The company is vigorously defending the actions and management believes there will be no adverse
financial effect
...
, gave a USD 20,000, 120-day, 12 per cent note to Dunston, Inc
...
Crawford uses periodic inventory procedure
...

Exercise I Based on the facts in the previous exercise, prepare the entries that Crawford, Inc
...
, would make at the maturity date, assuming Crawford defaults
...
, of USD 16,000 for 90 days
...
Prepare Wood's entries to record the loan under each of the following
assumptions:
a
...
Interest is deducted in calculating the proceeds turned over to him
...
Wood signs a note for USD 16,000 and receives that amount
...


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...

Exercise L Pistol Pete provides communication services and products, as well as network equipment and
computer systems, to businesses, consumers, communications services providers, and government agencies
...
Use net sales
instead of net credit sales in the calculation
...

Problems
Problem A As of 2009 December 31, Fargo Company's accounts prior to adjustment show:
Allowance for uncollectible accounts (credit balance)
Accounts receivable
Allowance for uncollectible accounts (credit balance)
Sales

$ 40,000
750
250,000

Fargo Company estimates uncollectible accounts at 1 per cent of sales
...
On 2010 August 12, Hall remitted USD 200 and indicated that he intends to pay the balance due as
soon as possible
...

a
...

b
...

Problem B At the close of business, Jim's Restaurant had credit card sales of USD 12,000
...
The balance of USD 8,000 consisted of American Express (nonbank credit card) charges,
subject to a 5 per cent service charge
...
Shortly thereafter, a check
was received
...

Problem C Ruiz Company sells merchandise in a state that has a 5 per cent sales tax
...
Sales taxes collected are recorded in a separate account
...
On 2010 January 31, the company remitted the sales
taxes collected to the state taxing agency
...
Prepare the general journal entries to record the January 2 sales revenue
...

b
...
The
federal excise taxes collected are remitted to the proper agency on January 31
...

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...
The average price
per car is USD 10,000, and the company sold 900 in 2009
...
The estimated average cost of warranty repairs per defective car is USD 600
...
On 2010 January 4, a
customer returned a car purchased in 2009 for repairs under warranty
...
The
cost of the repairs included parts, USD 400, and labor, USD 210
...
Calculate the amount of the estimated product warranty payable
...
Prepare the entry to record the estimated product warranty payable on 2009 December 31
...
Prepare the entry to record the repairs made on 2010 January 8
...
As of 2010 September
1, the balance in its Notes Receivable account is USD 256,000
...
A schedule of the notes (including the
dishonored note) is as follows:
Face
Amount
$ 100,000
72,000
84,000
60,000
$316,000

Maker
C
...

A
...

C
...

N
...


Date
of Note
2009/6/01
2009/6/15
2009/7/01
2009/7/01

Life
120 days
90
90
60

Interest
Rate
12%
8
10
6

Following are Celoron Power Boat Company's transactions for September:
Sept
...
Case Company as full settlement of the amount due from it
...

? The A
...

? The C
...

? C
...

30 Received a new 60-day, 12 per cent note from C
...
The note was dated as of the maturity date of the dishonored note
...

Prepare dated journal entries for these transactions
...
, discounted its own USD 30,000, non interest-bearing, 180-day
note on 2009 November 16, at Niagara County Bank at a discount rate of 12 per cent
...
The original discounting on November 16
...
The adjustment required at the end of the company's calendar-year accounting period
...
Payment at maturity
...
, a name brand shoe wholesale
store, as of 2009 December 31
...

Accounts receivable
Allowance for uncollectible accounts (credit)

$ 360,000
6,000

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...
Prepare journal entries to record all of these transactions and the uncollectible accounts expense for the
period
...

b
...

Alternate problem B The cash register at Frank's Restaurant at the close of business showed cash sales of
USD 7,500 and credit card sales of USD 10,000 (USD 6,000 VISA and USD 4,000 American Express)
...
The American Express (nonbank
credit card) charges were mailed to the company and were subject to a 5 per cent service charge
...

Prepare journal entries for all of these transactions
...
, sells merchandise in a state that has a 6 per cent sales tax
...
Sales taxes collected are recorded in a separate
account
...
On 2010 July 31, the company remitted the
sales taxes collected to the state taxing agency
...
Prepare the general journal entries to record the July 1 sales revenue and sales tax payable
...

b
...
The company remitted the federal excise taxes collected to the proper agency on July 31
...

Alternate problem D Quick Wheels, Inc
...
The average
price per bicycle is USD 560, and the company sold 4,000 in 2009
...
The estimated average cost of warranty repairs per defective
bicycle is USD 40
...
On 2010 January 2, a customer returned a bicycle purchased in 2009 for repairs under warranty
...
The cost of the repairs included parts, USD 25, and labor, USD 15
...
Calculate the amount of the estimated product warranty payable
...
Prepare the entry to record the estimated product warranty payable on 2009 December 31
...
Prepare the entry to record the repairs made on 2010 January 3
...
, has an accounting period of one year, ending on
July 31
...
A schedule of the notes receivable is as follows:
Face
Amount
$ 270,000
120,000
264,000
$654,000

Maker
Parker Co
...

Fixx Co
...
Notes Payable—Discount was debited for the
discount of USD 6,000
...
Receivables and payables
July 1 Vance Commercial Properties, Inc
...
The discount rate is 10 per cent, and the note was dated today
...

6 Purchased merchandise from Link Company, USD 288,000, and issued a 60-day, 12 per cent note, dated
today, for the purchase
...
A 30-day, 12 per cent note, dated today, is received to cover
the sale
...

15 Fixx Company sent a USD 120,000, 30-day, 12 per cent note, dated today, and a check to cover the part of the
old note not covered by the new note, plus all interest expense incurred on the prior note
...

23 Sox Company dishonored its note of July 3 and sent a check for the interest on the dishonored note and a
new 30-day, 12 per cent note dated 2009 July 23
...

Prepare dated journal entries for these transactions and necessary July 31 adjusting entries
...
, discounted its own
USD 50,000, 180-day, non interest-bearing note at its bank at 18 per cent
...

The company uses a calendar-year accounting period
...

Beyond the numbers—Critical thinking
Business decision case A Sally Stillwagon owns a hardware store; she sells items for cash and on account
...
The agency would pay her two days
after she submits sales charges, deducting 6 per cent from the amount and paying her 94 per cent
...
Using the data given, prepare an analysis showing whether or not Stillwagon would benefit from switching to
the credit card method of selling on credit
...
What other factors should she take into consideration?

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...
In a
typical year he sells USD 600,000 of goods to regular customers
...
He carries all of the credit himself
...
His income
before taxes is approximately USD 95,000
...

You are one of Perry's regular customers
...
The alternatives are as follows:
• Do not sell on credit
...

• Allow customers to charge only until their account balances reach USD 50
...


Write a report for Perry about the advisability of following any of these alternatives
...
cocacola
...
Calculate accounts receivable turnover and
the number of days' sales in accounts receivable and prepare a written comment on the results
...
Include a cover page with
the title and authors' names
...
With one or two other
students, research this topic in the library
...

Group project F In a group of two or three students, visit a fairly large company in your community to
investigate the effectiveness of its management of accounts receivable
...
Also ask about how it decides to write off accounts as uncollectible
...
In view of its credit policies, does its collection
period seem reasonable?
Using the Internet—A view of the real world
Visit one of the following Internet sites:
http://www
...
com
http://www
...
com

Accounting Principles: A Business Perspective

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9
...
invesco
...
Write a report to your instructor on your experience,
describing some of the things you learned at this site
...
Many investors with a limited amount to invest can have a diversified portfolio by investing in mutual
funds
...

Visit Procter & Gamble's site at:
http://www
...
com
Procter & Gamble markets more than 250 brands to nearly five billion consumers in over 140 countries
...
Write a memo to your instructor summarizing your findings
...

Answers to self test
True-false
False
...

False
...

True
...

False
...

True
...

True
...
The
maturity value plus any protest fee should be debited to Accounts Receivable
...
Discount on Notes Payable is recorded when a non interest-bearing note is issued
...
A write-off of an account receivable results in a debit to Allowance for Uncollectible Accounts and a credit to
Accounts Receivable for the same amount
...

a
...
05)
Balance before adjustment
Uncollectible accounts expense

$ 10,000
( 3,000)
$7,000

c
...
They must invest cash in raw materials,
convert these raw materials into work in process and then finished goods, sell the items on account, and then collect
the accounts receivable
...


USD 265,000
=USD 250,000;
1
...

c
...


100 - 30 already returned = 70 more expected to be returned
...


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...
The name of the payee is not needed to compute interest expense on a promissory note
...
The proceeds from a bank are computed as follows:
Discount amount =USD 10,000 X 0
...
0 License

10
...

• List the four major factors affecting depreciation expense
...

• Distinguish between capital and revenue expenditures for plant assets
...

• Analyze and use the financial results—rate of return on operating assets
...
These resources are necessary for the companies to operate and ultimately make a profit
...

Accountants employed by a company are deeply involved in nearly all decisions regarding the company's fixed
assets, from pre-acquisition planning to the ultimate disposal or sale of those assets
...
For example, should your company or client purchase
an airplane to visit clients? Accountants will investigate all the benefits, both financial and intangible, and compare
these benefits to the costs
...

Since these assets are so closely related to profits, good management is required
...
Many corporations have a staff of accountants
whose primary task is to manage operating assets
...
Once an asset has been acquired, accountants are responsible for determining the
original value of the asset, the period over which it will extend benefits to the company, and its current market
value while owned by the entity
...
The decision can range from trading the asset for a new asset to selling the asset to a salvage dealer
...
had over USD 10 billion dollars in property, plant, and equipment
...
Managing a portfolio of assets of this magnitude takes both accounting
knowledge and analytical skills
...

On a classified balance sheet, the asset section contains: (1) current assets; (2) property, plant, and equipment;
and (3) other categories such as intangible assets and long-term investments
...
Property, plant, and equipment
assets
...
Property,
plant, and equipment are often called plant and equipment or simply plant assets
...
Long-lived assets consist of tangible assets and
intangible assets
...
Intangible assets have no
physical characteristics that we can see and touch but represent exclusive privileges and rights to their owners
...

Common plant assets are buildings, machines, tools, and office equipment
...

Plant assets include all long-lived tangible assets used to generate the principal revenues of the business
...
What represents a plant asset to one company may be inventory to another
...
A business such as a truck dealership would classify the same delivery truck as inventory
because the truck is held for sale
...
However, standby
equipment used only in peak or emergency periods is a plant asset because it is used in the operations of the
business
...
For
example, over several years, a delivery truck may provide 100,000 miles of delivery services to an appliance
business
...
In each instance, purchase of the plant asset actually represents the advance payment or
prepayment for expected services
...
As with short-term prepayments,
the accountant must allocate the cost of these services to the accounting periods benefited
...

• Record the allocation of the asset's original cost to periods of its useful life through depreciation
...

• Account for the disposal of the asset
...
Then, as the asset provides services through time, accountants
record the asset's depreciation and any subsequent expenditures related to the asset
...
We discuss the first three steps in this chapter and the disposal of an asset in Chapter 11
...

Remember that in recording the life history of an asset, accountants match expenses related to the asset with the
revenues generated by it
...


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...

This cost is objective, verifiable, and the best measure of an asset's fair market value at the time of purchase
...
Even if the market value of the asset changes over time, accountants continue to report the acquisition cost in
the asset account in subsequent periods
...
Thus, cost includes all normal, reasonable, and necessary
expenditures to obtain the asset and get it ready for use
...
Unnecessary costs (such as traffic tickets or fines) that must be
paid as a result of hauling machinery to a new plant are not part of the acquisition cost of the asset
...

The cost of land includes its purchase price and other costs such as option cost, real estate commissions, title
search and title transfer fees, and title insurance premiums
...
Sometimes land purchased as a building site contains an unusable
building that must be removed
...


Exhibit 80: Recording the life history of a depreciable asset
To illustrate, assume that Spivey Company purchased an old farm on the outskirts of San Diego, California,USA,
as a factory site
...
In addition, the company agreed to pay unpaid
property taxes from previous periods (called back taxes) of USD 12,000
...
Spivey demolished (razed) the farm buildings at a cost of
USD 18,000
...


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...
Spivey computed the cost of the land as follows:

413

Cost of factory site
Back taxes
Attorneys' fees and other legal costs
Demolition
Sale of salvaged parts
City assessment

Land
$225,000
12,000
1,800
18,000
(3,000)
9,000
$262,800

Accountants assigned all costs relating to the farm purchase and razing of the old buildings to the Land account
because the old buildings purchased with the land were not usable
...

Land is considered to have an unlimited life and is therefore not depreciable
...
They have limited lives and therefore are depreciable
...
They record the cost of permanent landscaping,
including leveling and grading, in the Land account
...

Determining the cost of constructing a new building is often more difficult
...
Also included are labor and
materials to build the building; salaries of officers supervising the construction; and insurance, taxes, and interest
during the construction period
...
For example, an owner who could rent out a small completed portion during construction
of the remainder of the building, would credit the rental proceeds to the Buildings account rather than to a revenue
account
...
When land and buildings purchased together
are to be used, the firm divides the total cost and establishes separate ledger accounts for land and for buildings
...
This is especially important later
because the depreciation recorded on the buildings affects reported income, while no depreciation is taken on the
land
...
Then, Spivey would determine what portion of the purchase price of the farm, back taxes, and
legal fees (USD 225,000 + USD 12,000 + USD 1,800 = USD 238,800) it could assign to the buildings and what
portion to the land
...
) Spivey would assign the USD 238,800 to the land and the buildings on the basis of their appraised
values
...
Spivey
would determine the cost assignable to each of these plant assets as follows:
Asset
Land
Buildings

Land
Buildings

Appraised
Value
$162,000
108,000
$270,000
Per cent of
Total Value
60%
40

Per cent of Total
Value
60% (162/270)
40 (108/270)
100% (270/270)
X Purchase
Price =
X $238,800* =
X $238,800 =

Cost
Assigned
$ 143,280
95,520
$ 238,800

*The purchase price is the sum of the cash price, back taxes, and legal fees
...


143,280
95,520

238,800

When the city eventually assessed the charges for the water mains, sewers, and street paving, the company
would still debit these costs to the Land account as in the previous example
...
Its cost includes
the seller's net invoice price (whether the discount is taken or not), transportation charges incurred, insurance in
transit, cost of installation, costs of accessories, and testing and break-in costs
...
The cost of machinery does not
include removing and disposing of a replaced, old machine that has been used in operations
...

To illustrate, assume that Clark Company purchased new equipment to replace equipment that it has used for
five years
...
In addition, the company paid USD 1,500 to remove old
equipment and USD 2,000 to install new equipment
...
Also included in the cost of the asset are interest costs related to the asset and amounts
paid for utilities (such as heat, light, and power) and for supplies used during construction
...
The firm records the increase as part of the asset's cost
...
This year, the company
constructed a machine during June, and the utility bill was USD 975
...

To illustrate further, assume that Tanner Company needed a new die-casting machine and received a quote from
Smith Company for USD 23,000, plus USD 1,000 freight costs
...
The company incurred the following costs to build the machine: materials, USD 4,000; labor, USD 13,000;
and indirect services of heat, power, and supplies, USD 3,000
...
The
USD 20,000 is the cost of the resources given up to construct the machine
...
Accountants do not subscribe to the
idea that a business can earn revenue (or realize a gain), and therefore net income, by dealing with itself
...

The accounting methods are the same
...
However, when
a business acquires plant assets in exchange for other noncash assets (shares of stock, a customer's note, or a tract
of land) or as gifts, it is more difficult to establish a cash price
...


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The general rule on noncash exchanges is to value the noncash asset received at its fair market value or the fair
market value of what was given up, whichever is more clearly evident
...
Neither amount may adequately represent the actual fair market value of either asset
...

Appraised value Sometimes, neither of the items exchanged has a clearly determinable fair market value
...

An appraised value is an expert's opinion of an item's fair market price if the item were sold
...

Book value The book value of an asset is its recorded cost less accumulated depreciation
...
If a better basis is not available, however,
a firm could use the book value of the old asset
...
For example, to attract industry to
an area and provide jobs for local residents, a city may give a company a tract of land on which to build a factory
...

Accountants record gifts of plant assets at fair market value to provide information on all assets owned by the
company
...
They would credit assets received as
gifts to a stockholders' equity account titled Paid-in Capital—Donations
...
The site is secure in that
it can only be accessed by those who have paid the fee
...
Another firm,
PricewaterhouseCoopers, has an on-line service for tax professionals to seek advice
...


Depreciation of plant assets
Companies record depreciation on all plant assets except land
...
For this reason, most
financial statement users are interested in the amount of, and the methods used to compute, a company's
depreciation expense
...
Depreciation is a process of allocation, not valuation
...
They record depreciation even when the market value of a plant asset temporarily
rises above its original cost because eventually the asset is no longer useful to its current owner
...
Physical deterioration results from the use of the asset—wear and tear—and the action of the
elements
...
The
inadequacy of a plant asset is its inability to produce enough products or provide enough services to meet current
demands
...
The
obsolescence of an asset is its decline in usefulness brought about by inventions and technological progress
...

The use of a plant asset in business operations transforms a plant asset cost into an operating expense
...
Because
depreciation expense does not require a current cash outlay, it is often called a noncash expense
...

To compute depreciation expense, accountants consider four major factors:
• Cost of the asset
...
Salvage value (or scrap value) is the amount of money the company

expects to recover, less disposal costs, on the date a plant asset is scrapped, sold, or traded in
...
Useful life refers to the time the company owning the asset intends to

use it; useful life is not necessarily the same as either economic life or physical life
...
Various firms express useful life in years, months, working
hours, or units of production
...
For example, a machine capable of
producing units for 20 years, may be expected to be obsolete in 6 years
...
Another example, on TV you may have seen a demolition crew setting off explosives in a huge
building (e
...
The Dunes Hotel and Casino in Las Vegas, Nevada, USA) and wondering why the owners decided
to destroy what looked like a perfectly good building
...
The land on which the building stood could be put to better use, possibly by
constructing a new building
...
We describe the four common depreciation methods in

the next section
...
Property, plant, and equipment
Number of Companies
Method
Straight-line
Declining Balance
Sum of year's digits
Accelerated method-not specified
Units of production
Other
Source: Based on American Institute
Trends & Techniques
(New York: AICPA, 2004), p
...


2003
2002
2001
2000
580
579
579
576
22
22
22
22
5
5
6
7
41
44
49
53
30
32
32
34
4
7
9
10
of Certified Public Accountants, Accounting

Exhibit 82: Depreciation method used
In Exhibit 81, note the relationship among these factors
...
The building has an estimated salvage value of USD 15,000 and a useful life of 20 years
...
Ace would allocate this
depreciable base over the useful life of the building using the proper depreciation method under the circumstances
...
31 This section discusses
and illustrates the most common methods—straight-line, units-of-production, and accelerated depreciation method
(double-declining-balance)
...
According to accounting theory, companies should use a depreciation method that
reflects most closely their underlying economic circumstances
...
Exhibit 82 shows the frequency of use of these methods for 600 companies
...
Note that some companies use one method for certain
assets and another method for other assets
...
As a result, a depreciation method must meet only one standard: the
depreciation method must allocate plant asset cost to accounting periods in a systematic and rational manner
...


An accounting perspective:
Business insight
Regardless of the method or methods of depreciation chosen, companies must disclose their
depreciation methods in the footnotes to their financial statements
...

The disclosure is generally straightforward: Sears, Roebuck & Co
...
Its annual report states
simply that "depreciation is provided principally by the straight-line method"
...
General Electric Company is a highly
diversified multinational corporation that develops, manufactures, and markets aerospace

31 Because depreciation expense is an estimate, calculations may be rounded to the nearest dollar
...
0 License

products, major appliances, industrial products, and high-performance engineered plastics
...

In the illustrations of the four depreciation methods that follow, we assume the following: On 2010 January 1, a
company purchased a machine for USD 54,000 with an estimated useful life of 10 years, or 50,000 units of output,
and an estimated salvage value of USD 4,000
...
To apply the straight-line
method, a firm charges an equal amount of plant asset cost to each accounting period
...

Using the straight-line method for assets is appropriate where (1) time rather than obsolescence is the major
factor limiting the asset's life and (2) the asset produces relatively constant amounts of periodic services
...

Units-of-production (output) method The units-of-production depreciation method assigns an equal
amount of depreciation to each unit of product manufactured or service rendered by an asset
...
Under this method, you would compute the depreciation charge per unit of output
...
The formula is:
Deprecation per unit=

Asset cost – Estimated salvage value
Estimated total units of production service during useful life of asset

Depreciation per period=Deprecation per unit ×Number of units of goods /services produced
You would determine the deprecation charge for the USD 54,000 machine as:
USD 54,000 – USD 4,000
=$1per unit
50,000 units

Accounting Principles: A Business Perspective

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...
;
Accumulated
Depreciation Cr
...


Total
Accumulated
Depreciation
$ 5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
45,000
50,000

Book Value
$54,000
49,000
44,000
39,000
34,000
29,000
24,000
19,000
14,000
9,000
4,000*

Exhibit 83: Straight-line depreciation schedule
If the machine produced 1,000 units in 2010 and 2,500 units in 2011, depreciation expense for those years
would be USD 1,000 and USD 2,500, respectively
...
A business might choose an accelerated depreciation
method for the following reasons:
• The value of the benefits received from the asset decline with age (for example, office buildings)
...

• Repairs increase substantially in the asset's later years; under this method, the depreciation and repairs

together remain fairly constant over the asset's life (for example, automobiles)
...


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This book is licensed under a Creative Commons Attribution 3
...
;
Accumulated
Depreciation Cr
...
(20% of $54,000)
$10,800
$10,800
43,200
2
...
(20% of $34,560)
6,912
26,352
27,648
4
...
(20% of $22,118)
4,424
36,306
17,694
6
...
(20% of $14,155)
2,831
42,676
11,324
8
...
(20% of $9,059)
1,812
46,753
7,247
10
...
Then, accumulated depreciation would be $50,000
...
To do this,
divide 100 per cent by the number of years of useful life of the asset
...
Next, apply the
resulting double-declining rate to the declining book value of the asset
...
At the point where book value is equal to the salvage value, no more depreciation is taken
...
Property, plant, and equipment
Method

Base
Asset Estimated Cost Straight-line
salvage value
Double-declining balance Asset - Accumulated%
%Cost - Depreciation

Calculation
Number of accounting periods in Base estimated
useful life
Base X
(2 X Straight-line rate)

Exhibit 85: Summary of depreciation methods
Look at the calculations for the USD 54,000 machine using the DDB method in Exhibit 84
...
(Expressed as
fractions, the straight-line rate is 1/10, and the DDB rate is 2/10
...
In each of the following years, book value is the
basis of the calculation at the beginning of the year
...
This higher depreciation amount for the last year (USD 3,247) would reduce the book value of USD
7,247 down to the salvage value of USD 4,000
...

For a summary of the three depreciation methods, see Exhibit 85
...
The machine has an
estimated useful life of 10 years and an estimated salvage value of USD 4,000
...
Also, CPA firms hire many tax professionals to
address the tax matters of their clients
...
ey
...
aspx
This site was created by the CPA firm, Ernst & Young, and has many interesting features
...

So far we have assumed that the assets were put into service at the beginning of an accounting period and
ignored the fact that often assets are put into service during an accounting period
...
Normally, firms calculate the
depreciation for the partial year to the nearest full month the asset was in service
...
And they treat
an asset purchased after the 15th of the month as if it were acquired on the 1st day of the following month
...


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...
Begin by finding the 12-month charge by the normal computation explained earlier
...
For example, for the USD 7,600
machine purchased 2010 September 1 (estimated salvage value, USD 400; and estimated useful life, five years), the
annual straight-line depreciation is [(USD 7,600 - USD 400)/5 years] = USD 1,440
...
The 2010 depreciation is
(USD 1,440 X 1/3) = USD 480
...
To compute the partial-year depreciation, multiply the depreciation charge per unit
by the units produced
...

Double-declining-balance method Under the double-declining-balance method, it is relatively easy to
determine depreciation for a partial year and then for subsequent full years
...
For example, DDB depreciation on the
USD 7,600 asset for 2010 is (USD 7,600 X 0
...
For subsequent years, compute the depreciation
using the regular procedure of multiplying the book value at the beginning of the period by the fixed rate
...
4] = USD 2,635
...
Computers and accounting
software have simplified record keeping for all of a company's depreciable assets
...
In addition, they enter the method of depreciation
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...
After processing this information, the computer
calculates the company's depreciation expense and accumulates depreciation for each type of asset
and each individual asset (e
...
a machine)
...
At times, a firm finds the estimated useful life of an asset or its estimated salvage value
is incorrect before the asset is depreciated down to its estimated salvage value; then, it computes revised
depreciation charges for the remaining useful life
...
To compute the new depreciation charge per period, divide the book value less the newly estimated salvage
value by the estimated periods of useful life remaining
...
At the end of the fourth year of the machine's life, the balance
in its accumulated depreciation account (assuming use of the straight-line method) was (USD 30,000 - USD 3,000)
X 4/8 = USD 13,500
...

The newly estimated salvage value is USD 2,700
...
Thus, to determine depreciation expense, compute a new per-unit depreciation charge by dividing book value
less revised salvage value by the estimated remaining units of production
...

Using the double-declining-balance method, the book value at the beginning of year 5 would be USD 9,492
...
81)
...
The straight-line rate is 100 per cent/6 = 16
...
So twice
the straight-line rate is 33
...
Thus, 1/3 X USD 9,492
...
06
...
12 requires that companies separately disclose the methods of depreciation they use and the
amount of depreciation expense for the period in the body of the income statement or in the notes to the financial
statements
...

Showing cost less accumulated depreciation in the balance sheet gives statement users a better understanding of
the percentages of a company's plant assets that have been used up than reporting only the book value (remaining
undepreciated cost) of the assets
...
In the first case, the statement user can see that the assets are about 60 per cent used up
...


425

10
...
Nonetheless, notes (footnotes) actually provide
the additional information regarding the separate types of assets
...
is a world
leader in the design and distribution of numerous lines of women's and men's clothing
...
In a note to the financial statements (slightly modified to clarify), management
explained this amount as follows:
(Dollar amounts in thousands)
Property and Equipment, Net
Property and Equipment, at cost
Land, buildings and improvements
Furniture, fixtures and equipment
Leaseholds and improvements
Construction in progress
Total
Less: accumulated depreciation and amortization
Property and equipment, net

2000
$ 362,997
2,079,567
655,736
46,748
$3,145,048
1,750,429
$1,394,619

1999
$ 390,121
2,020,651
498,232
35,823
$2,944,827
1,715,215
$1,229,612

A misconception Some mistaken financial statement users believe that accumulated depreciation represents
cash available for replacing old plant assets with new assets
...
Companies use the plant asset and its contra account, accumulated depreciation, so that data
on the total original acquisition cost and accumulated depreciation are readily available to meet reporting
requirements
...
One of the justifications for reporting the remaining undepreciated costs of the asset
rather than market values is the going-concern concept
...
Generally, analysts do not consider market values relevant for plant assets in primary
financial statements, although they may be reported in supplemental statements
...
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A broader perspective:
Wolverine World Wide, Inc
...
Property, plant, and equipment
(Dollars in Thousands)
Total current assets
Property, Plant and Equipment
Land
Buildings and improvements
Machinery and equipment
Software
Less accumulated depreciation
Total plant assets
Other Assets
Goodwill and other intangibles,
less accumulated amortization
(2002-$3,565; 2001-$2,447)
Cash value of life insurance
Prepaid pension costs
Assets held for exchange
Notes receivable
Other
Total other assets
Total Assets

2002
$ 349,301

2001
$ 340,978

1,177
64,848
117,524
29,217
$212,766
96,483
$ 116,283

1,177
63,006
108,094
22,097
$194,374
83,239
$ 111,135

16,178
16,443
19,099
7,706
4,736
4,649
$ 68,811
$534,395

19,931
14,725
15,242
7,942
4,921
6,604
$ 69,365
$521,478

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1 (In Part): Summary of Significant Accounting Policies
Property, Plant and Equipment
Property, plant and equipment are stated on the basis of cost and include expenditures for new
facilities, major renewals, betterments and software
...

Depreciation of plant, equipment and software is computed using the straight-line method
...

As required, the Company adopted the American Institute of Certified Public Accountants
Statement of Position (SoP) 98-1, Accounting for the Costs of Computer Software Developed and
Obtained for Internal Use, in 1999
...

The Company's accounting policies for such items were already in substantial compliance with SOP
98-1 and, therefore, the adoption did not have a material effect on its 1999 consolidated financial
position or results of operations
...
They debit these
expenditures to: (1) an asset account; (2) an accumulated depreciation account; or (3) an expense account
...
Capital expenditures increase the book value of plant assets
...
As a result, companies expense these revenue expenditures immediately and
report them in the income statement as expenses
...
Because betterments or improvements add to the service-rendering

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...
For example, installing an air conditioner in an
automobile that did not previously have one is a betterment
...

Occasionally, expenditures made on plant assets extend the quantity of services beyond the original estimate but
do not improve the quality of the services
...
However, since there is no visible, tangible addition to, or
improvement in, the quality of services, they charge the expenditures to the accumulated depreciation account, thus
reducing the credit balance in that account
...

To illustrate, assume that after operating a press for four years, a company spent USD 5,000 to recondition the
press
...
The
journal entry to record the extraordinary repair is:
Accumulated Depreciation-Machinery (+A)

5,000

Cash (for Accounts Payable) (-A)

5,000

To record the cost of reconditioning a press
...
At the end of the fourth year, the balance in its accumulated depreciation account under the straight-line
method is [(USD 40,000/10) X 4] = USD 16,000
...
Under the straight-line method, we would divide the new book value of the press, USD
29,000, equally among the 10 remaining years in amounts of USD 2,900 per year (assuming that the estimated
salvage value is still zero)
...
This avoids distorting net income by expensing these expenditures in the year incurred
...

This treatment is not theoretically correct
...
Because of the size of this expenditure, the company still charges it to accumulated
depreciation
...
Under the straight-line method, annual depreciation would then be (USD 29,000/6) = USD 4,833
...
Property, plant, and equipment

Exhibit 88: Expenditures on plant assets after acquisition
Accountants treat as expenses those recurring and/or minor expenditures that neither add to the asset's servicerendering quality nor extend its quantity of services beyond its original estimated useful life
...
For example, a company that spends USD 190 to repair a machine after
using it for some time, debits Maintenance Expense or Repairs Expense
...
Because of the small dollar amounts involved, it is impractical to use
the ordinary depreciation methods for such assets, and it is often costly to maintain records of individual items
...
Accordingly, it is more efficient to
record the items as expenses when they are purchased
...
This
practice of accounting for such low unit cost items as expenses is an example of the modifying convention of
materiality that was discussed in Chapter 5
...

In practice, it is difficult to decide whether to debit an expenditure to the asset account or to the accumulated
depreciation account
...

Even if the wrong account were debited for the expenditure, the book value of the plant asset at that point would be
the same amount it would have been if the correct account had been debited
...

As an example of the effect of misstated asset and accumulated depreciation accounts, assume Watson Company
had an asset that had originally cost USD 15,000 and had been depreciated to a book value of USD 6,000 at the
beginning of 2010
...
The
company spent USD 4,000 in early January 2010 to install a new motor in the equipment
...
Since the expenditure extended the life, the firm
should capitalize it by a debit to the accumulated depreciation account
...
0 License
expense if the entry was made correctly and if the expenditure had been improperly charged (debited) to the asset
account in Exhibit 89
...
Assume now that USD
6,000 in repairs expense is incurred for a plant asset that originally cost USD 40,000 and had a useful life of four
years and no estimated salvage value
...
The company capitalized the USD 6,000 that should have been charged to repairs expense in 2010
...
With the incorrect
entry, however, depreciation increases
...
These errors would cause net income for the
year 2010 to be overstated USD 4,000: (1) repairs expense is understated by USD 6,000, causing income to be
overstated by USD 6,000; and (2) depreciation expense is overstated by USD 2,000, causing income to be
understated by USD 2,000
...

Note that the USD 6,000 recording error affects more than just the expense accounts and net income
...
To see the effect of
incorrectly capitalizing the USD 6,000 to the asset account rather than correctly expensing it, look at Exhibit 90
...
These records include an asset account and a related accumulated depreciation
account in the general ledger for each major class of depreciable plant assets, such as buildings, factory machinery,
office equipment, delivery equipment, and store equipment
...
Subsidiary ledgers for Accounts
Receivable and Accounts Payable were explained briefly in An accounting perspective in Chapter 4
...
For instance, assume a company has a general ledger account for
office furniture
...
Alternatively, a company could even have a separate subsidiary account for
each piece of furniture
...
Each general ledger account for each
class of depreciable asset, such as Buildings, Delivery Equipment, and so on, could have a subsidiary ledger backing
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...
These subsidiary
ledgers and detailed records provide more information and allow the company to maintain better control over plant
and equipment
...
Then there may be an additional
subsidiary ledger for each type of asset within each category
...
Companies also
keep a detailed record for each item represented in a subsidiary ledger account
...

Each detailed record should include a description of the asset, identification or serial number, location of the asset,
date of acquisition, cost, estimated salvage value, estimated useful life, annual depreciation, accumulated
depreciation, insurance coverage, repairs, date of disposal, and gain or loss on final disposal of the asset
...

To enhance control over plant and equipment, companies stencil on or attach the identification or serial number
to each asset
...
A
company that does not use detailed records and identification numbers or take physical inventories finds it difficult
to determine whether assets have been discarded or stolen
...
Also, the totals in the detailed records
for a specific subsidiary ledger account (such as Microcomputers) should equal the balance of that account
...
It also updates the detailed record for the items affected
...
0 License
Item Dell Precision M40
Id
...
Z-43806
Location Rm
...
bldg
...
1
Cost $3,000
Estimated salvage value $200
Estimated useful life
4 yrs
...
Co
...
No
...
$3,000
Repairs:
2010/6/13 $140
Disposal date
Gain or loss

Exhibit 91: Detailed record of a specific plant asset
DEMENT & PEERY, INC
...
Management uses these ratios to measure performance by establishing targets and evaluating results
...
Analysts use these figures to calculate the ratios and to explain the importance of this
information to management and investors
...
13 per cent
2010: USD 560,000/USD 5,441,000 = 10
...
In calculating
Dement & Peery's ratio, we have assumed that all assets are operating assets used in producing operating revenues
...
For Dement &
Peery, these figures indicate a slight increase in the earning power of the company in 2010
...
Perhaps this performance
justifies the increase in operating assets
...
The next chapter
discusses how to record the disposal of plant assets and how to account for natural resources and intangible assets
...
Property, plant, and equipment
Understanding the learning objectives
• To be classified as a plant asset, an asset must: (1) be tangible; (2) have a useful service life of more than

one year; and (3) be used in business operations rather than held for resale
...

(b) Record the allocation of the asset's original cost to periods of its useful life through depreciation
...

(d)Account for the disposal of the asset
...

• Straight-line method: Assigns an equal amount of depreciation to each period
...
The units-of-production depreciation formulas are:
Deprecation per period=

Asset cost – Estimated salvage value
Estimated total units of production service during useful lifeof asset

Depreciation per period=Depreciation per unit× Number of unitsof goods / servicesproduced
• Double-declining-balance method: DDB is an accelerated deprecation method
...
The formula for DDB deprecation is:
Deprecation per period=2×straight−line rate×Asset cost – Accumulated deprecation
• Capital expenditures are debited to an asset account or an accumulated depreciation account and increase

the book value of plant assets
...

• Revenue expenditures are expensed immediately and reported in the income statement as expenses
...

• Plant asset subsidiary ledgers contain detailed information that cannot be maintained in the general ledger

account about each item in a major class of depreciable plant assets
...


Information in a detailed record may include a description of the asset, identification or serial number,
location of the asset, date of acquisition, cost, estimated salvage value, estimated useful life, annual
depreciation, accumulated depreciation, insurance coverage, repairs, date of disposal, and gain or loss on final
disposal of the asset
...

• To calculate the rate of return on operating assets, divide net operating income by operating assets
...


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...
The company paid USD 55,200 for brokerage and legal services to acquire the property and secure
clear title
...

Clearing and leveling costs of USD 21,600 were paid
...
A house on the
land, to be moved by the buyer of the house, was sold for USD 5,040
...

Approximately 6 acres of the land were deeded to the township for roads, and another 10 acres was deeded to
the local school district as the site for a future school
...
The company secured a total of 1,200 salable lots from the remaining
land
...

Demonstration problem B Calvin Company acquired and put into use a machine on 2010 January 1, at a
total cost of USD 45,000
...
It was also estimated that the machine would produce one million units of product during its life
...

Compute the amounts of depreciation to be recorded in 2010 and 2011 under each of the following:
a
...

b
...

c
...

d
...
Compute depreciation for this quarter under
each of the three methods
...
Straight-line method:
2010:

USD 45,000 – USD 5,000
=USD 4,000
10

2011:

USD 45,000 – USD 5,000
=USD 4,000
10

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Units-of-production method:
2010:

USD 45,000 – USD 5,000
×90,000=USD 3,600
1,000,000

2011:

USD 45,000 – USD 5,000
×125,000= USD 5,000
1,000,000

c
...
Straight-line:

USD 45,000 – USD 5,000 1
× =USD 1,000
10
4

Units-of-production: (USD 30,000 – USD 0
...
2× =USD 1,440
4

Key terms
Accelerated depreciation methods Record higher amounts of depreciation during the early years of an
asset's life and lower amounts in later years
...

Appraised value An expert's opinion as to what an item's market price would be if the item were sold
...

Book value An asset's recorded cost less its accumulated depreciation
...

Depreciation The amount of plant asset cost allocated to each accounting period benefiting from the plant
asset's use
...
The units-of-production depreciation method assigns an equal amount of depreciation for each
unit of product manufactured or service rendered by an asset
...

Double-declining-balance (DDB) depreciation See depreciation
...

Fair market value The price that would be received for an item being sold in the normal course of business
(not at a forced liquidation sale)
...

Land improvements Attachments to land, such as driveways, landscaping, parking lots, fences, lighting
systems, and sprinkler systems, that have limited lives and therefore are depreciable
...

Obsolescence Decline in usefulness of an asset brought about by inventions and technological progress
...

Plant and equipment A shorter title for property, plant, and equipment; also called plant assets
...

Rate of return on operating assets Net operating income/Operating assets
...

Revenue expenditures Expenditures (on a plant asset) that are immediately expensed
...
0 License
Salvage value The amount of money the company expects to recover, less disposal costs, on the date a plant
asset is scrapped, sold, or traded in
...

Straight-line depreciation See depreciation
...

Units-of-production depreciation See depreciation
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

Depreciation is the process of valuation of an asset to arrive at its market value
...

Expenditures made on plant assets that increase the quality of services are debited to the accumulated
depreciation account
...

Multiple-choice
Select the best answer for each of the following questions
...
The equipment has an estimated useful life of 10 years and an estimated salvage value of
USD 40,000
...
USD 36,000
...
USD 40,000
...
USD 44,000
...
USD 80,000
...
USD 88,000
...
USD 88,000
...
USD 72,000
...
USD 36,000
...
USD 44,000
...
USD 40,000
...
The computer had an estimated
salvage value of USD 3,000 and an estimated useful life of five years
...

Using the straight-line method, the depreciation expense for 2010 is:
a
...

b
...

c
...

d
...

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USD 3,100
...
Overstatement of current year's expense
...
Understatement of current year's expense
...
Understatement of subsequent year's net income
...
Overstatement of current year's net income
...
None of the above
...


Questions
➢

What is the main distinction between inventory and a plant asset?

➢

Which of the following items are properly classifiable as plant assets on the balance sheet?
➢

Advertising that will appear in the future to inform the public about new energy-saving programs
at a manufacturing plant
...


➢

An automobile acquired by an insurance company to be used by one of its salespersons
...


➢

The cost of constructing and paving a driveway that has an estimated useful life of 10 years
...

Brown decided to use the building in its operations
...


➢

In any exchange of noncash assets, the accountant's task is to find the most appropriate valuation for
the asset received
...


➢

What four factors must be known to compute depreciation on a plant asset? How objective is the
calculation of depreciation?

➢

A friend, Mindy Jacobs, tells you her car depreciated USD 5,000 last year
...


➢

What does the term accelerated depreciation mean? Give an example showing how depreciation is
accelerated
...


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At
the end of the third year, Nancy determined that the machine would last only three more years
...


➢

For each of the following, state whether the expenditure made should be charged to an expense, an
asset, or an accumulated depreciation account:
➢

Cost of installing air-conditioning equipment in a building that was not air-conditioned
...


➢

Cost of replacing the roof on a 10-year-old building that was purchased new and has an
estimated total life of 40 years
...


➢

Cost of repairing an electric motor
...


➢

Indicate which type of account (asset, accumulated depreciation, or expense) would be debited for
each of the following expenditures:
➢

Painting an office building at a cost of USD 1,000
...


➢

Adding on a new plant wing at a cost of USD 24,000,000
...


➢

Replacing a stairway with an escalator at a cost of USD 20,000
...


➢

Replacing a broken fan belt at a cost of USD 600
...
, contained in the Annual report appendix, what was the 2000 ending net property and
equipment balance? Did the company acquire any of these assets in 2000? What depreciation
method did the company use?

Exercises
Exercise A Stephon Company paid USD 640,000 cash for a tract of land on which it plans to erect a new
warehouse, and paid USD 8,000 in legal fees related to the purchase
...
The company incurred a cost of USD 28,800 to remove an old
apartment building from the land
...

Exercise B Laural Company paid USD 840,000 cash for real property consisting of a tract of land and a
building
...
To allocate the cost of the property acquired,

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The appraised values were as follows: land, USD 576,000, and office building,
USD 384,000
...
The building was remodeled at a cost of USD 76,800
...
Prepare a schedule showing the cost of
the assets acquired
...
The company paid a fine of USD 3,600 because an employee hauled the machine over city
streets without securing the required permits
...
Prepare a schedule showing the recorded cost of the
machine
...
The stock
recently traded at USD 400 per share
...
At what amount should the
machine be recorded?
Exercise E Keely Company purchased some office furniture for USD 29,760 cash on 2009 March 1
...
The furniture is being depreciated over four years under the straight-line
method, assuming a salvage value of USD 1,440
...
On 2010
July 1, it spent USD 192 to refinish the furniture
...

Exercise F On 2009 January 2, a new machine was acquired for USD 900,000
...
The machine is expected to produce a total of
500,000 units of product throughout its useful life
...
Straight line
...
Units of production (assume 30,000 and 60,000 units were produced in 2009 and 2010, respectively)
...
Double-declining balance
...

According to the company records, the machinery has an estimated useful life of 10 years and an estimated salvage
value of USD 24,000
...
If the
accumulated depreciation account shows a balance of USD 72,000, what is the original cost of the machinery and
how many years remain to be depreciated?
Exercise H Katherine Company purchased a machine on 2009 April 1, for USD 72,000
...
The company's accounting year ends on December
31
...

Exercise I Australia Company purchased a machine for USD 3,200 and incurred installation costs of USD 800
...
The machine has an estimated useful life of four years
...

Exercise J Regal Company acquired a delivery truck on 2009 January 2, for USD 107,200
...
At the beginning of 2009, a
revised estimate shows that the truck has a remaining useful life of six years
...

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Exercise K Assume that the truck described in the previous exercise was used 40 per cent of the time in 2010
to haul materials used in the construction of a building by Regal Company for its own use
...
) During the remaining time, Regal used the truck to deliver
merchandise to its customers
...

Exercise L Vineland Company purchased a computer for USD 60,000 and placed it in operation on 2008
January 2
...
The introduction of a new model of this computer in 2010 caused the
company to revise its estimate of useful life to a total of four years and to reduce the estimated salvage value to zero
...

Exercise M On 2009 January 2, a company purchased and placed in operation a new machine at a total cost of
USD 60,000
...
Early in 2011, the machine was overhauled at a
cost of USD 20,000
...

Compute the depreciation expense on the machine for 2011
...
It debited
freight and installation charges of USD 10,000 to Repairs Expense
...

Compute the amount of the error in net income for 2009 and 2010, and state whether net income is understated
or overstated
...
During 2009, Bragg incorrectly
capitalized USD 120,000 in repairs on the plant asset rather than expensing them
...

Problems
Problem A Bolt Company purchased a machine for use in its operations that had an invoice price of USD
80,000 excluding sales tax
...
Terms were net 30
...
In delivering the machine to its plant, a Bolt employee damaged the truck used; repairs
cost USD 3,600
...

Bolt incurred installation costs of USD 32,000 that included the USD 4,000 cost of shoring up the floor under
the machine
...
Safety guards were installed on the machine at a cost of USD
640, and the machine was placed in operation
...

Problem B Pressler Company planned to erect a new factory building and a new office building in Atlanta,
Georgia, USA
...

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Pressler Company paid
USD 18,000 cash for brokerage and legal services in acquiring the property
...
Construction of the factory building was to begin in a week
...

Problem C Timothy Company acquired and placed into use a heavy factory machine on 2009 October 1
...
An employee of Timothy Company hauled the machine down a city street without a
permit
...
Installation and testing costs totaled USD 35,800
...
(A fraction should be
used for the DDB calculation rather than a percentage
...
Prepare the journal entry to record the acquisition of the machine
...
Prepare the journal entry to record depreciation for 2009 under the double-declining balance method
...
Assume Timothy Company used the straight-line depreciation method
...
Prepare the journal entry to record depreciation for 2009
...

Problem D Peach Company has the following entries in its Building account:

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...
10

Cost of building parking lot for employees in back of building

4,960

Sept
...
10

Repairs due to regular usage

2,240

5
2010
Jan
...
5

Proceeds from leases of second floor for six months ended
2009/12/31

8,000

Peach acquired the original property on 2009 May 5
...
While the new wing was being constructed, the company leased the
second floor as temporary warehouse space to Kellett Company
...
Regular operations
began on 2010 January 2
...
Compute the correct balance for the Buildings account as of 2010 December 31
...

b
...
No
depreciation entries are required
...
Transportation charges amounted to USD 7,500, and installation and testing costs totaled USD
55,000
...
It was further estimated that the equipment would be used in the production of 1,920,000 units of product
during its life
...

Compute the depreciation to the nearest dollar for the year ended December 31, using:
a
...

b
...

c
...

Problem F Goodrich Company purchased a machine on 2009 October 1 for USD 100,000
...

Compute to the nearest dollar the amount of depreciation Goodrich should record on the machine for the years
ending 2009 December 31, and 2010, under each of the following methods:

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...
Straight-line
...
Double-declining-balance
...
Terms were net 30
...
The company incurred and
paid freight costs of USD 10,000
...
The machine was dropped and
damaged while being mounted on this base
...
Raw materials with a cost of USD 1,000 were
consumed in testing the machine
...
In addition, USD 500 of costs were incurred in removing an old machine
...

Alternate problem B Maxwell Company purchased 2 square miles of farmland under the following terms:
USD 968,000 cash; and liability assumed on mortgage note of USD 320,000 and interest accrued on mortgage note
assumed, USD 12,800
...

The company planned to use the land as a site for a new office building and a new factory
...
It sold crops on the land for USD 7,360 and sold one of the houses on the
property for USD 19,200
...
Approximately 1 per cent of the land acquired was deeded to the county for
roads
...

Prepare a schedule showing the amount at which the land should be carried on Maxwell Company's books
...
The next
day the company's name and business were painted on the truck at a total cost of USD 1,488
...
The truck was placed in service on 2009 April 1, at
which time it had an estimated useful life of five years and a salvage value of USD 3,360
...
Prepare a schedule showing the cost to be recorded for the truck
...
Prepare the journal entry to record depreciation at the end of the calendar-year accounting period, 2009
December 31
...

c
...
At the beginning of 2009 it is estimated the
truck will last another four years
...
Prepare the entry to record
depreciation for 2012
...
While reviewing the accounts, you find an
account entitled "Fixed Assets", which contains the following items:
Cash paid to previous owner of land and old buildings
Cash given to construction company as partial payment for the new building
Legal and title search fees
Real estate commission
Cost of demolishing old building
Cost of leveling and grading
Architect's fee (90% of building and 10% improvements)
Cost of excavating (digging) basement for new building

444

$ 192,000
72,000
2,400
14,400
16,800
9,600
6,000
21,600

This book is licensed under a Creative Commons Attribution 3
...
Digging deeper, you find that the plant manager spent all of his
time for the first nine months of 2009 supervising installation of land improvements (10 per cent), building
construction (40 per cent), and installation of machinery (50 per cent)
...

a
...
Sort the
items into the appropriate columns, omitting those items not properly included as an element of asset cost
...
Total your columns
...
Prepare one compound journal entry to reclassify and adjust the accounts and to eliminate the Fixed Assets
account
...

Alternate problem E Land Company acquired and put into use a machine on 2009 January 1, at a cash cost
of USD 120,000 and immediately spent USD 5,000 to install it
...
It was further estimated that the
machine would produce 500,000 units of product during its life
...

Prepare journal entries to record depreciation to the nearest dollar for 2009, using:
a
...

b
...

c
...

Alternate problem F Crawford Company paid USD 60,000 for a machine on 2009 April 1, and placed it in
use on that same date
...

Compute the amount of depreciation to the nearest dollar the company should record on this asset for the years
ending 2009 December 31, and 2010, under each of the following methods:
a
...

b
...

Beyond the numbers—Critical thinking
Business decision case A You are a new staff auditor assigned to audit Cray Company's Buildings account
...
2
2
2
12
June 16

Debits
Cost of land and old buildings purchased
Legal fees incident to purchase
Fee for title search
Cost of demolishing old buildings on land
Cost of insurance during construction of new building

Accounting Principles: A Business Perspective

$ 720,000
9,600
1,200
19,200
4,800

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...
5
Sept
...
6
Nov
...
15

Payment to contractor on completion of new building
Architect's fees for design of new building
City assessment for sewers and sidewalks (considered permanent)
Cost of landscaping (considered permanent)
Cost of driveways and parking lots
Credits
Proceeds received upon sale of salvaged materials from old
buildings

1,080,000
48,000
16,800
9,600
60,000
4,800

In addition to the entries in the account, you obtained the following information in your interview with the
accountant in charge of the Buildings account:
The company began using the new building on 2009 September 1
...

The company began using the driveways and parking lots on 2009 November 1
...

The company uses the straight-line depreciation method to depreciate all of its plant assets
...
Prepare a schedule that shows the separate cost of land, buildings, and land improvements
...
Compute the amount of depreciation expense for 2009
...
Complete the journal entries required to correct the accounts at 2009 December 31
...

d
...

Business decision case B On 2010 October 1, Besler Company acquired and placed into use new equipment
costing USD 504,000
...
Besler estimates that the equipment will produce 2 million units of product during its life
...
As the company's accountant, management has
asked you to do the following:
a
...

Units-of-production
...

b
...

Business decision case C The notes to the financial statements of Wolverine World Wide, Inc
...
Explain why
the straight-line method of depreciation may be appropriate for this company
...

Calculate the rate of return on operating assets for The Limited in the Annual report appendix for the two most
recent years
...
Comment on the results
...
0 License
Property, plant, and equipment is depreciated over its estimated life by the unit-of-production or the straightline-method
...
How many different depreciation methods are used by Kerr-McGee Corporation? Does this practice conform
with generally accepted accounting principles?
b
...

Group project F In a group of two or three students, visit a large company in your community and inquire
about the subsidiary records it maintains to establish accounting control over its plant assets
...

Write a report to your instructor summarizing your findings and be prepared to give a short report to your class
...
Try to locate companies that use several depreciation methods in
accounting for various depreciable fixed assets
...
Write a report to your instructor summarizing your findings
...
In other
words, how does it decide whether to debit the asset account, the accumulated depreciation account, or an expense
account? What role does materiality play in the decision? Evaluate the reasonableness of the decision model used
...

Using the Internet—A view of the real world
Visit the CPA Review site at:
http://www
...
com
Investigate this site
...
Make note of any interesting information at this site
...
Be prepared to make a short presentation to the class
...
bestsoftware
...
Write a report to your instructor
summarizing your findings
...
The cost of land includes all normal, reasonable, and necessary expenditures to obtain the land and get it
ready for use
...
Depreciation is a process of allocation, not valuation, and the book value of an asset has little to do with
its market value
...
Depreciation accounting does not provide funds required to replace plant assets
...

False
...


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...
Plant asset subsidiary ledgers provide detailed information that the general ledger account cannot
provide and thus give better control over plant assets
...
The depreciation expense for 2010 using the straight-line method is computed as follows:
USD 440,000− USD 40,000
=USD 40,000
10

d
...
At the beginning of 2010, the balance of accumulated depreciation is USD 2,800 (annual depreciation of USD
1,400 X 2) and book value is USD 7,200, or (USD 10,000 - USD 2,800)
...

2

a
...


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Plant asset disposals,
natural resources, and
intangible assets
Learning objectives
After studying this chapter, you should be able to:
• Calculate and prepare entries for the sale, retirement, and destruction of plant assets
...

• Determine the periodic depletion cost of a natural resource and calculate depreciation of plant assets located

on extractive industry property
...

• Analyze and use the financial results-total assets turnover
...
These assets are referred to as intangible
...

The accountant must first place a value on something that cannot be seen by the naked eye
...

As we move ever more toward an information based economy, the per cent of intangible assets to total assets
also increases
...
Thus, the earning
power of such companies is primarily based on the valuation of assets that cannot be seen or touched
...
This makes it even more difficult to value the assets and determine their contribution to earnings
...

This ratio is referred to as the price to book ratio (PB)
...
In 1998 Tootsie Roll had a PB ratio of approximately 5
...
The
recorded net assets were approximately USD 400 million, yet the market perceived Tootsie Roll to have net assets
worth over USD 2,000 million
...
4
...
4
...
How does the accountant value something that has no physical substance and in many cases has not
been recorded? It is similar to walking around in a dark closet wearing a blindfold
...
Plant asset disposals, natural resources, and intangible assets
This function is closely related to the work of the plant asset accountant
...
The question still remains, how can you measure something you
cannot see?
Your study of long-term assets—plant assets, natural resources, and intangible assets—began in Chapter 10,
which focused on determining plant asset cost, computing depreciation, and distinguishing between capital and
revenue expenditures
...
The next topic is accounting
for natural resources such as ores, minerals, oil and gas, and timber
...

Note that accounting for all the long-term assets discussed in these chapters is basically the same
...
As the company receives benefits from the asset and its future
service potential decreases, the accountant transfers the cost from an asset account to an expense account
...
Because the lives of long-term assets can extend for many
years, the methods accountants use in reporting such assets can have a dramatic effect on the financial statements
of many accounting periods
...
When disposing of a plant asset, a company must remove both the asset's cost and
accumulated depreciation from the accounts
...

• Record the disposal by:

(a) Writing off the asset's cost
...

(c) Recording any consideration (usually cash) received or paid or to be received or paid
...

As you study this section, remember these common procedures accountants use to record the disposal of plant
assets
...


Sale of plant assets
Companies frequently dispose of plant assets by selling them
...
If the sales price is greater than the asset's book value, the company shows a gain
...
Of course, when the sales price equals
the asset's book value, no gain or loss occurs
...
The firm realizes a gain of USD 4,000:
Equipment cost
Accumulated depreciation
Book value

$ 45,000
14,000
$ 31,000
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...


35,000
14,000
45,000
4,000

If on the other hand, the company sells the equipment for USD 28,000, it realizes a loss of USD 3,000 (USD
31,000 book value—USD 28,000 sales price)
...


45,000

If a firm sells the equipment for USD 31,000, no gain or loss occurs
...


31,000
14,000
45,000

Accounting for depreciation to date of disposal When selling or otherwise disposing of a plant asset, a
firm must record the depreciation up to the date of sale or disposal
...
When depreciation is not recorded for the three months, operating expenses for that period are
understated, and the gain on the sale of the asset is understated or the loss overstated
...
When purchased on
2003 January 2, the machine cost USD 12,000; Ray was depreciating it at the straight-line rate of 10 per cent per
year
...
Before determining a gain or loss and before making an entry to record the sale, the
firm must make the following entry to record depreciation for the seven months ended 2011 July 31:
July

31 Depreciation Expense—Machinery (-SE)

700

Accumulated Depreciation—Machinery (-A)

700

To record depreciation for seven months
[$12,000 X 0
...
Plant asset disposals, natural resources, and intangible assets
Loss realized

$

200

The journal entry to record the sale is:
Cash (+A)
Accumulated Depreciation—Machinery (+A)
Loss from Disposal of Plant Assets (-SE)
Machinery(-A)
To record the sale of machinery at a price less than book
value
...
For example, Hayes Company would make the following journal entry when it retired a
fully depreciated machine that cost USD 15,000 and had no salvage value:
Accumulated Depreciation—Machinery (+A)
Machinery (-A)
To record the retirement of a fully depreciated machine
...
In such a case, the
firm should not remove the asset's cost and accumulated depreciation from the accounts until the asset is sold,
traded, or retired from service
...

Sometimes a business retires or discards a plant asset before fully depreciating it
...
In addition, the accountant records its estimated salvage value in a Salvaged
Materials account and recognizes a gain or loss on disposal
...
If the machine's estimated salvage value is
USD 500, the following entry is required:
Salvaged materials (+A)
Accumulated Depreciation—Machinery (+A)
Loss from Disposal of Plant Assets (-SE)
Machinery (-A)
To record the retirement of machinery, which will
be
sold for scrap at a later time
...
A home
page can be developed for a small company for a few hundred dollars and can be maintained for a
fairly low monthly fee
...
sba
...
One concern that companies have regarding

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...

Sometimes accidents, fires, floods, and storms wreck or destroy plant assets, causing companies to incur losses
...
The journal entry is:
Fire Loss (-SE)
Accumulated Depreciation—Buildings (+A)
Buildings (-A)
To record fire loss
...
To illustrate, assume the company partially
insured the building and will recover USD 22,000 from the insurance company
...


22,000
6,000
12,000
40,000

Exchanges of nonmonetary assets Until late 2004, the rules according to APB Opinion No
...
If the exchange classified as an exchange of
dissimilar assets, the acquired asset would be recorded at its fair value and any gain or loss would be recognized
...
153, "Exchanges of
Nonoperating Assets: an amendment of APB Opinion No
...
This new standard was issued to bring about
greater agreement between US Generally Accepted Accounting Principles and International Financial Reporting
Standards and is effective for exchanges occurring during fiscal periods beginning after 2005 June 15
...

The new FASB standard no longer distinguishes between dissimilar and similar asset exchanges
...
An exchange has commercial substance if, as a result of the exchange, future cash flows are expected
to change significantly
...
Most exchanges qualify as
having commercial substance
...
For example, if a company exchanges one truck for
another truck (a similar exchange) that will perform the same function as the old truck and for the same time
period so that the future cash flows are not significantly different, then the exchange does not result in commercial
32 APB, APB Opinion No
...

33 FASB, FASB Statement No
...
29"
(Norwalk, CT: FASB Board, December 2004)
...
Plant asset disposals, natural resources, and intangible assets
substance
...

Exchanges of nonmonetary assets having commercial substance For exchanges of nonmonetary assets
that have commercial substance, accountants record the new asset at the fair market value of the asset received or
the asset(s) given up, whichever is more clearly evident
...
If the cash price is not stated, they assume that the fair market value of the old
asset plus any cash paid would equate to the cash price of the new asset and use that value to record the new asset
...

Debiting accumulated depreciation and crediting the old asset removes the book value of the old asset from the
accounts
...
If the amount at which the new asset is recorded
exceeds the book value of the old asset plus any cash paid, a company records a gain to balance the journal entry
...
To illustrate such an exchange having
commercial substance, assume a company exchanges an old machine for a new delivery truck
...

The machine cost USD 45,000 and had an up-to-date accumulated depreciation balance of USD 38,000
...
The journal entry to record the exchange is:
Trucks (+A)
Accumulated Depreciation—Machinery (+A)
Loss from Disposal of Plant Assets (-SE)
Machinery (-A)
Cash (-A)
To record loss on exchange of dissimilar plant
assets
...
The calculation is as follows:
Machine cost
Accumulated depreciation
Book value
Fair market value of old asset
(trade-in allowance)
Loss realized

$ 45,000
38,000
$ 7,000
3,000
$ 4,000

To illustrate the recognition of a gain from such an exchange having commercial substance, assume that the fair
market value of the machine was USD 9,000 instead of USD 3,000, and that only USD 46,000 was paid in cash
...


55,000
38,000
45,000
46,000
2,000

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...
The calculation is as follows:
Machine cost
Accumulated depreciation
Book value
Fair market value of old asset
(trade-in allowance)
Gain realized

$ 45,000
38,000
$ 7,000
9,000
$ 2,000

Remember, when the book value and the market value of the old asset are different, companies always recognize
a gain or a loss on an exchange of nonmonetary assets having commercial substance
...

Exchanges of nonmonetary assets not having commercial substance Often firms exchange plant
assets such as automobiles, trucks, and office equipment by trading the old asset for a similar new one
...
When such an exchange occurs, the company receives a trade-in allowance for the old asset, and pays
the balance in cash
...
If not, accountants assume the cash price of
the new asset is the fair market value of the old asset plus the cash paid
...
Thus, companies record the new asset at the book
value of the old asset plus the cash paid
...

To illustrate the accounting for exchanges of nonmonetary assets that do not have commercial substance,
assume that a delivery service exchanged USD 50,000 cash and truck No
...
2
...
The delivery service realized a loss of USD 2,000 on the
exchange which cannot be recorded
...
1
Accumulated depreciation
Book value
Fair market value of old asset
(trade-in allowance)
Loss indicated (but not recorded)

$ 45,000
38,000
$ 7,000
5,000
$ 2,000

However, if a loss is indicated and is added to the recorded value of the new asset, the asset may later be written
down because of rules of impairment (as required by FASB Standard No
...


34 Trade-in allowance is sometimes expressed as the difference between list price and cash paid, but we choose to
define it as the difference between cash price and cash paid because this latter definition seems to agree with
current practice for exchange transactions
...
0 License
Truck (cost of No
...
1) (-A)
Cash (-A)
To record the exchange of non-monetary assets
with no
commercial substance (no loss recorded)
...
To illustrate, assume that in the preceding example, the
delivery service gave truck No
...
2
...

Book value of old truck (No
...
2)
Fair market value of new truck (No
...
2)

$ 7,000
46,000
$ 53,000
$ 55,000
2,000
$ 53,000

1
1
(equal)

1

The company would record the new asset at the book value of the old asset (USD 7,000) plus cash paid (USD
46,000)
...
Thus, the cost basis of the
new delivery truck is equal to USD 55,000 less than the USD 2,000 gain, or USD 53,000
...

The journal entry to record the exchange is:
Cost of trunk No
...
In the preceding example, annual depreciation expense is less if it is based on the truck's USD 53,000 cost
basis than if it is based on the truck's USD 55,000 cash price
...

Trucks (cost of No
...
1) (-A)
Cash (-A)
To record exchange of nonmonetary assets with no
commercial substance (no gain recorded)
...


An accounting perspective:
Uses of technology
Although sophisticated computer systems automatically compute the gain or loss on the disposal of
assets, such programs depend on human input
...
Plant asset disposals, natural resources, and intangible assets

disposal or exchange, or if the life of the asset was estimated inaccurately, the calculated gain or
loss would be incorrect
...
0 License

Recognize Gains?
Recognize Losses?
Record
New Asset At:

Exchanges Having Commercial
Substance

Exchanges NOT Having Commercial
Substance

Yes
Yes
Fair market value of asset
received (new asset) or fair
market value of asset given up
(old asset), whichever is more
clearly evident

No
No
Book value of old asset plus
cash paid

Exhibit 93: Summary of rules for recording exchanges of plant assets
Companies incur removal costs when dismantling and removing old plant assets
...
(The removal costs could be greater than the salvage
proceeds
...

The next section discusses natural resources
...


Natural resources
Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timber
stands, are natural resources or wasting assets
...
g
...

On the balance sheet, we classify natural resources as a separate group among noncurrent assets under headings
such as "Timber stands" and "Oil reserves"
...

(Accumulated depletion is similar to the accumulated depreciation used for plant assets
...


An accounting perspective:
Business insight
Kerr-McGee Corporation is a global energy and chemical company engaged in oil and gas
exploration and production, and the production and marketing of titanium dioxide pigment
...
These estimates include reserves that may be obtained in the future by improved
recovery methods now in operation or for which successful testing has been exhibited
...
In each
accounting period, the depletion recognized is an estimate of the cost of the natural resource that was removed
from its natural setting during the period
...


Accounting Principles: A Business Perspective

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...
Thus, statement users can see the percentage of the
resource that has been removed
...
We can assign this total cost to either the cost of natural
resources sold or the inventory of the natural resource still on hand
...
If all of the
resource is sold, we expense all of the depletion and removal costs
...

Computing periodic depletion cost To compute depletion charges, companies usually use the units-ofproduction method
...
This calculation provides a per-unit depletion cost
...
The company spent
USD 100,000 in exploration costs
...
The company incurred costs of USD
200,000 to develop the site, including the cost of running power lines and building roads
...
When the
property is purchased, a journal entry assigns the purchase price to the two assets purchased—the natural resource
and the land
...


50,000
600,000
650,000

After the purchase, an entry debits all costs to develop the site (including exploration) to the natural resource
account
...


300,000
300,000

The formula for finding depletion cost per unit is:
Depletion cost per unit =

Cost of site – Residual value of land if owned Costs develop site
Estimated number of units that can be economicallyextracted

In some instances, companies buy only the right to extract the natural resource from someone else's land
...
If there is an obligation to restore
the land to a usable condition, the firm adds these estimated restoration costs to the costs to develop the site
...
The unit (per ton) depletion charge is USD 1 (or USD 900,000/900,000 tons)
...
0 License
Accumulated Depletion—Ore Deposits4 (-A)
To record depletion for 2010
...
Combined with
other extractive costs, this cost determines the total cost of the ore mined
...
If 80,000 tons were sold and 20,000
remained on hand at the end of the period, the firm would allocate the total cost of USD 480,000 as follows:
Depletion cost
Mining labor costs
Other mining costs
Total cost of 100,000 tons mined (USD 4
...
80)
Cost of ore sold (80,000 tons at USD 4
...
80 (or USD 480,000/100,000)
...
The mining company does not report depletion separately
as an expense because depletion is included in cost of ore sold
...
80 X 20,000)
...
Because firms use this
method only for income tax purposes and not for financial statements, we do not discuss it in this text
...

If such assets will be abandoned when the natural resource is exhausted, they depreciate these assets over the
shorter of the (a) physical life of the asset or (b) life of the natural resource
...
Using this method matches the life of the plant asset
with the life of the natural resource
...

Assume a mining company acquires mining property with a building it plans to use only in the mining
operations
...

Relevant facts are:
Building cost
Estimated physical life of building

$310,000
20

Estimated salvage value of building (after mine is
exhausted)
Capacity of mine
Expected life of mine

$ 10,000

year
s

1,000,000 tons
10
year
s

35 Instead of crediting the accumulated depletion account, the Ore Deposits account could have been credited
directly
...

Accounting Principles: A Business Perspective

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...
The basis of the depreciation charge is tons of ore rather
than years because the mine's life could be longer or shorter than 10 years, depending on how rapidly the ore is
removed
...
Building depreciation
for the first year is USD 45,000, computed as follows:
Depreciation per unit =

=

Asset cost – Estimated salvage value
Total tons of ore∈mine that can be economicallyextracted

$ 310,000−$ 10,000
tons=$ 0
...
30 per ton X 150,000 tons=USD 45,000

On the income statement, depreciation on the building appears as part of the cost of ore sold and is carried as
part of inventory cost for ore not sold during the period
...

Plant assets and natural resources are tangible assets used by a company to produce revenues
...


Intangible assets
Although they have no physical characteristics, intangible assets have value because of the advantages or
exclusive privileges and rights they provide to a business
...

All intangible assets are nonphysical, but not all nonphysical assets are intangibles
...

Intangible assets are generally both nonphysical and noncurrent; they appear in a separate long-term section of the
balance sheet entitled "Intangible assets"
...
However, computing an intangible asset's
acquisition cost differs from computing a plant asset's acquisition cost
...
If an intangible asset is internally generated in its entirety, none of its
costs are capitalized
...
To explain the reasons for this practice, we discuss the history of accounting for research and
development costs next
...
Prior to 1975, businesses often capitalized research and
development costs as intangible assets when future benefits were expected from their incurrence
...
Other companies capitalized those costs that related to proven products and expensed the rest as
incurred
...
0 License
As a result of these varied accounting practices, in 1974 the Financial Accounting Standards Board in Statement
No
...
Immediate expensing is justified on the grounds that (1) the
amount of costs applicable to the future cannot be measured with any high degree of precision; (2) doubt exists as
to whether any future benefits will be received; and (3) even if benefits are expected, they cannot be measured
...
The Board applies
the same line of reasoning to other costs associated with internally generated intangible assets, such as the internal
costs of developing a patent
...
A portion of an intangible
asset's cost is allocated to each accounting period in the economic (useful) life of the asset
...
Only recognized intangible assets with finite useful lives are amortized
...
(Pertinent factors that should be considered in estimating useful life include legal, regulatory, or
contractual provisions that may limit the useful life)
...
If no pattern is apparent, the straight-line method of
amortization should be used by the reporting entity
...
Amortization will
however begin when it is determined that the useful life is no longer indefinite
...
36
Straight-line amortization is calculated the same was as straight-line depreciation for plant assets
...
An accumulated
amortization account could be used to record amortization
...

A patent is a right granted by the federal government
...
The value of a patent lies in its ability to
produce revenue
...
Protection for the patent owner begins at the time of patent
application and lasts for 17 years from the date the patent is granted
...
The firm also debits the Patents
account for the cost of the first successful defense of the patent in lawsuits (assuming an outside law firm was hired
rather than using internal legal staff)
...
In addition, the firm debits the cost of any competing patents purchased to ensure the revenuegenerating capability of its own patent to the Patents account
...
If a patent cost USD 40,000 and has a useful life of 10 years, the journal entries to record the patent and
periodic amortization are:
Patents (+A)
Cash (-A)
To record purchases of patent
...
142
...
11
...
Plant asset disposals, natural resources, and intangible assets
Patient Amortization Expense (-SE)
Patents (-A)
To record annual patent amortization
...

As noted earlier, all R&D costs incurred in the internal development of a product, process, or idea that is later
patented must be expensed, rather than capitalized
...
If the patent had been the result of an internally generated product
or process, the firm would have expensed its cost of USD 40,000 as incurred, in accordance with Statement No
...

A copyright is an exclusive right granted by the federal government giving protection against the illegal
reproduction by others of the creator's written works, designs, and literary productions
...
37 Most publications have a limited (finite) life; a creator
may amortize the cost of the copyright to expense on a straight-line basis or based upon the pattern in which the
economic benefits are used up or consumed
...
In many instances, both
parties are private businesses
...
This franchise would allow the business owner to use the McDonald's name and golden arch, and
would provide the owner with advertising and many other benefits
...

The parties involved in a franchise arrangement are not always private businesses
...
A city may give a franchise to a utility company, giving the utility company
the exclusive right to provide service to a particular area
...
These
restrictions generally are related to rates or prices charged; also they may be in regard to product quality or to the
particular supplier from whom supplies and inventory items must be purchased
...
If a lump-sum payment is made to obtain the franchise, the franchisee records the cost in an asset
account entitled Franchise and amortizes it over the finite useful life of the asset
...

A trademark is a symbol, design, or logo used in conjunction with a particular product or company
...
Often trademarks and trade
names are extremely valuable to a company, but if they have been internally developed, they have no recorded asset
cost
...


37 In 1998 Congress changed the period from 50 to 70 years
...

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...
The property owner is the grantor of the lease and is the lessor
...
The rights granted under the lease
are a leasehold
...

Capital leases A capital lease transfers to the lessee virtually all rewards and risks that accompany
ownership of property
...

A capital lease is a means of financing property acquisitions; it has the same economic impact as a purchase
made on an installment plan
...
Because a capital lease is an asset, the lessee depreciates the leased property over its
useful life
...

The proper accounting for capital leases for both lessees and lessors has been an extremely difficult problem
...

Operating leases A lease that does not qualify as a capital lease is an operating lease
...
Such leases make no attempt to
transfer any of the rewards and risks of ownership to the lessee
...

In some situations, the lease may call for an immediate cash payment that must be recorded
...
The lessee would record the payment as follows:
Prepaid Rent (+A)
Leasehold (+A)
Cash (-A)
To record first and fifth years' rent on a five-year
lease
...
Then the Leasehold account becomes a current asset and may
be transferred into a Prepaid Rent account
...
In the previous example, the firm would charge the USD 15,000 in the Leasehold account to
expense over the fifth year only
...
Thus,
assuming the lease year and fiscal year coincide, the entry for the first year is:
Rent Expense (-SE)
Prepaid Rent (-A)
To record rent expense
...


15,000
15,000

The accounting for the second, third, and fourth years would be the same as for the first year
...
As stated above, the lessee may
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...
If this entry was made, the previous entry would have credited Prepaid Rent
...
The lessee
debits this payment to the Leasehold account and amortizes it over the life of the lease
...
Assume the USD 15,000 rent for the fifth year in the
example was, instead, a lump-sum payment on the lease in addition to the annual rent payments
...


3,000
3,000

In this example, the annual rental expense is USD 18,000: USD 15,000 annual cash rent plus USD 3,000
amortization of leasehold (USD 15,000/5)
...
For
example, if a lease called for rent equal to 5 per cent of current-year sales and sales were USD 400,000 in 2010, the
rent for 2010 would be USD 20,000
...

A leasehold improvement is any physical alteration made by the lessee to the leased property in which
benefits are expected beyond the current accounting period
...
However, since leasehold improvements are an asset
of the lessee during the lease period, the lessee debits them to a Leasehold Improvements account
...
The amortization
period for leasehold improvements should be the shorter of the life of the improvements or the life of the lease
...

As an illustration, assume that on 2010 January 2, Wolf Company leases a building for 20 years under a
nonrenewable lease at an annual rental of USD 20,000, payable on each December 31
...
The improvements have an estimated life of 30 years
...
If only annual financial statements are prepared, the
following journal entry properly records the rental expense for the year ended 2010 December 31:
Rent Expense (or Leasehold Improvement Expense) 4,000
(-SE)
Leasehold Improvements (-A)
To record amortization of leasehold improvement
...


4,000

20,000

Thus, the total cost to rent the building each year equals the USD 20,000 cash rent plus the amortization of the
leasehold improvements
...
0 License
Although leaseholds are intangible assets, leaseholds and leasehold improvements sometimes appear in the
property, plant, and equipment section of the balance sheet
...
A company's value may be greater than
the total of the fair market value of its tangible and identifiable intangible assets
...
Thus, proof of a company's
goodwill is its ability to generate superior earnings or income
...
A company cannot
purchase goodwill by itself; it must buy an entire business or a part of a business to obtain the accompanying
intangible asset, goodwill
...
Lenox
also agreed to assume responsibility for a USD 350,000 mortgage note payable owed by Martin
...
Notice that Lenox would use the fair market
value of the assets rather than book value to determine the amount of goodwill
...


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...
Since these
positive factors are not individually quantifiable, when grouped together they constitute goodwill
...


95,000
100,000
240,000
275,000
200,000
65,000
75,000
700,000
350,000

The intangible asset goodwill is not amortized
...
The amount
of any goodwill impairment loss is to be recognized in the income statement as a separate line before the subtotal
income from continuing operations (or similar caption)
...
39
Look at Exhibit 94, a partial balance sheet for ANY company
...


38 Discussion of testing for impairment is beyond the scope of this text
...
142
...
142
...
18
...
Plant asset disposals, natural resources, and intangible assets

Analyzing and using the financial results—Total assets turnover
In determining the productivity of assets, management may compare one year's assets turnover ratio to a
previous year's
...
To calculate this ratio:
Total assets turnover=

Net sales
Average total assets

This ratio indicates the efficiency with which a company uses its assets to generate sales
...
Thus, if the ratio is relatively low and there was no significant decrease in sales
during the current year, management should identify and dispose of any inefficient equipment
...
41%
35,870,150
36,374,300 79
...
83%

These three companies compete in very different industries
...
To see if each
of these companies is performing above standard, management should compare its company's percentage to the
industry's standard
...

This chapter concludes your study of accounting for long-term assets
...

Understanding the learning objectives
• By comparing an asset's book value (cost less up-to-date accumulated depreciation) with its sales price, the

company may show either a gain or a loss
...

If sales price is less than book value, the company shows a loss
...

• When a plant asset is retired from service, the asset's cost and accumulated depreciation must be removed

from the plant asset accounts
...
If the

asset was not insured, the loss is equal to the book value
...

• In exchanges of nonmonetary assets having commercial substance, the firm records the asset received at

either (1) the stated cash price of the new asset or (if the cash price is not stated) (2) the known fair market
value of the asset given up plus any cash paid
...


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...
ABC acquired the following assets:
Accounts receivable

$80,000
Old Book
Value

Merchandise inventory
Buildings
Land
Equipment

Fair Market
Value

$ 200,000
3,000,000
1,000,000
500,000

$ 300,000
4,000,000
3,000,000
700,000

An experienced appraiser with an excellent reputation established the fair market value of the
assets
...

John Gilbert, ABC's accountant, prepared the following journal entry to record the purchase: In
explaining the entry to ABC's president, Gilbert said that the assets had to be recorded at their fair
market values
...

Accounts Receivable
(+A)
Merchandise Inventory
(+A)
Buildings (+A)
Land (+A)
Equipment (+A)
Goodwill (+A)
Accounts Payable (+L)
Cash (-A)
To record the
purchase of XYZ
Company
...
Besides, appraisals are very inexact, and maybe some of our other
assets are worth more than the one appraiser indicated
...
Then, we can benefit
from the depreciation on these assets
...
"
When Gilbert protested, the president stated, "If you are going to have a future with us, you need to
be a team player
...
" Gilbert feared that if he did
not go along, he would soon be unemployed
...
Plant asset disposals, natural resources, and intangible assets
• Depletion charges usually are computed by the units-of-production method
...
This calculation provides a per
unit depletion cost that is multiplied by the units extracted each year to obtain the depletion cost for that year
...
The periodic depreciation charges usually are
computed using the units-of-production method
...

• Only outright purchase costs are included in the acquisition cost of an intangible asset
...

• Intangibles should be amortized over their finite useful lives
...
If no pattern is apparent, straight-line
amortization should be used
...


Demonstration problem
Demonstration problem A On 2007 January 2, Darton Company purchased a machine for USD 36,000
cash
...
Darton
uses the straight-line method of depreciation
...
Compute the book value of the machine as of 2010 July 1
...
Assume the machine was disposed of on 2010 July 1
...

• The machine was sold for USD 18,000 cash
...
The exchange has commercial substance
...
Darton expects to recover cash of USD 10,800 from the

insurance company
...
After the timber is removed, the land will be worth about USD 3,200,000 and
will be sold to another party
...
A building was erected at a cost of
USD 160,000
...
It was expected that 50,000,000 board feet of timber can be economically
cut
...
Howard uses the units-of-production basis to depreciate
the building
...
The acquisition of the property
...
The development costs
...
Depletion cost for the first year
...
Depreciation on the building for the first year
...
0 License
Demonstration problem C On 2010 January 2, Bedford Company purchased a 10-year sublease on a
warehouse for USD 30,000
...
Bedford immediately incurred costs of
USD 20,000 for improvements to the warehouse, such as lighting fixtures, replacement of a ceiling, heating system,
and loading dock
...

Prepare the entries to record:
a
...

b
...

c
...

d
...

e
...

Solution to demonstration problem
Solution to demonstration problem A
DARTON COMPANY
Schedule to Compute Book Value
2010 July 1

a
...
(1)

(2)

Cost
Less accumulated depreciation:
($35,000 - $1,800)/6 years= $5,700 per year
$5,700 X 31 1/2 years = $19,950
Book value
Cash (+A)
Accumulated Depreciation—Machinery (+A)
Loss from Disposal of Plant Assets (-SE)
Machinery (-A)
To record the sale of machinery at loss
...


Accounting Principles: A Business Perspective

$ 36,000
19,950
$ 16,050
12,000
19,950
4,050
18,000
19,950

471

36,000

36,000
1,950

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...


39,000
19,950
1,050
36,000
24,000

The exchange has commercial substance
...


10,800
19,950
5,250
36,000

Solution to demonstration problem B
a
...

c
...


Land (+A)
Timber Stands (+A)
Cash (-A)
To record purchase of land and timber
...

Depletion (-SE)
Accumulated Depletion—Timber Stands (-A)
To record depletion for 2007
...
112 per
board foot
...
112 X 16,000,000 = $1,792,000
...
0016
per board foot
...
0016 X 16,000,000 = $25,600
...

b
...

d
...


Leasehold (+A)
Cash (-A)
To record purchase of sublease on warehouse
...

Leasehold Improvements (+A)
Cash (-A)
To record payment for leasehold improvements
...
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Key terms
Amortization The term used to describe the systematic write-off of the cost of an intangible asset to
expense
...

Commercial substance The result if an exchange of nonmonetary assets causes future cash flows to differ
significantly
...

Depletion The exhaustion of a natural resource; an estimate of the cost of the resource that was removed
from its natural setting during the period
...

Franchise A contract between two parties granting the franchisee (the purchaser of the franchise) certain
rights and privileges ranging from name identification to complete monopoly of service
...
Evidenced by the ability to generate an aboveaverage rate of income on each dollar invested in the business
...

Lease A contract to rent property
...

Leasehold The rights granted under a lease
...

Natural resources Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas
deposits, and timber stands supplied by nature
...

Patent A right granted by the federal government giving the owner the exclusive right to manufacture, sell,
lease, or otherwise benefit from an invention for a limited period
...

Total assets turnover Equal to Net sales/Average total assets
...

Trademark A symbol, design, or logo used in conjunction with a particular product or company
...

Wasting assets See Natural resources
...

When a plant asset is still being used after it has been fully depreciated, depreciation can be taken in excess of its
cost
...

In calculating depletion, the residual value of acquired land containing an ore deposit is included in total costs
subject to depletion
...


Accounting Principles: A Business Perspective

473

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11
...

When a fully depreciated asset is still in use:
a
...

b
...

c
...

d
...

e
...

A truck costing USD 45,000 and having an estimated salvage value of USD 4,500 and an original life of five
years is exchanged for a new truck
...
The old truck has been depreciated for three years using the straight-line method
...
USD 55,200
...
USD 57,000
...
USD 34,500
...
USD 43,200
...
None of the above
...
After the ore deposit is removed, the land will be worth USD 75,000
...
USD 300,000
...
USD 37,500
...
USD 30,000
...
USD 375,000
...
None of the above
...
The patent is expected to have a finite life of 10 years even
though its legal life is 17 years
...
USD 36,000
...
USD 3,600
...
USD 2,118
...
USD 3,240
...
None of the above
...


Questions
➢

When depreciable plant assets are sold for cash, how is the gain or loss measured?

➢

A plant asset that cost USD 27,000 and has a related accumulated depreciation account balance of
USD 27,000 is still being used in business operations
...
0 License
depreciation on this asset? Explain
...
The exchange has commercial
substance
...
How is the cost of the new asset
determined?

➢

When nonmonetary assets not having commercial substance are exchanged, a resulting gain is not
recognized
...


➢

What is the proper accounting treatment for the costs of removing or dismantling a company's old
plant assets?
➢

Distinguish between depreciation, depletion, and amortization
...


➢

Distinguish between tangible and intangible assets, and classify the assets named in part (a)
accordingly
...
The
coal mine is expected to be completely exhausted within 20 years
...


➢

What reasons justify the immediate expensing of most research and development costs?

➢

Over what length of time should intangible assets be amortized?

➢

Should costs incurred on internally generated intangible assets be capitalized in asset accounts?

➢

Describe the typical accounting for a patent
...
Legal fees (outside counsel)
and other costs associated with registration of the patent totaled USD 22,800
...
The
effective date of the lease was 2009 July 1
...
The building was placed in operation on 2010
January 2, at which time it was estimated to have a physical life of 50 years
...
Does it follow automatically that this business should
have goodwill recorded as an asset? Explain
...
Plant asset disposals, natural resources, and intangible assets
Exercises
Exercise A Plant equipment originally costing USD 32,400, on which USD 21,600 of up-to-date depreciation
has been accumulated, was sold for USD 8,100
...
Prepare the journal entry to record the sale
...
Prepare the entry to record the sale of the equipment if USD 90 of removal costs were incurred to allow the
equipment to be moved
...
The truck was acquired on
2006 January 1, at a cost of USD 17,400
...

Prepare the journal entries to update the depreciation on the truck on 2009 August 31, and to record the sale of
the truck
...
What journal entry should record the machine's destruction and the
resulting fire loss under each of the following unrelated assumptions?
a
...

b
...

Exercise D Kale Company owned an automobile acquired on 2007 January 1, at a cash cost of USD 35,100; at
that time, the automobile was estimated to have a useful life of four years and a USD 2,700 salvage value
...
On 2010 January 1, the
automobile was traded for a new automobile
...
Cash of USD 31,050 was paid
...

Prepare the journal entry to record the trade-in under generally accepted accounting principles
...
What journal entries are required to record the equipment's
disposal under each of the following unrelated assumptions?
a
...

b
...

c
...
No material was salvaged
...
The equipment was exchanged for similar equipment having a cash price of USD 450,000
...
The exchange has no
commercial substance
...
The equipment was exchanged for similar equipment having a cash price of USD 450,000
...
The exchange has commercial substance
...
After spending
USD 90,000 in exploration costs, the company determined that 600,000 tons of ore existed on the tract but only
500,000 tons could be economically removed
...
When the company finishes with the
tract, it estimates the land will be worth USD 180,000
...

Exercise G Boyd Company paid USD 7,200,000 for the right to extract all of the mineral-bearing ore,
estimated at 10 million tons, that can be economically extracted from a certain tract of land
...
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Boyd Company extracted 1,000,000 tons of the ore and sold 800,000 tons
...
Though the building has a useful life of 10 years, the
mining operations are expected to last only 6 years
...
If 100,000 tons of ore are extracted in the first year
of operations, what is the appropriate depreciation charge using the units-of-production method?
Exercise I Talse Company purchased a patent on 1995 January 1, at a total cost of USD 61,200
...
The legal fees
amounted to USD 13,500
...
)
Exercise J Don Jackson paid Hungry Hannah's Hamburgers USD 54,000 for the right to operate a fast-food
restaurant in Thomasville under the Hungry Hannah's name
...
5 per
cent of sales for advertising and other services rendered by Hungry Hannah's
...
Sales for 2009 amounted to USD 540,000
...

Give the entries to record the payment of the USD 54,000 and to record expenses incurred relating to the right
to use the Hungry Hannah's name
...
The company paid USD 240,000 in cash (not representing a specific
period's rent) and agreed to make annual payments equal to 1 per cent of the first USD 1,500,000 of sales and 0
...
Sales for 2009 amounted to USD 4,500,000
...

Prepare journal entries to record the cash payment of 2009 January 1, and the proper expense to be recognized
for the use of the space in the leased building for 2009
...
Rye Company also
agreed to assume responsibility for Shef Company's liabilities of USD 90,000
...
How much goodwill should be recorded in this transaction? Give the journal entry to
record this transaction
...
The company received
a trade-in allowance (its fair value) for the old automobile of USD 2,100 and paid the balance in cash
...

Record the exchange of automobiles
...
The truck has
an estimated useful life of six years and an estimated salvage value of USD 6,750
...

a
...

b
...
Prepare the journal entry to record depreciation for the
six months ended 2010 June 30
...
Plant asset disposals, natural resources, and intangible assets
c
...
The truck was sold for USD 26,250 cash
...
The truck was sold for USD 48,000 cash
...
The truck was retired from service, and it is expected that USD 20,625 will be received from the
sale of salvaged materials
...
The truck and USD 60,000 cash were exchanged for office equipment that had a cash price of
USD 105,000
...

v
...
The exchange has no commercial substance
...
The truck was completely destroyed in an accident
...

Problem C Eagle Moving Company purchased a new moving van on 2009 October 1
...
The balance
was paid in cash
...
Depreciation has
been recorded through 2008 December 31, on a straight-line basis, with three years of expected useful life and no
expected salvage value
...

Prepare journal entries to update the depreciation and to record the exchange of the moving vans
...

• Building No
...
Building No
...

• The equipment had an expected useful life of eight years with no estimated salvage value
...
Truck B, purchased on 2007 July 1, at a cost of USD 131,040, had an
expected life of two years and an estimated salvage value of USD 21,840
...

The following transactions occurred in 2009:
Jan
...

April 1 Truck B was traded in for truck D
...
A trade-in
allowance of USD 28,080 was granted from the cash price
...
Truck D has an expected
life of 20 years and an estimated salvage value of USD 9,360
...

1 Truck A was sold for USD 28,080 cash
...
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Prepare journal entries to record the 2009 transactions and the necessary 2009 December 31, adjusting entries,
assuming a calendar-year accounting period
...

Problem D On 2009 January 2, York Mining Company acquired land with ore deposits at a cash cost of USD
1,800,000
...
The residual value of the land is
expected to be USD 360,000
...
Present technology will allow
the economical extraction of only 85 per cent of the total deposit
...
The assets will have no further value to the company when the ore body is
exhausted; they have a physical life of 12 years
...
The company expects
the mine to be exhausted in 10 years, with sharp variations in annual production
...
Compute the depletion charge for 2009
...

b
...

c
...
)
Problem E East Company spent USD 249,900 to purchase a patent on 2009 January 2
...
In January 2010, the company hired an outside law firm and
successfully defended the patent in a lawsuit at a cost of USD 48,000
...
The
purchased patents will never be used
...

Problem F Following are selected transactions and other data relating to Long Company for the year ended
2009 December 31
...
The company rented the second floor of a building for five years on 2009 January 2, and paid the annual rent
of USD 18,000 for the first and fifth years in advance
...
In 2008, the company incurred legal fees of USD 54,000 paid to an outside law firm in applying for a patent
and paid a fee of USD 18,000 to a former employee who conceived a device that substantially reduced the cost of
manufacturing one of the company's products
...

c
...

The company then incurred costs of USD 72,000 to install partitions, shelving, and fixtures
...

d
...
The trademark has an indefinite life
...
The company incurred costs amounting to USD 180,000 in 2008 and USD 234,000 in 2009 for research and
development of new products that are expected to enhance the company's revenues for at least five years
...
The company paid USD 180,000 to the author of a book that the company published on 2009 July 2
...

For each of the situations just described, prepare only the journal entries to record the expense applicable to
2009
...
Plant asset disposals, natural resources, and intangible assets
Alternate problems
Alternate problem A Ray, Inc
...
The cash
price of the new automobile was USD 28,080, from which Ray received a trade-in allowance of USD 4,320 for a
2008 model traded in
...

Depreciation has been recorded on the 2008 model through 2009 December 31, using the straight-line method, an
expected four-year useful life, and an expected salvage value of USD 2,700
...

a
...

b
...

Alternate problem B On 2007 January 1, Wood Company purchased a truck for USD 43,200 cash
...
Depreciation on the truck was
computed using the straight-line method
...
Prepare a schedule showing the computation of the book value of the truck on 2009 December 31
...
Prepare the journal entry to record depreciation for the six months ended 2010 June 30
...
Prepare journal entries to record the disposal of the truck on 2010 June 30, under each of the following
unrelated assumptions:
(a) The truck was sold for USD 3,600 cash
...

(c) The truck was scrapped
...

(d)The truck (which has a fair market value of USD 10,800) and USD 32,400 of cash were exchanged
for a used back hoe that did not have a known market value
...

(e) The truck and USD 29,700 cash were exchanged for another truck that had a cash price of USD
51,300
...

(f) The truck was stolen July 1, and insurance proceeds of USD 7,560 were expected
...
Cash price of the
new computer was USD 24,960; Jackson received a trade-in allowance of USD 9,300 from the cash price for a
Model I computer
...
Depreciation has
been recorded through 2008 December 31, on a straight-line basis, with an estimated useful life of four years and
USD 3,840 expected salvage value
...

Prepare the journal entries to record the exchange
...


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...
The factory building is on the owned land and was completed on 2004 July 1, at a
cost of USD 2,184,000; its life is also set at 40 years with no expected salvage value
...

The company owns three trucks—A, B, and C
...
Truck B, purchased on 2008 January 2, at a
cost of USD 84,000, had an expected life of four years and an estimated salvage value of USD 6,720
...

The following transactions occurred in the fiscal year ended 2010 June 30:
2009
July 1 Rent for2009 July 1, through 2010 June 30, on leased land was paid, USD 31,920
...
1 Truck A was traded in on truck D
...
Cash of USD 90,720 was
paid
...
The exchange has no commercial
substance
...
2 Truck B was sold for USD 47,040 cash
...
The truck was not insured
...
Use the
straight-line depreciation method
...
The mine
contained an estimated 10 million tons of ore
...
A
building was erected on the property at a cost of USD 360,000
...
Specialized mining equipment was installed at a cost of USD 495,000
...
The company began operating on
2009 January 1, and put all of its assets into use on that date
...
The company decided to use the units-of-production method to record depreciation on
the building and the straight-line method to record depreciation on the equipment
...

Show calculations
...
The patent
was estimated to have a finite life of 10 years
...
On 2010 January 1, the company incurred legal and court costs of USD 32,400 in a successful
defense of the patent in a lawsuit
...

a
...

b
...

Alternate problem G Selected transactions and other data for Grant Company:

Accounting Principles: A Business Perspective

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...
The company purchased a patent in early January 2006 for USD 144,000 and began amortizing it over its
finite life of 10 years
...

b
...

c
...

Rent for the first and last years was paid in advance
...
A total of USD 96,000 was spent uniformly throughout 2009 by the company in promoting its lesser known
trademark, which is expected to have a finite useful life of 20 years
...
In January 2007, the company purchased all of the assets and assumed all of the liabilities of another
company, paying USD 192,000 more than the fair market value of all identifiable assets acquired, less the liabilities
assumed
...

For each of these unrelated transactions, prepare journal entries to record only those entries (required for 2009
...

Beyond the numbers-Critical thinking
Business decision case A During your audit examination of the Shirley Company's Plant, Property, and
Equipment accounts, the following transaction came to your attention
...
Shirley Company acquired machine A for USD 90,000 on 2007 January 2
...
Machine B had a cash price of USD 108,000
...
Machine B has an estimated useful life of five years and no salvage value, and the machine is being
depreciated using the straight-line method
...
Upon further analysis, you
discover that the company recorded the transaction as an exchange of nonmonetary assets having commercial
substance instead of one not having commercial substance
...
What journal entry did the Shirley Company make when it recorded the exchange of machines? (Show
computations
...
What journal entry should the Shirley Company have made to record the exchange of machines?
c
...

What journal entries should be made to correct the accounting records? (Adjustments of prior years' net income
because of errors should be debited or credited to Retained Earnings
...
)
d
...
)
e
...
Tyre, Inc
...
Tyre, Inc
...
Your
review of the companies' books has revealed that both Amite and Beauman have assets with the following book
values and fair market values:

482

11
...

The only difference between the companies is that Amite has net income that is about average for the industry,
while Beauman's net income is greatly above average for the industry
...
, has asked you to respond in writing to the following possible situations:
a
...
, can buy Amite Company for USD 2,700,000 or Beauman Company for USD 3,450,000
...
What accounts for
the difference between the purchase price of the two companies?
b
...
Write a report for Tyre, Inc
...

Annual report analysis C The mission of Rational Software Corporation is to ensure the success of customers
constructing the software systems that they depend on
...
(Amounts are in USD thousands
...
Use the total assets turnover ratios you computed for Rational Software as an example
in your report
...

a
...
Assuming that the president cannot find another appraiser to support the new allocations, what would you do
if you were Gilbert?
c
...
Select one member of each team to give an informal presentation discussing intangible asset
disclosures on the face of the statements and in the notes to the financial statements
...

Group project F In a group of one or two other students, go to the library and locate Statement of Financial
Accounting Standards No
...
Write a report to your instructor giving the highlights of the standard
...
0 License
what alternatives were considered and why did the board conclude that all research and development costs should
be expensed when incurred?
Group project G In a group of one or two other students, go to the library and locate Statement of Financial
Accounting Standards No
...
Write a report to your instructor giving
the highlights of the standard
...

Using the Internet—A view of the real world
Visit the Accounting News Network at Microsoft's website:
http://sba
...
com/apnews/default
...
Browse any of the areas that look
interesting
...

Visit the Small Business Administration site at:
http://www
...
gov
Suppose you wanted to start a small business
...
Then write a
report to your instructor summarizing the types of helpful information this site provides
...
No more depreciation can be taken on a fully depreciated plant asset
...
The new asset is recorded at the fair market value of the asset received or given up, whichever is more
clearly evident
...
The residual value of land should be deducted from total costs subject to depletion
...
Only intangible assets with finite useful lives should be amortized
...
The cost and accumulated depreciation should not be removed from the accounts until the disposal of the
asset
...
On the date of exchange, the book value of the old truck is USD 20,700 (USD 45,000 minus accumulated
depreciation of USD 24,300)
...
In
an exchange of nonmonetary assets not having commercial substance, a gain is not recognized, but reduces the cost
of a new asset
...

c
...
30
Depletion charge for the year=USD 0
...
Plant asset disposals, natural resources, and intangible assets
Since all of the ore that was extracted was sold, all of the USD 30,000 is expensed as cost of ore sold
...
The patent is amortized over 10 years:
Annual amortization expense=

USD 36,000
10

= USD 3,600

485

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...
Stockholders' equity:
Classes of capital stock
Learning objectives
After studying this chapter, you should be able to:
• State the advantages and disadvantages of the corporate form of business
...

• List the various kinds of stock and describe the differences between them
...

• Account for the issuances of stock for cash and other assets
...

• Analyze and use the financial results—return on average common stockholders' equity
...
However, few people give much thought
to the other side of this transaction
...
The initial
public issuance of stock (i
...
going public) is one of the most significant milestones in the life of a public company
...
Who handles the stock transactions within a
company? The treasurer or the person that performs the treasury functions is this person
...

When a company decides to issue bonds or additional shares of stock, the treasurer is the person responsible for
executing the transaction at the lowest cost to the entity
...
When a company
issues stock for the first time (initial public offering, or IPO), the task requires a thorough review of the financial
position of the company and the public disclosure of this information for perhaps the first time
...
Among other things, the prospectus includes
financial accounting information that is used in setting the price of the IPO
...
The treasurer also plays a pivotal role in the distribution of cash and stock dividends
...
A career as a corporate
treasurer can involve the oversight of billions of dollars of stock, and the individual can earn a six-figure salary
...
Although corporations are fewer in number than single proprietorships and partnerships, corporations
possess the bulk of our business capital and currently supply us with most of our goods and services
...
Stockholders' equity: Classes of capital stock
This chapter discusses the advantages and disadvantages of the corporation, how to form and direct a
corporation, and some of the unique situations encountered in accounting for and reporting on the different classes
of capital stock
...


The corporation
A corporation is an entity recognized by law as possessing an existence separate and distinct from its owners;
that is, it is a separate legal entity
...

Corporations have a remarkable ability to obtain the huge amounts of capital necessary for large-scale business
operations
...
Investors buy shares of stock in a corporation for two basic reasons
...

Second, while investors hold stock, they expect the corporation to pay them dividends (usually in cash) in return for
using their money
...


Advantages of the corporate form of business
Corporations have many advantages over single proprietorships and partnerships
...
Although corporations have more owners than partnerships, both have a broader base for
investment, risk, responsibilities, and talent than do single proprietorships
...

• Easy transfer of ownership
...
In a publicly held
(owned by many stockholders) corporation, shares of stock are traded on a stock exchange between unknown
parties; one owner usually cannot dictate to whom another owner can or cannot sell shares
...
Each partner in a partnership is personally responsible for all the debts of the business
...
However, when a small, closely held corporation
(owned by only a few stockholders) borrows money, banks and lending institutions often require an officer of
the small corporation to sign the loan agreement
...

• Continuous existence of the entity
...
These same circumstances have no effect on a corporation because
it is a legal entity, separate and distinct from its owners
...
The easy transfer of ownership and the limited liability of stockholders are

attractive features to potential investors
...
Corporations with thousands of stockholders are not uncommon
...
0 License
• Professional management
...
In a publicly held
corporation, most of the owners (stockholders) do not participate in the day-to-day operations and
management of the entity
...

• Separation of owners and entity
...
This feature eliminates the potential problem of
mutual agency that exists between partners in a partnership
...

The corporate form of business has the following disadvantages:
• Double taxation
...
The corporation pays a tax on its income, and stockholders pay a tax on corporate income received as
dividends
...
Because corporations are created by law, they are subject to greater regulation

and control than single proprietorships and partnerships
...
A corporation may be burdened with an inefficient

management that remains in control by using corporate funds to solicit the needed stockholder votes to back
its positions
...

• Limited ability to raise creditor capital
...
At the same time, this limited liability feature restrains
the amount of creditor capital a corporation can amass because creditors cannot look to stockholders to pay
the debts of a corporation
...

Corporations are chartered by the state
...
Incorporators are persons seeking to bring a corporation into existence
...

The laws of each state view a corporation organized in that state as a domestic corporation and a corporation
organized in any other state as a foreign corporation
...
Corporations conducting interstate business usually incorporate in the
state that has laws most advantageous to the corporation being formed
...

Once incorporators agree on the state in which to incorporate, they apply for a corporate charter
...
The application for the corporation's charter is called the articles of incorporation
...
Stockholders' equity: Classes of capital stock
After supplying the information requested in the incorporation application form, incorporators file the articles
with the proper office in the state of incorporation
...

• Location of principal offices
...

• Number of shares of stock authorized, class or classes of shares, and voting and dividend rights of each

class of shares
...

• Limitations on authority of the management and owners of the corporation
...

As soon as the corporation obtains the charter, it is authorized to operate its business
...
Two of the purposes of this meeting are to elect a board of directors and to adopt
the bylaws of the corporation
...
The bylaws must be in agreement with the laws of the state and the policies and
purposes in the corporate charter
...

Organization costs are the costs of organizing a corporation, such as state incorporation fees and legal fees
applicable to incorporation
...
The Organization
Costs account is an asset because the costs yield benefits over the life of the corporation; if the fees had not been
paid, no corporate entity would exist
...
Most organizations write off these costs fairly rapidly because they are small in
amount
...
The entry to record
these costs is:
Organization Costs (+A)
Cash (-A)
To record costs incurred in organizing
corporation
...

(15,000/10 years = $1,500)
...
The stockholders elect the board of directors
...
0 License
board of directors formulates the broad policies of the company and selects the principal officers, who execute the
policies
...
However, stockholders do have certain basic rights, including the
right to (1) dispose of their shares, (2) buy additional newly issued shares in a proportion equal to the percentage of
shares they already own (called the preemptive right), (3) share in dividends when declared, (4) share in assets
in case of liquidation, and (5) participate in management indirectly by voting at the stockholders' meeting
...
For example, assume Joe Thornton owns 10 per cent of the outstanding shares of
Corporation X
...
Should he decide to do so, he maintains his 10 per cent interest in the
corporation
...
40

Exhibit 95: Typical corporation's organization chart
Normally, companies hold stockholders' meetings annually
...

At stockholders' meetings, each stockholder is entitled to one vote for each share of voting stock held
...
A proxy is a legal
document signed by a stockholder, giving a designated person the authority to vote the stockholder's shares at a
stockholders' meeting
...
The board appoints administrative officers and delegates to them the
execution of the policies established by the board
...
The decisions of the board are recorded in the minutes of its meetings
...

Accounting Principles: A Business Perspective

490

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...

Corporate officers A corporation's bylaws usually specify the titles and duties of the officers of a corporation
...

The president is the chief executive officer (CEO) of the corporation
...

Most corporations have more than one vice president
...
The corporate secretary maintains the official
records of the company and records the proceedings of meetings of stockholders and directors
...
A controller
carries out the accounting function
...


Documents, books, and records relating to capital stock
Capital stock consists of transferable units of ownership in a corporation
...
Typically, traders sell between 100 and 400 million shares of corporate capital stock every business
day on stock exchanges, such as the New York Stock Exchange and the American Stock Exchange, and on the overthe-counter market
...
Existing stockholders sell their shares to other individual or institutional investors
...

A stock certificate is a printed or engraved document serving as evidence that the holder owns a certain
number of shares of capital stock
...
When the old certificate arrives, the issuing corporation
cancels the certificate and attaches it to its corresponding stub in the stock certificate book
...
To determine the number of shares of stock outstanding at any time, the issuer
sums the shares shown on the open stubs (stubs without certificates attached) in the stock certificate book
...
The stockholders'
ledger contains a group of subsidiary accounts showing the number of shares of stock currently held by each
stockholder
...
Each stockholder's account shows the number of shares currently or
previously owned, their certificate numbers, and the dates on which shares were acquired or sold
...

The stockholders' ledger and the stock certificate book contain the same information, but the stockholders'
ledger summarizes it alphabetically by stockholder
...

Many large corporations with actively traded shares turn the task of maintaining reliable stock records over to
an outside stock-transfer agent and a stock registrar
...
The stock-transfer agent cancels the certificates

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...
It
sends new certificates to the stock registrar, typically another bank, that maintains separate records of the shares
outstanding
...

The minutes book, kept by the secretary of the corporation, is (1) a record book of the actions taken at
stockholders' and board of directors' meetings and (2) the written authorization for many actions taken by
corporate officers
...
The minutes book contains a variety of
data, including:
• A copy of the corporate charter
...

• Dividends declared by the board of directors
...

• Authorization for borrowing
...


Par value and no-par capital stock
Many times, companies issue par value stock
...
Par value per share is no indication of the amount for which
the stock sells; it is simply the amount per share credited to the capital stock account for each share issued
...
The concept of legal
capital protects creditors from losses
...
Stated value relates to no-par stock and is
explained below
...
The formula for determining legal capital is:
Legal Capital=Shares Issued X Par Stated Value

In 1912, the state of New York first enacted laws permitting the issuance of no-par stock (stock without par
value)
...

A corporation might issue no-par stock for two reasons
...
The use of a par value
may confuse some investors because the par value usually does not conform to the market value
...

A second reason is related to state laws regarding the original issue price per share
...
Thus, if stock with a par value of USD
100 is issued at USD 80, the discount is USD 20
...
Only Maryland, Georgia, and California allow its issuance
...
If the contingent liability has been transferred, the present stockholders are contingently liable to creditors
for the difference between par value and issue price
...


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...
Stated value is an arbitrary amount assigned by the board to each share of a given class of no-par stock
...
If not specified by applicable state law, the board may establish stated value
either before or after the shares are issued
...
Market price is directly affected by (1) all the factors that influence general economic
conditions, (2) investors' expectations concerning the corporation, and (3) the corporation's earnings
...
A later section discusses book value per share in greater detail
...

Since the assets might be sold for more or less than the amounts at which they are recorded in the corporation's
accounts, liquidation value may be more or less than book value
...
If two or more classes of stock are outstanding, liquidation value depends on the rights of the
various classes
...
Redemption
value is the price per share at which a corporation may call in (or redeem) its capital stock for retirement
...
Capital stock authorized is the number of shares of stock that a
corporation is entitled to issue as designated in its charter
...
If all authorized stock has been issued and more funds are needed, the
state of incorporation must consent to an increase in authorized shares
...
Instead, companies note the authorization in
the capital stock account in the ledger (and often in the general journal) as a reminder of the number of shares
authorized
...

Capital stock outstanding is the number of authorized shares of stock issued and currently held by
stockholders
...
For
example, when a corporation authorized to issue 10,000 shares of capital stock has issued only 8,000 shares, the
holders of the 8,000 shares own 100 per cent of the corporation
...
Shares authorized but not yet issued are referred to as unissued shares (the previous example
had 2,000 unissued shares)
...

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...
Issued stock has been
issued at some time, while outstanding shares are currently held by stockholders
...
The difference is due to shares returned to the corporation by
stockholders; it is called treasury stock
...


An accounting perspective:
Business insight
SCI Systems, Inc
...
The following illustration is adapted from the company's balance sheet
...
10 par value; authorized 2001
500,000,000 common shares, issued
147,132,428 shares in 2001 and 144,996,374
shares in 2000
...

If a corporation issues only one class of stock, this stock is common stock
...
Common stock is usually the residual equity in the corporation
...

Preferred stock is a class of capital stock that carries certain features or rights not carried by common stock
...

Companies issue preferred stock to avoid: (1) using bonds with fixed interest charges that must be paid
regardless of the amount of net income; (2) issuing so many additional shares of common stock that earnings per
share are less in the current year than in prior years; and (3) diluting the common stockholders' control of the
corporation, since preferred stockholders usually have no voting rights
...
Therefore, the firm fixes the dividend per
share
...


Accounting Principles: A Business Perspective

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...
307
...
It may be noncumulative or cumulative
...

• Convertible or nonconvertible
...


A dividend is a distribution of assets (usually cash) that represents a withdrawal of earnings by the owners
...

Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per
share before common stockholders receive any dividends
...
For no-par preferred stock, the dividend is a specific
dollar amount per share per year, such as USD 4
...
For par value preferred stock, the dividend is usually stated as
a percentage of the par value, such as 8 per cent of par value; occasionally, it is a specific dollar amount per share
...

Usually, stockholders receive dividends on preferred stock quarterly
...
In some states, corporations can declare preferred stock dividends
only if they have retained earnings (income that has been retained in the business) at least equal to the dividend
declared
...
When noncumulative preferred stock is
outstanding, a dividend omitted or not paid in any one year need not be paid in any future year
...

Cumulative preferred stock Cumulative preferred stock is preferred stock for which the right to receive
a basic dividend, usually each quarter, accumulates if the dividend is not paid
...
For example, assume a company
has cumulative, USD 10 par value, 10 per cent preferred stock outstanding of USD 100,000, common stock
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...
It has paid no dividends for two years
...

Dividends in arrears are cumulative unpaid dividends, including the quarterly dividends not declared for the
current year
...
However, since the amount of dividends in arrears may influence the
decisions of users of a corporation's financial statements, firms disclose such dividends in a footnote
...

Most preferred stocks are preferred as to assets in the event of liquidation of the corporation
...
Preferred stockholders receive the par
value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders
...
Also, the cumulative dividend for the current year is payable
...

Convertible preferred stock is preferred stock that is convertible into common stock of the issuing
corporation
...
Holders of
convertible preferred stock shares may exchange them, at their option, for a certain number of shares of common
stock of the same corporation
...
Second, the
conversion privilege may be the source of substantial price appreciation
...
The stock is convertible at any time into four shares of Olsen USD 10 par value common stock, which has
a current market value of USD 20 per share
...
Assume that the common
stock now sells at USD 40 per share
...

If all 1,000 shares of USD 100 par value Olsen Company preferred stock are converted into 4,000 shares of USD
10 par value common stock, the entry is:
Preferred Stock (-SE)
Common Stock (+SE)
Paid-In Capital in Excess of Par Value—Common (+SE)
To record the conversion of preferred stock into
common stock
...
Stockholders' equity: Classes of capital stock

An accounting perspective:
Business insight
In the early 1970s, only about 10 per cent of undergraduate degrees in accounting were awarded to
women
...
By 1996, the rate increased to slightly
more than half
...
For more
information see "Accounting's Big Gender Switch," Business Week, January 20, 1997, p
...

Most preferred stocks are callable at the option of the issuing corporation
...
Also, convertible preferred stockholders must either surrender their stock or convert it to common
shares
...
This call premium is the difference between the amount at which a corporation calls its preferred stock for
redemption and the par value of the stock
...
Stockholders who do not want to surrender their stock have to convert it to common shares
...
If the
market value of common shares into which the preferred stock could be converted is higher than the amount the
stockholders would receive in redemption, they should convert their preferred shares to common shares
...
Each share is callable at USD
104 per share, convertible to two common shares (currently selling at USD 62 per share), and entitled to USD 10 of
unpaid dividends
...
Obviously, the stockholder should convert these preferred shares to
common shares
...


Balance sheet presentation of stock
The stockholders' equity section of a corporation's balance sheet contains two main elements: paid-in capital
and retained earnings
...
Paid-in capital also results from services performed for the corporation in exchange for
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...
As stated earlier, retained earnings is
the part of stockholders' equity resulting from accumulated net income, reduced by dividends and net losses
...
In addition, dividends declared
to stockholders decrease Retained Earnings
...
We discuss retained
earnings in more detail in Chapter 13
...
Assume that a
corporation is authorized to issue 10,000 shares of USD 100 par value, 6 per cent, cumulative, convertible preferred
stock (five common for one preferred), all of which have been issued and are outstanding; and 200,000 shares of
USD 10 par value common stock, of which 80,000 shares are issued and outstanding
...
The company discloses the conversion rate in a parenthetical note within the
description of preferred stock or in a footnote
...
10 par value:
authorized 10,000 shares; issued
and outstanding: 5,883 shares

$588
...
The corporation's charter
determines the par value printed on the stock certificates issued
...
Low par values of USD 10 or less are common in our economy
...
Shares with a par value of USD 5
have traded (sold) in the market for more than USD 600, and many USD 100 par value preferred stocks have
traded for considerably less than par
...
New corporations can issue shares at prices well in excess of par value or for less than par value if state laws
Accounting Principles: A Business Perspective

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...
Par value gives the accountant a constant amount at which to record capital stock issuances in the capital
stock accounts
...

To illustrate the issuance of stock for cash, assume a company issues 10,000 authorized shares of USD 20 par
value common stock at USD 22 per share
...


200,000
20,000

Notice that the credit to the Common Stock account is the par value (USD 20) times the number of shares
issued
...
Thus, paid-in capital in excess of par (or stated)
value represents capital contributed to a corporation in addition to that assigned to the shares issued and recorded
in capital stock accounts
...
Any amounts received in excess of the stated value per share represent a part of the paid-in capital of
the corporation and the company credits them to Paid-In Capital in Excess of Stated Value
...

To illustrate, assume that the DeWitt Corporation, which is authorized to issue 10,000 shares of common stock
without par value, assigns a stated value of USD 20 per share to its stock
...
The entry to record this transaction is:
Cash (+A)
Common Stock (+SE)
Paid-In Capital in Excess of Stated Value—
Common (+SE)
To record issuance of 10,000 shares of stock for
cash
...
However, the legal capital of
the DeWitt Corporation is USD 200,000
...
For instance, consider the DeWitt Corporation's issuance of no-par stock
...
0 License
Common Stock (+SE)
To record issuance of 10,000 shares for cash
...
This contrasts with issuing par value shares or shares with a stated
value
...
In some states, the entire amount received for
shares without par or stated value is the amount of legal capital
...


Capital stock issued for property or services
When issuing capital stock for property or services, companies must determine the dollar amount of the
exchange
...

To illustrate, assume that the owners of a tract of land deeded it to a corporation in exchange for 1,000 shares of
USD 12 par value common stock
...
At the time of the
exchange, the stock has an established total market value of USD 14,000
...


14,000

12,000
2,000

As another example, assume a firm issues 100 shares of common stock with a par value of USD 40 per share in
exchange for legal services received in organizing as a corporation
...
The attorney previously agreed to a price of USD 5,000 for these legal services but
decided to accept stock in lieu of cash
...


4,000
1,000

The company should value the services at the price previously agreed on since that value is more clearly evident
than the market value of the shares
...
The company credits the amount by which the value of the services received
exceeds the par value of the shares issued to a Paid-In Capital in Excess of Par Value—Common account
...
They carry the amounts received in excess of par or
stated value in separate accounts for each class of stock issued
...
Stockholders' equity: Classes of capital stock
equity section of the balance sheet of a company with both preferred and common stock outstanding would appear
as follows:
Stockholders' equity:
Paid-in capital:
Preferred stock—$100 par value, 6%
cumulative; 1,000 shares authorized,
issued, and outstanding
Common stock—without par value, stated
value, $5; 100,000 shares authorized,
80,000 shares; issued and outstanding
Paid-in capital in excess of par (or stated)
value:
From preferred stock issuances
From common stock issuances
Total paid-in capital
Retained earnings
Total stockholders' equity

$100,000
400,000

$ 500,000

$ 5,000
20,000

25,000
$ 525,000
200,000
$ 725,000

The total book value of a corporation's outstanding shares is equal to its recorded net asset value—that is, assets
minus liabilities
...
When only common stock
is outstanding, companies compute the book value per share by dividing total stockholders' equity by the
number of common shares outstanding
...
Assume the stockholders' equity of a corporation is as
follows:
Stockholders' equity:
Paid-in capital:
Common stock—without par value, stated
value, $10; authorized, 20,000 shares;
issued and outstanding, 15,000 shares
Paid-in capital in excess of stated value
Total paid-in capital
Retained earnings
Total stockholders' equity
To determine the book value per share of the
stock:
Total stockholders' equity

$ 150,000
10,000
$ 160,000
50,000
$ 210,000
$210,000

Total shares outstanding

÷15,000

Book value per share

$ 14

When two or more classes of capital stock are outstanding, the computation of book value per share is more
complex
...
Preferred
stockholders typically are entitled to a specified liquidation value per share, plus cumulative dividends in arrears,
since most preferred stocks are preferred as to assets and are cumulative
...
To illustrate, assume the Celoron Corporation's stockholders' equity is as follows:
Stockholders' equity:
Paid-in capital:
Preferred stock—$100 par value, 6%
cumulative; 5,000 shares authorized,
issued, and outstanding
Common stock—$10 par value, 200,000
shares authorized, issued and outstanding
Paid-in capital in excess of par value—preferred
Total paid-in capital
Retained earnings
Total stockholders' equity

$ 500,000
2,000,000
200,000

$2,700,000
400,000
$3,100,000

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...
It is preferred as to dividends and as to assets in liquidation to the
extent of the liquidation value of USD 100 per share, plus any cumulative dividends on the preferred stock
...
You would calculate the book values of each class
of stock as follows:
Total stockholders' equity
Book value of preferred stock (5,000
shares)
Liquidation value (5,000 shares X $100)
Dividends (4 years at $30,000)
Book value of common stock (200,000 shares)

Total
$3,100,000
$ 500,000
120,000

Per Share

620,000
$2,480,000

$124
...
40T

* $620,000 ÷ 5,000 shares
...


Notice that Celoron did not assign the paid-in capital in excess of par value—preferred to the preferred stock in
determining the book values
...

Assume now that the features attached to the preferred stock are the same except that the preferred
stockholders have the right to receive USD 103 per share in liquidation
...
00
12
...
Thus, the market prices of the shares of many corporations traded regularly are different from their book
values
...
For each stock listed on the
NYSE, it lists the following data
...
The next two columns show the high and low price

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...
The next two columns show the company name
(Kellogg) and the NYSE's symbol (K) for that company
...
Yield per cent is calculated as
dividends paid divided by the current market price
...
The Vol 100s column shows the
unofficial daily total of shares traded, quoted in hundreds
...
The next to last column shows the closing price for that day
...


Analyzing and using the financial results—Return on average common stockholders'
equity
Stockholders' equity is particularly important to managers, creditors, and investors in determining the return on
equity, which is the return on average common stockholders' equity
...
From the common
stockholders' point of view, it is an important measure of the income-producing ability of the company
...
If no preferred stock is outstanding, the
numerator is net income, and the denominator is average stockholders' equity
...
1 per cent, or USD 2,922/[(USD
12,287 + USD 12,010)/2]
...

Since the stock market is frequently referred to as an economic indicator, the knowledge you now have on
corporate stock issuances should help you relate to stocks traded in the market
...


An ethical perspective:
Belex corporation
Joe Morrison is the controller for Belex Corporation
...


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...
The first alternative is to bury the
waste in steel drums on a tract of land adjacent to the factory building
...
The cost of disposing of the materials in this way is estimated to be
USD 50,000 per year
...
The second alternative is to seal the materials in
lead drums that would be disposed of at sea by a waste management company
...
The federal government has certified this
method as the preferred method of disposal
...

Belex Corporation has seen some tough economic times
...
So far, the
waste materials from that project have been accumulating in two large vats on the company's land
...

One group of managers is arguing in favor of the first alternative because it is legally permissible
and results in annual profits of about USD 700,000
...

They also claim that some of their competitors are now using the first alternative, and to use the
second alternative would place the company at a serious competitive disadvantage
...

They claim that when the steel drums start leaking they will contaminate the ground water and
could cause serious health problems
...
The cost of that cleanup could run into the
millions
...

(b) Limited liability
...

(d)Easy capital generation
...

(f) Separation of owners and entity
...

(b) Government regulation
...

(d)Limited ability to raise creditor capital
...
Stockholders' equity: Classes of capital stock
• Par value—an arbitrary amount assigned to each share of a given class of stock and printed on the stock

certificate
...

• Market value—the price at which shares of capital stock are bought and sold in the market
...

• Liquidation value—the amount a stockholder would receive if a corporation discontinues operations, pays

its liabilities, and distributes the remaining cash among the stockholders
...

• Capital stock authorized—the number of shares of stock that a corporation is entitled to issue as designated

in its charter
...

• Capital stock outstanding—the number of authorized shares of stock that have been issued and that are still

currently held by stockholders
...

(b) Preferred stock—may be preferred as to dividends and/or assets
...

• If the company has paid-in capital in excess of par value, the proper form would be:
Stockholders' equity:
Paid-in capital:
Preferred stock—$100 par value, 6%
cumulative; 1,000 shares
authorized,issued, and outstanding

$ 100,000

Common stock—without par value, stated
value, $5; 100,000 shares
authorized,80,000 shares; issued and
outstanding

400,000

$ 500,000

Paid-in capital in excess of par (or stated)value:
From preferred stock issuances
$ 5,000
From common stock issuances

20,000

25,000

Total paid-in capital

$ 525,000

Retained earnings

200,000

Total stockholders' equity

$ 725,000

The following examples illustrate the issuance for cash of: (1) stock with a par value, (2) no-par value stock with
a stated value, and (3) no-par value stock without a stated value
...

Cash (+A)
Common Stock (+SE)
Paid-In Capital in Excess of Par

220,000
200,000
20,000

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...

Cash (+A)

220,000

Common Stock (+SE)
Paid-In Capital in Excess of Stated
Value—Common (+SE)

200,000
20,000

• Issuance of no-par stock without a stated value for cash—10,000 shares (no-par value) issued at USD 22

per share
...
Preferred stock is 6 per cent and cumulative
...
Dividends for three years are unpaid
...

Calculations are as follows:
Total
Total stockholders' equity
Book value of preferred stock (5,000 shares)
Liquidation value (5,000 shares X $100)
Dividends (3 years at $30,000)
Book value of common stock (200,000 shares)

Per
Share

$4,100,000
$ 500,000
90,000

590,000
$3,510,000

$ 118
...
55

• The return on average common stockholders' equity equals net income available to common stockholders

divided by average common stockholders' equity
...

Demonstration problem
Demonstration problem A Violet Company has paid all required preferred dividends through 2004
December 31
...
During five successive years, the company's dividend declarations
were as follows:
2005
2006
2007
2008
2009

$85,000
52,500
7,500
15,000
67,500

Compute the amount of dividends that would have been paid to each class of stock in each of the last five years
assuming the preferred stock is:
a
...

b
...

Demonstration problem B Terrier Company has been authorized to issue 100,000 shares of USD 6 par
value common stock and 1,000 shares of 14 per cent, cumulative, preferred stock with a par value of USD 12
...
Prepare the entries for the following transactions that all took place in June 2009:
• 50,000 shares of common stock are issued for cash at USD 24 per share
...
Stockholders' equity: Classes of capital stock
• 750 shares of preferred stock are issued for cash at USD 18 per share
...
The fair market value of the legal services is USD 9,000
...
Prepare the paid-in capital section of Terrier's balance sheet as of 2009 June 30
...
06 = $30,000
† $30,000 + $22,500 preferred dividend missed in 2007 + $15,000
preferred dividend
missed in 2008
...

Year
2005

Solution to demonstration problem B
a
...


1,200,000

507

300,000
900,000

12
...

Organization Costs (+A)
9,000
Common Stock (+SE)
Paid-In Capital in Excess of Par Value—Common
(+SE)
To record the issuance of 1,000 shares in exchange
for
legal services
...


Paid-in Capital:
Preferred stock—$12 par value, 14% cumulative;
1,000shares authorized; issued and outstanding, 750
shares
Common stock—$6 par value per share; 100,000
shares
authorized; issued and outstanding, 51,000 shares

$ 9,000

306,000

$ 315,000

Paid-in capital in excess of par value:
From preferred stock issuances

$ 4,500

From common stock issuances

903,000

Total paid-in capital

907,500
$1,222,50
0

Key Terms
Articles of incorporation The application for the corporation's charter
...
The board also authorizes contracts, declares dividends, establishes executive salaries, and
grants authorization to borrow money
...

Bylaws A set of rules or regulations adopted by the board of directors of a corporation to govern the conduct
of corporate affairs
...

Callable preferred stock If the stock is nonconvertible, it must be surrendered to the company when the
holder is requested to do so
...

Call premium (on preferred stock) The difference between the amount at which a corporation calls its
preferred stock for redemption and the par value of the stock
...

Capital stock authorized The number of shares of stock that a corporation is entitled to issue as
designated in its charter
...

Capital stock outstanding The number of shares of authorized stock issued and currently held by
stockholders
...
If only one class of
stock is issued, it is known as common stock
...

Convertible preferred stock Preferred stock that is convertible into common stock of the issuing
corporation
...
0 License
Corporate charter The contract between the state and the incorporators of a corporation, and their
successors, granting the corporation its legal existence
...
A corporation is granted many of the rights, and placed under many of the
obligations, of a natural person
...

Cumulative preferred stock Preferred stock for which the right to receive a basic dividend accumulates if
any dividends have not been paid; unpaid cumulative preferred dividends must be paid before any dividends
can be paid on the common stock
...

The original issuance of shares at a discount is illegal in most states
...

Dividend on preferred stock The amount paid to preferred stockholders as a return for the use of their
money; usually a fixed or stated amount expressed in dollars per share or as a percentage of par value per
share
...

Domestic corporation See corporation
...

Incorporators Persons seeking to bring a corporation into existence
...

Liquidation value The amount a stockholder will receive if a corporation discontinues operations and
liquidates by selling its assets, paying its liabilities, and distributing the remaining cash among the
stockholders
...

Minutes book The record book in which actions taken at stockholders' and board of directors' meetings are
recorded; the written authorization for many actions taken by corporate officers
...

No-par stock Capital stock without par value, to which a stated value may or may not be assigned
...

Paid-in capital Amount of stockholders' equity that normally results from the cash or other assets invested
by owners; it may also result from services provided for shares of stock and certain other transactions
...

Par value An arbitrary amount assigned to each share of a given class of stock and printed on the stock
certificate
...

Preferred stock Capital stock that carries certain features or rights not carried by common stock
...
Preferred stock may
be callable and/or convertible and may be cumulative or noncumulative
...

Redemption value The price per share at which a corporation may call in (or redeem) its capital stock for
retirement
...


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...
It is the ratio of net income available to common stockholders divided by average common
stockholders' equity
...

Stated value An arbitrary amount assigned by the board of directors to each share of a given class of no-par
stock
...

Stockholders' ledger Contains a group of subsidiary accounts showing the number of shares of stock
currently held by each stockholder
...

Stock preferred as to dividends Means that the preferred stockholders are entitled to receive a specified
dividend per share before any dividend on common stock is paid
...

Stock-transfer agent Typically, a bank or trust company employed by a corporation to transfer stock
between buyers and sellers
...

Unissued shares Capital stock authorized but not yet issued
...

A person may favor the corporate form of organization for a risky business enterprise primarily because a
corporation's shares can be easily transferred
...

The par value of a share of capital stock is no indication of the market value or book value of the share of stock
...

Multiple-choice
Select the best answer for each of the following questions
...
Continuous existence of the entity
...
Limited liability of stockholders
...
Government regulation
...
Easy transfer of ownership
...
Quasi-par value
...
Stated value
...
Redemption value
...
Liquidation value
...
0 License
a
...

b
...

c
...

d
...

Quinn Corporation issued 10,000 shares of USD 20 par value common stock at USD 50 per share
...
USD 200,000
...
USD 300,000
...
USD 500,000
...
USD 700,000
...
None of the above
...
Assuming only one class of stock, the
book value per share is:
a
...

b
...

c
...

d
...

e
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...


➢

What is meant by the statement that corporate income is subject to double taxation? Cite several
other disadvantages of the corporate form of organization
...


➢

What are the differences between par value stock and stock with no-par value?

➢

Corporate capital stock is seldom issued for less than par value
...


➢

Explain the terms liquidation value and redemption value
...
Stockholders' equity: Classes of capital stock
➢

A corporation has 1,000 shares of 8 per cent, USD 200 par value, cumulative, preferred stock
outstanding
...
Is the corporation
legally liable to its preferred stockholders for these dividends? How should this fact be shown in the
balance sheet, if at all?

➢

Explain why a corporation might issue a preferred stock that is both convertible into common stock
and callable
...
Under what
circumstances is this account credited?

➢

Blake Corporation issued 5,000 shares of USD 100 par value common stock at USD 120 per share
...
The preferred stock is entitled to an annual dividend of USD 100 per share before
dividends are declared on common stock
...
The preferred stock is entitled to an annual dividend of USD 18 per share before dividends are
declared on common stock
...
What are the total
dividends received by each class of stock if Zeff Corporation distributes USD 108,000 in dividends?
Exercise C Gordon Company issued 10,000 shares of common stock for USD 1,120,000 cash
...
Give the journal entry for the stock issuance
...
What
is the journal entry for this transaction? What would the journal entry be if the common stock had no-par or stated
value?
Exercise E Li & Tu, Inc
...
It issued 100 shares of USD 480 par value common stock
to the incorporators of their corporation in exchange for land, which cost USD 56,000 one year ago
...
What journal entry would be appropriate to record the
acquisition of the land?
Exercise F Smart Corporation owes a trade creditor USD 30,000 on open account which the corporation does
not have sufficient cash to pay
...
Present the entry or entries
that should be made on Smart Corporation's books
...
0 License
Exercise G Why would a law firm ever consider accepting stock of a new corporation having a total par value of
USD 320,000 as payment in full of a USD 480,000 bill for legal services rendered? If such a transaction occurred,
give the journal entry the issuing company would make on its books
...
Compute the book
value per share of common stock
...

The preferred was issued at USD 412, the common at USD 480 per share
...
During the succeeding five years, net income was as follows:
2005
2006
2007
2008
2009

$767,500
510,000
48,000
160,000
662,500

No dividends were in arrears as of 2005 January 1, and during the five years 2005-2009, the board of directors
declared dividends in each year equal to net income of the year
...
Cumulative
...
Noncumulative
...
It then completed the following transactions:
2009
Jan
...

29 Gave the promoters of the corporation 25,000 shares of common stock for their services in organizing the
company
...

19 Exchanged 50,000 shares of common stock for the following assets at the indicated fair market values:
Land
Building
Machinery

USD 216,000
528,000
720,000

a
...

b
...


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...
The company issued 1,000 shares immediately for USD 82 per share, cash
...

On July 5, the company issued 1,000 shares to the principal promoter of the corporation in exchange for a
patent
...
The market value of the stock was USD 84 per share
...
Set up T-accounts, and post these transactions
...

b
...

c
...
Prepare the stockholders' equity section of the balance sheet
...
The stock is

entitled to a cumulative dividend of USD 9
...

• 1,500 shares of USD 400 par value, USD 20 cumulative preferred stock, which is callable at USD 420 and

entitled to USD 412 in liquidation
...


May 1 All of the USD 9
...

2 All of the USD 20 cumulative preferred was exchanged for merchandise inventory, land, and buildings valued
at USD 128,000, USD 160,000, and USD 425,000, respectively
...
In addition, 1,000 shares of common stock were issued to the promoters for their services
...

a
...

b
...
Prepare the stockholders' equity section of the 2009 May
31, balance sheet
...
It issued all of its authorized 3,000
shares of no-par preferred stock at USD 104 and all of its 12,000 authorized shares of no-par common stock at USD
40 per share
...
The common stock has a stated value of USD 10 per share
...
No
dividends have been declared or paid on either class of stock
...
Prepare the stockholders' equity section of King Company's 2009 December 31, balance sheet
...
Compute the book value of each class of stock
...
If USD 42,000 of dividends were declared as of 2009 December 31, compute the amount paid to each class of
stock
...
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Problem F The common stock of Lang Corporation is selling on a stock exchange for USD 90 per share
...

a
...
If all dividends have been paid on the preferred stock as of 2009 December 31, what are the book values of the
preferred stock and the common stock?
c
...
The book value is to be computed in
accordance with generally accepted accounting principles
...

Stockholders' equity:
Paid-in capital:
Preferred stock—without par value, $50 stated value, $15
cumulative; 3,000 shares authorized, issued, and outstanding
Common stock—$62
...

No dividends have been paid for 1 year
...
You have been employed by the stockholder's executor to compute the book value of each class of
stock and to determine the price to be paid for the stock held by her late husband
...

Alternate problems
Alternate problem A On 2005 January 1, the retained earnings of Quigley Company were USD 432,000
...
Stockholders' equity: Classes of capital stock
The outstanding capital stock of the corporation consisted of 2,000 shares of preferred stock with a par value of
USD 480 per share that pays a dividend of USD 19
...
No dividends were in arrears as of 2005 January 1
...
Cumulative
...
Noncumulative
...
It then completed the following transactions:
2009
Jan
...

29 Gave the promoters of the corporation 50,000 shares of common stock for their services in organizing the
company
...

Feb
...
Prepare general journal entries to record the transactions
...
Prepare the balance sheet of the company as of 2009 March 1
...
On July
5 of that year, an additional 300 shares were issued to the incorporators for services rendered in organizing the
company
...
On 2009 July 6, legal and printing costs of USD 12,000
were paid
...

a
...
Then prepare the balance sheet of the Barr Company as of the
close of 2009 July 10, assuming the authorized stock has a USD 160 par value
...
Repeat (a) for the T-accounts involving stockholders' equity, assuming the stock is no-par stock with a USD
240 stated value
...

c
...
Prepare the stockholders' equity section of the balance sheet
...

On April 2, incorporators of the corporation acquired 50,000 shares of the common stock for cash at USD 80
per share, and 200 shares were issued to an attorney for services rendered in organizing the corporation
...
The property was subject to a mortgage of USD 2,400,000
...
On April 10, the company issued 1,000 shares of common stock for cash at USD 80 per share
...
Prepare general journal entries for these transactions
...
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b
...
Assume retained earnings were
USD 80,000
...
Assume that each share of the USD 32 convertible preferred stock is convertible into six shares of common
stock and that one-half of the preferred is converted on 2009 September 1
...

Alternate problem E Kane Company issued all of its 5,000 shares of authorized preferred stock on 2008
January 1, at USD 100 per share
...
On this same date, Kane also issued
10,000 authorized shares of no-par common stock with a USD 10 stated value at USD 50 per share
...
No dividends have been declared or paid on either class of stock since the date of issue
...
Prepare the stockholders' equity section of Kane Company's 2009 December 31, balance sheet
...
Compute the book value in total and per share of each class of stock as of 2009 December 31
...
If USD 110,000 of dividends are to be declared as of 2009 December 31, compute the amount payable to each
class of stock
...

1)

2)

3)

Stockholders' equity:
Paid-in capital:
Preferred stock—7% cumulative, $240 par value,500
shares authorized, issued, and outstanding
Common stock—$48 par value, 10,000 shares
authorized, issued and outstanding
Total paid-in capital
Retained earnings
Total stockholders' equity
(All dividends have been paid
...
)
Stockholders' equity:
Paid-in capital:
Preferred stock—7% cumulative, $480 par
value,10,000 shares authorized, issued, and
outstanding
Common stock—$240 par value, 50,000shares
authorized, issued and outstanding
Total paid-in capital

$ 120,000
480,000
$ 600,000
422,400
$1,022,400

$ 800,000
7,200,000
$8,000,000
88,000
$8,088,000

$ 4,800,000
12,000,000

Retained earnings deficit
Total stockholders' equity
(Dividends have not been paid for 2 previous years or the current
year
...

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...
, is a corporation in which all of the outstanding preferred and common
stock is held by the four Lehman brothers
...

The stockholders' equity section of the balance sheet for the company on 2009 December 31, the date of the
death of James Lehman, shows:
Stockholders' equity:
Paid-in capital:
Preferred stock—6%; $320 par value; $320 liquidation value,
4,000 shares authorized, issued, and outstanding
Paid-in capital in excess of par—preferred
Common stock—without par value, $16 stated value,
60,000 shares authorized, issued and outstanding
Paid-in capital in excess of par value—common
Total paid-in capital
Retained earnings
Total stockholders' equity

$1,280,000
64,000
960,000
960,000
$3,264,000
128,000
$3,392,000

No dividends have been paid for the last year on the preferred stock, which is cumulative
...

a
...

b
...

c
...

Beyond the numbers—Critical thinking
Business decision case A Rudd Company and Clay Company have extremely stable net income amounts of
USD 4,800,000 and USD 3,200,000, respectively
...
Rudd Company has 100,000 shares of USD 80 par value, 6 per cent preferred stock, and 500,000 shares of
USD 8 par value common stock outstanding
...
Both preferred stocks are
cumulative
...
Compute the annual dividend per share of preferred stock and per share of common stock for each company
...
Based solely on the preceding information, which common stock would you predict to have the higher market
price per share? Why?
c
...
Both corporations have manufactured the
same types of products for five years
...
Stockholders' equity: Classes of capital stock
WEST CORPORATION
Stockholders' equity:
Paid-in capital:
Common stock—$125 par value, 30,000 shares
authorized, issued and outstanding
Retained earnings
Total stockholders' equity
EAST CORPORATION
Stockholders' equity:
Paid-in capital:
Preferred stock—8%, $500 par value, cumulative 4,000 shares
authorized, issued and outstanding
$2,000,000
Common stock—$125 par value, 40,000 shares authorized,
issued and outstanding
5,000,000
Retained earnings
Total stockholders' equity

$3,750,000
3,450,000
$7,200,000

$7,000,000
560,000
$7,560,000

The West Corporation has paid a cash dividend of USD 6 per share each year since its creation; its common
stock is currently selling for USD 590 per share
...
The current year's dividend and three prior years' dividends on the preferred stock are in arrears
...

a
...
Based solely on the previous information, which investment would you recommend to Waltrip? Why?
Annual report analysis C Determine the 2003 return on average common stockholders' equity for The
Limited in the Annual report appendix
...

Ethics case D Refer to the ethics case concerning Joe Morrison to answer the following questions:
a
...
Which alternative would benefit society?
c
...
At least two years
are needed to observe any changes
...
Appoint a
spokesperson for the team to explain to the class which company the team would invest in and why
...
Determine the features of the preferred stock
...
Are there
dividends in arrears? Write a report to your instructor summarizing your findings
...

Group project G In a group of one or two students, contact state officials and/or consult library resources to
inquire about the incorporation laws in your state
...
Write a report to your instructor summarizing the results of your
investigation and be prepared to make a short presentation to your class
...
0 License
http://www
...
com
Pursue choices on the screen until you locate the consolidated statement of stockholders' equity
...
This experience is all
part of learning to use the Internet
...
Check out the notes to the financial statements for further information
...

Visit the following website for Gartner Group:
http://www
...
com
Pursue choices on the screen until you locate the consolidated statement of stockholders' equity
...
This experience is all
part of learning to use the Internet
...
Check out the notes to the financial statements for further information
...

Answers to self-test
True-false
False
...
The primary reason is that stockholders can lose only the amount of capital
they have invested in a corporation
...
The claims of the creditors rank ahead of the claims of the stockholders, even those stockholders whose
stock is preferred as to assets
...
Par value is simply the amount per share that is credited to the Capital Stock account for each share
issued and is no indication of the market value or the book value of the stock
...
When capital stock is issued for property or services, the transaction is recorded at the fair market value
of (1) the property or services received or (2) the stock issued, whichever is more clearly evident
...
This feature of corporations is one of the disadvantages of the corporate form of organization
...
Stated value is an arbitrary amount assigned by the board of directors to each share of capital stock without a
par value
...
Dividends in arrears are cumulative unpaid dividends
...

b
...
The book value of common stock is computed as follows:
Total book value of stockholders'
equity
($80,000 + $200,000 + $400,000)
Total shares
Book value per share

$680,000
÷1,000
$ 680

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...
Corporations: Paid-in
capital, retained earnings,
dividends, and treasury stock
Learning objectives
After studying this chapter, you should be able to:
• Identify the different sources of paid-in capital and describe how to present them on a balance sheet
...

• Account for the acquisition and reissuance of treasury stock
...

• Define prior period adjustments and show their proper presentation in the financial statements
...


The accountant as a financial analyst
The primary purpose of financial reporting is to provide information to investors and creditors
...
In making these types of decisions,
investors and creditors rely on financial analysts to give them accurate assessments of the value and strength of the
company
...
It should therefore be no surprise that a successful financial analyst is
one that has a deep understanding of financial accounting
...
Thus, accountants are becoming increasingly important in assisting others to understand and
interpret financial information
...
Analysis could also involve performing data
comparisons with relevant financial and nonfinancial data
...
The model includes such items as retained earnings/total assets and sales/total
assets as variables in the calculation
...
07 in
a recent year
...
675 was considered an indication of possible bankruptcy
...


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...
These services are essential to the decisions of investors and creditors
...

As owners of a corporation, stockholders provide much of the capital for its activities
...
Also
included in stockholders' equity is the capital accumulated through the retention of corporate earnings (retained
earnings)
...

The preceding chapter discussed the paid-in capital obtained by issuing shares of stock for cash, property, or
services
...


Paid-in (or contributed) capital
As you have learned in the preceding chapter, paid-in capital, or contributed capital, refers to all of the
contributed capital of a corporation, including the capital carried in the capital stock accounts
...
Instead, paid-in capital is a category, and companies establish
a separate account for each source of paid-in capital
...
Chapter 12 discussed some of these general
ledger accounts
...

The stockholders' equity section of a balance sheet shows the different sources of the corporation's paid-in
capital because these sources are important information
...

Sources of stockholders' equity

Illustrative general ledger account titles

I
...
For, or assigned to, shares:
1
...

2
...

3
...
In excess or par
...
In excess of stated value
...
Resulting from declaration of stock dividends
...
Resulting from reissue of treasury stock at a
price above its acquisition price
...
Donations (gifts), whether from stockholders or
from others
...
Capital accumulated by retention of earnings
(retained earnings)
...
Appropriated retained earnings
...
Free and unappropriated retained earnings
...
A later section discusses and illustrates how the issuance of a stock dividend results in a
credit to a Paid-In Capital—Stock Dividends account
...
0 License

Paid-in capital—Treasury stock transactions
Another source of capital is treasury stock transactions
...
It is legally available for reissuance
...
If the reissue price is less than acquisition cost,
however, corporate capital decreases
...


Paid-in capital—Donations
Occasionally, a corporation receives a gift of assets, such as a USD 500,000 building
...
The entry to record the gift of a USD 500,000
building is a debit to Buildings and a credit to Paid-In Capital—Donations
...


Retained earnings
The retained earnings portion of stockholders' equity typically results from accumulated earnings, reduced by
net losses and dividends
...

Paid-in capital is the actual investment by the stockholders; retained earnings is the investment by the stockholders
through earnings not yet withdrawn
...
Net income
increases Retained Earnings, while net losses and dividends decrease Retained Earnings in any given year
...

When the Retained Earnings account has a debit balance, a deficit exists
...
The firm
need not change the title of the general ledger account even though it contains a debit balance
...
Occasionally, accountants
make other entries to the Retained Earnings account
...


Paid-in capital and retained earnings on the balance sheet
The following stockholders' equity section of a balance sheet presents the various sources of capital in proper
form:
Stockholders' equity:
Paid-in capital:
Preferred stock – 6%, $100 par value; authorized, issued, and
$400,000
outstanding, 4,000 shares
Common stock – no-par value, $5 stated value; authorized, issued,
and outstanding, 400,000 shares
2,000,000
Paid-in capital From preferred stock issuances*
$ 40,000
From donations
10,000
Total paid-in capital
Retained earnings
Total stockholders' equity
* This label is not the exact account title but is representative of the descriptions
but shorter descriptions are often shown
...
The exact account title could be used,

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13
...
The
exact account title could be used, but shorter descriptions are often shown
...
Usually the corporation pays
dividends in cash, but it may distribute additional shares of the corporation's own capital stock as dividends
...
Since dividends are the means whereby the
owners of a corporation share in its earnings, accountants charge them against retained earnings
...
Three dividend dates are significant:
• Date of declaration
...
The board action creates the liability for dividends payable (or stock
dividends distributable for stock dividends)
...
The board of directors establishes the date of record; it determines which stockholders

receive dividends
...

• Date of payment
...

To illustrate how these three dates relate to an actual situation, assume the board of directors of the Allen
Corporation declared a cash dividend on 2010 May 5, (date of declaration)
...
25
per share to stockholders of record on 2010 July 1, (date of record), payable on 2010 July 10, (date of payment)
...
No journal entry is required
on the date of record
...
Note that cash dividends are far more numerous than stock dividends or dividends in kind (paid in
merchandise or other assets)
...
The company makes no entry on its books for these outside trades
after issuance
...
These computer programs can print a report on the date of record
...
0 License

who own the stock on the date of record rather than to the stockholders who originally purchased
the stock
...
To
illustrate the entries for cash dividends, consider the following example
...
This
dividend is one-fourth of the annual dividend on 1,000 shares of USD 100 par value, 8 per cent preferred stock
...
An entry is not needed on the
date of record; however, the entries at the declaration and payment dates are as follows:
2010
Jan
...

Mar
...


2,000

2,000
2,000

Often a cash dividend is stated as so many dollars per share
...
When they declare a cash dividend, some companies debit a Dividends account
instead of Retained Earnings
...
) The Dividends account is then closed to Retained
Earnings at the end of the fiscal year
...
41 Thus, the credit balance in the Dividends Payable account
appears as a current liability on the balance sheet
...

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...
, is the nation's leading producer of manufactured housing and
recreational vehicles
...

Therefore, companies try to maintain a record of paying dividends, as Fleetwood noted in a 2001
press release
...
, Sept
...
(NYSE:
FLE) have declared the company's regular quarterly cash dividend of 19 cents per share of
Common stock, payable 2000 November 8, to shareholders of record 2000 October 6
...
Note that in the long run it may be more beneficial to the company and the
shareholders to reinvest the capital in the business rather than paying a cash dividend
...

Stock dividends are payable in additional shares of the declaring corporation's capital stock
...

Corporations usually account for stock dividends by transferring a sum from retained earnings to permanent
paid-in capital
...
For stock
dividends, most states permit corporations to debit Retained Earnings or any paid-in capital accounts other than
those representing legal capital
...

Stock dividends have no effect on the total amount of stockholders' equity or on net assets
...
Immediately after the distribution of a stock
dividend, each share of similar stock has a lower book value per share
...

Stock dividends do not affect the individual stockholder's percentage of ownership in the corporation
...
After a 10 per cent stock dividend, the stockholder still owns 1 per cent of the
outstanding shares—1,100 of the 110,000 outstanding shares
...

• The market price of the stock may have risen above a desirable trading range
...


526

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...
Some of the
stockholders receiving the stock dividend are likely to sell the shares to other persons
...

The percentage of shares issued determines whether a stock dividend is a small stock dividend or a large stock
dividend
...

Recording small stock dividends A stock dividend of less than 20 to 25 per cent of the outstanding shares is
a small stock dividend and has little effect on the market value (quoted market price) of the shares
...

Assume a corporation is authorized to issue 20,000 shares of USD 100 par value common stock, of which 8,000
shares are outstanding
...
The quoted market
price of the stock is USD 125 per share immediately before the stock dividend is announced
...
The entry for
the declaration of the stock dividend on 2010 August 10, is:
Aug
...


100,000
80,000
20,000

This entry records the issuance of the shares:
Sept
...


80,000
80,000

The stock dividend distributable—common account is a stockholders' equity (paid-in capital) account
credited for the par or stated value of the shares distributable when recording the declaration of a stock dividend
...
When a balance sheet is
prepared between the date the 10 per cent dividend is declared and the date the shares are issued, the proper
statement presentation of the effects of the stock dividend is:
Stockholders' equity:
Paid-in capital:
Common stock - $100 par value; authorized, $800,000
20,000 shares; issued and outstanding, 8,000
shares
Stock dividend distributable on 2010
80,000
September 20, 800 shares at par value
Total par value of shares issued and to be $880,000
issued
Paid-in capital
20,000
Total paid-in capital
$900,000
Retained earnings
150,000
Total stockholders' equity
$1,050,000

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...
The entry to record the declaration of the stock dividend (when the market value is USD
125) is:
Retained earnings (800 shares x $125) (-SE) 100,000
Stock dividends distributable – Common
(800 shares x $50) (+SE)
40,000
Paid-in capital – stock dividends (800 shares
60,000
x $75) (+SE)
To record the declaration of a stock dividend
...


Recording large stock dividends A stock dividend of more than 20 to 25 per cent of the outstanding shares
is a large stock dividend
...
They
account for such dividends at their par or stated value rather than at their current market value
...

To illustrate the treatment of a stock dividend of more than 20 to 25 per cent, assume X Corporation has been
authorized to issue 10,000 shares of USD 10 par value common stock, of which 5,000 shares are outstanding
...
The required entries are:

Exhibit 99: Stock dividends
Sept
...


Oct
...


15,000

15,000

Note that although firms account for the small stock dividend at current market value, they account for the 30
per cent stock dividend at par value (1,500 shares X USD 10 = USD 15,000)
...
0 License
accounting for large and small stock dividends, accountants must determine the relative size of the stock dividend
before making any journal entries
...

A stock split is a distribution of 100 per cent or more of additional shares of the issuing corporation's stock
accompanied by a corresponding reduction in the par value per share
...
A stock split causes a large reduction in the market price per share of the outstanding stock
...

The split reduces the par value per share at the same time so that the total dollar amount credited to Common Stock
remains the same
...
42 If the corporation issues 100
per cent more stock without a reduction in the par value per share, the transaction is a 100 per cent stock dividend
rather than a two-for-one stock split
...
Usually, firms change only the
number of shares outstanding and the par or stated value in the records
...
) Thus, they would record a two-for-one stock split in which the par value of the shares decreases from
USD 20 to USD 10 as follows:
Common stock - $20 par value (-SE)
100,000
Common stock - $10 par value (+SE)
100,000
To record a two- for-one stock split; 5,000 shares of $20
par value common stock were replaced by 10,000 shares
of $10 par value common stock
...
Stock dividends and stock splits
have no effect on the total amount of stockholders' equity
...
They merely increase the number of shares outstanding and
decrease the par value per share
...

Total
Stockholders'
equity
Stock
dividends:
Small
Large
Stock splits

Common
Stock

Paid-in
Capital common

Retained
Earnings

No effect
No effect
No effect

Increases
Increases
No effect

Increases* Decreases
No effect Decreases
No effect No effect

Number of
Shares
outstanding

Par value
Per share

Increases
Increases
Increases

No effect
No effect
Decreases

Exhibit 100: Summary of effects of stock dividends and stock splits
The preceding chapter discussed how corporate laws differ regarding the legality of a dividend
...
The legal capital
often equals the par or stated value of the shares issued or a minimum price per share issued
...
To illustrate the significance of the legal capital concept, assume a
corporation in severe financial difficulty is about to go out of business
...
Further discussion of this process, called recapitalization, is beyond the scope of this
text
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
dividends, the stockholders of that corporation might pay themselves a cash dividend or have the corporation buy
back their stock, leaving no funds available for the corporation's creditors
...
The legality of a dividend
generally depends on the amount of retained earnings available for dividends—not on the net income of any one
period
...
And in some states, companies can declare dividends from current earnings despite an
accumulated deficit
...

Normally, dividends are reductions of retained earnings since they are distributions of the corporation's net
income
...
These dividends are called liquidating
dividends
...
Corporations should disclose to
stockholders the source of any dividends that are not distributions of net income by indicating which paid-in capital
account was debited as a result of the dividend
...


An accounting perspective:
Business insight
The Private Securities Litigation Reform Act, passed in 1995, seeks to protect investors against
white-collar crime
...
Risk factors that might encourage management to engage in
fraudulent activities include weak internal controls, an aggressive effort to drive up the stock price
by reporting higher earnings, and/or executive bonuses or stock options based on earnings
...


Retained earnings appropriations
The amount of retained earnings that a corporation may pay as cash dividends may be less than total retained
earnings for several contractual or voluntary reasons
...
For example, a loan contract may state that part of a
corporation's USD 100,000 of retained earnings is not available for cash dividends until the loan is paid
...

An example of a voluntary restriction was General Electric's annual report statement that cash dividends were
limited "to support enhanced productive capability and to provide adequate financial resources for internal and
external growth opportunities"
...


530

This book is licensed under a Creative Commons Attribution 3
...

Other reasons for appropriations of retained earnings include pending litigation, debt retirement, and
contingencies in general
...
They merely disclose to
balance sheet readers that a portion of retained earnings is not available for cash dividends
...
Recording retained earnings appropriations does not
involve the setting aside of cash for the indicated purpose; it merely divides retained earnings into two parts—
appropriated retained earnings and unappropriated retained earnings
...
The only entry required to record the appropriation of USD
25,000 of retained earnings to fulfill the provisions in a loan agreement is:
Retained earnings (-SE)
Appropriation per loan agreement (+SE)
To record restriction on retained earnings
...
The entry to do
this is:
Appropriation per loan agreement(-SE)
Retained earnings (+SE)
To return balance in appropriation per Loan
Agreement account to Retained earnings
...

The formal practice of recording and reporting retained earnings appropriations is decreasing
...
Retained earnings restrictions
...

Such footnotes appear after the formal financial statements in "Notes to Financial Statements"
...
USD
45,000"
...
A separate formal statement—the statement of retained earnings—discloses such changes
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock

Statement of retained earnings
A statement of retained earnings is a formal statement showing the items causing changes in
unappropriated and appropriated retained earnings during a stated period of time
...
Changes in appropriated retained earnings consist of increases or decreases in
appropriations
...
The only new appropriation during 2010
was an additional USD 35,000 for plant expansion
...
An
alternative to the statement of retained earnings is the statement of stockholders' equity
...
A statement of stockholders' equity is a summary of the transactions
affecting the accounts in the stockholders' equity section of the balance sheet during a stated period
...
Thus, the statement of
stockholders' equity includes the information contained in a statement of retained earnings plus some additional
information
...
Each row indicates the effects of major transactions affecting one or
more stockholders' equity accounts
...
The first row indicates the beginning balances of each
account in the stockholders' equity section
...
After the
transactions' effects are indicated within each row, Larkin added or subtracted each column's components to
determine the ending balance in each stockholders' equity account
...
0 License

Treasury stock
Treasury stock is the corporation's own capital stock that it has issued and then reacquired; this stock has not
been canceled and is legally available for reissuance
...

Recall that when a corporation has additional authorized shares of stock that are to be issued after the date of
original issue, in most states the preemptive right requires offering these additional shares first to existing
stockholders on a pro rata basis
...

Larkin Corporation
Statement of stockholders' equity
For the Year ended 2010 December 31
$50 par, value,
$20 par value
6% preferred
Common stock
stock
Balance, 2010 January 1
$250,000
$300,000
Issuance of 10,000 shares of
200,000
common stock
5% stock dividend on common
25,000
stock, 1,250 shares
Purchase of 1,200 shares of
treasury stock
Net income
Cash dividends:
Preferred stock
Common stock
Balance, 2010 December 31

Paid-In capital
In excess of
par value
$200,000
100,000

Retained
Earnings

Treasury
Stock

$500,000

$(42,000)

27,500

(52,500)

185,000

$250,000

$525,000

$327,500

(15,000)
(25,000)
$592,500

(48,000)

$(90,000)

Exhibit 102: Statement of stockholders' equity
A corporation may reacquire its own capital stock as treasury stock to: (1) cancel and retire the stock; (2) reissue
the stock later at a higher price; (3) reduce the shares outstanding and thereby increase earnings per share; or (4)
issue the stock to employees
...

For dividend or voting purposes, most state laws consider treasury stock as issued but not outstanding, since the
shares are no longer in the possession of stockholders
...
However, they generally consider treasury shares outstanding for
purposes of determining legal capital, which includes outstanding shares plus treasury shares
...
This regulation protects creditors by preventing the
corporation in financial difficulty from using funds to purchase its own stock instead of paying its debts
...

When firms reacquire treasury stock, they record the stock at cost as a debit in a stockholders' equity account
called Treasury Stock
...
Thus, the
Treasury Stock account is debited at cost when shares are acquired and credited at cost when these shares are sold
...
We leave
further discussion of the par value method to intermediate accounting texts
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Any excess of the reissue price over cost represents additional paid-in capital and is credited to Paid-In Capital—
Common (Preferred) Treasury Stock Transactions
...
(The company's stockholders' equity consisted solely of common stock
and retained earnings
...
The entries to record
these events are:
2010
Feb
...


18

18

Treasury stock – Common (100 shares x $55) (-SE) 5,500
Cash (-A)
Acquired 100 shares of treasury stock at $55
...


1,650
90

When the reissue price of subsequent shares is less than the acquisition price, firms debit the difference between
cost and reissue price to Paid-In Capital—Common Treasury Stock Transactions
...
By definition, no paid-in capital account can have a debit balance
...


At this point, the credit balance in the Paid-In Capital—Common Treasury Stock Transactions account would be
USD 30
...


2,750

Notice that Hillside has exhausted the Paid-In Capital—Common Treasury Stock Transactions account credit
balance
...
Thus, the remaining USD
70 of the excess of cost over reissue price is a special distribution to the stockholders involved and is debited to the
Retained Earnings account
...
Since donated treasury shares have no cost to the
corporation, accountants make only a memo entry when the shares are received
...
For example, if donated
treasury stock is sold for USD 5,000, the entry would be:
Cash (+A)
Paid-In capital – Donations (+SE)
To record the sale of donated

5,000
5,000

44 The method illustrated here is called the memo method
...
Intermediate accounting texts discuss these latter two
methods
...
0 License
treasury stock
...
Popular brand names include Hamburger Helper, Betty
Crocker, and Yoplait
...
General Mills deducted the
cost of these shares in the stockholders' equity section of the balance sheet
...
This partial balance sheet shows: (1) the amount of capital assigned to
shares outstanding; (2) the capital contributed for outstanding shares in addition to that assigned to the shares; (3)
other forms of paid-in capital; and (4) retained earnings, appropriated and unappropriated
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Anson Company
Income Statement
For the Year Ended 2010 December 31

Net sales
$41,000,000
Other revenues
2,250,000
Total revenue
$43,250,000
Cost of goods sold
$22,000,000
Administrative, selling, and general expenses
12,000,000 34,000,000
Income before federal income taxes
$9,250,000
Deduct: Federal income taxes (40%)
3,700,000
Income from continuing operations
$5,550,000
Discounted operations:
Loss from operations of discontinued Cosmetics
Division (net of 40% tax effect of $800,000)
$(1,200,000)
Loss on disposal of Cosmetics Division (net of 40%
(1,500,000)
tax effect of $200,000)
(300,000)
Income before extraordinary item and the
$4,050,000
cumulative effect of a change in accounting principle
Extraordinary item:
Gain on sale of subsidiary over book value
$40,000
Less: Tax effect (40%)
16,000
24,000
Income after extraordinary item
$4,074,000
Net income
$4,074,000
Earnings per share of common stock:
Income from continuing operations
$ 5,550
Discontinued operations
(1
...
024
Net income
$4
...
Should net
income include only the revenues and expenses related to normal operations? Or should it include the results of
discontinued operations and unusual, nonrecurring gains and losses? And further, should the determination of net
income for 2010, for example, include an item that can be clearly associated with a prior year, such as additional
federal income taxes for 2009? Or should such items, including corrections of errors, be carried directly to retained
earnings? How are the effects of making a change in accounting principle to be reported?
APB Opinion No
...
The Opinion
directed that unusual and nonrecurring items having an earnings or loss effect are extraordinary items (reported in
the income statement) or prior period adjustments (reported in the statement of retained earnings)
...

In Exhibit 104 and Exhibit 106, we show the reporting of discontinued operations, extraordinary items, and
prior period adjustments
...
Also, assume the following:
• Anson sold its Cosmetics Division on 2010 August 1, at a loss of USD 500,000
...

• Anson had a taxable gain in 2010 of USD 40,000 from a sale of a subsidiary at an amount greater than what

was on the company's balance sheet (extraordinary item)
...
A prior period adjustment was made in 2010
...


536

This book is licensed under a Creative Commons Attribution 3
...
When a company discontinues a segment, it shows the relevant
information in a special section of the income statement immediately after income from continuing operations and
before extraordinary items
...

• The gain or loss (net of tax effect) on disposal of the segment
...
The
after-tax loss was USD 500,000 X 60 per cent = USD 300,000
...
The after-tax operating loss for that period was USD 2,000,000 X 60 per cent = USD 1,200,000
...

Prior to 1973, companies reported a gain or loss as an extraordinary item if it was either unusual in nature or
occurred infrequently
...
This inconsistency led to the issuance of APB Opinion No
...
Opinion No
...
Note that both conditions must be
met—unusual nature and infrequent occurrence
...
Examples of extraordinary items include gains or losses
that are the direct result of a major catastrophe (a flood or hurricane where few have occurred before), a
confiscation of property by a foreign government, or a prohibition under a newly enacted law
...
As shown in Exhibit 104,
Anson reported the extraordinary items after reporting the loss from discontinued operations
...
For
example, material write-downs of uncollectible receivables, obsolete inventories, and intangible assets are not
extraordinary items
...

2006 2005
Nature
Debt extinguishments
Other*
Total Extraordinary Items

2004 2003

4
8
12

40
2
42

70
8
78

48
7
55

42
588
600

78
522
600

55
545
600

Number of Companies
Presenting extraordinary items
12
Not presenting extraordinary items 588
Total Companies
600
*For the current year, the nature of
the other items included casualty
losses and gains from asset
disposals
...


Accounting Principles: A Business Perspective

537

A Global Text

13
...

Changes in accounting principle are changes in accounting methods pertaining to such items as inventory
...

According to APB Opinion No
...
However, a company may make a change if the newly adopted method is preferable and if the
change is adequately disclosed in the financial statements
...
Also, the company must show on the income statement for the year of the change and the
cumulative effect of the change on prior years' income (net of tax)
...
16, prior period adjustments consist almost entirely of corrections of
errors in previously published financial statements
...
Normal, recurring corrections and adjustments, which follow inevitably from the use of estimates in
accounting practice, are not treated as prior period adjustments
...
To illustrate a prior period adjustment, suppose that Anson purchased land
in 2009 at a total cost of USD 200,000 and recorded this amount in an expense account instead of in the Land
account
...
The adjustment would be recorded directly in the Retained Earnings account
...


An ethical perspective:
Ace chemical company
Ace Chemical Company is a small, privately held manufacturer that has been operating at a profit
for years
...
The company's plant assets consist of special purpose equipment that
can produce only certain chemicals
...
Its officers (all of whom are stockholders) are concerned about the future prospects
of the company
...
No such suits have yet
been filed against Ace, but the officers fully expect them to be filed within the next two years
...
The officers
hold 70 per cent of the stock and estimate that their total stockholdings have a current market value
of about USD 8 million (although its value would be much lower if all the facts were known)
...
Private legal counsel
has informed the officers that the company is likely to lose any suits that are filed
...
0 License

One of the officers suggested that they could at least receive something for their stock by having the
company buy half of the shares held by the officers at a total price of USD 4 million
...
The response was that the transaction
would be legal because it did not dip into the present legal capital of the company
...

Prior period adjustments do not appear on the income statements but in the current-year financial statements
as adjustments to the opening balance of retained earnings on the statement of retained earnings (Exhibit 106)
...
To report the income tax effect, FASB
Statement No
...
45 Net-of-tax effect means that items appear at the dollar amounts remaining after deducting the income tax
effects
...
The reference to "Income
from continuing operations" on the income statement represents the results of transactions (including income
taxes) that are normal for the business and may be expected to recur
...
Or the company may
mention it parenthetically with only the net amount shown (see loss from discontinued operations and change in
accounting principle in Exhibit 104 and correction of error in Exhibit 106)
...

• Following income, the special items from continuing operations appear at their actual impact on the

company—that is, net of their tax effect
...
550) and after (USD 4
...


45 FASB, Statement of Financial Accounting Standards No
...
Conn
...
Copyright © by the Financial Accounting Standards Board, High Ridge Park, Stamford, Connecticut
06905, U
...
A
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
• The correction of the USD 200,000 error adds only USD 120,000 to retained earnings ( Exhibit 106)
...
In the 2010 return, the USD 80,000 of taxes would have to be paid
...
Firms calculate the earnings per share amount only for
the common shares of ownership
...
Income available
to common stockholders is net income less any dividends on preferred stock
...

To illustrate, Sun Microsystems, Incorporated, had 3,417,000,000 weighted-average common shares
outstanding with income available to common shareholders of USD 922,590,000 during a recent year
...
27 per share
Firms calculate EPS for each major category on the face of the income statement
...
Note in Exhibit 104 that Anson reports the EPS amounts at the bottom of its
income statement
...
Stocks with future high income
potential tend to have a high price-earnings ratio
...
00
...
93 (average of class A & B common stock)
...
00
USD 0
...
20
This chapter completes the study of stockholders' equity
...

Understanding the learning objectives
• Paid-in capital is presented in the stockholders' equity section of the balance sheet
...

• Sources of paid-in capital are:

540

This book is licensed under a Creative Commons Attribution 3
...

(b) Preferred stock
...

(d)Stock dividends
...

(f) Donations
...

July

1

Sept
...

Jan
...


1

Stock dividend distributable –
Common (-SE)
Common stock (+SE)

100,000
100,000

• Thirty per cent stock dividend on 10,000 shares of common stock outstanding: declared on January 1 and

payable on February 1; par value, USD 100
...


Feb
...

Common stock - $50 par
50,000
value (-SE)
Common stock - $25 par
value (+SE)

50,000

• Retained earnings appropriation: USD 75,000 appropriated for plant expansion
...

Treasury stock – Common (100 shares x $100) 10,000
Cash
10,000
Cash (100 shares x $105)
10,500
Treasury stock – Common (100 shares x $100)
10,000
Paid-in Capital – Common treasury stock
transactions
500
(100 shares x $5)

Accounting Principles: A Business Perspective

541

A Global Text

13
...

• The gain or loss (net of tax effect) on disposal of the segment is also reported in that same section of the

income statement
...
Extraordinary items appear

on the income statement (net-of-tax effect) below "Income from continuing operations"
...
Also, the cumulative effect of the change on prior
years' income (net of tax effect) must be shown on the income statement for the year of the change below
"Income from continuing operations"
...
Prior period

adjustments appear (net-of-tax effect) as a correction to the beginning retained earnings balance on the
statement of retained earnings
...
Income available to common stockholders is net income less any dividends on
preferred stock
...

• The price-earnings ratio equals the current market price per share of common stock divided by EPS
...

Demonstration problem
Demonstration problem A Wylie Corporation has outstanding 10,000 shares of USD 150 par value common
stock
...
The declaration of a cash dividend of USD 1
...

b
...

c
...

Demonstration problem B Following are selected transactions of Brackett Company:
• The company reacquired 200 shares of its own USD 100 par value common stock, previously issued at USD

105 per share, for USD 20,600
...

• Seventy of the treasury shares were reissued at USD 95 per share, cash
...

• The 100 shares of treasury stock received by donation were reissued for USD 9,000
...

Demonstration problem C Selected account balances of Nexis Corporation at 2010 December 31, are:
Common stock (nor par value; 100,000 shares authorized, issued, and
outstanding; stated value of USD 20 per share
Retained earnings
Dividends payable (in cash, declared December 15 on preferred stock)
Preferred stock (8 per cent, par value USD 200; 1,000 shares
authorized, issued, and outstanding)
Paid-In capital from donation of plant site
Paid-in capital in excess of par value – preferred

USD 2,000,000
570,000
16,000
200,000
100,000
8,000

Present in good form the stockholders' equity section of the balance sheet
...
0 License
Solution to demonstration problem
Solution to demonstration problem A
a
...


c
...


15,000
15,000

Retained earnings (or stock dividends)
(1,000 shares x $185) (-SE)
Stock dividend distributable – Common
(1,000 shares x $150) (+L)
Paid-in capital – Stock dividends(+SE)
To record declaration of a small stock dividend
(10%)
...


600,000
600,000

Solution to demonstration problem B
1
...


3
...


20,600
20,600

Cash (50 shares x $110) (+A)
5,500
Treasury stock – Common (50 shares x
$103) (+SE)
Paid-in capital – common treasury stock
transactions (+SE)
Reissued 50 shares at $110 per share; cost is
$5,150
...


5,150
350

7,210

4
...
(Only memo entry is made
...
Cash (+A)
9,000
Paid-in capital – Donations (100 shares
x $90) (+SE)
Reissued donated shares at $90 per
share
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
00

Key terms
Cash dividends Cash distributions of accumulated earnings by a corporation to its stockholders
...

Contributed capital See paid-in capital
...

Date of payment (of dividends) The date of actual payment of a dividend, or issuance of additional
shares for a stock dividend
...

Deficit A debit balance in the Retained Earnings account
...

Dividends Distribution of earnings by a corporation to its stockholders
...

Dividends (stock) See stock dividends
...

Earnings per share (EPS) Earnings to the common stockholders on a per share basis, computed as
income available to common stockholders divided by the weighted-average number of common shares
outstanding
...

Income available to common stockholders Net income less any dividends on preferred stock
...

Net-of-tax effect Used for discontinued operations, extraordinary items, changes in accounting principle,
and prior period adjustments, whereby items are shown at the dollar amounts remaining after deducting the
effects of such items on income taxes, if any, payable currently
...
When the words paid-in capital are included in the account title, the account contains capital
contributed in addition to that assigned to the shares issued and recorded in the capital stock accounts
...

Price-earnings ratio The current market price per share of common stock divided by EPS
...
Prior period adjustments are reported in the statement of retained earnings net of their
tax effects, if any
...

Retained earnings appropriations Contractual or voluntary restrictions or limitations on retained
earnings that reduce the amount of dividends that may be declared
...

Statement of stockholders' equity A summary of the transactions affecting the accounts in the
stockholders' equity section of the balance sheet during a stated period of time
...

Stock dividends Dividends that are payable in additional shares of the declaring corporation's capital
stock
...
0 License
Stock split A distribution of 100 per cent or more of additional shares of the issuing corporation's stock,
accompanied by a corresponding reduction in the par value per share
...

Treasury stock Shares of capital stock issued and reacquired by the issuing corporation; they have not been
formally canceled and are available for reissuance
...

The retained earnings balance of a corporation is part of its paid-in capital
...

Dividends are expenses since they decrease stockholders' equity
...

A retained earnings appropriation reduces the total stockholders' equity shown on the balance sheet
...

Multiple-choice
Select the best answer for each of the following questions
...
Common Stock
...
Paid-In Capital—Donations
...
Stock Dividend Distributable
...
Appropriation per Loan Agreement
...
Bevins
reacquired 1,000 shares of its own stock at a cost of USD 30 per share
...


b
...

d
...


Cash (+A)
Treasury Stock (+SE)
Paid-In Capital – Treasury
Stock Transactions (+SE)

18,000

b
...


Cash (+A)
Treasury stock (+SE)
Retained earnings (+SE)

18,000

15,000
3,000
18,000
15,000
3,000

Accounting Principles: A Business Perspective

545

A Global Text

13
...


Cash (+A)
Treasury stock (+SE)
Retained earnings (+SE)

18,000
10,000
8,000

Treasury stock should be shown on the balance sheet as a:
a
...

b
...

c
...

d
...

An individual stockholder is entitled to receive any dividends declared on stock owned, provided the stock is
held on the:
a
...

b
...

c
...

d
...

ABC Corporation declared the regular quarterly dividend of USD 2 per share
...
What would be the total amount of the dividend?
a
...

b
...

c
...

d
...

Which item is not reported as a separate line item below income from continuing operations, net of tax effects,
in the income statement?
a
...

b
...

c
...

d
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...


➢

Name several sources of paid-in capital
...
0 License
➢

What is the effect of each of the following on the total stockholders' equity of a corporation: (a)
declaration of a cash dividend, (b) payment of a cash dividend already declared, (c) declaration of a
stock dividend, and (d) issuance of a stock dividend already declared?

➢

The following dates are associated with a cash dividend of USD 80,000: July 15, July 31, and August
15
...


➢

How should a declared but unpaid cash dividend be shown on the balance sheet? How should a
declared but unissued stock dividend be shown?

➢

On May 8, the board of directors of Park Corporation declared a dividend, payable on June 5, to
stockholders of record on May 17
...
Benton
placed the stock certificate in her safe
...
Who received the dividend? Why?

➢

What are the possible reasons for a corporation to declare a stock dividend?

➢

Why is a dividend consisting of the distribution of additional shares of the common stock of the
declaring corporation not considered income to the recipient stockholders?

➢

What is the difference between a small stock dividend and a large stock dividend?

➢

What are liquidating dividends?

➢

What is the purpose of a retained earnings appropriation?

➢

What is a statement of stockholders' equity?

➢

Describe a discontinued operation
...
How are the effects of changes in accounting
principle reported?

➢

What are prior period adjustments? Where and how are they reported?

➢

Why are stockholders and potential investors interested in the amount of a corporation's EPS? What
does the EPS amount reveal that total earnings do not
...

Exercise B Fogg Company has issued all of its authorized 5,000 shares of USD 400 par value common stock
...
Give the necessary journal entries
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Exercise C The stockholders' equity section of Jay Company's balance sheet on 2009 December 31, shows
100,000 shares of authorized and issued USD 20 stated value common stock, of which 9,000 shares are held in the
treasury
...
Give dated journal entries for these
...
The current market
price of the common stock is USD 120 per share
...

a
...

b
...
The
company then split its stock, two for one, by changing the par value of the old shares and issuing new USD 15 par
shares
...
Give the required journal entry to record the stock split
...
Suppose instead that the company declared and later issued a 10 per cent stock dividend
...

Exercise F The balance sheet of Willis Company contains the following:
Appropriation per loan agreement USD 900,000
a
...

b
...

Exercise G Kelly Company had outstanding 50,000 shares of USD 20 stated value common stock, all issued at
USD 24 per share, and had retained earnings of USD 800,000
...

a
...

b
...

c
...

Exercise H Evan Company received 200 shares of its USD 200 stated value common stock on 2009 December
1, as a donation from a stockholder
...
Give the
journal entry or entries necessary for these transactions
...
The assumed income tax rate is 40 per cent
...

a
...

b
...

Exercise J Conner Company had retained earnings of USD 56,000 as of 2009 January 1
...
In 2009, Conner Company discovered that it had, in error, depreciated land over the last
548

This book is licensed under a Creative Commons Attribution 3
...
The assumed tax rate for
Conner Company is 40 per cent
...

Exercise K The following information relates to Perry Corporation for the year ended 2009 December 31:
Common stock outstanding
75,000 shares
Income from continuing operations
$1,523,200
Loss on discontinued operations (net of
tax)
240,000
Extraordinary gain (net of tax)
144,000

Calculate EPS for the year ended 2009 December 31
...

Exercise L Dean Company had an average number of shares of common stock outstanding of 200,000 in 2009
and 215,000 in 2010
...
Calculate EPS for the years ended 2009 December 31, and 2010
...
What might the resulting figures tell a stockholder or a potential investor?
Problems
Problem A The bookkeeper of Hart Company has prepared the following incorrect statement of stockholders'
equity for the year ended 2009 December 31:
Stockholders' equity:
Paid-In Capital:
Preferred stock – 6%, cumulative (8,000
shares)
Common stock – 50,000 shares
Total paid-in capital
Retained earnings
Total stockholders' equity

$1,003,200
2,856,000
$3,859,200
1,636,800
$5,496,000

The authorized stock consists of 12,000 shares of preferred stock with a USD 120 par value and 75,000 shares of
common stock, USD 48 par value
...
40 per share
...
40 per share
...
The bookkeeper deducted the
cost of the treasury stock from the Common Stock account
...

Problem B The only stockholders' equity items of Jody Company at 2009 June 30, are:
Stockholders' equity:
Paid-in capital:
Common stock - $200 par value, 10,000
shares authorized, 6,000 shares issued and
outstanding
Paid-in capital in excess of par value
Total paid-in capital
Retained earnings
Total stockholders' equity

$1,200,000
480,000
$1,680,000
480,000
$2,160,000

On 2009 August 4, a 4 per cent cash dividend was declared, payable on September 3
...
The shares were issued on December 1
...

Prepare journal entries for these dividend transactions
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
2002
Dec
...
(On the last day of the next six
years, the same action was taken
...
)
2007
Jan
...

Mar
...

2009
Feb
...

Mar
...

Apr
...
The market price on this date was USD 55 per share
...

Problem D Following are selected data of Kane Corporation at 2009 December 31:
Net income for the year
Dividends declared on preferred stock
Retained earnings appropriated during the year for future plant
expansion
Dividends declared on common stock
Retained earnings, January 1, unappropriated
Directors ordered that the balance in the “Appropriation per loan
agreement”, related to a loan repaid on 2009 March 31, be returned
to unappropriated retained earnings

$512,000
72,000
240,000
64,000
720,000
480,000

Prepare a statement of retained earnings for the year ended 2009 December 31
...

• Declared a 4 per cent stock dividend when the market price was USD 48 per share
...

• Issued stock certificates for the stock dividend declared in transaction 2
...

• Increased the appropriation by USD 43,200 per loan agreement
...

Problem F The stockholders' equity of Briar Company on 2008 December 31, consisted of 1,000 authorized,
issued, and outstanding shares of USD 72 cumulative preferred stock, stated value USD 240 per share, which were
originally issued at USD 1,192 per share; 100,000 shares authorized, issued, and outstanding of no-par, USD 160
550

This book is licensed under a Creative Commons Attribution 3
...

Following are selected transactions and other data relating to 2009
...

• The company reacquired 2,000 shares of its common stock at USD 336
...

• Stockholders donated 1,000 shares of common stock to the company
...

• The first quarter's dividend of USD 18 per share was declared and paid on the preferred stock
...

The company suffered a net loss of USD 224,000 for the year 2009
...
Prepare journal entries for the preceding numbered transactions
...
Prepare the stockholders' equity section of the 2009 December 31, balance sheet
...
The suit was brought by a customer seeking
damages for the company's alleged breach of a contract to supply the customer with certain products at stated
prices in 2007
...
These damages were not deductible in determining the income tax liability
...
The loss does not qualify as an extraordinary item
...
On June 30, it

reissued 500 of these shares at USD 7
...

• Dividends declared and paid during the year were 6 per cent on preferred stock and 18 cents per share on

common stock
...

For the fiscal year, the company had net income after income taxes of USD 11,400, excluding the loss of the
lawsuit
...
Prepare journal entries for the preceding numbered transactions
...
Prepare a statement of retained earnings for the year ended 2009 October 31
...
Prepare the stockholders' equity section of the 2009 October 31, balance sheet
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
Common stock - $20 par value
Sales, net
Selling and administrative expenses
Cash dividends declared and paid
Cost of goods sold
Depreciation expense
Interest revenue
Loss on write-down of obsolete inventory
Retained earnings (as of 2008/12/31)
Operating less on Candy Division up to point of sale in 2009
Loss on disposal of Candy Division
Earthquake loss
Cumulative negative effect on prior years' income of changing from
straight-line to an accelerated method of computing depreciation
...
All of the items of expense, revenue, and loss are
included in the computation of taxable income
...
In addition, the company discovered that in 2008 it had erroneously charged to expense
the USD 160,000 cost of a tract of land purchased that year and had made the same error on its tax return for
2008
...
Prepare an income statement for the year ended 2009 December 31
...
Prepare a statement of retained earnings for the year ended 2009 December 31
...

Alternate problem B The stockholders' equity section of Carson Company's 2008 December 31, balance sheet
follows:
Stockholders' equity:
Paid-In Capital:
Common stock - $120 par value; authorized,
2,000 shares; issued and outstanding, 1,000
shares
$120,000
Paid-in capital in excess of par value
6,000
Total paid-in capital
$126,000
Retained earnings
48,000
Total stockholders' equity
$174,000

On 2009 July 15, the board of directors declared a cash dividend of USD 12 per share, which was paid on 2009
August 1
...
Market value of the stock was USD 144 on December 1 and USD 168 on December 15
...

Alternate problem C The ledger of Falcone Company includes the following account balances on 2009
September 30:
552

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...

• Decrease the appropriation for plant expansion by USD 160,000
...

• Declare a cash dividend of USD 140,000
...

Alternate problem D Following are selected transactions of Taylor Corporation:
2004
Dec
...
(On the last day of each of the next four years, the same action
was taken
...
)
2009
Jan
...

July 30 Paid USD 1,800,000 to Starke Construction Company for completion of the new wing
...
4 The board of directors authorized the release of the sum appropriated for expansion of the plant building
...
The market price on this date was USD 660 per share
...

Alternate problem E The following information relates to Dahl Corporation for the year 2009:
Net income for the year
Dividends declared on common stock
Dividends declared on preferred stock
Retained earnings, January 1, unappropriated
Appropriation for retirement of bonds
Balance in “Appropriation for possible loss of a lawsuit”, no longer
needed on December 31 because of a favorable court decision, is (by
directors' order) returned to unappropriated retained earnings

$ 1,680,000
235,000
134,000
5,040,000
672,000
840,000

Prepare a statement of retained earnings for the year ended 2009 December 31
...
Following are selected transactions for 2009:
May 1 Acquired 3,000 shares of its own common stock at USD 100 per share
...

30 Reissued 700 shares at USD 90
...
1 Declared a cash dividend of USD 5 per share
...

Net income for the year was USD 80,000
...

a
...

b
...


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13
...
13 Cash was received for 550 shares of previously unissued common stock at USD 13
...

Feb
...

Closing market price of the common stock on this date was USD 12 per share
...
24 All of the treasury stock was reissued at USD 14
...

June 23 The regular semiannual dividend on the preferred stock was declared
...

July 3 A 10 per cent stock dividend was declared on the common stock
...
80
...

Oct
...
40
...
18 The regular semiannual dividend on the preferred stock and a USD 0
...

31 Both dividends were paid
...

a
...

b
...

c
...

Alternate problem H Selected data of Ace Company for the year ended 2009 December 31, are:
Sales, net
Interest expense
Cash dividends on common stock
Selling and administrative expenses
Cash dividends on preferred stock
Rent revenue
Cost of goods sold
Flood loss (has never occurred before)
Interest revenue

$1,000,000
90,000
150,000
245,000
70,000
400,000
650,000
200,000
90,000

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...
All of the preceding items of expense, revenue, and
loss are included in the computation of taxable income
...
In addition, the company discovered that in 2005 it had erroneously charged to expense the USD 250,000
cost of a tract of land purchased that year and had made the same error on its tax return for 2008
...
Assume there were 10,000 shares of common stock and 5,000
shares of preferred stock outstanding for the entire year
...

Beyond the numbers—Critical thinking
Business decision case A The stockholders' equity section of the Bates Corporation's balance sheet for 2009
June 30, follows:
Stockholders' equity:
Paid-in Capital:
Common stock - $20 par value; authorized
200,000 shares; issued and outstanding
80,000 shares
Paid-in capital in excess of par value
Total paid-in capital
Retained earnings
Total stockholders' equity

$1,600,000
960,000

$2,560,000
1,520,000
$4,080,000

On 2009 July 1, the corporation's directors declared a 10 per cent stock dividend distributable on August 2 to
stockholders of record on July 16
...
40 per share annual cash
dividend payable on December 2 to stockholders of record on November 16
...
52
...
The market value of his stock was USD 48 per share on 2009 July 1, and USD 43
...

a
...
Jones has asked you, his CPA, to explain why the price of the stock dropped from USD 48 to USD 43
...
Write a memo to Jones explaining your answer
...
Do you think Jones is better off as a result of the stock dividend and the USD 2
...
52 cash dividend? Write a memo to Jones explaining your
answer
...

Retained earnings
Reserve for uncollectible accounts
To record the adjusting entry for
uncollectible accounts
...
Corporations: Paid-in capital, retained earnings, dividends, and treasury stock
2
...


4
...


6
...


Retained earnings
Reserve for depreciation
To record depreciation expense
...

Retained earnings
8,000
Stock dividend distributable – Common
To record 10% stock dividend declaration
(100 shares to be distributed - $80 par
value, $120 market value)
...


8,000
8,000

Treasury Stock
32,000
Cash
32,000
To record acquisition of 200 shares of $80
par value common stock at $160 per share
...


9
...


17,600

Cash
Treasury stock
To record sale of 50 treasury shares at
$136 per share
...


16,000

Dividends payable
Cash
To record payment of cash dividend
...


8,000

16,000

17,600

6,800

16,000

16,000

The management of Keel Corporation has asked you, a CPA, to analyze these journal entries and decide whether
each is correct
...
Wherever a journal entry is incorrect, prepare the journal entry
that should have been made
...
To view the report, go to the Coca-Cola web site at www
...
com
...
Go to investors and a menu will drop down that has financials as an option with
Financial Statements (select this) to its right
...
Then go to Selected Financial Data and open it to find the number of common shares outstanding
...
Based on the information in the balance sheet and the note, determine the number of common shares
outstanding; and the total cost of treasury stock shares on hand at the end of 2006
...
In writing, discuss what reasons Coca-Cola might have to acquire treasury stock
...
Find Coca-Cola's basic EPS for 2006 listed in its Income Statement
...
Is this transaction fair to the creditors?
556

This book is licensed under a Creative Commons Attribution 3
...
Why would the officers not merely declare a USD 4 million cash dividend? Is the proposed treasury stock
transaction fair to the other stockholders?
c
...
Use a periodicals index such as the Accounting and Tax Index or the Business Periodicals Index
to locate these articles
...
As a team, prepare a
memorandum to the manager of a small retail business
...
In the memorandum, cite the sources used in
gathering the data and properly reference any direct quotes or paraphrasing
...

Group project F With a small group of students, go to the library and locate Statement of Financial
Accounting Standards No
...
Write a report to your instructor giving the highlights of the standard
...
Determine why the number of common shares outstanding changed (if at all)
during the current year
...
The
number of shares outstanding may have decreased because of repurchases of stock (treasury stock transactions)
...
Also be prepared to make a short presentation to your
class
...
ge
...
You
will probably go down some "false paths" to get to this financial statement, but you can get there
...
Trace the changes that have occurred in the last three years in the dividends
and other transactions with stockholders
...

Write a memo to your instructor summarizing your findings
...
3m
...
You will probably go down some "false
paths" to get to this information, but you can get there
...

Trace the changes that have occurred in the stockholders' equity section for the most recent two years
...
Check out the notes to the financial statements for further information
...


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...
The paid-in capital of a corporation only includes capital contributed by stockholders or others
...

False
...

False
...

True
...

False
...
Thus, such an appropriation does not reduce total stockholders' equity
...
Such damage occurs too frequently to be considered nonrecurring
...
Appropriation per Loan Agreement is part of retained earnings
...
When treasury stock is reacquired, the stock is recorded at cost in a debit-balance stockholders' equity
account, Treasury Stock
...
The excess of the reissue price over the cost of treasury stock is recorded in the Paid-In Capital—Treasury
Stock Transactions account
...
Treasury stock is customarily shown as a deduction from total stockholders' equity
...
The date of record determines who is to receive the dividends
...
The total amount of dividends is computed as follows:
Total Outstanding shares at declaration:
(12,000 – 2,000) shares
Dividend per share
Total dividend amount

10,0000
X USD 2
USD 20,000

b
...


558

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...
Stock investments
Learning objectives
After studying this chapter, you should be able to:
• Report stock investments and distinguish between the cost and equity methods of accounting for stock

investments
...

• Describe the nature of parent and subsidiary corporations
...

• Describe the uses and limitations of consolidated financial statements
...


The role of accountants in business acquisitions
The number and size of corporate mergers and acquisitions has accelerated at an amazing pace over the last
decade
...
The potential rewards of mergers and acquisitions can be enormous-increased market share, broadened
product lines, stability for the overall company, strengthened financial position, captured key executive or technical
talent, and cost savings
...
The companies originally
estimated that the merger would save the companies USD 2
...

Not all mergers and acquisitions turn out this well
...
Beyond the need to record accounting transactions after the
combination, accountants are now being asked to play an increasing role in business valuation before the
combination
...
Accountants are used by acquirers to scope out the full details of a
target's financials, operations, and human assets
...
Discoveries by
accountants have canceled many giant mergers and acquisitions
...
Accounting professionals are asked to interpret the
financial statements and other financial data to determine the value of the target
...


Accounting Principles: A Business Perspective

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14
...
The role of accounting professionals in business
valuation is essential to the success of the company and represents one of the fastest growing areas in accounting
...
Some of these takeover attempts are friendly (not
resisted by the target company), and some are unfriendly (resisted by the target company)
...
The company that takes over another company is the parent company; the company
acquired is the subsidiary company
...

When a corporation purchases the stock of another corporation, the method of accounting for the stock
investment depends on the corporation's motivation for making the investment and the relative size of the
investment
...
On the balance sheet, the first type of
investment is a current asset, and the last two types are long-term (noncurrent) investments
...


Cost and equity methods
Investors in common stock can use two methods to account for their investments the cost method or the equity
method
...
Under the
cost method, the investor company does not adjust the investment account balance subsequently for its share of
the investee's reported income, losses, and dividends
...
Under the equity method, the investor company adjusts the investment
account for its share of the investee's reported income, losses, and dividends
...
This chapter illustrates each of those circumstances
...
0 License

Accounting for short-term stock investments and for long-term stock investments of less than
20 per cent
Accountants use the cost method to account for all short-term stock investments
...
A purchasing company that owns less than 20 per
cent of the outstanding stock of the investee company, and does not exercise significant influence over it, uses the
cost method
...
Thus, firms use the cost method for all short-term stock investments and almost all long-term stock
investments of less than 20 per cent
...


Cost method for short-term investments and for long-term investments of less than 20 per
cent
When a company purchases stock (equity securities) as an investment, accountants must classify the stock
according to management's intent
...
If the stock will be held for a longer term, it is called an
available-for-sale security
...
Available-for-sale securities may be
either current assets or noncurrent assets, depending on how long management intends to hold them
...
This topic will be discussed later in this chapter
...
These rules will be addressed in intermediate accounting
...
They purchase most stocks from other
investors (not the issuing company) through brokers who execute trades in an organized market, such as the New
York Stock Exchange
...

For example, assume that Brewer Corporation purchased as a near-term investment 1,000 shares of Cowen
Company's USD 10 par value common stock at USD 14
...
Brokers
quote most stock prices in dollars and cents
...
22) + $180
14,400
commission] (-SE)
Cash (-A)
Purchased 1,000 share of Cowen common stock as a nearterm investment at 14
...


14,400

Accounting for cash dividends received Investments in stock provide dividends revenue
...
The only exception to this general rule is
when a dividend declared in one accounting period is payable in the next
...
Assume that Cowen declared a USD 1 per share cash dividend
on 2010 December 1, to stockholders of record as of December 20, payable on 2011 January 15
...
1

Dividends receivable (+A)
1,000
Dividends revenue (+SE)
1,000
To record $1 per share cash dividend on
Cowen common stock, payable 2010 January
15
...
Stock investments
When collecting the dividend on 2011 January 15, Brewer debits Cash and credits Dividends Receivable:
2011
Jan
...


1,000
1,000

Stock dividends and stock splits As discussed in Chapter 13, a company might declare a stock dividend
rather than a cash dividend
...
The investor merely records the number of additional shares received and reduces the cost per share for
each share held
...
40 per share), would receive another 100 shares and would
then hold 1,100 shares at a cost per share of USD 13
...
Similarly, when a
corporation declares a stock split, the investor would note the shares received and the reduction in the cost per
share
...
115 (1993) governs the subsequent valuation of marketable equity securities accounted for
under the fair market value method
...
The Statement also addresses the subsequent valuation of debt
securities
...
159 (2007) amends FASB Statement No
...
The subsequent valuation of
debt securities will be addressed in intermediate accounting classes
...
of
shares
A
B
C

200
400
100

Cost per Market Price
Share
per share
2010/12/31
$35
$40
10
15
90
50

Total
cost
$ 7,000
4,000
9,000
$20,000

Total
market
2007/12/31
$ 8,000
6,000
5,000
$19,000

Increase/
(decrease)
in market value
$ 1,000
2,000
(4,000)
$ (1,000)

Exhibit 107: Stock portfolio of Hanson company
The FASB Statement requires that at year-end, companies adjust the carrying value of each of their two
portfolios (trading securities and available-for-sale securities) to their fair market value
...
An
unrealized holding gain or loss will usually result in each portfolio
...
Applying the fair
market value method reveals that the total fair market value of the trading securities portfolio is USD 1,000 less
than its cost
...
115, "Accounting for Certain Marketable Securities"
(Stamford, Conn
...
Copyright © by the Financial Accounting Standards Board, Stamford, Connecticut
06856, U
...
A
...
Copies of the complete document are available from the
FASB
...
FASB, Statement of Financial Accounting Standards No
...
, 2007)
...
S
...

562

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...


31

Unrealized loss on trading securities (-SE)
1,000
Trading securities (-A)
To record unrealized loss from market decline
of trading securities
...
This loss is unrealized because the
securities have not been sold
...
The credit in the preceding entry is to the Trading Securities account so as to adjust its
balance to its fair market value
...
)
If Hanson sold investment C on 2011 January 1, the company would receive USD 5,000 (assuming no change in
market values from the previous day)
...
The entry for the sale is:
2011
Jan
...


No adjustment needs to be made to the unrealized loss account previously debited because the unrealized loss
recorded in 2010 has flowed through the income statement and been closed to retained earnings through the
closing process
...
The
treatment of the loss depends on whether it results from a temporary decline in market value of the stock or a
permanent decline in the value
...
The required entry is:
2010
Dec
...


1,000
1,000

These accounts would appear on the balance sheet as follows:
Hanson Company
Partial Balance Sheet
2010 December 31
Investments (or Current Assets)*:
Available-for-sale securities
Stockholders' equity:
Capital stock
Additional paid-in capital
Total paid-in capital
Less: Unrealized loss on available-for-sale
securities

$31,000
$xxx,xxx
X,xxx
$xxx,xxx
1,000

$xxx,xxx
Retained earnings
Xx,xxx
Total stockholders' equity
$xxx,xxx
*Depending on the length of time management intends to hold the securities
...
An
unrealized gain would be shown as a separate positive component of stockholders' equity
...
These securities will probably not be sold soon
...
Stock investments
The sale of an available-for-sale security results in a realized gain or loss and is reported on the income
statement for the period
...
Assume
the stock discussed above is sold on 2011 January 1, for USD 31,000 (assuming no change in market value from the
previous day) after the company had held the stock for three years
...
1

Realized loss on available-for-sale
securities (-SE)
Unrealized loss on available-for-sale
securities (+SE)
Cash
Available-for-sale securities

1,000
1,000
31,000
31,000

The account debited in the first entry shows that the unrealized loss has been realized with the sale of the
security; the amount is reported in the income statement
...

A loss on an individual available-for-sale security that is considered to be "permanent" is recorded as a realized
loss and deducted in determining net income
...


1,400

No part of the USD 1,400 loss is subject to reversal if the market price of the stock recovers
...
When this stock is later sold, the sale will be treated in the same manner as trading
securities
...
Therefore, the entry would simply
record the cash received and write off the security sold for its fair market value
...


An accounting perspective:
Business insight
On Pearl Harbor Day, 1941 December 7, the stock market fell from 116
...
52
...
92 by April 1942
...
40
...
For instance, in 2007 the
Dow-Jones Industrial Average broke through the 14,000 barrier
...
Over the last 60 years,
investors have averaged about a 10 per cent to 12 per cent return annually by investing in the stock
market
...
You can visit the DJIA site on the Internet at http://www
...
com to
learn more about the stock market
...
0 License
influence over the investee company
...
In either situation, the investor must account for the investment under the
equity method
...
The logic behind this
treatment is that the investor company may exercise influence over the declaration of dividends and thereby
manipulate its own income by influencing the investee's decision to declare (or not declare) dividends
...
For example, assume that Tone Company (the investor) owns 30 per cent of Dutch
Company (the investee) and Dutch reports USD 50,000 net income in the current year
...
30)
15,000
(+SE)
To record 30% of Dutch Company's Net Income
...
The investment
account is also increased by USD 15,000
...
For example, assume Dutch incurs a loss of USD 10,000 in 2011
...
30) (-SE)
Investment in Dutch Company (-A)
To recognize 30% of Dutch Company's
loss
...
The USD 3,000 credit reduces Tone's
equity in the investee
...
30) (6,000
A)
To record receipt of 30% of dividends paid by Dutch
Company
...


Reporting for stock investments of more than 50 per cent
In recent years, many companies have expanded by purchasing a major portion, or all, of another company's
outstanding voting stock
...
Both corporations remain
separate legal entities, regardless of the investment purpose
...

As stated in the introduction to this chapter, a corporation that owns more than 50 per cent of the outstanding
voting common stock of another corporation is the parent company
...


Accounting Principles: A Business Perspective

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14
...
However, since a central management controls the parent and its subsidiaries and they are related to
each other, the parent company usually must prepare one set of financial statements
...

According to FASB Statement No
...
g
...
47 Thus, almost all subsidiaries must be included in the consolidated financial statements under FASB
Statement No
...
Previously, the consolidated statements did not include subsidiaries in markedly dissimilar
businesses than those of the parents
...
Examples include Tide, Ariel, Pantene Pro-V,
Pringles, and Folgers
...
Investments in companies over which the Company exerts
significant influence, but does not control the financial and operating decisions, are accounted
for by the equity method
...
In preparing consolidated financial statements, parent companies eliminate the
effects of intercompany transactions by making elimination entries
...
Elimination entries
appear only on a consolidated statement work sheet, not in the accounting records of the parent or subsidiaries
...

To illustrate the need for elimination entries, assume Y Company formed the Z Company, receiving all of Z
Company's USD 100,000 par value common stock for USD 100,000 cash
...
The parent records the following
entry on its books:
Investment in Z Company (+A)
Cash(-A)
To record an investment in Z Company
...


100,000
100,000

47 FASB, Statement of Financial Accounting Standards No
...
, 1987), p
...
Copyright © by the Financial Accounting Standards Board, High
Ridge Park, Stamford, Connecticut 06905, U
...
A
...
0 License
Z Company, the subsidiary, records the following entry on its books:
Cash (+A)
100,000
Common stock (+SE)
100,000
To record issuance of all the common stock to
Y Company
...
On the consolidated statements work sheet, the required elimination is:
Common stock (Z company) (- 100,000
SE)
Investment in Z Company (-A)
100,000

This elimination is required because the parent company's investment in the stock of the subsidiary actually
represents an equity interest in the net assets of the subsidiary
...
By eliminating Z Company's common stock, the parent avoids double counting
stockholders' equity
...

Consolidated financial statements present financial data as though the companies were a single entity
...
For example, assume the parent company purchased USD 5,000
of bonds issued by its subsidiary company
...

P Company and Subsidiary S Company
Work Sheet for Consolidated balance sheet
2010 January 1 (date of acquisition)
P
S
Eliminations
Consolidated
Assets
Company Company Debit
Credit Amounts
Cash
26,000
12,000
38,000
Notes receivable
5,000
(2) 5,000
Accounts receivable, 24,000
15,000
39,000
net
Merchandise
35,000
30,000
65,000
inventory
Investment in S
106,000
(1)
Company
106,000
Equipment, net
41,000
15,000
56,000
Building, net
65,000
35,000
100,000
Land
20,000
10,000
30,000
322,000 117,000
328,000
Liabilities and
stockholders' equity
Accounts payable
18,000
6,000
24,000
Notes payable
5,000
(2) 5,000
Common stock
250,000 100,000
(1) 100,000
Paid-in capital excess
of par
value - common
4,000
(1) 4,000
Retained earnings
54,000
2,000
(1) 2,000
322,000 117,000
111,000
111,000 328,000

Exhibit 108: Consolidated balance sheet work sheet (stock acquired at book value)
Accounting Principles: A Business Perspective

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...


Consolidated balance sheet at time of acquisition
A parent company may acquire a subsidiary at its book value or at a cost above or below book value
...

To consolidate its assets and liabilities with those of its subsidiaries, a parent company prepares a consolidated
statement work sheet similar to the one in Exhibit 108
...
The first two columns of the work sheet show assets, liabilities, and
stockholders' equity of the parent and subsidiary as they appear on each corporation's balance sheet
...
The final column shows the amounts that will appear on the consolidated balance sheet
...
P Company acquired S Company on 2010 January 1, by purchasing all of its outstanding voting common
stock for USD 106,000 cash, which was the book value of the stock
...
Thus, common stock (USD 100,000), paid-in capital in excess of par value—
common (USD 4,000), and retained earnings (USD 2,000) equal USD 106,000
...


106,000
106,000

The Investment in S Company account appears as an asset on P Company's balance sheet
...

Thus, if both the investment account and the subsidiary's assets appear on the consolidated balance sheet, the same
resources would be counted twice
...
Therefore, P's investment in S Company must be offset
against S Company's stockholders' equity accounts so that the subsidiary's assets and the ownership interest in
these assets appear only once on the consolidated balance sheet
...
The entry debits S Company's Common Stock for USD 100,000, Paid-In
Capital in Excess of Par Value—Common for USD 4,000, and Retained Earnings for USD 2,000 and credits
Investment in S Company for USD 106,000
...


Entry 2 eliminates the effect of an intercompany debt
...
The loan is a USD 5,000 note receivable on P's books and a USD 5,000 note payable on S's
books
...
From the viewpoint of the consolidated equity, neither an asset
568

This book is licensed under a Creative Commons Attribution 3
...
Therefore, entry 2 on the work sheet eliminates both the asset and liability
...
In general journal form, entry 2 is:
Notes payable (-L)
5,000
Notes receivable (-A)
5,000
To eliminate intercompany payable and
receivable
...
P Company uses the final work sheet
column to prepare the consolidated balance sheet
...

Spreadsheet programs in particular expedite the process of constructing consolidated financial
statements
...
In some
cases, firms acquire subsidiaries at a cost greater than or less than book value
...
The book value of this stock is USD 106,000
...
P Company's
management may have paid more than book value because (1) the subsidiary's earnings prospects justify paying a
price greater than book value or (2) the total fair market value of the subsidiary's assets exceeds their total book
value
...
Goodwill is an intangible value attached to a business primarily due to
above-average earnings prospects (as discussed in Chapter 11)
...
In Exhibit 109, USD 4,000 is due to the undervaluation of land owned by
the company, and the remaining USD 15,000 of the excess of cost over book value is due to expected above-average
earnings
...

P Company establishes Goodwill as part of the first elimination entry
...
In journal form, entry 1 is:
Common stock (-SE)
Paid-in capital in excess of par value –
common (-SE)
Retained earnings (-SE)
Land (+A)
Goodwill (+A)
Investment in S Company (-A)
To eliminate investment and subsidiary

100,000
4,000
2,000
4,000
15,000

125,000

Accounting Principles: A Business Perspective

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...


Entry 2 is the same as elimination entry 2 in Exhibit 108
...

After these elimination entries are made, the company consolidates and extends the remaining amounts to the
Consolidated Amounts column
...
Notice that the firm carries the USD 15,000 debit to Goodwill to the Consolidated Amounts column
and lists it as an asset in the consolidated balance sheet
...
FASB Statement No
...
We leave a discussion of this
topic to a more advanced text
...
In
such cases, it is highly unlikely that a bargain purchase has been made
...
Firms use the excess of book value over cost to reduce proportionately the
value of the noncurrent assets acquired (except long-term investments in marketable securities)
...

P Company and Subsidiary S Company
Work Sheet for consolidation balance sheet
2010 January 1 (date of acquisition)
P
S
Eliminations
Assets
Company
Company Debit
Cash
7,000
12,000
Notes receivable
5,000
Accounts receivable, 24,000
15,000
net
Merchandise
35,000
30,000
inventory
Investment in S
125,000
Company
Equipment, net
41,000
15,000
Building, net
65,000
35,000
Land
20,000
10,000
(1) 4,000
Goodwill
(1) 15,000
322,000
117,000
Liabilities and
stockholders' equity
Accounts payable
18,000
6,000
Notes payable
5,000
(2) 5,000
Common stock
250,000
100,000 (1) 100,000
Paid-in capital excess
of par value –
4,000
(1) 4,000
common
Retained earnings
54,000
2,000
(1) 2,000
322,000
117,000 130,000

Credits
(2) 5,000

Consolidated
Amounts
19,000
39,000
65,000

(1)
125,000
56,000
100,000
34,000
15,000
328,000
24,000
250,000
-0130,000

54,000
328,000

Exhibit 109: Consolidated balance sheet work sheet (stock acquired at more than book value)
Sometimes a parent company acquires less than 100 per cent of the outstanding voting common stock of a
subsidiary
...
P Company is the majority stockholder, but another group of stockholders owns the remaining 20 per cent of
the stock
...
Minority
570

This book is licensed under a Creative Commons Attribution 3
...

Look at Exhibit 111, which shows the elimination entries required when P Company purchases 80 per cent of S
Company's stock for USD 90,000
...
Assuming no assets are undervalued, P Company attributes the excess of cost (USD 90,000) over
book value (USD 84,800) of USD 5,200 to S Company's above-average earnings prospects (goodwill)
...
To
establish minority interest, it credits a Minority Interest account for USD 21,200 (20 per cent of USD 106,000)
...
The USD
5,200 debited to Goodwill makes the debits equal the credits
...


100,000
4,000
2,000
5,200

90,000
21,200

Elimination entry 2 is the same as shown in Exhibit 108
...

On the consolidated balance sheet (Exhibit 112), minority interest appears between the liabilities and
stockholders' equity sections
...
Stock investments

Accounting for income, losses, and dividends of a subsidiary
When a subsidiary is operating profitably, its net assets and retained earnings increase
...
The subsidiary records all transactions in its
accounting records in a normal manner
...
A parent company may use either the cost or equity method of accounting for its
investment in a consolidated subsidiary
...
To illustrate the consolidation
process at a date after acquisition, we assume the parent company uses the equity method
...
Thus, the balance in the
investment account differs after acquisition from its balance on the date of acquisition
...
As an illustration, assume the
following facts:
• P Company acquired 100 per cent of the outstanding voting common stock of S Company on 2010 January

1
...
The excess of cost over book
value is attributable to (a) an undervaluation of land amounting to USD 4,000 and (b) the remainder to S
Company's above-average earnings prospects
...

• On 2010 December 31, S Company paid a cash dividend of USD 8,000
...
0 License
• S Company owes P Company USD 5,000 on a note at December 31
...

• P
...

• P Company uses the equity method of accounting for its investment in S Company
...

The work sheet shown in Exhibit 113 allows us to prepare a consolidated income statement, statement of
retained earnings, and balance sheet
...
These
balances are the result of the following journal entries made by P Company in 2010:
2010
Jan
...


20,000

31

Dec
...


Cash (+A)
Investment in S Company (-A)
To record dividends received from
subsidiary
...
P Company increased its investment account
balance by USD 20,000
...
This entry reverses the entry made on the
books of P Company to recognize the parent's share of the subsidiary's income (the first December 31 journal
entry)
...
Stock investments
Work Sheet for Consolidated Balance Sheet
2010 December 31

574

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...
31 carried
forward

(10,000)
(8,000)

(2) 8,000

75,000

18,000

75,000*

Cash

38,000

16,000

54,000

Notes receivable

5,000

Accounts receivable,
net

25,000

18,000

43,000

Merchandise
inventory

40,000

36,000

76,000

Investment in S
Company

133,000

Balance sheet assets

(4) 5,000

(2) 8,000

(3) 121,000
(1) 20,000

Equipment, net

35,900

12,000

48,900

Building, net

61,700

33,000

94,700

Land

20,000

10,000

34,000

(3) 11,000

Goodwill

(3) 4,000

11,000

359,600

125,000

361,600*

19,600

2,000

21,600

Liabilities and
stockholders' equity
Accounts payable

Accounting Principles: A Business Perspective

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...
Entry 2 restores the investment account to its
balance before the dividends from S Company were deducted
...
On a consolidated basis, a company cannot pay a
dividend to itself
...
The entry also establishes goodwill of USD 11,000 and increases land by USD 4,000 to account for
the excess of acquisition cost over book value
...

After the first three entries have been made, the investment account contains a zero balance from the viewpoint
of the consolidated entity
...
Notice that certain totals in the first two columns do not add across to the total in
the Consolidated Amounts column
...
The firm carries the net income row in the Income Statement section forward to the net income row
in the Statement of Retained Earnings section
...
P
Company uses the final work sheet column to prepare the consolidated income statement (Exhibit 114), the
consolidated statement of retained earnings (Exhibit 115), and the consolidated balance sheet (Exhibit 116)
...
The parent company benefits from the income and other financial strengths of the subsidiary
...

Consolidated financial statements are of limited use to the creditors and minority stockholders of the subsidiary
...
Minority stockholders in the subsidiary do not benefit or suffer from the parent company's operations
...
Thus, the subsidiary's creditors and minority stockholders are more
interested in the subsidiary's individual financial statements than in the consolidated statements
...


576

This book is licensed under a Creative Commons Attribution 3
...
To locate this stock, potential stockholders may use the
dividend yield on common stock ratio or the payout ratio on common stock
...

P Company and Subsidiary S Company
Consolidated Income Statement
For the year ended 2010 December 31
Revenue from sales
$700,000
Cost of goods sold
430,000
Gross margin
$270,000
Expenses (excluding depreciation and taxes) $180,000
Depreciation expense
12,400
Federal income tax expense
46,600 239,000
Net sales
$31,000

Exhibit 114: Consolidated income statement
P Company and Subsidiary S Company
Consolidated statement of Retained Earnings
For the Year Ended 2010 December 31
Retained earnings, 2010 January 1
$54,000
Net income
31,000
Subtotal
$85,000
Dividends
10,000
Retained earnings, 2010 December 31
$75,000

Exhibit 115: Consolidated statement of retained earnings
P Company and Subsidiary S Company
Consolidation Balance Sheet
2010 December 31
Assets
Current assets:
Cash
Accounts receivable, net
Merchandise inventory
Total current assets
Property, plant, and equipment:
Equipment, net
Building, net
Land
Total property, plant, and equipment
Goodwill
Total assets
Liabilities and stockholders' equity
Current liabilities:
Account payable
Notes payable
Total liabilities
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders equity

$54,000
43,000
76,000
$173,000
$48,900
94,700
34,000
177,600
11,000
$361,600
$21,600
15,000
$250,000
75,000

$36,600

325,000
$361,600

Exhibit 116: Consolidated balance sheet (one year after acquisition
Dividend per share of common stock
Current market price per share
Earnings per share

2000
$ 0
...
81
2
...
05
50
...
62

Investors use the dividend yield on common stock ratio as a tool to compare stocks
...
Other investors would rather have the corporation

Accounting Principles: A Business Perspective

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...
The
formula for the dividend yield on common stock ratio is:
Dividend yield on common stock ratio=

Dividend per share of common stock
Current market price per share

For Tyco, the dividend yield on common stock ratios are:
2003: USD 0
...
81 =
...
05/USD 50
...
10 per cent
To determine the relevance of this ratio, an investor compares these numbers to ratios calculated on other
stocks
...
When computing the payout ratio, remember that negative earnings per share result in an invalid
calculation
...
05/USD 2
...
87 per cent
2002: USD 0
...
62 = 8
...
In Chapter 15 you learn about long-term financing, its
advantages and disadvantages, and how bonds differ from stocks
...
The cost method is used for all short-term
investments, long-term investments of less than 20 per cent where the purchasing company does not exercise
significant influence over the investee company, and may be used for long-term investments of more than 50
per cent
...
The
equity method is used for all long-term investments of between 20 per cent and 50 per cent and may be used
for investments of more than 50 per cent
...

• Under the cost method, the initial investment is debited to either Trading Securities or Available-for-Sale

Securities, depending on whether the investment is a near-term or longer-term investment
...
The

fair market value method is applied independently to each of these portfolios
...

• Under the equity method, the initial investment is debited to an Investment in (Company Name) account
...

• The equity method must be used for long-term investments of 20 per cent to 50 per cent and for long-term

investments of less than 20 per cent where significant influence is present
...
0 License
• The initial investment is debited to an Investment in (Company Name) account
...

• A corporation that owns more than 50 per cent of the outstanding voting common stock of another

corporation is called the parent company
...

• A parent company and its subsidiaries maintain their own accounting records and prepare their own

financial statements, but the parent company must also prepare consolidated financial statements
...

• Consolidated financial statements must be prepared (1) when one company owns more than 50 per cent of

the outstanding voting stock of another company and (2) unless control is likely to be temporary or if it does
not rest with the majority owner
...
Elimination entries are made only on a consolidated statement work
sheet, not in the accounting records of either company
...
Intercompany receivables and payables also must be eliminated
...

• A consolidated balance sheet work sheet is prepared at the time of acquisition
...
The next pair of columns shows the eliminations
...

• A consolidated work sheet is prepared at various dates after acquisition
...
The next
pair of columns shows the eliminations
...

• Consolidated financial statements are of primary importance to stockholders, managers, and directors of

the parent company
...

•

Dividend yield on common stock ratio=

Dividend per share of common stock
Current market price per share

• This ratio helps investors to compare stocks
...


Accounting Principles: A Business Perspective

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...
21 Purchased 600 shares of Sly Company common stock at USD 48
...
Also purchased 100 shares of Rob Company common stock at USD 225 per share, plus a USD 376
broker's commission
...

June 2 Received cash dividends of USD 1
...

Aug
...

30 Sold 100 shares of Rob common stock at USD 120 per share, less a USD 360 broker's commission
...
15 Received shares representing a 10 per cent stock dividend on the Sly common stock
...
50 per share
...
31 Per share market values for the two investments in common stock are Sly, USD 45
...
50
...

Prepare journal entries to record these transactions and the necessary adjustments for a December 31 closing
...
After the close of business on the date of acquisition, the
balance sheets for the two companies were as follows:
Landford
Company
Assets
Cash
Accounts receivable, net
Notes receivable
Merchandise inventory
Investment in Casey Company
Investment in bonds
Plant and equipment, net
Total assets
Liabilities and stockholders' equity
Accounts payable
Notes payable
Bonds payable
Common stock - $
...
On that
same day, Casey Company purchased USD 30,000 of Lanford Company's bonds
...

Prepare a work sheet for a consolidated balance sheet on the date of acquisition
...
21

June 2

Aug
...

Received 100 shares of Rob common stock as a 100$ stock
dividend
...
0 License
30

Sept
...
31

$114
...
38 x 100 shares
...
New cost per share is $29,700/660 shares = $45
...

Cost

Sly common stock
$29,700
Rob common stock
11,438
Total
$41,138
* $45
...

† $106
...


Market
$30,195*
10,650†
$40,845

293

293

Inc
...
) in
marketable
value
$495
(788)
$(293)

Solution to demonstration problem B
Landford Company and Subsidiary Casey Company
Work Sheet for Consolidation Balance Sheet
2010 January 2 (date of acquisition)
P

S

Eliminations

Consolidate
d

Assets

Company

Company

Debit

Cash

75,000

30,000

105,000

Accounts receivable,
net

90,000

37,500

127,500

Notes receivable

15,000

7,500

Merchandise
inventory

112,500

45,000

Investment in Casey
Company

300,000

Credit

(2) 15,000

Amounts

7,500
157,500

(1) 300,000

Investment in bonds

(3) 30,000

30,000

Plant and equipment, 303,000
net

-0-0-

195,000

Goodwill

498,000
(1) 15,000

15,000

895,500

345,000

910,500

Accounts payable

75,000

45,000

120,000

Notes payable

22,500

15,000

Bonds payable

225,000

Common stock

300,000

Liabilities and
stockholders' equity

(2) 15,000

22,500

(3) 30,000

195,000

150,000

(1) 150,000

300,000

60,000

(1) 60,000

-0-

273,000

75,000

(1) 75,000

273,000

895,500

345,000

345,000

Paid-in capital excess
of par value –
Common
Retained earnings

345,000

910,500

Key terms
Available-for-sale securities Securities purchased that will be held for longer than the near term
...
The
Accounting Principles: A Business Perspective

581

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...

Consolidated statement work sheet An informal record on which elimination entries are made to show
account balances as if the parent and its subsidiaries were a single economic enterprise
...

Dividends received are credited to Dividends Revenue
...
Investors use this ratio to compare stocks
...
Elimination entries allow the presentation of all account balances as if the parent and
its subsidiaries were a single economic enterprise
...

Goodwill An intangible value attached to a business primarily due to above-average earnings prospects
...

Investee A company that has 20 per cent to 50 per cent of its stock purchased by another company (the
investor) as a long-term investment
...

Marketable equity securities Readily saleable common and preferred stocks of other companies
...
The minority stockholders have an interest in the subsidiary's net assets
and share the subsidiary's earnings with the parent company
...

Payout ratio on common stock Calculated by dividing dividend per share of common stock by earnings
per share (EPS)
...

Subsidiary company A corporation acquired and controlled by a parent corporation; control is established
by ownership of more than 50 per cent of the subsidiary's outstanding voting common stock
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

The cost method should be used when a corporation makes a long-term investment of less than 20 per cent, and
there is no significant control
...

Trading securities and available-for-sale securities should be grouped separately in applying the fair market
value rules
...

Multiple-choice
Select the best answer for each of the following questions
...
0 License
In which of the following cases is the investor company limited to use of the equity method in accounting for its
stock investments?
a
...

b
...

c
...

d
...

Under the equity method, which of the following is true?
a
...

b
...

c
...

d
...

When the fair market value rules are followed, which of the following is true when the market value of the stocks
in the Trading Securities account falls below their cost?
a
...

b
...

c
...

d
...

Under the equity method, the investment account always reflects only the:
a
...

b
...

c
...

d
...

The excess of cost over the book value of an investment that is due to expected above-average earnings is labeled
on the consolidated balance sheet as:
a
...

b
...

c
...

d
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...


➢

Describe the valuation bases used for marketable equity securities
...


➢

Of what significance is par value to the investing corporation?

➢

What is the purpose of preparing consolidated financial statements?

➢

Under what circumstances must consolidated financial statements be prepared?

Accounting Principles: A Business Perspective

583

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14
...
What
does this item represent?

➢

How do a subsidiary's earnings, losses, and dividends affect the investment account of the parent
when the equity method of accounting is used?

➢

Why are consolidated financial statements of limited usefulness to the creditors and minority
stockholders of a subsidiary?

Exercises
Exercise A On 2010 July 1, Tam Company purchased 200 shares of Del Company capital stock as a temporary
investment (trading securities) at USD 676
...
On July 15, a 10 per cent
stock dividend was received
...
60 per share on 2010 August 12
...
20 per share, less a commission of USD 720
...

Exercise B Key Company purchased 200 shares of Franklin Company stock at a total cost of USD 7,560 on
2010 July 1
...
By 2011 December 31, the market value had risen to USD 7,920
...
The company classifies the securities as trading securities
...

Exericse C Corbit Company has marketable equity securities that have a fair market value at year-end that is
USD 13,440 below their cost
...
The securities are current assets classified as trading securities
...
The securities are noncurrent assets classified as available-for-sale securities, and the loss is considered to be
temporary
...
The securities are noncurrent assets classified as available-for-sale securities, and the loss is considered to be
permanent
...

Exercise D Ruiz Company owns 75 per cent of Sim Company's outstanding common stock and uses the equity
method of accounting
...
On 2010 December 31, Sim
Company paid a cash dividend of USD 189,000
...
Prepare
entries to reflect these events on Ruiz Company's books
...
The stockholders' equity of the TRD Company consisted of
common stock, USD 6,720,000, and retained earnings, USD 1,680,000
...


584

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...
90 per cent interest
...
70 per cent interest
...
55 per cent interest
...
After the close of business on the date of acquisition, Sumpter Company's stockholders' equity
consisted of common stock, USD 5,880,000, and retained earnings, USD 2,184,000
...
Prepare (a) the
entry to record the investment in Sumpter Company and (b) the elimination entry on the work sheet used to
prepare consolidated financial statements as of the date of acquisition
...
On that date, Company K's stockholders' equity consisted of:
Stockholders' equity:
Paid-in capital:
Common stock, $90 par; 30,000 shares authorized, issued, and
outstanding
Retained earnings
Total stockholders' equity

$2,700,000
675,000
$3,375,000

Compute the difference between cost and book value in each of the following cases:
a
...

b
...

c
...

Exercise I The 2010 January 1, stockholders' equity section of Saye Company's balance sheet follows:
Stockholders' equity:
Paid-in capital:
Common stock, $144 par; authorized, 200,000
shares; issued, and outstanding, 150,000 shares
Paid-in capital in excess of par value
Total paid-in capital
Retained earnings
Total stockholders' equity

$21,600,000
3,600,000
$25,200,000
2,160,000
$27,360,000

Ninety per cent of Saye Company's outstanding voting common stock was acquired by Tim Company on 2011
January 1, for USD 24,048,000
...

Exercise J Company S purchased 90 per cent of Company T's outstanding voting common stock on 2010
January 2
...
Company S paid USD 2,790,000 for its
proportionate equity of USD 2,430,000
...

Company T earned USD 324,000 during 2010 and paid cash dividends of USD 108,000
...
Compute the balance in the investment account on 2010 December 31
...
Compute the amount of the minority interest on (1) 2010 January 2, and (2) 2010 December 31
...
40 per share plus a broker's commission of USD 1,728
...
64 per share
...
Stock investments
share less a broker's commission of USD 1,152
...

On 2010 December 31, the end of Paris Company's calendar-year accounting period, the market quotation for
Rome Company's common stock was USD 331
...
The decline was considered to be temporary
...
Prepare journal entries to record all of these data assuming the securities are considered temporary
investments classified as trading securities
...
Assume Rome Company has become a major customer so the shares are held for long-term affiliation
purposes
...

Problem B On 2010 October 17, Strong Company purchased the following common stocks (all trading
securities) at the indicated per share prices that included commissions:
600 shares of X Company common stock @
$129,600
$216
1,000 shares of Y Company common stock @ 144,000
$144
1,600 shares of Z Company common stock @ 115,200
$72
$388,800

On 2010 December 31, the market prices per share of the above common stocks were X, USD 223
...
80; and Z, USD 54
...
40; Y, USD 7
...
40
...
80; Y, USD 115
...

All of these changes in market prices are considered temporary
...

If the securities acquired are considered available-for-sale securities, how would the entries differ?
For both parts a and b, give the descriptions (titles) and the dollar amounts of the items that would appear in the
income statements for 2010 and 2011
...
Long Company uses the equity method
...
The stockholders' equity section of the 2009 December
31, balance sheet for Fall follows:
Stockholders' equity:
Paid-in capital:
Common stock - $42 par
Retained earnings
Total stockholders' equity

$4,200,000
840,000
$5,040,000

a
...

b
...

Problem D Pearson Company acquired 75 per cent of the outstanding voting common stock of Frost Company
for USD 1,444,800 cash on 2010 January 1
...
During 2010,
2011, and 2012, Frost Company reported the following:

586

This book is licensed under a Creative Commons Attribution 3
...
Prepare general journal entries to record the investment and the effect of the subsidiary's income, losses, and
dividends on Pearson Company's accounts
...
Compute the balance in the investment account on 2012 December 31
...
At the end of business on the date of acquisition, the balance sheets for the
two companies were as follows:
Assets
Cash
Accounts receivable, net
Notes receivable
Merchandise inventory
Investment in Thorpe Company
Equipment, net
Building, net
Land
Total assets
Liabilities and stockholders' equity
Accounts payable
Notes payable
Common stock - $45 par value
Retained earnings
Total liabilities and stockholders' equity

Cord
Company

Thorpe
Company

$ 315,000
234,000
360,000
495,000
2,700,000
648,000
1,890,000
765,000
$7,407,000

$ 180,000
144,000
90,000
234,000

$ 117,000
90,000
5,400,000
1,800,000
$7,407,000

$ 135,000
108,000
1,800,000
450,000
$2,493,000

450,000
990,000
405,000
$2,493,000

The excess of cost over book value is attributable to the above-average earnings prospects of Thorpe Company
...

a
...

b
...

Problem F Refer to the previous problem, Cord Company uses the equity method
...
Stock investments
Total of the accounts with credit balances

$11,277,000

$3,870,000

There is no intercompany debt at the end of the year
...

Problem G Using the work sheet from Problem F, prepare the following items:
a
...

b
...

c
...

Alternate problems
Alternate problems A On 2010 September 1, Ramsey Company purchased the following relatively long-term
investments classified as available-for-sale securities:
• Two thousand shares of Lacey Company capital stock at USD 439
...

• One thousand shares of Membrow Company capital stock at USD 705
...

Cash dividends of USD 18
...
40 per share on the Membrow
capital stock were received on December 7 and December 10, respectively
...
80; and Membrow, USD 655
...

a
...

b
...
Where would the accounts appear in the financial statements?
Alternate problem B Kress, Inc
...

On 2010 July 15, a cash dividend of USD 7
...
On 2010 September 1, Baker Company
split its USD 180 par value common shares two for one
...

a
...

b
...
Assume the remaining shares were considered current assets classified as trading securities at the end of
2010, at which time their market value was USD 128 per share
...

Alternate problem C Prime Company acquired 90 per cent of the outstanding voting common stock of Orr
Company 2010 January 1, for USD 7,560,000 cash
...
During 2010 Orr
reported USD 1,512,000 of net income and paid USD 504,000 in cash dividends
...
00 $6,720,000
par
Retained earnings
1,680,000
Total stockholders'
$8,400,000

588

This book is licensed under a Creative Commons Attribution 3
...
Prepare general journal entries to record the investment and the effect of Orr's earnings and dividends on
Prime Company's accounts
...
Prepare the elimination entry that would be made on the work sheet for a consolidated balance sheet as of the
date of acquisition
...
The investment is accounted for under the equity method
...
Prepare general journal entries to record the investment and the effect of the subsidiary's income, losses, and
dividends on Codd Company's accounts
...
Compute the investment account balance on 2011 December 31
...
On the date of acquisition, the balance sheets for the two companies were
as follows:
Assets
Cash
Accounts receivable, net
Notes receivable
Merchandise inventory
Investment in Dodd Company
Equipment, net
Building, net
Land
Total assets
Liabilities and stockholders' equity
Accounts payable
Notes payable
Common stock - $120 par value
Retained earnings
Total liabilities and stockholders' equity

Maple
Company

Dodd
Company

$ 900,000
432,000
180,000
1,368,000
4,320,000
1,224,000
3,330,000
1,404,000
$13,158,000

$270,000
360,000
108,000
864,000

$792,000
216,000
9,540,000
2,610,000
$12,158,000

$360,000
252,000
3,564,000
270,000
$4,446,000

738,000
1,656,000
450,000
$4,446,000

The management of Maple Company thinks that the Dodd Company's land is undervalued by USD 162,000
...

On the date of acquisition, Dodd Company borrowed USD 180,000 from Maple Company by giving a note
...
Prepare a work sheet for a consolidated balance sheet as of the date of acquisition
...
Prepare a consolidated balance sheet for 2010 January 2
...
Maple Company uses the equity method
...
Stock investments
Investment in Dodd Company
Equipment, net
Building, net
Land
Cost of goods sold
Expense (excluding depreciation and taxes)
Depreciation expense
Income tax expense
Dividends
Total of the accounts with debit balances
Credit balance accounts
Accounts payable
Notes payable
Common stock - $90 par value
Retained earnings
Revenue from sales
Income from Dodd Company
Total of the accounts with credit balances

4,519,356
1,147,500
3,136,500
1,404,000
8,064,000
2,160,000
243,000
569,664
477,000
$25,037,556
$ 720,000
270,000
9,540,000
2,610,000
11,520,000
377,556
$25,037,556

691,860
1,573,200
450,000
2,160,000
810,000
128,940
123,504
178,200
$7,992,000
$ 378,000
180,000
3,564,000
270,000
3,600,000
$7,992,000

There is no intercompany debt at the end of the year
...

Alternate problem G Using the work sheet from the previous problem, prepare the following items:
a
...

b
...

c
...

Beyond the numbers—Critical thinking
Business decision case A You are the CPA engaged to audit the records of Quigley Company
...
You ask the vice president for finance if the client expects to sell these securities in the
coming year
...
The securities will be sold if additional cash is needed to finance
operations
...
It indicates no need to sell the marketable securities
...
Does it really make any difference whether the securities are classified as trading
securities or available-for-sale securities? Explain
...
The excess of cost over book value was due to above-average
earnings prospects
...
0 License
a
...
Is this correct? If not, why not?
b
...

Business decision case C International Flavors & Fragrances, Inc
...

Use the following excerpt from International Flavors & Fragrances Inc
...
Then comment on the results
...
22
Dividends per share ($)
1
...
31

1999
$1
...
52
37
...
90
1
...
19

Group project D In teams of two or three students, select three companies you believe may be profitable
short-term investments
...
Calculate the gain or loss that your team would have recorded if it had
purchased 500 shares of each company's stock six months ago and sold all of the shares today
...
Also, be prepared to describe your analysis to the class
...
94, "Consolidation of All Majority-Owned Subsidiaries", published by the Financial Accounting
Standard Board
...

Group project F In a small group of students, locate the annual reports of three companies with investments
in other companies
...
For
instance, by reading the notes to the financial statements, try to determine whether they account for the
investments using the cost or equity methods
...

Using the Internet—A view of the real world
Visit the following website for General Electric Company:
http://www
...
com
Pursue choices on the screen until you locate the consolidated statement of financial position
...
This experience is all part of
learning to use the Internet
...
Check out the notes to the financial statements for further information
...
Write a memo to your instructor summarizing your
findings
...
Stock investments
False
...

True
...

True
...
The new number of shares is recorded, and the cost
per share is reduced
...
Trading securities should be considered separately from available-for-sale securities in applying the fair
market value method
...
Eliminating entries are not made on the accounting records of the parent and subsidiary
...

Multiple-choice
c
...

a
...

d
...

b
...

a
...


592

This book is licensed under a Creative Commons Attribution 3
...
Long-term financing:
Bonds
Learning objectives
After studying this chapter, you should be able to:
• Describe the features of bonds and tell how bonds differ from shares of stock
...

• Prepare journal entries for bonds issued at face value
...

• Apply the concept of present value to compute the price of a bond
...

• Prepare journal entries for bond redemptions and bond conversions
...

• Analyze and use the financial results—times interest earned ratio
...


The accountant's role in financial institutions
Companies that require funds to maintain existing operations and expand new operations frequently do not
have the necessary cash available within the company
...
The operations of financial institutions are unique from those
of the typical manufacturing or service company
...
In addition to the
more traditional careers in accounting (auditing, professional services, financial reporting, cost accounting, and
taxation), accounting majors with interests in finance may pursue a career in financial institutions
...
In addition, accountants
in this area are being called upon to play an increasing role in the strategic operations of the financial institution
...
Some of these new areas include
issues related to asset/liability management, interest rate risk, present value measurements, capital structure, and
key ratio analysis
...
The decision to lend money hinges on the ability of the
prospective borrower to pay interest and repay debt
...
Long-term financing: Bonds
preparation and interpretation, accountants are some of the most sought after professionals for understanding the
financial position and risk of a prospective borrower
...
However, when situations arise that
require large amounts of cash, such as the purchase of a building, corporations also raise cash from long-term
borrowing, that is, by issuing bonds
...


Bonds payable
A bond is a long-term debt, or liability, owed by its issuer
...
In contrast to long-term notes, which usually mature in 10 years or less, bond maturities often run
for 20 years or more
...
For example,
a company seeking to borrow USD 100,000 would issue one hundred USD 1,000 bonds rather than one USD
100,000 bond
...

Bonds derive their value primarily from two promises made by the borrower to the lender or bondholder
...

Large companies often have numerous long-term notes and bond issues outstanding at any one time
...
Companies
present this information in the footnotes to their financial statements
...
Promissory notes, debenture bonds, and
foreign bonds are shown, with their amounts, maturity dates, and interest rates
...
95%, final maturity 2002
$ 346
$ --7
...
13%, final maturity 2003
7
...
70%, final maturity 2006
2,473
2,448
Subtotal
$3,267 $3,135
Foreign bonds at 2000 December 31
4
...
38%, final maturity 2001, Japanese Yen
5
...

• A bond has a maturity date when it must be paid
...


594

This book is licensed under a Creative Commons Attribution 3
...
In contrast, dividends to

stockholders are payable only when declared; even preferred dividends need not be paid in a particular period
if the board of directors so decides
...


Selling (issuing) bonds
A company seeking to borrow millions of dollars generally is not able to borrow from a single lender
...

Usually companies sell their bond issues through an investment company or a banker called an underwriter
...
Often the underwriter guarantees the issuer a fixed price for the bonds, expecting to earn a profit by
selling the bonds for more than the fixed price
...
Rather than deal with each
purchaser individually, the issuing company appoints a trustee to represent the bondholders
...
The main duty of the trustee is to see that the borrower fulfills the provisions of the
bond indenture
...
The
indenture deals with matters such as the interest rate, maturity date and maturity amount, possible restrictions on
dividends, repayment plans, and other provisions relating to the debt
...
Then, the trustee takes action to force the issuer to comply with the
indenture
...
We discuss these differences next
...
Such features usually do not affect the issue price of the bonds
...
These
sweeteners may increase the issue price of a bond
...
Mortgage bonds are the most common secured bonds
...

Unsecured bonds An unsecured bond is a debenture bond, or simply a debenture
...
A
financially sound company can issue debentures more easily than a company experiencing financial difficulty
...
Bonds may be registered as to principal
(or face value of the bond) or as to both principal and interest
...
For a bond registered as to both principal and interest, the issuer pays the bond interest by check
...

Therefore, owners can easily replace lost or stolen registered bonds
...
Long-term financing: Bonds
Unregistered (bearer) bonds An unregistered (bearer) bond is the property of its holder or bearer
because the owner's name does not appear on the bond certificate or in a separate record
...

Coupon bonds A coupon bond is a bond not registered as to interest
...
At the end of each interest period, the owner clips the coupon for the period and
presents it to a stated party, usually a bank, for collection
...
Serial bonds in a given bond issue have maturities spread over several dates
...

Callable bonds A callable bond contains a provision that gives the issuer the right to call (buy back) the
bond before its maturity date
...
A company is
likely to exercise this call right when its outstanding bonds bear interest at a much higher rate than the company
would have to pay if it issued new but similar bonds
...
A call premium is
the price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity
date
...
A convertible bond has a stipulated conversion rate of some number of
shares for each USD 1,000 bond
...

Bonds with stock warrants A stock warrant allows the bondholder to purchase shares of common stock at
a fixed price for a stated period
...
A bond
with nondetachable warrants is virtually the same as a convertible bond; the holder must surrender the bond to
acquire the common stock
...

Junk bonds Junk bonds are high-interest rate, high-risk bonds
...
These restructurings took the form of management buyouts (called leveraged
buyouts or LBOs), hostile takeovers of companies by outside parties, or friendly takeovers of companies by outside
parties
...
Some
issuers declared bankruptcy or sought relief from the bondholders by negotiating new debt terms
...
First, the current stockholders do
not have to dilute or surrender their control of the company when funds are obtained by borrowing rather than
issuing more shares of stock
...
Finally, probably the most
important reason to issue bonds is that the use of debt may increase the earnings of stockholders through favorable
financial leverage
...
An increase in EPS usually results from earning a higher
rate of return than the rate of interest paid for the borrowed money
...
The 5 per cent difference increases earnings
...
0 License
Exhibit 118 provides a more comprehensive example of favorable financial leverage
...
Company A issued only capital stock,
while Company B issued equal amounts of 10 per cent bonds and capital stock
...
If we divide income from
operations by assets (USD 4,000,000/USD 20,000,000), we see that both companies earned 20 per cent on assets
employed
...
The ratio of net income to stockholders' equity is 18 per
cent for B, while it is only 12 per cent for A
...
B's USD 1
...
20 EPS
...
B's larger EPS would also allow a larger dividend on B's shares
...
The company is using its
stockholders' equity as a basis for securing funds on which it pays a fixed return
...
As a result, Company B increases its rate of return on
stockholders' equity and EPS
...
20
$1
...
First, the borrower has a fixed interest payment that
must be met each period to avoid default
...
For example, assume that instead of having net income, both Company A and Company B in Exhibit 118
sustain a net loss in 2010 of USD 11,000,000
...
Company B, on the other hand, would
have negative stockholders' equity of USD 1,000,000 and the bondholders could force the company to liquidate if B
could not make interest payments as they came due
...
Other methods of using financial leverage include issuing
preferred stock or long-term notes
...
Long-term financing: Bonds
Companies A and B
Partial Balance Sheets
2010 December 31
Company A Company B
Stockholders' equity:
Paid-in capital:
Common stock
$20,000,000 $10,000,000
Retained earnings
(11,000,000) (11,000,000)
Total stockholders' equity $ 9,000,000 $ (1,000,000)

A third disadvantage of debt financing is that it also causes a company to experience unfavorable financial
leverage when income from operations falls below a certain level
...
In the
previous example, if income from operations fell to USD 1,000,000, the rates of return on stockholders' equity
would be 3 per cent for A and zero for B, as shown in this schedule:
Companies A and B
Income Statements
For the year ended 2010 December
Company A
Income from operations
$1,000,000
Interest expense
Income before federal income taxes
$1,000,000
Deduct: Federal income taxes (40%)
400,000
Net income
600,000
Rate of return on stockholders' equity:
Company A ($600,000/$20,000,000)
3%
Company B ($0/$10,000,000)

31
Company B
$1,000,000
1,000,000
$ -0-0$ -00%

The fourth disadvantage of issuing debt is that loan agreements often require maintaining a certain amount of
working capital (Current assets - Current liabilities) and place limitations on dividends and additional borrowings
...
If interest dates fall on other than balance sheet dates, the company must accrue interest
in the proper periods
...

Bonds issued at face value on an interest date Valley Company's accounting year ends on December 31
...

The bonds are dated 2010 December 31, call for semiannual interest payments on June 30 and December 31, and
mature on 2020 December 31
...
The entries for
the 10 years are as follows:
On 2010 December 31, the date of issuance, the entry is:
2010
Dec
...


On each June 30 and December 31 for 10 years, beginning 2010 June 30 (ending 2020 June 30), the entry
would be:
Each
year
June
30
And Dec
...
12 x 6,000
½) (-SE)
Cash (-A)
6,000
To record periodic interest payment
...
0 License
2020
Dec
...


Note that Valley does not need adjusting entries because the interest payment date falls on the last day of the
accounting period
...
At the end of 2019, Valley would reclassify the bonds as a current
liability because they will be paid within the next year
...
For example, assume the Valley bonds were dated 2010 October 31, issued
on that same date, and pay interest each April 30 and October 31
...
That entry would be:
2010
Dec
...
12 x
2/12) (-SE)
Bond interest payable (+L)
To accrue two month's interest expense
...
30 Bond interest expense ($100,000 x 0
...


The 2011 October 31, entry would be:
2011
Oct
...


Each year Valley would make similar entries for the semiannual payments and the year-end accrued interest
...

Bonds issued at face value between interest dates Companies do not always issue bonds on the date they
start to bear interest
...
Firms report bonds to be selling at a stated price "plus accrued interest"
...
Thus, investors purchasing bonds after the
bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest
date
...

Using the facts for the Valley bonds dated 2010 December 31, suppose Valley issued its bonds on 2011 May 31,
instead of on 2010 December 31
...
12 x
(5/12)) (+L)
To record bonds issued at face value plus
accrued interest
...
Long-term financing: Bonds
This entry records the USD 5,000 received for the accrued interest as a debit to Cash and a credit to Bond
Interest Payable
...
12 x
(1/12)) (-SE)
Bond interest payable (-L)
Cash (-A)
To record bond interest payment
...
Valley collected USD 5,000 from the bondholders on May 31 as accrued interest and is now returning it to
them
...
The amount a bond sells for above face value is a
premium
...
A difference between face value and issue
price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the
bonds
...
The higher the risk category, the higher the minimum rate of interest that
investors accept
...
Firms state this
rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each
interest period
...

Market and contract rates of interest are likely to differ
...
Assume, for instance, that the contract rate for a
bond issue is set at 12 per cent
...

However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate
...

Thus, if the market rate is 10 per cent and the contract rate is 12 per cent, the bonds will sell at a premium as the
result of investors bidding up their price
...
Thus, if the market rate is 14 per cent and the contract rate is 12 per cent, the
bonds will sell at a discount
...
Selling bonds at a premium or a discount allows the purchasers of the bonds to earn the
market rate of interest on their investment
...
The appendix to
this chapter explains the concepts of future value and present value
...

Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class
...
To compute present value, we
discount the promised cash flows from the bonds—principal and interest—using the market, or effective, rate
...
The life of the bonds is stated in interest (compounding) periods
...
0 License
per interest period, which is found by dividing the annual rate by the number of times interest is paid per year
...

Issuers usually quote bond prices as percentages of face value—100 means 100 per cent of face value, 97 means
97 per cent of face value, and 103 means 103 per cent of face value
...
Regardless of the issue price, at maturity the issuer of the bonds
must pay the investor(s) the face value of the bonds
...
Assume Carr Company issues 12 per cent bonds with a USD 100,000 face value to yield 12 per cent
...
49 The bonds would sell at face value because they offer 12 per cent and investors seek 12
per cent
...
One way to prove the
bonds would be sold at face value is by showing that their present value is USD 100,000:
Cash
Flow

X Present value
Factor

Principal of $100,000 due in six interest periods multiplied by
present value factor for 6% from Table A
...
70496
(end of text)
Interest of $6,000 due at the end of six interest periods
multiplied
6,000
X 4
...
4 of the
Appendix (end of text)
Total price (present value)

=Present
value
=$70,496
=29,504
$100,000

According to this schedule, investors who seek an effective rate of 6 per cent per six-month period should pay
USD 100,000 for these bonds
...
The entry to record the sale of these
bonds on 2010 June 30, debits Cash and credits Bonds Payable for USD 100,000
...

Accounting Principles: A Business Perspective

601

A Global Text

15
...
Therefore, you may want to set aside funds during your working career to provide for
retirement
...
Using the tables at the
end of the text we can determine how much you would have at age 65 if you invested USD 2,000
each year for 45 years in treasury bills, corporate bonds, or stocks, beginning at age 20
...
2 to determine the
future value of an annuity of USD 2,000 for 30 periods at 4 per cent (USD 2,000 X 56
...
(We would have used 45 periods, but the table only went up to 30 periods
...
1 to find the value of this lump sum of USD 112,170 for another 15 years at 4 per
cent (USD 112,170 X 1
...
Then we cannot forget that we have another 15
years of USD 2,000 annuity to consider
...
2 and calculate the future
value of an annuity of USD 2,000 for 15 periods at 4 per cent (USD 2,000 X 20
...
Then we add the USD 202,011 and the USD 40,047 to get the total future value of USD
242,058
...
) Would you be pleased?
Not when you see what you could have had at age 65 if you invested in stocks
...
However, if you
had invested in stocks at 10 per cent, you would have USD 1,437,810 at age 65
...
Carr computes the present value (selling
price) of the bonds as follows:
Cash
flow

X Present
value factor

Principal of $100,000 due in six interest periods multiplied by
present value factor for 7% from Table A
...
66634
(end of text)
0
Interest of $6,000 due at the end of six interest periods
multiplied by present
6,000 X4
...
4 of the Appendix (end of
text)
Total price (present value)

=Present value
=$66,634
=28,559
$95,233

Note that in computing the present value of the bonds, Carr uses the actual USD 6,000 cash interest payment
that will be made each period
...
However, the market rate per semiannual period—7 per cent—does change, and Carr uses this new
rate to find interest factors in the tables
...
0 License
The journal entry to record issuance of the bonds is:
2010
June 30 Cash (+A)
95,233
Discount on bonds payable (-L; Contra- 4,767
account)
Bonds payable (+L)
100,000
To record bonds issued at a discount
...
The company debits the
difference between face value and price received to Discount on Bonds Payable, a contra account to Bonds Payable
...
Carrying value is the face value of the bonds
minus any unamortized discount or plus any unamortized premium
...

Bonds issued at a premium Assume that Carr issued the USD 100,000 face value of 12 per cent bonds to
yield a current market rate of 10 per cent
...
74622
value factor for 5% from Table A
...
07569
present value factor for 5% from Table A
...


The carrying value of these bonds at issuance is USD 105,076, consisting of the face value of USD 100,000
and the premium of USD 5,076
...
A discount increases and a premium decreases the amount of interest
expense
...
If the bonds had been issued at USD 105,076, the total interest cost of borrowing would be USD 30,924: USD
36,000 less the premium of USD 5,076
...
Two methods are available for amortizing a
discount or premium on bonds—the straight-line method and the effective interest rate method
...
Long-term financing: Bonds
The straight-line method records interest expense at a constant amount; the effective interest rate method
records interest expense at a constant rate
...
21 states that the straight-line method may be used
only when it does not differ materially from the effective interest rate method
...


An accounting perspective:
Business insight
US government bonds have traditionally offered a fixed rate of interest
...
The amount of interest on these bonds is tied to
the officially reported rate of inflation
...
These bonds are designed to protect
purchasers against purchasing power loss due to inflation
...
This change in calculation, if adopted, would lower the
amount of interest earned on these bonds
...

The straight-line method The straight-line method of amortization allocates an equal amount of
discount or premium to each month the bonds are outstanding
...
For example, if
it sells USD 100,000 face value bonds for USD 95,233, Carr would charge the USD 4,767 discount to interest
expense at a rate of USD 132
...
Total discount amortization for six months
would be USD 794
...
42 X 6
...
52, calculated as follows: USD 6,000 + (USD 132
...
The entry to record the expense on
2010 December 31, would be:
2010
Dec
...
52
Cash (-A)
6,000
...
42 x 6)
794
...


By the maturity date, all of the discount would have been amortized
...
Carr would amortize the USD 5,076 premium on these bonds at a rate of USD 141 per
month, equal to USD 5,076/36
...
31 Bond interest expense (-SE)
Premium on bonds payable ($141 x 6) (-L)
Cash (-A)
To record interest payable and premium

5,154
846
6,000

604

This book is licensed under a Creative Commons Attribution 3
...


By the maturity date, all of the premium would have been amortized
...
21 recommends an amortization procedure called the
effective interest rate method, or simply the interest method
...
Using the Carr example of 12 per cent bonds with a face
value of USD 100,000 sold to yield 14 per cent, the carrying value at the beginning of the first interest period is the
selling price of USD 95,233
...
31 Bond interest expense ($95,233 x 0
...
12 x ½) (-A)
Discount on bonds payable (+L)
To record discount amortization and interest
payment
...
The cash payment is the face
value times the contract rate
...

After the preceding entry, the carrying value of the bonds is USD 95,899, or USD 95,233 + USD 666
...

Assuming the accounting year ends on December 31, the entry to record the payment of interest for the second
semiannual period on 2011 June 30 is:
2011
June 30 Bond interest expense ($95,899 x 0
...
12 x ½) (-A)
6,000
Discount on bonds payable (+L)
713
To record discount amortization and interest
payment
...
If the Carr bonds had been
issued at USD 105,076 to yield 10 per cent, the premium would be USD 5,076
...
However, the entry would differ somewhat, showing a debit to
the premium account
...
31

Bond Interest Expense ($105,076 x 0
...
12 x ½) (-A)
6,000
To record interest payment and premium amortization
...
The premium
account now carries a balance of USD 4,330, or USD 5,076 - USD 746
...
10 x ½) (-SE)
5,216*
Premium on bonds payable (-L)
784
Cash ($100,000 x 0
...

*Rounded down
...
Long-term financing: Bonds

Discount and premium amortization schedules A discount amortization schedule (Exhibit 120) and a
premium amortization schedule (Exhibit 121) aid in preparing entries for interest expense
...
The
companies then refer to the schedules whenever they make journal entries to record interest
...
This fluctuation occurs because the carrying value to which a constant interest rate is
applied changes each interest payment date
...
However, the actual cash paid as interest is always a constant amount determined by multiplying the
bond's face value by the contract rate
...
The total interest expense of USD 40,767 for the discount situation in Exhibit 120 is equal to USD 36,000
(which is six USD 6,000 payments) plus the USD 4,767 discount
...
In Exhibit 121, total interest expense in the premium situation is USD 30,924, or USD
36,000 (which is six USD 6,000 payments) less the USD 5,076 premium
...

Adjusting entry for partial period Exhibit 120 and Exhibit 121 also would be helpful if Carr must accrue
interest for a partial period
...
Using the information provided in the premium amortization schedule (Exhibit 121), the
adjusting entry needed on 2010 August 31 is:
2010
Aug
...


1,751
249
2,000

606

This book is licensed under a Creative Commons Attribution 3
...
14 x ½)

(C)
Cash credit
($100,000 x
0
...
The first line of Exhibit 121 shows the interest expense and premium amortization for the six months
...
Carr would
record the remaining four months' interest when making the first payment on 2010 December 31
...
31 Bond interest payable (-L)
Bond interest expense ($5,254 x (4/6)) (-SE)
Premium on bonds payable ($746 x 4/6) (-L)
Cash (-A)
To record four months' interest expense and semiannual interest
payment
...
The
amounts would differ, however, because Carr uses the interest method of accounting for bond interest
...


Redeeming bonds payable
Bonds may be (1) paid at maturity, (2) called, or (3) purchased in the market and retired
...
Each action is either a redemption of bonds or the extinguishment of debt
...
The only entry required at maturity would debit Bonds Payable and credit Cash for the
face amount of the bonds as follows:
2013
June 30 Bond payable (-L)
Cash (-A)
To pay bonds on maturity date
...
10 x ½) 0
...


Exhibit 121: Premium amortization schedule for bonds payable

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...
The issuer may also
purchase bonds in the market and retire them
...
Assume that on 2012
January 1, Carr calls bonds totaling USD 10,000 of the USD 100,000 face value bonds in Exhibit 121 at 103, or USD
10,300
...
A look at the last column on the line dated 2011/12/31 in Exhibit 121 reveals that the carrying value of
the bonds is USD 102,723, which consists of Bonds Payable of USD 100,000 and Premium on Bonds Payable of
USD 2,723
...
The firm incurs a loss for the excess of the price paid for the bonds, USD 10,300, over their carrying
value, USD 10,272
...
1

Bond payable (-L)
10,000
Premium on bonds payable ($2,723/10) (-L)
272
Loss on bond redemption 9$10,272 - $10,300) 28
(-SE)
Cash (-A)
10,300
To record bonds redeemed
...
4, gains and losses from voluntary early retirement of bonds are
extraordinary items, if material
...
The FASB is currently reconsidering the reporting of these gains and losses as
extraordinary items
...
Assume that on 2002 June 30, Jasper Company issued USD 100,000 face value, 12
per cent serial bonds at 100
...
A total of USD 20,000 of
the bonds mature each year starting on 2010 June 30
...
Entries
required for 2010 for interest expense and maturing debt are:
2010
June

Bond interest expense ($100,000 x 0
...


30

Dec
...


31

20,000
20,000

Bond interest expense ($80,000 x 0
...


Note that Jasper calculates the interest expense for the last six months of 2010 only on the remaining
outstanding debt (USD 100,000 original issue less the USD 20,000 that matured on 2010 June 30)
...
Jasper reports the USD
20,000 amount maturing the next year as a current liability on each year-end balance sheet
...

Naturally, bond investors are concerned about the safety of their investments
...
This concern has led to provisions in some bond
indentures that require companies to make periodic payments to a bond redemption fund, often called a
sinking fund
...
0 License
accrued bond interest
...

To illustrate, assume Hand Company has 12 per cent coupon bonds outstanding that pay interest on March 31
and September 30 and were issued at face value
...
The entry for the payment to the trustee is:
Sept
...


The trustee calls USD 50,000 of bonds, pays for the bonds and accrued interest, and notifies Hand
...
Assuming no interest has been recorded on these
bonds for the period ended September 30, the entries are:
Sept
...

30 Sinking fund expense (-SE)
Cash (-A)
To record trustee fee and expenses
...
Hand would describe the USD 50,000 of bonds that must be retired during
the coming year as "Current maturity of long-term debt" and report it as a current liability on the balance sheet
...
A sinking fund usually is contractual (required by
the bond indenture), and an appropriation of retained earnings is simply an announcement by the board of
directors that dividend payments will be limited over the term of the bonds
...
Also, even if the
indenture does not require a sinking fund, the corporation may decide to (1) pay into a sinking fund and not
appropriate retained earnings, (2) appropriate retained earnings and not pay into a sinking fund, (3) do neither, or
(4) do both
...
In accounting for the conversions of convertible bonds, a company treats
the carrying value of bonds surrendered as the capital contributed for shares issued
...
Each USD 1,000 bond is convertible into
50 shares of the issuer's USD 10 par value common stock
...
The entry required is:
May 1

Bond payable (-L)
10,000
Discount bonds payable (+L)
200
Common stock ($10,000/$1,000 = 10 bonds;
10 bonds x 50 share x $10 par) (+SE)
5,000
Paid-in capital in excess of par value – common
4,800
(+SE)
To record bonds converted to common stock
...
It credits Common Stock for the par value of

Accounting Principles: A Business Perspective

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...
The excess amount (USD 4,800) is credited to Paid-In Capital in
Excess of Par Value—Common
...
The residence of any person can only be called
between 8 am and 9 pm, without their prior consent
...
Also, a centralized "Do-not-call" list of people who do not wish to receive solicitations must
be maintained and honored
...
A2
...
The
bonds are rated as to their riskiness
...
As a company's
prospects change over time, the ratings of its outstanding bonds change because of the higher or lower probability
that the company can pay the interest and principal on the bonds when due
...

Bond prices appear regularly in certain newspapers
...
6

Price
113

Change
-2

The bonds carry a coupon rate of 7° per cent
...
The current price is USD 113 per
hundred, or USD 1,130
...
The price the preceding day was USD 115, since the change was
-2
...
6 per cent
...
Thus, if the market rate of interest increases, the market price of
bonds decreases, and vice versa
...
0 License

An accounting perspective:
Business insight
Companies sometimes invest in the bonds of other companies
...

115 (covered in Chapter 14), investments in these bonds fall into three categories—trading
securities, available-for-sale securities, or held-to-maturity securities
...
If the bonds were to be held for a longer period of time, but not until maturity, they
would be classified as available-for-sale securities
...
All trading securities are current assets
...
Discounts and premiums on bonds classified as trading and available-for-sale securities are
not amortized because management does not know how long they will be held
...
Discounts and premiums on bonds classified as held-to-maturity
securities are amortized by the holder of the bonds in the same manner as for the issuer of the
bonds
...


Analyzing and using the financial results—Times interest earned ratio
The times interest earned ratio (or interest coverage ratio) indicates the ability of a company to meet
required interest payments when due
...
To find IBIT
when the income statement is not complex, take net income and add back interest expense and taxes
...
The higher
the ratio, the more comfortable creditors feel about receiving interest payments in the future
...
One brother
served as president of the company, and the other two brothers served as vice presidents
...
Located in Jamesville, New York, USA, the company had provided steady

Accounting Principles: A Business Perspective

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...
The city had benefited from the
revenues the company attracted to the area and from the generous gifts provided by the father
...
No other stockholder held more than 4 per cent of the stock
...
The company has USD 10 million of 10 per cent bonds outstanding, which
mature in 15 years
...
They
also were frustrated by the fact that they did not own a controlling interest (more than 50 per cent)
of the company
...

With the assistance of a New York City brokerage house, the brothers decided to pursue a plan that
could increase their wealth
...
These shares would then be canceled, and the Rawlings brothers would have a
controlling interest
...
The brokerage house had located some financial institutions willing to buy the
bonds
...
The brothers
thought the company could make these payments unless the country entered a recession
...
If the junk bonds could be paid at maturity, the brothers would own a controlling
interest in what could be an extremely valuable company
...
The risks are high, but so are the potential rewards
...
Two of the brothers hoped that another buyer might bid as much as USD 50 per
share so they could sell their shares and pursue other interests
...

The times interest earned ratios in a recent year for several companies (described in footnotes to the table) were
as follows:
Earnings before
Interest
Times Interest
Interest and
Expense
Earned
Company
Taxes (millions)
(Millions)
Ratio
Ford Mother Companya
$19,136
$10,902
1
...
67
AMR Corporationc
1,754
467
3
...
96
Hewlett-Packard Companye
4,882
257
19
...

B
Proctor and Gamble markets more than 300 brands to nearly five billion customers in over 140 countries
...

d
Dell is the world's largest direct computer systems company
...


You can see from these data that a great deal of variability exists in the times interest earned ratios for real
companies
...

612

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...
Other companies
with high-interest bonds issued new low-interest bonds and used the proceeds to retire the high-interest bonds
...
This statement shows the cash inflows and outflows from operating, investing, and financing activities
...

• A stock is a unit of ownership on which a dividend is paid only if declared, and dividends are not deductible

in determining net income or taxable income
...

• Advantages include stockholders retaining control of the company, tax deductibility of interest, and

possible creation of favorable financial leverage
...

• If bonds are issued at face value on an interest date, no accrued interest is recorded
...

• If the market rate is lower than the contract rate, bonds sell for more than their face value, and a premium

is recorded
...

• The present value of the principal plus the present value of the interest payments is equal to the price of the

bond
...

• The effective rate of interest is used to discount the future payment of principal and of interest back to the

present value
...
For bonds issued at a discount,

Discount on Bonds Payable is also debited
...
For bonds issued between interest dates, Bond Interest Payable is also credited
...

• Under the effective interest rate method, interest expense for any period is equal to the effective (market)

rate of interest at date of issuance times the carrying value of the bond at the beginning of that interest period
...

• When bonds are redeemed before they mature, a loss or gain (an extraordinary item, if material) on bond

redemption may occur
...


Accounting Principles: A Business Perspective

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...
The carrying value of the bonds is the capital contributed for

shares of stock issued
...

• The two leading bond rating services are Moody's Investors Services and Standard & Poor's Corporation
...
For instance, the highest rating is Aaa (Moody's) and AAA

(Standard & Poor's)
...

• The ratio is equal to income before interest and taxes (IBIT) divided by interest expense
...

• Present value is the current worth of a future cash receipt and is the reciprocal of future value
...


Appendix: Future value and present value
Managers apply the concepts of interest, future value, and present value in making business decisions
...


The time value of money
The concept of the time value of money stems from the logical reference for a dollar today rather than a dollar at
any future date
...

Most business decisions involve a comparison of cash flows in and out of the company
...
That is, the dollars held now must be
accumulated or rolled forward, or future dollars must be discounted or brought back to the present dollar value,
before comparisons are valid
...


Future value
The future value or worth of any investment is the amount to which a sum of money invested today grows
during a stated period of time at a specified interest rate
...
Simple interest is interest on principal only
...
The principal of USD 1,000, plus 2
X USD 120, is equal to USD 1,240
...

For example, USD 1,000 invested for two years at 12 per cent compounded annually grows to USD 1,254
...
12 =
Value at end of year 1
Interest, year 2 = $1,120 x 0
...
00
120
...
00
134
...
40

In Exhibit 122, we graphically portray these computations of future worth and show how USD 1,000 grows to
USD 1,254
...
The effect of compounding is USD 14
...
12 = USD
14
...

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...
An example is Table A
...
To use the Appendix tables,
first determine the number of compounding periods involved
...
The number of
compounding periods is equal to the number of years in the life of the investment times the number of
compoundings per year
...

Second, determine the interest rate per compounding period
...
Divide the annual rate
by the number of compounding periods per year to get the proper rate per period
...
All other cases involve a lower rate
...

To use the tables, find the number of periods involved in the Period column
...
The factor
shows the amount to which an investment of USD 1 will grow for the periods and the rate involved
...
For example,
suppose your parents tell you that they will invest USD 8,000 at 12 per cent for four years and give you the amount
to which this investment grows if you graduate from college in four years
...
1
...
57352
...
16,
the answer to the first question
...
The factor is 1
...
68
...
68 - USD 12,588
...
52 to the value of your investment
...

An annuity is a series of equal cash flows (often called rents) spaced equally in time
...
Assume that USD 100 will be
received at the end of each of the next three semiannual periods
...
Using Table A
...
Long-term financing: Bonds

Exhibit 122: Compound interest and future value
Future value (after three periods) of $100
received at the end of the First period:
Second period:
Third period:
Total future value

1
...
36
1
...
00
1
...
00
$318
...
Fortunately, tables are
available to calculate the total future value directly
...
2
...
The factor is 3
...
36, which is the same answer
...


Present value
Present value is the current worth of a future cash receipt and is the reciprocal of future value
...
In present value, we calculate the current worth of
rights to future cash receipts possessed now
...

Assume that you have the right to receive USD 1,000 in one year
...
You also know that
the USD 1,000 due in one year is equal to some amount, P, plus interest on P at 12 per cent for one year
...
12P = USD 1,000, or 1
...
Dividing USD 1,000 by 1
...
86; this amount is the
present value of your future USD 1,000
...
86 by 1
...
20
...

Table A
...
We use Table A
...
1
...
29, computed as USD 1,000 X 0
...
The 0
...


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...
If
your investment increases at a 20 per cent rate compounded quarterly, how much should you invest now? To find
the amount, you would use the present value factor found in Table A
...
This
factor is 0
...
To have USD 4,000 at the end of three years, you must invest 4,000 times this factor
(0
...
36
...
As an example of calculating
the present value of an annuity, assume that USD 100 is received at the end of each of the next three semiannual
periods
...
By using Table A
...
89000 x 100 =
3 period: 0
...
34
89
...
96
$267
...
Long-term financing: Bonds

Exhibit 125: Present value of an annuity
Such a procedure could become quite tedious if the annuity consisted of a large number of payments
...
See the end-of-text Appendix, Table A
...
For the annuity just described, you can obtain a
single factor from the table to represent the present value of an annuity of USD 1 per period for three (semiannual)
periods at 6 per cent per (semiannual) period
...
67301; it is equal to the sum of the present value
factors for USD 1 due in one period, USD 1 in two periods, and USD 1 in three periods found in the Appendix, Table
A
...
When this factor is multiplied by USD 100, the number of dollars in each payment, it yields the present value of
the annuity, USD 267
...
In Exhibit 125, we graphically present the present value of this annuity and show how to
find the present value of the three USD 100 cash flows by multiplying the USD 100 by a present value of an annuity
factor, 2
...

Suppose you won a lottery that awarded you a choice of receiving USD 10,000 at the end of each of the next five
years or USD 35,000 cash today
...
Which
option should you choose? To answer the question, compute the present value of an annuity of USD 10,000 per
period for five years at 15 per cent
...
60, or USD 10,000 X 3
...
You should
accept the immediate payment of USD 35,000 since it has the larger present value
...
The
bonds are dated 2010 April 30, call for semiannual interest payments on April 30 and October 31, and are issued to
yield 16 per cent (8 per cent per period)
...
Compute the amount received for the bonds
...
Prepare an amortization schedule
...
Use the
effective interest rate method
...
Prepare journal entries to record issuance of the bonds, the first six months' interest expense on the bonds,
the adjustment needed on 2010 December 31 (assuming Jackson's accounting year ends on that date), and the
second six months' interest expense on 2011 April 30
...

Price received:
Present value of principal: $100,000 x 0
...
0 License
(see Appendix, Table A
...
92461
(see Appendix, Table A
...

(A)
Interest
Payment
Date
Issued price
2010/10/31
2011/4/30

(B)
Bond
Interest
Expense Debit
(E X 0
...
15 x ½)

(D)
Discount on
Bonds Payable
Credit
(B – C)

$7,523
7,525

$7,500
7,500

$23
25

(E)
Carrying Value
of Bonds Payable
(previous balance in
E + D)
$94,038
94,061
94,086

c
...
30

Cash
94,038
Discount on bonds payable
5,962
Bonds payable
100,000
Issued $100,000 face value of 20-year, 15% bonds to
yield 16%
...
31

Bond interest expense
Discount on bonds payable
Cash
Paid semiannual bond interest expense
...
31

Bond interest expense ($7,525 x (1/3))
Discount on bonds payable
Bond interest payable ($7,500 x (1/3))
To record accrual of two months' interest expense
...


2,500
5,017

2011
Apr
...

Bearer bond See unregistered bond
...
A bond certificate, a negotiable instrument, is the
formal, physical evidence of the debt owed
...

Bond redemption (or sinking) fund A fund used to bring about the gradual redemption of a bond issue
...

Call premium The price paid in excess of face value that the issuer of bonds must pay to redeem (call)
bonds before their maturity date
...
Sometimes referred to as net liability on the bonds
...

Contract rate of interest The interest rate printed on the bond certificates and specified on the bond
indenture; also called the stated, coupon, or nominal rate
...

Coupon bond A bond not registered as to interest; it carries detachable coupons that are to be clipped and
presented for payment of interest due
...

Discount (on bonds) Amount a bond sells for below its face value
...
Long-term financing: Bonds
Effective interest rate method (interest method) A procedure for calculating periodic interest expense
(or revenue) in which the first period's interest is computed by multiplying the carrying value of bonds
payable (bond investments) by the market rate of interest at the issue date
...
Computations for subsequent periods are based on the
carrying value at the beginning of the period
...

Favorable financial leverage An increase in EPS and the rate of return on stockholders' equity resulting
from earning a higher rate of return on borrowed funds than the fixed cost of such funds
...

Future value or worth The amount to which a sum of money invested today will grow during a stated
period of time at a specified interest rate
...

Junk bonds High-interest rate, high-risk bonds; many were issued in the 1980s to finance corporate
restructurings
...
Also called effective rate or yield
...
A bond secured by a mortgage is called a mortgage
bond
...

Present value The current worth of a future cash receipt(s); computed by discounting future receipts at a
stipulated interest rate
...

Secured bond A bond for which a company has pledged specific property to ensure its payment
...

Simple interest Interest on principal only
...

Stock warrant A right that allows the bondholder to purchase shares of common stock at a fixed price for a
stated period of time
...

Straight-line method of amortization A procedure that, when applied to bond discount or premium,
allocates an equal amount of discount or premium to each period in the life of a bond
...

Times interest earned ratio Income before interest and taxes (IBIT) divided by interest expense
...

Trading on the equity A company using its stockholders' equity as a basis for securing funds on which it
pays a fixed return
...

Underwriter An investment company or a banker that performs many tasks for the bond issuer in issuing
...

Unfavorable financial leverage Results when the cost of borrowed funds exceeds the revenue they
generate; it is the reverse of favorable financial leverage
...

Unsecured bond A debenture bond, or simply a debenture
...

An unsecured bond is called a debenture bond
...
0 License
Callable bonds may be called at the option of the holder of the bonds
...

If the market rate of interest exceeds the contract rate, the bonds are issued at a discount
...

Multiple-choice
Select the best answer for each of the following questions
...
The bonds are dated 2010 January
1, and were issued at 96 plus accrued interest
...

Cash
98,000
Discount on bonds payable 4,000
Bonds payable
Bonds interest payable
b
...


100,000
2,000

Cash
Bonds payable
Bond interest payable

100,000
2,000

102,000

Cash
96,000
Discount on bonds payable 4,000
Bonds payable

100,000

d
...

If the bonds in the first question had been issued at 104, the entry to record the issuance would have been:
a
...


c
...
None of the above
...
The bonds pay interest semiannually and mature on 2020 January 1
...
USD 36,113
...
USD 18,056
...
USD 32,000
...
USD 16,000
...
USD 39,170
...
USD 32,000
...
USD 18,000
...
Long-term financing: Bonds
d
...

Assume a company has net income of USD 100,000, income tax expense of USD 40,000, and interest expense of
USD 20,000
...
5 times
...
7 times
...
8 times
...
9 times
...


Questions
➢

What are the advantages of obtaining long-term funds by the issuance of bonds rather than
additional shares of capital stock? What are the disadvantages?

➢

What is a bond indenture? What parties are usually associated with it? Explain why
...


➢

What is meant by the term trading on the equity?

➢

When bonds are issued between interest dates, why should the issuing corporation receive cash equal
to the amount of accrued interest (accrued since the preceding interest date) in addition to the issue
price of the bonds?

➢

Why might it be more accurate to describe a sinking fund as a bond redemption fund?

➢

Indicate how each of the following items should be classified in a balance sheet on 2009 December
31
...


➢

Debenture bonds payable due in 2019
...


➢

First-mortgage bonds payable, due 2010 July 1
...


➢

First National Bank—Interest account
...


Convertible bonds payable due in 2012
...
Interest is paid semiannually on February
28 and August 31
...
Prepare journal entries to record the issuance
of these bonds, the accrual of interest at year-end, and the payment of the first interest coupon
...
0 License
Exercise B On 2009 December 31, East Lansing Office Equipment Company issued USD 1,600,000 face value
of 8 per cent, 10-year bonds for cash of USD 1,400,605, a price to yield 10 per cent
...

a
...

b
...

c
...

Exercise C Compute the annual interest expense on the bonds in the previous exercise, assuming the bond
discount is amortized using the straight-line method
...
, showed Bonds Payable of USD 300,000 and Premium on Bonds Payable of USD 10,572
...
The five-year, 12 per cent bonds have a face value of
USD 300,000 and were originally issued to yield 10 per cent
...
Use the interest method
...
)
Exercise E On 2010 June 30 (a semiannual interest payment date), Holiday Rollerblade Company redeemed
all of its USD 400,000 face value of 10 per cent bonds outstanding by calling them at 106
...
Prepare the journal entry to record the payment of the interest and the
redemption of the bonds on 2010 June 30
...
,
acquired USD 480,000 of its outstanding bonds on the open market at 96 plus accrued interest
...
The bonds are dated 2002
November 30, and pay semiannual interest on May 31 and November 30
...

Exercise G Cleveland Heating Systems, Inc
...
The bonds were issued at 100
...

Exercise H After interest was paid on 2010 September 30, USD 60,000 face value of Miami Video Rentals,
Inc
...

Prepare the journal entry to record the conversion, assuming the bonds were issued at 100
...

Exercise J What is the present value of a lump-sum payment of USD 20,000 due in five years if the market
rate of interest is 10 per cent per year (compounded annually) and the present value of USD 1 due in five periods at
10 per cent is 0
...
Long-term financing: Bonds
Exercise K What is the present value of a series of semiannual payments of USD 10,000 due at the end of each
six months for the next five years if the market rate of interest is 10 per cent per year and the present value of an
annuity of USD 1 for 10 periods at 5 per cent is 7
...
To his
amazement, he won USD 4,000,000
...
Mordino heard from relatives and friends he had not heard from in years
...
Federal and state income taxes were going to be about 40 per cent (36 per
cent for federal and 4 per cent for state) on each year's income from the lottery check
...

a
...
Is Mordino a multimillionaire according to the present value of his cash inflow after taxes?
c
...

Exercise M After Joe Mordino won USD 4,000,000 in the Georgia lottery, he decided to purchase USD 10,000
of lottery tickets at the end of each year for the next 20 years
...
If the state can earn 12 per cent on ticket revenue received, how much will the annuity of USD 10,000 from
Mordino grow to by the end of 20 years?
Problems
Problem A On 2009 June 1, Economy Auto Parts, Inc
...
Interest on bonds is payable semiannually on presentation of the appropriate coupon
...
The company's accounting period ends on June 30, with
semiannual statements prepared on December 31 and June 30
...

All of the first coupons on the bonds are presented to the company's bank and paid on 2009 October 2
...

Prepare all necessary journal entries for these transactions through 2010 April 1, including the adjusting entry
needed at 2009 June 30
...
, is going to issue USD 400,000 face value of 10 per cent, 15-year
bonds
...

a
...
Also, compute the
first six months' interest, assuming the bonds are issued at this price
...

b
...

Problem C On 2009 July 1, South Carolina Table Company issued USD 600,000 face value of 10 per cent, 10year bonds
...
The company received
cash of USD 531,180, a price that yields 12 per cent
...
Prepare journal entries (to the nearest dollar) to record
the bond interest expense on 2010 January 1, and the adjustment needed on 2010 March 31, using the interest
method
...


624

This book is licensed under a Creative Commons Attribution 3
...

The bonds are dated 2010 July 1, call for semiannual interest payments on July 1 and January 1, and were issued to
yield 12 per cent (6 per cent per period)
...
Compute the amount received for the bonds
...
Prepare an amortization schedule similar to that in Exhibit 121
...
Use the interest method
...
Prepare journal entries to record issuance of the bonds, the first six months' interest expense on the bonds,
and the adjustment needed on 2011 May 31, assuming the company's fiscal year ends on that date
...
The bonds are dated 2009 October 1, call for semiannual interest payments on April 1 and October
1, and are issued to yield 16 per cent (8 per cent per period)
...
Compute the amount received for the bonds
...
Prepare an amortization schedule similar to that in Exhibit 121
...
Use the interest method and make all calculations to the nearest dollar
...
Prepare entries to record the issuance of the bonds, the first six months' interest on the bonds, and the
adjustment needed on 2010 June 30, assuming the company's fiscal year ends on that date
...
The bonds are dated 2009 July 1; call for semiannual interest payments on July 1 and January 1; and mature
at the rate of USD 120,000 per year, with the first maturity date falling on 2010 July 1
...

Prepare journal entries to record the interest payment of 2010 July 1; the maturing of USD 120,000 of bonds on
2010 July 1; and the adjusting entry needed on 2010 September 30
...

Alternate problems
Alternate problem A On 2009 December 1, New Jersey Waste Management Company issued USD 300,000
of 10-year, 9 per cent bonds dated 2009 July 1, at 100
...
All of the bonds are registered
...
Quarterly financial
statements are prepared
...
The deposit is made
the day before the checks are drawn
...

Alternate problem B Safe Toy Company is seeking to issue USD 800,000 face value of 10 per cent, 20-year
bonds
...

a
...
Also, compute the
first six months' interest assuming the bonds are issued at that price
...

b
...


Accounting Principles: A Business Perspective

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...
These bonds call for semiannual interest payments and mature on 2019 July 1
...

Assume that the company's fiscal year ends on March 31
...
Calculate all
amounts to the nearest dollar
...
The bonds are dated 2010 October 1, call for semiannual interest payments on April 1 and October
1, and are issued to yield 16 per cent (8 per cent per period)
...
Compute the amount received for the bonds
...
Prepare an amortization schedule similar to that in Exhibit 120
...
Use the interest method
...
Prepare journal entries to record issuance of the bonds, the first six months' interest expense on the bonds,
and the adjustment needed on 2011 May 31, assuming Creative Web Page's fiscal year ends on that date
...
, issued USD 100,000 face value of 10 per cent, 20-year
bonds on 2009 July 1
...

a
...

b
...
Enter data in the schedule for only the first
two interest periods
...

c
...

Alternate problem F Western Solar Energy Company issued USD 400,000 of 12 per cent bonds on 2009 July
1, at face value
...
The company's accounting period ends on
September 30
...
Prepare journal entries to record the interest expense and payment for the six months ending 2010 July 1; the
maturing of the bonds on 2010 July 1; and the adjusting entries needed on 2010 September 30
...
Show how the bonds would be presented in the company's balance sheet for 2010 September 30
...
The USD 3 million
expansion is expected to increase business volume substantially
...
6 million to USD 2
...
The income tax rate will be about 40 per cent
...
Interest expense on debt now outstanding is USD 70,000 per year
...
The USD 3 million needed can be obtained in two
alternative ways:
• Finance entirely by issuing additional shares of common stock at an expected issue price of USD 75 per

share
...
0 License
• Finance two-thirds with bonds, one-third with additional stock
...
The issue price of the stock would be USD 80 per share
...
(Hint: Calculate
earnings per share for last year and for future years under each of the alternatives
...
635
per cent of the principal amount plus accrued interest if redeemed prior to [a certain date], and at decreasing prices
thereafter
...
and are intended to retire, at par plus accrued interest, 75 per cent of the issue prior to
maturity
...
What does the term debentures mean?
b
...
Under what circumstances might the company want to increase the sinking fund payments?
Business decision case C The Wall Street Journal contained a table showing yield comparisons for groups of
corporate bonds
...
08%
7
...
94% 7
...
26
7
...
32%
5
...
91
8
...
45

7
...
25
10
...
93
7
...
25

8
...
49
10
...

a
...
For the high quality and medium quality bonds, what could account for the increase in the yield rates from
4/27 to 4/28? Take into consideration possible economic events
...
Which risk class of bonds was closest to its 52-week high on 4/28? What could have been the cause?
Annual report analysis D Refer to the Annual report appendix and determine the times interest earned ratio
for 2003 for The Limited
...
Prepare written comments on the results of
your analysis
...
50 per share at any time prior to maturity
...

Accounting Principles: A Business Perspective

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...
If you held one USD 1,000 bond, how many shares of stock would you receive if you converted the bond into
shares of stock? (Hint: You can use the principal amount of the bond to buy shares of stock at the stated price
...
Assume you held one USD 1,000 bond and the bond was called by the company at a price of 105 per cent of
the face amount
...

Ethics case – Writing experience F Refer to "An ethical perspective: Rawlings furniture company”
...
What motivates the brothers to pursue this new strategy?
b
...
How will workers, the city, the holders of the original bond issue, and the other present stockholders be
affected if the junk bonds are issued and are then defaulted?
d
...
What ethical considerations are involved?
Group project G In groups of two or three students, write a two-page, double-spaced paper on one of the
following topics:
The Use of Junk Bonds in the 1980s
Why Market Rates of Interest and Prices of Bonds Are Inversely Related
How a Company Can Force Conversion of Callable, Convertible Bonds
How Bond Sinking Funds Work
Do some library research on your topic and properly cite your sources
...
Your
paper should be neat, contain no spelling or grammatical errors, and be the result of several drafts
...
Your paper should have a cover page with the title and the
authors' names
...
21 (from a
faculty member or from the library) relating to the amortization of premiums and discounts on bonds
...
Which method do you favor and why? Summarize the highlights of the APB Opinion and
your own opinions in a written report to your instructor
...
You should read the notes to the financial statements to determine the
composition of the long-term debt
...
g
...
Compare the bonds outstanding for the three companies
...

Using the Internet—A view of the real world
Visit the following site for the Eastman Kodak Company:
http://www
...
com
By following the instructions on the screen, locate the notes to the financial statements and find the one
pertaining to long-term debt
...

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This book is licensed under a Creative Commons Attribution 3
...
eastman
...
Then investigate long-term borrowings
...
This
experience is all part of learning to use the Internet
...
Check out the notes to the financial statements for further information
...
Write a memo to your instructor summarizing your
findings
...
These unsecured bonds are called debenture bonds and are backed only by the general creditworthiness
of the issuer
...
Callable bonds may be called at the option of the issuer
...
This statement is the definition of favorable financial leverage
...
Unfavorable financial leverage will result if income before
interest and taxes is much lower than anticipated
...

True
...
By paying less than the face value, purchasers can earn the market rate of interest on the bonds
...
The effective interest rate method is the recommended method
...

Multiple-choice
a
...
Also, the accrued interest must be recognized (USD 100,000 X
12 per cent X 2/12 = USD 2,000)
...
The premium is USD 4,000, and the accrued interest is USD 2,000
...

b
...
11 X 1/2 ) = USD 18,056
...
The interest would have been (USD 400,000 X 0
...

c
...
This total
of USD 160,000 divided by interest of USD 20,000 = 8 times
...
0 License

16
...

• Describe the content of the statement of cash flows and where certain items would appear on the statement
...

• Prepare a statement of cash flows, under both the direct and indirect methods, showing cash flows from

operating activities, investing activities, and financing activities
...

• Analyze and use the financial results–cash flow per share of common stock, cash flow margin, and cash flow

liquidity ratios
...


A career in external auditing
In 1929 the Dow Jones Industrial Average fell 40 per cent over the period from September 3rd to October 29th
...
Some blamed accounting for the run-up in
prices and the subsequent crash
...
At the time, accounting practices and reporting procedures were not
well-established
...
Investors panicked and sold stocks in a
frenzy
...
The Dow did not reach pre-crash levels again
until 1954
...
The SEC requires all listed firms in each year
to prepare financial statements in accordance with generally accepted accounting principles (GAAP) and to have
those financial statements audited by an independent party
...
If a company fails to follow GAAP,
it can be delisted from the stock exchange
...
It is the
job of auditors to use their understanding of accounting principles and business practices to provide reasonable
assurance that financial statements are free from such manipulation
...
Accrual earnings are typically easier to manipulate because they employ estimates,
whereas cash earnings are tied to actual cash receipts and payments from operations
...
Analysis using the statement of cash flows
managed upward by recognizing earnings prematurely (or falsely) or by underestimating expenses such as
depreciation expense or bad debts expense
...
Students can work for global auditing firms or small local firms, choose to travel frequently or on
a limited basis, and decide to live in any geographic area around the world
...
Companies realize that their auditors can be a valuable part of the
management team
...
Auditors
commonly leave the auditing profession to work for one of their many clients
...
Such questions include: How much
cash was generated by the company's operations? How can the Cash account be overdrawn when my accountant
said the business was profitable? Why is such a profitable company able to pay only small dividends? How much
was spent for new plant and equipment, and where did the company get the cash for the expenditures? How was
the company able to pay a dividend when it incurred a net loss for the year?
In this chapter, you will learn about the statement of cash flows, which answers these questions
...


Purposes of the statement of cash flows
In November 1987, the Financial Accounting Standards Board issued Statement of Financial Accounting
Standards No
...
50 The Statement became effective for annual financial statements for
fiscal years ending after 1988 July 15
...
The statement of cash flows replaced the statement of changes in financial
position, on which funds were generally defined as working capital
...

The main purpose of the statement of cash flows is to report on the cash receipts and cash disbursements of an
entity during an accounting period
...
Another purpose of this statement
is to report on the entity's investing and financing activities for the period
...
Firms show the effects of significant investing and financing activities that do not affect cash in a
schedule separate from the statement of cash flows
...
This information is available only in bits and pieces from

50 FASB, Statement of Financial Accounting Standards No
...
,
1987)
...

U
...
A
...
Copies of the complete document are available from the FASB
...
0 License
the other financial statements
...

The statement of cash flows presents the effects on cash of all significant operating, investing, and financing
activities
...
The statement may show a flow of cash from operating activities large enough to finance all
projected capital needs internally rather than having to incur long-term debt or issue additional stock
...
Using the statement of cash flows, management may also recommend
to the board of directors a reduction in dividends to conserve cash
...

• Enterprise's ability to meet its obligations
...

• Enterprise's need for external financing
...

• Effects on an enterprise's financial position of both its cash and noncash investing and financing

transactions during the period (disclosed in a separate schedule)
...
Both inflows and outflows are included within each category
...

Operating activities generally include the cash effects (inflows and outflows) of transactions and other events
that enter into the determination of net income
...


Exhibit 126: Statement of cash flows—Basic content

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...
g
...
g
...

Investing activities generally include transactions involving the acquisition or disposal of noncurrent assets
...
Cash outflows for investing activities include cash paid: (1) to purchase property, plant, and
equipment; (2) to purchase available-for-sale and held-to-maturity securities; and (3) to make long-term loans to
others
...
Cash inflows from financing activities include cash received from issuing capital
stock and bonds, mortgages, and notes, and from other short- or long-term borrowing
...
Payment of interest is not included because interest expense
appears on the income statement and is, therefore, included in operating activities
...
These payments are
included in the operating activities section
...
The disclosure may be in narrative form
...
A separate schedule might appear as follows:
Schedule of noncash financing also investing activities:
$ 35,000
Mortgage note issued for acquiring land also buildings

633

This book is licensed under a Creative Commons Attribution 3
...


Cash flows from operating activities
Cash flows from operating activities show the net amount of cash received or disbursed during a given
period for items that normally appear on the income statement
...
The direct method deducts from cash sales only those operating expenses that
consumed cash
...
Alternatively, the
indirect (addback) method starts with accrual basis net income and indirectly adjusts net income for items that
affected reported net income but did not involve cash
...
95 encourages use of the direct method but permits use
of the indirect method
...
The American Institute of Certified Public Accountants
reports that approximately 98 per cent of all companies choose the indirect method of cash flows
...
For instance, assume that sales
are stated at USD 100,000 on an accrual basis
...
The direct method also converts
all remaining items on the income statement to a cash basis, as we will illustrate later
...

The most common example of an operating expense that does not affect cash is depreciation expense
...

This transaction has no effect on cash and, therefore, should not be included when measuring cash from operations
...

Under the indirect method, since net income is a starting point in measuring cash flows from operating activities,
depreciation expense must be added back to net income
...
Company A had net income for the year of USD 20,000 after deducting
depreciation of USD 10,000, yielding USD 30,000 of positive cash flows
...
Company B had a net loss for the year of USD 4,000 after deducting

Accounting Principles: A Business Perspective

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16
...
Although Company B experienced a loss, it had USD 6,000 of positive cash flows from
operating activities, as shown here:
Company Company B
A
Net income (loss)
$20,000
$(4,000)
Add depreciation expense (which did not require 10,000
10,000
use of cash)
Positive cash flows from operating activities
$30,000
$ 6,000

Company B's loss would have had to exceed USD 10,000 to generate negative cash flows from operating
activities
...
Besides depreciation, the items added back include
amounts of depletion that were expensed, amortization of intangible assets such as patents and goodwill,
amortization of discount on bonds payable, and losses from disposals of noncurrent assets
...
, an Internet-access provider, said it would have a positive cash flow
from operations for the first time in early 1997
...
95 per month
...
The company decided to abandon
this market and sell only to the more profitable corporate market
...

Source: "PSINet Sees Positive Cash Flow in '97; Likely Financial Boost Lifts Shares 24 per cent,"
The Wall Street Journal, Friday, December 27, 1996, p
...

To illustrate the addback of losses from disposals of noncurrent assets, assume that Quick Company sold a piece
of equipment for USD 6,000
...
The journal entry to record the sale is:
Cash (+A)
Accumulated depreciation
Loss on sale of equipment (-SE)
Equipment (-A)
To record disposal of equipment at a loss
...
Although Quick deducted the loss of USD 1,000 in calculating net income,
it recognized the total USD 6,000 effect on cash (which reflects the USD 1,000 loss) as resulting from an investing
activity
...

Certain revenues and gains included in arriving at net income do not provide cash; these items are noncash
credits or revenues
...
Such items include gains from disposals of noncurrent assets, income from investments carried
under the equity method, and amortization of premiums on bonds payable
...
0 License
To illustrate why we deduct the gain on the disposal of a noncurrent asset from net income, assume that Quick
sold the equipment just mentioned for USD 9,000
...


9,000
3,000

10,000
2,000

Quick shows the USD 9,000 inflow from the sale of the equipment on its statement of cash flows as a cash inflow
from investing activities
...
Since the USD 2,000 gain is also included in calculating net
income, Quick must deduct the gain in converting net income to cash flows from operating activities to avoid
double-counting the gain
...
We show these procedures
using the financial statements and additional data for Welby Company in Exhibit 128
...
The second step is to analyze all of
the noncurrent accounts and additional data for changes resulting from investing and financing activities
...

The direct method converts the income statement from the accrual basis to the cash basis
...
The accounts
involved are all current assets or current liabilities
...
For instance, salaries payable relates to
salaries expense, federal income tax payable relates to federal income tax expense, prepaid rent relates to rent
expense, and so on
...
Analysis using the statement of cash flows
Increase or – Decrease in
related prepaid expense

Noncash operating expenses (such as depreciation expense and amortization expense), revenues, gains, and
losses are reduced to zero in the cash basis income statement
...

2
...


Equipment purchased for cash during 2010 amounted to $20,000
...

Cash dividends declared and paid in 2010 totaled $4,000
...
0 License
Accrual Basis

Add

Deduct

Cash Basis
(Cash
activities)

Sales
$140,000
$10,000*
Cost of goods sold $100,00
$6,000† 4,000‡
$102,000
0
Operating expenses 25,000
2,000§
23,000
Depreciation
5,000
5,000
expense
______
-0$130,000
Net income
$10,000
* Increase in
Accounts
Receivable
...

‡ Decrease in
Merchandise
Inventory
...


Flows from
operating
$130,000

125,000
$ 5,000

Exhibit 129: Working paper to convert income statement from accrual basis to cash basis
As a general rule, an increase in a current asset (other than cash) decreases cash inflow or increases cash
outflow
...
When inventory increases, cost of goods sold on a cash basis increases
(increasing cash outflow)
...
(For example, a company not only paid for insurance expense but also paid cash to increase prepaid
insurance
...

An increase in a current liability increases cash inflow or decreases cash outflow
...

When an accrued liability (such as salaries payable) increases, the related operating expense (salaries expense) on a
cash basis decreases
...
) Decreases in current
liabilities have just the opposite effect on cash flows
...
The current assets and current liabilities affecting the income
statement items changed as follows:
Accounts receivable
Merchandise inventory
Accounts payable
Accrued liabilities payable

Increase Decrease
$10,000
$4,000
6,000
2,000

Thus, Welby converted its income statement to a cash basis as shown in Exhibit 129
...

Welby must analyze the effects of changes in current accounts (other than cash) on cash
...
Welby had only one such
item—depreciation expense of USD 5,000
...
Analysis using the statement of cash flows
Increase in accounts receivable
Decrease in merchandise inventory
Decrease in accounts payable
Increase in accrued liabilities payable
Depreciation expense
Net cash provided by operating activities

(10,000)
4,000
(6,000)
2,000
5,000

$5,000

Notice that both the direct and indirect methods result in USD 5,000 net cash provided by operating activities
...
All changes in current
liability accounts require the opposite treatment of the current asset changes
...
For current liabilities, add increases to net income, and deduct decreases from net
income
...
Remember that a change in a noncurrent account usually comes about because cash is received
or disbursed
...

• The analysis of the noncurrent accounts can begin with any of the noncurrent accounts; we begin by

reviewing the Retained Earnings account
...
The USD 6,000 increase in this account consists of USD 10,000 of net income less USD
4,000 of dividends paid
...
Bal
...

36,000

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...
We enter both net income and dividends on the statement of
cash flows in Exhibit 130, Part B
...
Thus, we enter the net income of USD 10,000 on the statement in the cash flows from
operating activities section
...

• The Equipment account increased by USD 20,000
...
The additional data indicate that USD 20,000 of equipment was purchased
during the period
...

• The USD 5,000 increase in the Accumulated Depreciation—Equipment account equals the amount of

depreciation expense in the income statement for the period
...

• The USD 30,000 increase in common stock resulted from the issuance of stock at par value, as disclosed in

the additional data (item 2) in Exhibit 128
...

After we have analyzed the noncurrent accounts, we can prepare the statement of cash flows from the
information generated
...
Part B shows the statement of cash flows for Welby using the indirect method
...
However, we believe you will gain a greater conceptual understanding by not
using a working paper
...
The format in the operating activities section differs for
the direct and indirect methods
...
The
indirect method makes these same adjustments but to net income rather than to each item in the income statement
...

The only item in the cash flows from investing activities section is the cash outflow of USD 20,000 for the
purchase of equipment
...

Two items are under the cash flows from financing activities section: The issuance of common stock resulted in a
cash inflow of USD 30,000 and the payment of dividends resulted in a cash outflow of USD 4,000
...
Other examples could result in a
decrease in cash for the year
...
However, if the indirect method is used and the
reconciliation is shown in the statement of cash flows, no such separate schedule is required
...

However, if the indirect method is used, the amount of interest and income taxes paid must be provided in
related disclosures, usually immediately below the statement of cash flows
...
Analysis using the statement of cash flows
A
...
Direct Method
Welby Company
Statement of cash flows
For the year ended 2010 December 31
Cash flows from operating activities:
Net income
Adjustments to reconcile net income to net
cash
Provided by operating activities:
Increase in accounts receivable
Decrease in merchandise inventory
Decrease in accounts payable
Increase in accrued liabilities payable
Depreciation expense
Net cash provided by operating activities
Cash flows from investing activities:
Purchase of equipment
Cash flows from financing activities:
Proceeds from issuing common stock
Paid cash dividends
Net cash provided by financing activities
Net increase (decrease) in cash

$10,000

(10,000)
4,000
(6,000)
2,000
5,000

$ 5,000
(20,000)

$ 30,000
(4,000)

26,000
$11,000

Exhibit 130: Statement of cash flows-Welby company
Supplemental cash flow information:
Interest paid
Income taxes paid

$ 200
8,000

Analysis of the statement of cash flows
Business students will benefit throughout their careers from knowing how to analyze a statement of cash flows
...
to illustrate the analysis
...

The example is adapted from a real USA company's recent annual report
...
We also include portions of Management's Discussion and Analysis of the 2010 statement of cash flows
...


Liquidity and capital resources
Net cash provided by operations increased 13 per cent to USD 1,101
...
3 in
2009 and USD 995
...
The increase in cash generated by operating activities in 2010 reflects the Company's
improved profitability and working capital management
...

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This book is licensed under a Creative Commons Attribution 3
...
8 to USD 3,476
...
The Company continued to focus on
enhancing its debt portfolio, resulting in the refinancing of a substantial portion of commercial paper and other
short-term borrowings to longer term instruments
...
6 loan agreement
and obtained a USD 487
...

As of 2010 December 31, USD 410
...
These
borrowings carry a Standard & Poor's rating of A1
...
The Company has additional sources of liquidity available in the form of lines of
credit maintained with various banks
...
8
...
The decrease is primarily the result of higher Company earnings in 2010 as well as effective working capital
management and lower acquisitions than in prior years
...
The Company
primarily uses market value analyses to evaluate its optimal capitalization
...
2 per cent of net sales in both 2010 and 2009 and were 5
...
Capital spending continues to be focused primarily on projects that yield high aftertax returns, thereby
reducing the Company's cost structure
...

Other investing activities in 2010, 2009 and 2008 included strategic acquisitions and equity investments
worldwide
...
2, USD 1,586
...
8, respectively
...
Aggregate
repurchases for the year approximated 6
...
3
...
Analysis using the statement of cash flows
(USD millions)
2010
Operating activities
Net income
$762
...
7)
Depreciation and
379
...
6)
other, net
Cash effects of changes in:
Receivables
(18
...
4)
Other current assets
-0Payables and accruals
133
...
0
operations
Investing activities
Capital expenditures
$ (550
...
2)
of cash acquired
Sale of marketable securities 31
...
4)
Net cash used for investing $ (604
...
5)
Proceeds from issuance of
1,292
...
3
investors
Dividends paid
(355
...
9)
Proceeds from exercise of
36
...
9)
by financing activities
Effect of exchange rate
$ (2
...
5
equivalents
Cash and cash equivalents at 250
...
0
end of year
Supplemental cash flow
information
Income taxes paid
$ 304
...
9
Non-cash consideration in
-0payment for acquisitions
Principal payments on ESOP (6
...
4

$ 696
...
9
360
...
9)
282
...
5)

77
...
9)
(31
...
9)
106
...
3

(60
...
4)
(9
...
1
$ 995
...
2)
(1,560
...
0)
(175
...
4

70
...
6)
37
...
9) $ (549
...
5)
1,464
...
0)
379
...
6

18
...
8)
(10
...
9

(296
...
5)
22
...
4

$ (411
...
2)

$ (3
...
6

$ 31
...
9

172
...
5

$ 203
...
0
274
...
7

$ 313
...
3
9
...
3)

(4
...
- Indirect method
Dividend payments were USD 355
...
8 in 2009 and USD 296
...

Internally generated cash flows appear to be adequate to support currently planned business operations,
acquisitions and capital expenditures
...

The Company is a party to various superfund and other environmental matters and is contingently liable with
respect to lawsuits, taxes and other matters arising out of the normal course of business
...
While it is possible that the
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...

Refer to Exhibit 131
...

Operating activities The company used the indirect method of calculating net cash provided by operations
...

The "restructured operations, net" item resulted from the fact that many companies restructured their
operations by closing plants and significantly reducing their work forces
...
Apparently, the company recognized a net gain in 2010
because it deducted the item from net income on the statement of cash flows
...

"Depreciation and amortization" includes depreciation on plant assets and amortization of intangible assets
...

The "deferred income taxes and other, net" item deduction from net income results primarily from the fact that
income tax expense on the income statement was lower than the actual income taxes paid in 2010
...

Receivables and inventories increased (causing cash to decrease), while other current assets remained about the
same
...
These changes are net of any amounts related to
acquisitions, dispositions, or amounts that are included elsewhere, such as in "restructured operations, net"
...

Investing activities "Capital expenditures" include the purchase of plant assets, such as new machinery and
equipment, to modernize production facilities
...
For instance, if funds are limited (and they normally are) and two capital investments (a
machine and a mainframe computer) are being considered, one yielding a 20 per cent return and the other yielding
a 25 per cent return, the company will normally select the one with the 25 per cent return
...

The company sold "marketable securities and other investments"
...
For fiscal years beginning after 1993 December 15, marketable
securities must be identified as trading securities, available-for-sale securities, or held-to-maturity securities
...
Held-to-maturity
securities were mentioned briefly in Chapter 15
...
As
mentioned earlier, the proceeds from sales and purchases of trading securities must be shown as cash flows from

Accounting Principles: A Business Perspective

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16
...

Financing activities The company paid off some old debt (USD 1,397
...
9 million)
...

The "proceeds from outside investors" resulted from the other participants in the formation of certain
businesses in which the company holds more than a 50 per cent share
...
Dividends paid increased each year for the period
2008 through 2010
...
Companies often buy back their own shares
because they (1) need the shares to issue to employees or officers under stock option plans, (2) want to bolster the
market price of the stock, or (3) hope to later sell the stock at a substantially higher price
...
Stock options are usually granted to employees to encourage them to
work efficiently to increase profitability, which should increase the market price of the stock
...
Normally, an option gives
the recipient the right to buy a certain number of shares at a stated price within a given time frame
...
Assume that the current market price is USD 38
...
Executives of companies have become
multimillionaires by exercising their stock options
...
, paid the
company between USD 22
...
8 million per year to exercise their stock options during the threeyear period
...

We will discuss some examples of the ways that the information in the statement of cash flows can be used by
management, stockholders, and creditors to make decisions
...
The next chapter shows a more complete analysis of the company's performance
...
You
have already read portions of "Management's Discussion and Analysis" concerning the information contained in
that statement
...
Thus, unless the company engages in a significant acquisition it will not have to sell more stock or
borrow more funds in the foreseeable future
...
5 million) with lower interest rate debt (USD 1,292
...
Many companies are doing this
same thing recently to take advantage of the low interest rates available
...
5 million) are comfortably covered by
net cash provided by operations (USD 1,101
...
Stockholders are undoubtedly pleased that the per share
dividend rate has increased each year during 2008 through 2010
...
8 million) to modernize its productive facilities
...
0 License
stock (USD 32
...
Any net reduction in the number
of shares outstanding will tend to increase earnings per share and help to increase the market price per share in the
future
...
These favorable factors might
induce present stockholders to retain their stock or even increase their holdings
...


A broader perspective:
Johnson & Johnson
Johnson & Johnson and Subsidiaries
Consolidated statements of cash flows
For the years ended 2000 June 30, 1999, and 1998
(USD millions)
Cash flows from operating activities
2000
Net earnings
$ 4,800
Adjustments to reconcile net earnings to cash flows:
Depreciation and amortization of property and intangibles 1,515
Purchased in-process research and development
54
Increase in deferred taxes
(167)
Accounts receivable reserves
33
Changes in assets and liabilities, net of effects from
acquisition of businesses:
Increase in accounts receivable
(451)
Decrease (increase) in inventories
125
Increase in accounts payable and accrued liabilities
57
Decrease in other current and non-current assets
143
Increase in other current and non-current liabilities
454
Net cash flows from operating activities
$ 6,563
Cash flows from investing activities
Additions to property, plant and equipment
$(1,646)
Proceeds from the disposal of assets
161
Acquisitions of businesses, net of cash acquired
(68)
Purchases of investments
(5,383)
Sales of investments
4,670
Other
(102)
Net cash used by investing activities
$ (2,368)
Cash flows from financing activities
Dividends to shareowners
$(1,724)
Repurchase of common stock
(973)
Proceeds from short-term debt
814
Retirement from short-term debt
(1,485)
Proceeds from long-term debt
4
Retirement from long-term debt
(28)
Proceeds from the exercise of stock options
292
Net cash (used by) provided by financing activities $(3,100)
Effect of exchange rate changes on cash and cash
(47)
equivalents
Increase (decrease) in cash and cash equivalents
1,048
Cash and equivalents, beginning of year
2,363
Cash and cash equivalents, end of year
$3,411

1999
4,167

1998
3,003

1,444
(7)
11

1,285
298
(297)
24

(671)
(333)
242
457
450
$ 5,760

(163)
(100)
646
142
153
$ 4,991

$(1,728) $(1,545)
35
108
(271)
(3,818)
(3,538) (1,005)
2,817
400
(257)
(205)
$ (2,942) $ (6,065)
$(1,479)
(840)
3,208
(4,063)
793
(176)
180
$(2,377)
(72)

$(1,305)
(930)
2,424
(226)
535
(471)
178
$205
24

369
(845)
1,994
2,839
$2,363 $ 1,994

Creditors An encouraging factor is the increasing amount of net cash provided by operations in 2010
...
8 million in lines of credit
...
The next section describes three ratios that can provide further analyses of
cash flows
...
Analysis using the statement of cash flows

Analyzing and using the financial results—Cash flow per share of common stock, cash
flow margin, and cash flow liquidity ratios
The information in the statement of cash flows provides a basis for analyzing financial results
...
The ratios shown below are results for Synotech, Inc
...
All dollar amounts are rounded to the nearest million
...
This ratio indicates the company's ability to pay
dividends and liabilities
...
The cash flow per share of common
stock ratios for the companies were:
Company

Synotech, Inc
...
C
...

The Walt Disney
Company
General Electric
Company

Net cash provided
by operating
activities
(millions)
$1,101
1,598
6,434

Average shares of
common stock
outstanding*
(millions)
147
262
2,092

Cash flow
per
share

22,690

9,893

2
...
49
6
...
08

*To determine the average number of shares, add the beginning and ending numbers outstanding and divide by
two
...
This
ratio is a measure of a company's ability to turn sales revenue into cash
...
The cash
flow margin ratios for the companies were:
Company

Net Cash provided
by operating
activities
(millions)
$1,101
1,598
6,434

Synotech, Inc
...
C
...

The Walt Disney
Company
General Electric Company22,690

Net sales Cash
(millions) flow
Margin
10,499
31,846
25,402

10
...
02%
25
...
72%

The cash flow liquidity ratio is equal to the total of cash, marketable securities, and net cash provided by
operating activities divided by current liabilities
...

The higher the ratio, the better
...

J
...
Penney, Inc
...
64 times

...
87 times

35,913

156,116


...
, seems to be in the strongest position, although all of the
companies are financially sound
...
On the third measure, Walt Disney seems to be in the strongest position
...
0 License
companies in its industry
...

(This source could also be used for comparisons of ratios in the next chapter
...

Understanding the learning objectives
• The statement of cash flows summarizes the effects on cash of the operating, financing, and investing

activities of a company during an accounting period
...

• Investors and creditors can assess the entity's ability to generate positive future net cash flows, to meet its

obligations, and to pay dividends, and can assess the need for external financing
...
The cash flows from operating activities can be
measured in two ways
...
The indirect method starts with net income and adjusts net income for items that affected
reported net income but did not involve cash
...

• Financing activities generally include the cash effects (inflows and outflows) of transactions and other

events involving creditors and owners
...
The FASB

recommends use of the direct method
...
A large majority of
companies use the indirect method
...
Either the direct or indirect method

may be used
...

• The third step is to arrange the information gathered in steps 1 and 2 into the format required for the

statement of cash flows
...

• "Management's Discussion and Analysis" in the annual report provides part of the analysis
...

• The cash flow per share of common stock ratio tests a company's ability to pay dividends and liabilities and

is equal to net cash provided by operating activities divided by the average number of shares of common stock
outstanding
...


Accounting Principles: A Business Perspective

648

A Global Text

16
...

• A work sheet can be used to assist in preparing a statement of cash flows
...

• The work sheet technique makes the recording of the effects of transactions on cash flows almost a mechanical

process
...
We use the
comparative balance sheets, income statement, and additional data for the Welby Company, shown on Exhibit 129,
as the basis for this example
...
While discussing the steps in preparing the working paper, we describe the
items and trace their effects in the entries
...
Notice that the debit items precede the credit items
...

• Write "Cash Flows from Operating Activities" immediately below the total of the credit items
...

Then write "Cash Flows from Investing Activities" and allow enough space for those items
...

• Enter entries for analyzing transactions in the second and third columns
...
We discuss these entries individually in the next section
...
You will have one pair of

totals for the balance sheet items and another pair for the bottom portion of the working paper
...

To complete the working paper in Exhibit 132, we must analyze the change in each noncash balance sheet
account
...
After we have made the proper entries to analyze all changes in noncash balance sheet accounts, the
working paper shows all activities affecting cash flows
...
An entry on the working paper debits Cash for USD 11,000 and credits
Increase in Cash for Year near the bottom of the schedule
...
The entry sets out the change in cash that the statement seeks to explain
...


649

This book is licensed under a Creative Commons Attribution 3
...
These accounts can be dealt with
in any order; first, we record the net income for the period and analyze the current assets (other than cash) and the
current liabilities
...

Entry 1 The income statement shows a net income for 2010 of USD 10,000
...

The next task is to analyze changes in current accounts other than Cash
...

Entry 2 We deduct the USD 10,000 increase in accounts receivable from net income when converting it to cash
flows from operating activities
...
To convert net income to a cash basis, we must deduct the USD 10,000
...
By debiting Accounts
Receivable for USD 10,000, we increase it from USD 20,000 to USD 30,000
...
We deduct the increase from net income
in converting it to cash flows from operating activities
...

Entry 4 records the effect of a decrease in accounts payable on net income in converting it to cash flows from
operating activities
...

Next, we analyze the changes in the noncurrent balance sheet accounts
...
You can find the depreciation expense (1) on the income statement, or (2) by solving for the
credit needed to balance the accumulated depreciation account on the balance sheet
...
Analysis using the statement of cash flows
Retained earnings 30,000
Totals
110,000
Cash flows from
operating activities
Net income
Increase in
accounts receivable
Decrease in
merchandise
inventory
Decrease in
accounts payable
Increase in
accrued liabilities
payable
Depreciation
expense

(9) 4,000
51,000
(1) 10,000

(2) 10,000

(3) 4,000
(4) 6,000
(5) 2,000
(6) 5,000

Cash flows from
investing activities:
Purchase of
equipment
Cash flows from
financing activities:
Proceeds from
issuing common
stock
Payment of cash
dividends
Increase in cash for
year

(1) 10,000 36,000
51,000
147,000

(7) 20,000

(8) 30,000

51,000
Accumulated Depreciation - Equipment
Beg
...

5,000
(6)
5,000
End
...

10,000

(9) 4,000
(0) 11,000
51,000

Exhibit 132: Working paper for statement of cash flows
Entry 7 We debit the Equipment account and credit "Purchase of Equipment" in the investing activities section
for the USD 20,000 cash spent to acquire new plant assets (equipment)
...
The entry
also explains the change in the Common Stock account
...
However,
we would report the total amount of cash received from the issuance of common stock as a single figure on the
statement of cash flows
...

Entry 9 We debit Retained Earnings and credit Payment of Cash Dividends for the USD 4,000 dividends
declared and paid
...
Notice
that on the statement of cash flows, the dividends must be paid to be included as a cash outflow from financing
activities
...
30,000
Bal
...
36,000
Bal
...

651

This book is licensed under a Creative Commons Attribution 3
...
Also
provided is the statement of income and retained earnings for the year ended 2010 June 30, with additional data
...
Additional equipment was purchased for USD 220,000
...

The USD 50,000 bank note was paid
...
Prepare a statement of cash flows—indirect method
...
Analysis using the statement of cash flows
b
...
Then prepare a partial
statement of cash flows—direct method, showing only the cash flows from operating activities section
...

Dells Company
Statement of cash flows
For the year ended 2010 June 30
Cash flows from operating
activities:
Net income
$ 70,000
Adjustments to reconcile net
income to net cash provided
by operating activities:
Increase in accounts
(60,000)
receivable
Increase in merchandise
(30,000)
inventory
Increase in prepaid rent
(10,000)
Increase in accounts
10,000
payable
Decrease in salaries payable (10,000)
Increase in federal income 10,000
taxes payable
Loss on sale of equipment 7,000
Depreciation expense
20,000
Net cash provided by
$7,000
operating activities
Cash flows from investing
activities:
Proceeds from sale of
$ 3,000
equipment
Purchase of equipment
(220,000)
Net cash used by investing
(217,000)
activities
Cash flows from financing
activities:
Proceeds from issuing
$250,000
common stock
Repayment of bank note
(50,000)
Dividends paid
(40,000)
Net cash provided by
160,000
financing activities
Net increase (decrease) in
$(50,000)
cash

b
...

B
Increase in merchandise inventory
...

D
Decrease in salaries payable
...
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E

Increase in prepaid rent
...

Dells Corporation
Partial Statement of cash flows- Direct Method
For the Year Ended 2010 June 30
Cash flows from operating activities:
Cash received from customers
$ 940,000
Cash paid for merchandise
(620,000)
Salaries and wages paid
(210,000)
Rent paid
(50,000)
Interest paid
(3,000)
Federal income taxes paid
(50,000)
Net cash provided by operating activities
$ 7,000
F

Key terms
Cash flow liquidity ratio Cash and marketable securities plus net cash provided by operating activities
divided by current liabilities
...

Cash flow per share of common stock ratio Net cash provided by operating activities divided by the
average number of shares of common stock outstanding
...

Direct method Deducts from cash sales only those operating expenses that consumed cash
...
Cash payments made to settle current liabilities such as accounts payable, wages payable, and
income taxes payable are not financing activities
...

Indirect method A method of determining cash flows from operating activities that starts with net income
and indirectly adjusts net income for items that do not involve cash
...

Investing activities Generally include transactions involving the acquisition or disposal of noncurrent
assets
...

Noncash charges or expenses Expenses and losses that are added back to net income because they do
not actually use cash of the company
...

Noncash credits or revenues Revenues and gains included in arriving at net income that do not provide
cash; examples include gains from disposals of noncurrent assets, income from investments carried under
the equity method, and amortization of premium on bonds payable
...

Statement of cash flows A statement that summarizes the effects on cash of the operating, investing, and
financing activities of a company during an accounting period
...
The statement of cash flows must be prepared each time an income statement is prepared
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

The statement of cash flows is one of the major financial statements
...

The direct method of calculating cash flows from operations is encouraged by the FASB and is the predominant
method used
...
Analysis using the statement of cash flows
Issuance of capital stock and the subsequent reacquisition of some of those shares would both be financing
activities
...

Which of the following statements is true?
a
...

b
...

c
...

d
...

Investing activities include all of the following except:
a
...

b
...

c
...

d
...

If sales on an accrual basis are USD 500,000 and accounts receivable increased by USD 30,000, the cash
received from customers would be:
a
...

b
...

c
...

d
...

Assume cost of goods sold on an accrual basis is USD 300,000, accounts payable increased by USD 20,000, and
inventory increased by USD 50,000
...
USD 370,000
...
USD 230,000
...
USD 270,000
...
USD 330,000
...
The amount of cash flows from operating activities is:
a
...

b
...

c
...

d
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
0 License
➢

Which activities are generally included in operating activities?

➢

Which activities are included in investing activities?

➢

Which activities are included in financing activities?

➢

Where should significant investing and financing activities that do not involve cash flows be
reported?

➢

Explain the difference between the direct and indirect methods for computing cash flows from
operating activities
...


➢

Depreciation is sometimes referred to as a source of cash
...


➢

Why is it unlikely that cash flows from operating activities will be equal to net income for the same
period?

➢

If the net income for a given period is USD 25,000, does this mean there is an increase in cash of the
same amount? Why or why not?

➢

Why might a company have positive cash flows from operating activities even though operating at a
net loss?

➢

Indicate the type of activity each of the following transactions represents (operating, investing, or
financing) and whether it is an inflow or an outflow
...


➢

Issued capital stock
...


➢

Paid cash dividends
...


➢

Sold available-for-sale securities
...


➢

Paid interest on loan
...


➢

Received proceeds of insurance settlement
...


Made contribution to charity
...
Answer the following questions:
➢
➢

Was there a net negative or positive cash flow from investing activities?

➢
➢

What was the major investing activity in 2003?
Was the positive cash flow from operating activities large enough to pay the cash dividends?

Real world question Refer to The Limited in the Annual report appendix
...
Analysis using the statement of cash flows
Exercises
Exercise A Indicate how the following data should be reported in a statement of cash flows
...
A building was acquired for USD 2,500,000 by assuming a mortgage on the building
...
The
balances in Merchandise Inventory and Accounts Payable were:
2010 January 1
Merchandise inventory
Accounts payable

$160,000
44,000

2010 December
31
$180,000
36,000

Calculate the amount of cash paid for merchandise for 2010
...
Compute the cash flows from operating activities
under the indirect method
...
Net income was USD 350,000
...
Compute
the cash flows from operating activities under the indirect method
...
What amount appears for dividends paid in the statement of cash flows?
Exercise G Following are balance sheet data for Quality Merchandise, Inc
...
Compute the cash spent to purchase plant
assets, assuming no assets were sold or scrapped in 2011
...
Assume the net income for 2011 was USD 24,000,
depreciation was USD 15,000, and dividends declared and paid were USD 6,000
...
Prepare a statement of cash flows—indirect method
...

Exercise I The following data are from a company's Automobile and the Accumulated Depreciation—
Automobile accounts:
657

This book is licensed under a Creative Commons Attribution 3
...
1
July 1
Jan
...
31

Automobile
Balance brought forward
Traded for new auto
New auto
Accumulated depreciation Balance brought forward
One-half year's depreciation
Auto traded
One-half year's depreciation

Debit

Credit Balance
16,000
16,000 -0-

31,000
Automobile
2,000
14,000

4,000

12,000
14,000
-04,000

The old auto was traded for a new one, with the difference in values paid in cash
...

Indicate the dollar amounts, the descriptions of these amounts, and their exact locations in a statement of cash
flows—indirect method
...
, follow:
Dunbar Carpet Outlet, Inc
...

a
...

b
...

c
...
You need not prepare a
working paper
...
:
Cellular Telephone Sales, Inc
...
Analysis using the statement of cash flows
Accrued liabilities payable
Long-term note payable
Common stock ($5 par)
Paid-in capital in excess of par
Retained earnings
Total liabilities and stockholders' equity

2,000
150,000
185,000
32,500
91,500
$510,330

8,250
150,000
165,000
-087,450
$489,000

Land was bought for USD 37,500 cash
...
Currently the
company leases a building for its operations
...

Depreciation expense for the year was USD 37,500
...

Dividends declared and paid in 2011 totaled USD 32,950
...

The company paid interest of USD 3,000 and income taxes of USD 17,000
...
Also prepare any necessary supplemental
schedule(s)
...
, is leading business software company
...
2 billion in revenues
...
Then the relevant portion of
Management's Discussion and Analysis of the statement of cash flows is provided
...
0 License
Increase in capitalized development costs and
other
Net cash used in investing activities
Financing activities:
Dividends
Purchases of treasury stock
Proceeds from borrowings
Repayment of borrowings
Exercise of common stock options and other
Net cash provided by (used in) financing
activities
(Decrease) Increase in cash and cash
equivalents before effect of exchange rate
changes on cash
Effect of exchange rate changes on cash
(Decrease) Increase in cash and cash
equivalents
Cash and cash equivalents – Beginning of
year
Cash and cash equivalents – End of the
year

(49)

(36)

(29)

$ (524)

$ (3,606) $ (944)

$ (47)
(449)
1,049
(1,981)
50
$ (1,378)

$ (43)
--3,672
(776)
96
$ 2,949

$ (44)
(1,090)
2,141
(1,216)
38
$ (171)

$ (519)

$ 909

$ 152

(25)
$ (544)

(1)
$ 908

(4)
$ 148

1,307

399

251

$ 763

$ 1,307

$ 399

Management's discussion and analysis
Liquidity and capital resources
Cash, cash equivalents and marketable securities totaled USD 850 million at 2004 March 31, a decrease of USD
537 million from the 2003 March 31 balance of USD 1,387 million
...

Cash generated from operations for fiscal year 2001 was USD 1,383 million, a decrease of USD 183 million from the
prior year's cash from operations of USD 1,566 million
...

The Company's bank credit facilities consist of a USD 1 billion four-year revolving credit facility, a USD 2 billion
four-year term loan, and a 75 million British Pound Sterling denominated 364-day term loan
...
3 billion 364-day and four-year revolving credit
agreements
...
3 billion 364-day
revolving credit facility when it expired in May 2004
...
There are no
drawings under the Company's USD 1 billion four-year revolving credit facility
...
In addition, the Company established a USD 1 billion US Commercial Paper ("CP") program in the first
quarter of this year to refinance some of its debt at more attractive interest levels
...

The Company also utilizes other financial markets in order to maintain its broad sources of liquidity
...
75 billion of unsecured Senior Notes were issued in a transaction governed by Rule 144A of the
Securities Act of 1933
...
25 per
cent due 2006 April 15, USD 825 million at 6
...
5 per cent
due 2011 April 15
...
77 per cent
Senior Notes
...

Accounting Principles: A Business Perspective

660

A Global Text

16
...
These lines total USD 56 million, of which USD 14 million was
drawn as of 2004 March 31
...
The Company's Commercial Paper program is rated
A-2 from Standard & Poor's and P-2 from Moody's
...
4 billion with a weighted-average interest rate of 7
...

As of 2004 March 31, the cumulative number of shares purchased under the Company's various open market
Common Stock repurchase programs, including almost 16 million shares purchased in the current fiscal year, was
166 million
...

Capital resource requirements as of 2004 March 31 consisted of lease obligations for office space, computer
equipment, mortgage or loan obligations and amounts due as a result of product and company acquisitions
...

The Company expects its long-standing history of providing extended payment terms to customers to continue
under the new business model and thus does not expect a change to its future cash flow, since customers are
expected to continue to finance their purchases over the contract period
...
Explain how the company could have a net loss in 2004 and yet have a positive net cash provided by operating
activities
...
What was the reason given by management for repaying all outstanding amounts under revolving credit
agreements
...
What is the interest rate on borrowings?
d
...
Does the amount of cash provided by operating activities seem large enough to continue the present dividend
payments?
f
...

Average number of shares of common stock outstanding
Net sales
Cash and marketable securities
Current liabilities

(in millions)
583
4,198
850
2,286

Problem D Mechan Company develops, manufactures, markets, installs and supports a wide range of
standards-based LAN and WAN connectivity hardware and software products
...
Then the relevant portion of Management's Discussion and Analysis of the
statement of cash flows is provided
...
0 License
Depreciation and amortization
32,061
Provision for losses on accounts receivable
356
Loss on disposals of property, plant and equipment
93
Deferred taxes
(38,766)
Changes in assets and liabilities:
Accounts receivables
(55,101)
Inventories
(50,483)
Prepaid expenses and other assets
(18,844)
Accounts payable and accrued expenses
62,908
Income taxes payable
3,705
Net cash provided by operating activities
$100,347
Cash flows from investing activities:
Capital expenditures
$ (65,035)
Purchase of available-for-sale securities
(79,427)
Purchase of held-to-maturity securities
(205,852)
Materials of marketable securities
208,922
Net cash used in investing activities
$(141,392)
Cash flows from financing activities:
Repayment of notes receivable from stockholders
$ 174
Repurchase of common stock
(1,173)
Tax benefit of options exercised
7,215
Common stock issued to employee stock purchase plan
3,323
Proceeds from stock option exercise
16,021
Net cash provided by (used for) financing activities $ 25,560
Effect of exchange rate changes on cash
$ 166
Net increase (decrease) in cash and cash equivalents $ (15,319)
Cash and cash equivalents, beginning of year
114,032
Cash and cash equivalents, end of year
$ 98,713
Cash paid during the year for:
Income taxes
$ 105,233

26,832
72
174
(4,434)

17,335
1,734
113
(6,151)

(27,698)
(23,080)
(3,123)
11,336
10,476
$152,529

(17,707)
(8,758)
1,211
22,003
(3,924)
$125,074

$ (63,091)
(71,598)
(282,712)
323,682
$ (93,719)

$ (39,399)
(30,097)
(258,517)
197,406
$(130,607)

$ 131
(13,070)
5,712
2,287
4,887
$ (53)
$ 712
$ 59,469
54,563
$ 114,032

$ 66
--6,980
1,637
7,185
$ 15,868
$ 161
$ 10,469
44,067
$ 54,563

$ 68,420

$ 67,263

Management's discussion and analysis
Net cash provided by operating activities was USD 100
...
5 million
in fiscal 2009 and USD 125
...

Capital investment for fiscal 2010 of USD 65
...
8 million for building costs of which USD
3
...
4 million for engineering computer and computer
related software and equipment, USD 5
...
0 million
for expanding global sales operations
...
1 million included
approximately USD 8
...
5 million for manufacturing and manufacturing support
equipment and USD 15
...
Another USD 15
...
During fiscal 2008, capital expenditures of USD
39
...
9 million on buildings, USD 10
...
8 million
on manufacturing capacity expansions and USD 2
...

Cash, cash equivalents and marketable securities increased during fiscal 2010 to USD 407
...
9 million in the prior fiscal year
...
2 million,
maturing in approximately 1
...

At 2010 February 29, the Company did not have any short or long term borrowing or any significant financial
commitments outstanding, other than those required in the normal course of business
...

a
...
Analysis using the statement of cash flows
b
...
Did current liabilities increase or decrease during the year ended 2010 February 29?
d
...
What was the main source of cash from financing activities during the three-year period?
f
...
Given the following data, calculate the cash flow per share of common stock ratio, the cash flow margin ratio,
and the cash flow liquidity ratio
...
:
Dayton Tent & Awning Sales, Inc
...

Depreciation for the year was USD 356,850
...
The land was sold for USD 46,800
...
The amount of cash paid was USD 778,050
...

Fully depreciated machinery with a cost of USD 58,500 was scrapped and written off
...
The total proceeds were USD 1,228,500
...

A payment was made on the bank loan, USD 9,750
...

a
...


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...
Prepare a statement of cash flows under the indirect method
...

Alternate problems
Alternate problem A The following income statement and other data are for Kennesaw Auto Glass
Specialists, Inc
...

Income Statement
For the year ended 2010 December 31
Sales
$450,000
Cost of goods sold
125,000
Gross margin
$325,000
Operating expenses (other than depreciation) $60,000
Depreciation expense
20,000 80,000
Net income
$245,000

Changes in current assets (other than cash) and current liabilities during the year were:
Increase
$15,000

Accounts receivable
Merchandise inventory
Prepaid insurance
Accounts payable
Accrued liabilities payable

8,000
4,000

Decrease
$25,000
15,000

Depreciation was the only noncash item affecting net income
...
Prepare a working paper to calculate cash flows from operating activities under the direct method
...
Prepare the cash flows from operating activities section of the statement of cash flows under the direct
method
...
Prove that the same cash flows amount is obtained under the indirect method by preparing the cash flows
from operating activities section of the statement of cash flows under the indirect method
...

Alternate problem B The following information relates to Dunwoody Nursery & Garden Center, Inc
...

Dunwoody Nursery & Garden Center, Inc
...

Fully depreciated equipment costing USD 15,000 was sold for USD 3,750 (a gain of USD 3,750), and equipment
costing USD 112,500 was purchased for cash
...

Accounting Principles: A Business Perspective

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...

An additional 7,500 shares of common stock were issued for cash at USD 20 per share (total proceeds, USD
150,000)
...

The company paid interest of USD 6,000 and income taxes of USD 65,000
...
Also prepare any necessary supplemental schedule(s)
...
, is an independent service organization that markets and services
electronic credit card authorization and payment systems to small retail, wholesale, and professional businesses
located throughout the United States
...

As the use of credit cards has significantly expanded, electronic processing has proven more convenient by
accelerating customer purchases, lowering processing expenses, and reducing losses from fraudulent cards
...
With approximately 90,000 accounts at 2010
July 31, the company is one of the largest independent service organizations in the country
...
Then the relevant portion of
Management's Discussion and Analysis of the statement of cash flows is provided
...
0 License
Cash and cash equivalents at
end of year

$ 1,883,975

$ 475,145

$105,461,031

Supplemental schedule of noncash activities:
In connection with the purchase of merchant portfolios in fiscal years 2008 and 2009, the Company issued
promissory notes totaling USD 5,061,804 and USD 80,500, respectively
...

In connection with the purchase of merchant portfolio in March 2008, the Company issued 312,500 shares of
common stock
...

Reconciliation of net income to net cash
provided by operating activities:
Net income
Martin Howe fiscal year converstion
Adjustments:
Depreciation and amortization expense
Provision for merchant losses
Stock award compensation and other
Deferred income taxes
Changes in assets and liabilities:
Accounts receivable
Inventory
Other assets
Accounts payable
Accrued liabilities
Deferred revenues
Net cash provided by operating activities

$2,592,444
---

$3,640,155
---

$ 8,625,376
(356,914)

1,648,023
484,993
239,659
(453,658)

3,517,852
483,245
241,477
35,982

7,509,630
654,705
120,395
(761,705)

(1,562,961)
(50,235)
(1,716,464)
1,557,611
975,065
(56,123)
$ 3,658,354

(1,459,799)
(157,087)
(1,895,097)
44,106
(223,411)
169,677
$ 4,397,100

(2,125,510)
(186,289)
(501,353)
587,784
210,064
(55,232)
$ 13,720,951

Management's discussion and analysis
Capital expenditures and investing activities
Capital expenditures were approximately USD 1
...
9 million
for fiscal year 2009 and USD 1
...
The increase in capital expenditures was primarily the
result of additional expenditures related to the Company's management information system, the purchase of
additional credit card terminals, the Company's relocation of its office facilities and the purchase of peripheral
equipment for lease to merchants
...
4
million, USD 24
...
8 million for the purchase of merchant portfolios in fiscal years 2008, 2009
and 2010, respectively
...

Financing activities
The significant increase in cash provided by financing activities for fiscal year 2009 resulted from the
consummation of the Company's initial public offering in August 2008
...
7 million which reflects the net proceeds of the initial public offering after retirement
of the Company's outstanding indebtedness
...
3 million of long-term debt
in connection with three of the nine merchant portfolios purchased in fiscal year 2009
...
Net cash provided by financing activities was

Accounting Principles: A Business Perspective

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...
8 million in fiscal 2010 which reflects the net proceeds from the offerings after retirement of the
Company's outstanding bank indebtedness
...
Management expects to fund such purchases primarily
through cash generated from operations and additional bank borrowings
...
The Company, however, may pursue additional expansion opportunities, including purchases of
additional merchant portfolios, which may require additional capital, and the Company may incur, from time to
time, additional short-term and long-term indebtedness or issue, in public or private transactions, equity or debt
securities, the availability and terms of which will depend upon then prevailing market and other conditions
...
5 million
...
The amended agreement expires 2010 November 1, with all
amounts then outstanding under the agreement due on 2010 November 1, unless the agreement is extended or the
outstanding amounts have been converted to a term loan requiring equal monthly payments for 48 months
...
Borrowings are secured by substantially all the Company's assets
and life insurance policies on the lives of two of the Company's executive officers
...
Which method is the company using to determine net cash provided by operating activities?
b
...
What is the trend of net cash provided by operating activities over the three years?
d
...
What items of property and equipment were acquired during the three-year period?
f
...
How does the company expect to finance future expenditures to acquire additional merchant portfolios?
h
...
Given the following data, calculate the cash flow per share of common stock ratio, the cash flow margin ratio,
and the cash flow liquidity ratio
...
) How do the ratios compare with the ones for companies illustrated in the chapter?
Average number of shares of common stock outstanding
Net sales
Cash and marketable securities
Current liabilities

(in thousands)
28,539
$149,840
105,461
6,862

Alternate problem D Founded in 1901, The Gillette Company is the world leader in male grooming products,
a category that includes blades and razors, shaving preparations and electric shavers
...
The Company is the world's top seller of writing instruments and correction products, toothbrushes and
oral care appliances
...


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...

The company's statements of cash flows for the years 2001-2003 follow
...

Consolidated statement of cash flows (millions of dollars)
Years ended 2003,2002, 2001 December 31 2003
2002
Operating activities
Income from continuing operations
$ 832
$1,248
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision of restructuring and asset impairment 572
--Depreciation and amortization
535
464
Other
5
(7)
Changes in assets and liabilities, excluding
effects from acquisition and divestitures:
Accounts receivable
(100)
(48)
Inventories
149
(140)
Accounts payable and accrued liabilities
(45)
65
Other working capital items
(136)
97
Other noncurrent assets and liabilities
(197)
(252)
Funding German pension plans
----Net cash provided by operating activities
$ 1,604 $1,427
Investing activities
Additions to property, plant and equipment
$ (793) $ (889)
Disposals of property, plant and equipment
41
124
Acquisitions of businesses, less cash acquired
----Sale of businesses
539
--Other
(1)
2
Net cash used in investing act
$(214)
$ (763)
Financing activities
Purchase of treasury stock
$ (944) $(2,021)
Proceeds from sale of put options
23
72
Proceeds from exercise of stock options and
36
149
purchase plans
Proceeds from long-term debt
494
1,105
Repayment of long-term debt
(365)
--Increase (decrease) in loans payable
(385)
484
Dividends paid
(671)
(626)
Settlements of debt-related derivative contracts 279
42
Net cash used in financing activities
$ (1,553) $ (795)
Effect of exchange rate changes on cash
$ (5)
$ (2)
Net cash provided by discontinued operations
130
111
Decrease in cash and cash equivalents
$ (18)
$ (22)
Cash and cash equivalents at beginning of year 80
102
Cash and cash equivalents at end of year
$ 62
$ 80
Supplemental disclosure of cash paid for:
Interest
$ 243
$ 126
Income taxes
$ 480
$ 457
Noncash investing and financing activities:
Acquisition of businesses
Fair value of assets acquired
$--$--Cash paid
----Liabilities assumed
$ --$ ----

2001
$1,073
440
421
(46)
(442)
(62)
72
(104)
(142)
(252)
$ 958
$ (952)
65
(91)
200
5
$ (773)
$(1,066)
56
126
500
(12)
708
(552)
9
$ (231)
$ (2)
45
$ (3)
105
$ 102
$ 120
$ 473
$ 100
91
$9

Management's discussion and analysis*
Financial condition
The Company's financial condition continued to be strong in 2003
...
Net debt at 2003
December 31, amounted to USD 4
...
53 billion and USD 3
...
The market value of Gillette equity was USD 38 billion at the end of 2003,
Accounting Principles: A Business Perspective

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...
The Company's book equity position amounted to USD 1
...
06 billion at the end of 2002 and USD 4
...
The decreases in book equity in 2003 and 2002 were due primarily to the Gillette share repurchase program,
as well as to the effect of foreign currency translation
...
60 billion, compared with USD 1
...
96 billion in 2001
...
86 for 2003, compared with ratios of 1
...
40 for 2001
...
Capital spending in 2003 amounted to USD 793 million, compared with USD
889 million in 2002 and USD 952 million in 2001
...

In 2003, the Company sold the Stationery Products business for USD 528 million
...

Share repurchase funding in 2003, net of proceeds received from the sale of put options on Company stock,
amounted to USD 921 million, compared with USD 1,949 million in 2002 and USD 1,010 million in 2001
...
0 billion revolving credit facility in 2003 to USD 1
...
1 billion credit facility, expiring December 2004, to USD 550 million
in January 2004
...

In order to increase flexibility in sourcing short-term borrowing, the Company launched a USD 1 billion Euro
commercial paper program in 2003
...
45 billion outstanding under the US program, compared with USD 2
...
66 billion at the end of 2001
...

During 2002, the Company issued Euro-denominated notes for USD 343 million, due February 2007, and entered
into a USD 325 million Euro-denominated debt obligation, with redemption rights in March 2005, and a USD 437
million Euro-denominated debt obligation, with redemption rights in January 2007
...

During 2003, both Standard & Poor's and Moody's maintained the Company's current credit ratings
...
The commercial paper rating is A1+
by Standard & Poor's and P1 by Moody's
...
The Company has substantial unused lines of credit and access to worldwide financial market
sources for funds
...
22
...
Does the company use the direct or indirect method of calculating net cash provided by operating activities?
b
...

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...
How is the company expanding its asset base?
d
...
What is the likelihood that the company will be able to pay at least the current level of dividends in the future?
f
...
Given the following data, calculate the cash flow per share of common stock ratio, the cash flow margin ratio,
and the cash flow liquidity ratio
...
) How do the ratios compare with the ones for companies illustrated in the chapter?
Average number of shares of common stock
outstanding
Net sales
Cash and marketable securities
Current liabilities

(in millions)
1,059
9,295
62
5,471

Alternate problem E The following information is from the accounting records of Wescott Office Supplies,
Inc
...

Additional land was acquired for cash, USD 15,750
...

Equipment was purchased for cash, USD 47,250
...

Stock was issued at par for cash, USD 52,500
...

The company paid interest of USD 10,000 and income taxes of USD 40,000
...
Prepare a working paper for a statement of cash flows
...
Prepare a statement of cash flows under the indirect method
...

Beyond the numbers—Critical thinking
Business decision A National Sports, Inc
...
During 2011, the company
replaced USD 18,000 of its fully depreciated equipment with new equipment costing USD 23,000
...
Analysis using the statement of cash flows
midyear dividend of USD 5,000 was paid, the company found it necessary to borrow USD 5,000 from its bank on a
two-year note
...

Following are the income statement and "cash flow statement", as the company's accountant calls it, for 2011
...

Income Statements
For the year ended 2011 December 31
Sales
$195,000
Cost of goods sold
$140,000
Operating expense and taxes
49,700 189,700
Net income
$5,300
National Sports, Inc
...
He turns to you for help
...
Also, why is depreciation shown as providing cash?
You believe you can answer the president's questions after receiving the following condensed balance sheet data:

Assets
Current assets:
Cash
Accounts receivable, net
Merchandise inventory
Prepaid expenses
Total current assets
Property, plant, and equipment:
Equipment
Accumulated depreciation – equipment
Total property, plant, and equipment
Liabilities and stockholders' equity
Current liabilities:
Accounts payable
Accrued liabilities payable
Total current liabilities
Long-term liabilities:
Notes payable
Mortgage note payable
Total liabilities
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity

National Sports, Inc
...
0 License
Prepare a correct statement of cash flows using the indirect method that shows why National Sports, Inc
...
Also, answer the president's questions
...

Business decision case B Following are comparative balance sheets for Hardiplank Siding, Inc
...

Comparative Balance Sheets
2011 December 31, and 2010
2011
2010

Assets
Cash
Accounts receivable, net
Merchandise inventory
Land
Buildings
Accumulated depreciationbuildings
Equipment
Accumulated depreciation –
equipment
Goodwill
Total assets
Liabilities and stockholders' equity
Accounts payable
Accrued liabilities payable
Capital stock
Paid-in capital – stock dividends
Paid-in capital – land donations
Retained earnings
Total liabilities and stockholders'
equity

$ 80,000
60,000
90,000
67,500
90,000
(30,000)

$ 57,500
45,000
52,500
60,000
90,000
(27,000)

285,000
(52,500)

225,000
(48,000)

120,000 150,000
$710,000 $605,000
$ 95,000
30,000
315,000
75,000
15,000
180,000
$710,000

$ 65,000
22,500
300,000
67,500
-0150,000
$605,000

An analysis of the Retained Earnings account for the year reveals the following:
Balance, 2011 January 1
Add: Net income for the year
Less: cash dividends
Stock dividends
Balance, 2011 December 31

$55,000
22,500

$150,000
107,500
$257,500
77,500
$180,000

a
...
Included in net income is a gain on the sale of land of USD 9,000
...
The president of the company has set two goals for 2012: (1) increase cash by USD 40,000 and (2) increase
cash dividends by USD 35,000
...

Prepare a schedule showing cash flows from operating activities under the indirect method for 2011
...

Annual report analysis C Refer to the Annual report appendix
...
(Hint: Compare current dividend
amount with net cash provided by operating activities
...
Over the last three years from which major activities (operations, investing, financing) has Johnson &
Johnson received net cash inflows and on which major activities have they spent the funds?
b
...
Analysis using the statement of cash flows
c
...
By how much did the investments in marketable securities grow or shrink over the three-year period?
e
...
If you were a stockholder, would you feel uncertain or confident that this company will be able to pay future
dividends at the same rate as in the past?
g
...
For the latest year, did the current assets (other than cash) and current liabilities go up or down?
i
...
Your paper should be neat and
the result of several drafts
...
Use a word
processing program if possible
...
95, "Statement of Cash Flows", published by the Financial Accounting Standards Board
...
95, "Statement of Cash Flows", published by the Financial Accounting Standards Board
...

What is the Board's position on reporting cash flow per share? Why did they take that position?
What is the Board's position on noncash transactions? Why did they take that position?
Using the Internet—A view of the real world
Visit the following website for the Eastman Kodak Company:
http://www
...
com
By following the instructions on the screen, locate the latest statement of cash flows and then print it
...

Visit the following website for Verizon:
http://www
...
com
By following the information on the screen, locate the latest statement of cash flows and then print it
...

Answers to self-test
True-false

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...
Before July 1988, the statement of changes in financial position was required
...

True
...

False
...

Transactions with creditors and owners are financing activities
...
While the direct method is the method encouraged by the FASB, it is not the predominant method in use
...

True
...

Multiple-choice
c
...
The indirect method is easier to use,
and this characteristic is probably the main reason why it is used by most companies
...
Payment of debt is a financing activity because it is a transaction with creditors
...

b
...

d
...

a
...


Accounting Principles: A Business Perspective

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...
Analysis and
interpretation of financial
statements
Learning objectives
After studying this chapter, you should be able to:
• Describe and explain the objectives of financial statement analysis
...

• Calculate and explain changes in financial statements using horizontal analysis, vertical analysis, and trend

analysis
...

• Describe the considerations used in financial statement analysis
...
Duties in these fields involve understanding the operations of the
company, assessing the value of the company, and predicting its future performance
...
For example,
Apple's stock closed at USD 21
...
95 in March 2010
...
Not bad!
Of course, failure to understand the relationship between financial accounting information and company value can
result in negative consequences as well
...
com boom, the stock of Webvan, an online
grocer, plummeted from a high of USD 40 to just six cents within a few months as investors realized that the
company could not meet expected earnings projections and was therefore highly overvalued
...
oo as stark symbols of the dot
...

In the area of investing, what accounting information can be used to separate the winners from the losers?
This is the goal of investment analysts—to understand the current value of a company and then use available
information in predicting future performance
...
Since financial statements are prepared by accountants, it is no
surprise that accountants are being hired for purposes of interpreting financial information and making
predictions
...


Accounting Principles: A Business Perspective

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...
Solvency is the ability of a company
to pay debts as they come due; it is reflected on the company's balance sheet
...
Generally, all those interested in
the affairs of a company are especially interested in solvency and profitability
...
Internally, management analyzes a
company's financial statements as do external investors, creditors, and regulatory agencies
...


Objectives of financial statement analysis
Management's analysis of financial statements primarily relates to parts of the company
...
Management obtains any information
it wants about the company's operations by requesting special-purpose reports
...
Our primary focus in this
chapter, however, is not on the special reports accountants prepare for management
...

Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the
company as a whole
...
These statements include a balance sheet, an income
statement, a statement of stockholders' equity, a statement of cash flows, and the explanatory notes that accompany
the financial statements
...
This integral part of the annual report provides insight into the scope
of the business, the results of operations, liquidity and capital resources, new accounting standards, and geographic
area data
...

Financial statement analysis consists of applying analytical tools and techniques to financial statements and
other relevant data to obtain useful information
...
The
information shows the results or consequences of prior management decisions
...

Present and potential investors are interested in the future ability of a company to earn profits—its profitability
...

Since both dividends and price changes are likely to be influenced by earnings, investors may predict earnings
...

Some outside parties, such as creditors, are more interested in predicting a company's solvency than its
profitability
...
The company's liquidity is its state of
possessing liquid assets, such as cash and other assets easily converted to cash
...
For example, a bank asked to extend a 90-day

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...
Of course, the company's
predicted ability to repay the 90-day loan is likely to be based at least partially on its past ability to pay off debts
...
Generally, we consider a company to be solvent when its assets
exceed its liabilities so that the company has a positive stockholders' equity
...
Thus, the company's assets could shrink
significantly before its liabilities would exceed its assets and destroy the company's solvency
...
All of these analyses rely on
comparisons or relationships of data that enhance the utility or practical value of accounting information
...
Some usefulness is added when we know that the prior year's net income was USD 25,000
...
Such comparisons or
relationships may be expressed as:
• Absolute increases and decreases for an item from one period to the next
...

• Percentages of single items to an aggregate total
...

• Ratios
...
However, in this chapter we
apply all of these techniques in analyzing Synotech, Inc
...
This was the company introduced in
Chapter 16
...
Comparative financial statements present the
same company's financial statements for one or two successive periods in side-by-side columns
...
This analysis detects
changes in a company's performance and highlights trends
...
Vertical
analysis (item 3) consists of the study of a single financial statement in which each item is expressed as a
percentage of a significant total
...

Financial statements that show only percentages and no absolute dollar amounts are common-size
statements
...
The use of common-size statements
facilitates vertical analysis of a company's financial statements
...
Trend percentages are useful for comparing financial statements over several years because
they disclose changes and trends occurring through time
...
Analysts can compute many ratios from the same set of financial statements
...
g
...
Analysis and interpretation of financial statements
balance sheet and income statement)
...


Sources of information
Financial information about publicly owned corporations can come from different sources such as published
reports, government reports, financial service information, business publications, newspapers, and periodicals
...
The Annual report appendix gives such data for The
Limited, Inc
...
For examples of each statement, refer to the annual report booklet
...
The notes usually contain sections on
significant accounting policies, long-term debt, leases, stock option plans, etc
...

• Letters to stockholders Most annual reports are introduced with a letter to the stockholders
...

• Reports of independent accountants The Securities and Exchange Commission (SEC) requires the

financial statements of certain companies to be audited
...
The report also may include a paragraph
highlighting the significant accounting policies that the company has changed recently
...
The analysis is based on the financial
statements, the conditions of the industry, and ratios
...
These reports are available to the
public for a small charge and sometimes contain more detailed information than the published reports
...
Two
firms that provide information on individual companies and industries are Moody's Investors Service and Standard
& Poor's
...
, publishes Key Business Ratios and Robert Morris Associates publishes
Annual Statement Studies; both provide information for specific industries
...

Business publications such as The Wall Street Journal, Barron's, Forbes, and Fortune also report industry
financial news
...


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...
, will serve as a basis for an example of horizontal
analysis and vertical analysis of a balance sheet and a statement of income and retained earnings
...

Imagine that you are a prospective investor interested in Synotech, Inc
...

First, we begin with the balance sheets
...
Take a few minutes to study the balance sheets
...

Column (3) shows the change that occurred in each item between 2009 December 31, and 2010 December 31
...
If the change is
a decrease, the change is a negative figure and is shown in parentheses
...
You can calculate the percentage change by dividing the dollar change by the dollar balance of the earlier
year (2009)
...
3 million, consisting largely of increases in cash, marketable

securities, and other current assets despite a USD 63
...
4 million, largely as a result of increases in the current portion of long-term
debt and other accruals
...
1 million, while total assets increased by USD 311
...


Next, study Column (4), which expresses as a percentage the dollar change in Column (3)
...
Although the absolute amount of current liabilities has increased tremendously over the amount
of current assets, the percentages reveal that current assets increased
...
6 per cent
...
Current assets still exceed
current liabilities
...

Studying the percentages in Column (4) could lead to several other observations
...
9 per cent
decrease in long-term debt indicates that interest charges will be lower in the future, having a positive effect on
future net income
...
2 per cent increase in retained earnings could be a sign of increased dividends in the
future; in addition, the increase in cash of 19 per cent could support this conclusion
...
A vertical analysis of the
company's balance sheet discloses each account's significance to total assets or total equities
...
Columns (5) and (6) in Exhibit 133 express the dollar
amount of each item in Columns (1) and (2) as a percentage of total assets or equities
...
3 million in 2010, the decrease of 1
...
8 per cent of total assets and, therefore, probably does not have great significance
...
0 per cent of total equities (liabilities and stockholders' equity) in 2009,
to 74
...
At the same time, the percentage of stockholder financing to total assets of the company
increased from 22
...
7 per cent
...


Accounting Principles: A Business Perspective

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17
...
5

19
...
1 %

2
...
5
1,340
...
8
254
...
4
2,586
...
8
(63
...
0)
21
...
3
328
...
0
(4
...
5)
8
...
5
12
...
8
13
...
8
2
...
0
30
...
6
14
...
1
2
...
9
28
...
0

(25
...
8)

34
...
9

462
...
3)
$9,170
...
0

(1
...
4

4
...
0

5
...
0

$ 245
...
5)

(15
...
2

2
...
4

88
...
4

1
...
5

886
...
1
835
...
8

15
...
6
96
...
4

1
...
3
11
...
6

9
...
2
9
...
1

9
...
0
9
...
9

3,590
...
8
1,176
...
1

(246
...
6)
(45
...
1)

(6
...
3)
(3
...
6)

35
...
0
11
...
3

39
...
1
12
...
0

$ 484
...
9

$ (13
...
0

(2
...
0

5
...
3

5
...
4

1,240
...
5

6
...
9

13
...
6
(615
...
5
(26
...
2
4
...
6
-6
...
3
-6
...
5 $449
...
6) 8
...
7
(1
...
0
-4
...
8
-4
...
2) (32
...
7 $425
...
9
21
...
6
25
...
9
22
...
8 $311
...
4

100
...
0

December
31
(1)
Assets
2010
Current assets
Cash and cash
$ 298
...
3
Receivables, net
1,277
...
8
Other current assets 275
...
7
Property, plant and
2,914
...
5
intangibles, net
Other assets
455
...
8
Liabilities and
shareholders' equity
Current liabilities
Notes and loans
$ 206
...
5
long-term debt
Accounts payable
902
...
7
Other accruals
932
...
2
liabilities
Long-term debt
3,344
...
2
Other liabilities
1,130
...
0
Shareholders' equity
Preferred stock
$ 471
...
20 219
...
9
capital
Retained earnings
3,277
...
6)
adjustments
$4,648
...
1)
compensation
Treasury stock, at cost(1,762
...
8
equity
Total liabilities and
stockholders equity
$9,481
...
Such a statement merely combines the income statement and the statement of retained earnings
...
Study these
680

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...
Then examine Columns (9) and (10) which show the horizontal analysis that would
be performed on the company's comparative statements of income and retained earnings
...
The absolute change is
determined by deducting the 2009 amount from the 2010 amount
...
If the change is a decrease, the change is a negative figure and is
shown in parentheses
...

Synotech, Inc
...
8 $10,029
...
0
4
...
0% 100
...
3 5,233
...
6
2
...
9
52
...
5 $4,806
...
4
7
...
1
47
...
5 3,455
...
0
6
...
9
34
...
6
Interest expense, net of
236
...
2 and
$36
...
5
Provision for income taxes
383
...
0
Retained earnings, January 1 2,870
...
6
Dividends declared:
Series B convertible
25
...
6
Common stock
329
...
1
31

552
...
6)

(100
...
0

5
...
3
246
...
7)
(9
...
3)
(3
...
1
2
...
1
2
...
2
229
...
4
2,996
...
4

$709
...
7
$555
...
4)
$430
...
6
66
...
2
(4
...
4

10
...
7
7
...
3
2
...
1

25
...
2)

(0
...
6
305
...
6

0
...
9
$406
...
0
7
...
2

*Dollars = (7) – (8); Per cent = (9)/(8)

Exhibit 134: Comparative statements of income and retained earnings
Having completed the horizontal analysis and vertical analysis of Synotech's balance sheet and statement of
income and retained earnings, you are ready to study trend percentages and ratio analysis
...
Professional financial statement
analysts use several tools and techniques to determine the solvency and profitability of companies
...
0 million, an increase of 4
...
Since
cost of goods sold increased by a much smaller amount (USD 117
...
4, or
7
...
The USD 552
...

Although this is not a recurring expense, it does not classify as an extraordinary expense and is treated as part of
income from continuing operations
...
Columns (11) and (12)
express the dollar amount of each item in Columns (7) and (8) as a percentage of net sales
...
Therefore, gross profit as a
Accounting Principles: A Business Perspective

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...
The percentage of expenses to net sales decreased somewhat, thus
yielding an increase in income before income taxes as a percentage of net sales
...
You can calculate trend percentages by:
• Selecting a base year or period
...

• Expressing the corresponding amounts on the other years' financial statements as a percentage of base-year

or period amounts
...

The following information for Synotech illustrates the calculation of trend percentages:
(USD millions)
Net sales
Cost of goods sold
Gross profit
Operating expenses
Income before income taxes

2008
$ 9,105
...
0
$ 4,409
...
6
$ 1,055
...
8
5,223
...
1
4,369
...
2

2010
$10,498
...
3
$ 5,157
...
0
$ 1,145
...
5 million;
cost of goods sold by USD 4,696
...
5 million; operating expenses by USD 3,353
...
9 million
...
The resulting percentages reflect trends as follows:
Net sales
Cost of goods sold
Gross profit
Operating expenses
Income before income taxes

2008
100
...
0
100
...
0
100
...
2%
111
...
0
130
...
3

2010
115
...
7
117
...
6
108
...
For instance, the percentage of sales is increasing each year compared to the base year
...
Operating expenses in 2009 increased due to the provision for restructured operations, causing a
significant decrease in income before income taxes
...
In reviewing trend percentages, a financial statement user should pay close
attention to the trends in related items, such as the cost of goods sold in relation to sales
...

As useful as trend percentages are, they have one drawback
...
Analysts
cannot express a USD 30,000 increase in notes receivable as a percentage if the increase is from zero last year to
USD 30,000 this year
...

Proper analysis does not stop with the calculation of increases and decreases in amounts or percentages over
several years
...
Accurate predictions depend on many factors, including economic and political
conditions; management's plans regarding new products, plant expansion, and promotional outlays; and the
682

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...
Considering these factors along with horizontal analysis, vertical analysis, and
trend analysis should provide a reasonable basis for predicting future performance
...
These
accounts may appear on the same statement or on two different statements
...
These ratios include: (1) liquidity ratios; (2) equity, or longterm solvency, ratios; (3) profitability tests; and (4) market tests
...
Thus, these ratios show interested parties
the company's capacity to meet maturing current liabilities
...

The ratio that relates current assets to current liabilities is the current (or working capital) ratio
...

You can compute the current ratio by dividing current assets by current liabilities:
Current ratio=

Current assets
Current liabilities

The ratio is usually stated as a number of dollars of current assets to one dollar of current liabilities (although
the dollar signs usually are omitted)
...
7 million
and current liabilities totaled USD 2,285
...
25:1, meaning that the company has USD 1
...
00 of current liabilities
...
To illustrate, assume that we are comparing Synotech to Company B
...
7
2,285
...
5
1
...
0
53
...
8
2
...
However, Company B has a superior debtpaying ability since it has USD 2
...
00 of current liabilities
...
Long-term creditors are also interested in the current ratio because a company that is unable to pay
short-term debts may be forced into bankruptcy
...
A company can increase
its current ratio by issuing long-term debt or capital stock or by selling noncurrent assets
...
Decreased net income can result when too much capital that could be
used profitably elsewhere is tied up in current assets
...
Analysis and interpretation of financial statements
Refer to Exhibit 133
...
We could also make such an observation directly by looking at the change in the current
ratio
...
7
2,285
...
5
1
...
4 14
...
8 181
...
6 $(167
...
35:1

Synotech's working capital decreased by USD 167
...
9 per cent (USD 167
...
6), and its
current ratio decreased from 1
...
25:1
...

Acid-test (quick) ratio The current ratio is not the only measure of a company's short-term debt-paying
ability
...
Analysts exclude inventories and prepaid expenses from
current assets to compute quick assets because they might not be readily convertible into cash
...

The acid-test ratios for 2010 and 2009 for Synotech are:
(USD millions)

December 31
2010
2009

Quick assets (a)
Current liabilities (b)
Net quick assets (a – b)
Acid-test ratio (a/b)

$1,646
...
6
$ (639
...
72:1

$1,648
...
8
$ (455
...
78:1

Amount of
increase or
(decrease)
$ (1
...
8
$(183
...
An accumulation of poor-quality marketable securities or receivables, or both, could cause an acidtest ratio to appear deceptively favorable
...
Poor-quality receivables may be uncollectible or not collectible until long past
due
...
(Covered in Chapter 9
...
The numerator, as an approximation of cash resources, consists of (1) cash and marketable securities, or
liquid current assets, and (2) net cash provided by operating activities, or the cash generated from the company's
operations
...
The formula for the
cash flow liquidity ratio is:
Cash also marketable securities Net cash provided by operating activities
Current liabilities

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...
0 million in cash and cash equivalents, USD 71
...
2 million in current liabilities, and USD 1,101
...
Its cash flow liquidity ratio is:
USD 298
...
3 USD1,101
...
64 time
USD 2,285 :2
This indicates that the company is going to have to rely on some other sources of funding to pay its current
liabilities
...
Possibly
net cash provided by operations will be substantially higher in 2011
...
Accounts receivable turnover is the number of times per year that the average amount of
receivables is collected
...
Ideally, analysts calculate average net accounts
receivable by averaging the end-of-month balances or end-of-week balances of net accounts receivable outstanding
during the period
...
Often,
analysts average only the beginning-of-year and end-of-year balances because this information is easily obtainable

Accounting Principles: A Business Perspective

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...
Sometimes a formula calls for the use of an average balance, but only the

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...
Then the analyst must use the year-end amount
...
However, if cash sales are relatively small or their proportion to
total sales remains fairly constant, analysts can obtain reliable results by using total net sales
...

Synotech's accounts receivable turnover ratios for 2010 and 2009 follow
...
5 million
...
8 $10,029
...
0
$ 1,340
...
3
$ 2,617
...
8
8
...
5 $ 80
...
3
(63
...
8 $ 17
...
9
7
...

The accounts receivable turnover ratio for 2010 indicates that Synotech collected, or turned over, its accounts
receivable slightly more than eight times
...

Number of days' sales in accounts receivable The number of days' sales in accounts receivable
ratio is also called the average collection period for accounts receivable
...
72) in 2009 to 46 days (365/8
...
The change means that the average collection
period for the company's accounts receivable decreased from 47 to 46 days
...
Generally, the shorter the collection period, the higher the
quality of receivables
...
A
comparison of the average collection period with the credit terms extended customers by the
company provides further insight into the quality of the accounts receivable
...
It is important to determine why customers are paying their accounts much
later than expected
...
Analysis and interpretation of financial statements
Inventory turnover A company's inventory turnover ratio shows the number of times its average inventory is
sold during a period
...

Notice that we measure the numerator and denominator in cost rather than sales dollars
...
) Inventory turnover
relates a measure of sales volume to the average amount of goods on hand to produce this sales volume
...
7 million
...
85 times per year in 2009 to 5
...
To convert
these turnover ratios to the number of days it takes the company to sell its entire stock of inventory, divide 365 by
the inventory turnover
...
76 and 365/5
...

(USD millions)
Cost of goods sold (a)
Merchandise inventory:
January 1
December 31
Total (b)
Average inventory (c) (b/2 = c)
Turnover of inventory (a/c)

December31
2010
2009
$5,341
...
7 $117
...
8
924
...
6
$927
...
76

$856
...
1
929
...
0)
$1,786
...
1
$893
...
85

Other things being equal, a manager who maintains the highest inventory turnover ratio is the most efficient
...
For example, a company that achieves a high inventory turnover ratio by
keeping extremely small inventories on hand may incur larger ordering costs, lose quantity discounts, and lose sales
due to lack of adequate inventory
...


An accounting perspective:
Business insight
Cabletron Systems develops, manufactures, installs, and supports a wide range of standards-based
LAN and WAN connectivity hardware and software products
...
In its 2009 annual report, the company explained these increases as
follows:
Accounts receivable, net of allowance for doubtful accounts, were USD 210
...
4 million at 2008 December 31, or
54 days sales outstanding
...


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...
1 million at 2009 December 31 or 63 days of inventory,
compared to USD 85
...
The increase of days
in inventory was due to the increase in finished goods inventory purchased to protect against an
anticipated shortage of supply components
...
We calculate it as follows:
Total assets turnover=

Net sales
Average total assets

This ratio measures the efficiency with which a company uses its assets to generate sales
...
For Synotech, the total
asset turnover ratios for 2010 and 2009 follow
...
9 million
...
8 $ 10,029
...
0

Net sales (a)
Total assets:
January 1
$9,170
...
8
Total (b)
$18,652
...
8
Turnover of total assets (a/c)
1
...
9 $1,799
...
8
311
...
7 $2,110
...
9
1
...
21 of sales in 2009 and USD 1
...
In other words,
between 2009 and 2010, the company had a decrease of USD
...

Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a company
...
In ratio analysis, however, the term
equity generally refers only to stockholders' equity
...
The formula for
the equity ratio is:
Equity ratio=

Stockholders' equity
Total assets totalequities

Synotech's liabilities and stockholders' equity from Exhibit 133 follow
...
0 per cent in 2009 to 25
...
Exhibit 133 shows that stockholders increased their
proportionate equity in the company's assets due largely to the retention of earnings (which increases retained
earnings)
...
2
Long-term liabilities
4,755
...
0
Total stockholders' equity 2,440
...
8
assets)

2009
December
31
Per cent Amount
24
...
8
50
...
3
74
...
1
25
...
7
100%
$9,170
...
9%
55
...
0
22
...
0%

The equity ratio must be interpreted carefully
...
A high equity ratio indicates the existence of a large protective buffer for creditors in the event a

Accounting Principles: A Business Perspective

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...
However, from an owner's point of view, a high proportion of stockholders' equity may or
may not be desirable
...

To illustrate the effect of higher leveraging (i
...
a larger proportion of debt), assume that Synotech could have
financed an increase in its productive capacity with USD 40 million of 6 per cent bonds instead of issuing 5 million
additional shares of common stock
...
06 x $40 million)
Add reduced taxes due to interest deduction (
...
However, there
are also fewer shares of common stock outstanding
...
Earnings per share (EPS) with the additional debt would be USD 4
...
05 (or USD 762,000,000/188 million shares)
...

We should point out, however, that too low a percentage of stockholders' equity (too much debt) has its dangers
...
A period of business recession may result in operating losses and shrinkage in the value of assets,
such as receivables and inventory, which in turn may lead to an inability to meet fixed payments for interest and
principal on the debt
...

Stockholders' equity to debt (debt to equity) ratio Analysts express the relative equities of owners and
creditors in several ways
...
3 per cent interest in the assets of Synotech on 2010
December 31, is equivalent to saying stockholders held a 25
...
Another way of expressing this
relationship is the stockholders' equity to debt ratio:
Stockholders' equity for debt ratio=

Stockholders ' equity
Total debt

Such a ratio for Synotech would be
...
7 million/USD 7,155
...
35:1 (or USD 2,440
...
0 million) on 2010 December 31
...
Some analysts use only long-term debt rather than total debt in calculating these
ratios
...

Profitability is an important measure of a company's operating success
...
Each of the following ratios utilizes one of these
relationships
...
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Rate of return on operating assets The best measure of earnings performance without regard to the
sources of assets is the relationship of net operating income to operating assets, the rate of return on operating
assets
...
By disregarding both
nonoperating assets and nonoperating income elements, the rate of return on operating assets measures the
profitability of the company in carrying out its primary business functions
...

Operating margin reflects the percentage of each dollar of net sales that becomes net operating income
...
Another name for net operating income is "income before interest and taxes" (IBIT)
...
Operating assets are all assets actively used in producing operating revenues
...
Nonoperating assets are owned by
a company but not used in producing operating revenues, such as land held for future use, a factory building rented
to another company, and long-term bond investments
...
Nor do they use total assets that include nonoperating assets not contributing to the
generation of sales
...
The more a company earns per dollar of sales and the more sales it makes per dollar invested in
operating assets, the higher is the return per dollar invested
...

The rates of return on operating assets for Synotech for 2010 and 2009 are:
(USD millions)

2010

2009

Net operating income (a)*
Net sales (b)
Operating assets (c) †
Operating margin (a/b)

$ 1,382
...
8
$9,481
...
17%

$ 682
...
8
$ 9,170
...
81%

Accounting Principles: A Business Perspective

Amount of increase
or (decrease)
$699
...
0
$311
...
Analysis and interpretation of financial statements
Turnover of operating assets (b/c) 1
...
09 times
Rate of return on operating assets 14
...
44%
(a/c)
*Calculated as income before income taxes plus net interest expense
...

†When companies have no nonoperating assets, total assets are used in the calculation

Net income to net sales (return on sales) ratio Another measure of a company's profitability is the net
income to net sales ratio, calculated as follows:
Net income by net sales=

Net income
Net sales

This ratio measures the proportion of the sales dollar that remains after deducting all expenses
...
However, they can attain this minimum rate of return in many different ways
...
The grocery store normally would attain this rate of return with a low margin and
a high turnover, while the jewelry store would have a high margin and a low turnover, as shown
here:

Grocery store
Jewelry store

Margin x Turnover = Rate of return on
operating assets
1% x
8
...
4
= 8

(USD millions)
Net income (a)
Net sales (b)
Ratio of net income to net sales
(a/b)

2010

2009

Amount of
increase or
(decrease)
$ 762
...
4 $555
...
$10,029
...
0
8
8
7
...
06%

Although the ratio of net income to net sales indicates that the net amount of profit increased on each sales
dollar, exercise care in using and interpreting this ratio
...
Thus, a period that
contains the effects of an extraordinary item is not comparable to a period that contains no extraordinary items
...

Return on average common stockholders' equity From the stockholders' point of view, an important
measure of the income-producing ability of a company is the relationship of return on average common
stockholders' equity, also called rate of return on average common stockholders' equity, or simply the
return on equity (ROE)
...
0 License
assets as a measure of management's efficient use of assets, they are even more interested in the return the
company earns on each dollar of stockholders' equity
...
As described
in Chapter 12, the book value of common stock is equal to total stockholders' equity minus (1) the liquidation value
(usually equal to par value) of preferred stock and (2) any dividends in arrears on cumulative preferred stock
...
The ratios for the company follow
...
4 million
...
7 million in 2010 and USD
25
...

(USD millions)

2010

Net income – Preferred stock dividends
(a)
Total common stockholders' equity (book
value of common stock):*
January 1
December 31
Total (b)
Average common stockholders' equity:
(c) (b/2 = c)
Return on common stockholders' equity
(a/c)

2009

Amount of
increase or
(decrease)
$ 736
...
5 $ 555
...
5
1,969
...
1
$1,750
...
4 $(165
...
5 438
...
9 $ 272
...
5

42
...
18%

*Total stockholders' equity – par value of preferred stock

The stockholders would regard the increase in the ratio from 11
...
06 per cent favorably
...


An accounting perspective:
Business insight
Sometimes, two companies have the same return on assets but have different returns on
stockholders' equity, as shown here:
Return on assets
Return on stockholders'
equity

Company 1 Company 2
12
...
0%
6
...
0

The difference of 1
...
Use of these funds (or preferred stock

Accounting Principles: A Business Perspective

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...
When a company is trading profitably on the
equity, it is generating a higher rate of return on its borrowed funds than it is paying for the use of
the funds
...
6 per cent, is accruing to the benefit of the common
stockholders, because their earnings are being increased
...
Using
leverage is a risky process because losses also can be magnified, to the disadvantage of the common
stockholders
...

Cash flow margin The cash flow margin measures a company's overall efficiency and performance
...
Measuring the amount of cash a
company generates from every dollar of sales is important because a company needs cash to service debt, pay
dividends, and invest in new capital assets
...
0 million net cash provided by operating activities
=10
...
8 million net sales
Earnings per share of common stock Probably the measure used most widely to appraise a company's
operations is earnings per share (EPS) of common stock
...
The financial press
regularly publishes actual and forecasted EPS amounts for publicly traded corporations, together with period-toperiod comparisons
...
0 License
amounts be reported on the face of the income statement
...
)
The calculation of EPS may be fairly simple or highly complex depending on a corporation's capital structure
...
g
...
If a company has such securities
outstanding, it has a complex capital structure
...

A company with a simple capital structure reports a single basic EPS amount, which is calculated as follows:
EPS of common stock=

Earnings available for common stockholders
Weighted−average number of common shares outstanding

The amount of earnings available to common stockholders is equal to net income minus the current year's
preferred dividends, whether such dividends have been declared or not
...
If the number of common shares
outstanding did not change during the period, the weighted-average number of common shares outstanding would,
of course, be the number of common shares outstanding at the end of the period
...
9 million on 2010 December 31
...
20
par value
...
2 million (or USD 219
...
20 per share)
...
We ignore treasury stock transactions to simplify the illustrations
...
To compute the weighted-average
number of common shares outstanding, we weight the change in the number of common shares by the portion of
the year that those shares were outstanding
...

To illustrate, assume that during 2009 Synotech's common stock balance increased by USD 14
...
7
million shares)
...
5 million of these shares on 2009 April 1, and the other 2
...
The computation of the weighted-average number of common shares
outstanding would be:
171,5 million shares x 1 year
9
...
2 million shares x ¼ year (October – December)
Weighted-average number of common shares outstanding

171
...
125 million

...
125 million

An alternate method looks at the total number of common shares outstanding, weighted by the portion of the
year that the number of shares was outstanding, as follows:
171
...
0 million shares x ½ year (April – September)
183
...
875 million
90
...
800 million
179
...
5 million shares x 3 months = 514
...
0 million shares x 6 months = 1,086
...
2 million shares x 3 months = 549
...
Analysis and interpretation of financial statements
12 months

2,150
...
1 million share-months/12 months = 179
...
In 2010, the balance in the common stock account did not
change as it had during 2009
...
2 million
...
30

USD 180
...
80

Average number of shares of
common stock (b)

183
...
13

4
...
02

USD 1
...
0 per cent ([USD 4
...
01]/USD 1
...
01 to USD 4
...

EPS and stock dividends or splits Increases in shares outstanding as a result of a stock dividend or stock
split do not require weighting for fractional periods
...
All that is required is to restate all prior calculations of EPS using the
increased number of shares
...
20 (or USD
120,000/100,000 shares) and earned USD 180,000 in 2011
...
The firm
would restate EPS for 2010 as USD 0
...
90 (USD
180,000/200,000 shares) for 2011
...
Many of the securities issued were calls on common or possessed equity
kickers
...
As a result, many complex problems arose in computing EPS
...
15
provided guidelines for solving these problems
...
128, "Earnings per Share" replaced
APB Opinion No
...
A company with a complex capital structure must present at least two EPS calculations, basic
EPS and diluted EPS
...

Times interest earned ratio Creditors, especially long-term creditors, want to know whether a borrower can
meet its required interest payments when these payments come due
...
It is computed as follows:
Time interest earned ratio=

Income beforeinterest including taxesIBIT
Interest expense

The ratio is a rough comparison of cash inflows from operations with cash outflows for interest expense
...
(To find income before interest and taxes, take net income from continuing
operations and add back the net interest expense and taxes
...
We will use
net interest expense in the Synotech illustration
...
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For Synotech, the net interest expense is USD 236
...
With an IBIT of USD 1,382
...
84, calculated as:
USD 1,382
...
84 time
USD 236
...

Low or negative interest coverage ratios suggest that the borrower could default on required interest payments
...
On the other hand, interest coverage of 5 to 10 times or more suggests that the company is not likely to
default on interest payments
...
They are interested in the company's ability to make
preferred dividend payments each year
...
0 million and preferred dividends of USD 25
...
The number of
times the annual preferred dividends are earned for 2010 is:
USD762
...
65 :1 , or 29
...
7
The higher this rate, the higher is the probability that the preferred stockholders will receive their dividends
each year
...
These tests help investors and potential investors assess the relative merits of
the various stocks in the marketplace
...

Earnings yield on common stock You can calculate a company's earnings yield on common stock as
follows:
Earnings yield on common stock=

EPS
Current market price per share of common stock

Assume Synotech has common stock with an EPS of USD 5
...
70
...
03
=4
...
7
Price-earnings ratio When inverted, the earnings yield on common stock is the price-earnings ratio
...
7
=22
...
03
Investors would say that this stock is selling at 22 times earnings, or at a multiple of 22
...
Different investors
have different estimates of the proper price-earnings ratio for a given stock and also different estimates of the
Accounting Principles: A Business Perspective

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...
These different estimates may cause one investor to sell stock at a
particular price and another investor to buy at that price
...
Assume that Synotech's dividends per share were USD 1
...
03
...
The payout
ratio of stock in 2010 is:
Payout ratio on common stock=

Dividend per share of common stock
EPS

USD 1
...
8 per cent
USD 5
...
8 per cent means that the company paid out 35
...
Some investors are attracted by the stock of companies that pay out a large percentage of their earnings
...

The tax status of the investor has a great deal to do with this preference
...

Dividend yield on common stock The dividend paid per share of common stock is also of much interest to
common stockholders
...
Synotech's
2010 December 31, common stock price was USD 110
...
Its dividends per share were USD 1
...
The
company's dividend yield on common stock was:
Dividend yield on of common stock=

Dividend per share of common stock
Current market price per share of commonstock

USD 1
...
63 per cent
USD 110
...
The computation of the dividend yield on preferred stock is similar to the common stock
dividend yield computation
...
10 with a
current market price of USD 84
...
We compute the dividend yield on preferred stock as follows:
Dividend yield on preferred stock =

Dividend per share of preferredstock
Current market price per share of preferred stock

USD 5
...
07 per cent
USD 84
...

Cash flow per share of common stock Investors calculate the cash flow per share of common stock
ratio as follows:
Cash flow per shareof common stock=

Net cash provided by operating activities
Average number of shares of common stock outstanding

Currently, FASB Statement No
...

However, some mortgage and investment banking firms do use this ratio to judge the company's ability to pay
dividends and pay liabilities
...
0 License

Cash provided by operating activities (a)
Average shares outstanding (b) (assumed)
Cash flow per share of common stock (a)/(b)

Fiscal
2010
$1,101
...
6
$7
...
3
145
...
70

Final considerations in financial statement analysis
Standing alone, a single financial ratio may not be informative
...
Exhibit 135 summarizes the ratios presented in this chapter, and
Exhibit 136 presents them graphically
...
As guides to aid comparison, percentages and ratios are
useful in uncovering potential strengths and weaknesses
...


An accounting perspective:
Uses of technology
Most companies calculate some of the ratios we have discussed, if not all of them
...
Some programs that gather
information in the preparation of financial statements calculate the ratios at the end of a period
...
Remember, to interpret the numbers
correctly, investors and management must compare these ratios with the industry in which the
company operates
...
Analysis and interpretation of financial statements
Liquidity ratios
Current, or working capital, ratio
Acid-test (quick) ratio

Formula
Significance
Current assets + Current liabilities
Test of debt-paying ability
Quick assets (cash + marketable securities + net Test of immediate debt-paying
receivables) + Current liabilities
ability
Cash flow liquidity ratio
(Cash and marketable securities + Net cash
Test of short-term, debt-paying
provided by operating activities) + Current
ability
liabilities
Accounts receivable turnover
Net credit sales (or net sales) + Average net
Test of quality of accounts
accounts
receivable
receivable
Number of days' sales in accounts
Number of days in year (365) + Accounts
Test of quality of accounts
receivable (average collection period of receivable
receivable
accounts receivable)
turnover
Inventory turnover
Cost of goods sold + Average inventory
Test of whether or not a
sufficient volume of business is
being generated relative to
inventory
Total assets turnover
Net sales + Average total assets
Test of whether or not the
volume of business generated is
adequate relative to amount of
capital invested in the business
Equity, or Long-term Solvency,
Ratios
Equity (stockholders' equity) ratio
Stockholders' equity + Total assets (or total
Index of long-run solvency and
equities)
safety
Stockholders' equity to debt (debt to Stockholders' equity + Total debt
Measure of the relative
equity) ratio
proportion of stockholders' and
of creditors' equities
Profitability Tests
Rate of return on operating assets
Net operating income + Operating assets or
Measure of managerial
Operating margin x Turnover operating assets
Net income to net sales (return on
Net income + Net sales
Indicator of the amount of net
sales)
profit on each dollar of sales
Return on average common
Net income + Average common stockholders'
Measure of what a given
stockholders' equity
equity
company earned for its
stockholders from all sources as
a percentage of common
stockholders' investment
Cash flow margin
Net cash provided by operating activities + Net Measure of the ability of a firm to
sales
translate sales into cash
EPS of common stock
Earnings available to common stockholders' + Measure of the return to
Weightedinvestors
average number of common shares outstanding
Times interest earned ratio
Income before interest and taxes + Interest
Test of the likelihood that
expense
creditors will continue to receive
their interest payments
Time preferred dividends earned ratio Net income + Annual preferred dividends
Test of the likelihood that
preferred stockholders will
receive their dividend each year
Market Tests
Earnings yield on common stock
EPS + Current market price per share of
Comparison with other common
common stock
stocks
Price-earnings ratio
Current market price per share of common stock Index of whether a stock is
+ EPS
relatively cheap or expensive
based on the ratio
Pay cut ratio on common stock
Dividend per share of common stock + EPS
Index of whether company pays
out a large percentage of
earnings as dividends or
reinvests most of its earnings
Dividend yield on common stock
Dividend per share of common stock + Current Comparisons with other common
market price
stocks
per share of common stock
Dividend yield on preferred stock
Dividend per share of preferred stock + Current Comparison with other preferred
market price
stocks
per share of preferred stock
Cash flow per share of common stock Net cash provided by operating activities +
Test of ability to pay dividends
Average number of share of common stock
and liabilities
outstanding

Exhibit 135: Summary of ratios
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...
They must follow consistent accounting practices if valid interperiod
comparisons are to be made
...
Accountants
cannot do much more than disclose the fact that one company is using FIFO and another is using LIFO for
inventory and cost of goods sold computations
...

Also, when comparing a company's ratios to industry averages provided by an external source such as Dun &
Bradstreet, the analyst should calculate the company's ratios in the same manner as the reporting service
...
Net sales is sometimes preferable because all companies do not compute and report cost of goods sold
amounts in the same manner
...
A single
important event may have been largely responsible for a given relationship
...
Such an event would severely affect the percentage of gross margin to net
sales
...

Analysts must consider general business conditions within the industry of the company under study
...

Investors also need to consider the seasonal nature of some businesses
...

Potential investors should consider the market risk associated with the prospective investment
...

Potential investors should realize that acquiring the ability to make informed judgments is a long process and
does not occur overnight
...

Relationships between financial statement items also become more meaningful when standards are available for
comparison
...
Such standards consist of (1) those in the
analyst's own mind as a result of experience and observations, (2) those provided by the records of past
performance and financial position of the business under study, and (3) those provided about other enterprises
...

In financial statement analysis, remember that standards for comparison vary by industry, and financial
analysis must be carried out with knowledge of specific industry characteristics
...
Analysis and interpretation of financial statements
property, plant, and equipment, while an electric utility company would have no merchandise inventory (except for
repair parts) and a large investment in property, plant, and equipment
...
Acceptable current ratios, gross margin percentages, debt to
equity ratios, and other relationships vary widely depending on unique conditions within an industry
...


Exhibit 136: Graphic depiction of financial statement analysis utilizing financial rations
The bankruptcies of companies like General Motors and Lehman Brothers, with the resulting significant losses
to employees, stockholders, and other members of the general public, have caused important changes in corporate
governance, standards of accounting, and auditing procedures and standards
...
Further changes are likely
...
This means they will reveal more clearly the
results of operations and the financial condition of the company
...
0 License
proper identification of other risks
...
There
have been too many situations where companies have had to restate their earnings for prior years because they did
not properly disclose material facts or properly implement the revenue recognition and/or expense recognition
principles that were covered in Chapter 5
...
Enron was formed in 1985 and
became a major player in the energy industry
...
Top executives began selling stock shortly thereafter, while at least for a short
period during the ensuing fall in the stock's price, employees were prevented from doing so
...
2 billion write-off in stockholder's equity
...
In December 2001, Enron
filed for bankruptcy
...
Employees of
Enron not only lost their jobs, but many also lost their retirement savings because they consisted
largely of Enron stock
...
The
state of Florida's pension fund lost about USD 340 million
...
, was accused of shredding documents pertaining to Enron after the US Justice
Department confirmed its investigation and was indicated in March of 2002 for that action
...
S
...
They are also more likely to investigate questionable transactions
...

Management's letter to the stockholders contained in the annual report, and usually signed by the CEO, contains
the views of management regarding current operations, operating results, and plans for the future
...
There could be financial penalties if this letter is
purposely misleading in that its contents are not supported by the financial statements or they misrepresent
significant facts
...
The SarbanesOxley Act of 2002 in the US sets more stringent standards for financial reporting for public companies and their
managers
...

Financial statement analysis is going to have increasing importance
...
Some consider this amount to be less susceptible to manipulation than is net income
...
Analysis and interpretation of financial statements
Management may disclose in an accounting policy statement, its policies regarding their business practices and
those accounting policies that were followed in preparing the financial statements
...

Professional financial analysts, such as those working for stock brokerage firms and those employed to help
evaluate possible merger and acquisition candidates, typically go "beyond the numbers" in analyzing a company
...

They are interested in evaluating such factors as the competence and integrity of management
...
In other words, does everything seem legitimate or are there possible significant hidden factors that
have not yet been identified which makes one think that something is not right
...
Needed changes will be made to maintain public confidence in financial reporting
...

This chapter concludes our coverage of financial accounting
...
It is important to realize that it is impossible to completely separate financial and
managerial accounting information into neat packages
...
Also, some of the concepts covered in managerial
accounting (e
...
job costing and process costing) have a direct impact on the formal financial statements
...
Instead, management accountants can provide to management whatever
information in whatever form management requests
...
One of the best in this category is called “Smart Stops on
the Web”, a series authored by Megan Pinkston
...
journalofaccountancy
...

You may want to investigate this article and some of the others in the series and then visit some of
the websites they list
...
The more you know about it, the more marketable you will be upon graduation
...

• Management's analysis of financial statements primarily relates to parts of the company
...

• External users focus their analysis of financial statements on the company as a whole
...


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...

• This information is the significant relationships between data and trends in those data assessing the

company's past performance and current financial position
...

• Present and potential company investors use this information to assess the profitability of the firm
...

• Published reports are one source of financial information
...

• Government reports are another source of financial information and include Form 10-K, Form 10-Q, and

Form 8-K
...

• Financial service information, business publications, newspapers, and periodicals offer meaningful

financial information to external users
...
;
and Robert Morris Associates all provide useful industry information
...

• Horizontal analysis is the calculation of dollar changes or percentage changes in comparative statement

items or totals
...

• Vertical analysis consists of a study of a single financial statement in which each item is expressed as a

percentage of a significant total
...

• Trend analysis compares financial information over time to a base year
...

(b) Assigning a weight of 100 per cent to the amounts appearing on the base-year financial statements
...
The percentages are computed by dividing nonbase-year
amounts by the corresponding base-year amounts and then multiplying the results by 100
...

• Liquidity ratios indicate a company's short-term debt-paying ability
...

• Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a

company
...

• Profitability tests are an important measure of a company's operating success
...

Accounting Principles: A Business Perspective

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...
These tests include (1) earnings yield on common stock, (2) price-earnings ratio, (3) dividend
yield on common stock, (4) payout ratio on common stock, (5) dividend yield on preferred stock, and (6) cash
flow per share of common stock
...

• Need for comparative data: Analysts must be sure that their comparisons are valid—especially when

the comparisons are of items for different periods or different companies
...
Also, the general
business conditions and the possible seasonal nature of the business must be taken into consideration, since
these factors could have an impact on the financial statements
...

• Need for comparative standards: In financial statement analysis, remember that standards for

comparison vary by industry, and financial analysis must be carried out with knowledge of specific industry
characteristics
...
7 $6,984
...
0 3,325
...
7 $3,659
...
4 2,585
...
5
118
...
8 $ 954
...
0
198
...
8 $ 756
...
4
685
...
8
273
...
9
762
...
3

$ 150
...
5
503
...
3
2,640
...
6
$4,808
...
6
1,506
...
8
102
...
0
(374
...
8
2,407
...
8
104
...
2
(380
...
0 License
Currency translation adjustment
Total liabilities and stockholders' equity

(435
...
4)
$4,896
...
7

a
...

b
...

Demonstration problem B The balance sheet and supplementary data for Xerox Corporation follow:
Xerox corporation
Balance sheet with IOFS on an equity basis
2003 December 31
(USD millions)
2003
Assets
Cash
$ 1,741
Accounts receivable, net
2,281
Finance receivables, net
5,097
Inventories
1,932
Deferred taxes and other current assets
1,971
Total current assets
$ 13,022
Finance receivables due after one year, net
7,957
Land, buildings, and equipment, net
2,495
Investments in affiliates, at equity
1,362
Goodwill
1,578
Other assets
3,061
Total assets
$ 29,475
Liabilities and stockholders' equity
Short-term debt and current portion of long-term
$ 2,693
debt
Accounts payable
1,033
Accrued compensation and benefit costs
662
Unearned income
250
Other current liabilities
1,630
Total current liabilities
$ 6,268
Long-term debt
15,404
Liabilities for post-retirement medical benefits
1,197
Deferred taxes and other liabilities
1,876
Discontinued policyholders' deposits and other
670
operations liabilities
Deferred ESOP benefits
(221)
Minorities' interests in equity of subsidiaries
141
Preferred stock
647
Common shareholders' equity (108
...

• Net sales, USD 18,701
...

• Net interest expense, USD 1,031
...

• Net accounts receivable on January 1, USD 2,633
...


Compute the following ratios:
a
...

b
...

c
...

d
...

e
...

f
...


Accounting Principles: A Business Perspective

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...
Times interest earned ratio
...

Kellogg Company
Common-size comparative income statements
For the year ended 2003 December 31, and 2002

Net revenues
Cost of goods sold
Gross margin
Operating expenses
Nonoperating expense (interest)
Income before income taxes
Income taxes
Net earnings

Per cent
2003
100
...
84
52
...
69
1
...
49 %*
4
...
46 %*

2002
100
...
61
52
...
02
1
...
67 %
2
...
83%

*Difference due to rounding
...

Kellogg company
Comparative balance sheets
2003 December 31, and 2002
(USD millions)
Increase or Decrease
2003
2002
2003
2002
amount
per cent

Assets
Cash and temporary investments $204
...
3
Inventories
443
...
3
Property, net
2,526
...
9
Total assets
$4,896
...
6
Long-term liabilities
1,506
...
8
Capital in excess of par value
102
...
0
Treasury stock
(374
...
3)
Total liabilities and stockholders' $4,896
...
6
678
...
8
236
...
9
589
...
7

$ 53
...
8
(60
...
0
(114
...
0
$ 87
...
72 %
1
...
91)
15
...
32)
27
...
82 %

$ 1,587
...
7
103
...
5
1,317
...
9)
(331
...
7

$ 904
...
5)
0
...
5)
183
...
9
(103
...
6

56
...
44)
0
...
39)
13
...
81)
31
...
82 %

Solution to demonstration problem B
a
...
08 :1
Current liabilities USD 6,268,000,000

b
...
45 :1
Current liabilities USD 6,268,000,000

c
...
61 time
Average net accounts receivable USD 2,457,000,000

d
...
0 License
Cost of goods sold USD 6,197,000,000
=
=2
...
Total assets turnover:
Net sales
USD18,701,000,000
=
=
...
Equity ratio:
Stockholders ' equity USD 4,140,000,000
=
=14
...
Times interest earned ratio:
Income beforeinterest also taxes
USD 647,000,000
=
=
...

Acid-test (quick) ratio Ratio of quick assets (cash, marketable securities, and net receivables) to current
liabilities
...

Cash flow margin Net cash provided by operating activities divided by net sales
...

Common-size statements Show only percentages and no absolute dollar amounts
...

Current ratio Also called working capital ratio
...

Debt to equity ratio Total debt divided by stockholders' equity
...

Dividend yield on preferred stock Dividend per share of preferred stock divided by current market price
per share of preferred stock
...

Earnings yield on common stock Ratio of current EPS to current market price per share of common
stock
...

Horizontal analysis Analysis of a company's financial statements for two or more successive periods
showing percentage and/or absolute changes from prior year
...

Inventory turnover Cost of goods sold divided by average inventory
...

Net income to net sales Net income divided by net sales
...

Nonoperating assets Assets owned by a company but not used in producing operating revenues
...

Number of days' sales in accounts receivable The number of days in a year (365) divided by the
accounts receivable turnover
...

Accounting Principles: A Business Perspective

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...

Operating margin Net operating income divided by net sales
...

Price-earnings ratio The ratio of current market price per share of common stock divided by the EPS of
the stock
...
Result is equal to net
Net sales
Operating assets
operating income divided by operating assets
...

Return on equity (ROE) Net income divided by average common stockholders' equity
...

Times interest earned ratio A ratio computed by dividing income before interest and taxes by interest
expense (also called interest coverage ratio)
...

Total assets turnover Net sales divided by average total assets
...

Turnover The relationship between the amount of an asset and some measure of its use
...

Turnover of operating assets Net sales divided by operating assets
...

Yield (on stock) The yield on a stock investment refers to either an earnings yield or a dividend yield
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

Vertical analysis helps detect changes in a company's performance over several periods and highlights trends
...

Liquidity ratios show a company's capacity to pay maturing current liabilities
...

Financial statement analysts must be sure that comparable data are used among companies to make the
comparisons valid
...

The following data were abstracted from the 2007 December 31, balance sheet of Andrews Company (use for the
first two questions questions):
Cash
Marketable securities
Accounts and notes receivable,
net
Merchandise inventory
Prepaid expenses
Accounts and notes payable,

$136,000
64,000
184,000
244,000
12,000
256,000

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...
1:2
...
2:1
...
1
...

d
...

The acid-test ratio is:
a
...

b
...

c
...
2:1
...
3:1
...
5
...

b
...
714 times per year
...
5 times per year
...
6
...

The inventory turnover is:
a
...

b
...
8125 times per year
...
3
...

d
...

The times interest earned ratio is:
a
...
75 times per year
...
3
...

c
...

d
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
Do you agree? Why?

Accounting Principles: A Business Perspective

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...


➢

Before the Marvin Company issued USD 20,000 of long-term notes (due more than a year from the
date of issue) in exchange for a like amount of accounts payable, its current ratio was 2:1 and its acidtest ratio was 1:1
...


➢

Indicate which of the relationships illustrated in the chapter would be best to judge:
➢
➢

The overall efficiency of the firm without regard to the sources of assets
...


➢

The safety of long-term creditors' interest
...


The safety of preferred stockholders' dividends
...


➢

Price-earnings ratio
...


➢

Dividend yield on preferred stock
...


➢

Times preferred dividends earned
...


➢
➢

Payout ratio
...


How is the rate of return on operating assets determined? Is it possible for two companies with
operating margins of 5 per cent and 1 per cent, respectively, to both have a rate of return of 20 per
cent on operating assets? How?

➢

Cite some of the possible deficiencies in accounting information, especially regarding its use in
analyzing a particular company over a 10-year period
...


➢

Real world question From the Consolidated Statements of Income of The Limited in the Annual
report appendix, determine the 2003 net income per common share
...


➢

Real world question From the financial statements of The Limited in the Annual report appendix,
determine the 2003 cash flow margin
...
0 License
Exercises
Exercise A Income statement data for Boston Company for 2009 and 2010 follow:
Net sales
Cost of goods sold
Selling expenses
Administrative expenses
Federal income taxes

2009
$2,610,000
1,829,600
396,800
234,800
57,600

2010
$1,936,000
1,256,400
350,000
198,400
54,000

Prepare a horizontal and vertical analysis of the income data in a form similar to Exhibit 134
...

Exercise B A company engaged in the following three independent transactions:
• Merchandise purchased on account, USD 2,400,000
...

• Capital stock issued for cash, USD 2,400,000
...
Compute the current ratio after each of these transactions assuming current assets were USD 3,200,000 and
the current ratio was 1:1 before the transactions occurred
...
Repeat part (a) assuming the current ratio was 2:1
...
Repeat part (a) assuming the current ratio was 1:2
...
Its average net accounts receivable balance is USD
920,000
...
What is the average number of days accounts receivable are outstanding?
b
...

Exercise E From the following partial income statement, calculate the inventory turnover for the period
...
, had net sales of USD 3,520,000, gross margin of USD 1,496,000, and operating
expenses of USD 904,000
...
Compute Eastern's rate of return on
operating assets
...
Analysis and interpretation of financial statements
Exercise G Nelson Company began the year 2010 with total stockholders' equity of USD 2,400,000
...
Compute the rate of return on
average stockholders' equity for 2010
...

Exercise H Rogers Company had 60,000 shares of common stock outstanding on 2010 January 1
...
The amount of earnings available for common stockholders for
2010 was USD 600,000
...
On March 31, it
issued 96,000 shares for cash, and on September 30, it purchased 80,000 shares of its own stock for cash
...

Exercise J A company reported EPS of USD 2 (or

USD 2,400,000
) for 2009, ending the year with
1,200,000 shares

1,200,000 shares outstanding
...

Compute EPS for 2010, and compute the adjusted earnings per share for 2009 that would be shown in the 2010
annual report
...
How many times was interest earned?
Exercise L John Company had 20,000 shares of USD 600 par value, 8 per cent preferred stock outstanding
...
The market price per share was USD 720
...
How many times were the preferred dividends earned?
b
...
The amount of earnings available to common stockholders was USD 800,000
...
Compute the EPS and the price-earnings ratio
...

Loom
Consolidated statement of earnings
For the years ended 2010 December 31, and 2009
(USD thousands, except per data share)
December 31
(1)
(2)
2010
2009
Net sales
$ 2,403,100
$ 2,297,800
Cost of sales
1,885,700
1,651,300
Gross earnings
$ 517,400
$ 646,500
Selling, general and administrative expenses 429,700
376,300
Goodwill amortization
37,300
35,200
Impairment write down of goodwill
158,500
0
Operating earnings (loss)
$ (108,100)
$235,000
Interest expense
(116,900)
(95,400)
Other expense-net
(21,700)
(6,100)
Earnings (loss) before income tax (benefit)
$ (246,700)
$133,500
expense, extraordinary item and cumulative
effect of change in accounting principles
Income tax (benefit) expense
(19,400)
73,200
Earnings (loss) before cumulative effect of
$ (227,300)
$60,300

714

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...

Other
Total other assets
Total assets
Liabilities and stockholders' equity
Current liabilities
Current maturities of long-term debt
Trade accounts payable
Accrued insurance obligations
Accrued advertising and promotion
Interest payable
Accrued payroll and vacation pay
Accrued pension
Other accounts payable and accrued expenses
Total current liabilities
Noncurrent liabilities
Long-term debt
Net deferred income taxes
Other
Total noncurrent liabilities
Total liabilities
Common stockholders' equity
Common stock and capital in excess of par
value, $
...
Analysis and interpretation of financial statements
Currency translation and minimum pension
liability adjustments
Total common stockholders' equity
Total liabilities and stockholders' equity

(22,500)

(22,900)

$ 895,600
$ 2,919,500

$ 1,125,800
$ 3,163,500

Perform a horizontal and vertical analysis of Loom's financial statements in a manner similar to those illustrated
in this chapter
...

Problem B Deere & Company manufactures, distributes, and finances a full range of agricultural equipment; a
broad range of industrial equipment for construction, forestry, and public works; and a variety of lawn and grounds
care equipment
...
Consider the following information from the Deere & Company 2000 Annual Report:
(in millions)
Sales
Cost of goods sold
Gross margin
Operating expenses
Net operating income

1997
$12,791
8,481
4,310
2,694
$ 1,616

1998
$13,822
9,234
4,588
2,841
$ 1,747

1999 2000
$11,751 $13,137
8,178 8,936
3,573 4,201
3,021 3,236
$ 552 $ 965

a
...

b
...

Problem C The following data are for Toy Company:

Allowance for uncollectible accounts
Prepaid expenses
Accrued liabilities
Cash in Bank A
Wages payable
Accounts payable
Merchandise inventory
Bonds payable, due in 2005
Marketable securities
Notes payable (due in six months)
Accounts receivable
Cash flow from operating activities

December 31
2011
2010
$72,000
$57,000
34,500
45,000
210,000
186,000
1,095,000
975,000
-037,500
714,000
585,000
1,342,500
1,437,000
615,000
594,000
217,500
147,000
300,000
195,000
907,500
870,000
192,000
180,000

a
...

b
...

c
...

d
...

e
...

Problem D On 2011 December 31, Energy Company's current ratio was 3:1 before the following transactions
were completed:
• Purchased merchandise on account
...

• Sold equipment for cash
...

• Sold obsolete merchandise for cash (at a loss)
...

• Wrote off goodwill to retained earnings
...

• Purchased land for cash
...
0 License
• Returned merchandise that had not been paid for
...
Uncollectible amount is less than the balance in the

Allowance for Uncollectible Accounts
...

• Declared a stock dividend on common stock
...

a
...

b
...

Problem E Digital Company has net operating income of USD 500,000 and operating assets of USD
2,000,000
...

The accountant for the company computes the rate of return on operating assets after computing the operating
margin and the turnover of operating assets
...
Show the computations the accountant made
...
Indicate whether the operating margin and turnover increase or decrease after each of the following changes
...
The events are not interrelated;
consider each separately, starting from the original earning power position
...

(a) Sales increased by USD 160,000
...

(b) Management found some cost savings in the manufacturing process
...
The savings resulted from the use of less materials to manufacture
the same quantity of goods
...
Operating income was not affected by the reduction in inventory
...

(d)The federal income tax rate increased and caused income tax expense to increase by USD 20,000
...

(e) The company issued bonds and used the proceeds to buy USD 400,000 of machinery to be used in
the business
...
Net operating income increased by USD
100,000 (net sales did not change)
...
The
following information is for Polaroid:
(in millions)
Net sales
Income before interest and taxes
Net income
Interest expense
Stockholders' equity (on 1998 December 31,
$3,988)
Common stock, par value $1, December 31

2000
$13,994
2,310
1,407
178
3,428

1999
$14,089
2,251
1,392
142
3,912

978

978

Compute the following for both 2000 and 1999
...

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EPS of common stock
...
Net income to net sales
...
Net income to average common stockholders' equity
...
Times interest earned ratio
...
The following balance sheet and supplementary data are for The Walt
Disney Company for 2000
...
01 par value)
Retained earnings
Cumulative translation and other adjustments
Treasury shares
Total liabilities and stockholders' equity

$ 842
3,599
702
1,162
1,258
$7,563
5,339
2,270
$16,160
(6,892)

9,718
1,995
597
16,117
1,428
$25,027
$ 5,161
2,502
739
$ 8,402
6,959
2,833
2,377
356

$12,101
12,767
(28)
(740)

24,100
$45,027

• Net income, USD 920
...

• Cost of goods sold, USD 21,321
...

• Inventory on 1999 September 30, USD 796
...


Calculate the following ratios and show your computations
...

a
...

b
...

c
...

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...
Number of days' sales in accounts receivable (assume 365 days in 2000)
...
EPS of common stock (ignore treasury stock)
...
Times interest earned ratio
...
Equity ratio
...
Net income to net sales
...
Total assets turnover
...
Acid-test ratio
...
Selected data for the year are:
Merchandise inventory, January 1
Current assets
Total assets (operating)
Cost of goods sold (FIFO)
Merchandise inventory, December
31 (LIFO)
Merchandise inventory, December
31 (FIFO)
Current liabilities
Net sales
Operating expenses

$1,430,000
3,603,600
5,720,000
2,230,800
1,544,400
1,887,600
1,144,000
3,832,400
915,200

a
...

b
...

Alternate problems
Alternate problem A Steel Corporation's comparative statements of income and retained earnings and
consolidated balance sheet for 2010 and 2009 follow:
Steel Corporation
Consolidated statement of Earnings
For the years ended 2010 December 31, 2009
(USD thousands)
December31
(1)
(2)
2010
2009
Net sales
$4,876
...
4
Costs and expenses:
Cost of sales
$4,202
...
3
Depreciation
284
...
1
Estimated restructuring losses
111
...
4
Total costs
$4,598
...
8
Income from operations
$268
...
6
Financing income (expense):
Interest and other income
7
...
1
Interest and other financing costs
(60
...
2)
Loss before income taxes and cumulative
$ 216
...
5
effect of changes in accounting
Benefit (provision) for income taxes
(37
...
0)
Net earning (loss)
$ 179
...
5
Retained earnings, January 1
(859
...
9)
$ (679
...
4)
Dividends
0
...
0
Retained earnings, December 31
$ (679
...
4)
Steel Corporation
Consolidated balance sheet
As of 2010 December 31, and 2009
December 31
(1)
(2)
2010
2009

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...
9 and $2
...
5 and
$4167
...
2);
Authorized 20,000,000 shares
Preference stock – at $1 per share par value
(aggregate liquidation preference of $88
...
0
374
...
6

$ 159
...
5
$ 679
...
5
604
...
8

$ 331
...
9
16
...
2
13
...
8
2,714
...
9
7
...
1
2,759
...
3
885
...
0
$ 5,700
...
2
903
...
6
$ 5,782
...
4
208
...
0
72
...
5
146
...
6
$ 1,115
...
0
546
...
6
$ 3,412
...
0

$ 387
...
8
138
...
6
88
...
9
$ 1,011
...
1
1,441
...
4
388
...
4
$ 4,626
...
6

$ 11
...
6

2
...
7

111
...
4)

(59
...
6
(679
...
3
$ 5,700
...
6
(859
...
8
$ 5,782
...
Perform a horizontal and vertical analysis of Steel's financial statements in a manner similar to Exhibit 133
and Exhibit 134
...
Comment on the results obtained in part (a)
...
The following information pertains to
Ford: (in millions)
(in millions)
Sales
Cost of goods sold
Gross margin
Operating expenses
Net operating income

1998
$118
...
0 License
a
...

b
...

Alternate problem C The following data are for Clock Company: Allowance for uncollectible accounts
Notes payable (due in 90 days)
Merchandise inventory
Cash
Marketable securities
Accrued liabilities
Accounts receivable
Accounts payable
Allowance for uncollectible accounts
Bonds payable, due 2008
Prepaid expenses
Cash flow from operating activities

December
2011
$75,200
240,000
100,000
49,600
19,200
188,000
112,000
24,000
156,000
6,400
60,000

31
2010
$60,000
208,000
128,000
30,000
22,000
184,000
72,000
15,200
160,000
7,360
40,000

a
...

b
...

c
...

d
...

e
...

Alternate problem D Tulip Products, Inc
...

• Exchanged old equipment for new equipment
...
)
• Declared a cash dividend on preferred stock
...

• Retired mortgage notes that would have matured in 2011
...

• Paid cash for a patent
...

• Purchased inventory for cash
...
Uncollectible amount is less than the balance of the

Allowance for Uncollectible Accounts
...

• Purchased a computer and gave a two-year promissory note
...

• Borrowed from the bank on a 120-day promissory note
...
Interest expense was involved
...

a
...

b
...

Alternate problem E The following selected data are for three companies:
Operating

Net

Net

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...
Determine the operating margin, turnover of operating assets, and rate of return on operating assets for each
company
...
In the subsequent year, the following changes took place (no other changes occurred):
Company 1 bought some new machinery at a cost of USD 156,000
...

Company 2 sold some equipment it was using that was relatively unproductive
...
As a result of the sale of the equipment, sales declined by USD 312,000, and operating
income declined by USD 6,240
...
As a result, sales increased by USD
9,360,000, and operating income increased by USD 499,200
...
Operating margin ratio?
b
...
Rate of return on operating assets?
• Which one realized the largest dollar change in operating income? Explain this change in relation to the

changes in the rate of return on operating assets
...
, produces
a diverse array of specialty foods
...
:
(USD thousands)
Net sales
Income before interest and taxes
Net income
Interest expense
Stockholders' equity
Common stock, no par value, November 30

2000

1999

$2,123,500
225,700
137,500
39,700
359,300
175,300

$2,006,900
174,700
98,500
32,400
382,400
173,800

Assume average common shares outstanding for 2000 and 1999 are 69,600 and 72,000 (in thousands),
respectively
...
Then compare and comment
...

a
...

b
...

c
...

d
...

Alternate problem G Parametric Technology Corporation is in the CAD/CAM/CAE industry and is the top
supplier of software tools used to automate a manufacturing company
...
0 License
Current assets
Cash and cash equivalents
Short-term investments
Accounts receivable, net of allowances for doubtful account of $6,270
Other current assets
Total current assets
Marketable investments
Property and equipment, net
Other assets
Total assets
Liabilities and stockholders' equity
Current liabilities
Accounts payable and accrued expenses
Accrued compensation
Deferred revenue
Income taxes
Total currents liabilities
Other liabilities
Stockholders' equity
Preferred stock, $
...
01 par value; 500,000 shares authorized; 276,053
(2000) and 272,277 (1999) shares issued
Additional paid-in capital
Foreign currency translation adjustment
Accumulated deficit
Treasury stock, at cost, 6,456 (2000) and 2,113 (1999) shares
Total liabilities and stockholders' equity

$ 325,872
22,969
183,804
95,788
$ 628,433
26,300
66,879
203,271
$ 924,883
$ 77,144
52,112
231,495
1,601
$ 362,352
33,989
2,761
1,641,513
(12,629)
(1,036,456)
(66,647)
$ 924,883

• Net loss, (USD 3,980)
...

• Cost of goods sold, USD 244,984
...

• Total interest expense for the year, USD 367
...


Calculate the following ratios and show your computations
...

a
...

b
...

c
...

d
...

e
...

f
...

g
...

h
...

i
...

Alternate problem H Paper Company is considering switching from the FIFO method to the LIFO method of
accounting for its inventory before it closes its books for the year
...
Following are data compiled from the adjusted trial balance at the end of the year:
Merchandise inventory, December
31 (FIFO)
Current liabilities
Net sales
Operating expenses

$1,008,000
720,000
2,520,000
774,000

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...

a
...

b
...

Beyond the numbers – Critical thinking
Business decision case A The comparative balance sheets of the Darling Corporation for 2011 December 31,
and 2010 follow:
Darling Corporation
Comparative balance sheets
2011 December 31, and 2010
(USD millions)
2011
Assets
Cash
Accounts receivable, net
Merchandise inventory
Plant and equipment, net
Total assets
Liabilities and stockholders' equity
Accounts payable
Common stock
Retained earnings
Total liabilities and stockholders' equity

2010

$ 480,000
86,400
384,000
268,800
$ 1,219,200

$ 96,000
115,200
403,200
288,000
$902,400

$ 96,000
672,000
451,200
$1,219,200

$ 96,000
672,000
134,400
$902,400

Based on your review of the comparative balance sheets, determine the following:
a
...
What was the primary source of the large increase in the cash balance from 2010 to 2011?
c
...
What other comparisons and procedures would you use to complete the analysis of the balance sheet?
Business decision case B As Miller Manufacturing Company's internal auditor, you are reviewing the
company's credit policy
...
If cash sales account for 30 per cent of all sales and credit terms are always 1/10, n/60, determine all turnover
ratios possible and the number of days' sales in accounts receivable at all possible dates
...
)
b
...
, Baker Company, or Cookie Corp
...
The companies' investment
shares are selling at about the same price
...

Bonds with a 10% interest rate
Preferred stock with an 8%

Baker
Company
$2,400,000

Cookie
Corp
...
0 License
dividend rate
Common stock, $10 par value
Retained earnings
Total long-term equity
Number of common shares
outstanding

$4,800,000
384,000
$5,184,000
480,000

2,400,000
384,000
$5,184,000
240,000

2,400,000
384,000
$5,184,000
240,000

Prince has already consulted two investment advisers
...
The other adviser believes that each company will earn about USD
960,000 per year before interest and taxes
...
Compute each of the following, using the estimates made by the first and second advisers
...

(b) EPS of common stock
...

b
...
Are the stockholders as a group (common and preferred) better off with or without the use of long-term debt
in the companies?
Annual Report analysis D The following selected financial data excerpted from the annual report of
Appliance Corporation represents the summary information which management presented for interested parties to
review:
Appliance Corporation
Selected Financial Data
(USD thousands except per share data)
2010
2009
2008
Net sales
$3,049,524 $3,372,515 $2,987,054
Cost of sales
2,250,616 2,496,065
2,262,942
Income taxes
74,800
90,200
38,600
Income (loss) from continuing
(14,996)
151,137
51,270
operations
Per cent of income (loss) from
continuing operations to net sales
(0
...
5%
1
...
14)
1
...
48
Dividends paid per share
0
...
50
0
...
9%
50
...
0%
Shareowners' equity per share of
common stock
$ 6
...
82
$ 5
...
3%)

2
...
08)
0
...
75
0
...
7%

143,372
2,535,068
809,480
45
...
50

a
...
As an investor, what do you believe management's objectives should be? Which of the preceding items of
information would assist an investor in judging management's performance?
c
...
In
groups of two or three students, calculate either the liquidity, equity, profitability, or market test ratios
...
Analysis and interpretation of financial statements
should select a spokesperson to tell the rest of the class the results of the group's calculations
...

Group project F In a group of two or three students, go to the library and attempt to locate Dun & Bradstreet's
Industry Norms and Key Business Ratios
...
If it is not available at your institution, ask if it is available through an
interlibrary loan
...
) Then select and obtain the
latest annual report of a company of your choice
...
SIC Codes for specific companies are available on COMPACT
DISCLOSURE, an electronic source that may be available at your library
...
The annual report often contains the company's phone
number
...
Then compare these ratios to the industry norms for the company's SIC Code as
given in the Dun & Bradstreet source
...

Group project G In a group of two or three students, obtain the annual report of a company of your choice
Identify the major sections of the annual report and the order in which they appear
...
Comment on your perceptions of the credibility that a reader of the annual
report could reasonably assign to each section of the report
...

Using the Internet—A view of the real world
Visit the following website for Eastman Kodak Company:
http://www
...
com
By following choices on the screen, locate the income statements and balance sheets for the latest two years
...
Compare the ratios to those
shown for Synotech as presented in the chapter
...

Visit the following website for General Electric Company:
http://www
...
com
By following choices on the screen, locate the income statements and balance sheets for the latest two years
...
Compare the ratios to those
shown for Synotech as presented in the chapter
...

Answers to self-test
True-false
True
...


726

This book is licensed under a Creative Commons Attribution 3
...
Horizontal analysis provides useful information about the changes in a company's performance over
several periods by analyzing comparative financial statements of the same company for two or more successive
periods
...
Common-size statements show only percentage figures, such as percentages of total assets and
percentages of net sales
...
Liquidity ratios such as the current ratio and acid-test ratio indicate a company's short-term debt-paying
ability
...
The accrual net income shown on the income statement is not cash basis income and does not indicate
cash flows
...
Analysts must use comparable data when making comparisons of items for different periods or different
companies
...
Current assets: USD 136,000 + USD 64,000 + USD 184,000 + USD 244,000 + USD 12,000 = USD 640,000
Current liabilities: USD 256,000 + USD 64,000 = USD 320,000
Current ratio:

USD 640,000
=2 :1
USD 320,000

c
...
2 : 1
USD 320,000

a
...
5
USD 840,000

c
...
5
USD 960,000

b
...
75 times

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...
Managerial accounting
concepts/job costing
Learning objectives
After studying this chapter, you should be able to:
• Compare and contrast managerial accounting and financial accounting
...

• Explain the difference between product costs and period costs
...

• Explain the pattern of cost flows for a company
...

• Describe job cost flows and determine the cost of jobs
...

• Describe the differences in net income under absorption costing and variable costing (appendix)
...
As a manager, I need to understand
some basic accounting information in order to make decisions and to process the information flow in and out of my
office
...
I track all our invoices, then reconcile them
with a "Deck" report, which we receive from accounting
...

Every year we review our department's past expenditures and our anticipated expenditures, then establish a
budget for the next year
...

Aside from general administration, I am also responsible for a program called "Coca-Cola Cares", an employee
hotline set up in 1992 to provide a vehicle for employees to report any problems they notice in the marketplace such
as broken vending machines or inappropriate use of our trademark
...


Accounting Principles: A Business Perspective

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...
Since independent telemarketing services can be
very expensive, this system allows us to maintain high quality service to Coca-Cola customers in the most
economically feasible way
...

Managerial accounting helps managers make good decisions
...
It compares actual performance to planned performance and facilitates many other important
decisions critical to the success of organizations
...
This chapter provides an overview of
managerial accounting, defines cost terms, and shows how to determine the cost of a particular type of product
known as a job
...
By reporting on the financial activities of the organization, financial
accounting provides information needed by investors and creditors
...

For instance, in their external financial statements, large corporations such as General Electric Company show
single amounts on their balance sheets for inventory
...

We show the fundamental differences between managerial and financial accounting in the chart
...

financial analysts, and creditors
Compliance with generally accepted
Accounting Principles
Must comply with generally accepted accounting principles
...
Internal cost/benefit
evaluation determines how much information is
enough
...

May use estimates of the future for budgeting and
decision making
...

More detailed data are presented about product
...
Some people at lower levels in the organization need detailed information, but not the big picture
provided by a company's income statement
...

All of you will use accounting information in your careers
...

Managerial accountants face many choices involving ethics
...
Managers who fail to achieve these targets may lose their jobs
...
0 License
division or company is having trouble achieving financial performance targets, managers may be tempted to
manipulate the accounting numbers
...
58
The standards recommend that people faced with ethical conflicts follow the company's established policies that
deal with such conflicts
...
In extreme
cases, the accountants may have no alternative but to resign
...
Product costs are the
costs a company assigns to units produced
...

Manufacturing companies use the most complex product costing methods
...

However, since many of you could have careers in service or merchandising companies, we also use
nonmanufacturing examples
...
For instance, a manager or
accountant recorded a sale before the end of Year 1 when, in fact, the sale occurred in Year 2
...
A company known as Comserv provides an example of this type of fraud
...

Comserv recorded revenue for a software installation as follows: First, it recorded a portion of the
revenue when the customer signed a contract
...
This approach complied with generally accepted accounting principles
for external reporting and with company policy for internal reporting
...
Subsequent investigations by Comserv's external auditors and the Securities
and Exchange Commission uncovered several fraudulent activities
...
(The end of the fiscal year was December 31
...
J
...
)
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...
Because of this side agreement, the company should not
have recorded revenue at the time the contract was signed
...
The accounting department, not knowing of
the separate side agreement, recorded revenue at the time of the contract
...
In the end, several people were charged with committing fraud by the Securities and
Exchange Commission, and the company was taken over by another company in the computer
software industry
...

In manufacturing companies, a product's cost is made up of three cost elements: direct material costs, direct
labor costs, and manufacturing overhead costs
...
Direct materials are
those materials used only in making the product and are clearly and easily traceable to a particular product
...
In turn, steel becomes a direct material to an automobile manufacturer
...
Such
materials, called indirect materials or supplies, are included in manufacturing overhead
...
Indirect materials are part of overhead, which we will discuss later
...
As with direct material costs, direct labor costs of a product include only those
labor costs clearly traceable to, or readily identifiable with, the finished product
...

Many employees receive fringe benefits—employers pay for payroll taxes, pension costs, and paid vacations
...
Some companies treat fringe
benefit costs as direct labor
...

Firms account for some labor costs (for example, wages of materials handlers, custodial workers, and
supervisors) as indirect labor because the expense of tracing these costs to products would be too great
...
Indirect labor consists of the cost of labor that cannot, or will not for
practical reasons, be traced to the products being manufactured
...
(You may also
see other names for manufacturing overhead, such as factory overhead, factory indirect costs, or factory burden
...
Any of these

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...
Some people confuse overhead with selling and administrative costs
...

In general, overhead refers to all costs of making the product or providing the service except those classified as
direct materials or direct labor
...
) In
manufacturing companies, manufacturing overhead includes all manufacturing costs except those accounted
for as direct materials and direct labor
...
In addition to indirect materials
and indirect labor, manufacturing overhead includes depreciation and maintenance on machines and factory utility
costs
...

Selling costs Selling costs are costs incurred to obtain customer orders and get the finished product in the
customers' possession
...
The costs of delivery and storage of finished goods are selling costs because they are
incurred after production has been completed
...
Remember that retailers,
wholesalers, manufacturers, and service organizations all have selling costs
...

Executive salaries, clerical salaries, office expenses, office rent, donations, research and development costs, and
legal costs are administrative costs
...

Companies also classify costs as product costs and period costs
...
These costs include the costs of direct materials, direct labor, and manufacturing overhead
...
For this reason, firms expense
(deduct from revenues) period costs in the period in which they are incurred
...

Indirect labor:

Repairs and maintenance on factory buildings
and equipment
Janitors in factory buildings Payroll taxes and fringe benefits for
manufacturing employees
Supervisors in factory
Depreciation on factory buildings and equipment
buildings
Materials storeroom
Insurance and taxes on factory property and
personnel
inventories
Cost accountant
Utilities for factory buildings
Indirect materials:
Oil
Nails

Exhibit 137: Manufacturing overhead costs
To illustrate, assume a company pays its sales manager a fixed salary
...


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...
For example, consulting firms, public accounting
firms, and law firms have inventories of work not yet billed to clients
...
Inventories
represent the time and talent that have gone into the job
...


Financial reporting by manufacturing companies
Many of you will work in manufacturing companies or provide services for them
...
This section will help you understand how
manufacturing companies work and how to read both their internal and external financial statements
...
To determine your
profitability, you would subtract the cost of bicycles and accessories from your gross sales as cost of goods sold
...
Accounting for manufacturing costs is more complex than accounting
for costs of merchandise purchased that is ready for sale
...
A merchandiser purchases finished goods ready to be sold
...

Thus, while a merchandiser has only one type of inventory—merchandise available for sale—a manufacturer has
three types—unprocessed materials, partially complete work in process, and ready-for-sale finished goods
...
Looking at Exhibit 138, you can see how the inventory cost flows differ between
manufacturing and merchandising companies
...
There are two major differences in these cost of goods sold
sections: (1) goods ready to be sold are referred to as merchandise inventory by a merchandiser and finished goods
inventory by a manufacturer, and (2) the net cost of purchases for a merchandiser is equivalent to the cost of goods
manufactured by a manufacturer
...
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Exhibit 138: Comparison of inventory cost flows
Merchandiser
Cost of goods sold:
Merchandise inventory, January 1 $ 25,000
Net cost of purchases

165,000

Cost of goods available for sale
$ 190,000
Merchandise inventory, December 30,000
31
Cost of goods sold
$ 160,000

Manufacturer
Cost of goods sold:
Finished goods inventory, January
1
Cost of goods manufactured (from
statement of cost of goods
manufactured)
Cost of goods available for sale
Finished goods inventory,
December 31
Cost of goods sold

$ 50,000
1,100,000
$1,150,000
60,000
$1,090,000

Exhibit 139: Cost of goods sold comparison
The statement of cost of goods manufactured supports the cost of goods sold figure on the income
statement
...
) The two most important numbers
on this statement are the cost to manufacture and the cost of goods manufactured
...
We depict
the relationship among these terms in Exhibit 140
...
Cost of goods
manufactured consists of the cost of all goods completed during the period
...
Cost of goods sold includes
the cost of goods manufactured plus the beginning finished goods inventory minus the ending finished goods
inventory
...

Farside Manufacturing makes calendars and books
...

The statement totals these three costs as cost to manufacture during the period
...
Cost of goods sold does not appear on the cost of goods manufactured statement
but on the income statement
...
In Exhibit 142

Accounting Principles: A Business Perspective

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...
Notice in Exhibit 142 the
relationship of the statement of cost of goods manufactured to the income statement
...
The cost of
goods manufactured is in the same place that purchases would be presented on a merchandiser's income statement
...

This is similar to the merchandiser who presents purchases added to beginning merchandise to derive goods
available for sale
...
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Farside manufacturing company
Income statement
For the year ended 2010 December 31
Sales
$1,800,000
Cost of goods sold:
Finished goods inventory, January 1
$ 50,000
Cost of goods manufactured (see statement
of cost of goods manufactured in Exhibit 141) 1,100,000
Cost of goods available for sale
$1,150,000
Less: Finished goods inventory, December 31 60,000
Cost of goods sold
1,090,000
Gross margin
$ 710,000
Operating expenses:
Selling expenses
$ 300,000
Administrative expenses
200,000
Total operating expenses
500,000
Income from operations
$ 210,000
Note: Income statements presented in external financial statements also include nonoperating revenues and expenses and income taxes
...

These simplified statements show only the items and amounts in the right column of Exhibit 142, not the details in
the left column
...
A
manufacturer's balance sheet may also show greater detail in the property, plant, and equipment section because of
the significant investment in plant assets
...
They place materials received from suppliers in the materials storeroom
...
As they are needed for production, the materials move from the
materials storeroom to the production departments, and their cost is assigned to those production departments, as
shown in Exhibit 143
...

At any time during production, these partially manufactured products are collectively known as work in process
...

Completed products are finished goods
...
As the goods are sold, the company transfers related costs from Finished Goods Inventory to Cost
of Goods Sold
...
Managerial accounting concepts/job costing

Exhibit 143: Product and cost flows
Type of production
Job shop
Hospital, custom home builder,
consulting firm
Batch production
Furniture manufacturer, winery
Repetitive manufacturing
Computer manufacturer, bicycle
manufacturer
Continuous flow processing
Oil refinery, paint manufacturer

Accounting system
Job costing

Type of product
Customized

Mostly job costing

Several different products

Mostly process costing (operations)

Few new products

Process costing

Standardized

Exhibit 144: Production activities and types of accounting systems
The accounting flow of costs follows the physical flow of the manufacturing process in most companies
...
In this chapter and the next, we assume costs
follow the physical flow of products
...
Recall that
products can be either goods or services, so this discussion applies to service and merchandising companies as well
as to manufacturing companies
...
First, companies producing individual, unique products known as jobs use job costing (also called job
order costing)
...

Second, some companies, like furniture manufacturers, produce batches of products
...
g
...
They would then produce the components of
another product (e
...
dining room sets) in a new batch
...
) Companies such as these use job costing methods to accumulate the cost of each batch
...
Repetitive manufacturing lends itself to the use of automated equipment that minimizes
the amount of manual material handling
...

Continuous flow processing is the opposite of job shops
...
Companies use process cost systems in manufacturing paint, grinding
flour, and refining oil
...
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An accounting perspective:
Business insight
Engineers for automobile companies in the United States believe that Japanese manufacturers can
build cars for considerably less than their US counterparts
...
These organizations required a better understanding of their
costs
...
Companies with competitors have to know and control their costs to be
competitive
...
Companies
generally use job cost systems when they can identify separate products or when they produce goods to meet a
customer's particular needs
...

Consulting, law, and public accounting firms use job costing to measure the costs of serving each client
...
Hospitals also use job
costing to determine the cost of each patient's care
...
Creative Printers uses job costing
...

The company compares the cost of each job with the revenue received to be sure the jobs are profitable
...
For example,
Creative Printers recently learned that cookbooks were not profitable
...
To illustrate a
job costing system, this section describes the transactions for the month of July for Creative Printers
...
106: direct materials,
$4,200;direct labor, $5,000; and overhead, $4,000)
Finished goods inventory (Job No
...
105, a set of gardening books, but had not shipped them to the
customer as of June 30
...
106, a set of instruction manuals for computer software, in process at the
beginning of July and completed it in July
...
107, a travel guide for visitors to Southeast Asia, in
July but had not completed it
...
In Exhibit 145, we show the flow of
costs through accounts and the beginning balances just presented
...
Managerial accounting concepts/job costing
Materials Inventory
Beginning 20,000
inventory 25,000
(1)
Ending
21,000
inventory

Payroll
Incurred
Indirect
materials
Indirect
labor
Other
overhead

(2) 24,000

Summary

25,000
Distributed (3) 25,000
Overhead
Applied to
(2) 1,000 production (4) 16,000
(3) 5,000

Work in Process
Inventory Job No
...

Labor
Ovrhd
...

107

(7) 9,800
Overapplied 200
balance

Beginning
inventory
Current
period:
Mats
...

Total
Ending
inventory:
Materials
Labor
Overhead
Total

-0(2) 14,000
(3) 16,000
(4) 12,800
42,800

14,000
16,000
12,800
42,800

Note: Numbers in parentheses refer to journal entries in the text
...


Exhibit 145: Job cost flows-Creative Printers
• During July, Creative Printers purchased USD 25,000 of materials on account
...

Materials inventory
Accounts payable
To record purchase of
materials
...
106, and USD 14,000 to Job No
...
The company also sent indirect materials of USD 1,000
to jobs
...
(Manufacturing companies often use Manufacturing
Overhead for the Overhead account
...
) Each job has a separate Work in Process Inventory account to keep
track of the particular job's costs
...
106 (+A) 9,000
Work in process inventory – Job No
...
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from the storeroom to jobs
...

• Production workers keep track of the time spent on each job at Creative Printers
...
106, USD 16,000 to Job No
...

Work in process inventory – Job No
...
107
16,000
Overhead
5,000
Payroll summary
25,000
To distribute labor costs to jobs and overhead

The entry to record payroll incurred during the accounting period (not shown) includes a debit to Payroll
Summary and a credit to liability accounts to show payables for fringe benefits, such as health insurance, payroll
taxes, and employee wages
...
Look at
Exhibit 145, to see the assignment of labor costs to the Work in Process and Overhead accounts
...

By definition, overhead cannot be traced directly to jobs
...

A cost driver is a measure of activities, such as machine-hours, that is the cause of costs
...
Just as automobile mileage is a good cost driver for measuring the cause of gasoline consumption,
machine-hours is a measure of what causes energy costs
...

Creative Printers assigns overhead (such as machine maintenance) to jobs on a machine-hour basis
...

Creative Printers also assigns overhead (such as building depreciation) to jobs on a machine-hour basis, which is
less logical
...
For example, management did not
believe better overhead allocation would sufficiently improve company profits to justify hiring another accountant
to improve its overhead allocation method
...

Labor basis: Overhead is assigned at the rate of 25 per cent of the cost of labor used on the job
...

For now, assume these overhead rates are correct
...
Creative Printers assigned overhead to Jobs 106 and 107 as follows:
Job 106
Materials
Labor cost
Machine-hours
Job 107

$9,000
$4,000
875 hours

Overhead assigned to Job 106:
5% x $9,000
25% x $4,000
$2 x 875 hours
Total overhead assigned to Job 106
Overhead assigned to Job 107:

Accounting Principles: A Business Perspective

$ 450
1,000
1,750
$3,200

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...
106
Work in process inventory – Job No
...


3,200
12,800

16,000

See Exhibit 145 for the application of overhead to jobs
...
106 was completed
...
This entry records the completion
of Job 106:
Finished goods inventory (+A)
29,400
Work in process inventory – Job No
...


See Exhibit 145 for the flow of costs from Work in Process Inventory to Finished Goods Inventory
...
105 was sold on account in July for USD 9,000
...

Cost of goods sold (-SE)
Finished goods inventory (-A)
To record cost of goods sold in July
(Job 105)
...
Many of

the actual overhead costs are not known until the end of the month or later
...
In addition to the indirect materials and indirect
labor recorded in entries (2) and (3), Creative Printers incurred these other overhead costs for July:
Machinery repairs and maintenance
Utilities, including energy costs to run machines
Depreciation of building and machines
Other overhead
Total overhead incurred in July other than indirect materials and
indirect labor

$4,500
1,000
2,500
1,800
$9,800

To prepare the journal entry, we debit the Overhead account for the actual costs
...
(We assume an outside
contractor does the maintenance and repairs
...

And, finally we credit Accumulated Depreciation for USD 2,500
...


9,800

7,300
2,500

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...
Note that
Exhibit 145, shows only the inventory accounts, Payroll Summary, Overhead, and Cost of Goods Sold, not all of the
accounts in the preceding entries
...
Companies generally transfer the balance of the Overhead account to Cost of Goods Sold at the
end of the accounting period
...
The journal
entry to transfer Creative Printers' overhead balance to Cost of Goods Sold for the month of July is as follows:
Overhead (-SE)
Cost of goods sold (+SE)
To transfer the overhead balance to Cost of
goods sold
...

Why does the previous entry reduce the Cost of Goods Sold by USD 200? The overhead applied to the jobs was
too high—it was overapplied
...
Although those jobs are still in Work in Process
or Finished Goods Inventory, companies usually adjust the Cost of Goods Sold account instead of each inventory
account
...
All jobs appear in Cost of Goods Sold sooner or later, so companies simply adjust
Cost of Goods Sold instead of the inventory accounts
...
We leave the more
complicated procedure of allocating overhead balances to inventory accounts to textbooks on cost accounting
...
If overhead had been underapplied, the company would have debited Cost of Goods Sold and credited
Overhead to transfer the overhead balance
...
Managerial accounting concepts/job costing
Creative Printers
Income statement
For the month ended 2010 July 31

Sales
Cost of goods sold:
Finished goods inventory, July 1
$ 5,500
Cost of goods manufactured
29,400
Cost of goods available for sale
$34,900
Less: Finished goods inventory, July 31
29,400
Cost of goods sold before transfer of overapplied $ 5,500
overhead
Less: Overapplied overhead
200
Cost of goods sold
Gross margin
Selling and administrative expenses
Net income

$9,000

5,300
$3,700
3,000
$ 700

Exhibit 147: Creative Printers-Income statement
Sometime in July or August, Creative Printers would collect its receivables in cash and pay its payables
...
The payroll liabilities amount to USD 25,000
...
Assume the selling and
administrative expenses for July are USD 3,000
...
Later
chapters discuss the role of managerial accounting in performance evaluation
...
For example, Job 105 had revenue of USD 9,000 and costs of USD 5,500
...
If the actual overhead exceeds the applied overhead, they may wish to learn why
the actual overhead is so high
...
If the actual is less than the applied overhead, they may ask the accountants to
reduce the overhead applied to jobs
...
For example, they determined the 5 per
cent rate used to apply materials-related overhead to jobs before the month of July
...

To calculate a predetermined overhead rate, a company divides the estimated total overhead costs for a
period by an expected level of activity
...
Companies set predetermined overhead rates at the
beginning of the year in which they will use them
...
This formula computes a predetermined rate:

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...
Thus, the
predetermined overhead rate would be USD 2 per hour, calculated as follows:
Predetermined overhead rate=

Estimated overhead costs
Expected machine− hours

Predetermined overhead rate=

USD 120,000
60,000

= USD 2 per machine-hour

Some companies compute the overhead rate after the fact; that is, after the jobs are done and the overhead costs
are known
...

Reasons for using predetermined rates Most companies use predetermined overhead rates instead of
actual overhead rates for the following reasons:
• A company usually does not incur overhead costs uniformly throughout the year
...
However, allocating more overhead costs to a job produced in the
winter compared to one produced in the summer may serve no useful purpose
...
If the volume of goods produced

varies from month to month, the actual rate varies from month to month, even though the total cost is
constant from month to month
...

• Predetermined rates make it possible for companies to estimate job costs sooner
...
Without a predetermined rate, companies do not know the costs of production until the end of the
month or even later when bills arrive
...
If Creative Printers had used actual overhead, the company would not have determined the costs of its
July work until August
...


An accounting perspective:
Uses of technology
Recently, many high-tech companies have installed computer-assisted methods of manufacturing,
merchandising, or providing services
...
For example, where robots and computer-assisted manufacturing methods
have replaced people, labor costs have shrunk from 20 per cent to 40 per cent of product costs to
less than 5 per cent
...
On the other hand, in highly automated
Accounting Principles: A Business Perspective

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...

Understanding the learning objectives
• Financial accounting refers to providing financial information primarily for external use
...

• In manufacturing companies, a product's cost is made up of three cost elements: direct materials costs,

direct labor costs, and manufacturing overhead costs
...

• Direct labor costs include only those labor costs clearly traceable to, or readily identifiable with, the finished

product
...

• Product costs are costs incurred in making products
...

• Period costs are not assigned to units of a product but are related more closely to periods of time
...

• The major difference between a merchandiser and a manufacturer is in the types of inventories carried
...

• The manufacturer's balance sheet shows materials, work in process, and finished goods inventories

separately
...

• Accountants record the flow of direct materials costs from Materials Inventory into Work in Process

Inventory
...
When the products
are completed and transferred to the finished goods storeroom, accountants transfer their costs from Work in
Process Inventory to Finished Goods Inventory
...

• Companies producing individual, unique products known as jobs use job costing (also called job order

costing)
...

• Repetitive manufacturing companies (automobile assembly plants) and companies producing in a

continuous flow (oil refineries) use process costing, discussed in the next chapter
...
0 License
• A job cost system (job costing) is a cost system that accumulates costs incurred according to the individual

jobs
...

• The formula for the predetermined overhead rate is:

Predetermined overhead rate=

Estimated overhead costs
Expected level of activitysuch as machine−hours 

• Under variable costing, all the fixed manufacturing overhead costs are charged off (as period costs) during

the period rather than being deferred and carried forward (as product costs) to the next period as part of
inventory cost
...

Appendix: Variable versus absorption costing
Under absorption costing, companies treat all manufacturing costs, including both fixed and variable
manufacturing costs, as product costs
...
Total variable costs change proportionately with changes in total activity, while fixed costs do not
change as activity levels change
...
(Direct labor can be a fixed cost if the company chooses not to
decrease or increase its direct labor force as volume changes
...
)
Variable costing (also known as direct costing) treats all fixed manufacturing costs as period costs to be
charged to expense in the period received
...
Therefore, these fixed costs do not
specifically relate to the manufacture of products
...
Notice that Bradley's variable costing income statement carries the goods in
inventory at USD 3
...
90 full cost
...
It classifies all fixed costs as period costs
no matter what the source of the cost (manufacturing, selling, or administrative)
...
30)
Fixed overhead costs
Total costs of producing 10,000 units
Less: Ending inventory (1,000 units at $3
...
20 each)
Administrative expenses
Income before income taxes

$72,000
$33,000
6,000
$39,000
3,900 35,100
$36,900
$16,800
12,000 28,800
$ 8,100

Accounting Principles: A Business Perspective

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...
30)
Less: Ending inventory (1,000 units at $3
...
20)
Contribution margin
Fixed costs:
Manufacturing overhead
Selling expenses
Administrative expenses
Income before income taxes

costing

$72,000
$33,000
3,300
29,700
$42,300
1,800
$40,500
$ 6,000
15,000
12,000 33,000
$ 7,500

Exhibit 148: Comparative income statements
In comparing the two income statements in Exhibit 148, notice the USD 600 difference in net income for the
month and a USD 600 difference in ending inventory valuation, as shown in Exhibit 149, on the next page
...
Under absorption costing, each unit in ending
inventory carries USD 0
...
At the end of the month, Bradley has
1,000 units in inventory
...
60 X 1,000 units) and is valued at USD 600 more than under variable
costing
...

Therefore, USD 6,000 of fixed manufacturing costs appear on the variable costing income statement as an expense,
rather than USD 5,400 (USD 6,000 fixed overhead costs - USD 600 fixed manufacturing included in inventory)
under absorption costing
...


Exhibit 149: Comparison of results under absorption and variable costing
Finally, remember that the difference between the absorption costing and variable costing methods is solely in
the treatment of fixed manufacturing overhead costs and income statement presentation
...
0 License
selling and administrative expenses as period costs
...
Variable selling and administrative expenses are not part of product cost under either
method
...
Assuming a relatively constant level of production, if inventories increase during the year,
production exceeded sales and reported income before federal income taxes is less under variable costing than
under absorption costing
...

Variable costing is not currently acceptable for income measurement or inventory valuation in external financial
statements that must comply with generally accepted accounting principles (GAAP) in the United States
...

Demonstration problem
Demonstration problem A Good Earth Construction Company uses a job cost system to account for the
houses it builds
...
As of 2010 January 1, its records showed:
Inventories:
Materials and supplies
Work in process (Job No
...
211)

$ 48,000
103,200
120,000

The work in process inventory consists of two jobs:
Job No
...


Cost and sales data for 2010:
• Materials purchased on account, USD 198,000
...
212, USD 48,000; Job No
...


214 (started in 2010), USD 144,000; supervision and other indirect labor, USD 120,000
...
212, USD 31,200; Job No
...
214, USD 96,000; and

indirect materials, USD 4,800
...

• Job No
...

• Jobs 211 and 212 were sold for USD 540,000
...

Prepare journal entries to record the preceding data and close any underapplied or overapplied overhead to Cost
of Goods Sold
...

From the following estimated data, compute the predetermined rate used by each company
...
Managerial accounting concepts/job costing
Direct labor-hours
Direct labor cost
Overhead costs

52,000 48,000
$650,000 $735,000
$845,000 $864,000

39,000
$420,000
$750,000

Basis for predetermined overhead rate:
Company
A
B
C

Basis
Direct labor cost
Direct labor-hours
Machine-hours

Solution to demonstration problem
Solution to demonstration problem A
1
...


3
...


198,000
198,000

Work in process inventory – Job No
...
213
Work in process inventory – Job No
...


48,000
96,000
144,000
120,000

Work in process inventory – Job No
...
213
Work in process inventory – Job No
...


31,200
57,600
96,000
4,800

408,000

189,600

4
...
212
24,000
Work in process inventory – Job No
...
214
72,000
Construction overhead
144,000
To record overhead applied to jobs using the predetermined
rate 50% of direct labor cost: Job No
...
213, $48,000 (50% x $96,000); and Job
No
...


5
...
212
Work in process inventory – Job No
...


408,000
157,200
250,800

The following amounts were computed by adding beginning Work in Process balances to the current month's
debits to Work in Process for direct materials, direct labor, and construction overhead:
Job No
...
213: USD 250,800 (USD 49,200 + USD 57,600 + USD 96,000 + USD 48,000)
USD 408,000
6
...


Accounts receivable
Sales
To record sales on account
...


540,000

Construction overhead
Accumulated depreciation
Various accounts (Accounts payable, accrued liabilities
payable, cash, etc)
To record various construction overhead costs incurred
...
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8
...


4,8000

4,800

Solution to demonstration problem B Company A:
Predetermined overhead rate =

USD 845,000
=130 per cent of direct labor cost
USD 650,000

Company B:
Predetermined overhead rate =

USD 864,000
=USD 18 per direct labor− hour
48,000 hours

Company C:
Predetermined overhead rate =

USD 750,000
=USD6 per machine−hour
125,000 hours

Key terms
Absorption costing (Appendix) A concept of costing under which all manufacturing costs, including both
fixed and variable manufacturing costs, are accounted for as product costs
...

Administrative costs Costs of managing the organization, including the costs of top administrative
functions and various staff departments such as accounting, data processing, and personnel
...

Cost driver Activity or transaction that causes costs to be incurred
...

Cost of goods manufactured Consists of the total costs of all goods completed during the period; includes
cost to manufacture plus beginning work in process inventory minus ending work in process inventory
Cost of goods sold Cost of goods manufactured plus the beginning finished goods inventory minus the
ending finished goods inventory
...

Direct labor Labor costs of all employees actually working on materials to convert them to finished goods
...

Direct materials Materials that are used only in making the product and are clearly and easily traceable to
a particular product
...
Finished Goods Inventory is the title
of an inventory account maintained for such products
...

Indirect materials Materials used in making a product that cannot, or will not for practical reasons, be
traced directly to particular products
...

Managerial accounting Managerial accounting information is intended for internal use
...

Manufacturing overhead All manufacturing costs except for those costs accounted for as direct materials
and direct labor
...

Overapplied (overabsorbed) overhead The amount by which the overhead applied to production
exceeds the actual overhead costs incurred in that same period
...
See manufacturing overhead for overhead in manufacturing companies
...
Managerial accounting concepts/job costing
Period costs Costs related more closely to periods of time than to products produced
...

Predetermined overhead rate Calculated by dividing estimated total overhead costs for a period by the
expected level of activity, such as total expected machine-hours or total expected direct labor-hours for the
period
...
In manufacturing companies, these costs are
direct materials, direct labor, and manufacturing overhead
...

Selling costs Costs incurred to obtain customer orders and distribute the finished product to the customer
...

Underapplied (underabsorbed) overhead The amount by which actual overhead costs incurred in a
period exceed the overhead applied to production in that period
...

All fixed manufacturing costs are charged to expense in the period in which they are incurred
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

A manufacturer produces speedboats, and each one requires a motor
...

A Pepsi-Cola bottling plant is an example of a company that would use a job cost system
...

Overhead cannot be entered in Work in Process Inventory when using a predetermined overhead rate
...

Selling and administrative expenses are part of period costs under both absorption and variable costing
methods
...

Under which cost category are indirect material costs included?
a
...

b
...

c
...

d
...

For financial accounting and external reporting purposes, all selling and administrative expenses are treated as:
a
...

b
...

c
...

d
...


751

This book is licensed under a Creative Commons Attribution 3
...
A merchandiser uses Merchandise Inventory and Direct Labor, whereas a manufacturer uses Finished Goods
Inventory and Cost of Goods Manufactured
...
A merchandiser uses Merchandise Inventory and Cost of Goods Available for Sale, whereas a manufacturer
uses Finished Goods Inventory and Cost of Goods Available for Sale
...
A merchandiser uses Work in Process Inventory and Cost of Goods Sold, whereas a manufacturer uses
Finished Goods Inventory and Cost of Goods Sold
...
None of the above
...
When there are dissimilar products
...
By manufacturers and service companies
...
When goods are produced to meet a customer's particular needs
...
All of the above
...

a
...

b
...

c
...

d
...

The expected level of activity in a production center is 30,000 machine-hours
...
Which of the following is the
predetermined overhead rate per machine-hour?
a
...

b
...

c
...

d
...

You are given the following data relating to a company:
Estimated manufacturing overhead per
year
Expected level of activity per year
Predetermined overhead rate
Actual overhead costs incurred during
year
Actual machine-hours

USD 24,000
40,000 machine-hours
USD 0
...
Manufacturing overhead
Various accounts
Work in process inventory
Manufacturing overhead

22,500

b
...
Managerial accounting concepts/job costing
c
...
Various accounts
Manufacturing overhead
Manufacturing overhead
Work in process inventory

22,500

15,428

24,000
15,428

15,428

22,500
15,428

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...


➢

Why might a company claim that the total cost of employing a person is USD 15
...
50 per hour? How should this difference be classified and why?

➢

Why are certain costs referred to as period costs? What are the major types of period costs incurred
by a manufacturer?

➢

Explain why the income statement of a manufacturing company differs from the income statement of
a merchandising company
...


➢

What are the major reasons for using predetermined manufacturing overhead rates?

➢

What is the formula for computing a predetermined overhead rate? If the expected level of activity in
a production center is 50,000 machine-hours and the estimated overhead costs are USD 750,000,
what is the predetermined overhead rate? Show the calculation
...
101, USD 2,000;
Job No
...
103, USD 5,000
...
101, USD
5,000; Job No
...
103, USD 3,000
...


➢

Record the direct and indirect materials issued in journal entry form
...
24 cm) pizza
...
24 cm) pizza?

➢

Real world question Why is it becoming more important that the managers of hospitals
understand their product costs?

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...


➢

(Appendix) Under what specific circumstances would you expect net income to be larger under
variable costing than under absorption costing? What is the reason for this difference?

Exercises
Exercise A The following costs are incurred by an electrical appliance manufacturer
...

a
...

b
...

c
...

d
...

e
...

f
...

g
...

h
...

i
...

j
...

Exercise B Classify the costs listed in the previous exercise as either product costs or period costs
...
The following data are for the year ended 2010
December 31:
Materials inventory, 2010 January 1
Materials inventory, 2010 December 31
Materials purchases
Direct labor
Work in process inventory, 2010 January 1
Work in process inventory, 2010 December 31
Manufacturing overhead
Finished goods inventory, 2010 January 1
Finished goods inventory, 2010 December 31

$ 45,000
65,000
175,000
225,000
30,000
40,000
130,000
80,000
140,000

Prepare a Cost of Goods Manufactured Statement and compute the cost of goods sold
...
100 and completed it on June 30
...
100 before June 1
...
Assuming
manufacturing overhead is applied at the rate of USD 12 per machine-hour, what is the total cost of Job No
...
100 to Finished Goods Inventory
...
710 has an accumulated total cost of USD 37,800
...
Job No
...
It was also completed in the third week
...
710 used 160 machine-hours during the third week in March
...
710, and give the
journal entry required to record its completion and transfer to Finished Goods Inventory
...
Managerial accounting concepts/job costing
Exercise F Different companies use different bases in computing their predetermined overhead rates
...
Assume the actual hours and cost data were:
Actual
Manufacturing overhead
Direct labor cost
Direct labor-hours
Machine-hours

Paper
$450,000
$850,000
45,000
105,000

Rock
$400,000
$700,000
46,000
200,000

Scissors
$375,000
$400,000
38,000
130,000

a
...

b
...

Exercise H Ernest Peat Consultants uses a job cost system and had the following activity during December:
There were no jobs in beginning Work in Process or Finished Goods Inventory
...
222, 223, and 224
...
222 was completed and the customer was billed for
USD 10,000 on account
...
223 was completed and in Finished Goods Inventory awaiting billing to the client
at the end of the month
...
224 was still in process at month-end
...
222
Job No
...
224

200 hours @ $21/hour
300 hours @ $18/hour
120 hours @ $17/hour

Assume overhead is applied at the rate of USD 10 per labor-hour
...
(The credit part of the journal entry is to Accounts Payable
...

Exercise I The following data relate to Socks Company for the year ended 2010 December 31:
Cost of production:
Direct materials (variable)
Direct labor (variable)
Manufacturing overhead:
Variable
Fixed
Sales commissions (variable)
Sales salaries (fixed)
Administrative expenses (fixed)
Units produced
Units sold (at $18 each)
Beginning inventory, 2010 January 1

$360,000
504,000
180,000
360,000
108,000
72,000
144,000
150,000
120,000
-0-

There were no beginning inventories
...
Prepare two
income statements—a variable costing income statement and an absorption costing income statement
...
0 License
Problems
Problem A Total Block, Inc
...
These would be particularly useful for people who do not want to carry a bottle of sunscreen, according to
Sunspot's marketing manager
...

a
...

b
...

c
...

d
...

e
...

f
...

g
...

h
...

i
...

j
...

Problem B Classify the costs listed in the previous problem as either product costs or period costs
...
, produces videotapes of musical performances
...
You find the following data from records prepared by Good Vibrations, Inc
...
Sales for the year were USD 400,000
...

a
...
, for the year ended 2009
December 31
...
Prepare an income statement for Good Vibrations, Inc
...

Problem D Log Cabin Homes, Inc
...
As of 2010 January 1, its records showed inventories as follows:
Materials and supplies
$100,000
Work in process (Job Nos
...
Managerial accounting concepts/job costing
Finished goods (Job No
...

22
23

Direct
materials
$36,000
40,000

Direct
labor
$40,000
28,000
$76,000

Manufacturing
overhead
$20,000
16,000
$68,000

Total
$ 96,000
84,000
$180,000

Cost and sales data for 2010:
Materials purchased on account, USD 400,000
...
22, USD 60,000; Job No
...
24, USD 180,000
...

Direct labor costs: Job No
...
23, USD 200,000; and Job No
...

Indirect labor costs, USD 80,000
...
Job No
...
23
used 1,000 machine-hours, and Job No
...

Job No
...

Job No
...

Manufacturing overhead costs incurred, other than indirect materials and indirect labor, were depreciation,
USD 80,000, and heat, light, power, miscellaneous, USD 40,000
...
Prepare journal entries to assign the preceding costs to jobs
...
Transfer overapplied or underapplied overhead to Cost of Goods Sold
...
Assuming selling and administrative expenses were USD 100,000, prepare an income statement for 2010
...
As of 2010 January 1, its records
showed the following inventory balances:
Materials (shrubs, trees,
etc
...

211)

$ 13,500
25,800
30,000

The work in process inventory consisted of two jobs:
Job No
...

1010 Wilshire Blvd
...

Landscaping direct labor costs: direct labor to Job No
...
213, USD 24,000; and to
Job No
...
Indirect labor, USD 30,000
...
212, USD 7,800; for Job No
...
214, USD 24,000
...

Overhead is assigned to jobs at USD 3 per labor-hour, with 8,000 labor-hours to Job 212 and 2,000 labor-hours
each to Jobs 213 and 214
...


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This book is licensed under a Creative Commons Attribution 3
...
211 that was in
Finished Goods Inventory on 2010 January 1
...

a
...

b
...

Problem F Speedy Delivery, Inc
...
Speedy
applies overhead to jobs using a predetermined overhead rate based on truck miles
...
Compute the predetermined overhead rate per mile
...
Assume that in 2010, actual manufacturing overhead for hauling operations amounted to USD 15 million, and
24 million truck miles were driven
...

c
...

Problem G Costner Company uses an absorption costing system in accounting for the single product it
manufactures
...
Direct materials and direct labor are variable costs
...
Overhead rates are based on a volume of 12,000
units and are USD 1
...
44 per unit for variable and fixed overhead, respectively
...
There was no inventory at the beginning of 2009
...
Prepare an income statement for 2009 under variable costing
...
Prepare an income statement for 2009 under absorption costing
...
Explain the reason for the difference in net income between a and b
...
, is considering producing a new type of umbrella
...
Classify the following costs of this new product as direct
materials, direct labor, manufacturing overhead, selling, or administrative
...
Cost of advertising the product
...
Fabric used to make the umbrellas
...
Maintenance of cutting machines used to cut the umbrella fabric so it will fit the umbrella frame
...
Wages of workers who assemble the product
...
Managerial accounting concepts/job costing
e
...

f
...

g
...

h
...

i
...

j
...

Alternate problem B Classify the costs listed in Alternate problem A as either product costs or period costs
...

The following account balances are for the year ended 2009 December 31
Administrative expenses
Depreciation expense – Manufacturing equipment
Direct labor
Manufacturing supplies expense
Indirect labor
Beginning inventories, 2009 January 1:
Direct materials
Work in process
Finished goods
Ending inventories, 2009 December 31
Direct materials
Work in process
Finished goods
Direct materials purchases
Rent expense – Factory
Sales
Selling expense
Other manufacturing overhead

$ 60,000
50,000
468,000
40,000
36,000
14,000
20,000
128,000
44,000
56,000
92,000
216,000
28,000
1,400,000
72,000
126,000

a
...

b
...

Alternate problem D Cathy's Catering Company uses a job cost system
...
It completed all jobs in November
...
The actual overhead for the month was USD 160,000, of which USD
120,000 should be credited to Accounts Payable and USD 40,000 should be credited to Accumulated Depreciation
...
Transfer any underapplied or overapplied overhead to Cost of Goods Sold
...

Alternate problem E Sullivan Company applied overhead to production using a predetermined overhead rate
based on machine-hours
...
Compute the predetermined overhead rate
...
Assume that in 2010, actual manufacturing overhead amounted to USD 997,500, and 86,000 machine-hours
were used
...

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This book is licensed under a Creative Commons Attribution 3
...
Prepare the journal entry to transfer underapplied or overapplied overhead to Cost of Goods Sold
...
That is, Company B
reimburses Company A for the cost of doing work for Company B
...
Following are costs that various
organizations incur; they fall into three categories: direct materials (DM), direct labor (DL), or overhead (OH)
...

Compressed air used in operating paint sprayers for Student Painters, a company that paints houses and
apartments
...

A production department supervisor's salary
...

Iron ore in a steel mill
...

Services of painters in building construction
...

Cost of paper towels in a factory employees' washroom
...

The plant electricians' salaries
...

Copy editor's salary in a book publishing company
...
Classify each of these items as direct materials, direct labor, or overhead
...
Assume your classifications could be challenged in a court case
...
In which answers are you completely
confident?
Business decision case B Quality Painters, Inc
...
As of 2010 January 1, its records
showed the following inventory balances:
Materials
Work in process
Finished goods

$ 7,000
50,000
0

The work in process inventory consisted of two jobs:
Job No
...

Direct labor costs: direct labor to Job No
...
101, USD 48,000; and to Job No
...
Indirect labor, USD 10,000
...
100, USD 15,600; for Job No
...
102, USD 48,000
...

Accounting Principles: A Business Perspective

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...

All three jobs were completed in January
...

Overhead costs incurred other than indirect labor and indirect materials were depreciation, USD 6,000, and
utilities, fuel, and miscellaneous, USD 6,000
...
Here are the expected total costs (direct materials, direct labor, and
overhead) for the three jobs:
Job 100
Job 101
Job 102

$ 60,000
120,000
130,000

These cost estimates cover the entire job, including both costs in beginning Work in Process Inventory and costs
incurred during January
...
Compare the costs incurred on each job, including the costs in beginning Work in Process Inventory and costs
incurred during January with the expected costs
...
Prepare an income statement for January 2010 assuming selling and administrative expenses for January
were USD 50,000
...

c
...
Assume the newly hired
executive is a whiz at marketing, but a person whose eyes glaze over at the sight of a number
...
Essentially, assume the executive has not seen the
financial statements prepared
...

Ethics case – Writing experience D Refer to the Ethical Perspective discussion of Comserv's activities
entitled “High pressure sales tactics and creative accounting”
...

Ethics case E Suzie Garcia, an accountant for a consulting firm, had just received the monthly cost reports for
the two jobs she supervises: one for Arrow Space, Inc
...
She immediately called her
boss after reading the figures for the Arrow Space job
...
"The job is only about
three-fourths complete, but we have spent all the money that we had budgeted for the entire job
...
"Meanwhile, charge the
rest of the costs needed to complete the Arrow Space job to your US government job
...
Besides, we get reimbursed for costs on the government job, so we will not lose any money on
this problem you have with the Arrow Space contract
...
0 License
What should Suzie do? Does it matter that Suzie's company is reimbursed for costs on the US government
contract? Explain
...
As a salesperson, suppose your boss asked you to write a side agreement that allowed a customer to back
out of a contract, and insisted that you not reveal the side contract to anyone else in your organization
...
In groups of three, discuss
how you would respond to your boss
...
Choose a group
spokesperson to report to the class
...
Ask how this person assigns costs to products and how this
information affects business decisions
...
Be flexible with your use of accounting terminology in this interview
...
Information contained in
the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of
the interview, examples of the use of accounting information for decision making, and any other pertinent
information
...
Does it use cost information from former jobs
that are similar to prospective ones, for example? Does it have a specialist in cost estimation who estimates the
costs of prospective jobs? Each team should write a memorandum to the instructor summarizing the results of the
interview
...

Using the Internet—A view of the real world
Visit the website for a high technology company, such as HP, Intel Corporation, or IBM, and locate its annual
report
...
Write a report addressing the following questions based on your research
...
Managerial accounting concepts/job costing
business decisions within the company, what additional information would you need? (Remember that the income
statement may be referred to using different terminology such as statement of earnings or statement of operations
...
hp
...
intel
...
ibm
...
wellsfargo
...
Write a report addressing the following questions based on your research
...
)
Visit the following website for Home Depot (a retail organization) and locate its annual report:
http://www
...
com
Review the annual report to gain a general understanding of the company's primary business segments and
products
...
What products or services are
provided by the company? How does the financial information provided in the annual report (focus on the income
statement) differ from financial information used for managerial accounting purposes? As a manager making
business decisions within the company, what additional information would you need? (Remember that the income
statement may be referred to using different terminology such as statement of earnings or statement of operations
...
Managerial accounting is for internal use by managers, not external use, and gives more detailed
information than financial accounting
...
The motors are direct materials, and they are product costs
...
Because bottling soft drinks is a process, the plant would not use job costing
...
The answer is the opposite
...

False
...

True
...

Multiple-choice
b
...

a
...


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...
A merchandiser uses Merchandise Inventory and Cost of Goods Available for Sale, whereas a manufacturer
uses Finished Goods Inventory and Cost of Goods Available for Sale
...
All of the answers are true
...
Both (a) and (c) are advantages of using a predetermined overhead rate
...


USD 15=

USD 360,000USD 90,000 

...

Manufacturing overhead 22,500
Various accounts
Work in process inventory 21,000
Manufacturing overhead

22,500
21,000

Note the predetermined overhead rate times the actual activity is USD 0
...


Accounting Principles: A Business Perspective

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Process: Cost systems
Learning objectives
After studying this chapter, you should be able to:
• Describe the types of operations that require a process cost system
...

• Discuss the concept of equivalent units in a process cost system
...

• Prepare a production cost report for a process cost system and discuss its relationship to the Work in Process

Inventory account
...

• Compute equivalent units of production and unit costs under the first-in first-out (FIFO) system (Appendix

19-A)
...


This chapter continues the discussion of cost accumulation systems
...
The job cost system (job costing) accumulates costs incurred to produce a product according to
individual jobs
...

This chapter discusses another cost accumulation system, process costing
...
We review the similarities and differences between job costing and process
costing
...
In the chapter appendixes, we discuss and illustrate FIFO process
costing and the allocation of joint product costs
...
Pepsi-Cola makes soft drinks,
Exxon Mobil produces oil, and Kellogg Company produces breakfast cereals on a continuous basis over long
periods
...
Instead, production is an ongoing
process
...
Companies making paint, gasoline,
steel, rubber, plastic, and similar products using process costing
...
Accountants compute the cost per
unit by first accumulating costs for the entire period (usually a month) for each process or department
...


Accounting Principles: A Business Perspective

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...
Job costing and process costing have important similarities:
• Both job and process cost systems have the same goal: to determine the cost of products
...
Accountants record production in separate

accounts for materials inventory, labor, and overhead
...

• Both job and process cost systems use predetermined overhead rates (defined in Chapter 18) to apply

overhead
...
Companies that use job costing work on many different jobs with different

production requirements during each period
...
All the products that the company produces under process
costing are the same
...
Job costing accumulates costs by individual jobs
...

• Work in Process Inventory accounts
...
Process cost systems have a Work in Process Inventory account for each department or process
...
That is, the production and processing of products begin in Department A
...
Department B inputs direct materials and further processes the products
...
For illustration purposes, we assume that all the process cost
systems in this chapter are sequential
...


Process costing illustration
Assume that Jax Company manufactures and sells a chemical product used to clean kitchen counters and sinks
...
Department A crushes powders and blends the basic
materials
...
Exhibit 151 shows this
manufacturing process
...
0 License

Exhibit 150: Cost flows in a process cost system
(Jax's accountant applies manufacturing overhead in Departments A and B based on the machine-hours used in
production
...

Work in process inventory –
A
Department
Direct materials
16,500
Direct labor
Applied overhead
Balance

Transferred to department
B:
11,000 unites @ $2
...
So all the costs
assigned to these units were transferred to Department B
...
The result is USD 2
...

Computations are seldom this simple; one complication is partially completed inventories
...
Before Department B transfers the cost of completed units, its Work in Process Inventory account
for June is as follows:
Work in process inventory – Department B
Transferred in from department A
Costs added in Dept
...
Process: Cost systems

Exhibit 151: Possible production flow combinations

A broader perspective:
Producing cans of Coca-Cola®
How was the Diet Coke® I just finished drinking produced? A Coca-Cola bottling plant purchased
cola syrup or a concentrate from The Coca-Cola Company, combined it with carbonated water, put
it in cans, and sealed the cans
...
)
In a bottling plant, the first process combines the syrup or concentrate with carbonated water to
make cola
...
A third process combines
these two materials by pouring the cola into the cans
...
Finally, the
cans are combined into packages
...

The product enters finished goods inventory when it is sent to the warehouse
...


768

This book is licensed under a Creative Commons Attribution 3
...
CocaCola, Diet Coke, and Coke are registered trademarks of The Coca-Cola Company
...
Thus, Transferred in from Department A in the T-account represents the direct materials, direct labor, and
applied overhead costs assigned to products in Department A
...

Now, Jax's accountant must divide the USD 39,260 total costs charged to Department B in June between the
units transferred out and those remaining on hand in the department
...
Department B has 9,000 finished
units and has 2,000 partially finished units
...

Essentially, the concept of equivalent units involves expressing a given number of partially completed units as
a smaller number of fully completed units
...
Accountants base this concept on the supposition
that a company must incur approximately the same amount of costs to bring 1,000 units to a 40 per cent level of
completion as it would to complete 400 units
...
As you examine the diagram,
think of the amount of water in the glasses as costs that the company has already incurred
...
These units are 100 per cent complete as to transferred-in costs; if
they were not, Department A would not have transferred them to Department B
...
Assume that
Department B adds all materials at the beginning of the production process
...
Therefore, equivalent production for materials
would be 11,000 units
...

Accountants call the combined labor and overhead costs conversion costs
...

Let us assume that, on average, the 2,000 units in ending inventory are 40 per cent complete as to conversion
costs
...
Department B now has an equivalent of 800 fully completed units remaining in
inventory (800 = 2,000 X 40 per cent)
...


Accounting Principles: A Business Perspective

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...
The average unit cost formulas for each cost element are:
Unit cost for transferred=
Unit cost for materials=

Total transferred costs
Equivalent unitsfor transferred costs

Total materials costs
Equivalent unitsfor conversion costs

Unit cost for conversion=

Total conversion costs
Equivalent units for conversion costs

Know we can compute unit costs for each element in Department B as follows:
Transferred-in Materials Conversion Total
Costs to be accounted for:
Charged to Department B
$26,000
$1,100
$11,760*
$39,260
Equivalent units
11,000
11,000
9,800†
Unit costs
$ 2
...
10
$ 1
...
70
*Conversion costs consist of direct labor + overhead ($2,880 + $8,880)
...


We can use the USD 3
...
We do this in
the following table:
Costs accounted for:
Units completed and
transferred out
(9,000 units)
Units remaining in ending
inventory
(2,000 units)
Costs accounted for

Transferred-in Materials
(@ $2
...
10)

Conversion Total
(@ $1
...
40), USD 900 of materials costs (9,000 X USD 0
...
20), or a total cost of USD 3
...
The 2,000 units of ending inventory in

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This book is licensed under a Creative Commons Attribution 3
...
We calculate the ending inventory cost as follows:
Costs from Department A (2,000 x $2
...
10)
Conversion (800 equivalent units x $1
...
70 each until
they are sold
...


An ethical perspective:
Rynco Scientific Corporation
Rynco Scientific Corporation was a manufacturer of contact lenses that the Securities and Exchange
Commission (SEC) investigated concerning the way it computed equivalent units of production
...
As a result of the SEC's
investigation, Rynco agreed to hire an accounting firm to conduct a thorough study of its financial
statements for a five-year period, and it agreed to restate its financial statements to conform to
generally accepted accounting principles
...
Now let us look at the summary of the journal entries for these
activities for the month of June
...


2
...


Work in process inventory – Department A (+A)
Work in process inventory – Department B (+A)
Materials inventory (-A)
To record materials placed in production in June
...


2,500
2,880

Work in process inventory – Department A (+A)
Work in process inventory – Department B (+A)
Overhead (or manufacturing overhead) (+SE)
To apply overhead to production
...


Work in process inventory – Department B (+A)
26,400
Work in process inventory – Department A (-A)
26,400
To record transfer of goods from Department A to Department
B
...


Overhead (of Manufacturing Overhead) (-SE)
Various accounts – Cash, Accounts payable, accruals, and
accumulated depreciation (varies)
To record actual overhead costs incurred in June
...


33,300

6
...
Process: Cost systems
7
...


60,000

8
...
70
...
A production cost report shows
both the flow of units and the flow of costs through a processing center
...
This report makes the equivalent unit and unit cost computations easier
...

• Convert actual units to equivalent units
...

• Distribute the total cost between the units completed and transferred out and the units remaining in the

ending inventory
...

The first step in the preparation of a production cost report is to trace the physical flow of actual units in and out
of Department 3
...
Department 3 also had 18,000 units transferred in from Department 2
...


772

This book is licensed under a Creative Commons Attribution 3
...
At the end of the month, Department 3 had 8,000 partially completed units
...
Now we are ready for the second step in the preparation of the
production cost report—to convert actual units to equivalent units
...
Under the average cost
procedure, the number of equivalent units for each cost element equals the number of units transferred out plus
the number of equivalent units of that cost element in the ending inventory
...

Alternatively, Storey could use First-in, First-out (FIFO) or Last-in, First-out (LIFO)
...


Units
Units in beginning
inventory
Units transferred in
from Department 2
Units to be accounted
for
Units completed and
transferred out
Units in ending
inventory*
Units accounted for
Costs

Storey Company
Production Cost Department
Report 3
For the month of
Equivalent
June 2011
units
Actual units
Transferred- Materials
in
6,000

Conversion

18,000
24,000
16,000

16,000

16,000

16,000

8,000

8,000

8,000

4,000

24,000

24,000

24,000

20,000

Transferred- Materials
in

Conversion

Costs to be accounted
for:
Costs in beginning
$12,000
$6,000
$3,000
inventory
Costs transferred in
37,200
from Department 2 in
June
Costs added in
18,480
18,000
Department 3
Costs to be accounted
$49,200
$24,480
$21,000
for
Equivalent units (from
24,000
24,000
20,000
above)
Unit cost (per
$2
...
02
$1
...

† Unit cost equals costs to be accounted to divided for divided by equivalent units
...
12
$65,920
28,760
$94,680

Exhibit 153: Production cost report
Storey's units in the ending inventory are fully complete as to costs transferred in and materials cost
...
Process: Cost systems
out + [8,000 units in the ending inventory X 100 per cent complete for transferred-in costs and materials costs])
...
Therefore, there are
20,000 equivalent units with regards to conversion—16,000 units transferred out plus 8,000 units in ending
inventory that were 50 per cent complete
...
This is the third step in
preparing the production cost report
...
Notice in Exhibit 153 that for each cost element, we total the costs of beginning
inventory and costs of the current month
...
These costs must either be transferred out or appear in the ending inventory of Department 3
...
(Since we totaled all costs for each cost element before
the division, we can average the computed unit costs across the current and prior period
...
05; materials costs, USD 1
...
05
...

The last step in preparing the production cost report is to allocate costs between the units completed and
transferred out and the units remaining in ending inventory
...
Therefore, we can multiply the 16,000 units by USD 4
...
The result,
USD 65,920, is the amount Storey assigns to the next department as cost transferred in or to finished goods as the
cost of completed current period production
...
05
8,000 equivalent units of materials costs @ $1
...
05
Total cost of ending inventory

The sum of the ending inventory cost and the cost of the units transferred out must equal the total costs to be
accounted for
...
As shown in the production cost report, Department 3 adds the USD 65,920 costs transferred out to the
USD 28,760 ending inventory cost
...

Some companies replace the production cost report with three schedules
...
This schedule computes the equivalent units of production for the period for transferred-in,
materials, and conversion costs
...
This schedule sums all the
costs charged to the Work in Process Inventory account of each production process department
...
The third schedule is the cost
summary schedule
...
Companies generally show these three schedules in a
process cost analysis report
...
Generally, under FIFO, the equivalent number of units for each cost element consists of:
• Work needed to complete the units in beginning inventory
...

• Work done on partially completed units in ending inventory
...
0 License
Appendix 19-A, at the end of this chapter, illustrates this method
...
Without accurate cost accounting
information, a manufacturing company cannot determine the cost of its products for managerial decision making
or prepare accurate financial statements
...
For example, a clinic dispensing flu shots, a delicatessen selling only pastrami sandwiches, and a photo
shop that processes pictures could use process costing
...
(And that is
what most people find difficult about process costing
...
Nurses do not leave for home halfway through giving a flu shot, and the delicatessen does not
partially serve a sandwich one month and complete it the next
...

Note that some service companies do have partially completed work at the end of the period
...
You could apply the methods described
in this chapter for manufacturing to those service companies
...


Spoilage
If you have ever tried to make something that did not work out, you know the concept of spoilage
...
For example, suppose some of the cans are dented during the canning
of tuna fish
...

Accountants treat spoilage either as normal spoilage or abnormal spoilage
...
Accountants generally assign normal spoilage costs to the good units produced
...

For example, suppose the total cost of producing tuna fish for one day is USD 100,000
...

Consequently, these 20,000 units were considered to be spoiled in the normal production process
...
That is:
Cost per good unit=

USD 100,000
200,000 good units producted

= USD 0
...

For example, if denting the tuna fish cans is unusual, accountants would treat the cost of those dented cans of tuna
fish as abnormal spoilage
...
Process: Cost systems
are typically expensed
...

Advocates of total quality management may prefer to classify all spoilage as abnormal
...
Unless management personnel ask for a special analysis of spoilage costs,
they will not know whether the spoilage costs are a small per cent or a large per cent of product costs
...
50 per can, but they do not
know how much of the USD 0
...

We recommend that accountants report spoilage costs to management, whether normal spoilage or abnormal
spoilage, so management can make informed decisions to reduce spoilage
...

• Paint, paper, chemicals, gasoline, beverages, and food products should be accounted for under a process

cost system
...
Companies that use process costing produce a
single product, either on a continuous basis or for long periods
...


Process costing accumulates costs by process or department
...
Process

cost systems have a Work in Process Inventory account for each department or process
...
Basically, the concept of equivalent units involves expressing a given number of partially
completed units as a smaller number of fully completed units
...
In manufacturing, we estimate the degree of completion for a group of products with respect to
transferred-in, materials, and conversion (direct labor and overhead)
...

• Accountants compute equivalent units of production for transferred-in units, materials, and conversion
...

• Unit costs for the three categories—transferred-in units, materials, and conversion—are determined by

dividing the equivalent units into the cost in beginning inventory plus the costs transferred in or added in the
department during this period
...
The

report is divided into two parts
...
The second part shows the costs to be accounted for,
computes unit costs based on equivalent units as determined in the first part, and shows how the costs were

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The costs to be accounted for and the costs accounted for must balance
...
Each processing

department normally has its own Work in Process Inventory account and related production cost report
...

• Normal spoilage occurs in the normal course of production and is treated as a product cost
...

• Under FIFO equivalent units of production are computed by taking the equivalent units of work done to

complete the beginning inventory, plus units started and completed during the current period, plus equivalent
units of work done on the ending inventory
...

• Unit costs for the three categories—transferred-in units, materials, and conversion—are determined by

dividing cost to be accounted for during the period by units produced during the period
...

• The relative sales value method is the most commonly used method to allocate joint product costs
...

Appendix 19A: The FIFO process cost method
In this chapter, the discussion assumed the use of the average cost method for determining unit costs under
process costing
...
This appendix presents a detailed illustration of the FIFO process costing system
...
60)
Units started and completed this period (10,000 – 5,000 in ending
inventory)
Equivalent units of work done to partially complete the ending
inventory (5,000 x 0
...

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...
Both departments add materials only at the
beginning of processing
...
The May 31 inventory in Department B consists of
2,000 units that are fully complete as to materials and 50 per cent complete as to conversion
...

The following transactions and additional data summarize manufacturing operations in both departments for
June:
Raw materials purchased on account, USD 25,000
...
50), USD 21,000; and Department B (10,000
units at USD 0
...

Indirect materials issued: Department A, USD 400; and Department B, USD 200
...

Manufacturing overhead is applied as follows: USD 5,280 in Department A and USD 5,400 in Department B
...

• The company computed cost of goods sold at USD 55,866 on a FIFO basis
...


Materials inventory (+A)
Accounts payable (+L)
To record materials purchased on account
...


Work in process – Department A (+A)
Work in process – Department B (+A)
Manufacturing overhead (-SE)
Materials inventory (+L)
To record direct and indirect materials used
...


6,600
5,400
3,000

Work in process – Department A (+L)
Work in process – Department B (-A)
Manufacturing overhead (+A)
To record assignment of overhead to
production
...


4
...


25,000

22,900

15,000

10,680

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...


5,100
3,000

6
...
(For
details of computation, see production cost
report of Department A in Exhibit 155)
...


Accounts receivable (-SE)
Sales (-A)
To record sales for the month
...


55,866

8
...
For product costing purposes, the production cost report is the primary report in
a process cost system
...

Production cost report—Department A To illustrate flexibility in format, Exhibit 154 shows the production
cost report for Department A in a format different from the one in the chapter
...
Then, Department A completed and transferred out 10,000 units
...
The footnote in the illustration shows
the computation of equivalent units
...
50)
Conversion (4,000 x 50% x
1,980
$0
...
50
0
...
49

$2
...
Process: Cost systems
Equivalent units in partially completed ending 4,000
inventory
Equivalent units of production for month
14,000

2,000

Materials
Computations of equivalent units:
Equivalent units to complete beginning
-0inventory
Units started and completed
10,000
Equivalent units in partially completed ending 4,000
inventory
Equivalent units of production for month
14,000

Conversion

12,000

-010,000
2,000
12,000

Exhibit 154: Production cost report—Department A
The costs section of the report shows that the only costs to be accounted for were those added in the department
in June
...

Department A had no beginning inventory and no transfers in
...
50 for materials and USD 0
...
The
total current unit cost is USD 2
...
The report shows the disposition of the costs—the cost of the units transferred
to Department B (USD 24,900) and the amount of ending inventory remaining in Department A (USD 7,980 based
on current unit costs)
...
The current unit cost and the cost of the transferred units is not always the same, as
we will show for Department B in Exhibit 155
...
13
Conversion
9,000*
10,800
1
...
33
Costs in beginning inventory
6,180
Costs transferred in from
24,900
Department A
Total costs to be accounted for
$43,180
Costs accounted for:
Cost of ending inventory:
Transferred in from Department
$ 7,340
A (3,000 units at $2
...
13)
Conversion (3,000 x 1/3 x
1,200
$1
...
791
out
Costs accounted for
$43,180
*Supporting computations and data:

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...
Beginning inventory is 50% complete and ending inventory 33 1/2% complete
as to processing
...
Note how the report highlights the current unit cost of the operations performed in
the department
...
Department B determines the cost of the ending inventory through the
use of the current month's unit cost (USD 1
...
All of Department B's other costs are included in the costs of the
9,000 units transferred to Finished Goods
...
We
can compute average unit cost of USD 3
...

Appendix 19B: Allocation of joint costs
A company incurs joint costs when it produces two or more products through the same production process or
from a common raw material
...
The products are not
identifiable as different individual products until a particular point in the manufacturing process known as the
split-off point
...
We refer to any costs beyond the split-off point as separable costs because they can be
directly traced to individual products
...
In Exhibit 156, we show the joint production process
...
Any allocation of joint costs to one of the
products is inherently arbitrary
...
57 The accounting problem
we face is how to allocate the joint costs that a company incurred before the products become separately identified
...

The physical measures method allocates joint costs on the basis of physical measures such as units, pounds,
or liters
...
The cost and production data of Roy Company for July are:
Product AProduct B Total

57 For example, a survey of oil refineries indicated that seven of the nine companies did not allocate joint costs
...
Slater and C
...
K
...
110
...
Process: Cost systems
Units (barrels) produced
Unit selling price at split-off
Revenue at split-off
Joint product costs:
Direct materials
Direct labor
Manufacturing overhead

15,000
25,000
$ 15
$6
$225,000 $150,000

40,000

$125,000
105,000
70,000
$300,000

Exhibit 156: Production cost report-Department B
The physical measures method uses a ratio of the physical volume of each product to total volume as a basis for
allocation of joint costs
...
Product B incurs a loss of USD 37,500, or USD 150,000 less USD 187,500
...
In this instance, product B suffers a loss of USD 37,500 because the company allocated a high portion
of joint costs based on product B's high volume of physical units even though its selling price is less than that of
product A
...
Thus, because any allocation of joint costs to one product is arbitrary, the resulting measures
of each product's income are arbitrary
...

Accountants use the relative sales value method because it matches joint costs with revenue much like the matching
concept
...


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A partial July income statement would appear as shown:

Sales
Cost of goods sold
Gross margin

Product A
Physical
Measures
Method
$225,000
112,500
$112,500

Relative
Sales Value
Method
$225,000
180,000
$ 45,000

Product B
Physical
Measures
Method
$150,000
187,500
$(37,500)

Relative
Sales Value
Method
$150,000
120,000
$ 30,000

Demonstration problem
Zarro, Inc
...
The May 1 inventory in the finishing department consisted of 36,000 units, fully
complete as to materials and 80 per cent complete as to conversion
...
The costs incurred in the finishing department for May appear as follows:
Costs transferred in from molding department
$720,000
(excluding costs in beginning inventory)
Costs added in finishing department in May
(excluding costs in beginning inventory):
$63,600
Materials
131,376 194,976
Conversion costs
$914,976

The finishing department received 120,000 units from the molding department in May
...
As of May 31, 28,800 units, complete as to
materials and 60 per cent complete as to conversion, were left in inventory of the finishing department
...
Using the average cost procedure, prepare a production cost report for the finishing department for May
...
Compute the average unit cost for conversion in the finishing department in April
...


Units

Zarbo, Inc
...


Conversion

127,200*
17,280†
144,480

†(28,800 x 60% = 17,280)
...
Process: Cost systems
Unit costs
Costs accounted for:
Units completed and
transferred out (127,200
units)
Units remaining in May 31
inventory (28,800 units)
Costs accounted for

$ 6
...
60

$ 1
...
80

$763,200

$76,320

$ 152,640*

$992,160

172,800

17,280

20,736*

210,816

$936,000

$93,600

$173,376

$1,202,976

*17,280 equivalent units x $1
...


b
...
46, calculated as
USD 42,000

...
8×36,000

Key terms
Abnormal spoilage Spoilage that exceeds the amount expected under normal operating conditions
...

Conversion costs Costs of converting raw materials into the final product
...

Equivalent units A method of expressing a given number of partially completed units as a smaller number
of fully completed units; for example, bringing 1,000 units to a 75 per cent level of completion is the
equivalent of bringing 750 units to a 100 per cent level of completion
...
This method computes equivalent
units by adding equivalent units of work needed to complete the units in beginning inventory, work done on
units started and completed during the period, and work done on partially completed units in ending
inventory
...

Joint costs Those production costs incurred up to the point where the joint products split off from each
other
...

Physical measures method A method of allocating joint product costs on the basis of physical measures
such as units, pounds, or liters
...

Production cost report A report that shows both the flow of units and the flow of costs through a
processing center
...

Relative sales value method A method of allocating joint product costs on the basis of the relative market
value at the split-off point
...

Spoilage The loss of goods during production
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

Both job and process cost systems can only have one Work in Process Inventory account
...


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(Based on Appendix 19-B
...

Multiple choice
Select the best answer for each of the following questions
...
Uses the equivalent unit concept
...
Includes overhead in product costs
...
Costs of production are first recorded in Work in Process Inventory accounts then transferred to Finished
Goods Inventory and Cost of Goods Sold
...
Keeps track of the actual cost of each individual unit produced
...
Units completed - [Units in ending inventory X Percentage complete] = Equivalent production
b
...
Units completed + [Units in ending inventory X Percentage complete] = Equivalent production
d
...

Using the following data, compute the ending inventory cost:
1,000 units are in ending inventory in Department B
...
The unit cost for materials is USD 0
...
60
...
20
...
USD 1,370
...
USD 1,170
...
USD 1,320
...
USD 1,250
...
Units in a production department
...
Costs related to production
...
Unit costs
...
Equivalent units
...
All of the above are included in the production cost report
...
3,000
...
3,900
...
3,400
...
3,600
...

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...


➢

How does a process cost system differ from a job costing system?

➢

Would a lumber mill use process or job costing?

➢

What is meant by the term equivalent units? Of what use is the computation of the numbers of
equivalent units of production?

➢

Distinguish between the number of units completed and transferred during a period and the
equivalent units for the same period
...
What is
the reason for this assumption?

➢

What is the basic information conveyed by a production cost report?

➢

What are the four steps in preparing a production cost report?

➢

What is meant by average cost procedure? What other two cost flow assumptions could be used?

➢

Would an automobile plant that makes specialty race cars use job costing or process costing? Would
an automobile plant that makes all terrain vehicles use job costing or process costing? Explain your
answer
...


➢

Describe the relative sales value method and show how it is used (Appendix 19B)
...
Describe the
different processes used in a cola bottling plant
...


Exercises
Exercise A Using the average cost method, compute the equivalent units of production in each of the following
cases:
a
...
(There was no beginning inventory
...
Units in process at the beginning of the month (100 per cent complete as to materials; 30 per cent complete as
to conversion), 12,000; units started during the month, 48,000; and units in process at the end of the month (100
per cent complete as to materials; 40 per cent complete as to conversion), 24,000
...
0 License
Exercise B In Department C, materials are added at the beginning of the process
...
The ending inventory in Department C in June was 40 per cent complete as to
conversion costs
...
The beginning inventory
was considered 80 per cent complete, as was the ending inventory
...
What are the equivalent units for the period using the average cost method?
Exercise D If in the previous exercise the total costs charged to the department amounted to USD 960,000,
including the USD 48,000 cost of the beginning inventory, what is the cost of the units completed and transferred
out?
Exercise E The following data relate to Work in Process—Department C, in which all materials are added at the
start of processing:
Work in process – Department C:
Inventory, March 1:
Materials cost (1,200 pounds; 100%
complete)
Conversion cost (20% complete)
Costs incurred this period:
Direct materials used (9,000 pounds)
Direct labor
Overhead
Inventory, March 31
Materials cost (1,800 pounds, 100%
complete)
Conversion cost (1,800 pounds, 80%
complete)
Pounds of product transferred out: 8,400

$7,020
1,804
$36,330
10,880
17,820
?
?

Using these data, compute:
a
...

b
...

Problems
Problem A The following data refer to a production center of Sipp-Fizz, a soft drink bottler:
Work in process inventory, August 1, 4,000 units
(units equal 12-bottle cases):
Direct materials
Direct labor
Manufacturing overhead applied
Units started in August
Costs incurred in August:
Direct materials
Direct labor
Manufacturing overhead applied

$12,000
6,120
8,000
$26,120
12,000
$36,000
48,000
60,000

The beginning inventory was 100 per cent complete for materials and 50 per cent complete for conversion costs
...

Compute the following:
a
...

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...
The equivalent units of production for materials and conversion costs using the average cost method
...
Cost per equivalent unit for materials and conversion costs
...
Cost of units completed and transferred
...
Cost of ending inventory
...

Problem C Shine Company uses a process cost system to account for the costs incurred in making its single
product, a hair conditioner
...
Materials are
added in both departments
...

a
...

b
...

Problem D A bottling company bottles soft drinks using a process cost system
...

Prepare a production cost report for the month ended June 30 using the average cost method
...
Assume the beginning inventory on June 1 was 100
per cent complete as to materials and 25 per cent complete as to conversion
...
Prepare a production cost report for the month ended June 30, using FIFO
...

b
...
0 License
Problem F Quality Lumber Company produces two products from logs, Grade A lumber and Grade B lumber
...
00
?

Grade B
120,000
$2
...
Allocate the joint costs to the two products using the physical measures method
...
Allocate the joint costs to the two products using the relative sales value method
...
Explain the difference in unit costs using the two methods
...
What are advantages of the relative sales value method if all of Grade A lumber has been sold and none of
Grade B lumber has been sold at the end of a month?
Alternate problems
Alternate problem A Pure Aqua Company is a producer of flavored mineral water
...

Compute the following:
a
...

b
...

c
...

d
...

e
...

Alternate problem B The following data pertain to a production center of Sunbelt Company, a maker of
sunscreen products:
Units
Inventory, October 1
Placed in production in October
Inventory, October 31

Materials
costs
70,000 $12,000
200,000 20,400
100,000 ?

Conversion
costs
$16,000
18,200
?

The October 31 inventory was 100 per cent complete as to materials and 20 per cent complete as to conversion
costs
...

Alternate problem C Healthbar Company produces a health food and determines product costs using a
process cost system
...
Production and cost data
for the bottling department in August follow
...
Process: Cost systems
Costs transferred in
Materials costs
Conversion costs
Costs incurred in August:
Transferred in (100,000 pints)

$30,000
15,000
9,000
$100,00
0
50,000
39,300

Materials costs
Conversion costs

All materials are added at the beginning of the bottling process
...

Prepare a production cost report for August using the average cost method
...
, produces bicycles
...

Karol Ring, the production manager, has been concerned with cost overruns during July in the frames department,
which produces the bicycle frames
...
These units were 100 per
cent complete as to materials and 40 per cent complete as to conversion
...

The department handled 30,000 units during the month, including the 6,000 units in beginning inventory on
July 1
...
The month's costs were allocated on the
number of units processed during the month as follows:
Materials
$60,000
30,000
$2

Costs
Units handled during month
Cost per unit

Conversion
$300,216
30,000
$ 10

The USD 12 per unit cost was assigned in a way that resulted in the following costs:
Beginning
work
in process
Cost per unit incurred during the
month:
Units
Cost per unit

Work
started
and
completed

Ending work
in process

6,000
$12

20,400
$12

3,600
$12

Ring realized that this per unit cost is incorrect and asks you to develop a better method of computing these
costs for the month ended July 31
...
How would you recommend that July's costs be assigned to the units produced? How would this differ from
the present method?
b
...
Present your analysis in
a production cost report
...
A good friend manages the Stitching Department at the same company
...

That leaves 3,000 pairs in ending inventory, Yung thought, that is a lot of jeans they did not finish
...
0 License
Later, Yung visited his friend who managed the Stitching Department
...

"One of the new workers set several machines wrong, and the stitching was bad on 2,400 pairs," the manager
replied
...
The other 600 pairs are complete
now, and have been transferred out
...
"
"Company policy is to send all defective products to the Rework Department
...
That is their
job," Yung said
...
"We would all be in trouble if plant management finds
out
...
I do not want that
...
"
a
...
Would your answer change if Yung learned that the Stitching Department had fixed the jeans and sent them
on to the next department?
Financial analysis C Suppose a bottling company made an error in estimating the stage of completion of its
work in process inventory
...
The beginning and ending
Finished Goods Inventory amounts are correct
...
Use examples to demonstrate your points
...
What is the cost
of spoilage in the vegetable and fruit section as a percentage of the total cost of goods sold? Does the manager
differentiate between normal and abnormal spoilage? If so, provide some examples
...
Information contained in the memo
should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, and
information responding to the questions above
...
What is the cost of spoilage as a percentage of the total cost of goods sold? Does the manager
differentiate between normal and abnormal spoilage? If so, provide some examples
...
Information contained in the memo
should include:
Date:
To:
From:
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...

Using the Internet—A view of the real world
Using the Internet as a research tool, describe the conversion activities (or processes) involved in producing oil
or oil-related products
...
Write your report in the
form of a memorandum
...
Be sure to attach your research materials obtained from the Internet to the
memorandum
...
Your description should include examples of raw materials used as inputs,
production activities required to convert inputs into products, and resulting outputs (finished goods)
...
The heading of the memorandum should contain the date, to whom it is
written, from whom, and the subject matter
...

Answers to self-test
True-false
True
...

False
...

False
...

False
...

True
...

Multiple-choice
d
...

c
...
USD 1,370 [USD 1,200 + (1,000 X USD
...
60)]
e
...

b
...
60)
Units started and completed this period (5,000 –
2,500
2,500)
Equivalent units of work done to partially complete the 500
ending
inventory (2,500 x 0
...
0 License
Comprehensive review problem
The Compack Company assembles personal computers
...
Each order is treated as a job, and the entire job is
shipped at once
...

Although the company has grown rapidly, it has yet to show a profit
...

Management believes some jobs are profitable and others are not, but it is not clear which are profitable
...
Completed Job No
...

b
...
102
...
Started Job No
...

• Inventory values:

a
...
101
Direct materials
Direct labor
Overhead
April 30: Job No
...
Job No
...
103 was exactly one-half complete in direct labor-hours and machine-hours at the end of April
...

c
...

• Manufacturing overhead is applied at USD 30 per machine-hour
...
The actual overhead for the
month of April was USD 50,000
...
101:
Materials $60,000
Labor
?
Overhead ?
Total
?
Job No
...
The same rate

had been used since the company began operations
...

• All direct materials were purchased on account
...

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...
All labor costs were the same rate per hour for

April for all laborers
...
Compute the cost of each job, whether in inventory or sold
...
Show the transactions in journal entry form
...

c
...


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...
Using accounting for
quality and cost management
Learning objectives
After studying this chapter, you should be able to:
• Describe why managers need good accounting information to be competitive in the new production

environment
...

• Develop measures of performance that help achieve high quality
...

• Explain how just-in-time purchasing and production can reduce costs and improve quality
...

• Define activity-based costing and explain its benefit to companies
...

• Compare product costs using activity-based costing with product costs using traditional costing methods
...


Importance of good accounting information
Have you ever purchased a product and found it to be defective? If so, you may have sworn to yourself that you
would never buy one of those again
...
Successful companies remain in business by seeking continual improvement in the quality of their
products
...
Nordstrom's department stores, Southwest Airlines Company, and Apple
...

In its plant near Nashville, Tennessee, USA, Nissan Motor Corporation places some of the previous day's
production of cars and trucks in the lobby with charts showing the number of production defects for that day
...


Quality and the new production environment
Attention to quality is an important feature of the new production environment
...
Both actions are necessary to stay competitive
...

Computer-assisted manufacturing enables managers to reduce inventories, yet respond quickly to customers'

Accounting Principles: A Business Perspective

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...
For example, robots perform certain repetitive functions more reliably than humans
...

The new production environment is rooted in the new management philosophies that we discuss in this chapter
...
Many
companies have adopted a just-in-time philosophy for managing purchasing and production
...
Many observers believe that United States industry has fallen behind foreign competitors because
managers and accountants have not worked together to produce the information management needs to make good
decisions
...
0 License

Improving quality

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...
0 License
quality are
...
Prevention costs cover the cost of preventing poor-quality products from being produced
...

• Appraisal costs
...
Appraisal costs include the

costs of inspecting materials when purchased and product testing during production
...
Internal failure costs are the costs of producing poor-quality products detected before

products are shipped to customers
...

• External failure costs
...
External failure costs include the costs of dealing with returned products and future lost
profits because customers are dissatisfied
...
By incurring substantial costs of prevention, for
example, a company might reduce costs of appraisal, internal failure, and external failure costs
...
Small prevention costs
may even result in large cost savings in the other three categories
...
A marketing manager concerned about
customer satisfaction noticed a substantial amount of returned merchandise
...

The company decided to invest USD 5,000 per month in a training program for order takers
...
Working with people in the marketing
department, accountants estimated the company saved USD 4,000 per month by having less returned merchandise
and fewer refilled orders
...
Management considered the USD
5,000 cost of prevention to be justified by the benefits of reduced returned merchandise and increased customer
satisfaction
...
It is difficult to
measure increased customer satisfaction (reflected in sales) resulting from additional spending on prevention costs
(or any of the four categories), and it is difficult to measure decreased customer satisfaction resulting from a
reduction in prevention costs
...

A current theme in business today is that "quality is free"
...
Cost-benefit analyses are no longer the primary focus in improving quality
...

Those who subscribe to the quality is free concept believe that zero defects is the only acceptable goal
...
The result? Quality will improve, customers will be
increasingly satisfied, and the cost of improving quality will pay for itself through increased sales and lower costs
(providing for increased profit margins)
...
Using accounting for quality and cost management
Although both cost of quality and quality is free concepts strive for improved quality, the cost of quality
approach assumes a cost-benefit trade-off when spending money on quality improvement
...
One thing is for
certain: quality is important to the success of any company!
The key quality concept in the new production environment is total quality management
...
The key ideas are that the organization strives for excellence and that quality is
ultimately defined by the customer
...
It is not enough for production managers or engineers to say an
automobile is well-designed and produced; customers must say they like it—a lot
...
Southwest Airlines learned that customers want flights to
leave and arrive on time
...
So Southwest Airlines went to work to
improve those things its customers wanted most; namely, on-time departures and arrivals
...
)
How do companies identify quality problems? Three methods managers use to identify quality problems are the
following:
• Control charts
...

• Cause and effect analyses
...
For example, the managers of CD, Inc
...
They use a control chart to plot data that
shows trends or unusually high rates of returned merchandise
...
Every
compact disc player is tested to ensure it works
...
Management expects an average failure rate of 2 per cent of the daily production
...
If the failure rate exceeds 4 per
cent, management investigates to find out what is causing such a high rate
...
Managers can call up the results on their computers
at any time
...
Management investigated
the problem Wednesday afternoon and found a machine improperly installing a switch
...


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...
Note the Pareto
diagram for compact disc player production at CD, Inc
...
Pareto diagrams have more information
than simple control charts, but they require quality testers to classify and report defects
...


Exhibit 158: Pareto diagram for production at CD, Inc
...
Consider the
problem of cracked compact disc player cases, for example
...
Managers must know the cause of problems to solve
them
...


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...
For instance, in Exhibit 159 the second nonfinancial
measure deals with delivery performance
...

Performance measure
1
...
Delivery performance
Percentage of on-time deliveries
3
...
Machine downtime
Percentage of time machines are not
working

Objective
Create customer satisfaction
Make a high-quality product
Increase on-time deliveries
Decrease scrap and waste; improve
the quality of products
Decrease machine downtime;
increase on-time delivery to
customers

Exhibit 159: Nonfinancial performance measures
The success of Lands' End, L
...
Bean, The Territory Ahead, and other companies that sell through catalogs
depends on quick delivery of their merchandise
...
Ideally, the truck or railroad car unloads
containers right onto the production line
...
For example, Exhibit 159 presents four nonfinancial performance
measures used by managers to evaluate performance in providing quality products and service at a reasonable cost
...
Firms measure their product
quality by the number and type of customer complaints or by the number of product defects
...
The objective is to increase
customer satisfaction with the product, reduce the costs of dealing with customer complaints, and reduce the costs
of repairing products or providing a new service
...
As we noted earlier, delivery performance is critical for many companies
...
The objective is to deliver goods and services when promised
...

Materials waste Companies can take several steps to reduce materials waste, the third type of nonfinancial
measure
...
Reducing waste
can improve quality
...
For example, waste may reflect poor
training of employees
...
Generally, workers are motivated to find ways to reduce waste when companies keep track of
the quantity of materials wasted every day
...

Machine downtime The fourth type of nonfinancial measure, machine downtime, is very important in all
companies
...
0 License
see something wrong
...
Stopping production causes a loss of output while people wait for the machinery to
start up again
...
You may have
experienced this dissatisfaction at a bank when you could not be served because the computer was down, or when
your airline flight was canceled because of an airplane's maintenance problems
...
Surveys indicate that workers prefer to do high-quality work rather than
low-quality work
...

Many companies use high quality as their strategic advantage
...
By continually delivering on
this promise, the company built up trust in its customers
...

Benchmarking is the continuous process of measuring how well one is doing against performance levels either
inside or outside of the organization
...
Students often are interested in how well
graduates of their school compare to graduates of other schools on CPA exams, bar exams, or other standardized
exams
...
American Airlines looks at its own on-time arrival performance
by computing the percentage of its flights that land within 15 minutes of their scheduled arrival time
...
American Airlines also
compares its own per cent of lost luggage to its own past experience and the performance of major competitors such
as United Airlines and Delta Air Lines
...
Benchmarking focuses
attention on the objective
...


An accounting perspective:
Managers executed for poor quality
Business insight
Eighteen managers were executed for poor product quality in a refrigerator plant on the outskirts
of Beijing, China
...

A government official stated the action was required for committing unpardonable sins against the
people of China
...
When workers complained that components did not meet specifications and
the refrigerators did not function as required, the managers told them to ship the products
...
Using accounting for quality and cost management

Customers also had complained
...

Source: Authors' research
...
It is a management tool that recognizes organizational responsibility to
different stakeholder groups, such as employees, suppliers, customers, business partners, the community, and
shareholders
...
The concept of a balanced scorecard is to measure how well the organization is doing in view of those
competing stakeholder concerns
...
As you can see, the focus is to balance the efforts of
the organization between the financial, customer, process, and innovative responsibilities
...
In recent
years, organizations have shifted attention to customer issues, such as quality and service, to employees, and to the
community
...
Johnson & Johnson's code of
conduct makes it clear that the company has a responsibility to several competing stakeholders
...
0 License
The balanced scorecard has been developed and used in many companies
...
For example, Kaplan and Norton
describe the development of the balanced scorecard at an insurance company as follows: 56
Step 1: Ten of the company's top executives formed a team to clarify the company's strategy and objectives to
meet responsibilities
...
These performance measures
became the scorecards for each part of the business and reflected the company's desired balance in satisfying
different stakeholders
...

Step 4: Top management reviewed the scorecards for each part of the organization
...

Organizations using the balanced scorecard generally have found it to be helpful for top and middle
management to shape and clarify organization goals and strategy in the face of competing stakeholder wants
...
One of these innovations is the just-in-time (JIT) method
...

The principal feature of the just-in-time system is that production does not begin on an item until an order is
received
...
As soon as
the order is filled, production ends
...

In theory, a JIT system eliminates the need for inventories because no production takes place until the company
knows its products will be sold
...
The benefits of the JIT system would be lost if a
company had to shut down its operations for lengthy periods while waiting for new orders
...
If a unit is defective, employees cannot simply put it aside in inventory
...

To achieve just-in-time production, many companies install a system of flexible manufacturing
...
The system does what its name implies: it enables companies to be flexible in making products just-intime to fill customers' orders
...
Customers install these
running boards on trucks after they purchase them
...
S
...
P
...

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...
A traditional production system, by contrast, would produce
numerous sets of running boards for the Dodge which would remain in inventory until needed to fill customer
orders
...

Just-in-time is part of a lean production philosophy that has helped many companies successfully reduce costs
and increase quality
...
For an example of lean production, imagine you are building a house and you have
just enough materials arriving just when you need them
...
If your supplier of plumbing products does not deliver in time for your
needs, you have to shut down production until the plumbing products arrive
...


Accounting perspective:
Business insight
A labor strike at General Motors' Dayton, Ohio, USA, plant, which produces brake parts,
demonstrated the far-reaching effects of just-in-time when companies face plant shutdowns
...
As General Motors has moved toward just-in-time production methods, its
inventories of brakes and other parts have decreased
...
Mexican plants were slower to shut down
because inventory in transit kept the Mexican plants going for about a week longer than their US
and Canadian counterparts
...

Accountants using traditional costing methods assign costs to products as they go through the production steps
...
One of the reasons for assigning costs as products proceed through production steps is to know the value
of work-in-process inventory at the end of an accounting period
...
By assigning costs at each step along the way,
accountants know the cost of the product at the end of the third step
...
There
are no such inventories
...
Companies
have been known to save the time of two or three full-time accountants by assigning costs directly to Cost of Goods
Sold
...
When it is necessary to report
inventory amounts in the financial statements, accountants back the inventory amounts out of the Cost of Goods
Sold account using a method called backflush costing
...
0 License
inventories backwards from Cost of Goods Sold to Finished Goods Inventory and/or Work in Process Inventory
accounts
...
Direct materials costs are USD 3
...
50 per bottle
...
Materials costs were USD 30,000 and other manufacturing costs were USD 15,000
...

Assume also the company had an inventory of USD 4,500 left in work in process as of the date financial statements
were prepared
...


30,000

(2) Work in process inventory (+A)
Materials inventory (-A)
Payroll summary (+L)
Overhead (applied) (+SE)
To record production costs in the work in
process account
...


40,500

(4) Cost of goods sold (-SE)
Finished goods inventory (-A)

40,500

30,000

30,000
6,000
9,000

40,500

40,500

To record the cost of the goods sold
...
Therefore, they would debit all costs directly to Cost of Goods Sold, as
follows:
(1) Cost of goods sold (-SE)
Accounts payable (+L)
To record the use of materials
...


15,000

30,000

6,000
9,000

Upon learning the company has USD 4,500 of inventory in work in process, the accountants would back out
USD 4,500 from Cost of Goods Sold, as follows:
(3) Work in process inventory (+A)
Cost of goods sold (+SE)
To record inventory
...
These entries appear in T-accounts in Exhibit 161
...
If the costs of these sunscreen bottles were charged
into production using traditional costing methods, it would be necessary to debit the materials costs to a Materials
Inventory account
...
As goods were completed, costs would

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...
Exhibit 161 contrasts traditional versus just-in-time cost flows
...
As noted earlier, it simplifies
the accounting system
...
Companies also have found that reducing inventories where defective products
could be hidden helps management detect production problems more quickly
...


Activity-based costing and management
Suppose you go to a movie theater that has five screens showing five different movies
...
Suppose management wants to know the cost of selling tickets
per movie and asks you to assign Justin's wages to each of the five movies
...
Or you could figure out how many tickets he sold to each movie, and allocate his wages on the basis of ticket
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This book is licensed under a Creative Commons Attribution 3
...
For example, if 50 per cent of the ticket sales were for Avatar, you might allocate 50 per cent of Justin's
wages to Avatar
...
No matter how we
allocate Justin's wages, his wages would not be directly traceable to one of the movies if he sold tickets for all five
movies
...
Justin's wages would be
indirect costs to the different movies because his wages could not be directly assigned to any one of the movies
...
Nevertheless, accountants have
discovered that they can improve the ways costs are assigned, such as to movies in this case, by using activity-based
costing
...
Activity-based costing is based on the premise: Products consume activities;
activities consume resources
...
Activitybased costing (ABC) has revealed startling information in these companies
...

Activity-based costing identifies the activities generating costs and assigns costs to those activities
...
By focusing on Justin's activities, management could learn what caused costs and find ways
to improve Justin's efficiency
...
Based on this information, management could think about better ways to use Justin's time
...

Closely related to activity-based costing is the notion of activity-based management (ABM)
...
The focus is then to effectively manage costly
activities with the goal of reducing costs and improving quality
...
Using
activity-based management, managers would identify what Justin did with his time and perhaps find ways to help
him become more efficient
...
The participants are
concerned about their company's ability to compete with foreign manufacturers that have lower labor costs
...
In
this discussion, George, a managerial accountant, reports on his recent study of activity-based costing
...
Reducing
the work in process and finished goods inventories meant the accountants no longer needed to keep
detailed records for inventory valuation
...
Using accounting for quality and cost management

Lowering inventories to immaterial levels for financial reporting purposes reduces the amount of
accounting time required to make journal entries to transfer costs between inventory accounts
...

JIT did not eliminate the need for product costing
...
After simplifying inventory
accounting at the Hewlett-Packard plant, the accountants turned their attention to providing better
information in a form managers could understand and use
...

Source: Authors' research
...
Their symptoms are similar to ours
...

Pam (company president): That sounds like us! What are they doing about it?
George: Well, they are putting in a new type of cost system called activity-based costing, or ABC for short
...

Applying this to ourselves, we may find, for example, that activity-based costing could reveal that the cost of skirts
is lower than we thought, meaning we could lower our prices
...
How can a product cost less under one cost system than under another?
George: Actually, Lynn, the product does not cost less under one system or another
...
We are able to trace some costs directly to the product
...

Overhead costs are another matter
...
All these costs are allocated to products
...
So we make
some assumptions about the relation between products and overhead costs
...
While that is probably a reasonable way to
allocate the costs of electricity to run machines, its not a desirable way to allocate the cost of quality control
inspectors
...
How will activity-based costing help?
George: Activity-based costing provides more accurate information because we can identify which activities
cause costs, and we can determine the cost of the activity
...
For example, if a
particular jacket requires 10 inspections for a production run of 1,000 jackets, we figure out the cost of those
inspections and assign that cost to the production run for this particular jacket
...
0 License
Martha (vice president of production): That makes sense to me
...
For example, if
we find that a jacket requires too many costly inspections, we could redesign the jacket to reduce the need for
inspections
...
We really do not know how much it costs to make an inspection and how much inspection cost is
required by each product
...
New accounting methods sound great in theory, but there must be enough
benefit from improved management decisions to justify the additional work required to provide numbers
...

Pam: I see many benefits in better pricing, reducing the costs of high-cost activities, and possibly dropping
some products if we learn that their costs are too high
...
We need the best cost information we can get to succeed in
those markets
...
Installing a new cost system requires teamwork between management,
accounting, marketing, engineering, production, purchasing, and everybody else
...

Remember these important points about activity-based costing:
• The allocation of indirect costs is at least somewhat arbitrary, even using sophisticated accounting

methods
...

• Activity-based costing can help marketing people by providing more accurate product cost numbers for

decisions about pricing and which unprofitable products the company should eliminate
...
In practice, ABC helps managers identify cost-causing activities
...

• Activity-based costing provides more information about product costs than traditional methods but

requires more record-keeping
...

• Installing activity-based costing requires teamwork among accountants, production managers, marketing

managers, and other nonaccounting people
...


Methods used for activity-based costing
Activity-based costing requires accountants to use the following four steps:
• Identify the activities that consume resources and assign costs to those activities
...


Accounting Principles: A Business Perspective

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...
A cost driver is an activity or transaction that

causes costs to be incurred
...
Each activity could have multiple cost drivers
...
The cost driver rate could be the cost per purchase order, for

example
...
For example, the cost per purchase order times the number of orders required for Product A
for the month of December would measure the cost of the purchasing activity for Product A for December
...

Step one is often the most interesting and challenging part of the exercise
...
Imagine the activities involved in making a simple
product like a pizza—ordering, receiving and inspecting materials, making the dough, putting on the ingredients,
baking, and so forth
...

Complexity as an activity that consumes resources One of the lessons of activity-based costing has been
that the more complex the business, the higher the indirect costs
...
Further,
assume your ice cream is sold only in one liter containers, while your friend sells ice cream in various containers
...
Your friend has more machine setups, too
...
Your friend has to set the machines each time a new flavor is
produced
...

In Exhibit 162, we present several examples of the cost drivers companies use
...
In deciding which cost
drivers to use, managers consider these three factors:
Cost driver
Miles driven
Machine-hours
Customers served
Flight hours
Number of customers

Cost of assigned cost driver
Automobile costs
Electricity to run machines
Overhead in a bank
Airplane maintenance costs
Selling costs

Exhibit 162: Cost drivers
• Causal relation
...
For example, suppose students in

biology classes are messier than students in history classes
...
Further, it is possible to keep track
of the time maintenance people spend cleaning classrooms and labs
...

• Benefits received
...
For

example, if the physics department in a university benefits more from the university's supercomputer than the
German department does, the university should select a cost driver that recognizes such differences in
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This book is licensed under a Creative Commons Attribution 3
...
The cost driver could be the number of faculty and/or students in each department who use the
computer
...
Some costs that cannot be linked to products based on causality or benefits received are

assigned on the basis of reasonableness
...

Using activity-based costing, we first define the notion of an activity center
...
For example, the costs of setting up machines would be assigned to the
activity center that sets up machines
...
When the cost driver is the
number of inspections, for example, the company must keep track of the cost of inspections
...
Accountants allocate costs to
products by multiplying each activity's indirect cost rate by the volume of activity used in making the product
...
We
contrast the results using activity-based costing to those using a departmental rate
...
The touring
bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product
...

• Managers and accountants developed an overhead rate based on the following data for 2011:
Overhead for department A for 2011
Machine-hours worked during 2011 in
department A
Department A overhead rate
($2,000,000/20,000 hours)

$2,000,000
20,000 hours
$100 per machinehour

• To compare activity-based costing with the company's traditional method, the accountants selected the

month of January to study
...
These activities were (1) purchasing materials, (2) setting up machines when a new
product was started, (3) inspecting products, and (4) operating machines
...
Using accounting for quality and cost management
Accountants estimated the overhead and the volume of events for each activity
...
These overhead costs included salaries of people to purchase, inspect, and store materials
...
00 (USD
200,000/100,000 pieces)
...
In practice, companies most frequently set rates for
the entire year, although some set rates for shorter periods, such as a quarter
...
Note that the total overhead for 2011 is USD 2,000,000 using activity-based
costing, just as it was using a traditional costing method
...
The primary difference between
activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of
activities used to assign overhead costs to products
...
Activity-based costing used four activities in this case
...
We used four to keep the
illustration as simple as possible
...
)
(1)
Activity

(2)
Cost driver used to
allocate
overhead cost
driver
1
...
Machine setups Machine setups
3
...
Running
Machine-hours
machines
Total overhead

(3)
Overhead
cost for
the activity

(4)
Cost driver
units
for 2011

(5)
Rate: column
(3)/column (4)

$ 200,000

100,000 pieces $2/piece

800,000
400,000
600,000

400 setups
4,000 hours
20,000

$2,000/setup
$100/hour
$30/hour

$ 2,000,000

Exhibit 163: Overhead rates for activity-based costing
For January 2011, the High Challenge Company has the following information about the actual number of cost
driver units for each of the two products:
1
...
Machine setups
3
...
Running machines

Touring Mountain
bicycles bicycles
6,000
4,000 pieces
pieces
10 setups 30 setups
200 hours 200 hours
1,500
500 hours
hours

Multiplying the actual activity events for each product times the predetermined rates computed earlier resulted
in the overhead allocated to the two products shown in Exhibit 164
...
0 License
Touring
Actual
cost
driver
units
1
...
Machine setups
$2,000/setup10 setups
3
...
Running machines $30/hour
1,500
hours
Total cost allocated to
each product
Activity

Rate

Bicycles
Cost
allocated
to Product
$12,000
20,000
20,000
45,000

Mountain
Actual
cost
driver
units
4,000
pieces
30 setups
200 hours
500 hours

$97,000

Bicycles
Cost
allocated
to product
$ 8,000
60,000
20,000
15,000
$ 103,000

Exhibit 164: Overhead costs assigned to products using activity-based costing
Now we can compare the overhead allocated to the two product lines using the traditional method and activitybased costing, as follows:
Touring
bicycles
Traditional method
$150,000
Activity-based costing 97,000

Mountain
bicycles
$50,000
103,000

Unit costs Assume High Challenge Company produced 1,000 units of touring bicycles and 200 units of
mountain bicycles in January
...
Direct labor cost is USD 20 per unit for touring bicycles and USD 30 per unit for
mountain bicycles
...

Traditional Costing
Activity-based Costing
Touring
Mountain Touring
Mountain
bicycles
bicycles
bicycles
bicycles
Direct materials
$ 100
$200
$100
$200
Direct labor
20
30
20
30
Overhead
150a
250b
97
515d
Total
$270
$480
$217
$745
A
$150 = overhead cost allocation to products using departmental rate divided by number of units produced = $150,000/1,000 units
...

C
$97 = overhead cost allocation to products using activity-based costing divided by number of units produced = $97,000/1,000 units
...


Exhibit 165: Comparison of product costs using traditional costing and activity-based costing
Analysis More overhead is allocated to the lower volume mountain bicycles using activity-based costing
...
By failing to assign costs to all of the activities, touring bicycles
were subsidizing mountain bicycles
...
Activity-based
costing has revealed that low-volume, specialized products have been the cause of greater costs than managers had
realized
...
The majority of the overhead cost was related to the support of labor, so it made sense to allocate overhead to
products based on the amount of labor in the products
...
Often they allocate overhead to products (which
are called jobs) on the basis of the amount of labor in the product
...
Using accounting for quality and cost management
As manufacturers and service companies have become more automated, direct labor has become less
appropriate as a basis for allocating overhead
...
Thus, companies that continue to allocate overhead to products
based on direct labor are seeing rates increase as high as 500 per cent or more
...
)
When labor is such a small part of product costs, there is little—if any—relationship between labor and
overhead
...

Finally, allocating overhead on the basis of direct labor sends signals that direct labor is more expensive than it
really is
...
While this may be
desirable in particular circumstances, such decisions should be based on accurate cost numbers, not numbers
heavily biased because of an arbitrary cost allocation method
...
The principles and methods are the same as discussed earlier: (1) identify
activities or cost drivers, (2) compute an indirect cost rate for each activity, and (3) allocate indirect costs by
multiplying the indirect cost rate for each activity by the volume of activities
...
Tissue products, for example, can be sold to grocery stores, convenience
stores, the industrial market, and other channels of distribution
...

• Grocery stores would require relatively large shipments, a variety of products, and considerable marketing

support
...


Information on the cost of alternative channels of distribution is useful to marketing managers who make
decisions about which channel to use
...


Strategic use of activity-based management
Many believe activity-based costing offers strategic opportunities for companies
...
Companies such as Wal-Mart Stores
in retailing, UPS in delivery services, and Southwest Airlines in the airline industry have created competitive
advantages by reducing costs
...

Activity-based costing plays an important role in companies' strategies and long-range plans to develop a
competitive cost advantage
...
Cost reduction generally requires
a change in activities
...
If you have been in school during a period when education costs
were cut, you know that achieving the cut required a change in activities such as canceled classes, larger class sizes,
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This book is licensed under a Creative Commons Attribution 3
...
It is impossible to know the effect of a change in activities on costs without the cost
information provided by activity-based costing
...
In identifying activities, accountants team up with management and people from production,
engineering, marketing, and other departments in identifying the activities that drive the company's costs
...
Nonaccounting
personnel also feel a greater sense of ownership of the numbers reported by the accounting system so accounting
improves its credibility among nonaccountants
...
Accounting methods in companies are like rules in sports; people
become accustomed to playing by the rules and oppose changing to something unknown
...
Their analysis revealed several hundred products that
were clearly unprofitable and should be eliminated
...
Why? The analysts had failed to talk to these key managers early
in the process
...
Moral: If you are involved in trying to make a change, get all of the people who are important
to that change to buy into the process early
...
Companies are continually encountering
limitations and finding ways to improve activity-based costing
...
But the larger the circle, the greater its boundary and the more we
realize the limits of our knowledge
...

Understanding the learning objectives
• The new production environment refers to an environment in which company managers are concerned

with (1) improving quality and (2) reducing costs
...

• Three methods managers use to identify quality problems are control charts, Pareto diagrams, and cause

and effect analyses
...

• Four such measures are quality control, delivery performance, materials waste, and machine downtime
...

• The balanced scorecard is a set of performance targets and results that show an organization's performance

in meeting its stakeholder objectives
...
Using accounting for quality and cost management
• JIT substantially reduces or eliminates the need for inventories and improves quality by eliminating the

flexibility provided by inventories
...

• Just-in-time accounting procedures normally debit all costs directly to cost of goods sold and bypass the

usual inventory accounts
...

• Activity-based costing is a costing method that assigns costs to activities and then to the products based on

each product's use of activities
...

• Companies benefit from activity-based costing because managers have more detailed information about the

cost of activities and better product cost information
...
Second, identify the

cost drivers associated with each activity
...
Fourth, assign costs
to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product
...

• By focusing attention on activities that cause costs, activity-based management helps managers eliminate

activities that consume resources, thereby becoming more efficient and competitive
...
Recall that the
departmental overhead rate for 2011 was USD 100 per machine-hour
...
Purchasing materials 10,000
pieces
2
...
Inspections
200 hours
4
...
The actual
activity levels for December are given in this problem; however, you should use the rates presented earlier in the
text
...
Assume the direct materials
costs are USD 100 and USD 200 per unit for touring bicycles and mountain bicycles, respectively; and direct labor
costs are USD 20 and USD 30 per unit, respectively
...
Round unit costs to the nearest dollar
...
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hours)
Total

$300,000

Overhead costs assigned to products using activity-based costing:
Touring
Actual cost
driver units
1
...
Machine setups
$2,000/setup 15 setups
3
...
Running machines $30/hour
2,000 hours
Total cost allocated
to each product
Activity

Rate

Bicycles
Cost allocated
to product
$ 20,000
30,000
20,000
60,000
$ 130,000

Mountain
Actual cost
driver units
10,000 pieces
40 setups
400 hours
1,000

Bicycles
Cost allocated
to product
$ 20,000
80,000
40,000
30,000
$ 170,000

Comparison of product costs using traditional costing and activity-based costing:
Traditional Costing Activity-based Costing
Touring
Mountain Touring
Mountain
bicycles
bicycles bicycles
bicycles
Direct materials
$100
$200
$100
$200
Direct labor
20
30
20
30
Overhead
154a
250b
100c
425d
Total
$274
$480
$220
$655
A
$154 = overhead cost allocation to products using departmental rate divided by number of units produced = $200,000/1,300 units
...

C
$100 = overhead cost allocation to products using activity-based costing divided by number of units produced = $130,000/1,300 units
...


Key terms
Activity-based costing A costing method that first assigns costs to activities, then assigns costs to products
based on their consumption of activities
...

Backflush costing Backflush costing is a method of assigning costs to inventories backwards from Cost of
Goods Sold to Work in Process or Finished Goods Inventory accounts
...

Benchmarking Benchmarking is the continuous process of measuring how well one is doing against
performance levels either inside or outside of the organization
...

Control charts Control charts help managers distinguish between random or routine variations in quality
and variations that they should investigate
...

Just-in-time (JIT) method The just-in-time method manages purchasing and production so that
materials are purchased just in time for production, parts are produced just when needed for the next step in
the production process, and finished goods are completed just in time for sale
...

Total quality management (TQM) Defined as managing the entire organization so it excels in its goods
and services that are important to the customer
...

In Texas Instruments' cost of quality program, the managers' task was to maximize the sum of prevention,
appraisal, internal failure, and external failure costs
...

The allocation of indirect costs is never arbitrary
...

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...

Multiple-choice
Select the best answer for each of the following questions
...
Improving customer service and product quality
...
Reducing costs
...
Increasing government regulation
...
a and b above
...
All of the above
...
Must be used in conjunction with activity- based costing
...
Require government regulation
...
Eliminate the need for inventories in theory because production does not take place until it is known the item
will be sold
...
Require the use of Pareto charts
...
All of the above
...
Overhead costs are presently allocated to the two products based on
the labor-hours used to produce each product
...
The chief
financial officer has suggested converting to activity-based costing
...
USD 113,600
...
USD 130,000
...
USD 146,400
...
USD 160,000
...
None of the above
...
What is the overhead per unit assigned to Product R using activitybased costing? (Round to the nearest cent
...
USD 2
...

b
...
27
...
USD 2
...

d
...
83
...
None of the above
...
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Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
You may
find it useful to use examples
...
After producing a compact disc player, the company
tests it, then scraps it because it does not work
...
Why would the company
measure the number of customer complaints?

➢

A company's performance measure is the percentage of time that machines are not working
...


➢

What is the benefit to American Airlines of benchmarking on-time airplane arrivals?

➢

How does just-in-time help assure quality of production?

➢

Elimination of inventories through a just-in-time (JIT) method is believed to result in different types
of cost savings
...


➢

What is the difference between accounting for costs using a JIT method and using traditional cost
flows through inventory accounts?

➢

What operating conditions are necessary for a company to make use of a JIT method?

➢

What is the difference between activity-based costing and activity-based management?

➢

Activity-based costing methods use four steps in computing a product's cost
...
" Do you agree with this statement? Explain
...


➢

The vice president of marketing wonders how products can cost less under one cost system than
under another
...
What are the potential benefits of a more detailed product cost system?

➢

Give three criteria for choosing cost drivers for allocating costs to products
...
I plan to be a marketing
specialist so ABC will not help me
...


➢

Observe the workings of a food service or coffee house
...
(For example, cooking food is an
activity; the number of meals could be a cost driver for the cooking activity
...
What activities are
being performed? Give examples of some cost drivers that cause the cost of those activities
...
Using accounting for quality and cost management
example, opening checking accounts is an activity; the number of accounts opened could be a cost
driver for the opening accounts activity
...
What is a benefit of this approach compared to a traditional approach
that allocates costs to products based on the machine-hours used to produce the product?

➢

What is a balanced scorecard?

➢

Real world question Refer to the discussion “A broader perspective: HP” of the impact of just-intime on accounting methods at HP
...
(Appraisal costs would not be affected
...
The following food service information is for the month of February:
Customer complaints
Waste as a percentage of total food
prepared
Cases of food poisoning

60
10%
2

What additional information would you like to have to assess the quality of the food service organization's
performance?
Exercise C Network, Inc
...
After receiving an order for 300 devices, the company bought materials (for cash) costing USD 14,000 to
fill this order
...

After the production was finished, but before all goods were sold, the company needed to compute an inventory
cost for financial statement purposes
...

a
...

b
...

c
...

Exercise D Quality Sound Corporation produces two types of compact discs (CDs), one is to install on touring
bicycles and the other is a high-grade product for home and car use
...
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durability rather than accurate sound reproduction
...
Management believes the accounting system may not be accurately allocating costs to products
...
You found that manufacturing overhead is
currently assigned based on the direct labor costs in the products
...
Last year's manufacturing overhead was USD 440,000 based on production of 320,000 touring bicycle
CDs and 100,000 high-grade CDs
...
The cost drivers and related costs for your analysis
are as follows:
Cost drivers

Cost assigned

Number of production runs
Quality tests performed
Shipping orders processed
Total overhead

$200,000
180,000
60,000
$440,000

Activity
Touring
bicycle
40
12
100

Level
High
grade
10
18
50

Total
50
30
150

a
...
How much of the overhead would be assigned to each product if direct labor costs had been used as the basis
for allocating overhead to each product? What would be the cost per unit (including materials, labor, and overhead)
for each product if overhead is allocated to products using direct labor cost as the allocation base?
Exercise E Landscape, Inc
...
The company originally specialized in serving small
residential clients; recently it has started contracting for work on larger office building grounds
...

Wages amounted to USD 10 per hour for all work done
...
All overhead is allocated on the basis of labor-hours worked, which is also the basis for customer charges
...
, can charge USD 30 per hour for residential work but, because of greater competition for
commercial accounts, only USD 20 per hour for commercial work
...
Using labor-hours as the basis for allocating overhead, what was the gross margin (revenues minus labor and
overhead expense) for (1) commercial and (2) residential service? Assume overhead was USD 50,000
...
Overhead consists of transportation, lawn mowing and landscaping equipment costs, depreciation on
equipment, supplies, fuels, and maintenance
...


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...
Would you advise Landscape, Inc
...

Problems
Problem A Here are cost items from Huskie Company's accounts for a typical month:
Inspection at the end of the production process
Cost of returned goods
Design work to improve the way products are
made
Repairs to satisfy customer complaints
Employee training
Incoming materials inspection
Scrap

$80,000
36,000
48,000
20,000
24,000
20,000
36,000

a
...

b
...
(Appraisal costs would not be affected
...
Give two examples of additional nonfinancial quality measures that Huskie Company could use to help
improve quality
...
)
Problem B You have been hired by Bucks 'R' Us Bank to help assess the quality of their services
...
The company has a
large backlog of orders and no beginning inventories because all units in production last year were sold by the end
of the year
...

The company purchased and used USD 105,000 of materials in production for this order
...
Goods representing 10 per cent of
these costs were still in finished goods inventory at the end of the period
...
Use T-accounts to show the flow of costs under a traditional costing system
...
Prepare journal entries for these transactions using backflush costing
...
Use T-accounts to show the flow of costs using a JIT system with backflush costing
...
Overhead costs are currently allocated
using direct labor-hours, but the controller has recommended using an activity-based costing system based on the
following data:
Activity

Cost driver Cost

Production setup
Material handling and
requisition
Packaging and shipping
Total overhead

Setups
Parts

$100,000
30,000

Units shipped 60,000
$190,000

Activity Level
Travel Watches
clocks
20
30
24
36
80,000

120,000

a
...


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This book is licensed under a Creative Commons Attribution 3
...
Compute the amount of total overhead allocated to each product using labor-hours as the allocation base
...
5 per travel clock and 1
...

c
...
Sunshield
presently allocates overhead to products using a rate based on direct labor-hours
...
Management decided to give ABC a try and identified the following
activities, cost drivers, and costs for a typical year for each activity center
...

Activity

Recommended
cost driver
Production runs
Orders
Pounds of
materials used
Machine-hours
Inspections
Units shipped

Production setup
Order processing
Materials handling
Equipment depreciation
and maintenance
Quality management
Packing and shipping
Total overhead

Costs
$ 30,000
50,000
20,000

Cost driver
units
100
200
8,000

60,000

10,000

50,000
40,000
$250,000

40
20,000

In addition, there are 2,500 direct labor-hours in a typical year
...

a
...

b
...
Compute the production costs for each product for February using direct labor-hours as the allocation
base
...
)
c
...

d
...
Write a brief
response to management
...
Last
year, Filmworks had the following costs and revenues:
Filmworks
Photography
Income
statement
Deluxe

Family

Accounting Principles: A Business Perspective

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...
After interviewing the sales and production staff, management
decides to allocate administrative costs on the basis of direct labor costs and to use the following bases to allocate
the remaining overhead:
Activity
Production setup
Quality control
Marketing

Cost driver
Photo sessions
Customer inspections
Advertisements

Cost driver
Student
150
300
60

Units
Family
250
200
40

a
...

b
...

c
...

d
...
Indicate whether the activity-based costing method provides more accurate information
and why (if you believe it does provide more accurate information)
...

Alternate problems
Alternate problem A These cost items are from Rocket Company's accounts for a typical month:
Design work to improve the way products are
made
Warranty work to satisfy customer complaints
Employee training
Incoming materials inspection
Scrap
Cost of returned goods
Inspection at the end of the production process

$48,000
24,000
36,000
40,000
36,000
48,000
60,000

a
...

b
...
Would this
be a wise thing for Rocket Company to do?
c
...
(Hint: See Exhibit 159
...
You have been looking over the following information for the month of May:
Number of patient complaints
Minutes the average patient waits
Cases of missed diagnosis

120
3
...
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Alternate problem C Precision Instruments produces high-tech devices
...

At the start of this year, the firm received an order for 6,000 items
...
Direct labor costs of
USD 150,000 and overhead costs of USD 400,000 were incurred
...

a
...

b
...

c
...

Alternate problem D The manager of Rafting Excursions uses activity-based costing to compute the costs of
her raft trips
...
She offers two types of raft trips, a three-day float
trip for beginners, and a three-day white-water trip for seasoned rafters
...
Compute the cost of a 28-person (including guides) float trip with four rafts and four guides
...
Compute the cost of a 28-person (including guides) white-water trip with four rafts and four guides
...
How much should the manager charge each customer if she wants to cover her costs?
Alternate problem E Shoe Express, Inc
...
The B-Ball
shoe has a complex design that uses gel-filled compartments to provide support
...
Last year, Shoe Express had the following revenues and costs:

Revenue
Direct materials
Direct labor
Indirect costs:
Administration
Production setup
Quality control
Advertising
Net income before
taxes

Shoe Express, Inc
...
After interviewing the sales and production staff, management decides to allocate
administrative costs on the basis of direct labor costs, but to use the following bases to allocate the remaining
overhead:
Activity
Production setup
Quality control
Advertising

Cost drivers
Production runs
Inspections
Advertisements

ActivityLevel
B-ball Marathon
20
20
40
20
12
48

a
...

b
...

Accounting Principles: A Business Perspective

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...
Restate the income statement for Shoe Express, Inc
...

d
...
Indicate whether the activity-based costing method provides more accurate information
and why (if you believe it does provide more accurate information)
...

Beyond the numbers—Critical thinking
Business decision case A Many companies recognize that their cost systems are inadequate for today's global
market
...

Write a short paper describing the benefits management should expect from implementing activity-based
costing
...
Write a short paper describing the problems this company might face in using
just-in-time
...
Give an example of a cost for each
of these four categories
...

Group project D The chapter listed the following six important points to remember about activity-based
costing
...
After forming six groups, discuss one of these
points in each group
...
) Choose one group member to report your group's response to the class
...
("This means no method gives you a true cost; all are arbitrary
...
("Who

needs more detail? Life is already too complicated"
...
("Why should
accountants want to help marketing people?")
• Production also benefits because activity-based costing provides better information about the cost of each

activity
...
To manage costs, production
managers learn to manage the activities that cause costs
...
)
• Activity-based costing provides more information about product costs than traditional methods but

requires more record-keeping
...
("ABC sounds like a lot of work
...
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• Installing activity-based costing requires teamwork among accountants, production managers, marketing

managers, and other nonaccounting people
...
Accountants
and marketing people? You have got to be kidding!")
Group project E Form a group of three or four students and assume you are hired as business consultants for
each of the cases below
...
Your response should assume
you are talking directly to the CEO
...
(Hint: Consider the potential costs and benefits associated with each case
...

After lengthy discussion regarding the company's costing system, the CEO makes the following statement: "From
what I have seen at other companies lately, activity-based costing is the wave of the future
...
After lengthy discussion regarding the company's costing system, the CEO makes the following
statement: "From what I have seen at other companies lately, activity-based costing is the wave of the future
...
Ask the manager how
items are ordered to replace those sold
...
Information contained in the memo
should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of
the interview, and the results of the interview
...

Give examples of warning and diagnostic signals the organization uses
...
This award is issued annually by the National Institute of Standards and Technology (NIST)
...
baldrige
...
gov
Click on "Criteria and their Impact"
...
Who were the most recent winners of the Baldrige Award? What products or services do these
companies provide?
Based on the results of the previous Internet project, perform an Internet search to find at least one recent
Baldrige Award winning company
...
Using accounting for quality and cost management
of the award? If so, write a report summarizing this information
...

Answers to self-test
True-false
False
...

True
...

False
...

True
...

True
...

Multiple-choice
d
...

c
...

d
...
USD 2 X 80,000 hours = USD 160,000
...
USD 2
...

812

USD 48,000
= USD600
...

80,00050,000 
Next assign overhead to Product R:
(USD 4,100 X 12) + (USD 600 X 24) + (USD 1 X 50,000) = USD 49,200 + USD 14,400 + USD 50,000 = USD
113,600
...
27
...
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21
...

• Separate mixed costs into fixed and variable components using the scatter diagram and high-low method
...

• Find the break-even point
...

• Demonstrate applications of cost-volume-profit analysis
...

• Describe how computer spreadsheets expand your capability to use cost-volume-profit analysis
...


A manager's perspective
Renee Vaughn
Manager, Administration and Special Projects
Public and Media Relations
The Coca-Cola Company
I am responsible for providing scheduling and assisting with staffing with the Public and Media Relations group
...
I also administer budgets for three
departments (about 35 employees)
...
I learned to plan and manage budgets in that capacity
...
We also review a rolling estimate of annual expenses and adjust the
budget accordingly
...
If an unforeseen need develops, we will review
our plan and make revisions as necessary on a case-by-case basis
...
The organization can rent a particular
movie for one weekend for USD 1,000
...
The organization would sell tickets for USD 4 per
person
...
Cost-volume-profit analysis
holder
...
)
Solving problems like this requires an understanding of the relationship between costs, revenue, and volume
...
(Although
accountants call this topic cost-volume-profit analysis, it could just as easily have been called cost-volume- revenue
analysis
...

In this chapter we will focus on short-run decisions
...
The short run is one year or less for
practical purposes
...
In contrast, GM's decision to begin producing cars in China
...
However,
all costs are subject to change in the long run
...
Someday the building rental agreement
will change, so the building rental expense will change
...
As
discussed in earlier chapters, fixed costs remain constant (in total) over some relevant range of output
...
Depreciation, insurance, property taxes, and administrative salaries are
examples of fixed costs
...

For example, a local high-tech company did not lay off employees during a recent decrease in business volume
because the management did not want to hire and train new people when business picked up again
...
Although volume decreased, direct labor costs remained fixed
...

In particular, total variable costs change as total volume changes
...
0 License
pizzas to 200 10-inch pizzas per day, the amount of dough required per day to make 10-inch pizzas would double
...
Direct materials and sales commissions are variable costs
...
If the total direct labor cost increases as the volume of output
increases and decreases as volume decreases, direct labor is a variable cost
...
In addition, direct labor is frequently a variable cost for workers paid on an hourly
basis, as the volume of output increases, more workers are hired
...

Mixed costs have both fixed and variable characteristics
...
Electricity is an example of
a mixed cost
...
As the company increases its volume
of activity, it runs more machines and runs them longer
...
As activity
increases, so does the cost of electricity
...

They include the fixed portion of mixed costs with other fixed costs, while assuming the variable part changes with
volume
...


Exhibit 167: Separation of mixed costs into fixed and variable parts
A step cost remains constant at a certain fixed amount over a range of output (or sales)
...
Visually, step costs appear like stair steps, as shown in Exhibit 166
...
For instance, the local McDonald's restaurant has one supervisor until sales exceed 100 meals during the
lunch hour
...
In Exhibit
168, we show a step cost for supervisors' salaries, assuming each supervisor is paid USD 2,000 per month
...


Accounting Principles: A Business Perspective

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...

Many costs do not vary in a strictly linear relationship with volume
...
We show a curvilinear cost pattern in
Exhibit 169
...
The relevant range is the range of production or sales volume over which the
assumptions about cost behavior are valid
...
Within that relevant range, the total cost varies linearly with volume, at least
approximately
...

834

This book is licensed under a Creative Commons Attribution 3
...
Even within the relevant
range, the assumed cost behavior is usually only approximately linear
...


Methods for analyzing costs
You can use several methods to break down a mixed cost into its fixed and variable cost components
...

A scatter diagram shows plots of actual costs incurred for various levels of activity
...
Each dot represents one month's activity for one city
...
The next point to the right represents USD 42,000 for
approximately 40,000 miles for another month
...
The line
we drew is subjective
...

Estimating fixed and variable costs using a scatter diagram is subjective
...
Your line and cost estimates would not
necessarily be right or wrong compared to ours, just different
...
Cost-volume-profit analysis

Exhibit 171: Scatter diagram
In Exhibit 171, our line intersects the vertical axis at USD 25,000, which we estimate to be the fixed portion of
the mixed cost
...
Thus, our line rises from USD 25,000, representing 0 (zero) miles, to USD 57,000 over a volume of
80,000 miles on the horizontal axis
...
40 per mile
80,000 miles –0 miles
Using this result, we estimate the company's truck maintenance costs are USD 25,000 per month plus 40 cents
for every mile driven
...
This method uses only the
highest and lowest points (levels of operation) on a scatter diagram to fit a line to the data
...
Calculate the amount of variable cost per mile as follows:
Change for cost USD 60,000 – USD 38,000
=
Change for units 80,000 miles – 30,000 miles

=

USD 22,000
= USD 0
...
44)
Fixed cost at all levels of mileage within the
relevant range

$60,000
35,200
$24,800

The high-low method is less precise than the scatter diagram because it uses only two data points in the
computation
...

Many people use more sophisticated statistical techniques to divide mixed costs into fixed and variable portions
...

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This book is licensed under a Creative Commons Attribution 3
...
The first of these tools is cost-volume-profit (CVP) analysis
...
A careful and
accurate cost-volume-profit (CVP) analysis requires knowledge of costs and their fixed or variable behavior as
volume changes
...

Look at Exhibit 172, a cost-volume-profit chart for Video Productions, a company that produces videotapes
...
The variable cost per tape is USD 12, and the fixed costs per month are USD 40,000
...
Thus, if Video
Productions produces and sells 6,000 tapes, the company's total costs are USD 112,000, made up of USD 40,000
fixed costs and USD 72,000 total variable costs (USD 72,000 = USD 12 per unit X 6,000 units produced and sold)
...
Total revenue is USD
120,000 for sales of 6,000 tapes (USD 120,000 = USD 20 per unit X 6,000 units sold)
...


Exhibit 172: The cost-volume-profit chart
At each volume, one can estimate the company's profit or loss
...
We can find the net income either by constructing an income statement or using the profit
equation
...
Cost-volume-profit analysis
Less: variable costs
Contribution margin
Less: Fixed costs
Net income

72,000
$ 48,000
40,000
$ 8,000

We have introduced a new term in this income statement—the contribution margin
...
We can calculate it on a per
unit or total sales volume basis
...

The contribution margin indicates the amount of money remaining after the company covers its variable costs
...
In Video Production's income
statement, the USD 48,000 contribution margin covers the USD 40,000 fixed costs and leaves USD 8,000 in net
income
...
According to the profit equation:
Net income = Revenue - Total variable costs - Fixed costs
For Video Productions, the profit equation looks like this:
Net income=USD 120,000−USD 72,000− USD 40,000
Net income=USD 8,000

Exhibit 172 shows cost data for Video Productions in a relevant range of output from 500 to 10,000 units
...
For volumes outside these ranges, costs behave differently and alter the assumed relationships
...
In either case, the assumed cost relationships would no longer be valid
...
Thus,
the break-even point is that level of operations at which a company realizes no net income or loss
...
No
matter how a company expresses its break-even point, it is still the point of zero income or loss
...

Fixed costs per period total USD 40,000, while variable cost is USD 12 per unit
...
The contribution margin per unit is USD 8 (USD 20 selling price per unit - USD 12
variable cost per unit)
...
We can prove that
to be true by computing the revenue and total costs at a volume of 5,000 units
...
0 License
sales price per unit = USD 100,000
...

Look at Exhibit 172 and note that the revenue and total cost lines cross at 5,000 units—the break-even point
...

Break-even in sales dollars Companies frequently think of volume in sales dollars instead of units
...
GM breaks even in sales dollars
...

BE dollars=

Fix costs
Contribution margin ratio

A broader perspective:
Even colleges use CVP
The dean of the Business School at a particular university was considering whether to offer a
seminar for executives
...
Variable costs, including meals,
parking, and materials, would be USD 80 per person
...
Such costs, which could be
thought of as fixed costs, amounted to USD 8,000 for the seminar
...

Although the salaries paid to these staff were not affected by offering the seminar, working on it
took these people away from other duties, thus creating an opportunity cost, estimated to be USD
7,000 for this seminar
...
3 students
...

Based on the authors' research
...
To calculate this
ratio, divide the contribution margin per unit by the selling price per unit, or total contribution margin by total
revenues
...
40
Or, referring to the income statement in which Video Productions had a total contribution margin of USD
48,000 on revenues of USD 120,000, we compute the contribution margin ratio as follows:

Accounting Principles: A Business Perspective

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...
40
That is, for each dollar of sales, there is a USD 0
...

Using this ratio, we calculate Video Production's break-even point in sales dollars as:
BE dollars=

Fix costs
Contribution margin rate

BE dollars=

USD 40,000
0
...
At this level of sales, fixed
costs plus variable costs equal sales revenue, as shown here:
Revenue
Less: variable costs
Contribution margin
Less: Fixed costs
Net income

$120,000
72,000
$ 48,000
40,000
$ 8,000

The cost-volume-profit chart in Exhibit 172 shows that in a period of complete idleness, Video Productions
would lose USD 40,000 (the amount of fixed costs)
...
Other points on the graph show that sales of 7,500 units results
in USD 150,000 of revenue
...

Although you are likely to use cost-volume-profit analysis for a single product, you will more frequently use it in
multi-product situations
...
For CVP purposes, a multi-product company must assume a given product
mix
...

To illustrate the computation of the break-even point for Wonderfood, a multi-product company that makes
three types of cereal, assume the following historical data:
Product
1
AmountPer cent
$60,000 100%

Sales
Less:
Variable costs
40,000 67%
Contribution margin $20,000 33%

2
AmountPer cent
$30,000 100%

3
Amount Per cent
$10,000 100%

Total
Amount Per cent
$100,000100%

16,000 53%
$14,000 47%

4,000
40%
$ 6,000 60%

60,000 60%
$ 40,000 40%

We use the data in the total columns to compute the break-even point
...
Assuming the product mix remains constant and fixed costs for the company
are USD 50,000, break-even sales are USD 125,000, computed as follows:
BE dollars=

Fix costs
Contribution margin ratio

BE dollars=

USD 50,000
0
...
0 License
[To check our answer: (USD 125,000 X 0
...
]
To find the three product sales totals, we multiply total sales dollars by the per cent of product mix for each of
the three products
...
That is, out of the USD
100,000 total sales, there were sales of USD 60,000 for product 1, USD 30,000 for product 2, and USD 10,000 for
product 3
...
6 X USD 125,000), USD 37,500 of
product 2 (0
...
1 X USD 125,000) to break even
...
nearly went bankrupt several times before he finally made
Domino's a financial success
...
Because they were
small, the company could not charge enough to cover its costs
...

If a company's current sales are more than its break-even point, it has a margin of safety equal to current sales
minus break-even sales
...
For example, assume Video Productions currently has sales of USD 120,000 and its break-even sales
are USD 100,000
...
The margin of
safety rate is equal to

Current sales – Break−even sales 

...
67 per cent
This means that sales volume could drop by 16
...


Cost-volume-profit analysis illustrated
CVP analysis has many applications
...

The management of a major airline wishes to know how many seats must be sold on Flight 529 to break even
...


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...
Fixed costs include the fuel
required to fly the plane and crew (with no passengers) to its destination; depreciation on the plane used on the
flight; and salaries of required crew members, gate attendants, and maintenance and refueling personnel
...
Variable costs include snacks and beverages
provided to passengers, baggage handling costs, and the cost of the additional fuel required to fly the plane with
passengers to its destination
...

Assume that after analyzing the various costs and separating them into fixed or variable categories, management
finds the fixed costs for Flight 529 are USD 12,000 and variable costs are USD 25 per passenger
...
Thus, the contribution margin ratio is 80 per cent or [(USD 125 - USD 25)/USD 125]
...
The break-even
point in sales dollars is:
BE dollars=

=

Fix costs
Contribution margin ratio

USD 12,000
0
...

With a simple adjustment in the break-even formulas, CVP analysis can also show the sales volume needed to
generate some desired level of net income (ignore taxes)
...
From this, management can determine the necessary
sales volume in dollars or units to provide the desired net income
...

How many passenger tickets must the airline sell to earn USD 8,000? Remember, the contribution margin per
ticket is USD 100
...
To check our answer: (200 tickets X USD 125
sales price per ticket) - (200 tickets X USD 25 variable cost per ticket) - USD 12,000 fixed costs = USD 25,000 USD 5,000 - USD 12,000 = USD 8,000
...
0 License
The airline management can also use cost-volume-profit analysis to determine the effect of changing the sales
price
...
If variable and fixed costs remain
constant and passenger load does not change, net income increases from USD 3,000 to USD 3,937
...
05) x 150 passengers] – (USD 25 x 150 passengers) – USD 12,000 = NI
USD 19,687
...
50 = NI
Net income would rise by the entire amount of the price increase (USD 19,687
...
50)
...
For example, assume both fixed and variable costs would increase for the airline if the price of fuel
rises
...
25 per passenger
...
25/USD 125), of the sales price
...
75, or (USD 125 - USD 31
...
The contribution margin ratio is now 75 per cent, or (USD
93
...

To maintain the current net income of USD 3,000, the airline needs to increase sales revenue to USD 25,333:
Revenue required =
=

Fix costs Desired net income
Contribution margin ratio

USD16,000 USD3,000
0
...
In
general, the careful study of cost behavior helps management plan future courses of action
...
Most new shows do not break even
...

As the networks find it more and more difficult to break even on their regular shows, they are
expanding into cable, satellite, and pay-per-view television
...
The company has also invested in CNBC, a cable
network that specializes in consumer and business issues
...


Assumptions made in cost-volume-profit analysis
To summarize, the most important assumptions underlying CVP analysis are:

Accounting Principles: A Business Perspective

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...
This

means that a company can sell more or fewer units at the same price and that the company has no change in
technical efficiency as volume changes
...

• Costs can be accurately classified into their fixed and variable portions
...


Using computer spreadsheets for CVP analysis
Computer spreadsheet packages are well suited for CVP analysis because they enable managers to answer whatif questions
...
Since they are used in
planning and decision making, it is reasonable to ask whether plans or decisions would change if the estimates
changed
...
The output is only as good as the
information that goes in
...
The analyst prepared the following formulas for the
spreadsheet:
• Revenue equals ticket price times number of passengers (amounts to be inserted for ticket price and

number of passengers)
...

• Fixed costs equal USD 200,000
...


Management then inserted various values for ticket price, number of passengers, the per cent of variable cost to
revenue, and fixed costs, all per cruise
...
Based on these results, management sees
what combinations of ticket price, number of passengers, and contribution ratio are required for the cruise to be
profitable
...
Spreadsheets provide the
advantage of a large number of possible combinations with minimal data entry
...
0 License

An accounting perspective:
Uses of technology
Cost-volume-profit analysis using a computer spreadsheet is becoming routine
...


Effect of automation on cost-volume-profit analysis
Increasing automation does not affect the fundamental CVP model or the types of analysis we have discussed
...
As companies become more automated, they
substitute machinery for labor
...
For example, when banks installed automated teller machines, their labor costs decreased but their
fixed costs, including machine depreciation, increased
...
At
low levels of volume, becoming more automated increases total costs, but at high levels of volume it decreases
them
...


Exhibit 174: Effects of automation
If it crosses at low volumes, to the left of point A in Exhibit 174, then increasing automation increases the
company's break-even point
...

In this chapter we began studying short-run decisions based on cost-volume-profit analysis
...


Accounting Principles: A Business Perspective

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...
These costs remain constant in total over some relevant range of output and are often

described as time-related costs
...

• Variable costs
...
Direct

materials and sales commissions are examples
...
These costs contain a fixed portion of cost incurred even when the plant is completely idle

and a variable portion that increases directly with production volume
...

• Step costs
...
The cost of supervisors' salaries is an example
...

• The high-low method uses the highest and lowest points on a scatter diagram to fit a line to the data
...

• The break-even point is that level of operations at which a company realizes no income or loss
...

• Selling price, variable cost per unit, and total fixed costs remain constant through the relevant range
...

• Costs can be accurately classified into their fixed and variable portions
...

• As companies become more automated, they substitute machinery for labor, which generally increases

fixed costs and decreases variable costs
...
50 per unit
...
50 per unit
...
The contribution margin
is USD 5 per unit (USD 12
...
50)
...
Compute the break-even point in (1) sales dollars and (2) units
...
Compute the number of units the company must sell if it wishes to have net income of USD 300,000
...
Recall that the movie rental would be USD 1,000
...
0 License
ticket takers and other personnel, and other fixed costs would be USD 800 for the weekend
...
In addition, profits from the sale of soft drinks, popcorn, and candy are
estimated to be USD 1 per ticket holder
...
(1) The contribution margin ratio is 0
...

BE dollars=

Fix costs
Contribution margin ratio

BE dollars=

USD625,000
0
...


Number of units=

=

USD625,000USD 300,000
USD5

=

USD925,000
USD5

= 185,000 units
Solution to demonstration problem B
Number of ticket buyers so they break even=
=

USD 1,000 USD800
USD4 USD1

USD1,800
USD5

= 360 ticket buyers

Key terms*
Break-even point That level of operations at which revenues for a period are equal to the costs assigned to
that period so there is no net income or loss
...

The contribution margin per unit is the selling price minus the variable cost per unit
...

Cost-volume-profit (CVP) analysis An analysis of the effect that any changes in a company's selling
prices, costs, and/or volume will have on income (profits) in the short run
...

Cost-volume-profit (CVP) chart A graph that shows the relationships among sales, volume, costs, and
net income or loss
...

High-low method A method used in dividing mixed costs into their fixed and variable portions
...

Margin of safety Amount by which sales can decrease before a loss is incurred
...

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...

Product mix The proportion of the company's total sales attributable to each type of product sold
...

Relevant range The range of production or sales volume over which the assumptions about cost behavior
are valid
...

Short run The time during which a company's management cannot change the effects of certain past
decisions; often determined to be one year or less
...

Step cost A cost that remains constant at a certain fixed amount over a range of output (or sales) but then
keeps increasing to a higher amount at certain points
...

*Some terms listed in earlier chapters are repeated here for your convenience
...

The scatter diagram method is less precise than the high-low method for evaluating costs
...

Total contribution margin indicates the amount of money remaining after variable and fixed costs are covered
...

Multiple-choice
Select the best answer for each of the following questions
...
Variable cost
...
Fixed cost
...
Mixed cost
...
Step cost
...
A fixed component
...
Costs increase in steps as production volume increases
...
Can remain constant over some relevant range of output
...
All of the above
...
USD 40,000
...
USD 33,333
...
USD 50,000
...
0 License
d
...

Using the following data, calculate the contribution margin:
Selling price USD 20
Fixed costs 4
Variable cost 6
a
...

b
...

c
...

d
...

Using the following data, calculate the break-even point in units:
Selling price per unit USD 20
Fixed costs 28,000
Variable cost per unit 6
a
...

b
...

c
...

d
...

Which of the following describe(s) the underlying assumptions of cost-volume-profit analysis?
a
...

b
...

c
...

d
...

Now turn to “Answers to self-test” at the end of the book to check your answers
...


➢

Describe two methods of determining the fixed and variable components of mixed costs
...
Cost-volume-profit analysis
➢

Real world question Assume your college is considering hiring a lecturer to teach a special class in
communication skills
...


➢

Real world question Two enterprising students are considering renting space and opening a class
video recording service
...
The
students taking the classes would be charged a fee to rent and view the video on their laptops or
smart phones
...


Exercises
Exercise A Name and match the types of cost behavior with the appropriate diagram below:

Exercise B Research Inc
...
Use the high-low method to determine the fixed and
variable components of a mixed cost, given the following observations:
Volume (number of tests)
4,800
19,200

Total cost
$6,000
9,600

Exercise C Compute the break-even point in sales dollars if fixed costs are USD 200,000 and the total
contribution margin is 20 per cent of revenue
...
One product, Michael Bears, sells for USD 28
per bear
...
How
many Michael Bears must be produced and sold each month to break even?
Exercise E Peter Garcia Meza is considering buying a company if it will break even or earn net income on
revenues of USD 80,000 per month
...

Use the following cost data to compute the variable cost per unit and the fixed cost for the period
...
Should Peter buy this company?
Volume (units) Cost
8,000
$70,000
68,000
190,000

Exercise F Never Late Delivery currently delivers packages for USD 9 each
...
Compute the break-even point in both sales dollars and units
under each of the following independent assumptions
...

a
...

b
...

c
...
(Fixed costs are USD 60,000
...
0 License
d
...
50 per unit
...
)
Exercise G Best Eastern Motel is a regional motel chain
...
The
variable cost is USD 40 a room per night
...
The company currently rents
200,000 units per year, with each unit defined as one room for one night
...
Last year's sales were USD 600,000 for parachutes,
USD 800,000 for hang gliders, and USD 200,000 for bungee jumping harnesses
...
Fixed costs were USD
240,000
...

Exercise I Early Horizons Day Care Center has fixed costs of USD 300,000 per year and variable costs of USD
10 per child per day
...
This cost is a mixed cost
...
Using the high-low method, determine the total amount of fixed costs and the amount of variable cost per
unit
...

b
...
Estimate the
amount of total fixed costs and the amount of variable cost per unit
...
Cost-volume-profit analysis

a
...

b
...
At 8,000 units, is there net income or loss? How much?
Problem C The management of Bootleg Company wants to know the break-even point for its new line hiking
boots under each of the following independent assumptions
...
(Each pair of boots is one unit
...
Fixed costs are USD 300,000; variable cost is USD 30 per unit
...
Fixed costs are USD 300,000; variable cost is USD 20 per unit
...
Fixed costs are USD 250,000; variable cost is USD 20 per unit
...
Fixed costs are USD 250,000; selling price is USD 40; and variable cost is USD 30 per unit
...

Problem D Refer to the previous problem
...
Determine the margin
(safety in dollars for cases (a) through (d)
...

Problem F Bikes Unlimited, Inc
...
It has fixed costs of USD 258,000 per month
...

Problem G a
...
Determine the break-even point in sales dollars
...
0 License
b
...
In 2010, its sales were USD
14,400,000, and its variable costs amounted to USD 5,760,000
...

c
...
At what level of sales dollars would the Niners Corporation
break even?
d
...
What would have been the net income of the Niners Corporation in part (c), if variable costs had been 10 per
cent lower?
f
...
Determine the break-even point in sales dollars for the Niners Corporation on the basis of the data given in (e)
and then in (f)
...

Problem H After graduating from college, M
...
Orth started a company that produced cookbooks
...
He discovered the company has fixed costs of USD
1,200,000 per year, variable cost of USD 14
...
90 per
cookbook (on average)
...
Prepare a cost-volume-profit chart for Sierra Company, indicating the break-even point, the contribution
margin, and the areas of income and losses
...
Compute the break-even point of both companies in sales dollars and units
...
Assume that without changes in selling price, the sales of each company decline by 10 per cent
...

Problem J Soundoff, Inc
...
On the CD player line, the company incurred USD 2,520,000 of fixed
costs per month while selling 20,000 units at USD 600 each
...

Recently, a new machine used in the production of CD players has become available; it is more efficient than the
machine currently being used
...

a
...

b
...

c
...

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...
Should the new machine be leased? Why?
Problem K Surething CD Company reports sales of USD 720,000, variable costs of USD 432,000, and fixed
costs of USD 108,000
...

Determine whether the sales promotion campaign should be undertaken
...

Alternate problems
Alternate problem A Hear Right Company has identified certain variable and fixed costs in its production of
hearing aids
...
Here are
the data for this cost:
Month
January
February
March
April
May
June
July
August
September
October

Units
20,800
20,000
22,000
25,600
28,400
30,000
32,800
35,600
37,600
40,000

Costs
$57,600
54,000
58,500
57,600
58,500
62,100
63,900
68,400
72,000
77,400

a
...
Draw the cost line
...
Prepare a scatter diagram, plot the actual costs, and visually fit a linear cost line to the points
...

Alternate problem B

a
...

b
...
At 18,000 units, would there be a profit or loss? How much?

854

This book is licensed under a Creative Commons Attribution 3
...
Fixed costs are expected to be USD 432,000
...

a
...

b
...
If the selling price were raised to USD 14
...
Determine the break-even point in sales dollars and units for Cowboys Company that
has fixed costs of USD 63,000, variable cost of USD 24
...
00 per unit
...
Wildcats Company breaks even when sales are USD 280,000
...
Compute the amount of fixed costs
...
Hoosiers Company had sales in June of USD 84,000; variable costs of USD 46,200; and fixed costs of USD
50,400
...
What would the break-even point in sales dollars have been in (c) if variable costs had been 10 per cent
higher?
e
...
Compute the break-even point in sales dollars for Hoosiers Company in (c) under the assumptions of (d) and
(e) together
...

Alternate problem E See Right Company makes contact lenses
...
Variable costs are USD 4,000,000 at 100 per cent capacity
...

a
...

Indicate on the chart the relevant range, break-even point, and the areas of net income and losses
...
Compute the break-even point in units
...
How many units would have to be sold to earn USD 200,000 per year?
Alternate problem F Mr Feelds Cookies has fixed costs of USD 360,000 per year
...
The cost and revenue data for these products follow:
Sales
Variable costs

Cookies
Cream cake Goo fill
$64,000
$95,0000
38,400
55,100

Sweet tooth
$131,000
66,000

Compute the break-even point in sales dollars
...
The
company expects sales to increase by 25 per cent in 2011
...
The second alternative would not affect fixed costs but increase variable costs to 60 per cent of the selling
price of the company's product
...
Cost-volume-profit analysis
Fixed
Income before taxes

330,000

1,950,000
$1,650,000

a
...

b
...

c
...
When the plant operates at levels of 50 per cent of capacity or less, its fixed costs are USD 840,000;
at levels more than 50 per cent of capacity, its fixed costs are USD 1,200,000
...

a
...
Using only the data given, at what level of sales would it be more economical to close the factory than to
operate it? In other words, at what level would operating losses approximate the losses incurred if the factory closed
down completely?
c
...
At what percentage of capacity must the company
operate to break even at the reduced sales price?
Business decision case C Monroe Company has recently been awarded a contract to sell 25,000 units of its
product to the federal government
...
When the news of the contract was released to the public, President Mary Monroe, received a call from the
president of the McLean Corporation, Carl Cahn
...
00 each
...

You go to the company's records and obtain the following information concerning the production of Part J
...
12 or (USD 2,424,000/200,000)
...
To find out, you consult the production manager
...
She estimates the machine rental to be USD 60,000 and the total overtime premiums to be
USD 108,000
...
0 License
The production manager advises you to reject Cahn's offer, since the unit cost of Part J would be only USD 12
...
This
amount still is less than the USD 15
...
Undecided, you return to your office to consider
the matter further
...
Using the high-low method, compute the variable cost portion of manufacturing overhead
...
Subtract these
amounts before performing the calculation)
...
Compute the total costs to manufacture the additional units of Part J
...
)
c
...

d
...

Business decision case D Refer to the "A broader perspective: Major television networks are finding it harder
to break even" discussion of cost-volume-profit analysis for television networks
...

Group project E In teams of two or three students, develop a cost-volume-profit equation for a new business
that you might start
...

Your equation should be in the form: Profits = (Price per unit X Volume) – (Variable cost per unit X Volume) Fixed costs per period
...
From this information, you will be able to estimate the profits—or losses—for the
period
...
Good luck, and have fun
...
In teams of two or three students, write a memo to your instructor defining step costs
and explain why the step costs identified in the case are classified as such
...

Group project G In teams of two or three students, address the following questions:
• Why would a company consider increasing automation and decreasing the use of labor if the result would

be an increase in the break-even point?
• Would an increase in automation increase fixed costs over the short-run, long-run, or both?

Write a memo to your instructor that addresses both questions
...

Using the Internet—A view of the real world
Visit the website for Intel Corporation, a high technology manufacturing company
...
intel
...
What
additional information, if any, would you need to perform cost-volume-profit analysis? Why is this information
excluded from Intel's income statement?
Visit the website for Wal-Mart Corporation, a retail company
...
walmart
...
Cost-volume-profit analysis
Go to the company's most recent financial statements and review the statement of income
...
The high-low method is less precise than the scatter diagram because it requires only two data points in
the computation
...
The break-even point can also be expressed in units produced or sold
...
Total contribution margin is the amount by which revenue exceeds variable costs of producing that
revenue
...
Margin of safety = Current sales - Break-even sales
...
Dollars of sales are used as the measure of volume when a company has many different products
...
Electricity is a mixed cost
...
Step costs have all of these characteristics—a fixed component, costs increase, and constancy over a relevant
range for a step
...


Fix costs
Contribution margin ratio

Contribution margin ratio =
BE dollars =

USD 10 – USD 6
=0
...
40

a
...


BE units=

BE units=

Fix costs
Contribution margin per unit

USD28,000
USD14 per unit

= 2,000
d
...


858

This book is licensed under a Creative Commons Attribution 3
...
Short-term decision
making: Differential analysis
Learning objectives
After studying this chapter, you should be able to:
• Compare and contrast contribution margin income statements to traditional income statements
...

• Make pricing decisions using differential analysis
...

• Decide whether to eliminate or add product lines or segments of the business using differential analysis
...

• Decide whether to make or buy products using differential analysis
...


In this chapter, we will discuss how companies use financial information in making decisions
...
We begin by presenting an alternative to the traditional income statement
format
...
Then we discuss differential analysis as a method of choosing the best solution
to decision problems
...


Contribution margin income statements
Both this and the previous chapter discuss the use of accounting for managerial decision making
...

However, income statements published for external use do not break costs down into fixed and variable
components
...
The contribution margin income statement
subtracts variable costs from revenues to show the contribution margin, and then subtracts fixed costs to derive net
income
...
Assume Bart Company had the following data relating to
manufacturing and sales activities for May 2011:
Bart Company
May 2011
Variable manufacturing costs (per unit):
Direct materials
Direct labor
Overhead
Total
Variable selling expenses (per unit)
Fixed costs:

$1
1
1
3
$0
...
Short-term decision making: Differential analysis
Manufacturing overhead ($1
...

A
...
50
variable selling cost
37,500
per unit, plus fixed costs of $15,000 for selling and $18,000 for
administrative)
Net income tax
$7,500
B
...
50 per unit)
Total contribution margin
$ 49,500
Less: Fixed manufacturing costs
$ 9,000
Less: Fixed selling expenses
15,000
Less: Fixed administrative expenses
18,000
42,000
Net income before tax
$ 7,500

Exhibit 175: Comparative income statements
The contribution margin method shows managers the amount of variable costs, the amount of fixed costs, and
the contribution the company is making toward covering fixed costs and earning net income
...

The traditional statement does not break down costs into fixed and variable components, so we cannot easily
answer the question posed by Bart's management
...
Management often needs information on the contribution margin rather than the gross margin to
calculate break-even points and make decisions regarding special-order pricing
...
0 License

An accounting perspective:
Uses of technology
Generating multiple financial reports in different formats does not mean companies must keep
several sets of books
...
Two problems remain: First, the reports are only as good as the quality of
the data in the database
...


Differential analysis
Differential analysis involves analyzing the different costs and benefits that would arise from alternative
solutions to a particular problem
...
Differential revenue is the difference in
revenues between two alternatives
...
53
Future costs that do not differ between alternatives are irrelevant and may be ignored since they affect both
alternatives similarly
...

For certain decisions, revenues do not differ between alternatives
...
In other situations, costs do not differ between alternatives
...
Many times both future
costs and revenues differ between alternatives
...

To illustrate relevant, differential, and sunk costs, assume that Joanna Bennett invested USD 400 in a tiller so
she could till gardens to earn USD 1,500 during the summer
...
The costs that she would incur in
tilling are USD 100 for transportation and USD 150 for supplies
...
If Bennett works at the stable, she would still have the tiller,
which she could loan to her parents and friends at no charge
...
The transportation cost of
USD 100 is also not relevant because it is the same for both alternatives
...
This text uses the term relevant to identify which costs
should be considered in a situation and the term differential to identify the amount by which these costs differ
...
Short-term decision making: Differential analysis
service

Based on this differential analysis, Joanna Bennett should perform her tilling service rather than work at the
stable
...

In many situations, total variable costs differ between alternatives while total fixed costs do not
...
The differential
costs of driving a car to work or taking the bus would involve only the variable costs of driving the car versus the
variable costs of taking the bus
...
If
you bought a second car for commuting, certain costs such as insurance and an auto license that are fixed costs of
owning a car would be differential costs for this particular decision
...
For this reason, we discuss committed
fixed costs, discretionary fixed costs, and opportunity costs before concentrating on the applications of differential
analysis
...
Now we describe two types of fixed costs—
committed fixed costs and discretionary fixed costs
...
These costs cannot be changed in the short run without seriously
disrupting operations
...
In the short run, these costs are not subject to the discretion or control of management
...
For instance, once a company constructs a
building to house production operations, it is committed to use the building for many years
...

Discretionary fixed costs In contrast to committed fixed costs, management controls discretionary fixed
costs from year to year
...
Because it makes such decisions each year, these
costs are under management's discretion
...
In the next period, management may change the level of expense or eliminate
the expense completely
...
For instance, some companies terminate people in the upper levels of management when they
downsize, while other companies keep their management team intact
...

The discussion of committed fixed costs and discretionary fixed costs is relevant to CVP analysis
...
A company with a large proportion of
discretionary fixed costs may be able to reduce fixed costs dramatically in recessionary periods
...
As a result, the company may
enhance its chances of long-run survival
...
0 License
Another cost concept relevant to decision making is opportunity cost
...
For example, assume that the two
best uses of a plot of land are as a mobile home park (annual income of USD 100,000) and as a golf driving range
(annual income of USD 60,000)
...

Companies do not record opportunity costs in the accounting records because they are the costs of not following
a certain alternative
...
However,
opportunity cost is a relevant cost in many decisions because it represents a real sacrifice when one alternative is
chosen instead of another
...

Although these five decisions are not the only applications of differential analysis, they represent typical short-term
business decisions using differential analysis
...

When applying differential analysis to pricing decisions, each possible price for a given product represents an
alternative course of action
...
Total fixed costs often remain the same between pricing alternatives
and, if so, may be ignored
...

A high price is not necessarily the price that maximizes income
...
If a
company sets a high price, the number of units sold may decline substantially as customers switch to lower-priced
competitive products
...
In making any pricing decision, management should
seek the combination of price and volume that produces the largest total contribution margin
...

For example, assume that a company selling fried chicken in the New York market estimates product demand
for its large bucket of chicken for a particular period to be:
Choice
1
2
3
4

Demand
15,000 units at $6 per unit
12,000 units at $7 per unit
10,000 units at $8 per unit
7,000 units at $9 per unit

The company's fixed costs of USD 20,000 per year are not affected by the different volume alternatives
...
What price should be set for the product? Based on the calculations shown in the table
below, the company should select a price of USD 8 per unit because choice (3) results in the greatest total
contribution margin
...

Choice
1
2

Contribution
margin per unit*
x
$1
2

Number
of units =

Total
Fixed
margin costs

Net
income (loss)

15,000
12,000

$15,000 $20,000
24,000 20,000

$(5,000)
4,000

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...


10,000
7,000

30,000
28,000

20,000
20,000

10,000
8,000

Sometimes management has an opportunity to sell its product in two or more markets at two or more different
prices
...
Differential analysis can determine whether companies should sell their products at prices
below regular levels
...
When operating at less than
full capacity, management should seek additional business
...
By accepting special orders at a discount, businesses can keep people employed that they would
otherwise lay off
...

(See Exhibit 176 for details
...
The selling
price is USD 20 per unit and production and sales are budgeted at 5,000 units
...

Rios company
Income statement
For the period ending 2011
May 31
Revenue (5,000 units at $20)
$100,000
Variable costs:
Direct materials cost
$20,000
Labor
5,000
Overhead
10,000
Marketing and administrative
5,000
costs
Total variable costs ($8 per unit)
$40,000
Fixed costs:
Overhead
$28,000
Marketing and administrative
20,000
costs
Total fixed costs
48,000
Total costs ($17
...
This USD
10 price is not only half of the regular selling price per unit, but also less than the USD 17
...
However, the USD 10 price offered exceeds the variable cost per unit by USD 2
...

As shown in the income statement in Exhibit 177, revenue increases to USD 130,000 with the special order
...


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...
Because the special order does not increase the
fixed costs, the special order's revenues need only cover its variable costs
...
By accepting the special order, net income increases by USD 6,000
...
Even if the price exceeds variable costs
only slightly, the additional business increases net income, assuming fixed costs do not change
...
In the long
run, companies must cover all of their costs, not just the variable costs
...
If
you have watched a store or a plant open or close in your area, you have seen the results of these decisions
...
Thus, companies must reclassify costs as those that
the action would change and those that it would not change
...
The fixed costs may
change, but not in many cases
...

To illustrate, assume that the Campus Bookstore is considering eliminating its art supplies department
...
The bookstore's
management assigns costs of USD 110,000 (USD 80,000 variable and USD 30,000 fixed) to the art supplies
department
...
But careful cost analysis reveals that if the art supplies department were dropped, the reduction in
costs would be only USD 80,000
...
These fixed costs would continue to be incurred and would not be saved by closing the art
supplies department
...
Note that the art supplies department has
Accounting Principles: A Business Perspective

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...
Consequently, its elimination could be a costly mistake unless there is a more profitable
use for the vacated facilities
...
Assume, for example,
that the bookstore could use the facilities currently occupied by the art supplies department to open a new
department to display and sell personal computers, printers, and software
...

The relevant costs in the decision to retain the art supplies department are USD 115,000 (USD 80,000 of
variable manufacturing costs and USD 35,000 of opportunity cost), while the relevant revenues are still USD
100,000
...

Sometimes two or more products result from a common raw material or production process; these products are
called joint products
...
For
instance, when Chevron refines crude oil, it produces a wide variety of fuels, solvents, lubricants, and residual
petrochemicals
...
Joint costs are those costs incurred up to the point where the joint products split off from each
other
...

The following example illustrates the issue of whether to process or sell joint products
...
, produces two paper products, A and B, from a common manufacturing process
...
Data for both products
follow:
Product
A
B

Selling price per
unit at split-off
point
$10
12

Cost per unit
of further
processing
$6
7

Selling price per unit
after further
processing
$21
18

The differential revenues and costs of further processing of the two products are as follows:
Product

A
B

Different
revenue of
further
processing
$11
6

Differential cost Net advantage
of further
(disadvantage)
processing
of further
processing
$6
$5
7
(1)

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...
The company should not process product B further because that would decrease income by USD 1 per unit
sold
...
By-products are additional products resulting from the production of a main product and
generally have a small market value compared to the main product
...
For example, the bark from trees cut into lumber is a by-product of lumber production
...
When the differential
revenue of further processing exceeds the differential cost, firms should do further processing
...

Managers also apply differential analysis to make-or-buy decisions
...

Management must compare the price paid for a part with the additional costs incurred to manufacture the part
...

To illustrate the application of differential analysis to make-or-buy decisions, assume that Small Motor
Company manufactures a part costing USD 6 for use in its toy automobile engines
...
00; labor, USD 1
...
05; and variable overhead costs, USD 0
...
Small could
purchase the part for USD 5
...
Fixed overhead would presumably continue even if the part were purchased
...
95 (USD 3
...
50 + USD 0
...
This amount is 30
cents per unit less than the purchase price of the part
...
25

Differential
$0
...
30

In make-or-buy decisions, management also should consider the opportunity cost of not utilizing the space for
some other purpose
...

In some manufacturing situations, firms avoid a portion of fixed costs by buying from an outside source
...
In such a
situation, firms should treat these fixed costs the same as variable costs in the analysis because they would be
relevant costs
...

Then management should place considerable weight on other factors such as the competency of existing personnel
to undertake manufacturing the part or material, the availability of working capital, and the cost of any loans that
may be necessary
...
Therefore, companies use differential analysis
to make decisions about the quality of their products
...
Short-term decision making: Differential analysis
Assume Erie Waters produces bottled water
...
00
1
...
00
$6
...

The company inspects the product at various stages
...
The cost of inspecting the product
and replacing water and/or bottles averages USD 1
...

Management of Erie Waters is concerned about product quality
...
Management is considering
purchasing a high-quality water product
...
50 per case
while decreasing inspection and rework costs to USD
...
All other variable costs would remain at USD
3
...
Erie Waters would sell this water for USD 8
...
If the high-quality water is purchased, Erie
Waters expects to sell 100,000 cases of water this year at USD 8
...
If Erie continues to use the current
low-quality water, the company expects to sell 90,000 cases of water this year at USD 8
...
Fixed costs are
USD 150,000 per year whether the company buys high-quality water or low-quality water
...


An accounting perspective:
Business insight
The 1950s through 1970s were boom periods for manufacturing companies in the United States
...
But, countries such as Japan, Taiwan and
Korea made a comeback and dominated in steel, automobiles, and electronics
...


Revenue at $8
...
00 per
case for
low quality and $2
...
00
per case
for low quality and $0
...
00
per case
Fixed costs
Net income

Low-quality
water (90,000
cases)
$ 720,000

High-quality
water
(100,000 cases)
$ 800,000

(180,000)

(250,000)

(90,000)

(40,000)

(270,000)

(300,000)

(150,000)
$ 30,000

(150,000)
$ 60,000

Exhibit 179: Decision whether to improve quality

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...
In addition, a high-quality product improves the company's prospects for maintaining or even
increasing its market share in years to come
...

The focus of this chapter has been short-term decision making
...
The topic of Chapter 23 is budgeting—an important tool for company management
...

• The contribution margin format reports contribution margin; the traditional method reports gross margin
...

• The components are: (1) differential revenue, the difference in revenue between two alternatives; and (2)

differential cost or expense, the difference between relevant costs for two alternatives
...


A broader perspective:
Differential analysis in sports
When the major sports teams acquire stars, many observers think the price is too high
...

When the a major league baseball team acquires an expensive super-star many people in the
baseball world wonder if it is a wise financial decision
...
The differential costs of acquiring the super-star appears to have been justified
...
Some teams, such as
the New York Yankees, have extensive farm systems
...
Teams also buy players by waiting until young players have proven
themselves with other teams, then acquiring them
...
Such pricing should be appraised concerning their long-range effects on company
and industry price structures
...

• Costs must be reclassified as those that would be changed by the elimination and those that would not
...


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...
These

costs are sunk costs in deciding whether to process a joint product further before selling it or to sell it in its
condition at the split-off point
...
The price that would be paid for the part if it were purchased is compared
with the additional costs that would be incurred if the part were manufactured
...
Therefore, companies use differential

analysis to make decisions about the quality of their products
...
If
the company dropped the East European market, it would lose revenues of USD 1,000,000 annually
...

Therefore, the East European market has an apparent annual loss of USD 200,000 per year (USD 1,000,000
revenue minus USD 1,200,000 costs)
...
The remaining USD
150,000 of fixed costs were general fixed costs the company allocated to the East European market
...

Solution to demonstration problem
The differential analysis for National Express's analysis of its East European operations is as follows:

Revenues
Variable costs
Fixed costs
Net advantage of keeping East
European operations open

East
European
Operations
Keep
$1,000,000
800,000
400,000

Eliminate
$ -0-0150,000

Differential
$1,000,000
800,000
250,000
$ (50,000)

Elimination of the East European market is justified according to this analysis
...


Key terms*
By-products Additional products resulting from the production of a main product
...

Committed fixed costs Costs relating to the basic facilities and organizational structure that a company
must have to continue operations
...

Differential cost or expense The difference between the amounts of relevant costs for two alternatives
...

Discretionary fixed costs Fixed costs subject to management control from year to year; an example is
advertising expense
...

Joint products Two or more products resulting from a common raw material or production process
...
0 License
Make-or-buy decision A decision concerning whether to manufacture or purchase a part or material used
in manufacturing another product
...

Relevant revenues or costs Revenues or costs that will differ in the future depending on which
alternative course of action is selected
...

*Some terms listed in earlier chapters are repeated here for your convenience
...

Opportunity costs are recorded in the accounting records because they are the costs of not following a certain
alternative
...

Contribution margin is often more valuable to management than gross margin when making decisions
...

The decision whether to sell at the split-off point or process further is one that a petroleum company might
make
...
This decision is an example of a make-or-buy decision
...

Differential analysis is best described by which of the following statements:
a
...

b
...

c
...

d
...

In selecting a price for a product using differential analysis, which of the following decisions should be made?
a
...

b
...

c
...

d
...

Which of the following decisions involve differential analysis?
a
...

b
...

c
...

d
...

Assume Mikey Shoe Company is considering making special shoes just for Olympic athletes
...
Differential variable cost
...
Short-term decision making: Differential analysis
b
...

c
...

d
...

Now turn to “Answer to self-test” at the end of the chapter to check your answers
...


➢

What is a committed fixed cost? Give some examples
...


➢

Give an example of a fixed cost that might be considered committed for one company and
discretionary for another
...


➢

What is an opportunity cost? Give some examples
...


➢

Real world question Give an example in which your campus bookstore replaces one of its
departments with another it currently does not have
...
) What revenues and costs would be differential?

➢

Real world question Assume that McDonald's, of McDonald's fast-food restaurants, currently
buys its french fries from agricultural growers and food processors
...
(Assume that making french
fries includes growing the potatoes
...
Which differential revenues and costs would be affected by that
decision?

Exercises
Exercise A The following data are for Paso Robles Company for the year ended 2009 December 31:
Costs:
Direct material
Direct labor
Manufacturing overhead:
Variable
Fixed
Sales commissions (variable)
Sales salaries (fixed)
Administrative expenses (fixed)
Selling price per unit
Units produced and sold

$ 90,000
130,000
45,000
90,000
25,000
20,000
35,000
$ 10
60,000

Assume direct materials and direct labor are variable costs
...

Exercise B Assume you had invested USD 1,000 in a lawn mower to set up a lawn mowing business for the
summer
...
0 License
1,400 or to help paint a garage for USD 1,360
...
You cannot do both
...
These costs include USD 60 under
each alternative for transportation to the job
...

Exercise C The marketing department of Specialty Coffees estimates the following monthly demand for
espresso in these four price-quantity relationships:
1
2
3
4

Demand
9,000 cups
8,000 cups
6,000 cups
4,000 cups

at
at
at
at

$1
...
25 per cup
$1
...
75 per cup

The fixed costs of USD 3,000 per month are not affected by the different price-volume alternatives
...
25 per cup
...

Variable cost is USD 100 per unit
...

Wholesaler Z proposes to buy 1,500 additional units at USD 140 per unit
...

Exercise E Analysis of Hair Care Company's citrus hair conditioner reveals that it is losing USD 5,000
annually
...
Variable costs are
USD 6 per unit
...

What would be the increase or decrease in company net income if citrus hair condition were eliminated?
Exercise F The luggage department of Sampson Company has revenues of USD 1,000,000; variable expenses
of USD 250,000; direct fixed costs of USD 500,000; and allocated, indirect fixed costs of USD 300,000 in an
average year
...
At the split-off point, they have sales values of:
Product 1
Product 2

$18 per unit
12 per unit

After further processing, the company can sell them for USD 36 and USD 16, respectively
...
Should further processing be done on
either or both of these products? Why or why not?
Exercise H Gopherit Corporation currently is manufacturing 40,000 units per year of a part used in its final
product
...
The variable portion of this cost consists of direct
materials of USD 25, direct labor of USD 15, and variable manufacturing overhead of USD 3
...
Assuming equal quality and
availability, what is the maximum price per unit that Gopherit Corporation should pay to buy the part rather than
make it? (The total fixed costs would not be affected by this decision
...
The variable cost of a case of
strawberry jam is as follows:
Materials (strawberries and jars)
Inspection and rework costs
All other variable costs
Total variable cost per case

$10
...
00
8
...
00

In addition, the company has USD 1,000,000 of fixed costs per year
...
Short-term decision making: Differential analysis
The company inspects the product at various stages
...
00 per case, shown as in the inspection and rework costs
...
This would increase materials costs to USD
12
...
00 per case
...
00 per case for variable costs and USD 1,000,000 for fixed costs whether or not the high-quality
strawberries were purchased
...
If the high-quality strawberries were
purchased, the company could sell 100,000 cases of jam this year at USD 40 per case
...

Should Ortez purchase the high-quality strawberries?
Problems
Problem A Montonya Company has the following selected data for the current year:
Sales (10,000 units)
Direct materials
Direct labor costs
Variable manufacturing overhead
Fixed manufacturing overhead
Variable selling and administrative
expenses
Fixed selling and administrative
expenses

$90,000
30,000
10,000
3,500
7,500
2,500
15,000

The company produced and sold 10,000 units
...

a
...

b
...

c
...
An estimated demand schedule for the product follows:
Price
$5
6
7
8
9
10

One-pound units demanded
80,000
72,000
56,000
48,000
36,000
30,000

Estimated costs follow:
Variable manufacturing costs
Fixed manufacturing costs
Variable selling and administrative
costs
Fixed selling and administrative
costs

$2 per unit
$40,000 per year
$1 per unit
$20,000 per year

a
...

b
...

Problem C Ocean View Company operates tour boats
...
0 License
The company has received a request to offer 100 tours for USD 300 each
...
Doing these tours would not affect the company's regular sales or
its fixed costs
...
Should the company do the special tours for USD 300 per tour?
b
...
All variable
costs are direct costs and would be eliminated if Product C were dropped
...
Assume that the space used to produce Product C would be left idle
...

Problem E Sierra Lumber Company produces lumber
...
Grade A sells for USD 4 per board foot and Grade B sells for USD 2 per board foot
...
Either grade can be further
processed to make it suitable for interior work at a cost of USD 1
...
After this further processing,
the firm can sell Grade A lumber for USD 5
...
00 per board foot
...

Problem F Skate-Right Company, a skateboard manufacturer, is currently operating at 60 per cent capacity
and producing about 8,000 units a year
...

Currently the company purchases wheels from a supplier at a unit price of USD 20
...
) Estimates show the company can manufacture its own wheels at USD 10 for direct materials costs
and USD 4 for direct labor cost per unit
...
The company's
accountants would probably allocate another USD 6 per unit to the wheels
...
Should Skate-Right make or buy the wheels?
b
...

How would this affect your decision in (a), if at all?
Problem G Quality Calc, Inc
...

The variable cost of one Model A-25 is as follows:
Materials
Inspection and rework costs
All other variable costs

$10
2
5

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...

The company inspects the product at various stages
...

Management is considering purchasing better components that would both increase quality and expand the
calculator's capacity
...
50 per calculator, but would
decrease inspection and rework costs to USD 1
...
All other variables cost would remain at USD 5 per
calculator
...

Quality Calc currently sells each A-25 calculator for USD 25 at a volume of 1 million calculators per year
...
Sales volume would remain at 1 million calculators per year for
the improved A-25 STAR
...

a
...

b
...

c
...
An
estimated demand schedule for the product is as follows:
Price
$5
6
7
8
9
10

Units demanded
20,000
18,000
14,000
12,000
9,000
8,000

Estimated costs are as follows:
Variable manufacturing costs
Fixed manufacturing costs
Variable selling and administrative
costs
Fixed selling and administrative costs

$2
...
00 per unit
$5,000 per year

a
...

b
...

Alternate problem C Following are sales and other operating data for the three products made and sold by
Marine Enterprises:
Product

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...
All
variable costs are direct costs and would be eliminated if Product B were dropped; all fixed costs are indirect costs
and would not be eliminated
...

Would you recommend the elimination of Product B? Give supporting computations
...
To use more capacity, the manager has been
considering the research and development department's suggestion that Sailboard manufacture its own sails
...
Estimates show that Sailboard can
manufacture its own sails for a USD 40 direct materials cost and a USD 32 direct labor cost per unit
...
The company's accountants would allocate fixed manufacturing overhead of
USD 30 per sail to the sail production
...
Should Sailboard Enterprises make or buy the sails?
b
...
How would this affect the decision in (a)?
Alternate problem E Cool-Snacks Company produces and sells ice cream for ice cream shops
...
The variable cost of producing a gallon of ice cream is as follows:
Materials (cream, containers, etc
...
40

...
70
$2
...

The company inspects the product at various stages
...
40 per gallon, shown as the inspection and replacement costs
...

These high-quality ingredients would increase materials costs to USD 1
...
30 per gallon
...
70 per gallon for
variable costs and USD 1,000,000 for fixed costs whether or not the high-quality ingredients are purchased
...
If the company continues to use the current low-quality ingredients, the company expects to sell
1,000,000 gallons of ice cream at USD 3
...
Should Cool-Snacks Company buy the high-quality
ingredients for its ice cream?
Beyond the numbers—Critical thinking
Business decision case A Prior to 2011, Starks Wholesalers Company had not kept department income
statements
...
Short-term decision making: Differential analysis
accounts
...
The following income statement for the dry goods department reports on
operations for 2011:
Starks wholesalers company
Dry goods department
Partial income statement for 2011

Sales
$1,200,000
Cost of goods sold
800,000
Gross margin
$ 400,000
Costs:
Payroll, direct labor, and supervision
$120,000
Commissions of sales staff a
60,000
Rent b
40,000
Insurance on inventory
20,000
Depreciation c
80,000
Administration and general office d
80,000
Interest for inventory carrying costs e
10,000
Total costs
410,000
Net income (loss)
$ (10,000)
A
All sales staff are compensated on straight commission on sales
...
The company rents an entire building, and the dry goods department occupies 15% of
the building
...
5% of the cost of the departmental equipment
...

D

Based on average inventory quantity multiplied by the company's borrowing rate for three-month loans
...
Members of the
management team agree that keeping the dry goods department is not essential to maintaining good customer
relations and supporting the rest of the company's business
...

Prepare a written report recommending whether or not Starks should close the dry goods department
...
State your assumptions
...
Major customers include corporate,
professional, and government organizations that are setting up information networks
...

(A billable hour is one hour billed to a client
...
Unless given otherwise, the regular fee per hour is USD
200
...
How many hours must the firm bill per month to break even? (You may need to refer to Chapter 21 to answer
this question
...
Market research estimates that a fee increase to USD 250 per hour would decrease monthly volume to 2,000
hours
...
What effect would a fee increase have on profits?
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This book is licensed under a Creative Commons Attribution 3
...
Assume C & T Software is operating at its normal volume of 3,000 hours per month
...
Because of the long-term
nature of the contract (four months) and the magnitude (1,000 hours per month), the customer believes a fee
reduction is in order
...
Fixed costs would not
change if the firm accepts the special order
...
In a memorandum
to your instructor identify which costs and revenues you think would be differential for a sports team acquiring a
major star like Bonds
...

Group project D In teams of two or three students, visit a local department store and imagine the types of
costs that it would save if it closed a significant department (for example, the housewares department)
...
For example, would rent be
saved? Would security be saved? What about taxes on inventories? Consider the effects of closing the department
on the people who work there
...
The heading of the memorandum should contain the date, to whom it is
written, from whom, and the subject matter
...

The manager points to the document and says, "These are the kinds of orders that will get you in trouble
...
If we sell below our full cost, we will be out of business
in no time
...
The heading of the memorandum should contain the date, to whom it is
written, from whom, and the subject matter
...
Assume you are considering driving to a weekend
resort for a quick break from school
...
The heading of the memorandum should contain the
date, to whom it is written, from whom, and the subject matter
...

http:/www
...
com
Go to the company's most recent financial statements and review the consolidated statement of income
...
Furthermore, assume all other costs and expenses (research and
development, marketing, general and administrative, interest, taxes, etc
...
Prepare an income statement using the contribution margin format
...

Visit the following website for Wal-Mart, a retail company
...
walmart
...
Looking at the most
recent year on the statement of income, assume 45 per cent of the cost of sales are variable costs and the remaining
55 per cent are fixed costs
...
Short-term decision making: Differential analysis
marketing, general and administrative, interest, taxes, etc
...
Prepare
an income statement using the contribution margin format
...

Answers to self-test
True-false
False
...
However, opportunity costs are relevant
costs in many decisions because they represent real sacrifices that come about because one alternative is chosen
instead of another
...
Fixed costs also can be differential costs
...

True
...

False
...

True
...

True
...

Multiple-choice
d
...

b
...
Assuming fixed costs remain the same for each price-quantity combination,
maximizing the total contribution margin maximizes net income
...

d
...

d
...
(Those who believe the salary should be a
discretionary fixed cost have a good point
...
0 License

23
...
I then spent some time as Area Marketing Manager and Area Sales Development
Manager before reaching my current position
...

I manage three division vice presidents and four regional vice presidents, and I try to spend about 60 percent of my
time working with account managers who call on retail trade accounts
...
We hold monthly meetings with each division to
assess sales and provide motivation for the account managers
...

Behind increasing sales, a strong emphasis on training is one of my most important objectives
...
The program brings new
members of the sales team up to speed on the company and sales techniques, then puts them out in the field
...

All of this training helps the region achieve its number one objective—increasing sales and making the "bottom
line"
...

In managing your personal finances, you may prepare a written plan of your anticipated cash inflows and
outflows
...
Such a written plan is a budget
...

Failure to prepare a budget could lead to significant cash flow problems or even financial disaster for a company
...

This chapter first provides a conceptual foundation for budgeting
...
The chapter concludes with special topics relating to budgeting
...
Budgeting for planning and control

The budget—For planning and control
Time and money are scarce resources to all individuals and organizations; the efficient and effective use of these
resources requires planning
...
Control is also necessary to ensure that plans
actually are carried out
...
A
budget is a plan showing the company's objectives and how management intends to acquire and use resources to
attain those objectives
...

Responsibility budgets, discussed in Chapter 25, are designed to judge the performance of an individual segment or
manager
...
This chapter examines the master budget, which consists of a planned
operating budget and a financial budget
...
The financial budget helps management plan the financing of assets and
results in a projected balance sheet
...
A company must devise some method to deal with the uncertainty
of the future
...
Most businesses, however, devise a blueprint for the actions they will take given the
foreseeable events that may occur
...

Companies can use budget-to-actual comparisons to evaluate individual performance
...
This figure can be compared
with the actual cost of producing personal computers to help evaluate the performance of the personal computer
production managers and employees who produce personal computers
...

Many other benefits result from the preparation and use of budgets
...

The planning process that results in a formal budget provides an opportunity for various levels of management
to think through and commit future plans to writing
...
For all these reasons, a budget must clearly reflect the expected results
...
In fact, the less
stable the conditions, the more necessary and desirable is budgeting, although the process becomes more difficult
...

Remember, however, that budgets involve more than a company's past results
...
As a result, budgeted performance is more useful than past
performance as a basis for judging actual results
...
0 License
A budget should describe management's assumptions relating to: (1) the state of the economy over the planning
horizon; (2) plans for adding, deleting, or changing product lines; (3) the nature of the industry's competition; and
(4) the effects of existing or possible government regulations
...

Budgets are quantitative plans for the future
...
Thus, accounting data related to the past play an important part in budget preparation
...
The details of the budget must agree with the company's
ledger accounts
...

Management should frequently compare accounting data with budgeted projections during the budget period
and investigate any differences
...
Instead, the budget
is an important tool of managerial control
...

The period covered by a budget varies according to the nature of the specific activity involved
...

Budgeting involves the coordination of financial and nonfinancial planning to satisfy organizational goals and
objectives
...
However, budget makers should carefully
consider the conditions that follow:
Top management support All management levels must be aware of the budget's importance to the company
and must know that the budget has top management's support
...
These goals and objectives must be communicated throughout the organization
...
Overemphasis on the mechanics of the budgeting process should be avoided
...
Employees are more likely to strive toward organizational goals if they
participate in setting them and in preparing budgets
...
Also, employees may be motivated to perform their own functions within budget
constraints if they are committed to achieving organizational goals
...
Effective
communication implies (1) timeliness, (2) reasonable accuracy, and (3) improved understanding
...

Flexibility If significant basic assumptions underlying the budget change during the year, the planned
operating budget should be restated
...

Follow-up Budget follow-up and data feedback are part of the control aspect of budgetary control
...
Often management uses performance reports
as a follow-up tool to compare actual results with budgeted results
...
Budgeting for planning and control
The term budget has negative connotations for many employees
...
Such a dictatorial
process may result in resistance to the budget
...
Employees
may believe that the performance evaluation method is unfair or that the goals are unrealistic and unattainable
...
Often these fears are completely unfounded, but if employees believe these problems exist,
it is difficult to accomplish the objectives of budgeting
...
Participatory budgeting means that all levels of management responsible for actual performance
actively participate in setting operating goals for the coming period
...

Within a participatory budgeting process, accountants should be compilers or coordinators of the budget, not
preparers
...

Accountants must identify the relevant cost data that enables management's objectives to be quantified in dollars
...
Also, accountants must continually strive to
make the accounting system more responsive to managerial needs
...

Although many companies have used participatory budgeting successfully, it does not always work
...
Whether or not participation works depends on management's leadership
style, the attitudes of employees, and the organization's size and structure
...
However, it is one way to achieve better results in organizations that are receptive
to the philosophy of participation
...
In Exhibit 180,
we depict a flowchart of the financial planning process that you can use as an overview of the elements in a master
budget
...
We emphasize the
master budget because of its prime importance to financial planning and control in a business entity
...
These plans take into
consideration various policy decisions concerning selling price, distribution network, advertising expenditures, and
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...
Managers arrive at the sales budget in dollars by multiplying sales units times sales price per unit
...
Next, managers project
operating expenses such as selling and administrative expenses
...

However, the following presentation provides an overview of a budgeting procedure that many successful
companies have used
...

The projected balance sheet, or financial budget, depends on many items in the projected income statement
...
However, since the planned operating budget shows the net effect of many interrelated activities,
management must prepare several supporting budgets (sales, production, and purchases, to name a few) before
preparing the planned operating budget
...

Sales budget The cornerstone of the budgeting process is the sales budget because the usefulness of the entire
operating budget depends on it
...
Sales
forecasting can involve either formal or informal techniques, or both
...
For example, to predict sales for the
coming period, management may use economic indicators (or variables) such as the gross national product or gross
national personal income, and other variables such as population growth, per capita income, new construction, and
population migration
...
Then management can
use statistical techniques to predict sales based on the economic indicators
...
In some instances, management modifies sales projections using formal techniques based on other
changes in the environment
...
In
other instances, companies do not use any formal techniques
...
Managers then add up the estimates to arrive at total estimated sales for the period
...
The sales budget in units is the basis of the remaining budgets that
support the operating budget
...
Managers develop the production budget in units and then in dollars
...
Companies should schedule production carefully to maintain certain minimum
quantities of inventory while avoiding excessive inventory accumulation
...

Companies using a just-in-time inventory system, which we discussed in Chapter 20, need to closely coordinate
purchasing, sales, and production
...
However, businesses must compare the convenience of carrying
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...

Firms often subdivide the production budget into budgets for materials, labor, and manufacturing overhead
...
Fixed manufacturing overhead costs do not vary directly with production but
are constant in total within a relevant range of production
...
However, when production is 80,001 to
95,000 units, the fixed manufacturing overhead costs might be USD 250,000
...

Selling, administrative, and other expense budgets (schedules) The costs of selling a product are
closely related to the sales forecast
...

Administrative expenses are likely to be less dependent on the sales forecast because many of the items are fixed
costs (e
...
salaries of administrative personnel and depreciation of administrative buildings and office equipment)
...
Once management has prepared the planned operating budget, the next task is to prepare
the financial budget (or projected balance sheet)
...
The
beginning balance for each account is the amount on the balance sheet prepared at the end of the preceding period
...
Many accounts are affected by items
appearing in the operating budget and by either cash inflows or outflows
...

The complexities encountered in preparing the financial budget often require the preparation of detailed
schedules
...
Dividend policy, inventory policy, financing policy and constraints, credit policy, and
planned capital expenditures also affect the amounts in the financial budget
...
Like the
blueprints, a budget shows the details of each part of the plan and how the various parts fit
together into the overall plan
...
The general
manager, like the house builder, must be able to see the big picture and tie all of the pieces
together
...
0 License

The master budget illustrated
Earlier this chapter discussed general concepts relating to the preparation of a master budget
...

A company develops its planned operating budget in units rather than dollars
...

To illustrate this step, assume that Leed's management forecasts sales for the year 2010 at 100,000 units (each
pair of shoes is one unit)
...

Assuming the company's policy is to stabilize production, it would produce 100,000 units uniformly throughout
the year
...
To simplify our
example, assume the company has no beginning or ending work in process inventories (although it would be
equivalent to assume that work in process inventories would remain at a constant amount throughout the year)
...
From these data, we can prepare the schedule of
planned production and sales
...

Leed Company
Planned production and Sales
(in units)
Beginning finished goods inventory
Add: Planned production
Units available for sale
Less: sales forecast
Ending finished goods inventory
* Actual on January 1

Quarter
2010 March 31
10,000*
25,000
35,000
20,000
15,000

Ending
2010 June 30
15,000
25,000
40,000
35,000
5,000

Exhibit 181: Leed Company: Planned production and sales (in units) for the first two quarters of 2010
Notice that if Leed wants to maintain a stable production of running shoes, it must allow the ending inventory to
fluctuate if sales vary
...

When establishing inventory policy, Leed's management has decided that it is less costly to deal with fluctuating
inventories than with fluctuating production
...
Assume Leed Company wishes to have ending
inventory of 15,000 units
...
To do this, management forecasts the
expected selling price and costs
...
Note that Leed's
management classifies costs into variable or fixed categories and budgets accordingly
...
Fixed costs are unaffected in total by the relative level of
production or sales
...
Budgeting for planning and control
Leed Company
Budget Estimates of selling price and costs
For quarters ending March 31 and 2010
June 30
Forecasted selling price
$ 20
Manufacturing costs:
Variable (per unit manufactured):
Direct materials
2
Direct labor
6
Manufacturing overhead
1
Fixed overhead (total each quarter)
75,000
Selling and administrative expenses:
Variable (per unit sold)
2
Fixed (total each quarter)
100,000

Exhibit 182: Leed Company: Budget estimate of selling price and costs
Management must now prepare a schedule to forecast cost of goods sold, the next major amount in the planned
operating budget
...
Notice that the beginning finished goods inventory amount for
the quarter ending March 31 is the amount shown on the 2009 December 31, year-end balance sheet (see Exhibit
188)
...
The amount
of ending finished goods inventory is the number of units determined to be in ending inventory (from Exhibit 181)
times the cost per unit manufactured during the period
...

† First in, first-out procedure assumed
...
Several supporting schedules may be prepared for items such as advertising expense, office expense, and
payroll department expense
...

Exhibit 184 shows the operating budget for Leed Company
...
State and federal income taxes are
budgeted for Leed Company at an assumed rate of 40 per cent of income before income taxes
...
0 License
If the planned operating budget does not show the desired net income, managers must formulate new operating
plans and develop a new budget
...

A company seldom operates at the level of operations assumed in preparing the planned operating budget
...
To facilitate adjusting the budgeted items to the actual level of operations,
management sometimes prepares in advance flexible budgets for the entire operating budget or for certain
expenses
...

Early in the chapter, you learned that a budget should be adjusted for changes in assumptions or variations in
the level of operations
...

A flexible operating budget is a special kind of budget that provides detailed information about budgeted
expenses (and revenues) at various levels of output
...
The oldfashioned phone company monopoly is over; it now faces intense competition from new
technologies ranging from wireless telephones to free audio and video calls over the Internet
...
Indeed, the industry has been
transformed by rapidly changing technology and accompanying changes in consumer behavior
...
provides telecommunications services
...

To start thinking about planning in the new environment, the company's managers met to discuss
the company's basic values
...
Management then established corporate goals along the lines of these
values, such as profit growth goals, and goals for achieving excellence in customer service, taking
the changing competitive environment into account
...
in communicating corporate values and goals
...
This action put Verizon's goals in terms that
employees could understand
...


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...
To keep the example simple, we assume that the first four costs are strictly variable, starting at zero
...

Leed Company
Flexible budget for
manufacturing overhead
Element of
Volume
manufacturing overhead
70%
Units
17,500
Supplies
$ 1,400
Power
7,000
Insurance
4,200
Maintenance
4,900
Depreciation
18,000
Supervision
57,000
$ 92,500
*Capacity is 25,000 units
per three-month period
...
Using flexible budgeting, a company calculates variable expenses for
various levels of sales volume, while fixed costs remain constant within the relevant range
...
The difference between actual
costs incurred and the flexible budget amount for that same level of operations is called a budget variance
...

To illustrate the computation of budget variances, assume that Leed's management prepared an overhead
budget based on an expected volume of 100 per cent, or 25,000 units
...
By the end of the period, Leed has used USD 1,900 of supplies
...


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...
Why? Because at 90 per cent of capacity, according to the flexible
operating budget, only USD 1,800 of supplies should have been used
...

To give another example using the data in Exhibit 185, Leed's management may have budgeted maintenance at
USD 5,600 for a given period assuming the company planned to produce 20,000 units (80 per cent of operating
capacity)
...
This result does not
necessarily mean that Leed had an unfavorable variance of USD 600
...

Assume once again that Leed actually produced 22,500 units during the period
...
Therefore, there would actually be a favorable
variance of USD 100 (USD 6,300 - USD 6,200)
...
However, actual production may fall
between the levels shown in the flexible budget
...
The main advantage of using a
flexible operating budget along with a planned operating budget is that management can appraise performance on
two levels
...
Second, given the actual level of
operations, management can compare actual costs at actual volume with budgeted costs at actual volume
...

Using the data from Exhibit 182, Exhibit 186 and Exhibit 187, present Leed's detailed planned operating budget
and flexible operating budget for the quarter ended 2010 March 31
...
Exhibit 186 and Exhibit 187 show actual
sales of 19,000 units and actual production of 25,000 units
...
) The actual selling price was USD 20 per unit, the same price that management had
forecasted
...
Budgeting for planning and control
Leed Company
Comparison of planned operating budget
and actual results
For quarter ended 2010 March 31
Sales (budgeted 20,000 units, actual 19,000
units)
Cost of goods sold:
Beginning finished goods inventory
Cost of goods manufactured (25,000 units):
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Cost of goods manufactured
Cost of goods available for sale
Ending finished goods inventory
Cost of goods sold
Gross margin
Selling and administrative expenses:
Variable
Fixed
Total selling and administrative expenses
Income before income taxes
Deduct: Estimated income taxes (40%)
Net income

Planned budget Actual
$400,000
$380,000
$130,000

$130,000

$ 50,000
150,000
25,000
75,000
$300,000
$430,000
180,000
$250,000
$150,000

$ 62,500
143,750
31,250
75,000
$312,500
$442,500
200,000
$242,500
$137,500

$ 40,000
100,000
$ 140,000
$ 10,000
4,000
$ 6,000

$ 28,500
95,000
$123,500
$ 14,000
5,600
$ 8,400

Exhibit 186: Leed Company: Comparison of planned operating budget and actual results
In Exhibit 186 we compare the actual results with the planned operating budget
...
For example, sales were 1,000 units lower than expected, sales revenue was
USD 20,000 less than expected, gross margin was USD 12,500 less than expected, and net income was USD 2,400
more than expected
...
For example, in Exhibit 186, the
cost of goods sold was USD 7,500 less than expected
...

A company makes a valid analysis of expense controls by comparing actual results with a flexible operating
budget based on the levels of sales and production that actually occurred
...
Note that the flexible budget in Exhibit 187 is made up of
several pieces
...


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...
Instead, the flexible operating
budget may show the number of units actually sold multiplied by the budgeted unit cost of direct materials, direct
labor, and manufacturing overhead
...

The comparison of the actual results with the flexible operating budget (Exhibit 187) reveals some inefficiencies
for items in the cost of goods manufactured section
...
Direct labor costs, on the other hand, were somewhat lower than expected
...
Net income was USD 6,000 more
than expected at a sales level of 19,000 units
...
Remember that the financial budget is a projected balance sheet
...
Managers
take the beginning balance from the balance sheet at the end of the preceding period
...
Management must consider the effects of planned activities on
these balances
...
Management uses the planned operating budget in Exhibit 184 and the other illustrations
previously given to prepare Leed Company's financial budget for the first two quarters of 2010
...
Budgeting for planning and control
Inventories:
Materials
$ 40,000
Finished goods
130,000
Prepaid expenses
Total current assets
Property, plant, and equipment:
Land
Buildings
$1,000,000
Less: accumulated depreciation
400,000
Equipment
$ 600,000
Less: accumulated depreciation
180,000
Total property, plant, and equipment
Total assets
Liabilities and stockholders' equity
Current liabilities:
Accounts payable
$ 80,000
Accrued liabilities payable
160,000
Income taxes payable
100,000
Total current liabilities
$ 340,000
Stockholders' equity:
Capital stock 100,000 shares of $10 par value)
$ 1,000,000
Retained earnings
260,000
Total stockholders' equity
$ 1,260,000
Total liabilities and stockholders' equity
$ 1,600,000

170,000
20,000
$ 520,000
$ 60,000
600,000
420,000
$ 1,080,000
$ 1,600,000

Exhibit 188: Leed Company: Balance sheet at beginning of period
Accounts receivable Leed must prepare several new schedules to prepare a financial budget
...
Assume that Leed will collect 60 per cent of the
current quarter's sales in that quarter, and the remaining 40 per cent will be collected in the following quarter
...
The USD 440,000 equals 60 per cent of budgeted sales
of USD 400,000 for the first quarter plus the uncollected sales of the previous quarter [(0
...
Second quarter collections would be USD 580,000 [(0
...
We
have simplified the illustration by assuming all sales are on credit, and that there are no sales returns or allowances,
no discounts, and no uncollectible accounts
...

Planned usage and cost per unit of materials are from the planned cost of goods sold schedule (Exhibit 183)
...

In Exhibit 190, we show a schedule of planned purchases and inventories of materials for Leed Company
...
The USD 40,000
beginning inventory was greater than normal because of a strike threat in the supplier company
...
0 License
now passed, and the materials inventory is reduced at the end of the first quarter to the normal planned level
...

Leed Company
Planned materials purchases
and inventories
Quarter
2010 March 31
Planned usage (25,000 x $2) (per Exhibit 183) $50,000
Planned ending inventory (½ x 25,000 x2)
25,000
(per discussion in text)
Planned materials available for use
$ 75,000
Inventory at beginning of quarter
40,000*
Planned purchases for the quarter
$35,000
*Actual on January 1

Ending
2010 June 30
$50,000
25,000
$75,000
25,000
$50,000

Exhibit 190: Leed Company: Planned materials purchases and inventories
Accounts affected by operating costs Leed's management would prepare individual schedules for each of
the accounts affected by operating costs
...
We assume that:
• All purchases of materials are made on account
...

• Manufacturing overhead incurred is credited to the following accounts:

Accounts payable
Accrued liabilities payable
Prepaid expenses
Accumulated depreciation – Building
Accumulated depreciation – Equipment
Total

Quarter
March 31
$ 16,000
60,000
6,000
5,000
13,000
$100,000

Ending
June 30
$ 13,000
64,000
5,000
5,000
13,000
$100,000

• Selling and administrative expenses incurred are credited to the following accounts:

Accounts payable
Accrued liabilities payable
Prepaid expenses
Accumulated depreciation – Building
Accumulated depreciation – Equipment
Total

Quarter Ending
March 31 June 30
$ 5,000 $ 10,000
130,000 154,000
2,000
3,000
1,000
1,000
2,000
2,000
$140,000 $170,000

• Planned cash payments are as follows:

Accounts payable
Accrued liabilities payable
Prepaid expenses
Total

Quarter
March 31
$ 80,000
330,000
-0$410,000

Ending
June 30
$ 56,000
354,000
10,000
$420,000

Exhibit 191, shows analyses of the accounts credited as a result of these data
...
The balances on both dates for Accounts Payable, Accrued Liabilities Payable, Prepaid
Expenses (the only debit balance account shown), Accumulated Depreciation—Building, and Accumulated
Depreciation—Equipment are computed in the schedule
...
Balances reported in the financial
budgets assume that Leed pays one-half of the USD 100,000 liability in the 2009 December 31, balance sheet in
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...
The accrual for the current quarter is added (Exhibit
184)
...
The balance on 2010 June 30, is USD 48,000, calculated as (USD 54,000 - USD 50,000 + USD 44,000)
...

Analysis of accounts

Credited for
materials
For quarters ending March 31 and 2010
Total debits
Beginning balances, January
1 (per Exhibit 188)
Purchases or operating costs,
quarter ending March 31
(credits made to accounts
shown at right):
Direct materials (per Exhibit $ 35,000*
190)
Direct labor (per Exhibit 183) 150,000*
Manufacturing overhead (per 100,000*
Exhibit 183 and above
schedules)
Selling and administrative
140,000*
expenses (perExhibit 184 and
above schedules)
Total
$425,000
Total including January 1
balances
Planned cash payments
(debits made to accounts
shown)
Planned balances, March 31
Purchases or operating costs,
quarter ending June 30
(credits made to accounts
shown at right):
Direct materials (per Exhibit $ 50,000*
190)
Direct labor (per Exhibit 183) 150,000*
Manufacturing overhead (per 100,000*
Exhibit 183 and above
schedules)
Selling and administrative
170,000*
expenses (per Exhibit 184
and above schedules)
Total
$470,000
Total including March 31
balances
Planned cash payments
(debits made to accounts
shown)
Planned balances, June 30
*Debit balance or debit to
account
...
Preparing a cash
budget requires information about cash receipts and cash disbursements
...
0 License
Cash receipts We can prepare the cash receipts schedule from the information used to compute the accounts
receivable schedule (Exhibit 189)
...

Cash disbursements Companies need cash to pay for purchases, wages, rent, interest, income taxes, cash
dividends, and most other expenses
...
Look at Exhibit 193, the cash disbursements schedule for Leed Company
...
Income taxes are assumed to be 40
per cent of income before income taxes
...

Leed Company
Planned Cash receipts
Collections on accounts receivable:
From preceding quarter's sales
From current quarter's sales
Total cash receipts (per Exhibit 189)

Quarter
ending
2010 March 31 2010 June 30
$200,000
240,000 (0
...
4 x $400,000)
420,000 (0
...
The cash budget is a plan indicating expected inflows and outflows of cash
...


ending
2010 June 30
$ 90,000
580,000
$670,000
$ 56,000
354,000
50,000
40,000
10,000
$510,000
$ 160,000

Exhibit 194: Leed Company: Planned cash flows and cash balances
This cash budget helps management to decide whether enough cash will be available for short-term needs
...
Budgeting for planning and control
short-term basis
...
Knowing in advance that a possible cash
shortage or excess may occur allows management sufficient time to plan for such occurrences and avoid a cash
crisis
...
Management now has information to help appraise the policies it has adopted before
implementing them
...

Leed Company
Projected balance sheet
As of March 31 and 2010 June 30
Assets
Current assets:
Cash (per Exhibit 194)
Accounts receivable (per Exhibit 189)
Inventories:
Materials (per Exhibit 190)
Finished goods (per Exhibit 183)
Prepaid expenses (per Exhibit 191)
Total current assets
Property, plant, and equipment:
Land (per Exhibit 188)
Buildings, net ($1,000,000 less accumulated
depreciation of $406,000 and $412,000) (per
Exhibit 188 and Exhibit 191)
Equipment, net ($600,000 less accumulated
depreciation of $195,000 and $210,000) (per
Exhibit 188 and Exhibit 191)
Total property, plant, and equipment
Total assets
Liabilities and stockholders' equity
Current liabilities:
Accounts payable (per Exhibit 191)
Accrued liabilities payable (per Exhibit 191)
Income taxes payable (per discussion in the
text)
Total current liabilities
Stockholders' equity:
Capital stock (100,000 shares of $10 par
value) (per Exhibit 188)
Retained earnings (see footnotes below)
Total stockholders' equity
Total liabilities and stockholders' equity
*$260,000 (per Exhibit 188) + Income of
$6,000 – Dividends of $20,000
...


2010 March 2010 June 30
31
$ 90,000
160,000

$ 160,000
280,000

25,000
180,000
12,000
$ 467,000

25,000
60,000
14,000
539,000

$ 60,000
594,000

$ 60,000
588,000

405,000

390,000

$1,059,000
$1,526,000

$1,038,000
$1,577,000

$ 56,000
170,000
54,000

$ 73,000
184,000
48,000

$ 280,000

$ 305,000

$1,000,000

$1,000,000

246,000*
$1,246,000
$1,526,000

272,000†
$1,272,000
$ 1,577,000

Exhibit 195: Leed Company: Projected balance sheet
For example, Leed Company's management had a policy of stable production each period
...
However, the planned ending inventory
at June 30 may be considered somewhat low in view of the fluctuations in sales
...


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...
BP has oil and gas exploration, production, and marketing
facilities in various countries
...


Recent

advances

in

telecommunications networks and collaboration software have made this process much faster and
easier
...
Corporate headquarters can get answers to its questions fast and can
coordinate the budgets from various worldwide operations quickly
...
This section discusses budgeting in merchandising companies
...
Suppose managers in a
retail merchandising business, such as a dress shop or a furniture store, prepare a budget
...
To compute the purchases for each quarter,
management must estimate the cost of the goods to be sold during the quarter and the inventory required at the
end of the quarter
...
Assume the company
maintains sufficient inventory to cover one-half of the next quarter's sales
...

The ending inventory on 2009 December 31, was USD 8,250
...
For the first quarter of 2010, notice that the ending inventory is one-half of the second quarter's cost
of goods sold [0
...
55 X USD 80,000) = USD 22,000]
...

Strobel Furniture
Company
Sales budget
For quarters ending
2010 March 31,
through 2011 March 31
2010 March 2010 June 30
2010 September 30
31
$30,000
$80,000
$50,000

2010
December 31
$90,000

2011 March
31
$40,000

Exhibit 196: Strobel furniture company: Sales budget

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...
Service firms have service
revenues and operating expenses that must be budgeted
...


Additional concepts related to budgeting
Two additional concepts that affect budgeting are sometimes used in industry
...

Chapter 20 described just-in-time inventory
...

The overall purpose of the just-in-time inventory system is to decrease, or in some cases eliminate, inventories
in a company
...
Consequently, companies using just-in-time inventory must budget purchasing, production, and sales so the
goods are purchased just in time for production and produced just in time for sales
...
It has received less attention since then
...
Managers do not assume any costs incurred in previous years should be
incurred this year
...
Top organization officials rank the
decision packages and approve those that they believe are most worthy
...

This chapter discussed the general concepts of budgeting
...

The next chapter discusses standard costs, which are used in budgeting and are important in controlling
operations
...
0 License
Understanding the learning objectives
• A budget is a plan showing the company's objectives and how management intends to acquire and use

resources to attain those objectives
...

• A budget: (1) shows management's operating plans for the coming periods; (2) formalizes management's

plans in quantitative terms; (3) forces all levels of management to think ahead, anticipate results, and take
action to remedy possible poor results; and (4) may motivate individuals to strive to achieve stated goals
...

• Top management support: All management levels must be aware of the budget's importance to the

company and must know that the budget has top management's support
...

• Communicating results: People should be promptly and clearly informed of their progress
...
For control purposes, after the actual level of operations is known, the actual revenues and
expenses should be compared to the expected performance at that level of operations
...

• Managers develop a planned operating budget in units rather than dollars
...
Then, based on the sales forecast and the company's inventory policy, they forecast production
requirements in units
...
A forecast of expected selling prices must be made, and

costs must be analyzed
...

• After forecasting the cost of goods sold, management prepares a separate budget for all selling and

administrative expenses
...

• The totals on the separate budgets are combined to form the planned operating budget, which shows the

budgeted income after income taxes for a certain period
...

• This budget shows the effect that different volume changes, in per cents of capacity, have on the expenses of

a company
...

• Managers usually prepare a separate cash budget to show sources, uses, and net changes in cash for the

period
...
Budgeting for planning and control
• Supporting budgets also may be developed for accounts receivable, inventories, accounts affected by

operating costs, and federal income taxes payable
...

The company estimates selling expenses to be USD 120,000 plus 2 per cent of sales revenue
...
Federal income tax expense is estimated
to be 40 per cent of income before federal income taxes
...
50 for labor, and USD 4
...
Estimated fixed overhead cost is USD 60,000
per month
...
The
company uses FIFO inventory procedure
...

Solution to demonstration problem

Sales (40,000 x $30)
Cost of goods sold (see planned
cost of goods sold)
Gross margin
Selling expenses:
Fixed
Variable (0
...
01 x $1,200,000)
Income before federal income
taxes
Deduct: Federal income tax
expense (40%)
Net income

Beginning finished goods
inventory (8,000 x $15)
Cost of goods manufactured:
Direct materials (50,000 x $3)
Direct labor (50,000 x $7
...
50)
Fixed manufacturing overhead
Cost of goods manufactured
(50,000 x $16,20)
Cost of goods available for sale
Ending finished goods inventory
(18,000 x $16,20)
Cost of goods sold

Ramos Company
Projected income
statement
For January 2010

$1,200,000
638,400
$561,600

$120,000
24,000
90,000
12,000

246,000
$315,600
126,600
$189,360

Ramos Company
Planned cost of goods
sold

$ 120,000

$150,000
375,000
225,000
60,000

810,000
$ 930,000
291,600
$ 638,400

Key terms*
Budget A plan showing a company's objectives and proposed ways of attaining the objectives
...

Budgeting The coordination of financial and nonfinancial planning to satisfy an organization's goals
...

Cash budget A plan indicating expected inflows (receipts) and outflows (disbursements) of cash; it helps
management decide whether enough cash will be available for short-term needs
...
0 License
Financial budget The projected balance sheet portion of a master budget
...

Flexible operating budget A special budget that provides detailed information about budgeted expenses
(and revenues) at various levels of output
...

Master budget The projected income statement (planned operating budget) and projected balance sheet
(financial budget) showing the organization's objectives and proposed ways of attaining them; includes
supporting budgets for various items in the master budget; also called master profit plan
...

Participatory budgeting A method of preparing the budget that includes the participation of all levels of
management responsible for actual performance
...

Production budget A budget that takes into account the units in the sales budget and the company's
inventory policy
...

Zero-base budgeting Managers in a company start each year with zero budget levels and must justify
every dollar that will appear in the budget
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

Cash budgets may cover a week or a month, sales and production budgets a month, a quarter, or a year, and
general operating budgets may cover a quarter or a year
...

Planned operating budgets based on planned activity levels and flexible budgets are the same if planned activity
levels and actual activity levels are not the same
...

Which of the following best describes some of the benefits related to the preparation and use of budgets:
a
...

b
...

c
...

d
...

e
...

When preparing a projected income statement, which of the following budgets is prepared first?
a
...

b
...

c
...

d
...

Fixed costs are USD 60,000, variable cost per unit is USD 1
...

Determine the budgeted production costs
...
USD 300,000
...
Budgeting for planning and control
b
...

c
...

d
...

Production costs (including USD 30,000 of fixed costs) are budgeted at USD 150,000 for an expected output of
100,000 units
...
What is the budget variance
and is it favorable or unfavorable?
a
...

b
...

c
...

d
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...


➢

What are the two major budgets in the master budget? Which should be prepared first? Why?

➢

Distinguish between a master budget and a responsibility budget
...
At the end of the period, the supplies used amounted to USD 44,000
...
What areas should be considered?

➢

Why is budgeted performance better than past performance as a basis for judging actual results?

➢

Describe the concepts of just-in-time inventory systems and zero-base budgeting
...
An industry
analyst has asked you to forecast sales for each of the next five years (after the current year)
...
That is, the percentage increase for next year is
expected to be the same as it was last year
...

Evaluate the simple forecasting method you were asked to use in that question
...
0 License
➢

Real world question Do you think the sales for a particular grocery store in your neighborhood
will go up, go down, or stay the same next year compared to this year? Give your answer in sales
volume, then give it in sales dollars
...
Assume your
college bookstore is preparing a budget for next year and wants to include employees in the
budgeting process
...


Exercises
Exercise A Hike n' Run Company has decided to produce 288,000 pairs of socks at a uniform rate throughout
2010
...
Prepare a schedule of
planned sales and production for the first two quarters of 2010
...
Production costs are
USD 1
...
Variable selling and administrative expenses are USD 0
...
Compute the budgeted income before income taxes
...

Production costs are USD 14
...
Selling and administrative expenses are: variable, USD 7
...
What are the budgeted earnings for next quarter? (Do not consider federal income
taxes
...
Expected
production for the year is 50,000 units
...
Prepare a flexible budget for materials and labor for
possible production levels of 52,500, 60,000, and 67,500 units of product
...
What are the budget variances?
Exercise F Fixed production costs for Alexia Company are budgeted at USD 576,000, assuming 40,000 units
of production
...
Actual fixed
costs used in computing cost of goods sold amounted to USD 504,000
...
The department expects to begin in April with a USD 50,000 inventory
and to end the month with an USD 42,500 inventory
...

Prepare a purchases budget for the department showing the amount of goods to be purchased during April
...
The operating budgets for
June and July are based on the following data:
Units produced

Units sold

Accounting Principles: A Business Perspective

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...
Direct materials, direct labor, and variable manufacturing overhead are
estimated at USD 3, USD 6, and USD 3 per unit, respectively
...
Selling and administrative expenses are budgeted at USD 1,200,000 plus 10 per cent of
sales, while federal income taxes are budgeted at 40 per cent of income before federal income taxes
...
10 each
...
Prepare monthly budget estimates of cost of goods sold assuming that FIFO inventory procedure is used
...
Prepare planned operating budgets for June and July
...
Direct
materials, direct labor, and all costs labeled as variable are completely variable
...
Actual operating data for 2009 are:
Sales
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Variable selling expenses
Fixed selling expenses
Variable administrative expenses
Fixed administrative expenses

$2,160,000
444,000
288,000
148,800
246,000
186,000
157,200
198,000
218,200

a
...

b
...
(Hint: Prepare budget data on a flexible basis and use the
percentage by which sales were actually experienced
...
Comment on the differences revealed by the two reports
...
60
$1
...
25

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20
$60,000

Assume no beginning or ending inventory
...

The actual operating data for the year ending 2009 December 31, follow:
Sales
Cost of goods sold:
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Total
Less: Ending inventory ($783,000 x 10/90)
Gross margin
Selling expenses:
Variable
Fixed
Income before federal income taxes
Deduct: Federal income taxes at 40%
Net income

$1,080,000
$337,500
135,000
202,500
108,000
$783,000
87,000
102,000
72,000

696,000
$384,000
174,000
$210,000
84,000
$126,000

a
...

b
...

Problem D Kim Company wants you to prepare a flexible budget for selling and administrative expenses
...
In
addition, the company employs nine regional sales managers with a salary of USD 21,600 per month, none of whom
is entitled to any commissions
...

Sales commissions are either 10 per cent or 5 per cent of the selling price, depending on the product sold
...

Salespersons' travel allowances average USD 1,500 per month per salesperson (excluding managers)
...

Selling supplies expense is estimated at 1 per cent of sales
...

Other administrative expenses include the following:
Rent—USD 48,000 per month
Office supplies—2 per cent of sales
Other administrative expenses (telephone, etc
...

Accounting Principles: A Business Perspective

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...
Estimated sales for the next
three months are:
September
October
November

$350,000
500,000
400,000

Sales for August were USD 400,000
...
Galaxy Lighting Company estimates that 60 per
cent of the accounts receivable are collected in the month of sale with the remaining 40 per cent collected the
following month
...
The cash balance for September 1 is USD 100,000
...
Purchase cost per unit for materials is USD 18
...

Prepare a cash receipts schedule for September and October and a purchases budget for August, September, and
October
...
In addition to the information given, selling and administrative
expenses paid in cash are USD 120,000 per month
...

Alternate problems
Alternate problem A Cougars Company prepares monthly operating and financial budgets
...
Production is scheduled at a level high enough to take care of current needs and
to carry into each month one-half of the next month's unit sales
...
Total fixed
manufacturing overhead is budgeted at USD 480,000 per month
...
The inventory at 2009 April 1, consists of 50,000
units with a cost of USD 28
...

a
...

b
...

Alternate problem B Following is a summary of operating data of Bugs Company for the year 2008:
Sales
Cost of goods manufactured and
sold:
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Gross margin
Selling expenses:
Variable
Fixed
General and administrative
expenses:
Variable
Fixed
Net operating income

$ 7,00,000
$1,200,000
1,100,000
300,000
800,000
$ 300,000
400,000

$ 100,000
1,200,000

3,400,000
$ 3,600,000
700,000
2,900,000

1,300,000
$ 1,600,000

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...
Prices are not expected to change
...
Actual operating data for 2009 follow:
Sales
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Variable selling expenses
Fixed selling expenses
Variable administrative expenses
Fixed administrative expenses

$5,800,000
1,300,000
1,100,000
300,000
780,000
270,000
290,000
110,000
1,100,000

a
...

b
...

(Hint: Prepare a flexible operating budget
...
00
9
...
00
$900,000
$ 3
...
Federal income taxes are budgeted at 40 per cent of income before income
taxes
...
(Note: The actual sales
price was USD 80 per unit
...
)
Sales (500,000 units @ $80 per unit)
Cost of goods sold:
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Gross margin
Selling and administrative expenses:
Variable
Fixed
Income before federal income taxes
Deduct: Federal income taxes
Net income

$40,000,000
$12,000,000
4,400,000
4,000,000
1,000,000
$ 1,400,000
800,000

21,400,000
$18,600,000
2,200,000
$16,400,000
6,560,000
$ 9,840,000

a
...

b
...
Comment on the results of 2009 and
on the company's sales policy in (2)
...
Budgeting for planning and control
Salaries and wages
Rent
Supplies
Insurance
Other cash expenses

194,000
10,000
8,000
2,000
12,000

A cash balance of USD 36,000 is planned for July 1
...
All but one-half of 1 per cent of the July 1 Accounts Receivable balance will be collected in the quarter ending
September 30
...
Accounts payable will be USD 30,000 on July 1 and will be paid during the coming quarter
...
Expenses are paid in the quarter in which they are incurred
...

Beyond the numbers—Critical thinking
Business decision case A Golden State Company has applied at a local bank for a short-term loan of USD
150,000 starting on 2009 October 1
...
The following information is needed to prepare the cash budget:
Sales
$600,000
Purchases
350,000
Salaries and wages to be paid 125,000
Rent payments
7,000
Supplies (payments for)
4,500
Insurance payments
1,500
Other cash payments
22,000

A cash balance of USD 24,000 is planned for October 1
...
All of these accounts will be collected in the quarter ending December 31
...
Accounts payable will be USD
480,000 on October 1 and will be paid during the quarter ending December 31
...

a
...
Assume that the USD 150,000 loan will be
made on October 1 and will be repaid with interest at 10 per cent on December 31
...
Will the company be able to repay the loan on December 31? If the company desires a minimum cash balance
of USD 18,000, will the company be able to repay the loan as planned?
Ethics case B The state of California, USA faced large budget deficits
...
The
community college was entering the last three months of the fiscal year with excess funds because the area had
experienced a mild winter resulting in lower than usual utilities and maintenance costs
...

The state will claim we do not need as much money next year
...
I am concerned about the memorandum that we received requesting that we cut
expenditures wherever possible to help reduce the state's deficit
...
0 License
The first official responded, "That deficit is the state's problem, not ours
...
Let us deal with our
problems and let them deal with theirs!"
Write a response from the point of view of the taxpayers of the state of California
...
Describe and
evaluate Verizon Communications, Inc
...
How would you advise company management
to communicate the company's values and plans to employees?
Group project D In groups of three, develop a budget for an organization that publishes financial statements,
such as The Coca-Cola Company or Maytag Corporation
...
These three income statements should be for
optimistic, pessimistic, and expected scenarios
...
For example, to prepare a budgeted income statement for a publicly traded company such as Coca-Cola,
look at previous annual reports and collect whatever additional information you can from news reports
...
The heading of the
memorandum should contain the date, to whom it is written, from whom, and the subject matter
...

Group project E The chief executive officer (CEO) of Rigid Plastics Corporation remarked to a colleague, "I do
not understand why other companies waste so much time in the budgeting process
...
What is wrong with that approach?" In groups of two or three students, write a
memorandum to your instructor stating whether you agree with this comment or not and explain why
...

Group project F Multigoal Corporation has established a bonus plan for its employees
...
If the
department's costs exceed the budget, its employees earn no bonus
...
The heading of the
memorandum should contain the date, to whom it is written, from whom, and the subject matter
...
Examples include Intel
Corporation, IBM, and Dell
...
Collect or develop as much information
as possible to prepare the budget
...
Be sure to state the assumptions used in preparing the budget in a
memorandum
...
Do not forget to include the three different projected income statements
...
Develop a budgeted income statement
(operating budget) for the coming year and include three categories for optimistic, pessimistic, and expected
scenarios
...
For example, look at previous
annual reports and collect whatever additional information you can from news reports
...
The heading of the memorandum should contain the
Accounting Principles: A Business Perspective

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...
Do not forget to include the three different
projected income statements
...
The company's post-closing trial balance as of 2010
December 31, is as follows:
Cash
Accounts receivable
Allowance for uncollectible accounts
Inventories
Prepaid expenses
Furniture and equipment
Accumulated depreciation – Furniture and
equipment
Accounts payable
Accrued liabilities payable
Notes payable, 5% (due 2008)
Capital stock
Retained earnings (deficit)

Debits
$138,000
360,000
156,000
12,000
180,000

Credits
$ 12,000

12,000
120,000
36,000
480,000
300,000
114,000
$960,000

$960,000

All of the capital stock of the company was recently acquired by Juan Jackson
...

There are no accrued federal income taxes payable, but future earnings will be subject to income taxation
...
Thus, he is quite interested in the
budgets for the quarter ending 2011 March 31
...
All sales are priced to yield a gross margin of 40 per cent
...
All sales are on account, and 95 per cent of the 2010 December 31, receivables plus 70 per cent of the
current quarter's sales will be collected during the quarter ending 2011 March 31
...

Purchasing expenses are budgeted at USD 34,800 plus 5 per cent of purchases for the quarter; USD 9,000 will
be incurred on account, USD 48,000 accrued, USD 13,800 from expired prepaid expenses, and USD 1,200 from
allocated depreciation
...

Uncollectible accounts are estimated at 1 per cent of sales
...

All of the beginning balances in Accounts Payable and Accrued Liabilities Payable, plus 80 per cent of the
current credits to Accounts Payable, and all but USD 30,000 of the current accrued liabilities will be paid during
the quarter
...


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The taxes should be
accrued, and no payments are due in the first quarter
...
Prepare a planned operating budget for the quarter ending 2011 March 31, including supporting schedules for
planned purchases and operating expenses
...
Prepare a financial budget for 2011 March 31
...

c
...
The company's post-closing balance as of 2010 December
31, is as follows:
Davis corporation
Post-closing trial
balance
2010 December 31
Debits
Credits
Cash
$240,000
Accounts receivable
480,000
Allowance for uncollectible
$ 36,000
accounts
Inventories
600,000
Prepaid expenses
72,000
Land
600,000
Buildings and equipment 1,800,000
Accumulated depreciation
240,000
– Buildings and equipment
Accounts payable
360,000
Accrued liabilities payable
240,000
(including income taxes)
Capital stock
2,400,000
Retained earnings
516,000
$3,792,000
$3,792,000

Sales in the last quarter of 2010 amounted to USD 2,400,000 and are projected at USD 3,000,000 and USD
4,800,000 for the first two quarters of 2011
...
Management is especially
concerned about the probable cash balance of 2011 March 31, since a payment of USD 360,000 for some new
equipment must be made on delivery on April 2
...

Purchases, all on account, are to be scheduled so that the inventory at the end of any quarter is equal to onethird of the goods expected to be sold in the coming quarter
...

Selling expenses are budgeted at USD 120,000 plus 8 per cent of sales; USD 24,000 is expected to be incurred
on account, USD 288,000 accrued, USD 33,600 from expired prepayments, and USD 14,400 from allocated
depreciation
...

Administrative expenses are budgeted at USD 150,000 plus 3 per cent of sales; USD 24,000 will be incurred on
account, USD 132,000 accrued, USD 13,200 from expired prepayments, and USD 10,800 from allocated
depreciation
...
Budgeting for planning and control
Federal income taxes are budgeted at 40 per cent of income before federal income taxes and are recorded as
accrued liabilities
...

All 2010 December 31, accounts payable plus 80 per cent of current credits to this account will be paid in the
first quarter
...
Of the current quarter's accrued liabilities, all but USD 288,000 will be paid during the first quarter
...

All sales are made on account; 80 per cent of the sales are collected in the quarter in which made, and all of the
remaining sales are collected in the following quarter, except for 2 per cent which is never collected
...

a
...
Supporting schedules for planned
purchases and operating expenses should be included
...
Prepare a financial budget for 2011 March 31
...

c
...
Budgets are estimates of the future and should consider future plans and conditions
...
Cash budgets may cover a week or a month; sales and production budgets a month, a quarter, or a year;
and general operating budgets may cover a quarter or a year
...
The planned operating budget is developed first in units, then in dollars
...
Flexible budgets are based on actual activity and planned operating budgets are based on planned
activity
...

Multiple-choice
e
...

c
...
We need to know sales before we predict cost of goods sold, selling and
administrative expenses, and the financial budget
...
Budgeted amount = Fixed cost + (Variable cost per unit x Units of output)
= USD 60,000 + (USD 1
...
USD 150,000 – USD 30,000 = USD 120,000 variable cost
USD 120,000
=USD 1
...
20
Fixed costs

Actual costs

USD 108,000
30,000
USD 138,000
142,500

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0 License

24
...

• Define budgets and discuss how budgets are used in a standard cost system
...

• Calculate the six variances from standard and determine if the variance is favorable or unfavorable
...

• Discuss the three selection guidelines used to investigate variances from standard
...


This chapter discusses the uses of standard costs, the advantages and disadvantages of using standard costs, and
how to compute the difference, or variance, between an actual cost and a standard cost
...


Uses of standard costs
Whenever you have set goals that you have sought to achieve, these goals could have been called standards
...
Similarly, management sets goals, such as standard costs, and compares actual costs
with these goals to identify possible problems
...
Next, we explain how managers use
standard costs to establish budgets
...
We also explain setting standards and how management
decides whether to use ideal or practical standards
...


Nature of standard costs
A standard cost is a carefully predetermined measure of what a cost should be under stated conditions
...
When standards are
properly set, their achievement represents a reasonably efficient level of performance
...
Also considered in
setting standards are general economic conditions because these conditions affect the cost of materials and other
services that must be purchased by a manufacturing company
...
Determining the
Accounting Principles: A Business Perspective

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...

The standard direct materials cost per unit of a product consists of the standard amount of material required to
produce the unit multiplied by the standard price of the material
...
Standard price usually refers to the price per unit of inputs into the production process,
such as the price per pound of raw materials
...
For example, if the standard price of cloth is USD 3 per yard and the standard quantity of
material required to produce a dress is 3 yards, the standard direct materials cost of the dress is 3 yards x USD 3 per
yard = USD 9
...

Standard manufacturing overhead cost To find the standard manufacturing overhead cost of a unit, use
the following steps
...
This level of output is called the
standard level of output
...
The total budgeted overhead cost includes both fixed and variable components
...
Total variable overhead varies in direct proportion to the
number of units produced
...
The result is
standard overhead cost (or rate) per unit of output
...
To find the standard overhead cost per unit, multiply the direct labor-hours per unit times the standard
overhead cost per direct labor-hour
...

As discussed in Chapter 23, budgets are formal written plans that represent management's planned actions in
the future and the impacts of these actions on the business
...
To control operations, management investigates any
differences between the actual and budgeted amounts and takes corrective action
...
The responsibility of management is to investigate significant variances
...
This process of focusing on only the most
significant variances is known as management by exception
...

In developing standards, management must consider the assumed conditions under which these standards can
be met
...


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...
The company can attain these unrealistic standards only when it has highly efficient, skilled workers who
are working at their best effort throughout the entire period needed to complete the job
...
Companies can meet these standards if average workers are efficient at their work
...

Generally, management does not use ideal standards because ideal standards do not allow for normal repairs to
machinery or rest periods for workers
...
Since planning
under ideal standards is unrealistic, managers rarely use ideal standards in budgeting
...
Any variances that result when practical standards are used indicate abnormal or unusual
problems
...

Firms evaluate management's and workers' performances through the use of a budget
...
Management also can evaluate workers based on how well they performed relative to the budgeted
amounts pertaining to the activities they performed
...
The budget shows the expected expenses incurred by the
business
...
As the business actually incurs these expenses, management determines if the
selling prices set are still reasonable and, when necessary, considers some price adjustments after taking
competition into account
...

• More useful information for managerial planning and decision making
...

• Cost savings in record-keeping
...


Improved cost control Companies can gain greater cost control by setting standards for each type of cost
incurred and then highlighting exceptions or variances—instances where things did not go as planned
...

Assume, for example, that in a production center, actual direct materials costs of USD 52,015 exceeded standard
costs by USD 6,015
...
Now the firm can investigate
the cause of the excess of actual costs over standard costs and take action
...
Control through standard costs
Further investigation should reveal whether the exception or variance was caused by the inefficient use of
materials or resulted from higher prices due to inflation or inefficient purchasing
...

More useful information for managerial planning and decision making When management develops
appropriate cost standards and succeeds in controlling production costs, future actual costs should be close to the
standard
...
A standard cost system can be valuable for top management in planning and decision
making
...
Under an actual cost system, unit costs for batches of identical products may
differ widely
...
Under a standard cost system, the
company would not include such unusual costs in inventory
...

Thus, in a standard cost system, a company assumes that all units of a given product produced during a
particular time period have the same unit cost
...

Cost savings in record-keeping Although a standard cost system may seem to require more detailed recordkeeping during the accounting period than an actual cost system, the reverse is true
...

It records these varying amounts of actual unit costs that must be calculated during the period
...
It needs no special calculations to determine actual unit costs during the
period
...

Possible reductions in production costs A standard cost system may lead to cost savings
...
Only when employees become active in reducing costs can companies really become successful in cost
control
...

• Nonreporting of certain variances
...


Controversial materiality limits for variances Determining the materiality limits of the variances may be
controversial
...
Because materiality involves individual judgment, many problems or conflicts may arise in
setting materiality limits
...
If
management only investigates unusual variances, workers may not report negative exceptions to the budget or may

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Workers who succeed in hiding variances diminish the
effectiveness of budgeting
...

Management often focuses on unfavorable variances while ignoring favorable variances
...
As a result, the morale of these workers may
suffer
...
In most cases, industrial engineers shut themselves in a room and ponder how to set
standards
...
In the
alternative scenario, workers themselves hold the stopwatches and set the standards
...
They
standardize each task so everyone in the team does it the same way
...

Source: Based on the authors' research
...
Standard cost is the amount a cost should be under a given set
of circumstances
...

The amount by which actual cost differs from standard cost is called a variance
...
When actual costs exceed the standard costs, a cost variance is
unfavorable
...
You must base
such an appraisal on the causes of the variance
...
Beta manufactures and sells a single product, each unit of which has the
following standard costs:
Materials – 5 sheets at $6
Direct labor – 2 hours at $10
Manufacturing overhead – 2 direct labor
hours at $5
Total standard cost per unit

$30
20
10
$60

We present additional data regarding the production activities of the company as needed
...
Actual costs may differ from standard costs
for materials because the price paid for the materials and/or the quantity of materials used varied from the
standard amounts management had set
...

Accounting Principles: A Business Perspective

920

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24
...
First, different individuals may be
responsible for each variance—a purchasing agent for the price variance and a production manager for the usage
variance
...
The variance associated with the
purchase should be isolated in the period of purchase, and the variance associated with usage should be isolated in
the period of use
...
Third,
it is unlikely that a single materials variance—the difference between the standard cost and the actual cost of the
materials used—would be of any real value to management for effective cost control
...

Materials price variance In a manufacturing company, the purchasing and accounting departments usually
set a standard price for materials meeting certain engineering specifications
...
A
materials price variance (MPV) occurs when a company pays a higher or lower price than the standard price
set for materials
...
In equation form, the materials
price variance is:
Materials price variance = (Actual price – Standard price) x Actual quantity purchased
To illustrate, assume that a new supplier entered the market enabling Beta Company to purchase 60,000 sheets
of material at a price of USD 5
...
Since the standard price set by management is USD 6 per sheet, the
materials price variance is computed as:
Materials price variance= Actual price – Standard price× Actual quantity purchased

=

USD 5
...
00×60,000

=

USD−0
...
If the actual price had exceeded the standard price, the variance would be unfavorable
because the costs incurred would have exceeded the standard price
...


360,000

6,000
354,000

Note that the Accounts Payable account shows the actual debt owed to suppliers, while the Materials Inventory
account shows the standard price of the actual quantity of materials purchased
...

Materials usage variance Because the standard quantity of materials used in making a product is largely a
matter of physical requirements or product specifications, usually the engineering department sets it
...


921

This book is licensed under a Creative Commons Attribution 3
...
The variance shows only differences from the standard quantity caused by
the quantity of materials used; it does not include any effect of variances in price
...

Since the standard price of the material is USD 6 per sheet, the materials usage variance of USD 3,000 would be
computed as follows:
Materials usage variance=Actual quantity used – Standard quantityallowed x Standard price

=

55,500−55,000 ×USD 6

=

500× USD 6

= USD 3,000 (unfavorable)
The variance is unfavorable because more materials were used than the standard quantity allowed to complete
the job
...

The journal entry to record the use of the materials is:
(b) Work in process inventory (+A)
330,000
Materials usage variance (+A)
3,000
Materials inventory (-A)
To record the use of materials and
to establish the materials usage
variance
...
Note also that the
Work in Process Inventory account contains both standard quantity and standard prices
...
Unfavorable variances are debits in variance accounts because they add to the
costs incurred, which are recorded as debits
...
Thus, favorable variances are recorded in variance accounts as credits
...
Far greater understanding is achieved if you determine
whether a variance is favorable or unfavorable by reliance on reason or logic
...
If the reverse
is true, the variance is favorable
...
00
Actual price per sheet of material
$5
...
Control through standard costs
Purchase of
materials
Actual cost of
materials
purchased:
Actual price
5
...
00
X 60,000 sheets =
$360,000
Use of materials
Standard cost of
materials used
to
Actual number
of sheets used
55,500
Standard cost of
materials
allowed to
Standard
number of
sheets allowed
55,500*
*(11,000 x 5) =
55,000
...
00 = $333,000
Produce 11,000 units:

<--Usage variance:
$333,000 - $330,000
=

X standard price

$ 3,000 (unfavorable)

X $ 6
...
Here again, it follows that the actual labor cost may differ from standard
labor cost because of the wages paid for labor, the quantity of labor used, or both
...

Labor rate variance The labor rate variance (LRV) occurs when the average rate of pay is higher or lower
than the standard cost to produce a product or complete a process
...

To compute the labor rate variance (LRV), multiply the difference between the actual direct labor-hour rate paid
(AR) and the standard direct labor-hour rate allowed (SR) by the actual hours of direct labor services worked (AH):
Labor rate variance=Actual rate – Standard rate× Actual hours worked

To continue the Beta example, assume that the direct labor payroll of the company consisted of22,200 hours at a
total cost of USD 233,100 (an average actual hourly rate of USD 10
...
Because management has set a standard
direct labor-hour rate of USD 10 per hour, the labor rate variance is:
Labor rate variance=Actual rate – Standard rate× Actual hours worked

=

USD 10
...
00×22,200

=

USD 0
...
If the
reverse were true, the variance would be favorable
...
0 License
Labor efficiency variance Usually, the company's engineering department sets the standard amount of
direct labor-hours needed to complete a product
...
The labor efficiency variance (LEV) occurs when
employees use more or less than the standard amount of direct labor-hours to produce a product or complete a
process
...

To compute the labor efficiency variance (LEV), multiply the difference between the actual direct labor-hours
worked (AH) and the standard direct labor-hours allowed (SH) by the standard direct labor-hour rate per hour
(SR):
Labor efficiency variance= Actual rate – Standard rate×Actual hours worked
=

USD10
...
00×22,200

=

USD 0
...
If the
reverse were true, the variance would be favorable
...
Engineers may base the direct labor-hours standard on time and
motion studies or on bargaining with the employees' union
...
The labor efficiency variance is similar to the materials usage variance
...
Assume these units have a standard direct labor-hours of 22,000 hours (11,000 units
at 2 hour unit)
...
If the reverse were true, the variance would be favorable
...
The standard direct labor cost is USD 10 per hour; therefore, the standard direct labor cost for the output
achieved is assigned to inventory, regardless of the actual direct labor cost
...
Control through standard costs
labor and to establish the two labor
variances
...
The unfavorable labor rate variance is not necessarily caused by paying employees more wages
than they are entitled to receive
...
Favorable rate variances, on the other hand, could be
caused by using less-skilled, cheaper labor in the production process
...
For this reason, labor efficiency
variances are generally watched more closely than labor rate variances
...
The illustration is based on the following data relating to Beta
Company:
Standard direct labor-hours per unit
2 hours
Equivalent units produced in period
11,000 units
Standard labor rate per direct labor-hour
$ 10
Total direct labor wages paid (at actual rate of $10,50 $233,100
per hour)
Actual direct labor-hours worked
22,200 hours

Actual Labor Cost:
Actual labor rate
X actual hours worked
$ 10
...
00
Standard cost of hours allowed to
produce 11,000 units:
Standard labor rate

X 22,200 = $222,000

$10
...


X 22,000* = $220,000

X standard hours allowed

Labor rate variance:
$233,100 - $222,000
=
$11,100
(unfavorable)
Labor efficiency
variance:
$222,000 - $220,000
=
$2,000 (unfavorable)

Exhibit 199: Labor rate and efficiency variances
Summary of labor variances The accuracy of the two labor variances can be checked by comparing their
sum with the difference between actual and standard labor cost for a period
...
50)
Standard labor cost allowed
220,000
(22,000 hours x $10)
Total labor variance (unfavorable) $ 13,100

This USD 13,100 is made up of two labor variances, both unfavorable:
Labor rate variance (22,200 x
$11,100
$0
...
Banks, public accounting firms, law firms,
hospitals, and parking enforcement agencies are just a few organizations that monitor labor costs closely
...
0 License
University officials developed the following standards for a university's parking enforcement people
...
)
Standard direct labor time per ticket
Number of tickets written in March
Standard labor rate per hour
Total labor costs for ticket writing (at an average rate of
$13
...
50 – USD14
...
50× 420 hours

= USD -210 (favorable)
Labor rate variance= Actual hours – Standard hours ×Standard rate
Standard hours=
=

12 minutes
×2,000 tickets
60 minutes

0
...
They set the rate prior to the start of the period by dividing the budgeted manufacturing
overhead cost by a standard level of output or activity
...

Managers use a flexible budget to isolate overhead variances and to set the standard overhead rate
...

Look at Beta Company's flexible budget for the period in Exhibit 200 below
...
For product costing purposes, Beta must estimate the expected level of
activity in advance and set a rate based on that level
...
This
standard volume of output (or activity) may be expressed in terms of any of the activity bases used in setting
standard overhead rates
...
In our example, standard volume is assumed to be 10,000 units produced
...


Accounting Principles: A Business Perspective

926

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24
...
According to the
flexible manufacturing overhead budget, the expected manufacturing overhead cost at the standard volume
(20,000 machine-hours) is USD 100,000, so the standard overhead rate is USD 5 per machine-hour (USD
100,000/20,000 machine-hours)
...
The variable overhead rate is USD 2 per hour (USD 40,000/20,000 hours), and the fixed
overhead rate is USD 3 per hour (USD 60,000/20,000 hours)
...
33 (USD 96,000/18,000 hours)
...
73 (USD 104,000/22,000
hours)
...

That is, the variable overhead cost per unit stays constant (USD 2 per machine-hour) regardless of the number of
units expected to be produced, and only the fixed overhead cost per unit changes
...
The actual costs
would be debited to Manufacturing Overhead and credited to a variety of accounts such as Accounts Payable,
Accumulated Depreciation, Prepaid Insurance, Property Taxes Payable, and so on
...
Therefore, USD
110,000 of manufacturing overhead is applied to production (USD 5 per machine-hour times 22,000 hours) by
debiting Work in Process Inventory and crediting Manufacturing Overhead for USD 110,000
...


These accounts show that manufacturing overhead has been overapplied to production by the USD 2,000 credit
balance in the Manufacturing Overhead account
...

927

This book is licensed under a Creative Commons Attribution 3
...
In this approach, known as the two-variance approach to overhead variances, we calculate only two variances
—an overhead budget variance and an overhead volume variance
...
This overhead variance is
similar to a combined price and usage variance for materials or labor
...

To calculate the total budgeted overhead costs, multiply the variable overhead rate times the standard machinehours allowed for production achieved, plus the constant amount of fixed overhead
...
Since the total actual overhead was USD 108,000 and the total budgeted
overhead was USD 104,000, the overhead budget variance is computed as follows:
Overhead budget variance= Actual overhead−Budgeted overhead at actual production volume level
=

USD 108,000− USD104,000

= USD 4,000 (unfavorable)
The variance is unfavorable because actual overhead costs were USD 108,000, while according to the flexible
budget, they should have been USD 104,000
...
The OVV shows whether plant assets
produced more or fewer units than expected
...
The OVV is the difference
between the budgeted amount of overhead for the actual volume achieved (BOH) and the applied overhead
(Applied OH):
Overhead volume variance=Budgeted overhead− Applied overhead
In the Beta Company illustration, the 11,000 units produced in the period have a standard allowance of 22,000
machine-hours
...
The flexible
budget in Exhibit 200, at the top of the previous page, shows that the budgeted overhead for 22,000 machine-hours
is USD 104,000
...
The overhead volume variance then is:
Overhead volume variance=Budgeted overhead− Applied overhead
=

USD 104,000−USD 110,000

= USD -6,000 (favorable)
Note that the amount of the overhead volume variance is related solely to fixed overhead
...
Since Beta Company used 20,000 machine-hours as its
standard, the fixed overhead rate is USD 3 per machine-hour
...
Beta also can calculate the overhead volume variance as follow s:
(Number of hours used in setting - Number of standard hours X Fixed overhead rate per hour
predetermined overhead rates
allowed for production level
achieved)
(20,000
- 22,000)
X USD 3

Accounting Principles: A Business Perspective

928

= Overhead volume variance
=USD -6,000 (favorable)

A Global Text

24
...

Recording overhead variances These journal entries are related to overhead:
(d) Work in Process (+A)
110,000
Manufacturing Overhead (+SE)
To record the application of manufacturing
overhead to work in process
...


110,000

108,000

(f) Manufacturing overhead (-SE)
2,000
Overhead budget variance (-SE)
4,000
Overhead volume variance (+SE)
To record the variances related to overhead
and close the manufacturing overhead
account
...
The second entry records the actual manufacturing overhead costs incurred during the period by Beta
Company
...

Summary of overhead variances To easily determine the accuracy of the two overhead variances, Beta
would compare the sum of the budget and volume variances with the difference between the costs of actual
manufacturing overhead and applied manufacturing overhead (the amount of over- or underapplied overhead)
...

Materials price
(Actual price – Standard price) x Actual quantity
variance =
purchased
Materials usage
(Actual quantity used – Standard quantity allowed) x
variance =
Standard price
Labor rate variance = (Actual rate – standard rate) x Actual hours worked
Labor efficiency
(Actual hours worked – standard hours allowed) x
variance =
Standard rate
Overhead budget
Actual overhead – budgeted overhead
variance =
Overhead volume
Budgeted overhead – applied overhead
variance =

Exhibit 201: Summary of variances from standard

929

This book is licensed under a Creative Commons Attribution 3
...
The key to this simplicity is the computer's capability to
store, retrieve, and update standards
...


Goods completed and sold
To complete the standard cost system example, assume Beta Company completed and transferred 11,000 units
to finished goods and sold on account 10,000 units at a price equal to 160 per cent of standard cost
...
Journal entry
(g) transfers the standard cost of the units completed, 11,000 x USD 60 = USD 660,000, from Work in Process
Inventory to Finished Goods Inventory
...
Entry (i) records the cost of goods sold, 10,000 x USD 60 = USD 600,000
...

(h) Accounts receivable (+A)
Sales (+SE)
To record sales for the period
...


960,000

600,000

Beta debits the Work in Process Inventory with the standard cost of materials, labor, and manufacturing
overhead for units put into production
...

Sales for the period amount to 10,000 units at USD 96 each (160 per cent of USD 60)
...
Note that Beta debited Finished Goods Inventory
with the standard cost of goods completed and credited it with the standard cost of goods sold
...


Investigating variances from standard
Once all variances have been computed, management must decide which variances should be investigated
further
...
Management needs some
selection guidelines
...
Control through standard costs
controllable or noncontrollable
...
For instance, they could determine the average value of actual costs for a period so that only those
variances deviating from the average by more than a certain percentage would be investigated
...

Any analysis of variances is likely to disclose some variances that are controllable within the company and others
that are not
...
Prices paid for materials purchased
may or may not be controllable
...
On the other hand, a raw materials shortage may exist that drives the price upward, and the price paid may be
beyond the buyer's control
...
For example, an unfavorable labor rate variance may result from using higher paid employees in a
certain task
...
These employees also may be more highly skilled and may waste fewer materials, resulting in a favorable
materials usage variance
...

At the end of a month or quarter, management may develop performance reports that compare the actual results
and costs with the budgeted results and costs
...
At the bottom of the performance report, the supervisor or
manager responsible for the elements mentioned in the report gives reasons for any variances
...


Disposing of variances from standard
At the end of the year, variances from standard must be disposed of in the accounting records
...
Theoretically, the alternative chosen should depend on whether the standards set were
reasonably attainable and whether the variances were controllable by company employees
...
The
business may consider an unfavorable materials price variance caused by an unexpected price change an added cost
and allocate it to the inventory accounts and Cost of Goods Sold because the standard was unattainable and the
variance was uncontrollable
...

Entry (j) reflects this practical disposition of Beta Company's variances by closing them to Cost of Goods Sold:
(j) Materials price variance (+A)
Overhead volume variance (+A)
Cost of goods sold (-SE)
Materials usage variance (-A)
Labor rate variance (-A)
Labor efficiency variance (-A)
Overhead budget variance (-A)
To close the variance accounts
...
0 License
Companies do not report variances separately in financial statements released to the public but simply include
them in the reported cost of goods sold amount
...


A broader perspective:
Quality management and the Baldrige award
Many of the methods successfully used in the Japanese quality movement originated in the United
States
...
Although lagging in implementing quality management
programs, many US companies have jumped on the quality management bandwagon
...
The award is given to businesses that excel in major aspects of quality, such
as quality planning, human resource development, and customer focus
...
The award has also been given to large service
organizations—Ritz-Carlton Hotels, Federal Express, and AT&T (Network Systems Group)—and to
small businesses such as Granite Rock Co
...
The Baldrige Award promotes sharing of information about effective
quality management programs and identifies companies with role-model quality management
systems
...


Nonfinancial performance measures
Although variances provide important measures of performance, nonfinancial performance measures are also
important
...
Chapter 20 discussed various nonfinancial measures of performance
...
If they reduce the number of product defects, firms are likely to reduce the number of customer complaints
...

Managers can reduce materials waste by improving the quality of raw materials so there is less waste from
defective materials
...
Materials waste may show up in the materials efficiency variance
...
While reporting
variances from standard costs is important to department heads and plant managers, workers are more likely to be
motivated by immediate feedback in nonfinancial language
...
Control through standard costs

Activity-based costing, standards, and variances
Activity-based costing is commonly used with standard costing
...
In our example, we applied overhead using just one cost
driver—machine-hours
...

By striving to meet standards, management assumes responsibility for reducing the production costs of its
products
...
Many successful
companies rely on responsibility accounting to make their business operations profitable
...
These managers argue that workers who achieve standards do not try to
improve beyond those standards
...

Understanding the learning objectives
• A standard cost is a carefully predetermined measure of what a cost should be under stated conditions
...

• Budgets are formal written plans that represent management's planned actions in the future and the

impacts of these actions on the business
...

• Advantages of using standard costs include improved cost control, more useful information for managerial

planning and decision making, more reasonable inventory measurements, cost savings in record-keeping, and
possible reductions in production costs incurred
...

• Materials price variance:

Actual price−Standard price×Actual quantity purchased
...

• Labor rate variance:

Actual rate−Standard rate×Actual hours worked
...

• Overhead budget variance:

933

This book is licensed under a Creative Commons Attribution 3
...

• Overhead volume variance:

Budgeted overhead - Applied overhead
...
This journal entry records the purchase of materials:
Materials inventory (debit)
Materials price variance (debit or credit)
Accounts payable (credit)

The Materials Price Variance account is debited if the variance is unfavorable and credited if the variance is
favorable
...
The journal entry to record materials usage is:
Work in process inventory (debit)
Materials usage variance (debit or credit)
Materials inventory (credit)

The Materials Usage Variance account is debited if unfavorable and credited if favorable
...

• The labor efficiency variance shows whether the actual direct labor-hours worked were greater or less

than the standard hours
...
The Labor Efficiency Variance account is debited if the variance is unfavorable and credited if the
variance is favorable
...

• The overhead volume variance shows the difference between the budgeted amount of overhead for the

actual volume achieved and the applied overhead
...
The Overhead Budget Variance account is
debited if the variance is unfavorable and credited if the variance is favorable
...

• Three possible selection guidelines are (1) amount of variance, (2) size of the variance relative to cost

incurred, and (3) controllability of the cost associated with the variance
...

• Variances may be viewed as losses due to inefficiency and closed to the Income Summary account; allocated

as adjustments to the recorded cost of Work in Process Inventory, Finished Goods Inventory, and Cost of
Goods Sold; or closed to Cost of Goods Sold
...


Accounting Principles: A Business Perspective

934

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24
...
The standard cost of each toy is:
Direct materials:
Three blocks of wood at $0
...
72
6
...
36
0
...
56

Gleim bases the standard overhead rate on a volume of 60,000 units per month
...
Using the following detailed data relative to production, compute the six variances from standard for
the month
...
26
$ 6
...
026 - $0
...
24
Total materials variance
Labor rate variance:
($6
...
00) x 49,000

$ 3,200
(unfavorable)
480 (unfavorable)
$ 3,680
(unfavorable)
$ 5,880
(unfavorable)

Labor efficiency variance:
(49,000 – 50,000) x $6
...
48)] 45,600
Overhead budget variance
$660 (unfavorable)
Overhead volume variance:
Budget – Applied [$45,600 – (50,000 x $ 3,600
$0
...


Key terms
Budgets Formal written plans that represent management's planned actions in the future and the impacts of
these actions on the business
...

Ideal standards Standards that can be attained under the best circumstances—that is, with no machinery
problems or worker problems
...

Labor efficiency variance (LEV) A variance from standard caused by using more or less than the
standard amount of direct labor-hours to produce a product or complete a process; computed as (Actual
hours worked - Standard hours allowed) x Standard rate per hour
...
0 License
Labor rate variance (LRV) A variance from standard caused by paying a higher or lower average rate of
pay than the standard cost to produce a product or complete a process; computed as (Actual rate -Standard
rate) x Actual hours worked
...

Materials price variance (MPV) A variance from standard caused by paying a higher or lower price than
the standard for materials purchased; computed as (Actual price - Standard price) x Actual quantity
purchased
...

Overhead budget variance (OBV) A variance from standard caused by incurring more or less than the
standard manufacturing overhead for the actual production volume achieved, as shown by a flexible budget;
computed as Actual overhead - Budgeted overhead at the actual production volume level
...

Practical standards Standards that are strict but attainable
...
These standards are generally used in planning
...

Standard level of output A carefully predetermined measure of what the expected level of output should
be for a specified period of time, usually one year
...
That is, actual
costs may be less than or more than standard costs
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...

Standard costs are useful in evaluating management's and workers' performance
...

This journal entry records the use of materials and establishes a Materials Usage Variance account: debit
Accounts Payable and Materials Usage Variance; credit Materials Inventory
...

Multiple-choice
Select the best answer for each of the following questions
...
Different individuals may be responsible for each variance
...
Materials might not be purchased and used in the same period
...
These two variances are likely to be more informative to top management than one overall materials variance
...
All of the above
...
00
$3
...
Control through standard costs
Standard quantity allowed

22,000 units

a
...

b
...

c
...

d
...

To which account would an unfavorable materials usage or labor efficiency variance caused by carelessness or
inefficiency be closed?
a
...

b
...

c
...

d
...

Which of the following journal entries is correct for closing out the variance accounts?
a
...
Materials Price Variance
Overhead Volume Variance
Accounts Payable
Materials Usage Variance
Labor Rate Variance
Labor Efficiency Variance
Overhead Budget Variance
c
...
Materials Price Variance
Overhead Budget Variance
Accounts Receivable
937

This book is licensed under a Creative Commons Attribution 3
...


Questions
➢

Is a standard cost an estimated cost? What is the primary objective of employing standard costs in a
cost system?

➢

What is a budget?

➢

What is the difference between ideal and practical standards? Which standard generally is used in
planning?

➢

What is meant by the term management by exception?

➢

What are some advantages of using standard costs? What are some disadvantages?

➢

Describe how the materials price and usage variances would be computed from the following data:

➢

Standard—1 unit of material at USD 20 per unit
...
30;
used—990 units
...


➢

When might a given company have a substantial favorable materials price variance and a substantial
unfavorable materials usage variance?

➢

What is the usual cause of a favorable or unfavorable labor rate variance? What other labor variance
is isolated in a standard cost system? Of the two variances, which is more likely to be under the
control of management? Explain
...
Usually three wheels of such size are cut out of
each sheet
...
This purchase and the related depreciation had not been anticipated when the overhead
was budgeted
...
Lands took her place for the normal
40-hour week
...

Production was at capacity last week and the week before
...


➢

How does the use of standard costs permit the application of the principle of management by
exception?

➢

How do standards help in controlling production costs?

Accounting Principles: A Business Perspective

938

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24
...
What are the advantages and disadvantages of having employees set
their own standards?

➢

Real world question Imagine you are making and selling pizzas for Domino's Pizza
...
40 per square foot
...
20 per square foot, for a total cost of USD 36,080
...
Compute the materials price and usage variances
...

Direct materials – 4 pounds at $5 per
pound
Direct labor – 3 hours at $6 per hour
Manufacturing overhead – 150% of
direct labor

$20
18
27
$65

Exercise B Whitewater's purchasing agent took advantage of a special offer from one of its suppliers to
purchase 44,000 pounds of material at USD 4
...
Assume 5,500 units were produced and 34,100
pounds of material were used
...
Comment on the purchasing agent's decision to
take the special offer
...
20 hours 80
...
20
Production for month (in units)
10,000

Exercise D Blackman Company manufactures a product that has a standard direct labor cost of four hours per
unit at USD 24 per hour
...
Compute the labor variances and comment on the foreman's
decision to use a different crew
...
00
$37,200
$88,800

Compute the overhead budget variance and the overhead volume variance
...
)
Exercise F Assume that the actual production in the previous exercise was 26,000 units rather than 24,000
...
0 License
Materials price variance (unfavorable)
Materials usage variance (unfavorable)
Labor rate variance (favorable)
Labor efficiency variance (unfavorable)
Overhead budget variance (favorable)
Overhead volume variance (unfavorable)

$18,000
14,400
10,800
39,600
2,000
21,600

Prepare one journal entry to record the closing of the variance accounts to Cost of Goods Sold
...
00 per pound
...
30 per pound
...

Compute the materials variances
...
2 square feet per unit at USD 0
...
The actual material used consisted of 3,050
square feet at an actual cost of USD 2,664
...
The actual purchase of this material amounted to 4,500 square feet at
a total cost of USD 3,931
...

Prepare journal entries (a) for the purchase of the materials and (b) for the issuance of materials to production
...
One box of bags requires one hour of direct labor at
an hourly rate of USD 6
...

Compute the labor variances
...
The
standard number of direct labor-hours per unit is two hours
...
80
...

a
...
Record the labor data in a journal entry
...
Record the journal entry to dispose of any variances (close to Cost of Goods Sold)
...
Overhead is applied based on units produced
...
80 per unit of output for variable overhead
...

Compute the overhead budget variance and the overhead volume variance assuming the following actual
production in units and actual variable overhead in dollars:
a
...

b
...

Problem F Based on a standard volume of output of 96,000 units per month, the standard cost of the product
manufactured by Tahoe Company consists of:
Direct materials (0
...
5 hours x $7
...
00
3
...
50
1
...
80

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...
40 per pound
...
40)
Direct labor (50,000 hours at $7
...
(Overhead is applied based on units produced
...
80 per pound
Direct labor: 5,800 hours at a total cost of $69,600
Standard labor per unit: 2 hours at $11 per hour
...
Compute the materials and labor variances
...
Prepare journal entries to record the transactions involving these variances
...
Creative has a standard materials cost of two pieces per unit at USD 8 per piece
...
Actual purchases of the materials amounted to 40,000 pieces
at a cost of USD 300,000
...

Alternate problem C Some of the records of Gonzaga Company's repair and maintenance division were
accidentally shredded
...

The total labor variance was USD 6,000, favorable
...

Compute the actual direct labor rate per hour and prepare the journal entry to record the labor rate and the
labor efficiency variances
...
Fixed manufacturing overhead for the current year is budgeted at USD 30,000
...
Overhead is applied based on units produced
...
12,500 units
...
22,500 units
...
For each of the variances
listed, give a possible reason for its existence
...
She has just received the following report:
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...
60 - $3
...
60 per pound)

$9,000
2,070
1,350
$12,420

La Hoya has discussed the unfavorable price variance with Jim Montel, the purchasing officer
...
But he objects
to the inclusion of USD 270 (450 pounds of excess materials used at USD 0
...
This, he argues, is the
responsibility of the production department
...

On the other hand, Ken Kechum, the production manager, agrees that he is basically responsible for the excess
quantity of materials used
...
"That is Jim's responsibility," he says
...
Specifically, she wants you to tell her:
a
...
If responsibility cannot be clearly assigned, how should the accounting department categorize the variance
(price or usage)? Why?
c
...

Prepare written answers to the three questions La Hoya asked
...
The
Baldrige Award has been criticized for fostering a winner-versus-loser mentality, instead of encouraging every
organization to improve its quality
...

Write a response to each of these criticisms of the Baldrige Award
...
Some people claim standards reduce morale and productivity
...
Based on your own experience in school or on a job,
what do you think?
In groups of three, choose an organization or business to use as an example
...
Then decide whether your group favors setting standards
...
If the group does not favor standards, discuss your
reasons
...

Group project E The chief executive officer (CEO) of Tax Preparation Services, Incorporated, remarked to a
colleague, "Establishing standard costs and performing variance analysis is only useful for companies with
inventories
...
The heading of the memorandum should contain the date, to whom it is written, from whom,
and the subject matter
...
This way we can prepare the price

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...
" In groups of two or three
students, write a memorandum to your instructor stating whether you agree with this suggestion or not and explain
why
...

Using the Internet—A view of the real world
Using any Internet search engine enter "standard costs" (be sure to include the quotation marks)
...
You are encouraged (but not required)
to find an article that answers some of the following questions: When is the use of standard costing appropriate?
How do certain industries use standard costing? How are standard costs established? How do standard costs help
management in production?
Write a memorandum to your instructor summarizing the key points of the article
...
Be sure to
include a copy of the article used for this assignment
...
Be sure to include quotation marks (for example: "Management by exception")
...
Write a memorandum to your instructor
summarizing the key points of the article
...
Be sure to include a copy of the article used for this assignment
...
Standard cost is the standard quantity of an input required per unit of output times the standard price
per unit of that input
...
Standard costs are useful in evaluating the performance of management and workers
...
Under a standard cost system all units of a given product are carried in inventory at the same unit cost
...
The general journal entry to record the use of materials and establish the materials usage variance debits
Work in Process Inventory (not Accounts Payable) and Materials Usage Variance and credits Materials Inventory
...
Favorable variances are shown as credits
...
All of these answers are correct
...

b
...
10

=

3,000× USD 3
...
00 – USD3
...
10×30,000

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An unfavorable materials usage or labor efficiency variance caused by carelessness or inefficiency may be
considered a loss and closed to Income Summary because the standard was attainable and the variance was
controllable
...
The other answers incorrectly close the variance accounts
...


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Responsibility
accounting: Segmental
analysis
Learning objectives
After studying this chapter, you should be able to:
• Explain responsibility accounting and its use in a business entity
...

• Prepare a segmental income statement using the contribution margin format
...

• Calculate the residual income of a segment
...


When a business is small, the owner usually supervises many different activities in the business
...
Obviously, the success of a
business depends to a great extent on the persons responsible for these activities
...
You also learn
how to assess the performance of these managers
...

The company measures the performance of each center manager in terms of the items of revenue and expense over
which that manager has control
...
A responsibility accounting system provides
information to evaluate each manager on the revenue and expense items over which that manager has primary
control (authority to influence)
...
When both
controllable and uncontrollable items are included in the report, accountants should clearly separate the categories
...

To implement responsibility accounting in a company, the business entity must be organized so that
responsibility is assignable to individual managers
...
The organization chart in Exhibit 202
demonstrates lines of authority and responsibility that could be used as a basis for responsibility reporting
...
Responsibility accounting: Segmental analysis

Exhibit 202: A corporate functional organization chart including four levels of management
To identify the items over which each manager has control, the lines of authority should follow a specified path
...
The president is ultimately responsible to
stockholders or their elected representatives, the board of directors
...
The president often carries the title, Chief Executive Officer (CEO) and usually delegates authority to lower
level managers since one person cannot keep fully informed of the day-to-day operating details of all areas of the
business
...
The
president is usually considered a first-level manager
...
Notice on the organization chart in Exhibit 202 that individuals at a specific
management level are on a horizontal line across the chart
...
The degree of a manager's authority varies from company to company
...
For example, in some companies, large capital (plant and equipment)
expenditures may be approved only by the president
...

The controllability criterion is crucial to the content of performance reports for each manager
...
A plant manager, however, has the authority to make decisions regarding many other

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These other costs
would be included in the performance evaluation of the store manager, not the supervisor
...
Top management is accountable to stockholders
...
chilcotecompany
...

Employees wear two hats: They own the company and they work for the company
...
Presumably, after employees buy their
company, they have greater incentives to make the company successful
...


Responsibility reports
Responsibility accounting provides reports to different levels of management
...
A performance report to a department manager of a retail
store would include actual and budgeted dollar amounts of all revenue and expense items under that supervisor's
control
...
The report to the company's president includes summary totals of all the stores' performance levels plus
any additional items under the president's control
...

Management by exception is the principle that upper level management does not need to examine operating
details at lower levels unless there appears to be a problem
...
Most executives do not have time to study detailed accounting reports and search for problem areas
...

The condensation of data in successive levels of management reports is justified on the basis that the
appropriate manager will take the necessary corrective action
...

For example, if sales personnel costs have been excessively high in a particular department, that departmental
manager should find and correct the cause of the problem
...
Hence, it is not necessary to report to any higher authority that a particular department within
one of the stores is not operating satisfactorily because the matter has already been resolved
...
Responsibility accounting: Segmental analysis
manager's entire store has been performing poorly, summary totals reported to the vice president of operations
discloses this situation, and an investigation of the store manager's problems may be indicated
...
In the first approach, only those items over which a manager has direct control are included in the
responsibility report for that management level
...
The second approach is to include all revenue and expense items that can be traced directly or
allocated indirectly to a particular manager, whether or not they are controllable
...
When this approach is
used, care must be taken to separate controllable from noncontrollable items to differentiate those items for which
a manager can and should be held responsible
...
That is, accountants should prepare
reports as soon as possible after the end of the performance measurement period
...
When reports are delayed excessively, they lose their effectiveness as control devices
...

Companies also should issue reports regularly so that managers can spot trends
...
Regular reporting allows managers to rely on reports and
become familiar with their contents
...
Confusing
terminology should be avoided
...
To assist management in quickly spotting budget variances, companies can
report both budgeted (expected) and actual amounts
...
Because variances highlight problem areas (exceptions), they are helpful in applying
the management-by-exception principle
...


Responsibility reports—An illustration
Exhibit 203 on the next page, shows how Macy's Corporation could relate its responsibility accounting reports
...
In Exhibit 203 on the next page, we show that a responsibility report would be prepared for
each management level
...
Only the
individual manager's controllable expenses are contained in these reports
...
In turn, the report to the vice president
includes only totals from the store manager's report, and so on
...

You can see that at each level, more and more costs become controllable
...
The only store cost not
included at the store manager's level is the store manager's salary because it is noncontrollable by that store
manager
...


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The store manager may ask the
department manager what the problems were and whether they are now under control
...
The president may ask each vice president why the budget was exceeded
this month and what corrective action has been taken
...

Traditionally, owners have organized their companies along functional lines
...
Responsibility accounting: Segmental analysis
or shipping
...

A responsibility center is a segment of an organization for which a particular executive is responsible
...
In
designing a responsibility accounting system, management must examine the characteristics of each segment and
the extent of the responsible manager's authority
...
The following sections of the chapter discuss the characteristics of each
of these centers and the appropriate bases for evaluating the performance of each type
...
0 License
Amount
Controllable
Expenses
Inventory losses
Supplies
Salaries
Overtime
Total (include in
report for next higher
level)

Over or
(Under)
Budget
This
Year to This
Month Date
Month
$ 2,000 $ 10,000 $ 100
1,800
8,500
800
11,000 53,000
(100)
2,000
14,500
800
$ 16,800 $ 86,000 $ 1,600

Year to
Date
$ 400
950
810
140
$ 2,300

Exhibit 204: Responsibility reports for Macy's corporation
An expense center is a responsibility center incurring only expense items and producing no direct revenue
from the sale of goods or services
...
g
...
Managers of expense centers are held responsible only for specified expense items
...
Short-run minimization of
expenses may not be appropriate
...

A profit center is a responsibility center having both revenues and expenses
...

The manager must have the authority to control selling price, sales volume, and all reported expense items
...
Controllable
profits of a segment result from deducting the expenses under a manager's control from revenues under that
manager's control
...
An investment center is a responsibility
center having revenues, expenses, and an appropriate investment base
...
Accountants compute the return on
investment (ROI), also called the rate of return, by dividing segmental income by the appropriate investment
base
...

Determining the investment base to be used in the ROI calculation is a tricky matter
...
But accountants disagree on whether depreciable
assets should be included in the ROI calculation at original cost, original cost less accumulated depreciation, or
current replacement cost
...
Original cost less accumulated
depreciation is the book value of the assets—the amount paid less total depreciation taken
...
A different rate of return results from each of these measures
...

Even after the investment base is defined, problems may still remain because many segment managers have
limited control over some of the items included in the investment base of their segment
...
Therefore, the segment manager may have little control over the store assets used by the
segment
...
The segment
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...

Usually these problems are overcome when managers realize that if all segments are treated in the same
manner, the inclusion of noncontrollable items in the investment base may have negligible effects
...
To avoid adverse reactions or
decreased motivation, segment managers must agree to this treatment
...
Segments with more resources should produce more profits than segments with
fewer resources, so it is difficult to compare the performance of segments of different sizes on the basis of profits
alone
...
The segment with the highest percentage ROI is presumably the most effective in using
whatever resources it has
...
The centers are often separated
from one another by location, types of products, functions, and/or necessary management skills
...
But the investment center concept can be applied
even in relatively small companies in which the segment managers have control over the revenues, expenses, and
assets of their segments
...
The Pontiac,
Buick, and other divisions of General Motors buy and sell automobile parts from each other, for example
...

A transfer price is an artificial price used when goods or services are transferred from one segment to another
segment within the same company
...
Usually no cash actually changes hands between the segments
...

Segments are generally evaluated based on some measure of profitability
...
The higher the transfer price, the better for
the seller
...

Ideally, a transfer price provides incentives for segment managers to make decisions not only in their best
interests but also in the interests of the entire company
...
A seller with
excess capacity, however, should be willing to transfer a product to the buying segment for any price at or above the
differential cost of producing and transferring the product to the buying segment (typically all variable costs)
...


Use of segmental analysis
So far we have described only the fundamentals of responsibility accounting
...

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...
In other words, the extent of decentralization refers to the degree of control that segment managers
have over the revenues, expenses, and assets of their segments
...
Thus, the more decentralized the decision
making is in an organization, the more applicable is the investment center concept to the segments of the company
...

Some advantages of decentralized decision making are:
• Managing segments trains managers for high-level positions in the company
...

• Top management can be more removed from day-to-day decision making at lower levels of the company

and can manage by exception
...

• Decisions can be made at the point where problems arise
...

• Since decentralization permits the use of the investment center concept, performance evaluation criteria

such as ROI and residual income (to be explained later) can be used
...
Next, we describe each concept
...
A cost object is a segment, product,
or other item for which costs may be accumulated
...
It
is only direct or indirect in relation to a given cost object
...
An indirect cost (expense) is not
traceable to a given cost object but has been allocated to it
...
Thus, a cost that is direct to one cost object may be indirect to
another
...
In this example, the segment and the product
are two distinct cost objects
...
For instance, if the plastics segment of a business closes down, the salary of the manager of that
segment probably is eliminated
...

An indirect cost is not traceable to a particular cost object; therefore, it only becomes an expense of the cost
object through an allocation process
...
The depreciation expense is a direct cost for the company
headquarters, but it is an indirect cost to each segment
...
Responsibility accounting: Segmental analysis
segments
...

Because the direct costs of a segment are clearly identified with that segment, these costs are often controllable
by the segment manager
...
Be careful, however, not to equate direct costs with
controllable costs
...

When preparing internal reports on the performance of segments of a company, management often finds it is
important to classify expenses as fixed or variable and as direct or indirect to the segment
...
As a result, many
companies prepare an income statement for internal use with the format shown in Exhibit 205(A)
...
All Expenses Allocated to Segments
Segment A Segment B
Sales
$ 2,500,000
$ 1,500,000
Less: Variable expenses (all 700,000
650,000
of which are direct
expenses)
Contribution margin
$ 1,800,000 $ 850,000
Less: Direct fixed expenses 450,000
550,000
Contribution to indirect $ 1,350,000 $ 300,000
expenses
Less: Indirect fixed
270,000
330,000
expenses
Net Income
$ 1,080,000 $ (30,000)
B
...
Contribution margin is defined as sales revenue less variable
expenses
...
The second
subtotal in the contribution margin format income statement is the segment's contribution to indirect expenses
...
The final total in the income statement is segmental net
income, defined as segmental revenues less all expenses (direct expenses and allocated indirect expenses)
...
It is
tempting to use segmental net income to make this evaluation since total net income is used to evaluate the
performance of the entire company
...
0 License
segmental net income includes certain indirect expenses that have been allocated to the segment but are not
directly related to it or its operations
...

Given the facts in Exhibit 205(A), if management relied on segmental net income to judge segmental
performance, management might conclude that Segment B should be eliminated because it shows a loss of USD
30,000
...
These
costs would need to be allocated to Segment A if Segment B no longer existed
...
The difference is that
indirect fixed costs are not allocated to individual segments in Exhibit 205(B)
...
The computation for each segment
stops with the segment's contribution to indirect expenses; this is the appropriate figure to use for evaluating the
earnings performance of a segment
...

Arbitrary allocations of indirect fixed expenses As stated earlier, indirect fixed expenses, such as
depreciation on the corporate administration building or on the computer facility maintained at company
headquarters, can only be allocated to segments on some arbitrary basis
...

Accountants can make an allocation on the basis of benefit received for certain indirect expenses
...
If it used 4,000 hours, Segment
K could be charged (allocated) with 40 per cent of the computer's depreciation for the period because it received 40
per cent of the total benefits for the period
...
For instance,
assume that Segment M contracts with a magazine to run an advertisement benefiting Segment M and various
other segments of the company
...

To further illustrate the allocation of indirect expenses based on a measure of benefit or responsibility for
incurrence, assume that Daily Company operates two segments, X and Y
...
Responsibility accounting: Segmental analysis
Number of employees 50

80

130

The following expense allocation schedule shows the allocation of indirect expenses:
Segment X

Segment Y Total
$ 27,778b

$ 50,000

13,462c

21,538d

35,000

15,385

24,615

40,000

Administrative office
building occupancy
expense

$ 22,222

Insurance expense
General administrative
expenses

a

e

f

$ 400,000/$ 900,000 x $ 50,000 = $ 22,222

D

$400,000/$650,000 x $35,000 = $ 21,538

B

$500,000/$900,000 x $50,000 = $27,778

e

50/130 x $40,000 = $ 15,385

c

$250,000/$650,000 x $35,000 = $13,462

F

A

80/130 x $40,000 = $24,615

When it uses neither benefit nor responsibility to allocate indirect fixed expenses, a company must find some
other reasonable, but arbitrary, basis
...
For instance, if Segment X's net sales were 60 per cent of total company sales, then 60 per cent
of the indirect expenses would be allocated to Segment X
...

Having covered some basic concepts essential to segmental analysis, we next present some specific procedures
for performance evaluation
...
Now we introduce the investment base concept into the analysis
...

A segment that has a large amount of assets usually earns more in an absolute sense than a segment that has a
small amount of assets
...
To measure the relative effectiveness of segments, a company might use return
on investment (ROI), which calculates the return (income) as a percentage of the assets employed (investment)
...

Segment A
(a) Income
$ 250,000
(b) Investment
2,500,000
Return on investment (a) ÷ (b) 10 per cent

Segment B
$1,000,000
5,000,000
20 per cent

Segment C
$ 500,000
2,000,000
25 per cent

Total
$1,750,000
9,500,000
18
...
However, using ROI to evaluate the segments indicates that Segment C is really performing the best (25
per cent), Segment B is next (20 per cent), and Segment A is performing the worst (10 per cent)
...

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...
These alternatives focus on what is meant by income and investment
...

Situation
Definition of Income
1
...
*
company
...

2
...

segment
...

3
...
Begin with contribution to
segment manager
...

* Often net operating income is used; this term
is defined as income before interest and taxes
...
This definition excludes assets not
used in normal operations
...
†

Assets directly used by and identified with the
segment
...


Exhibit 207: Possible definitions of income and investment
As discussed earlier in the chapter, alternative valuation bases include cost less accumulated depreciation,
original cost, and current replacement cost
...
First, cost less accumulated depreciation is probably the most widely used valuation base and is easily
determined
...
Also, as book value decreases, a constant income results in a steadily increasing ROI even though the
segment's performance is unchanged
...
The cost of old assets is much less than an investment in new assets, so a segment
with old assets can earn less than a segment with new assets and realize a higher ROI
...
Whichever valuation basis is adopted, all ROI calculations that are
to be used for comparative purposes should be made consistently
...
For example, Johnson & Johnson has a culture
emphasizing high ethical standards
...
HP is known as a
people-oriented company that emphasizes personal development and long-term employment
...
This encourages constant innovation and new product development
...
With this corporate culture, 3M has a worldwide reputation for innovation
...
Responsibility accounting: Segmental analysis
Expanded form of ROI computation The ROI formula breaks into two component parts:
ROI=

Income
Sales
×
Sales
Investment

The first part of the formula, Income/Sales, is called margin or return on sales
...
This percentage shows the number of cents of profit generated
by each dollar of sales
...
Turnover shows the
number of dollars of sales generated by each dollar of investment
...

A manager can increase ROI in the following three ways
...

• By concentrating on increasing the profit margin while holding turnover constant: Pursuing this strategy

means keeping selling prices constant and making every effort to increase efficiency and thereby reduce
expenses
...


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...

ROI=

USD 140,000 USD 2,000,000
×
USD 2,000,000 USD 1,000,000

ROI=7 per cent ×2 time
ROI = 14 per cent

• Increase turnover through reducing investment in assets by USD 200,000; no effect on sales or investment
...
5time
ROI = 12
...

ROI=

USD 110,000 USD 2,000,000
×
USD 2,000,000 USD 800,000

ROI=5
...
5 time
ROI = 13
...

ROI=

USD 150,000 USD 2,500,000
×
USD 2,500,000 USD 1,000,000

ROI=6 per cent ×2
...

ROI =
ROI =
ROI =

USD 112,500
USD 2,500,000
4
...
25%

X
X

USD 2,500,000
USD 1,000,000
2
...
Thus, both margin and turnover would increase
...
Turnover would increase, and margin might increase or decrease
depending on the relative amounts of the increases in income and sales
...
Responsibility accounting: Segmental analysis

Economic value added and residual income
When a company uses ROI to evaluate performance, managers have incentives to focus on the average returns
from their segments' assets
...

To illustrate, assume the manager of Segment 3 in Exhibit 209, has an opportunity to take on a project involving
an investment of USD 100,000 that is estimated to return USD 22,000, or 22 per cent, on the investment
...
Suppose however, from the
company's point of view, all projects earning greater than a 10 per cent return should be accepted, even if they are
lower than a particular segment's ROI
...
Income
b
...
Cost of capital
d
...
Residual Income (RI)

Segment 1
$ 100,000
1,000,000
10%
$ 100,000
-0-

Segment 2
$ 500,000
2,500,000
10%
$ 250,000
250,000

Segment 3
$ 250,000
1,000,000
10%
$ 100,000
150,000

With acceptance of the project by Segment 3, the amounts would be as follows:
Segment Segment
1
2
a
...
Investment
1,000,000 2,500,000
c
...
Desired minimum income$ 100,000 $ 250,000
e
...

‡ $1,000,000 original
investment + $100,000
new investment
...
Suboptimization occurs when a segment manager takes an action that is in the
segment's best interest but is not in the best interest of the company as a whole
...
Residual income (RI) is defined as the amount of income a
segment has in excess of the segment's investment base times its cost of capital percentage
...
The formula for residual
income (RI) is:
RI=Income−Investment×Cost of capital percentage
When a company uses RI to evaluate performance, the segment rated as the best is the segment with the greatest
amount of RI rather than the one with the highest ROI
...
In fact, the project generates RI of USD 12,000, calculated as (USD 22,000 - [10 per cent X USD
100,000])
...
That choice would also be beneficial
to the entire company
...
0 License
Critics of the RI method complain that larger segments are likely to have the highest RI
...

A manager tends to make choices that improve the segment's performance
...
When performance is
evaluated using RI, choices that improve a segment's performance are more likely also to improve the entire
company's performance
...
When calculating RI for a manager of a segment, the
income and investment definitions should be income controllable by the manager and assets under the control of
the segment manager
...
Consideration must be given to factors such as
general economic conditions and market conditions for the product being produced
...
However, segments in Company A may be
more profitable because of market conditions and the nature of the company's products rather than because of the
performance of the segment managers
...


Segmental reporting in external financial statements
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards
No
...
This statement requires publicly
held companies to publish certain segmental information in their annual and interim financial statements
...
Thus, external users of financial statements of a company can (1)
better understand the company's performance, (2) better assess the prospects for future net cash flows, and (3)
make more informed judgments about the company
...
Chapter 26 discusses capital
budgeting and long-term planning
...

• Although the amount of detail varies, reports issued under a responsibility accounting system are

interrelated
...

• The contribution margin format for the income statement shows the contribution margin for the company
...

• The final total in the income statement is segmental net income, defined as segmental revenues less all

expenses (direct expenses and allocated indirect expenses)
...
Responsibility accounting: Segmental analysis
• Return on investment measures the relative effectiveness of segments
...
This percentage shows the

number of cents of profit generated by each dollar of sales
...
Turnover measures

how effectively each dollar of assets was used
...

• Each company sets its cost of capital based on debt costs and desired returns to stockholders
...

Appendix: Allocation of service department costs
Throughout this text, we have emphasized cost allocations only in the operating departments of a company
...
Examples of operating departments are the assembly departments of manufacturing firms and the
departments in hotels that take and confirm reservations
...
Examples of service departments are maintenance, administration, cafeterias, laundries,
and receiving
...
It is crucial that these service department costs be allocated to the
operating departments so that the costs of conducting business in the operating departments are clearly and
accurately reflected
...
When the companies' managers choose
bases to use, they consider such criteria as the types of services provided, the benefits received, and the fairness of
the allocation method
...

Two basic methods exist for allocating service department costs
...
The direct method allocates costs of each of the service departments to each operating
department based on each department's share of the allocation base
...
For example, if Service Department A uses some of Service Department B's services, these services would
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...
Because these services are not allocated to other service departments,
some accountants believe the direct method is not accurate
...
This method allocates service
costs to the operating departments and other service departments in a sequential process
...
After this department's
costs have been allocated, the service department with the next highest costs has its costs allocated, and so forth
until the service department with the lowest costs has had its costs allocated
...

To illustrate the direct method and the step method, we use the following data:
Service
Maintenance
Costs
$ 8,000
Machine-hours used 1,000
Number of employees 100

Department
Operating
Administration 1
$ 4,000
$ 32,000
2,000
1,500
200
250

Departments
2
$ 36,000
2,500
150

The costs of the maintenance department are allocated based on the machine-hours used
...

Using the preceding data, an example of the direct method follows:
Service

Departments

Operating

Departments

Maintenance

Administration 1

2

Costs

$ 8,000

$ 4,000

$ 32,000

$ 36,000

Allocation of
maintenance
department's costs*

(8,000)

3,000

5,000

(4,000)

2,500

1,500

$ -0Allocation of
administration
department's costs†

$ -0-

$ 37,500

$ 42,500

* Department 1's
2,500/4,000
...


fraction is

250/400;

Department

2's fraction is

Using the same data, an example of the step method follows:
Service

Departments

Operating

Departments

Maintenance Administration 1

2

Costs

$ 8,000

$ 4,000

$ 32,000

$ 36,000

Allocation of
maintenance
department's costs*

(8,000)

2,667

2,000

3,333

(6,667)

4,167

2,500

$ -0-

$ 38,167

$ 41,833

$ -0Allocation of
administration
department's costs†

* Administration 1's
1,500/6,000;

fraction is
Department

2,000/6,000;
2's fraction:

Department 1's fraction:
2,500/6,000
...


fraction:

250/400;

Department

Accounting Principles: A Business Perspective

2's fraction is

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...
Also, to eliminate the
administration department's costs, under the step method those costs allocated to the administration department
from the maintenance department must be allocated to the operating departments as part of the total
administration department's cost
...
Prepare a statement showing the contribution margin, contribution to indirect expenses for each segment,
and the total income for Alan Company
...
Determine the return on investment for each segment and then for the entire company
...
Comment on the results of (a) and (b)
...

Alan Company
Income statement showing segmental contribution to indirect expenses
For the year ended 2009 December 31
Segment 1
Segment 2
Total
Sales
$ 90,000
$ 135,000
$ 225,000
Less: Variable expenses
63,000
81,000
144,000
Contribution margin
$ 27,000
$ 54,000
$ 81,000
Less: Direct fixed expenses
9,000
25,2000
34,200
Contribution to indirect expenses
$ 18,000
$ 28,800
$ 46,800
Less: Indirect fixed expenses
12,600
Net income
$ 34,200

b
...

ROI =

2
...
67%
USD 108,000

ROI=

Net operating income
=
Operating assets

ROI =

Segment 2
USD 28,800 =
USD 180,000

16%

USD34,200
=10
...
In part (a), Segment 2 showed a higher contribution to indirect expenses
...
The difference between these calculations shows that when a segment is evaluated as a
profit center, the center with the highest investment base usually shows the best results
...
The computations in (b) also demonstrate that the return on investment for the company as a whole
will be lower than that of each segment because of the increased investment base
...

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...

Contribution margin format An income statement format that shows the contribution margin (Sales Variable expenses) for a segment
...

Controllable profits of a segment Profit of a segment when expenses under a manager's control are
deducted from revenues under that manager's control
...

Current replacement cost The cost of replacing the present assets with similar assets in the same
condition as those now in use
...

Direct cost (expense) A cost that is specifically traceable to a given cost object
...
Examples include the accounting department and the maintenance department
...

Investment center A responsibility center having revenues, expenses, and an appropriate investment base
...

Margin (as used in ROI) The percentage relationship of income (or profits) to sales
...

Original cost less accumulated depreciation The book value of an asset—the amount paid less total
depreciation taken
...

Residual income (RI), Economic Value Added The amount of income a segment has in excess of the
investment base times the cost of capital percentage
...

Responsibility accounting Refers to an accounting system that collects, summarizes, and reports
accounting data relating to the responsibility of the individual managers
...

Responsibility center A segment of an organization for which a particular executive is responsible
...

Income
Income
Sales
Return on investment =
×
Or
Investment
Sales
Investment
Segment A fairly autonomous unit or division of a company defined according to function or product line
...

Suboptimization A situation when a segment manager takes an action in the segment's best interest but
not in the best interest of the company as a whole
...

Turnover (as used in ROI) The number of dollars of sales generated by each dollar of investment
...

Self-test
True-false
Indicate whether each of the following statements is true or false
...
Responsibility accounting: Segmental analysis
Items that a manager has direct control over are included in responsibility accounting reports for that
management level
...

The salary of a segment manager would be considered a direct cost as well as an uncontrollable cost to that
segment
...

When calculating RI for a segment, the income and investment definitions are income controlled by a manager,
and assets directly used by and identified with the segment
...

The investment base used when determining the ROI calculation could be which of the following?
a
...

b
...

c
...

d
...

Which of the following actions would increase ROI?
a
...

b
...

c
...

d
...

Calculate ROI using the expanded form (margin times turnover) from the following data:
Sales
Investment
Income

$1,000,000
500,000
50,000

a
...

b
...

c
...

d
...

In evaluating the performance of a segment or manager, comparisons should be made with:
a
...

b
...

c
...

d
...

Calculate the ROI and RI for each of the following segments and determine if a segment should be dropped
based on RI
...
9 per cent, 20 per cent, 20 per cent

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...

b
...

c
...

d
...

Now turn to “Answers to self-test” at the back of the chapter to check your answers
...


➢

How soon should accounting reports be prepared after the end of the performance measurement
period? Explain
...


➢

Describe a segment of a business enterprise that is best treated as an expense center
...


➢

Compare and contrast an expense center and an investment center
...


➢

Differentiate between a direct cost and an indirect cost of a segment
...


➢

Describe some of the methods by which indirect expenses are allocated to a segment
...
What are its two components?

➢

Give the three sets of definitions for income and investment that can be used in ROI calculations,
and explain when each set is applicable
...

Discuss some of the advantages and disadvantages of these methods
...
Responsibility accounting: Segmental analysis
➢

If the RI for segment manager A is USD 50,000 while the RI for segment manager B is USD
100,000, does this necessarily mean that B is a better manager than A? Explain
...
Which of the
company's geographic regions performed better? Explain
...


Exercises
Exercise A The following information refers to the inspection department of a chemical packaging plant for
September:
Amount
$ 54,000
270,000
108,000
32,400

Supplies
Repairs and maintenance
Overtime paid to inspectors
Salary of inspection department
manager
Salary of plant manager
43,200
Allocation of company accounting
32,400
costs
Allocation of building depreciation to 21,600
the inspection department

Over or
(Under) Budget
$ (10,800)
21,600
10,800
(5,400)
-010,800
(5,400)

Using this information, prepare a responsibility report for the manager of the inspection department for
September
...

Exercise B Present the following information for the Hardware Division of ABC Computer Company,
Sales
Variable selling and administrative
expenses
Fixed direct manufacturing expenses
Fixed indirect manufacturing expenses
Variable manufacturing expenses
Fixed direct selling and administrative
expenses
Fixed indirect selling and administrative
expenses

$ 1,400,000
100,000
35,000
56,000
400,000
175,000
28,000

Exercise C Given the following data, prepare a schedule that shows contribution margin, contribution to
indirect expenses, and net income of the Sharks Division of Hockey, Inc
...
A decision is made to allocate the pool of USD 25,000 of administrative overhead
expenses of the home office to the segments, using net sales as the basis for allocation
...
How much of the USD 25,000 should be allocated to each segment?
b
...
0 License
with the segment
Sales

3,360,000

6,720,000

a
...

b
...

Exercise F Calculate the new margin, turnover, and return on investment of the Mountain Bike segment for
each of the following changes
...

a
...
Sales and assets were unaffected
...
Assets used by the segment were reduced by USD 540,000, while income and sales were unaffected
...
An advertising campaign increased sales by USD 336,000 and income by USD 50,000
...

Exercise G The following data are available for Segment A of ABC Company:
Net income of the segment
Contribution to indirect expenses
Controllable income by manager
Assets directly used by the manager
Assets under the control of the segment
manager

$ 50,000
40,000
48,000
360,000
240,000

Determine the return on investment for evaluating (a) the income performance of the manager of Segment A
and (b) the rate of income contribution of the segment
...
Data concerning income and investment
follow:
Air
Land
Sea
Contribution to indirect expenses
$ 43,200 $ 86,400 $ 115,200
Assets directly used by and identified 288,000 576,000 1,296,000
with the segment

Assuming that the cost of capital on investment is 12 per cent, calculate the residual income of each of the
segments
...
The company is organized according to functions:
Plant
Vice
President
President
Manager
Of
Manufacturing
Controllable Budget Actual Budget Actual
Budget Actual
expenses
Office expense $ 7,200 $ 9,600 $
$ 16,800
$ 24,000 $
12,000
16,800
Printing
19,200 16,800
Paging
2,400
2,160
Binding
4,800
4,800
Purchasing
24,000 26,400
Receiving
12,000 14,400
Inspection
19,200 16,800
Vice president
192,000 168,000
of marketing
Controller
144,000 120,000
Treasurer
96,000
72,000
Vice president
48,000
72,000
of personnel

Prepare the responsibility accounting reports for the three levels of management—plant manager, vice president
of manufacturing, and president
...
Responsibility accounting: Segmental analysis
Problem B Joey Bauer Corporation has production plants in Sacramento, Dallas, and Seattle
...
If the plants are treated as profit centers, which plant manager appears to have done the best job?
b
...
)
c
...
Allocations
are based on the following selected expense account balances and additional data:
Expenses (allocation bases)
Home office building expense (net sales)
Buying expense (net purchases)
Uncollectible accounts (net sales)
Depreciation of home office equipment (net sales)
Advertising expense (indirect, allocated on basis of relative amounts of
direct advertising)
Insurance expense (relative amounts of equipment plus average inventory
in department)
Segment A

Segment B

$ 243,200

$ 76,800

$ 320,000

Sales (net)

512,000

128,000

640,000

Equipment (cost)

96,000

64,000

160,000

Advertising (cost)

25,600

12,800

38,400

Average inventory

160,000

64,000

23,040

Total

Purchases (net)

$ 76,800
67,200
8,000
21,120
86,400

224,000

a
...

b
...

Problem D Allentown, Inc
...
Its revenues and expenses for 2009
follow:
Net sales
Direct expenses:*
Cost of goods sold
Selling
Administrative:
Uncollectible accounts
Insurance
Interest
Indirect expenses (all
fixed):
Selling
Administrative
* All the direct expenses
are variable except
insurance and interest,
which are fixed
...
Prepare a schedule showing the contribution margin, the contribution to indirect expenses of each segment,
and net income for the company as a whole
...


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...
Assume that indirect selling expenses are to be allocated on the basis of net sales and that indirect
administrative expenses are to be allocated on the basis of direct administrative expenses
...

c
...

Problem E The following data pertain to the operating revenues and expenses for Golden State Company for
2009:
Sales
Variable expenses
Direct fixed expenses
Indirect fixed expenses

Los Angeles
(LA) Segment
$ 180,000
96,000
24,000

San Francisco
(SF) Segment
$ 360,000
240,000
30,000

Total
$ 540,000
336,000
54,000
72,000

Regarding the company's total operating assets of USD 900,000, the following facts exist:
Los Angeles San
Segment
Francisco
Segment
Assets directly used by and identified$ 180,000
$ 360,000
with the segment

a
...

b
...

c
...

Problem F Shaq Company operates with three segments, Louisiana, Orlando, and LA
...
Calculate the return on investment for each segment
...

b
...
Calculate residual income for each segment
...

c
...
Rank them from highest to lowest
...
Comment on the rankings achieved
...
Determine the margin, turnover, and return on investment for the segment in 2009
...
Determine the effect on margin, turnover, and return on investment of the segment in 2010 if each of the
following changes were to occur
...


Accounting Principles: A Business Perspective

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...
As a result, investment decreased by USD 900,000, and expenses
decreased by USD 72,000
...

An investment was made in productive assets costing USD 900,000
...

Problem H For the year ended 2009 December 31, Fore Company reported the following information for the
company as a whole and for the sports segment of Fore Corporation:

Sales
Income
Investment

Fore
company
$ 12,000,000
1,125,000
4,500,000

Sports
Woods
Project
$ 1,350,000
300,000
900,000

Segment
Irons
Project
$ 600,000
37,500
105,000

Total
$ 1,950,000
337,500
1,005,000

Fore Company anticipates that these relationships (return on investment, margin, and turnover) will hold true
for the upcoming year
...
Determine the return on investment for Fore Company, for the sports segment, and for the Woods and Irons
projects separately for the year ended 2009 December 31
...
Using this information, determine the effect of adding the Putters project on the sports segment's return on
investment
...
What is the effect on
the sport segment's residual income if the Putter project is added? How does this result compare with your answer
to the previous problem?
Alternate problems
Alternate problem A Swiss Corporation has three production plants (X, Y, and Z)
...
If the plants are treated as profit centers, which plant manager appears to have done the best job?
b
...
)
c
...
, allocates expenses and revenues to the two segments that it operates
...

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...

Revenue and Expenses (allocation bases)
Revolving charge service revenue (net sales)
$ 600,000
Home office building occupancy expense (net sales) 45,000
Buying expenses (net purchases)
150,000
General administrative expenses (number of
75,000
employees in
department)
Insurance expense (relative average inventory plus 18,000
cost
of equipment and fixtures in each department)
Depreciation expense on home office equipment (net 30,000
sales)
High Risk Low Risk Total
Segment Segment
Number of employees
3
7
10
Net sales
$ 300,000 $ 600,000 $ 900,000
Net purchases
240,000
360,000 600,000
Averaging inventory
60,000
120,000 180,000
Cost of equipment fixtures 90,000
180,000 270,000

a
...

b
...
, operates two segments, interior and exterior
...


a
...
Do not allocate indirect expenses to the segments
...
Assume that indirect selling expenses are to be allocated to segments on the basis of net sales (round to the
nearest per cent) and that indirect administrative expenses are to be allocated on the basis of direct administrative
expenses
...

c
...

Alternate problem D Elliott Corporation has three segments
...
Responsibility accounting: Segmental analysis
Segment A
Assets directly used by and $ 50,400,000
identified with the segment

Segment B Segment C
$ 28,800,000 $ 14,400,000

a
...

b
...

c
...

Alternative problem E Goodwin Company has three segments, 1,2, and 3
...
Calculate the return on investment for each segment
...

b
...
Calculate the residual income for each segment
...

c
...
Rank the segments from highest to lowest
...
Comment on the rankings achieved
...
Because the company's business is
seasonal, between August and December skilled manufacturing employees are laid off
...
Instead, she suggested that they
work in general labor from August to December but still be paid their manufacturing wages of USD 10 per hour
...
60 per hour
...
Sarah Richards is in charge of the construction
department
...
Piero Company does not do its own foundation work
...

To start the development of a 500-home community, Larue hired Dire Company to build the foundations for the
homes
...
Consequently, construction was
delayed six weeks while Larue hired a new subcontractor
...
The annual
budget for Silva's department is as follows:
Annual budget for Department 103
Small tools
Set up
Direct labor
Direct materials
Supplies
Supervision
Property taxes

$ 6,750
7,500
8,250
15,000
3,750
22,500
3,750

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...
The remaining USD 7,500 in supervision is the salary of
the assistant supervisor directly responsible to Silva
...

Broader perspective – Writing experience D Refer to "A broader perspective: Employee buyouts"
...

Group project E Macrofast Software, Inc
...
Macrofast's top
management feels considerable pressure from the company's stockholders to increase earnings
...

Washington could think of only one way to increase earnings by the end of the year
...

For each of those jobs, he asked the customers to sign a Completed Installation document stating the job was
completed to the customer's satisfaction
...

Several customers signed Completed Installation documents even though the jobs were not complete because
Washington gave them a personally signed letter stating the Completion Installation document was not legally
binding
...
Revenues were prematurely recorded for these jobs, sales and earnings for the year
were up, Macrofast's top management was delighted with the results, and Washington was rewarded with a large
bonus and a promotion to a vice presidency at corporate headquarters
...
When the accountant produced the customer's Completed
Installation document, the customer produced Washington's letter saying the document was not binding
...
When she presented the results to her supervisor,
the supervisor said, "This practice is unfortunate and is against company policy
...
Do not
worry about last year's financial statements
...
"
a
...

b
...

c
...
The heading of the memo
should contain the date, to whom it is written, from whom, and the subject matter
...
, found that its market share was slipping
...
Nonetheless, there were frequent
customer complaints, with resulting loss of business
...
What would you suggest Bleak Prospects' management do to improve the situation? In groups of two
or three students, write a memorandum to your instructor addressing this question
...


Accounting Principles: A Business Perspective

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...
The division can
either rent or buy a certain asset
...
The heading of the memorandum should contain the date, to whom it is written, from whom, and the
subject matter
...

http://www
...
com
Go to the company's most recent annual report
...
(You will find business segment information in the
notes to the financial statements
...
Be sure to submit a copy of PepsiCo's business segment information from the annual report
...

http://www
...
com
Go to the company's most recent annual report
...
) Use end-of-year "identifiable assets" to measure
investment, "operating profits" to measure income, and "net sales" to measure sales
...

Answers to self-test
True-false
True
...

True
...

True
...
(The salary
would be controllable by someone higher in the organization
...
Segments should be evaluated using their revenues and direct expenses
...
The income and investment definitions when calculating RI for a segment are contribution to indirect
expenses and assets directly used by and identified with the segment
...
Any of these bases—current replacement cost, original cost, or original cost less accumulated depreciation—
could be used
...
ROI would increase if operating expenses were reduced, all other things remaining constant
...

ROI=

Income
Sales
×
Sales
Investment

ROI=

50,000
1,000,000
×
1,000,000 500,000
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...
05×2
ROI = 10 per cent
d
...

c
...


Accounting Principles: A Business Perspective

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...
Capital budgeting:Longrange planning
Learning objectives
After studying this chapter, you should be able to:
• Define capital budgeting, explain budgeting and explain the effects of making poor capital-budgeting

decisions
...

• Evaluate projects using the payback period
...

• Evaluate projects using the net present value
...

• Evaluate projects using the time-adjusting rate of return
...


In your personal life, you make many short-run decisions, such as where to go on vacation this year, and many
long-run decisions, such as whether to buy a home
...
Businesses also face short-run and long-run decisions
...
Accountants also play an important role in advising management on
long-range decisions that will benefit the company for many years, such as investing in new buildings and
equipment
...
Incorrect long-run
decisions can threaten the survival of a company
...
Planning for these investments is referred to as capital budgeting
...
Then, it discusses and illustrates four
methods for selecting the best alternatives among capital projects
...
Finally, the chapter stresses the importance of the postaudit review of capital project decisions
...
A
capital project is any available alternative to purchase, build, lease, or renovate buildings, equipment, or other
long-range major items of property
...
Once a company builds a plant or undertakes
some other capital expenditure, its future plans are less flexible
...
Capital budgeting:Long-range planning
Poor capital-budgeting decisions can be costly because of the large sums of money and relatively long periods
involved
...
In addition, other actions taken within the
company regarding the project, such as finding suppliers of raw materials, are wasted if the capital-budgeting
decision must be revoked
...

Investment of funds in a poor alternative can create other problems as well
...
Many of the fixed costs still remain
even if a plant is closed or not producing
...

On the other hand, failure to invest enough funds in a good project also can be costly
...
At the time of the original capital-budgeting decision, if Ford had correctly
estimated the Mustang's popularity, the company would have expended more funds on the project
...

Finally, the amount of funds available for investment is limited
...
The benefits or returns lost by
rejecting the best alternative investment are the opportunity cost of a given project
...
Capital expenditures
do not occur as often as ordinary expenditures such as payroll or inventory purchases but involve substantial sums
of money that are then committed for a long period
...


Project selection: A general view
Making capital-budgeting decisions involves analyzing cash inflows and outflows
...
Because money has a time value, these benefits
and costs are adjusted for time under the last two methods covered in the chapter
...
This principle is known as the time value of money
...
For example, USD 100 today is worth more than USD 100 to be received
one year from today because the USD 100 received today, once invested, grows to some amount greater than USD
100 in one year
...
If you need to review these concepts, refer back to the appendix to
Chapter 15, which covers these concepts
...

The net cash inflow is the difference between the periodic cash inflows and the periodic cash outflows for a
proposed project
...
The equipment is expected (1) to have a useful life of 15 years and no salvage value, and (2) to

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...
Ignoring
depreciation and taxes, the annual net cash inflow is computed as follows:
Cash inflows

$75,000
...
Although depreciation does not involve a cash outflow, it is deductible in arriving at federal taxable
income
...
This reduction is a tax
savings made possible by a depreciation tax shield
...
For example, if depreciation is USD 8,000, the tax shield is USD 8,000
...
Straight-line depreciation can be elected for tax purposes, even under the new tax law
...
The amount of the tax savings can be found by multiplying the tax rate by
the amount of the depreciation tax shield
...

Now, considering taxes and depreciation, we compute the annual net cash inflow from the USD 120,000 of
equipment as follows:
Change in net Change in cash flow
income
Cash inflows

$ 75,000

$75,000

Cash outflows

50,000

50,000

Net cash inflow before taxes

$25,000

$25,000

Depreciation

8,000

Income before income taxes

$17,000

Deduct: Income at 40%

6,800

Net income after taxes

$10,200

Net cash inflow (after taxes)

6,800

$18,200

If there were no depreciation tax shield, federal income tax expense would have been USD 10,000, or (USD
25,000 x 40 per cent), and the net after-tax cash inflow from the investment would have been USD 15,000, found
by (USD 25,000 - USD 10,000), or [USD 25,000 x (1 - 40 per cent)]
...
Therefore, the following
formula also can be used to determine the after-tax net cash inflow from an investment:
Net cash inflow after taxes= [Net cash inflow before taxes X (1 – Tax rate)] + [Depreciation expense X Tax rate]
v
v
Net cash inflow after taxes (ignoring
Tax savings attributable To depreciation tax
depreciation)
shield

=

USD 25,000×1−
...
4=USD 18,200

Accounting Principles: A Business Perspective

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26
...

Such replacement decisions often occur when faster and more efficient machinery and equipment appear on the
market
...
To illustrate, assume that a company operates two machines purchased four years ago at a cost of USD
18,000 each
...
Each machine will
produce 40,000 units of product per year
...
) for the two
machines together total USD 14,000
...
The new machine can be acquired for USD 28,000 and has an estimated useful life of eight years (with no
salvage value)
...
The USD 4,000 reduction in operating expenses (USD 14,000 - USD 10,000) is a USD 4,000 increase
in net cash inflow (savings) before taxes
...
In addition to this initial outlay, the
annual net cash inflow from replacement is computed as follows:
Net cash inflow after taxes=Annual net cash inflows savings before taxes×1 – tax rateAdditional annual depreciation expense×Tax rate

Using these data, the following display shows how you can use this formula to find the net cash flow after taxes:
Annual cash operating expenses:
Old machines

$ 14,000

New machines

10,000

Annual net cash inflow (savings) before
taxes

$ 4,000

1 – Tax rate

X 60%

Annual net cash inflow (savings)* after
taxes ignoring depreciation (1)

$ 2,400

Annual depreciation expense:
Old machines

$ 3,000

New machine

3,500

Additional annual depreciation expense

$ 500

Tax rate

X 40%

Tax savings from additional depreciation (2)

200

Net cash inflow after taxes (1) + (2)

$ 2,600

*Cash savings are considered to be cash inflows
...
4 USD500×
...
Two other
items also are relevant to the decision
...
Second, the two old machines can probably be sold, and the selling price or salvage
value of the old machines creates a cash inflow in the period of disposal
...
If the modified Accelerated Cost Recovery System (modified ACRS) had been used, the tax shield
would have been larger in the early years and smaller in the later years of the asset's life
...
0 License
Out-of-pocket and sunk costs A distinction between out-of-pocket costs and sunk costs needs to be made for
capital budgeting decisions
...

Out-of-pocket costs can be avoided or changed in amount
...

Sunk costs are costs already incurred
...
The price paid for a machine becomes a sunk cost the minute the purchase has
been made (before that moment it was an out-of-pocket cost)
...
Thus, depreciation is a sunk cost because it represents a
past cash outlay
...

A sunk cost is a past cost, while an out-of-pocket cost is a future cost
...
Sunk costs are not relevant, except for any effect they have
on the cash outflow for taxes
...
If an investment has a salvage value, that
value is a cash inflow in the year of the asset's disposal
...
Certainly, any acceptable proposal
should offer a return that exceeds the cost of the funds used to finance it
...
For convenience, most current
liabilities, such as accounts payable and federal income taxes payable, are treated as being without cost
...
The subject of determining the cost of capital is a
controversial topic in the literature of accounting and finance and is not discussed here
...
Next, we describe several techniques for deciding whether to invest in capital
projects
...
In effect, the payback period answers the question: How long will it take the capital
project to recover, or pay back, the initial investment? If the net cash inflows each year are a constant amount, the
formula for the payback period is:
Payback period=

Initial cash outlay
Annual net cash inflow benefit

For the two assets discussed in the previous section, you can compute the payback period as follows
...
6 years, computed as follows:
Payback period =

USD 120,000
=6
...
8 years, computed as follows:
Payback period = USD 28,000/USD 2,600 = 10
...
The replacement
machine being considered has a payback period of 10
...
Therefore, because the
Accounting Principles: A Business Perspective

982

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...

In each of the previous examples, the projected net cash inflow per year was uniform
...

Neil Company is considering a capital investment project that costs USD 40,000 and is expected to last 10 years
...

When using payback period analysis to evaluate investment proposals, management may choose one of these
rules to decide on project selection:
• Select the investments with the shortest payback periods
...


Both decision rules focus on the rapid return of invested capital
...

Some managers use payback period analysis in capital budgeting decisions due to its simplicity
...
For example, assume Allen

Company is considering two alternative investments; each requires an initial outlay of USD 30,000
...
The
payback period for Y is five years (USD 30,000/USD 6,000) and for Z is six years (USD 30,000/USD 5,000)
...
This is because Z returns a total of USD 40,000, while Y simply recovers the initial
USD 30,000 outlay
...
For example, assume the following net cash inflows

are expected in the first three years from two capital projects:
Net Cash Inflows
Project A
First year

Project B

$ 15,000

$ 9,000

983

This book is licensed under a Creative Commons Attribution 3
...
If the cost of each
project is USD 36,000, each has a payback period of three years
...
Because larger amounts of cash
are received earlier under Project A, it is the preferable project
...
To compute the unadjusted rate of return, divide the average annual income
after taxes by the average amount of investment in the project
...
If the ending balance is zero (as we assume), the average investment equals the original cash
investment divided by 2
...
54
To illustrate the use of the unadjusted rate of return, assume Thomas Company is considering two capital
project proposals, each having a useful life of three years
...
Information relating to the projects follows:
Average annual Before-tax

Average

Proposal

Initial cost

Salvage Value

Net cash inflow

Annual depreciation

1

$ 76,000

$ 4,000

$ 45,000

$ 24,000

2

95,000

5,000

55,000

30,000

Assuming a 40 per cent tax rate, Thomas Company can determine the unadjusted rate of return for each project
as follows:
Proposal 1

Proposal 2

$ 40,000

$ 50,000

Annual net cash inflow (before income taxes)

$ 45,000

$ 55,000

Annual depreciation

24,000

30,000

Annual income (before income taxes)

$ 21,000

$ 25,000

Average investment: (original outlay + Salvage
value)/2

(1)

54 Some formulas use the initial investment in the denominator instead of the average investment
...

51 These general comments about the use of averages in a ratio apply to the other ratios involving averages
discussed in this chapter
...
15, "Reporting Earnings per Share" (New York: AICPA, 1969), par
...

FASB Statement No
...

55 "Texas Instruments: Cost of Quality (A)" (Boston: Harvard Business School, Case 9-189-029)
...
Capital budgeting:Long-range planning
Deduct: Income taxes at 40%

8,400
(2)

Rate of return (2)/(1)

$ 12,600

$ 15,000

31
...

Also, the company could compute the unadjusted rate of return with the following formula:
Rate of return =

Average annual before−tax net cash inflow – Averageannual depreciation×1 – Tax rate
Averageinvestment

For Proposal 1, the computation is as follows:
Rate of return =

=

USD 45,000 – USD 24,000×1– 0
...
6 USD 12,600
=
=30 per cent
USD 40,000
USD 50,000

For Proposal 2, the computation is as follows:
Rate of return=

=

USD55,000 – USD 30,000 ×1−0
...
6 USD 15,000
=
=30 per cent
USD 50,000
USD 50,000

Sometimes companies receive information on the average annual after-tax net cash inflow
...
Given this information, the firms
could deduct the depreciation to arrive at average net income
...

• The rate allows a sunk cost, depreciation, to enter into the calculation
...

• The timing of cash flows is not considered
...


Unlike the two project selection methods just illustrated, the remaining two methods—net present value and
time-adjusted rate of return—take into account the time value of money in the analysis
...
Often used in capital budgeting analysis, this
assumption makes the calculation of present values less complicated than if we assume the cash flows occurred at
some other time
...
Then you learn how to use the
profitability index to evaluate projects costing different amounts
...

985

This book is licensed under a Creative Commons Attribution 3
...
The net present value of the proposed investment is the difference between the present value of the annual
net cash inflows and the present value of the required cash outflows
...
Therefore, in such projects, a company may compute the net present
value of the proposed project as the present value of the annual net cash inflows minus the initial investment
...
In those cases, the company must discount the cash outflows to their present value before comparing them
to the present value of the net cash inflows
...
Management requires some
minimum rate of return on its investments
...
Therefore, under the net present value method, management often selects a target rate that it
believes to be at or above the company's cost of capital, and then uses that rate as a basis for present value
calculations
...
Morris expects net cash inflows after taxes for the next four years to be USD 8,000, USD
7,500, USD 8,000, and USD 7,500, respectively
...
The following analysis uses the tables in the Appendix at the end of this
text:
Annual net

Present value of

Total

Cash inflow (after taxes) $ 1 at 14% (from table
A
...
87719

$ 7,018

Second year

7,500


...
67497

5,400

Fourth year

7,500


...
The net present value for the project is equal to the present value of its net cash inflows
less the present value of its cost (the investment amount), which in this instance is -USD 2,370, calculated as (USD
22,630 - USD 25,000)
...
In general, a proposed capital investment is acceptable if it has a
positive net present value
...
4 in the
Appendix):
USD 10,000× 2
...
Capital budgeting:Long-range planning
This calculation yields a net present value of USD 4,137, or USD 29,137 - USD 25,000
...
However, a competing project may have an even higher net
present value
...
A
profitability index provides this additional information to management
...
The profitability index
formula is:
Profitability index=

Present value of net cash inflows
Initial cash outlay present valueof cash outlays if future outlays are required 

Management should consider only those proposals having a profitability index greater than or equal to 1
...

Proposals with a profitability index of less than 1
...

To illustrate use of the profitability index, assume that a company is considering two alternative capital outlay
proposals that have the following initial costs and expected net cash inflows after taxes:
Proposal X

Proposal Y

$ 7,000

$ 9,500

Year 1

$ 5,000

$ 9,000

Year 2

4,000

6,000

Year 3

6,000

3,000

Initial outlay
Expected net cash inflow (after taxes):

Management's minimum desired rate of return is 20 per cent
...
3 in the Appendix at
the end of this book:
Present value
Proposal X

Proposal Y

Year 1 (net cash inflow in year 1 x 0
...
69444)

2,778

4,167

Year 3 (net cash inflow in year 3 x 0
...
49

$ 13,403 = 1
...
However, the profitability indexes indicate Proposal X is the more desirable investment
because it has the higher profitability index
...
Proposal X earns a higher rate of return on a smaller investment than Proposal Y
...
0 License
Another technique for evaluating capital projects that accounts for the time value of money is the time-adjusted
rate of return method
...


An accounting perspective:
Business insight
Like US managers, Japanese managers incorporate the cost of capital into their capital investment
decisions
...
Discount rates in Japan are generally lower than in the United States
...
It does this by finding the
rate at which the net present value of the project is zero
...
If the proposal's time-adjusted
rate of return is less than the minimum rate, the firm should reject the proposal
...

Calculators and computer software with time-adjusted rate of return functions are readily available
...
To illustrate, assume Young Company is
considering a USD 90,000 investment expected to last 25 years with no salvage value
...
This USD 15,000 is referred to as an annuity, which is a series of equal
cash inflows
...
In this case, the payback
period is six years (USD 90,000/USD 15,000)
...
4 in the Appendix (present
value of an annuity) to find the present value factor that is nearest in amount to the payback period of 6
...
In that row, the factor nearest to 6
is 5
...
5 per cent interest column
...
92745 factor; the result is USD 88,912, which is just below the USD 90,000 cost of the project
...
5 per cent
...
5 per cent but
more than 16 per cent because as interest rates increase, present values decrease because less investment is needed
to generate the same income
...

Caterpillar, Inc
...
5 billion in a worldwide factory modernization program
...


Accounting Principles: A Business Perspective

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...
For example, all of the
new assets used for a new product would be bundled together
...
32]
...

Many firms believe their evaluation of project performance leaves much to be desired
...

Source: Based on the article by James A
...
Bastian, and Thomas L
...
31-35
...
But what happens when net cash
inflows are not uniform? In such instances, a trial and error procedure is necessary if present value tables are used
...
Based on this average net cash inflow, the
payback period is USD 200,000/USD 72,500 = 2
...
Looking in the four-year row of Table A
...
77048 is nearest to the payback period of 2
...
In this case, however, cash flows
are not uniform
...
Since the early returns have the
largest present value, the rate of return is likely to be less than the 16
...
77048
...
5 per cent
...
The rate of return
is found by trial and error
...
89286

$ 17,857

2

40,000

0
...
71178

56,942

4

150,000

0
...
0 License
Since the cost of capital is not a precise percentage, some financial theorists argue that the time-adjusted rate of
return method is preferable to the net present value method
...

No matter which time value of money concept is considered better, these methods are both theoretically
superior to the payback period and the unadjusted rate of return methods
...
In reality, no single method should be used by itself to make capital-budgeting decisions
...
The company commits itself to its investment in a capital project for a long time and should
use the best selection techniques and judgment available
...
The next section
shows how to incorporate this factor into the analysis
...
Decisions about investing in
capital projects require a lot of thinking about the future
...
PC spreadsheets make the preparation of numerous
forecasts (scenarios) feasible, and even fun
...
For example, companies often invest in a capital project expecting to increase
sales
...
The increases in current assets—accounts receivable and inventory—are
investments in working capital that usually are recovered in full at the end of a capital project's life
...

To illustrate, assume that a company is considering a capital project involving a USD 50,000 investment in
machinery and a USD 40,000 investment in working capital
...
The annual cash inflows (before taxes) are estimated at
USD 25,000, with annual cash outflows (before taxes) of USD 5,000
...
Capital budgeting:Long-range planning
1 – Tax rate

X 60%

Net cash inflow after taxes (ignoring depreciation)
(1)

$ 12,000

Depreciation tax shield ($ 50,000/8 years)

$ 6,250

Income tax rate

X 40%

Depreciation tax savings (2)

$ 2,500

Annual net cash inflow, years 1-8 (1) + (2)

$ 14,500

The annual net cash inflow from the machine is USD 14,500 each year for eight years
...
The investment of USD 40,000 in working capital at the start of the project
is an additional outlay that must be made when the project is started
...
At that point, the working capital
would be released, and the USD 40,000 could be used for other investments
...

The net present value of the project is computed as follows (assuming a 14 per cent minimum desired rate of
return):
Net cash inflow, years 1-8 ($ 14,500 x 4
...
35056)

14,022

Present value of net cash inflows

$ 81,285

Initial cash outlay ($ 50,000 + $ 40,000)

90,000

Net present value

$ (8,715)

The discount factor for the cash inflows, 4
...
4 in the Appendix at the end of the book,
because the cash inflows in this example are a series of equal payments—an annuity
...
As such, it is
discounted using a factor (0
...
3 in the Appendix
...
If the working capital investment
had been ignored, the proposal would have had a rather large positive net present value of USD 17,263 (USD 67,263
- USD 50,000)
...

The next topic discussed in the chapter is the postaudit
...


The postaudit
The last step in the capital-budgeting process is a postaudit review that should be performed by a person not
involved in the capital-budgeting decision-making process
...
This step should be performed early in the project's life, but enough time should have passed
for any operational bugs to have been worked out
...
The postaudit review
performs these functions:
• Let management know if the projections were accurate and if the particular project is performing as

expected regarding cash inflows and outflows
...
0 License
• May identify additional factors for management to consider in upcoming capital-budgeting decisions, such

as cash outflows that were forgotten in a particular project
...


The postaudit provides information that allows management to compare the actual results of decisions with
the expectations it had during the planning and selection phases of the capital-budgeting process
...
A US auto manufacturer, for
example, found it difficult to justify investing in a new computer-based flexible manufacturing system because its
cost savings occurred so far in the future
...
The president of the company was convinced, however, that the new system had benefits not
quantified in the cash flow estimates, so he approved the investment even though it had a negative net present
value
...
First, often
several years pass before companies see the cash inflows from the investment
...

Second, management has difficulty identifying and measuring all of the benefits of new technology
...
These benefits occurred because people used computers and experimented with
them
...
Managers believe that sometimes they just have to have faith that the
investment is a good one, even though they cannot justify it on quantifiable economic grounds
...
Since these organizations are not subject to as many taxes as profitmaking organizations, the cash flows related to taxes are usually zero or near zero
...
Thank you for using our textbook
...
Good luck!
Understanding the learning objectives
• Capital budgeting is the process of considering alternative capital projects and selecting those alternatives

that provide the most profitable return on available funds, within the framework of company goals and
objectives
...

• Asset addition:

Net cash inflow after taxes=Net cash inflow before taxes×1 – Tax rateDepreciation expense×Tax rate
• Asset replacement:
Net cash inflow after taxes=Annual net cash inflows savings before taxes×1 – Tax rate Additional annual depreciation expense×Tax rate

Accounting Principles: A Business Perspective

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26
...
The net present value
of the proposed investment is the difference between the present value of the annual net cash in flows and the
present value of the required cash outflows
•

Profitability index=

Present value of net cash inflows
Initial cash outlay  present value of cash outlays if future outlays are required 

• The time-adjusted rate of return equates the present value of expected after-tax net cash inflows from an

investment with the cost of the investment by finding the rate at which the net present value of the project is
zero
...
If the rate is less than the minimum rate, the project should be rejected
...
Therefore, the required return of a project must be higher to account for the
investment in working capital
...
Use straight-line depreciation
...
The salvage value of each investment is zero
...

Rank these proposals using the following selection techniques:
a
...

b
...

c
...

d
...

Solution to demonstration problem
a
...
00

B

60,000

8,800

6
...
14

993

This book is licensed under a Creative Commons Attribution 3
...
Unadjusted rate of return:
(a)

(b)

(c)

(d)=[(b – c) x (1 -
...

c
...
21612

$ 52,161

$ 50,000

1
...
14217

54,051

60,000

0
...
62313

69,543

75,000

0
...
However, the amount can also be calculated as follows:

Expected before-tax net cash inflow

$ 13,333

Less depreciation

5,000

Taxable income

$ 8,333

1 – Tax rate

X 60%

After-tax annual income

$ 5,000

Add back depreciation

5,000

Annual after-tax net cash inflow

$ 10,000

The proposals in order of desirability are A, C, and B
...
)
d
...
82 in 15 period row

C

13% (slightly below)

($ 75,000/$ 10,500) = Factor of 7
...
(But neither B nor C earns the minimum rate of return
...

Capital budgeting The process of considering alternative capital projects and selecting those alternatives
that provide the most profitable return on available funds, within the framework of company goals and
objectives
...

Cost of capital The cost of all sources of capital (debt and equity) employed by a company
...


Accounting Principles: A Business Perspective

994

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...

Net present value A project selection technique that discounts all expected after-tax cash inflows and
outflows from the proposed investment to their present values using the company's minimum rate of return
as a discount rate
...

Opportunity cost The benefits or returns lost by rejecting the best alternative investment
...

Payback period The period of time it takes for the cumulative sum of the annual net cash inflows from a
project to equal the initial net cash outlay
...

Sunk costs Costs that have already been incurred
...

Tax shield The total amount by which taxable income is reduced due to the deductability of an item
...

Unadjusted rate of return The rate of return computed by dividing average annual income after taxes
from a project by the average amount of the investment
...

Self-test
True-false
Indicate whether each of the following is true or false
...

The price a company is going to pay for a machine is an out-of-pocket cost
...

A formula for unadjusted rate of return is as follows:
Unadjusted rate of return = Average annual income after taxes/Average amount of investment
When investment projects cost different amounts are being compared, the net present value does not provide a
valid means by which to rank projects in order of contribution to income or desirability assuming limited financial
resources
...

Which of the following is incorrect regarding the payback period method?
a
...

b
...

c
...
Payback analysis ignores the time value of money
...
Employee morale
...
No single time value of money method should be used by itself to make capital budgeting decisions
...
0 License
c
...

d
...

Which of the following correctly describe(s) the limitations when using the unadjusted rate of return
...
Timing of cash flows is not considered
...
It allows a sunk cost, depreciation, to enter into the calculation
...
The length of time over which the return will be earned is not considered
...
All of the above
...
Only proposals with profitability indexes greater than 1
...

b
...
00 should be considered
...
The profitability index is the ratio of the initial cash outlay divided by the present value of cash benefits
(before taxes)
...
b and c
...
When determining an appropriate discount rate, management uses net cash outflow
...
With projects that require an investment at a later date, management must discount the cash outflow to its
present value before it is compared to the present value of cash inflows
...
When using the net present value to screen alternative projects, as long as the project's net present value is
equal to the investment the project is desirable
...
b and c
...
The first step in computing the rate of return is determining the payback period
...
The annual after-tax net cash inflow also is called an annuity
...
The cost of capital is used only as a cutoff point in deciding which projects should be considered further
...
All of the above
...


Questions
➢

How do capital expenditures differ from ordinary expenditures?

➢

What effects can capital-budgeting decisions have on a company?

➢

What effect does depreciation have on cash flow?

➢

Give an example of an out-of-pocket cost and a sunk cost by describing a situation in which both are
encountered
...
The salesperson attempting to sell the machine says that
it will pay for itself in five years
...


➢

What is the profitability index, and of what value is it?

➢

What is the time-adjusted rate of return on a capital investment?

➢

What role does the cost of capital play in the time-adjusted rate of return method and in the net
present value method?

Accounting Principles: A Business Perspective

996

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...
In just a few words, what would you tell your friend to think about in making this
decision?

Exercises
Exercise A Diane Manufacturing Company is considering investing USD 600,000 in new equipment with an
estimated useful life of 10 years and no salvage value
...
The company uses straight-line depreciation, and has a 40 per
cent tax rate
...

Exercise B Zen Manufacturing Company is considering replacing a four-year-old machine with a new,
advanced model
...
The new machine would cost USD 45,000, but
annual maintenance costs would be only USD 6,000
...
Using straight-line depreciation and an assumed 40 per cent tax rate, compute the
additional annual cash inflow if the old machine is replaced
...

Old machine

New machine

Depreciation

$ 18,000

$ 42,000

Labor

72,000

63,000

Repairs

21,000

4,500

Other costs

12,000

3,600

$ 123,000

$ 113,100

Exercise D Jefferson Company is considering investing USD 33,000 in a new machine
...
Annual before-tax net cash inflow from the
machine is expected to be USD 7,000
...
The income tax rate is 40 per cent
...
Based on the profitability indexes, which proposal is better?
Proposal 1

Proposal 2

$ 16,000

$ 10,300

First year

10,000

6,000

Second year

9,000

6,000

Third year

6,000

4,000

Fourth year

-0-

2,500

Initial cash outlay
Net cash inflow (after taxes):

Exercise F Ross Company is considering three alternative investment proposals
...


Initial outlay
Net cash inflow (after taxes):
First year
Second year

A
$ 360,000

Proposal
B
$ 360,000

C
$ 360,000

$ -0180,000

$ 90,000
270,000

$ 90,000
180,000

997

This book is licensed under a Creative Commons Attribution 3
...
It is expected
to save USD 9,000 cash per year for 10 years, has an estimated useful life of 10 years, and no salvage value
...
Using the net
present value method, determine if the proposal is acceptable
...

Exercise H Refer to the data in previous exercise
...

Exercise I Rank the following investments for Renate Company in order of their desirability using the (a)
payback period method, (b) net present value method, and (c) time-adjusted rate of return method
...

Initial

Expected after-tax net cash

Expected life of proposal

Investment

Cash outlay

Inflow per year

(years)

A

$ 120,000

$ 15,000

8

B

150,000

26,000

20

C

240,000

48,000

10

Problems
Problem A Hamlet Company is considering the purchase of a new machine that would cost USD 300,000 and
would have an estimated useful life of 10 years with no salvage value
...
The company will
depreciate the machine using straight-line depreciation, and the assumed tax rate is 40 per cent
...
Determine the net after-tax cash inflow for the new machine
...
Determine the payback period for the new machine
...
The machines
were bought three years ago for USD 50,000 each and have an expected useful life of 10 years with no salvage value
...

The company is considering replacing the four machines with one technologically superior machine capable of
producing 400,000 units annually by itself
...
Annual repair and maintenance costs are estimated at USD 14,000
...

Problem C Macro Company owns five machines that it uses in its manufacturing operations
...
Each machine has an estimated life of 10 years
with no expected salvage value
...
One new machine has the same productive
capacity as the five old machines combined; it can produce 800,000 units each year
...
A trade-in allowance of
USD 24,000 is available for each of the old machines
...
6796

$ 0
...
1500

0
...
1890

0
...
Capital budgeting:Long-range planning
Other operating costs

0
...
0496

$ 1
...
4788

Ignore federal income taxes
...

a
...
Disregard all
factors except those reflected in the data just given
...
If the old machines were already fully depreciated, would your answer be different? Why?
c
...

Problem D Span Fruit Company has used a particular canning machine for several years
...
The company is considering buying a technologically improved machine at a cost of USD
232,000
...
If the company
decides not to buy the new machine, it can use the old machine for an indefinite time by incurring heavy repair
costs
...

a
...

b
...

Compute the time-adjusted rate of return for the new machine if its useful life is (1) 5 years and (2) 12 years, instead
of 8 years
...
Suppose the new machine's useful life is eight years, but the annual after-tax cost savings are only USD
45,000
...

d
...
Compute the time-adjusted rate of return
...
, is considering three different investments involving depreciable assets with no
salvage value
...
Management requires a minimum return on investment of 12 per cent
...
Payback period
...
Unadjusted rate of return
...
Profitability index
...
Time-adjusted rate of return
...
The company has two
alternatives—it can lease a computer under a three-year contract or purchase a computer outright
...
The first lease payment will be due on
the day the lease contract is signed
...
The
lessor will provide all repairs and maintenance
...
0 License
If the company purchases the computer outright, it will incur the following costs:
Acquisition cost

$ 10,500

Repairs and maintenance:
First year

300

Second year

250

Third year

350

The computer is expected to have only a three-year useful life because of obsolescence and technological
advancements
...

Slow to Change Company's cost of capital is 16 per cent
...
Calculate the net present value of out-of-pocket costs for the lease alternative
...
Calculate the net present value of out-of-pocket costs for the purchase alternative
...
Do you recommend that the company purchase or lease the machine?
Problem G Van Gogh Sports Company is trying to decide whether to add tennis equipment to its existing line
of football, baseball, and basketball equipment
...
The machines
and equipment will cost USD 450,000, have an estimated 10-year useful life, and have a USD 10,000 salvage value
...

The company must advertise its new product line to gain rapid entry into the market
...

Using the net present value method, decide whether or not Van Gogh Sports Company should add the tennis
equipment to its line of products
...
) Round to the nearest dollar
...
Jordan
estimates that the useful life of the equipment will be five years and that it will have a salvage value of USD
600,000
...
The new equipment is expected to have a net cash inflow
(before taxes) of USD 258,000 annually
...

Using the net present value method, determine whether the equipment is an acceptable investment
...
Capital budgeting:Long-range planning
Problem I Penny Company has an opportunity to sell some equipment for USD 40,000
...
If the equipment is not sold, it is expected to produce net cash inflows after
taxes of USD 8,000 for the next 10 years
...

Assume a 40 per cent federal income tax rate
...
Using the net present value method,
show whether the company should sell the equipment
...

Alternate problems
Alternate problem A Mark's Manufacturing Company is currently using three machines that it bought seven
years ago to manufacture its product
...
Each machine originally cost
USD 25,500 and has an estimated useful life of 17 years with no salvage value
...
Each new machine would produce 15,000
units annually and would have an estimated useful life of 10 years with no salvage value
...

Each old machine costs USD 2,500 per year to maintain; each new machine would cost only USD 1,500 a year to
maintain
...

Alternate problem B Fed Extra Company is considering replacing 10 of its delivery vans that originally cost
USD 30,000 each; depreciation of USD 18,750 has already been taken on each van
...
Each van travels an average of 150,000 miles per
year
...
Each van will be driven 150,000 miles per year and
will have no salvage value at the end of its three-year estimated useful life
...
Following is a comparison of costs of operation per mile:
Fuel, lubricants, etc
...
152
0
...
110
0
...
051
$ 0
...
119
0
...
087
0
...
043
$ 0
...

a
...

b
...
Assume that all cost flows for operating costs fall at the end of each year and that 18 per cent is an appropriate
rate for discounting purposes
...

Alternate problem C Mesa Company has been using an old-fashioned computer for many years
...
The company is considering buying a computer system at a cost of USD 35,000
...
If the

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This book is licensed under a Creative Commons Attribution 3
...
The new
computer system will have an estimated useful life of 10 years
...
Compute the time-adjusted rate of return for the new computer system
...
The company is uncertain about the new computer system's 10-year useful life
...

c
...
Compute the time-adjusted rate of return
...
Assume the annual after-tax cost savings will be USD 7,500 and the useful life will be eight years
...

Alternate problem D Ott's Fresh Produce Company has always purchased its trucks outright and sold them
after three years
...
If the trucks are purchased, the company will incur
the following costs:
Costs per fleet
Acquisition cost

$ 312,000

Repairs:
First year

3,600

Second year

6,600

Third year

9,000

Other annual costs

9,600

At the end of three years, the trucks could be sold for a total of USD 96,000
...
The costs just listed, including the same acquisition cost, also would be incurred with respect to the
second fleet of trucks
...

If the company leases the trucks, the lease contract will run for six years
...
The company will pay USD
126,000 per year under the lease contract
...
The lessor bears the cost of all repairs
...
Assume the
company's cost of capital is 18 per cent
...
)
Beyond the numbers—Critical thinking
Business decision case A Lloyd's Company wishes to invest USD 750,000 in capital projects that have a
minimum expected rate of return of 14 per cent
...
Acceptance of one
proposal does not preclude acceptance of any of the other proposals
...
The relevant information related to the five proposals is
as follows:
Initial cash

Expected after-tax net

Expected life of

Investment

Outlay

Cash inflow per year

Proposal (years)

A

$ 150,000

$ 45,000

5

B

300,000

60,000

8

C

375,000

82,500

10

Accounting Principles: A Business Perspective

1002

A Global Text

26
...
Compute the net present value of each of the five proposals
...
Which projects should be undertaken? Why? Rank them in order of desirability
...
The machine has an expected useful life
of 10 years and no salvage value
...
The company uses straight-line depreciation
...

The company's new accountant computed the net present value of the project using a minimum required rate of
return of 16 per cent (the company's cost of capital)
...
833
$283,980
225,000
$ 64,980

a
...

b
...
Write a brief paper explaining why managers in Japan might use lower measures of the cost of capital than
US managers
...
Peters' software consulting firm specializes in working with financial
institutions
...

Following up, Peters learned that First Bank's investment review committee liked the idea but were not
convinced that the new software's financial benefits would justify the cost of the software
...
We even have data from that bank that you could present
...
She knew First Bank would be pleased with the software if they installed it,
and she wanted to make the sale
...

What should Rebecca Peters do? Write her a letter telling what you would do
...
Being unfamiliar with the concepts in this chapter, your friend does not know how to
make the decision
...
(For example, how much will the investment be? How much are the estimated cash flows
from sales?) Prepare a memorandum from the group to your instructor; list your questions and suggestions for
your friend
...


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This book is licensed under a Creative Commons Attribution 3
...
In groups of two or three students, determine which project should be
selected for investment
...
Be sure to provide examples
to reinforce your answer
...

Group project G A manager comments to her superior, "There is no need to perform a postaudit
...
It has been a year since
we started the project, a postaudit would be a waste of time
...
Do you agree? Do you disagree? If this manager is right, why bother with a postaudit? Write a
memorandum to your instructor addressing these questions
...

Using the Internet—A view of the real world
Using any Internet search engine enter "budgeting"
...
You are encouraged (but not required) to find an article that
answers some of the following questions: What is the purpose of budgeting? How are budgets developed? How is
budgeting used to motivate employees? How might budgeting create ethical dilemmas?
Write a memorandum to your instructor summarizing the key points of the article
...
Be sure to
include a copy of the article used for this assignment
...
Be sure to include quotation marks (for example: "Payback period")
...
Write a memorandum to your instructor summarizing the key
points of the article
...
Be sure to include a copy of the article used for this assignment
...
Depreciation does not involve a cash outflow; it is deductible in arriving at federal taxable income
...
The price paid for a machine becomes a sunk cost the minute the purchase has been made
...
Only the out-of-pocket costs (the future cash outlays) are relevant to capital-budgeting decisions
...


Unadjusted rate of return =

Average annual income after taxes
Average amount of investment

True
...

Multiple-choice
c
...
All of the above choices are correct answers
...
All of the above choices are correct answers
...
A profitability index is the ratio of the present value of the expected net cash inflows (after taxes) divided by
the initial cash outlay (or present value of cash outlays if future outlays are required)
...
Capital budgeting:Long-range planning
b
...

d
...


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