ch04
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ch04

Course Number: ACCOUNTING 510, Spring 2009

College/University: CSU Fullerton

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JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 106 TEAM-B 204:JWCL006:ch04: 106 Part 1 An Overview of Financial Accounting The Mechanics of Financial Accounting CHAPTER 4 KEY POINTS The following key points are emphasized in this chapter: Two criteria necessary for economic events to be reflected in the financial statements. The accounting equation and how it relates to the balance sheet, income statement,...

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3/18/08 JWCL006_c04_106-165.qxd 11:40 PM Page 106 TEAM-B 204:JWCL006:ch04: 106 Part 1 An Overview of Financial Accounting The Mechanics of Financial Accounting CHAPTER 4 KEY POINTS The following key points are emphasized in this chapter: Two criteria necessary for economic events to be reflected in the financial statements. The accounting equation and how it relates to the balance sheet, income statement, statement of shareholders' equity, and statement of cash flows. Journal entries (and T-accounts) and how they express the effect of economic events on the basic accounting equation and the financial statements. Why managers need to understand how economic events affect the financial statements. Why the financial statements are adjusted periodically to reflect certain economic events. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 107 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 107 The U.S. General Accounting Office (GAO) periodically reports to Congress on the performance and accountability of various U.S. government agencies. In its report on the Small Business Administration (SBA), established to help small U.S. businesses, the GAO concluded: The SBA continues to have difficulties producing complete, accurate, and timely financial statements. It incorrectly calculated the accounting losses on loan sales and did not perform key analyses to determine the overall financial impact of the sales. These errors and lack of key analyses also mean that congressional decisionmakers are not receiving accurate financial data to make informed decisions about the SBA's budget and appropriations. This quote reflects a problem confronting many large and well-known U.S. companies, not just governmental agencies--a lack of high-quality internal control designed to ensure that all transactions are recorded in a timely and accurate manner. As discussed in Chapter 1, the SarbanesOxley Act recently placed greater emphasis on the need for internal control as many believe that costly corporate financial frauds are in part due to internal control breakdowns. This chapter covers the mechanics underlying the preparation of financial statements and how they help to ensure that a company's transactions are accurately and completely accounted for. After completing it, you should be able to construct financial statements from economic events. Understanding the mechanics underlying the preparation of financial statements is crucial for effective management. Timely and accurate reporting is critical. Also, managers often choose among transactions, and such choices should not be made without considering the financial statement effects and the associated economic consequences. Consequently, managers must understand the mechanics that link transactions to the financial statements. Managers must also understand how to read, interpret, and analyze financial statements. To do so effectively, it is useful to be able to infer from the financial statements events and transactions that occurred during the accounting period. A mechanical process, called T-account analysis, can enable users to make such inferences. This process is covered in Appendix 4A, titled "Mechanics--A User's Perspective." ECONOMIC EVENTS Economic events reflected in the financial statements must be both relevant to the financial condition of a company and objectively measurable in monetary terms. Relevant Events Relevant events have economic significance to a particular company and include any occurrence that affects its financial condition. Events of general economic significance, like the election of a new U.S. president, the passage of federal legislation, or the outbreak of war, could be considered relevant. Events that are more companyspecific, like the signing of a new labor agreement, the hiring of a new chief executive officer, the sale of an item of inventory, or simply the payment of monthly wages, are also relevant. Each of these events could have a significant impact on the financial resources of a particular company. Anyone interested in the company's financial status (shareholders, investors, creditors, managers, auditors, and other interested parties) wants to be able to assess the financial impact of all such events. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 108 TEAM-B 204:JWCL006:ch04: 108 Part 2 Measurement, Mechanics, and Use of Financial Statements Objectivity Unfortunately, only a small percentage of all relevant events are reflected on the financial statements. The dollar values assigned to the accounts on the financial statements must be determined in an objective manner. In general, a dollar value is considered objective if it results from an exchange in which two parties with differing incentives reach agreement. To illustrate, when Boeing Company offered to purchase Hughes Space and Communications from Hughes's shareholders, Boeing and Hughes's shareholders had differing incentives. Boeing wanted to pay as little as possible, while the shareholders wanted to receive as much as possible. When they reached agreement on the value of Hughes, a transaction took place. Hughes passed to Boeing for a price of $3.75 billion. The price represented an objective valuation of Hughes because two parties with differing incentives reached agreement on it. The transaction was accompanied by documented evidence (e.g., receipts, canceled checks, vouchers, a bill of sale) that could be used to verify its entry into Boeing's financial records, and after the purchase, an investment of $3.75 billion was reflected on Boeing's balance sheet. Unfortunately, the most relevant information is not always the most objective. King World Productions Inc., for example, is a television syndicator with the rights to Jeopardy, Wheel of Fortune, and Oprah, which generate millions of dollars in licensing fees. Yet, these rights are valued on the balance sheet at their purchase costs, less accumulated amortization, which are much less. Similarly, a partner at a major accounting firm once noted: "Coca-Cola is one of the best-recognized trademarks in the world, but it is not on their books. It got that recognition through advertising, but you don't book advertising as an asset, because you don't know if it will have future value." In the pharmaceutical industry, when a drug passes its clinical tests, huge value is created. In the software industry, when software passes a beta test, it suddenly becomes valuable. In these two examples, do the pharmaceuticals and the software companies become more valuable when these events occur? Are the events recorded in the financial statements? Explain. THE FUNDAMENTAL ACCOUNTING EQUATION The four financial statements are all based on a mathematical equation, which states that the dollar value of a company's assets equals the dollar value of its liabilities plus the dollar value of its shareholders' equity. In fact, the balance sheet is a statement of this equation. Assets Liabilities Shareholders' Equity The mechanics of accounting are structured so that this equality is always maintained. If the two sides of this equation are unequal, the books do not balance, and an error has been made. However, maintaining this equality does not ensure that the financial statements are correct; errors can exist even if the accounting equation balances. Assets Assets are items and rights that a company acquires through objectively measurable transactions that can be used in the future to generate economic benefits (i.e., more assets). Such acquisitions are usually made by purchase: an asset is received in JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 109 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 109 exchange for another asset (often cash) or a payable. Assets include cash, securities, receivables from customers, land, buildings, machinery, equipment, and rights such as patents, copyrights, and trademarks. Simply, the left side of the accounting equation represents the dollar values of the items and rights that have been acquired by a company and are expected to benefit the company in the future. Assets come from three sources: (1) they are borrowed; (2) they are contributed by shareholders (owners); and (3) they are generated by a company's operating activities. The right side of the equation, liabilities and shareholders' equity, represents the dollar values attached to these three sources. For each dollar amount on the asset side of the equation, a corresponding dollar amount is reflected on the liability and shareholders' equity side. Liabilities Liabilities consist primarily of a company's debts or payables. They are existing obligations for which assets must be used in the future. The dollar amount of the total liabilities on the balance sheet represents the portion of the assets that a company has borrowed and must repay. Shareholders' Equity Shareholders' equity consists of two components: (1) contributed capital, the dollar value of the assets contributed by shareholders; and (2) retained earnings, the dollar value of the assets generated by operating activities and retained in the business (i.e., not paid to the shareholders in the form of dividends).1 Operating activities are those transactions directly associated with the acquisition and sale of a company's products or services. Dividing shareholders' equity into its components, the fundamental accounting equation appears as follows: Assets Liabilities Contributed Capital Retained Earnings That is, the dollar value of the assets is equal to the sum of the dollar amounts owed, the dollar amount of shareholders' contributions, and the dollar amount retained from profitable operations. A summary of the 2006 balance sheet for Zimmer Holdings, a manufacturer of healthcare products, is provided below (dollars in millions). Describe it in terms of the basic accounting equation. Current assets Noncurrent assets Total $1,746 4,228 $5,974 Liabilities Contributed capital Retained earnings Total $1,051 2,154 2,769 $5,974 BUSINESS TRANSACTIONS, THE ACCOUNTING EQUATION, AND THE FINANCIAL STATEMENTS Companies conduct operations by exchanging assets and liabilities with other entities (e.g., individuals and businesses). These economic events are referred to as business transactions. Exchanging cash for a piece of equipment, for example, is a transaction that represents the purchase of equipment. Borrowing money is a transaction in which 1. The second component of shareholders' equity is actually earned capital, the primary part of it is retained earnings. Later in the text we introduce another part of earned capital, called accumulated comprehensive income. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 110 TEAM-B 204:JWCL006:ch04: 110 Part 2 Measurement, Mechanics, and Use of Financial Statements a promise to pay in the future (i.e., note payable) is exchanged for cash. The sale of a service on account is a transaction in which the service is exchanged for a receivable. In each of these exchanges, and in all business transactions, something is received and something is given up. These receipts and disbursements affect the financial condition of a company in a way that always maintains the equality of the fundamental accounting equation. That is, each business transaction is recorded in the books so that the dollar values of a company's assets always equal the dollar values of its liabilities and shareholders' equity. Transactions and the Accounting Equation The six transactions described here were entered into by Joe's Landscaping Service during 2008, its first year of operations. Figure 41 shows how each transaction affects the accounting equation. Study it carefully and read the following discussion of each transaction. FIGURE 41 Business transactions and the accounting equation Transaction Assets Liabilities Contributed Capital Retained Earnings (1) (2) (3) (4) (5) (6) End-of-year balance $ 10,000 3,000 5,000 5,000 8,000 4,000 9,000 1,000 $ 15,000 $ 10,000 $ 3,000 $ 12,000 9,000 1,000 $ 3,000 $ 10,000 $ 2,000 TRANSACTION (1). Joe, the owner of the company, contributes $10,000. This dollar amount increases the company's cash balance, an asset, by $10,000 and is also recorded on the right side of the accounting equation under contributed capital. Note that both sides of the accounting equation are increased by $10,000, so its equality is maintained. TRANSACTION (2). $3,000 is borrowed from a bank. The dollar amount of this exchange also increases the company's cash balance, but in this case liabilities are also increased; the company now owes $3,000 to the bank. TRANSACTION (3). The company purchases equipment for $5,000 cash. This exchange both increases and decreases the company's assets. It now has an asset called equipment, and its cash balance is reduced by $5,000. Still, the equality of the accounting equation is maintained because the asset side was both increased and decreased by $5,000. TRANSACTION (4). The company performs a service for $12,000. This transaction increases the company's cash balance by $8,000 and creates a receivable of $4,000. Thus, total assets increase by $12,000. The corresponding $12,000 adjustment on the right side of the equation, which maintains its equality, is reflected in retained earnings because the company generated this $12,000 through its own operations. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 111 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 111 TRANSACTION (5). The company pays $9,000 for expenses--wages, interest, and maintenance. This transaction decreases the company's cash balance by $9,000 and maintains the equality of the equation by decreasing retained earnings in the amount of $9,000. Retained earnings is decreased because, as in Transaction 4, these expenses are associated with the company's operating activities. TRANSACTION (6). Joe pays himself a $1,000 dividend as a return on his original investment. The dollar amount of the dividend reduces the company's cash balance by $1,000 and is also reflected on the right side of the equation by a $1,000 reduction in retained earnings. Retained earnings is reduced because the fundamental objective of the company's operating activities is to provide a return for the owner, and retained earnings is the measure of the assets that have been accumulated through operations. During 2006, the Coca-Cola Company purchased property, plant, and equipment in the amount of $1.4 billion. The company also borrowed over $600 million. How were these transactions reflected in the basic accounting equation? The Accounting Equation and the Financial Statements This section introduces and defines the concept of an account and describes the preparation of simplified versions of the balance sheet, statement of cash flows, income statement, and statement of shareholders' equity for Joe's Landscaping Service. ACCOUNTS AND THE ACCOUNTING EQUATION For purposes of recording transactions and preparing financial statements, the main components of the accounting equation (assets, liabilities, and shareholders' equity) can be further subdivided into separate categories called accounts. The general category of assets is normally divided into a number of accounts including, for example, a cash account, a receivables account, and an equipment account. Liabilities normally consist of various payable accounts, and as mentioned earlier, shareholders' equity can be divided into a contributed capital account and a retained earnings account. Accounts serve as "storage units," where the dollar values of business transactions are initially recorded and later compiled into the financial statements. The accounts that appear on the financial statements represent a balance between enough detail to provide meaningful breakdowns of assets, liabilities, and shareholders' equity but not so much as to overwhelm the user. In Figure 42, the main components of the accounting equation are divided into separate accounts for the purpose of recording the six transactions entered into by Joe's Landscaping Service. Note that Figure 42 is very similar to Figure 41. It differs only in that it records the transactions in more specific categories, which represent the accounts that eventually appear on the financial statements. Note that total assets in Figure 42 ($15,000 $6,000 $4,000 $5,000) equal total assets in Figure 41 as well as total liabilities plus shareholders' equity ($15,000 $3,000 $10,000 $2,000). The components of the accounting equation have simply been divided into more specific "storage units." In the next sections, the information contained in Figure 42 is used to prepare the financial statements. THE BALANCE SHEET The balance sheet is the statement of the basic accounting equation as of a particular date: in this case, the end of 2008. It is called a balance sheet because assets are always JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 112 TEAM-B 204:JWCL006:ch04: 112 Part 2 Measurement, Mechanics, and Use of Financial Statements FIGURE 42 Accounts and the accounting equation Assets Transaction Cash Receivables Equipment Liabilities Loan Payable Shareholders' Equity Contributed Capital Retained Earnings (1) (2) (3) (4) (5) (6) Total $ 10,000 3,000 5,000 8,000 9,000 1,000 $ 6,000 $ 10,000 $ 3,000 $ 5,000 $ 4,000 $ 12,000 9,000 1,000 $ 2,000 $ 4,000 $ 5,000 $ 3,000 $ 10,000 in balance with liabilities plus shareholders' equity. That is, there is a source for each asset the company has acquired. Figure 43 shows the balance sheet for Joe's Landscaping Service at the end of its first year of operations. This balance sheet was prepared by simply listing and grouping the totals of the individual asset, liability, and shareholders' equity accounts, which appear at the bottom of Figure 42. FIGURE 43 Balance sheet for Joe's Landscaping Joe's Landscaping Service Balance Sheet December 31, 2008 ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY Cash Receivables Equipment Total assets $ 6,000 4,000 5,000 $15,000 Loan payable Contributed capital Retained earnings Total liabilities and shareholders' equity $ 3,000 10,000 2,000 $15,000 STATEMENT OF CASH FLOWS The statement of cash flows in Figure 44 was prepared directly from the activity recorded in the cash account in Figure 42. Each dollar value on the statement of cash flows corresponds to an increase or decrease in the cash account indicated in Figure 42. Note also that the ending cash balance of $6,000 on the statement of cash flows equals the balance in the cash account on the balance sheet. The statement of cash flows is nothing more than a summary of the activity in the company's cash account, divided into three sections--operating, investing, and financing activities. INCOME STATEMENT The income statement is a measure of the assets generated from the company's operating activities during a period of time. It compares revenues (the asset inflows due to operating activities) to expenses (the asset outflows required to generate the revenues). The difference between revenues and expenses is called net income or net loss. If JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 113 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 113 FIGURE 44 Statement of cash flows for Joe's Landscaping Joe's Landscaping Service Statement of Cash Flows for the Year Ended December 31, 2008 Operating activities: Sale of a service (4) Payments for expenses (5) Net cash from operating activities Investing activities: Purchase of equipment (3) Net cash from investing activities Financing activities: Borrowings (2) Owner contributions (1) Payment of dividends (6) Net cash from financing activities Increase in cash balance Cash balance at beginning of year Cash balance at end of year $ 8,000 (9,000) $ (1,000) $ (5,000) (5,000) $ 3,000 10,000 (1,000) 12,000 $ 6,000 0 $ 6,000 revenues exceed expenses, there is net income or profit; if expenses exceed revenues, there is a net loss. In terms of the accounting equation, revenues, expenses, and dividends are reflected in the retained earnings account. Like the general categories of assets, liabilities, and shareholders' equity, retained earnings can be further subdivided into revenue accounts, expense accounts, and dividend accounts. Recording a transaction in a revenue account increases retained earnings; recording a transaction in an expense or dividend account decreases retained earnings. In the example of Joe's Landscaping Service, revenues in the form of cash and a receivable were generated in Transaction (4), the sale of landscaping services for $12,000. Expenses were recognized in Transaction (5), which reflects payments made for wages, interest, and equipment maintenance. The dollar amounts of these two transactions are recorded in the retained earnings account in Figure 42, but in practice they would be recorded in separate revenue and expense accounts, which are components of retained earnings. An income statement can be prepared by disclosing revenues and expenses in the manner shown in Figure 45. FIGURE 45 Income statement for Joe's Landscaping Joe's Landscaping Service Income Statement for the Year Ended December 31, 2008 Revenues: Fees earned for service Expenses: Wages, interest, maintenance Net income $12,000 9,000 $ 3,000 STATEMENT OF SHAREHOLDERS' EQUITY The statement of shareholders' equity describes the changes during 2008 in the shareholders' equity accounts--in this case, contributed capital and retained earnings. The JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 114 TEAM-B 204:JWCL006:ch04: 114 Part 2 Measurement, Mechanics, and Use of Financial Statements statement appears in Figure 46, and note that it simply summarizes the activities in the contributed capital and retained earnings accounts indicated on Figure 42, except that the net income number appears on the statement instead of the individual revenues and expenses. FIGURE 46 Statement of shareholders' equity Joe's Landscaping Service Statement of Shareholders' Equity for the Year Ended December 31, 2008 Contributed Capital Retained Earnings Total Beginning balance (1/1/2008) Contribution by owner Net income Less: Dividends Ending balance (12/31/08) $ 0 10,000 $ 0 $10,000 3,000 (1,000) $2,000 0 10,000 3,000 (1,000) $12,000 $ A summary of the 2006 financial statements for Campbell's Soup is follows (dollars in millions). Discuss each statement in terms of the basic accounting equation. How can a company have negative contributed capital? Income statement: Revenues Expenses Net income Balance sheet: Current assets Noncurrent assets Total Statement of cash flows: Cash from operations Cash from investing Cash from financing Increase in cash Beginning cash Ending cash $7,343 6,577 $ 766 $2,112 5,758 $7,870 $1,226 (294) (315) 617 40 $ 657 Retained Earnings $6,069 766 (296) $6,539 Liabilities Contributed capital Retained earnings Total $6,102 (4,771) 6,539 $7,870 Statement of Shareholders' Equity: Contributed Capital Beginning balance (4,199) Share purchased from owners (506) Net income Less: dividends Other Ending balance (4,771) Total $1,270 (506) 766 (296) 534 $1,768 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 115 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 115 THE JOURNAL ENTRY In the previous section, we demonstrated how economic events affect the accounting equation and, ultimately, the financial statements. Journal entries provide a more efficient way to represent such effects. They are used to represent relevant and measurable economic events, and their content and structure indicate how such events affect the accounting equation. The form of a typical journal entry follows: Debit Credit Equipment Cash Purchased equipment for cash 5,000 5,000 The affected accounts in this entry are equipment and cash, and the dollar amount of the transaction is $5,000. Placing the $5,000 assigned to equipment on the left side of the entry indicates that the equipment account has been increased by $5,000. That account is said to have been debited. In the terminology of financial accounting, to debit an account simply means to place the dollar amount assigned to it on the left side of the journal entry. Placing the $5,000 assigned to the cash account on the right side of the entry, or crediting it, indicates that the cash account has been decreased by $5,000. To credit an account means to place it on the right side of the journal entry. The sample entry indicates that equipment was purchased for $5,000 cash. Compound journal entries are treated in exactly the same way, but they involve more than two accounts. For example, if equipment is purchased for $5,000 cash and a $10,000 note payable, we would record the following compound journal entry: Debit Credit Equipment Cash Notes payable Purchased equipment for cash and a note payable 15,000 5,000 10,000 THE DOUBLE ENTRY SYSTEM Note in the preceding journal entries that the total dollar value on the left side is always equal to the total dollar value on the right side and that at least two different accounts were affected. Both characteristics are true of all journal entries and illustrate the double entry system, which is the cornerstone of financial accounting. The equality of the debit and credit sides maintains the equality of the accounting equation, and the fact that at least two different accounts are affected indicates that in all exchange transactions, something is received and something is given up. THE JOURNAL ENTRY BOX A useful way to learn journal entries is to view them as shown in Figure 47, which provides a systematic way of converting exchange transactions to journal entries. The top of the box is an expression of the accounting equation. Answers to the three questions identify the three components of each transaction: (1) the accounts affected, (2) the direction of the effect, and (3) the dollar value of the transaction. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 116 TEAM-B 204:JWCL006:ch04: 116 Part 2 Measurement, Mechanics, and Use of Financial Statements FIGURE 47 The journal entry box 1. What accounts are affected? Liabilities and Shareholders' Equity Payables, other liabilities, common stock, retained earnings (revenues, expenses, and dividends) B LEFT Assets = Cash, marketable securities, receivables, inventory, prepaids, investments, property, plant, and equipment, intangible assets A Increase RIGHT 2. What is the direction of the effect? C Decrease 3. What is the dollar value of the transaction? D RIGHT LEFT Increases in asset accounts (Cell A) and decreases in liability and shareholders' equity accounts (Cell D) are always represented on the debit (left) side of the journal entry. Decreases in asset accounts (Cell C) and increases in liability and shareholders' equity accounts (Cell B) are always recorded on the credit (right) side of the journal entry. It is important to recall that revenue, expense, and dividend accounts are all part of the shareholders' equity account, retained earnings. Thus, revenues, which increase retained earnings, are recorded on the credit side of the journal entry. Expenses and dividends, which decrease retained earnings, are recorded on the debit side of the journal entry. Figure 47 shows that journal entries have been devised so that transactions are recorded in a way that always maintains the equality of the accounting equation. Debits always equal credits, and accordingly, assets always equal liabilities plus shareholders' equity. JOURNAL ENTRIES AND THE ACCOUNTING EQUATION: EXAMPLES In Figure 48, seven different transactions give rise to seven different journal entries, affecting the accounting equation in seven different ways. The equality of the accounting equation is always maintained, and the debit side of each journal entry is exactly equal to the credit side. Note especially Transactions 5, 6, and 7, where the equality of the accounting equation is maintained through the effect of a revenue, an expense, and a dividend on retained earnings. The explanations on the right side of the chart indicate how the journal entry box was used to construct each journal entry. The account names in each journal entry contained in Figure 48 are followed by parenthetical notations designed to indicate how the entry affects the fundamental accounting equation. We use this notation throughout the remainder of the text because it emphasizes the important relationship between the economic event represented by the journal entry and the accounting equation and, ultimately, the financial statements. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 117 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 117 FIGURE 48 Journal entries and the accounting equation Accounting Equation Transaction Assets Liabilities and Shareholders' Equity Journal Entry Debit Credit Explanation* 1. Company receives $100 cash in payment from a customer on account. Cash Accts. Rec. 100 100 0 Cash ( A)** Accts. Rec. ( A) 0 100 100 Cash, an asset, is increased. Accts. Rec., an asset, is decreased. Cash, an asset, is increased. Notes Pay., a liability, is increased. Cash, an asset, is decreased. Accts. Pay., a liability, is decreased. Notes Pay., a liability, is decreased. Com. Stk., an equity, is increased. Accts. Rec., an asset, is increased. Fees Earned, a revenue, increases Retained Earnings. Cash, an asset, is decreased. Salary Exp. decreases Retained Earnings. Dividends Pay., a liability, is increased. Dividends decreases Retained Earnings. 2. Company borrows Cash $500 from a bank in exchange for a shortterm note payable. 3. Company pays $300 cash in payment of an account payable. 4. Company issues common share in exchange for an outstanding note payable. 5. Company provides a service for which it bills its clients $2,000. Accts. Rec. Cash 500 Notes Pay. 500 Cash ( A) Notes. Pay. ( L) 500 500 500 300 Accts. Pay. 500 300 Accts. Pay. ( L) Cash ( A) 300 300 300 Notes Pay. Com. Stk. 0 300 1,000 1,000 0 Notes. Pay. ( L) Com. Stk. ( CC) 1,000 1,000 2,000 2,000 Ret. Earn. via Fees Earned 2,000 2,000 Accts. Rec. ( A) Fees Earned (R, 2,000 RE) 2,000 6. Company pays $500 in salaries to its employees. Cash 500 500 Ret. Earn. via Salary Expense 500 500 Salary Exp. (E, Cash ( A) RE) 500 500 7. Company declares an $800 dividend to be paid later to its owners. Dividends Pay. Ret. Earn. via Dividends 0 800 800 0 Dividends ( RE) Dividends Pay. ( L) 800 800 Note: Accts. Rec. Accounts Receivable; Accts. Pay. Accounts Payable; Com. Stk. Common Stock; Dividends Pay. Dividends Payable; Notes Pay. Notes Payable; Ret. Earn. Retained Earnings; Salary Exp. Salary Expense. *See journal entry box in Figure 47. **Typically, journal entries would not include the information in parentheses: increase and decrease; A Asset; L Liability; SE Shareholders' Equity; R Revenue; E Expense; Ga Gain; Lo Loss; CC Contributed Capital; RE Retained Earnings Balance Sheet (A L SE) Income Statement (R Ga E Lo NI). Note: No gains or losses are illustrated in this example. SE CC RE During 2006, Cisco Systems recorded revenues of $28.5 billion, most of which were recorded on account. Describe how these transactions would be represented in Figure 48. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 118 TEAM-B 204:JWCL006:ch04: 118 Part 2 Measurement, Mechanics, and Use of Financial Statements T-ACCOUNTS When analyzing the effects of many economic events on the financial statements, it is useful to keep running tallies of the balances for each asset, liability, shareholders' equity, revenue, expense, and dividend account. This can be achieved by creating a T-account for each of the financial statement accounts. T-accounts are so named because they are in the form of a T--the left side of the T represents the debit side of the entry, and the right side corresponds to the credit side. Since journal entries also have a debit and credit side, the debited and credited dollar amounts are easily transferred (posted) to their respective T-accounts. The following example demonstrates how financial statements can be prepared from a group of economic events (transactions), each of which is represented by a journal entry. The balances are maintained in T-accounts. AN EXAMPLE. The December 31, 2008 balance sheet of Maple Services Company appears in Figure 49. The journal entries and associated T-accounts for ten transactions, entered into during 2009, are provided in Figure 410. Note first that the account balances from the balance sheet are the beginning balances in the T-accounts. Note also that the journal entries, numbered 110, are posted in the T-accounts. Review each journal entry and trace the dollar amounts of the debits and credits to the T-accounts. The financial statements, which appear in Figure 411, can be prepared directly from the T-accounts.2 FIGURE 49 Maple Services balance sheet Maple Services Company Balance Sheet December 31, 2008 ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY Cash Accounts receivable Land $12,000 9,000 15,000 Total assets $36,000 Salaries payable Notes payable Contributed capital Retained earnings Total liabilities and shareholders' equity $ 4,000 6,000 21,000 5,000 $36,000 INCOME STATEMENT. The income statement for the period ending December 31, 2009 is prepared by subtracting the balances in the expense T-accounts (salary expense, rent expense, insurance expense, and interest expense) from the balances in the revenue T-accounts (service revenue), resulting in net income. The statement of shareholders' equity for that same period consists of adding the $5,000 common share issuance to the beginning balance in common share, coming to the ending (2009) balance of $26,000. Common stock is a form of contributed capital. The reconciliation of the retained earnings account consists of the addition of net income less the amount of dividends declared during the period. The result ($6,900) is the ending (December 31, 2009) balance in retained earnings. BALANCE SHEET. The December 31, 2009 balance sheet consists of the balances in the asset (cash, accounts receivable, land), liability (notes payable), and shareholders' 2. The closing process is not illustrated in this example. It is illustrated, however, in the review problem at the end of the chapter (p. 137). JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 119 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 119 equity (contributed capital and retained earnings) T-accounts. Note that the ending balance in retained earnings ($6,900), which was computed on the statement of shareholders' equity, appears on the balance sheet. FIGURE 410 Maple Services Company JOURNAL ENTRIES (1) Cash ( A) 5,000 Common Stock ( CC) Issued common share (2) Land ( A) 7,000 Cash ( A) Purchased land (3) Salaries Payable ( L) 4,000 Cash ( A) Paid salaries owed at the end of 2008 (4) Cash ( A) 6,000 Accounts Receivable ( A) Received cash on outstanding accounts receivable (5) Cash ( A) 7,000 Service Revenue (R, RE) Received cash for services provided 5,000 7,000 4,000 6,000 7,000 (6) Rent Expense (E, RE) 500 Cash ( A) Paid rent (7) Insurance Expense (E, RE) 100 Cash ( A) Paid for insurance coverage (8) Salary Expense (E, RE) 3,000 Cash ( A) Paid salaries (9) Interest Expense (E, RE) 500 Notes Payable ( L) 2,000 Cash ( A) Paid interest and principal on an outstanding loan (10) Dividends ( RE) 1,000 Cash ( A) Paid cash dividend 500 100 3,000 2,500 1,000 T-ACCOUNTS Cash Accounts Receivable Land Salaries Payable 12,000 (1) 5,000 (4) 6,000 (5) 7,000 9,000 (2) (3) (6) (7) (8) (9) (10) 7,000 4,000 500 100 3,000 2,500 1,000 (4) 3,000 15,000 6,000 (2) 7,000 22,000 4,000 (3) 4,000 0 11,900 Notes Payable Contributed Capital Retained Earnings Service Revenue 6,000 (9) 2,000 4,000 Salary Expense Rent Expense (1) 21,000 5,000 26,000 5,000 (5) 7,000 Insurance Expense Interest Expense (8) 3,000 Dividends (6) 500 (7) 100 (9) 500 (10) 1,000 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 120 TEAM-B 204:JWCL006:ch04: FIGURE 411 Financial statements for Maple Services Company Income Statement for the Year Ended December 31, 2009 Service revenue Expenses: Salaries Rent Insurance Interest Total expenses Net income $7,000 $3,000 500 100 500 4,100 $2,900 Statement of Shareholders' Equity for the Year Ended December 31, 2009 Common Share Retained Earnings Total Beginning balance Common share issuances Net income Less: Dividends Ending balance $21,000 5,000 $ 5,000 2,900 (1,000) $ 6,900 $26,000 $26,000 5,000 2,900 (1,000) $32,900 Balance Sheet December 31, 2009 ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY Cash Accounts receivable Land Total assets $11,900 3,000 22,000 $36,900 Notes payable Contributed capital Retained earnings Total liabilities and shareholders' equity $ 4,000 26,000 6,900 $36,900 Statement of Cash Flows December 31, 2009 Operating activities: Cash receipts for services Cash receipts from accounts receivable Cash payments for salaries Cash payments for rent Cash payments for insurance Cash payments for interest Cash increase (decrease) due to operating activities Investing activities: Cash payment for purchase of land Cash increase (decrease) due to investing activities Financing activities: Cash receipt from issuing share Cash payment for loan principal Cash payment for dividends Cash increase (decrease) due to financing activities Increase (decrease) in cash balance Beginning cash balance Ending cash balance $ 7,000 6,000 (7,000) (500) (100) (500) $ 4,900 $(7,000) (7,000) $ 5,000 (2,000) (1,000) 2,000 $ (100) 12,000 $11,900 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 121 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 121 The dollar amounts on the balance sheet represent the beginning balances for asset, liability, and shareholders' equity T-accounts for the next period (2010). Since the dollar amounts in the revenue, expense, and dividend accounts are reflected in the ending balance of retained earnings, the revenue, expense, and dividend T-accounts begin the next period (2010) with zero balances. The balance sheet accounts are described as permanent because their balances accumulate from one period to the next. The income statement and dividend accounts are described as temporary because their balances begin each new period at zero.3 STATEMENT OF CASH FLOWS. The statement of cash flows is prepared from the cash T-account. Each cash inflow and outflow is classified as operating, investing, or financing and then placed on the statement. This statement reconciles the change in the cash balance during the period, expressing it in terms of cash increases (decreases) due to operating, investing, and financing activities. RECOGNIZING GAINS AND LOSSES Companies often sell investments and noncurrent assets, receiving dollar amounts that do not match the amounts at which the investments are carried on the balance sheet. In such cases, a gain or loss must be recognized in the amount of the difference between the proceeds and the carrying amount. When J.C. Penney sold the Eckerd drugstore chain to CVS Corporation for $4.53 billion, it recorded a $77 million loss on the transaction. How can a company sell a subsidiary for over $4 billion and record a loss on the transaction? When McDonnell Douglas sold its North American Field Service business for $100 million, it recognized a $29 million gain because the investment was carried on the company's balance sheet at $71 million. Assuming that the business was acquired for $71 million, the following journal entries were used to record these events. (Dollar amounts are in millions.) Investment ( A) Cash ( A) Acquired North American Field Service for cash Cash ( A) Investment ( A) Gain on Sale (Ga, RE) Sold North American Field Service for gain 71 71 100 71 29 If McDonnell Douglas would have sold the business for an amount less than the $71 million carrying amount, $55 million for example, a loss would have been recognized in the following manner. Cash ( A) Loss on Sale (Lo, RE) Investment ( A) Sold North American Field Service for loss 55 16 71 3. In actual accounting systems, the year-end balances in the revenue, expense, and dividend accounts are formally transferred to retained earnings through a series of journal entries. This closing process zeroes out the balances in the temporary accounts so that they begin at zero the next period. This process is illustrated in the review problem at the end of this chapter. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 122 TEAM-B 204:JWCL006:ch04: 122 Part 2 Measurement, Mechanics, and Use of Financial Statements The gain or loss in the entry represents the profit or loss on the transaction in the amount of the difference between the proceeds and the balance sheet value of the investment. Note also that the gain or loss appears on the income statement, and the cash proceeds from the sale would appear on the statement of cash flows under cash flows from investing activities. Goodyear Tire & Rubber sold assets in its Latin America and European segments for $53.3 million. The value of the assets on the balance sheet prior to the sale was $27.6 million. How did Goodyear record this transaction? PERIODIC ADJUSTMENTS Up to now the discussion has focused on the financial statement effects of exchange transactions--transactions backed by documented evidence, in which assets and/or liabilities are transferred between parties. Assets and liabilities, however, are often created or discharged without the occurrence of a visible, documentable exchange transaction. They sometimes build up or expire as time passes. Interest, for example, is earned continually on bank savings accounts, and machinery depreciates as it is used in a company's operations. Such phenomena are not evidenced by exchange transactions, but they can be very important to a company's performance and financial condition. Net income for a particular period is measured by (1) recognizing revenues when the earning process is complete and (2) matching against those revenues the expenses incurred to generate them. Under this view of performance, called the accrual system of accounting, revenues are booked when assets are created (or liabilities are discharged) and expenses are recorded when liabilities arise (or assets are reduced). In other words, revenues and expenses can be recognized either before or after the related cash is received or paid. The accrual system requires that periodic adjustments be made to the financial statements so that net income for a given period of time will be the result of a proper matching of the revenues and expenses within that period. Periodic adjustments take one of three forms: (1) accruals, (2) deferrals, and (3) revaluations. The first two are covered in this chapter; revaluation adjustments are covered in subsequent chapters as they arise. Accruals Accruals refer to amounts in asset and liability accounts that build up over time. The term accrue simply means to build up gradually.4 Two very common examples are accrued wages and accrued interest. ACCRUED WAGES Suppose that employees of Taylor Motor are paid at the end of each week. The total weekly payroll is $10,000, which is earned at a rate of $2,000 per day for each of the 4. Note that the term accrual refers to a system of accounting that recognizes revenues and expenses as assets and liabilities are created or discharged, as well as one of two kinds of adjusting entries. The double meaning of this term can be a source of confusion, and it is important that you be aware of the context in which it is used. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 123 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 123 five working days. Assume that December 31 falls on a Tuesday, and the financial statements are prepared as of that day. Figure 412 illustrates these facts and the journal entries that would be recorded under accrual accounting. FIGURE 412 Accrued wages Period 1 Monday (12/30) Wages Earned: $2,000 Tuesday Wed. (1/1) $2,000 Thur. (1/2) $2,000 Period 2 Friday (1/3) $2,000 Wages Pay. ( L) 4,000 Wage Exp. (E, RE) 6,000 Cash ( A) 10,000 Paid accrued wages (12/31) $2,000 Adjustment Wage Exp. (E, RE) 4,000 4,000 Wages Pay. ( L) Recognized accrued wages In applying the accrual system, it must be recognized that although no cash has been paid as of December 31, a liability has been created. The company owes its employees two days' worth of wages, or $4,000. This liability is recognized with an adjusting journal entry of the form indicated in Figure 412. Wage expense of $4,000 is reflected on the income statement of the period ending on December 31 (Period 1). Wages payable of $4,000 appears in the liability section of the December 31 balance sheet, and the amount is carried into Period 2. Note that on Friday, when the $10,000 cash payment for wages is made, $4,000 serves to remove the wages payable (the liability is discharged), and $6,000 is charged to wage expense of Period 2 and thus will appear on the income statement of Period 2. The adjustment in this example achieves matching, in that it matches the cost of the effort expended by the employees in Period 1 with the revenues generated in Period 1. Wage expense of $4,000 is subtracted from Period 1 revenues in the computation of Period 1 net income. Similarly, the cost of the effort expended by the employees in Period 2 ($6,000) is matched against Period 2 revenues on the Period 2 income statement. It is also important to realize that Taylor would prepare statements of cash flows for Periods 1 and 2 and the entire $10,000 cash payment would be reflected in the operating section of that statement in the second period only. None of it would appear on the statement of cash flows of Period 1. As Figure 413 indicates, the total resource FIGURE 413 Expenditure recognition Accounting System/Financial Statement Period 1 Period 2 Period 3 Accrual/Income statement Cash/Statement of cash flows $4,000 0 $ 6,000 10,000 $10,000 10,000 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 124 TEAM-B 204:JWCL006:ch04: 124 Part 2 Measurement, Mechanics, and Use of Financial Statements expenditure recognized under the accrual system is the same as that recognized under the cash system. The difference lies in the timing of the recognition. Due to the adjustment, the accrual system recognizes $4,000 in Period 1 and $6,000 in Period 2. ACCRUED INTEREST Suppose that on December 1, Bank of America Corporation loans $12,000 to Exxon Mobil Oil Company at an annual interest rate of 10 percent. Assume that the accounting period ends on December 31 and that Exxon pays Bank of America in full (principal and interest) on January 31 of the next year. Figure 414 illustrates these facts and the journal entries that would be recorded under accrual accounting. FIGURE 414 Accrued interest revenue Period 1 December 1 December 31 Adjustment Period 2 January 31 Cash ( A) 12,200 Interest Rec. ( A) 100 Interest Rev. (R, RE) 100 Note Rec. ( A) 12,000 Received cash on outstanding note Note Rec. ( A) 12,000 Cash ( A) 12,000 Received note for cash Interest Rec. ( A) 100 Interest Rev. (R, RE) 100 Recognized accrued interest received Bank of America records an adjustment on December 31 to reflect the fact that an asset, interest receivable, has been created. The company has earned $100 ([$12,000 10%] 12 months) in interest during the month of December. Interest receivable of $100 is recognized (debited), and interest revenue is credited. When the $12,200 cash payment is received on January 31, $12,000 serves to reduce the outstanding note receivable, $100 is charged against the interest receivable account, and the remaining $100 is recognized as interest revenue. As in the example of accrued wages, the adjustment here helps to achieve a matching of revenues and expenses in the appropriate time period. It does so by dividing the total interest earned on the loan ($200) into two components, based on the periods in which it was earned and the time when the asset, interest receivable, was created. Half of the $200 interest payment was earned in Period 1 and therefore should appear as a revenue on the income statement of Period 1. The remaining $100 should appear as a revenue on the income statement of Period 2 because the loan was outstanding during one month of Period 2. Consider again the effect of these transactions on the statements of cash flows for Periods 1 and 2. No cash inflow related to interest is recorded in Period 1, and therefore nothing would be reflected on the statement of cash flows for that period. Instead, all $200 would appear on the statement of cash flows in Period 2, when the cash is actually received. Once again, the total interest recognized across the two periods under the cash system ($200) is the same as that recognized under the accrual system, but the timing of the recognition is different. The adjusting journal entry prepared under the accrual system ensures that $100 is recognized on the income statement of Period 1, with the remaining $100 appearing on the income statement of Period 2. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 125 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 125 Figure 415, using the same facts as Figure 414, considers the borrower's (Exxon Mobil's) point of view. Examine the journal entries, and note especially how the adjusting journal entry matches revenues and expenses in the appropriate time period and gives rise to expense recognition in a time period when no cash payment is made. FIGURE 415 Accrued interest expense Period 1 January 31 Period 2 December 1 December 31 Adjustment Cash ( A) 12,000 Note Pay. ( L) 12,000 Borrowed cash and issued note payable Interest Exp. (E, RE) 100 Interest Pay. ( L) 100 Recognized accrued interest payable Note Pay. ( L) 12,000 Interest Pay. ( L) 100 Interest Exp. (E, RE) 100 12,200 Cash ( A) Paid interest and outstanding note Honeywell International, an advanced technology and manufacturing company, reported accrued liabilities of $5.5 billion on its 2006 balance sheet. Explain the meaning of that number. Deferrals The second type of adjustment is called a deferral (or cost expiration). Like accruals, these adjusting entries (1) are recorded in the books at the end of an accounting period to achieve an appropriate matching of revenues and expenses and (2) do not reflect cash exchanges. They are called deferrals because they are entries that serve to defer the recognition of an expense or revenue until the proper time. ASSET CAPITALIZATION AND THE MATCHING PRINCIPLE Before studying deferrals, you should understand one very important concept in financial accounting measurement--asset capitalization and how it relates to the matching principle. The matching principle involves a four-step process: (1) a cost is incurred in the current period for the purpose of generating revenue; (2) the revenue recognition principle determines the period in which the revenue is recognized; (3) if the revenue is recognized in the current period, the cost is expensed (appearing on the income statement as an expense); if the revenue is expected to be recognized in a future period, the cost is capitalized (appearing on the balance sheet as an asset); and (4) capitalized costs are converted to expenses (by recording cost expiration adjusting journal entries) in those future periods when revenue is recognized. Assets, by definition, are expected to generate economic benefits in the form of future revenues, and, according to the matching principle, the costs of acquiring assets should be matched against those benefits when they are recognized. The accrual system of accounting accomplishes this matching by initially capitalizing the costs of assets and then converting them to expenses (through periodic adjustments) as their usefulness expires and their benefits are realized. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 126 TEAM-B 204:JWCL006:ch04: 126 Part 2 Measurement, Mechanics, and Use of Financial Statements To illustrate the important difference between expensing and capitalizing a cost, consider a company with the following simplified balance sheet as of December 31, 2008: Assets Total $1,000 $1,000 Liabilities Shareholders' equity Total $ 600 400 $1,000 During 2009, the company recognizes $2,500 in revenues and $1,500 in expenses. In a separate transaction the company also spends $500 on its facilities. Should the $500 be considered an expense for 2009 or an asset? Figure 416 provides the resulting financial statements if the company expenses or capitalizes the $500 expenditure, assuming that all transactions were in cash. FIGURE 416 Expensing vs. capitalizing Expenses $500 Capitalizes $500 Balance sheet: Assets Liabilities Shareholders' equity Income statement: Revenues Expenses Net income $1,500 600 900 $2,500 2,000 $ 500 $2,000 600 1,400 $2,500 1,500 $1,000 Note the differences in total assets, shareholders' equity, expenses, and net income. Assets and net income are clearly much higher if the company chooses to capitalize the $500 cost. As illustrated in the next section, however, if the cost is capitalized it will have to be amortized against revenues in future periods, reducing reported net income in those periods. The Baltimore Sun reported that the WorldCom fraud, which costs investors billions of dollars, "was not complicated: the company's financial officers recorded routine maintenance expenses totaling $3.9 billion as capital expenditures. . . ." Explain how this scheme violated the matching principle and affected the financial statements. EXPENSE OR CAPITALIZE EXAMPLES Figure 417 illustrates the basic procedures used to account for expenses and capitalized costs. It is divided into two sections. The upper section depicts the matching process. The lower section consists of nine different transactions, each carried through the four steps involved in applying the matching principle. CURRENT EXPENSES. The first three transactions (salaries, interest, and utilities) represent resource expenditures, either through the creation of a liability or the payment of cash, for which the benefit is assumed to be realized in the current period. Salaries and interest in this case are accrued at the end of the current period with an accrual adjusting journal entry, and the associated cash payments are expected to follow in a future period. The utility expense is both recognized and paid in the current period. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 127 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 127 Since the benefit from each of these three expenditures is assumed to be realized in the current period, all are expensed, regardless of the timing of the cash payment. These expenditures have not been capitalized and, therefore, Step 4 in the matching process, an adjusting journal entry, is not necessary. FIGURE 417 Expense or capitalize? 1. Incur cost in current period for the purpose of generating revenue. 2. Decide in what period the revenue is to be generated. 3a. Current: Expense on income statement. 4. Cost Expiration: As revenue is generated, convert asset to expense via an adjusting journal entry. 3b. Future: Capitalize on balance sheet. (Deferral) Salaries Current period (expense) Current period (expense) Current period (expense) Salary Exp. (E, RE) XX Salary Pay. ( L) XX Interest Exp. (E, RE) XX XX Interest Pay. ( L) Utility Exp. (E, Cash ( A) RE) XX XX XX XX None required Interest None required Utilities None required Purchase of supplies Future period (asset) Supplies Inv. ( A) Cash ( A) Supplies Exp. (E, RE) Supplies Inv. ( A) Adjusted for supplies used. XX XX Purchase of merchandise inventory XX Future period (asset) Merch. Inv. ( A) Accounts Pay. ( L) XX Cost of Goods Sold (E, RE) XX XX Merchandise Inv. ( A) Adjusted for inventory sold. XX Rent Expense (E, RE) XX Prepaid Rent ( A) Adjusted for rent period expired. XX Unearned Revenue ( L) XX Earned Revenue (R, RE) Adjusted for service performed. Depreciation Exp. (E, RE) XX Accumulated Depr. ( A) XX Adjusted for useful life expired. Amortization Exp. (E, RE) XX XX Accumulated Amort. ( A) Adjusted for useful life expired. Prepaid expenses (e.g., insurance, interest, rent) Payments received in advance Future period (asset) Prepaid Rent ( A) Cash ( A) XX XX Future period (liability) XX Cash ( A) XX Unearned Rev. ( L) Purchase of property, plant, or equipment Future period (asset) Equipment ( A) Cash ( A) Note Payable ( L) Future period (asset) Trademark ( A) Cash ( A) XX XX XX XX XX Purchase of intangible asset (e.g., patent, trademark) JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 128 TEAM-B 204:JWCL006:ch04: 128 Part 2 Measurement, Mechanics, and Use of Financial Statements SUPPLIES INVENTORY. The fourth transaction in Figure 417, the purchase of supplies, is capitalized because supplies are normally expected to be useful beyond the current period. Typically, at the end of each period, an inventory of the remaining supplies is taken, and a cost expiration adjusting journal entry is entered in the books to reflect the cost of the supplies that were used (expired) during the period. This entry also restates the supplies inventory account on the balance sheet to reflect the supplies actually on hand at the end of the period. To illustrate, assume that during 2008 Weyerhaeuser Company purchased materials and supplies to support the manufacture of forest products at a total cost of $700. On December 31, a count revealed that supplies in the amount of $300 remained on hand. If the company began the year with $500 in the supplies account, the cost of the supplies used during 2008 would be computed as shown below, and the following journal entries would have been recorded to reflect these facts. Supplies Used $900 Beginning Inventory $500 Purchases $700 Ending Inventory $300 2008: Purchase of Supplies Dec. 31: Cost Expiration Adjusting Entry Supplies Inventory ( A) Cash ( A) Purchased supplies 700 700 Supplies Expense (E, RE) Supplies Inventory ( A) Recognized use of supplies 900 900 In this situation, supplies in the amount of $300 would be reported on the company's December 31 balance sheet. MERCHANDISE INVENTORY. The purchase of merchandise inventory is capitalized because inventories are expected to generate revenues in the future when they are sold. According to the matching principle, the cost of the merchandise should be converted to an expense, cost of goods sold, in the period when the inventories are sold. According to the matching principle, the cost of the merchandise inventory should be converted to an expense (called cost of goods sold) when the revenue associated with the sale of the inventory is recognized. Assuming that the May Department Stores sold merchandise inventory with a cost of $5,000, the journal entries following demonstrate how the capitalized cost would become cost of goods sold. 2008: Purchase of Merchandise At Time of Sale Merchandise Inv. ( A) Cash ( A) Purchased merchandise 5,000 5,000 Cost of Goods Sold (E, RE) 5,000 Merchandise Inv. ( A) Adjusted for inventory sold 5,000 PREPAID EXPENSES. Prepaid expenses represent costs such as insurance, interest, and rent that are paid in advance, before the associated benefit is realized. Insurance premiums, for example, are paid in advance and usually cover an entire year or more. Similarly, interest on loans is sometimes paid before the borrowed funds are used. In applying the matching principle, such prepayments are capitalized and then converted JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 129 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 129 to expenses as the time period expires and benefits are realized. This periodic conversion is achieved through cost expiration adjusting journal entries. To illustrate, assume that on January 1, 2008, Merck purchased a $1,000 insurance premium for a two-year period. The following journal entries would be made on the books of Merck over the life of the insurance coverage. Jan. 1, 2008: Purchase of Insurance Dec. 31, 2008 and 2009: Cost Expiration Adjusting Entry Prepaid Insurance ( A) Cash ( A) Paid insurance in advance 1,000 1,000 Insurance Expense (E, RE) 500 Prepaid Insurance ( A) Adjusted for expiration of insurance 500 In this example, Merck would report in the current asset section of its 2008 balance sheet $500 of prepaid (unexpired) insurance, which would be converted to an expense at the end of 2009. UNEARNED (DEFERRED) REVENUES. Unearned revenues are the reverse of prepaid expenses. For every entity that prepays an expense before the associated benefit is realized, another entity receives a payment before it performs the required service. When applying the revenue recognition principle to the entity that receives payment and has yet to provide the service, a liability account, called unearned revenues, is credited when the cash is initially collected. This account is then converted to a revenue as the service is performed with an end-of-period adjusting journal entry.5 To illustrate, suppose that Delta Air Lines received $5,000 during 2008 for tickets not yet used. Delta's cash account would immediately increase by $5,000, but the company would not recognize revenue at that time because it had not yet performed the contracted service. Instead, Delta would recognize a $5,000 liability, indicating that it owed services in the form of airplane travel. Assume that as of the end of 2008, Delta had fulfilled 60 percent of the services. At that time, therefore, an adjusting journal entry would be recorded to remove 60 percent of the liability from the company's balance sheet and, at the same time, recognize 60 percent of the revenue. The following journal entries reflect these facts. Receipt of Advance Payment Cost Expiration Adjusting Entry Cash ( A) 5,000 Unearned Revenue ( L) Received cash prior to providing service 5,000 Unearned Revenue ( L) 3,000 Fees Earned (R, RE) Recognized revenue from providing service 3,000 This sequence of journal entries would leave a liability for unearned revenues on Delta's 2008 balance sheet of $2,000, representing airline travel that Delta still had to fulfill. 5. Technically, an unearned revenue does not represent a capitalized cost because it is not an asset, and therefore, the adjusting journal entry to convert it to a revenue is not a cost expiration adjusting journal entry. However, we have chosen to categorize it as such because the concept of deferring the recognition of a revenue until the service is performed is the same as deferring the recognition of an expense until the associated benefit is realized. Both are essential to implementing the matching principle. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 130 TEAM-B 204:JWCL006:ch04: 130 Part 2 Measurement, Mechanics, and Use of Financial Statements PROPERTY, PLANT, AND EQUIPMENT. Transaction 8 in Figure 417 considers the costs of purchasing property, plant, and equipment. Since these assets are expected to help generate revenues beyond the current time period, the matching principle specifies that the acquisition costs be capitalized and systematically converted to an expense (amortized) over the estimated useful lives of the assets. At the end of each period of the estimated useful life, a cost expiration adjusting journal entry is recorded to amortize a portion of the capitalized cost. The process of amortizing the cost of property, plant, and equipment is called depreciation. To illustrate, assume that Federal Express invested $10,000 in flight equipment on January 1, 2008. At the time of the purchase, FedEx management subjectively estimated that the equipment would have a useful life of ten years and chose to depreciate an equal amount of the capitalized cost ($1,000 $10,000/10 years) at the end of each of the ten one-year periods. The following journal entries would have been recorded in FedEx's books. Jan. 1, 2008: Purchase of Equipment Dec. 31, 2008, 2009 . . . , 2017: Cost Expiration Adjusting Entry Equipment ( A) Cash ( A) Purchased equipment 10,000 10,000 Depr. Exp. (E, RE) Accumulated Depr. ( A) Adjusted for depreciation on equipment 1,000 1,000 Note that the cost expiration adjusting journal entry involves a debit to depreciation expense that appears on the income statement for each of the ten years. It also involves a credit to an account called accumulated depreciation, instead of a credit to the equipment account itself. Accumulated depreciation is a special account that appears on the asset side of the balance sheet. It offsets the asset account to which it applies (i.e., equipment), maintaining an accumulated balance of the amount of depreciation taken on the asset up to the date of the balance sheet. Balance sheet accounts like accumulated depreciation, which are used to offset other balance sheet accounts, are called contra accounts. Subtracting the balance in the accumulated depreciation account from the original cost of the equipment on the balance sheet gives rise to a number referred to as book value. Using the same information as in the preceding example, at the end of the second year (December 31, 2009) the equipment account would appear on FedEx's balance sheet as follows. The original cost of the equipment is $10,000, the accumulated depreciation is $2,000, and the net book value is $8,000. Equipment Less: Accumulated depreciation $10,000 2,000 $8,000 Estimating the useful life of property, plant, and equipment and choosing a method of allocating the capitalized cost to future periods is a subjective and difficult task for management. These choices can also have a significant effect on the amount of net income recognized each year because they have a direct bearing on the amount of depreciation expense that appears on the income statement. To illustrate the importance of such estimates, when Delta Air Lines decided to change the useful life estimate of its flight equipment from ten years to fifteen years, it disclosed in its financial report that the change decreased depreciation expense of that year by $130 million. INTANGIBLE ASSETS. The final transaction in Figure 417 is the purchase of an intangible asset, such as a patent or trademark. The cost of this purchase is, once again, JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 131 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 131 capitalized because the benefit of the purchase is expected to extend beyond the current period. Many intangibles have definable lives (often determined by law) over which the capitalized cost is typically amortized. The cost expiration adjusting journal entry consists of a debit to amortization expense and a credit to the contra account, accumulated amortization. To illustrate, assume that Johnson & Johnson, a leading manufacturer of consumer health care products, purchased a patent for $20,000, which was determined by law to have a twenty-year life. The following journal entries would be recorded by Johnson & Johnson over the patent's legal life. Purchase of Patent End of Each of 20 Subsequent Years: Cost Expiration Adjusting Entry Patent ( A) Cash ( A) Acquired patent. 20,000 20,000 Amortization Exp. (E, RE) Patent ( A) Adjusted for amortization of patent. 1,000 1,000 Note that the patent account is credited directly in the entry to amortize the cost of the patent. This practice is common, although GAAP recommends the use of a separate accumulated amortization account. CAPITALIZING AND MATCHING: EXAMPLES Figure 418 contains several examples in which cost expiration adjusting journal entries are used to apply the matching principle. Such entries are designed to convert capitalized costs to expenses in future time periods as the benefits (revenues) from the initial expenditures are recognized. The transactions illustrated in Figure 418 consider supplies, merchandise inventory, prepaid insurance, unearned revenue, equipment, and a patent. Note in Figure 418 that equal amounts of the cost of the equipment and the patent are depreciated, or amortized, in each of the three time periods. For example, the $9,000 equipment cost is depreciated at a rate of $3,000 per period. This method is referred to as straight-line depreciation. It is almost always used to amortize intangible assets, but it is only one of several methods that can be used to depreciate the capitalized costs of property, plant, and equipment. During 2006, Eastman Kodak Company booked revenues of $13.3 billion; paid interest costs on outstanding debt of $262 million; purchased inventory of $9.7 billion; purchased property, plant, and equipment of $379 million; and recognized depreciation and amortization of $1.3 billion. Explain each of these transactions in terms of Figures 417 and 418. Revaluation Adjustments At various points in the remainder of this text, we cover adjustments that do not fall into the categories of accruals or cost expirations. Such adjustments serve to restate certain accounts to keep their reported values in line with existing facts. For example, the balance sheet dollar amounts of short-term investments, accounts receivable, and inventories are sometimes adjusted when the market values of these assets change. The entries required in such situations are called revaluation adjustments. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 132 TEAM-B 204:JWCL006:ch04: 132 Part 2 Measurement, Mechanics, and Use of Financial Statements FIGURE 418 Capitalize and match Capitalize Adjusting Entries During Cost Expiration Period 1 2 Sup. Exp. (E, RE) 50 Supplies ( A) 50 Supplies costing $20 on hand. Explanation 3 Sup. Exp. (E, RE) Supplies ( A) No supplies on hand. 20 20 The cost of supplies is converted to expense as the supplies are used up. The cost of inventory is converted to expense (Cost of Goods Sold) as the inventory is sold. The cost of prepaid insurance is converted to expense as the insurance coverage expires. Revenue is recognized as the service is completed. Supplies ( A) 100 Cash ( A) 100 Purchased supplies. Sup. Exp. (E, RE) 30 Supplies ( A) 30 Supplies costing $70 on hand. Inventory ( A) 600 Accts. Pay. ( L) 600 Purchased 6 items at $100 per item. COGS (E, RE) Inventory ( A) One item sold. 100 100 COGS (E, RE) Inventory ( A) Two items sold. 200 200 COGS (E, RE) Inventory ( A) Three items sold. 300 300 Pre. Ins. ( A) 300 Cash ( A) 300 Paid 3 years of insurance coverage in advance. Ins. Exp. (E, RE) 100 Prepaid Ins. ( A) 100 The first year of insurance coverage expires. Ins. Exp. (E, RE) 100 Prepaid ins. ( A) 100 The second year of insurance coverage expires. Ins. Exp. (E, RE) 100 Prepaid Ins. ( A) 100 The third year of insurance coverage expires. Cash ( A) 240 Un. Rev. ( L) 240 Received $240 for services to be performed later. Un. Rev. ( L) 120 Fees Earned (R, RE) 120 Half of the service is performed. Un. Rev. ( L) 60 Fees Earned (R, RE) 60 One quarter of the service is performed. Un. Rev. ( L) 60 Fees Earned (R, RE) 60 One quarter of the service is performed. Equip. ( A) 9,000 Notes Pay. ( L) 9,000 Purchased machinery with an estimated 3-year life and no salvage value. Dep. Exp. (E, RE) 3,000 Accum. Dep. ( A) 3,000 First year passes, assuming straight-line depreciation rate. Dep. Exp. (E, RE) 3,000 Accum. Dep. ( A) 3,000 Second year passes. Dep. Exp. (E, RE) 3,000 Accum. Dep. ( A) 3,000 Third year passes. The cost of machinery is converted to expense (Depreciation Expense) as the estimated useful life passes. Patent ( A) 900 Cash ( A) 900 Acquired patent with 3-year legal life. Amort. Exp. (E, RE) 300 Accum. Amort. ( A) 300 First year passes, assuming straight-line amortization rate. Amort. Exp. (E, RE) 300 Accum. Amort. ( A) 300 Second year passes. Amort. Exp. (E, RE) 300 Accum. Amort. ( A) 300 Third year passes. The cost of obtaining the patent is converted to an expense (Amortization Expense) as the legal life passes. FINANCIAL STATEMENT PRESENTATION IN A MULTINATIONAL ENVIRONMENT In this chapter, we have covered the mechanics of preparing financial statements, measured in U.S. dollars, written in the English language, and using U.S. accounting principles. We now briefly discuss how multinationals, corporations that have their home in one country but operate and own subsidiaries in other countries, report to JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 133 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 133 shareholders, creditors, and other interested parties who transact in different currencies, speak different languages, and are familiar with different accounting principles. There are four basic approaches: 1. 2. 3. 4. Do nothing. Translate the language only. Translate the language, and express monetary amounts in the foreign currency. Translate the language, express monetary amounts in the foreign currency, and restate accounting classification format and voluation principles. The first approach is followed by most of the multinational companies based in the United States. These companies choose not to adjust their statements because they raise most of their capital in the United States, and the English language, the dollar, and U.S. accounting principles are well known throughout the world. The second and third approaches are popular for multinationals based in Europe, who often prepare versions in several different languages and sometimes prepare versions denominated in both euros and U.S. dollars. Most of these statements are based on international financial reporting standards (IFRS). Complete restatements, approach (4), are prepared by a number of Japanese multinationals, like Honda and Mitsubishi. Many of these companies list their common stock shares on the New York and American share exchanges, which require that all registrants follow either U.S. generally accepted accounting principles, or IFRS. A small number of companies, like the oil giant Royal/Dutch Shell, which now follows IFRS, prepared financial statements that attempt to synthesize the "best" accounting practices of several countries. Such statements are intended to satisfy all user needs on a global basis. APPENDIX 4A MECHANICS--A USER'S PERSPECTIVE Chapter 4 covered accounting mechanics from an economic consequence perspective. That is, we have discussed and illustrated how economic events affect the financial statements. Managers need such understanding to assess in advance the financial statement effects and associated economic consequences of transactions under their consideration. To be astute financial statement users, managers need an additional skill--one that involves working backward from the financial statements to identify underlying economic events. When evaluating solvency, earning power, and the quality of a company's management, it is often useful to be able to infer information that is not directly disclosed. T-account analysis is employed by many financial statement users to infer economic events from the financial statements. It is a mechanical process that involves examining the activity in a given T-account to acquire information that is not directly disclosed on the financial statements or footnotes. Consider, for example, a situation where a financial statement user is analyzing the financial statements of Wildcat Industries, which are provided in Figure 4A2. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 134 TEAM-B 204:JWCL006:ch04: 134 Part 2 Measurement, Mechanics, and Use of Financial Statements Assume that the user is interested in the amount of cash paid during 2009 for salaries, information that is not disclosed anywhere on the financial statements. T-account analysis, as illustrated in Figure 4A1, involves constructing a T-account for salaries payable and analyzing the activity in that account during 2009. Note first that the beginning and ending balances are $7,000 and $9,000, respectively, amounts that appear on the 2008 and 2009 balance sheets. Since salaries are accrued, the dollar amount for salary expense on the income statement indicates that during 2009 the salaries payable account must have been increased by $4,000. The entry to the left side of the T-account, therefore, must have been $2,000, the amount of cash paid for salaries during 2009. This $2,000 is disclosed nowhere on the financial statements (it is buried inside net cash provided by operating activities), yet it may be useful in assessing solvency and earning power. In a second example, assume that the user is interested in the dollar amount of inventory purchased during 2009, additional information--not disclosed directly on the financial statements--that may be useful in assessing solvency and earning power. In this case, T-account analysis involves analyzing the activity in the inventory account, as shown in Figure 4A3. Once again, the beginning and ending balances ($15,000 and $18,000, respectively) come directly from the 2008 and 2009 balance sheets. Since cost of goods sold on the income statement represents the outflow of inventory, sold the inventory account must have been reduced by $30,000 during 2009. Inventory purchases, therefore, must have been $33,000. In the final example, assume that a user noticed on the income statement that Wildcat incurred a $1,000 loss on the sale of equipment and was interested in reconstructing the transaction that produced that loss. Assume also that the footnotes indicate that Wildcat acquired equipment at a cost of $15,000 during 2009. In this case, T-account analysis involves analyzing both the equipment and the accumulated depreciation accounts, as illustrated in Figure 4A4. As in the previous examples, the beginning and ending balances in the equipment and accumulated depreciation T-accounts come directly from the 2008 and 2009 balance sheets. The footnotes indicate that Wildcat acquired equipment at a cost of $15,000, which explains the $15,000 entry to the left (debit) side of the equipment account. Therefore, Wildcat must have sold equipment with a cost of $5,000 during 2009. The income statement shows depreciation expense of $6,000, which means that the accumulated depreciation T-account must have been credited by $6,000 during 2009. To make this account balance, it must have been reduced by $1,000, the amount of accumulated depreciation associated with the equipment that was sold during 2009. Finally, the loss on the sale of equipment comes from the income statement, and to make the journal entry balance, cash of $3,000 must have been received in the exchange. FIGURE 4A1 T-account analysis of salaries payable account Salaries Payable 12/31/08 7,000 4,000 2,000 12/31/09 9,000 Salaries Payable ( L) 2,000 2,000 Cash ( A) Entry to record cash payments for salaries during 2009 Salaries Expense (E, RE) 4,000 4,000 Salaries Payable ( L) Entry to accrue salaries during 2009 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 135 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 135 FIGURE 4A2 Financial statements for Wildcat Industries Wildcat Industries Abbreviated Financial Statements for the Years Ended December 31, 2009 and 2008 2009 BALANCE SHEET ASSETS 2008 Cash Accounts receivable Inventory Prepaid rent Equipment Less: Accumulated depreciation Total assets LIABILITIES AND SHAREHOLDERS' EQUITY $ 4,000 15,000 18,000 5,000 50,000 (10,000) $82,000 $ 8,000 9,000 2,000 5,000 35,000 15,000 8,000 $82,000 $ 7,000 12,000 15,000 3,000 40,000 (5,000) $72,000 $ 4,000 7,000 3,000 8,000 30,000 15,000 5,000 $72,000 Accounts payable Salaries payable Dividends payable Unearned revenue Long-term debt Contributed capital Retained earnings Total liabilities and shareholders' equity INCOME STATEMENT Revenues Less: Cost of goods sold Salaries expense Rent expense Depreciation expense Loss on sale of equipment Net income RECONCILIATION OF RETAINED EARNINGS $52,000 (30,000) (4,000) (6,000) (6,000) (1,000) $ 5,000 Beginning retained earnings balance (12/31/08) Plus: Net income Less: Dividends Ending retained earnings balance (12/31/09) STATEMENT OF CASH FLOWS $ 5,000 5,000 (2,000) $ 8,000 Net cash provided by operating activities Net cash used by investing activities Net cash used by financing activities Change in cash balance Beginning cash balance (12/31/08) Ending cash balance (12/31/09) $ 7,000 (7,000) (3,000) $ (3,000) 7,000 $ 4,000 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 136 TEAM-B 204:JWCL006:ch04: 136 Part 2 Measurement, Mechanics, and Use of Financial Statements FIGURE 4A3 T-account analysis of inventory account Inventory 12/31/08 15,000 30,000 33,000 12/31/09 18,000 33,000 Inventory ( A) 33,000 Accounts Payable ( L) Entry to record inventory purchases during 2009 Cost of Goods Sold (E, RE) 30,000 30,000 Inventory ( A) Entry to recognize cost of goods sold during 2009 In each of the three preceding examples, information not directly disclosed on the financial statements was derived through a technique called T-account analysis, which normally includes the following four steps. 1. One or more balance sheet accounts are identified for analysis depending on what the user wishes to learn. 2. T-accounts are created for each account, and the beginning and ending balances are taken directly from the balance sheets. FIGURE 4A4 T-account analysis of equipment and accumulated depreciation account Equipment Purchase of equipment (footnotes) 12/31/08 40,000 15,000 5,000 12/31/09 50,000 Cash ( A) 3,000 Loss on Sale of Equipment (Lo, RE) 1,000 1,000 Accumulated Depreciation ( A) 5,000 Equipment ( A) Entry to record the sale of equipment Accumulated Depreciation 12/31/08 1,000 12/31/09 10,000 5,000 6,000 6,000 Depreciation Expense (E, RE) 6,000 Accumulated Depreciation ( A) Entry to depreciate equipment JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 137 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 137 3. Additional information from various sources is used to re-create the activity (increases or decreases) that explains the change in the T-account balance. Sometimes the information can be found in the footnotes, and sometimes it is contained in the other financial statements. Often, the information is disclosed on the income statement, which includes certain accounts closely related to the T-accounts under analysis. For example, salaries expense is closely related to salaries payable; cost of goods sold is closely related to inventory; and depreciation expense is closely related to accumulated depreciation. These accounts are closely related because they often appear in the same journal entry. By re-creating this journal entry, the user can determine a portion of the activity in the T-account under analysis. 4. Given the information compiled in steps 13, the missing part of the activity in the T-account can be inferred because it represents the dollar amount needed to complete the explanation of the change in the T-account balance. In this section, we have only introduced T-account analysis and shown how it can be used to produce useful information in three relatively simple cases. It can involve highly sophisticated procedures, and for most accounting students it is a difficult concept that requires time, effort, practice, and experience before it can be mastered. The remainder of this textbook provides a number of opportunities to learn more about this technique and to practice it because it can significantly improve your ability to learn as much as possible from the financial statements. REVIEW PROBLEM Consider the balance sheet of a small retail company, Kelly Supply, as of December 31, 2008 (Figure 419). Exchange transactions that occurred during 2009 are recorded in Figure 420 and posted to T-accounts in Figure 421. The financial statements are contained in Figures 422 and 423. The December 31, 2008 balance sheet accounts are reflected in the T-accounts as beginning balances. The exchange transactions are numbered (1)(11), and each is described and has been posted in the T-accounts. FIGURE 419 Balance sheet for Kelly Supply Kelly Supply Balance Sheet December 31, 2008 LIABILITIES AND SHAREHOLDERS' EQUITY ASSETS Cash Accounts receivable Merchandise inventory Prepaid rent Machinery Less: Accum. depr. Patent $12,000 15,000 12,000 3,000 $25,000 5,000 20,000 5,000 Total assets $67,000 Accounts payable Wages payable Interest payable Dividends payable Unearned revenue Short-term notes pay. Long-term notes pay. Contributed capital Retained earnings Total liabilities and shareholders' equity $ 8,000 3,000 1,000 2,000 3,000 5,000 10,000 30,000 5,000 $67,000 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 138 TEAM-B 204:JWCL006:ch04: 138 Part 2 Measurement, Mechanics, and Use of Financial Statements FIGURE 420 General journal for Kelly Supply Daily Journal Entries Adjusting Journal Entries (1) Cash ( A) 10,000 Accounts Receivable ( A) 15,000 Sales (R, RE) 25,000 Cost of Goods Sold (E, RE) 9,000 Merchandise Inventory ( A) 9,000 Sold merchandise with a cost of $9,000 for cash and on account. (2) Cash ( A) Accounts Receivable ( A) Received cash on account. 8,000 8,000 (12) Unearned Revenue ( L) 2,000 Sales (R, RE) Recognized 2/3 of goods delivered. (13) Interest Receivable ( A) Interest Revenue (R, RE) Recognized accrued interest on savings account. 50 2,000 50 (3) Merchandise Inventory ( A) 10,000 Cash ( A) Accounts Payable ( L) Purchased merchandise inventory for cash and on account. (4) Accounts Payable ( L) Cash ( A) Paid cash on account. (5) Wages Payable ( L) Wage Expense (E, RE) Cash ( A) Paid accrued wages. (6) Interest Payable ( L) Interest Expense (E, RE) Cash ( A) Paid accrued interest. (7) Short-Term Notes Pay. ( L) Cash ( A) Paid short-term note. 10,000 (14) Depreciation Expense (E, RE) 3,000 Accumulated Depr. ( A) Recognized depreciation on machinery. (15) Amortization Expense (E, RE) 500 Patent ( A) Recognized amortization of patent. (16) Wage Expense (E, RE) Wages Payable ( L) Recognized accrued wages. (17) Interest Expense (E, RE) Interest Payable ( L) Recognized accrued interest on note payables. (18) Rent Expense (E, RE) Prepaid Rent ( A) Recognized 1/3 of rent period expired. 1,000 3,000 3,000 7,000 500 10,000 3,000 7,000 10,000 1,000 1,000 2,000 2,500 2,500 1,000 2,000 2,000 1,000 1,000 (8) Cash ( A) 10,000 Contributed Capital ( CC) 10,000 Issued common stock for cash. (9) Dividends Payable ( L) Cash ( A) Paid cash dividend. (10) Machinery ( A) Cash ( A) Acquired machinery for cash. (11) Dividends ( RE) Dividends Payable ( L) Declared dividends. 2,000 2,000 1,000 1,000 1,000 1,000 (19) Sales 27,000 Interest Revenue 50 Cost of Goods Sold Wage Expense Rent Expense Interest Expense Deprec. Expense Amortization Expense Retained Earnings To close revenue and expense accounts to Retained Earnings. 9,000 8,000 1,000 3,000 3,000 500 2,550 (20) Retained Earnings 1,000 Dividends 1,000 To close dividends to Retained Earnings. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 139 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 139 FIGURE 421 T-accounts for Kelly Supply Cash Accounts Receivable Interest Receivable Merchandise Inventory 12,000 (1) 10,000 (2) 8,000 (3) 3,000 (4) 10,000 (5) 10,000 (6) 2,000 (7) 2,500 (9) 2,000 (10) 1,000 15,000 (1) 15,000 (2) 8,000 (13) 50 12,000 (3) 10,000 (1) 9,000 (8) 10,000 9,500 22,000 50 Accumulated Depreciation 13,000 Prepaid Rent Machinery Patent 3,000 2,000 (18) 1,000 25,000 (10) 1,000 26,000 Wages Payable (14) 5,000 3,000 8,000 5,000 4,500 (15) 500 Accounts Payable Interest Payable Dividends Payable (3) (4) 10,000 8,000 7,000 (5) 5,000 3,000 (16) 3,000 1,000 (6) 1,000 1,000 (17) 1,000 2,000 (9) 2,000 2,000 (11) 2,000 1,000 1,000 Unearned Revenue Short-Term Notes Payable Long-Term Notes Payable Contributed Capital 3,000 (12) 2,000 1,000 Retained Earnings Sales 5,000 (7) 2,500 2,500 10,000 10,000 Interest Revenue 30,000 (8) 10,000 40,000 (20) 1,000 (19) 5,000 (19) 27,000 2,550 6,550 (1) 25,000 (19) (12) 2,000 0 50 (13) 50 0 Cost of Goods Sold Wage Expense Rent Expense Interest Expense (1) 9,000 0 (19) 9,000 (5) 7,000 (16) 1,000 0 (18) 1,000 (19) 8,000 0 Dividends (19) (6) 1,000 1,000 (17) 2,000 0 (19) 3,000 Depreciation Expense Amortization Expense (14) 3,000 0 (19) 3,000 (15) 500 0 (19) 500 (11) 1,000 0 (20) 1,000 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 140 TEAM-B 204:JWCL006:ch04: 140 Part 2 Measurement, Mechanics, and Use of Financial Statements FIGURE 422 Financial statements for Kelly Supply Kelly Supply Income Statement for the Year Ended December 31, 2009 Revenues: Sales Interest revenue Total revenues Expenses: Cost of goods sold Wage expense Rent expense Interest expense Depreciation expense Amortization expense Total expenses Net income $27,000 50 $27,050 $ 9,000 8,000 1,000 3,000 3,000 500 24,500 $ 2,550 Kelly Supply Statement of Shareholders' Equity for the Year Ended December 31, 2009 Contributed Capital Retained Earnings Total Beginning balance Common stock issuances Net income Less: Dividends Ending balance $30,000 10,000 $ 5,000 2,550 (1,000) $ 6,550 $40,000 $35,000 10,000 2,550 (1,000) $46,550 Kelly Supply Balance Sheet December 31, 2009 LIABILITIES AND SHAREHOLDERS' EQUITY ASSETS Cash Accounts receivable Interest receivable Merchandise inventory Prepaid rent Machinery Less: Accumulated depreciation Patent Total assets $ 9,500 22,000 50 13,000 2,000 $26,000 8,000 18,000 4,500 $69,050 Accounts payable Wages payable Interest payable Dividends payable Unearned revenue Short-term notes pay. Long-term notes pay. Contributed capital Retained earnings Total liabilities and shareholders' equity $ 5,000 1,000 2,000 1,000 1,000 2,500 10,000 40,000 6,550 $69,050 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 141 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 141 FIGURE 423 Statement of cash flows for Kelly Supply Kelly Supply Statement of Cash Flows for the Year Ended December 31, 2009 Operating activities: Collections from sales Collections of accounts receivable Payments for inventory purchases Payments on accounts payable Payments for wages Payments for interest Net cash increase (decrease) from operating activities Investing activities: Purchase of machinery Net cash increase (decrease) from investing activities Financing activities: Issuance of common stock Payment of dividend Principal payments on short-term notes payable Net cash increase (decrease) from financing activities Net cash increase (decrease) during 2009 Beginning cash balance (December 31, 2008) Ending cash balance (December 31, 2009) $10,000 8,000 (3,000) (10,000) (10,000) (2,000) $(7,000) $ (1,000) (1,000) $10,000 (2,000) (2,500) 5,500 $(2,500) 12,000 $ 9,500 At year-end, the adjusting journal entries are recorded and posted to the T-accounts. Adjusting entries are numbered (12)(18). Entries (13), (16), and (17) are accruals, and entries (12), (14), (15), and (18) are cost expirations. Entries (19) and (20) close revenues, expenses, and dividends to retained earnings. The income statement contains revenues and expenses; the statement of shareholders' equity explains the change in the contributed capital and retained earnings balances; and the balance sheet consists of the ending balances in the asset, liability, and shareholders' equity accounts. The statement of cash flows was prepared directly from the entries in the cash T-account. SUMMARY OF KEY POINTS Two criteria necessary for economic events to be reflected in the financial statements. Economic events must be both relevant and objectively measurable in monetary terms if they are to be reflected on the financial statements. Relevant events have economic significance to the company. Objectively measurable events must be backed by documented evidence. Economic events must be relevant so that they can be used to evaluate the financial condition of the company; they must be objectively measurable so that they can be audited and viewed as credible by users. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 142 TEAM-B 204:JWCL006:ch04: 142 Part 2 Measurement, Mechanics, and Use of Financial Statements The accounting equation and how it relates to the balance sheet, income statement, statement of shareholders' equity and statement of cash flows. The accounting equation states that assets equal liabilities plus shareholders' equity. The main components of the accounting equation (assets, liabilities, and shareholders' equity) are divided into subcategories, called accounts, in which transactions are recorded and from which the financial statements are compiled. When a business transaction occurs, two or more accounts are increased or decreased in such a way as to maintain the equality of the equation. The balance sheet contains the balances as of a given point in time of all the asset, liability, and shareholders' equity accounts. It is a statement of the accounting equation. The income statement contains a summary of the operating transactions, measured on an accrual basis, entered into by a company during a period of time. Operating transactions affect asset or liability accounts and always either increase or decrease retained earnings in the shareholders' equity section of the accounting equation. The statement of shareholders' equity and the statement of cash flows summarize the transactions that affect the shareholders' equity and cash accounts, respectively. The statement of shareholders' equity includes the net effect of the operating transactions as well as transactions with shareholders. The statement of cash flows is composed of cash inflows and outflows and explains the change in the cash account during the period. Journal entries (and T-accounts) and how they express the effect of economic events on the basic accounting equation and the financial statements. Journal entries (and T-accounts) are structured to indicate three aspects about economic events: (1) the accounts affected, (2) the direction of the effect, and (3) the dollar amount of the effect. Increases (decreases) in asset accounts and decreases (increases) in liability and equity accounts are placed on the left (right) side of the entry. Recognized revenues (expenses) are always placed on the right (left) side of the entry because they are always accompanied by increases (decreases) in assets or decreases (increases) in equities, which are indicated on the left (right) side. Following these rules ensures that economic events will be recorded in a way that maintains the equality of the accounting equation, and understanding these rules enables one to efficiently communicate the effects of any economic event on the financial statements. Why managers need to understand how economic events affect the financial statements. Managers often face situations in which they must choose whether to enter into certain transactions or how to structure transactions. Such choices should not be made without considering their economic consequences. The financial statement effects of transactions can lead to important economic consequences because outsiders use financial statement numbers to control and evaluate the firm and its management. Therefore, astute managers must understand in advance how transactions and other economic events affect the financial statements. In addition, adequate internal controls over the recording process are crucial to ensure that all transactions are recorded in a timely and accurate manner. Why the financial statements are adjusted periodically to reflect certain economic events. A large number of economic events are not represented by exchange transactions (e.g., depreciation of productive assets, and accruals of salaries, interest, and rent), yet they meet the criteria (relevant and objective) for inclusion on the financial statements. These events require that adjustments be made to the financial statements periodically. Normally such adjustments are made to apply the principles of revenue recognition JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 143 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 143 and matching. Revenue recognition states that revenues should be recognized when the earning process is substantially complete, not necessarily when cash is received. Matching states that expenses should be recognized in those periods when the associated benefit (revenue) is realized, not necessarily when cash is paid. These principles are fundamental to an accrual accounting system. KEY TERMS Note: Definitions for these terms are provided in the glossary at the end of the text. Accounting equation (p. 108) Accrual system of accounting (p. 122) Accruals (p. 122) Amortized (p. 130) Assets (p. 108) Book value (p. 130) Business transactions (p. 109) Capitalized (p. 125) Compound journal entries (p. 115) Contra accounts (p. 130) Contributed capital (p. 109) Credit (p. 115) Debit (p. 115) Deferral (cost expiration) (p. 125) Depreciation (p. 130) Double entry system (p. 115) Economic events (p. 107) Expensed (p. 125) Journal entries (p. 115) Liabilities (p. 109) Matching principle (p. 125) Multinationals (p. 132) Permanent accounts (p. 121) Relevant events (p. 107) Retained earnings (p. 109) Revaluation adjustments (p. 131) Shareholders' equity (p. 109) Straight-line depreciation (p. 131) T-accounts (p. 118) T-account analysis (p. 133) Temporary accounts (p. 121) Unearned revenues (p. 129) ETHICS IN THE REAL WORLD In an article about the subjectivity involved when deciding to capitalize or expense a cost, Forbes reports: A dollar spent on a toaster doesn't reduce wealth in the same way as one spent on a Twinkie. One lasts, the other doesn't. But where do toasters end and Twinkies begin in [today's] economy? . . . Accountants understand the general problem, but they do not know what to do about it. Capitalizing anything that you can't drop on your foot--software, worker training, marketing expense--can be hugely speculative. You never find out whether such things have real future value until the future arrives. A case in point involves Fine Host Corp., which spent huge dollar amounts to obtain new food service contracts. The company listed these costs on the balance sheet and depreciated them over time. When the company was accused of aggressive accounting, the share price dropped from $12 to $3 per share. Many believed that the food service contract costs should have been accounted for "as current expenses against revenue." Fine Host ended up restating its net income number, reducing it from $13 million to a loss of almost $18 million. ETHICAL ISSUE Fine Host management was not convicted, nor even accused, of fraud. The company just subjectively called an asset what many in the financial community considered an expense. Was it ethical for Fine Host to do so? Was management acting in the interests of the shareholders? JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 144 TEAM-B 204:JWCL006:ch04: 144 Part 2 Measurement, Mechanics, and Use of Financial Statements INTERNET RESEARCH EXERCISE The chapter opener points out that there are some accounting problems in U.S. federal agencies. The government organization assigned to oversee budgeting and accounting for the federal government is the General Accounting Office (GAO). What is the GAO, what kind of reports does it provide, and how is it organized? Begin your search at www.gao.gov. BRIEF EXERCISES REAL DATA BE41 Effects of transactions on the accounting equation During 2006, Intel entered into the transactions listed below. a. On a separate sheet of paper, complete the following chart to show the effect of these transactions on the accounting equation and compute the net effect (dollars in millions). Transaction Assets Liabilities Shareholders' Equity 1. Paid $5,779 to purchase property, plant, and equipment. 2. Issued common stock for $1,046. 3. Recorded depreciation of $4,654. Net effect b. Which one of the transactions did not appear to affect the accounting equation? Why didn't it? REAL DATA BE42 Effects of transactions on the accounting equation During 2006, The Limited entered into the transactions listed below. a. On a separate sheet of paper, complete the following chart to show the effect of these transactions on the accounting equation and compute the net effect (dollars in millions). Transaction Assets Liabilities Shareholders' Equity 1. Repaid $7 of long-term debt. 2. Paid cash dividends of $238. 3. Repurchased common stock for $193. Net effect b. Compare and discuss how transactions 2 and 3 affected the basic accounting equation. REAL DATA During 2006, Yahoo!, Inc. entered into the transactions listed below. a. On a separate sheet of paper, complete the following chart to show the effect of these transactions on the accounting equation and compute the net effect (dollars in millions). BE43 Effects of transactions on the accounting equation JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 145 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 145 Transaction Assets Liabilities Shareholders' Equity 1. Recognized service revenues of $50 in exchange for accounts receivable. 2. Paid $25 for sales and marketing. 3. Issued common stock for $318. 4. Purchased marketable securities for $1,329 Net effect b. Which of these transactions would be reflected on the income statement? Which of these transactions would be reflected on the statement of cash flows? EXERCISES E41 Effects of transactions on the accounting equation On a separate piece of paper, complete the following chart to show the effect of each transaction on the accounting equation. Transaction Assets Liabilities Shareholders' Equity 1. 2. 3. 4. 5. 6. E42 Effects of transactions on accounts Owners contributed $30,000 cash. Purchased land for $20,000 cash. Borrowed $9,000 cash from bank. Provided services for $8,000 on account. Paid $5,500 cash for expenses. Paid $500 cash dividend to owners. Consider the same transactions as in E41, but this time complete the following chart, using a separate sheet of paper. Assets Trans. Cash Accounts Receivable Land Liabilities Notes Payable Shareholders' Equity Contributed Capital Retained Earnings 1. 2. 3. 4. 5. 6. E43 Preparing the financial statements from the accounts Total each asset, liability, and shareholders' equity account in E42, and prepare an income statement, a statement of shareholders' equity, a balance sheet, and a statement of cash flows. Assume that the current year is the company's first year of operations. Assume that Cathedral Enterprises, which is in its first year of operations, entered into the following transactions. Show how the five transactions affect the accounting equation, and prepare an income statement, statement of shareholders' equity, balance sheet, and statement of cash flows. 1. Shareholders contributed $10,000 cash. 2. Performed services for $8,000, receiving $6,000 in cash and a $2,000 receivable. 3. Incurred expenses of $6,000. Paid $3,000 in cash, and $3,000 is still payable. (Continued) E44 Preparing the financial statements JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 146 TEAM-B 204:JWCL006:ch04: 146 Part 2 Measurement, Mechanics, and Use of Financial Statements 4. Purchased land for $12,000. Paid $2,000 in cash and signed a long-term note for the remainder. 5. Paid the shareholders $400 in the form of a dividend. 6. Sold one-half of the land purchased in (4) for $7,000 cash. E45 Which economic events are relevant and objectively measurable? The Brown Corporation experienced the following financial events on October 10, 2009: 1. The company entered into a new contract with the employees' union that calls for a $2.00 per hour increase in wages, a longer lunch break, and cost-of-living adjustments, effective January 1, 2010. 2. The company issued $200,000 in bonds that mature on October 10, 2019. The terms of the bond issuance stipulate that interest is to be paid semiannually at an annual rate of 10 percent. 3. The company president retired and was replaced by the vice president of finance. 4. The company received $10,000 from a customer in settlement of an open account receivable. 5. The company paid $1,000 interest on an outstanding loan. The interest is applicable to September 2009 and is included on the books as a liability, "Accrued Interest Payable." 6. The market value of all the company's long-lived assets is $275,000. They are currently reported on the balance sheet at $250,000. 7. The company purchased a fire insurance policy for $1,500 that will pay the Brown Corporation $1 million if its primary production plant is destroyed. The policy insures the company from November 1, 2009, through October 31, 2010. 8. The company placed an order to have $10,000 of inventory shipped on October 17, 2009. Indicate whether each of these economic events has accounting significance (i.e., whether the company would prepare a journal entry for the event). In each case, explain why or why not. REAL DATA E46 Preparing financial statements The following accounts and balances were taken from the records of US Airways (dollars in millions). Flight equipment Passenger revenue Retained earnings Notes payable Interest expense Accounts receivable Dividends Prepaid expenses $5,672 7,685 (551) 2,113 193 624 0 265 Accounts payable Common share Fuel expense Other revenues Short-term investments Depreciation expense Gain on sale of investment $474 101 727 761 215 401 274 Identify each account as an income statement or balance sheet account. Where is each account reflected in the basic accounting equation? REAL DATA E47 Preparing financial statements The following information was taken from the 2006 annual report of Bristol-Myers Squibb, a world-leading drug company (dollars in millions). Cost of goods sold Net cash from operations Accounts receivable Restructuring Expense Net cash from financing Shareholders' equity Net cash from investing Research and dev. expense Other assets Other expenses Marketable securities $ 5,956 2,083 3,247 (59) (3,351) 9,991 (206) 3,067 9,600 977 1,995 Cash and equivalents Short-term borrowings Advertising and product expense Accounts payable Long-term liabilities Net sales Property, plant, and equipment Other current assets Other current liabilities Selling and adm. expenses Accrued payables $ 2,018 187 1,351 1,239 9,088 17,914 5,673 3,042 1,915 4,919 3,155 Prepare an income statement, balance sheet, and statement of cash flows, and comment on the financial performance and condition of the company. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 147 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 147 E48 Preparing a statement of cash flows from the cash ledger The following cash T-account for Miller Manufacturing summarizes all the transactions affecting cash during 2009. Cash Beginning balance Sales of services Receivables collections Sale of land Issuance of common stock Long-term borrowings 9,000 45,000 50,000 7,500 15,000 16,000 Equipment purchases Rent payable payments Bank loan principal Loan interest Salaries Dividend payments Miscellaneous expenses Long-term investment purchase 24,000 7,000 12,000 3,000 26,500 4,000 13,000 10,000 a. Compute the ending cash balance. b. Prepare a statement of cash flows. E49 Preparing a statement of cash flows from journal entries Small and Associates, a small manufacturing firm, entered into the following cash transactions during January 2009: 1. 2. 3. 4. 5. 6. 7. Issued 600 shares of stock for $25 each. Sold services for $4,000. Paid wages of $1,600. Purchased land as a long-term investment for $9,000 cash. Paid a $2,000 dividend. Sold land with a book value of $3,000 for $3,500 cash. Paid $1,500 to the bank: $900 to reduce the principal on an outstanding loan and $600 as an interest payment. 8. Paid miscellaneous expenses of $1,800. a. Prepare journal entries for each transaction. b. Prepare a cash T-account, and compute Small's cash balance as of the end of January. Assume a beginning balance of $5,000. c. Prepare a statement of cash flows for the month of January. E410 Preparing statements from transactions Ed's Lawn Service entered into the following transactions during 2009, its first year of operations: 1. 2. 3. 4. 5. 6. 7. 8. Collected $12,000 in cash from shareholders. Borrowed $5,000 from a bank. Purchased two parcels of land for a total of $10,000. Paid $5,000 to rent lawn equipment for the remainder of the year. Provided lawn services, receiving $10,000 in cash and $4,000 in receivables. Paid miscellaneous expenses of $4,000. Sold one parcel of land with a cost of $3,000 for $2,800. Paid a $2,200 dividend to the shareholders. a. In a manner similar to Figure 42, show how each transaction affected the fundamental accounting equation and prepare an income statement, a statement of shareholders' equity, a year-end balance sheet, and a statement of cash flows for 2009. b. Journalize each transaction and post it in the appropriate T-accounts. From this information, prepare a year-end balance sheet, an income statement, a statement of shareholders' equity, and a statement of cash flows for 2009. E411 Preparing the statement of cash flows from the cash T-account The following cash T-account for Holcomb Manufacturing summarizes all the transactions affecting cash during 2009. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 148 TEAM-B 204:JWCL006:ch04: 148 Part 2 Measurement, Mechanics, and Use of Financial Statements Cash Beginning balance Sales of inventories Receivable collections Sales of long-term investments Issuance of common stock Long-term borrowings 8,000 34,000 40,000 12,500 14,000 9,000 Inventory purchases Accounts payable payments Bank loan principal payments Loan interest Wages Dividend payments Administrative expenses Equipment purchases 27,000 7,000 10,000 3,000 16,000 4,000 12,000 11,000 a. Compute the ending cash balance. b. Prepare a statement of cash flows (direct method). E412 Classifying adjusting journal entries Eaton Enterprises made the following adjusting journal entries on December 31, 2008: 1. Rent Expense Rent Payable 2. Insurance Expense Prepaid Insurance 3. Depreciation Expense Accumulated Depreciation 4. Interest Receivable Interest Revenue 5. Unearned Revenue Fees Earned 1,200 1,200 5,000 5,000 20,000 20,000 1,500 1,500 200 200 a. Give a brief explanation for each of the above entries. b. Classify each of the above entries as either a cost expiration adjusting entry or an accrual adjusting entry. E413 Classifying transactions Hog Heaven Rib Joint made the following journal entries on December 31, 2008: 1. Wage Expense Wages Payable 2. Interest Expense Cash 3. Cash Note Payable 4. Rent Expense Prepaid Rent 5. Insurance Expense Prepaid Insurance 6. Cash Unearned Revenues 7. Equipment Cash 8. Supplies Expense Supplies Inventory 9. Accounts Payable Cash 10. Depreciation Expense Accumulated Depreciation 11. Advertising Expense Cash 12. Advertising Expense Prepaid Advertising 6,000 6,000 1,000 1,000 10,500 10,500 1,500 1,500 2,800 2,800 2,000 2,000 9,000 9,000 12,000 12,000 8,000 8,000 13,000 13,000 8,000 8,000 3,000 3,000 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 149 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 149 Place each of the transactions above in one of the following five categories: (1) operating cash flow, (2) investing cash flow, (3) financing cash flow, (4) accrual adjusting journal entry, and (5) cost expiration adjusting journal entry. The Hurst Corporation pays its employees every Friday for the five-day week just ended. On January 2, 2010, the company paid its employees $70,000 for the week beginning Monday, December 29. a. Assuming that the employees earned wages evenly throughout the week, prepare any adjusting journal entries that were necessary on December 31, 2009. b. Prepare the journal entry that would be recorded on Friday, January 2, when the wages are paid. c. Complete a chart like the following. 2009 2010 Total E414 Recognizing accrued wages Wage expense Cash outflow associated with wages d. What is the purpose of the adjusting journal entry on December 31? REAL DATA E415 Depreciating a fixed asset At the beginning of fiscal 2006, Starbucks purchased equipment costing approximately $770 million. The company used straight-line depreciation and normally depreciates its equipment over three years. a. Compute the book value of the equipment at the end of each of the three years. b. Complete a chart like the following. 2006 2007 2008 Total Depreciation expense Cash outflow associated with the purchase of the equipment c. What is the purpose of the adjustments at the end of each period? Washington Forest Products began operations on January 1, 2008. On December 31, 2008, the company's accountant ascertains that the following amounts should be reported as expenses on the income statement: Insurance expense Supplies expense Rent expense $20,000 11,000 14,000 E416 The difference between accrual and cash accounting A review of the company's cash disbursements indicates that the company made related cash payments during 2008 as follows: Insurance Supplies Rent $29,000 27,000 8,000 a. Explain why the amounts shown as expenses do not equal the cash paid. b. For each expense account, compute the amount that should be in the related balance sheet account as of December 31, 2008. Hint: Note that Forest Products began operations on January 1, 2008. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 150 TEAM-B 204:JWCL006:ch04: 150 Part 2 Measurement, Mechanics, and Use of Financial Statements E417 The difference between net income and net cash flow from operations The following journal entries were recorded by Lauren Retailing during the month of July: 1. Cash Accounts Receivable Sales 2. Cash Accounts Receivable 3. Inventory Accounts Payable 4. Accounts Payable Cash 5. Cost of Goods Sold Inventory 6. Accrued Expenses Accrued Payables 5,000 3,000 8,000 2,000 2,000 5,800 5,800 2,800 2,800 3,700 3,700 2,500 2,500 a. Prepare an income statement and the operating section of a statement of cash flows. b. Explain why net income is not equal to net cash flow from operations, and reconcile the two numbers. E418 Preparing a statement of cash flows from original transactions Rahal and Watson, a small manufacturing company, entered into the following cash transactions during January of 2009: 1. 2. 3. 4. 5. 6. 7. Issued 800 shares of common stock for $30 each. Collected $3,900 on outstanding accounts receivable. Paid wages for the month of January of $1,530. Purchased land as a long-term investment for $12,000 cash. Paid a $6,000 dividend. Sold a piece of equipment with a book value of $5,000 for $7,000 cash. Paid $2,000 to the bank: $900 to reduce the principal on an outstanding loan and $1,100 as an interest payment. 8. Paid miscellaneous expenses of $5,000. a. Prepare a journal entry for each transaction. Indicate the classification and the effect on the accounting equation. b. Prepare a cash T-account, and compute the company's cash balance as of the end of January. Assume a beginning balance of $4,000. c. Prepare a statement of cash flows (direct method) for the month of January. E419 Cash and accrual accounting: comparison of performance measures Peters Company was in business for two years, during which it entered into the following transactions: Year 1: 1. The owners contributed $24,000 cash. 2. At the beginning of the year, rented a warehouse for two years with a prepaid rent payment of $12,000. 3. Purchased $10,000 of inventory on account. 4. Sold half the inventory for $24,000, receiving $20,000 in cash and an account receivable of $4,000. 5. Paid wages of $6,000 and also accrued wages payable of $4,000. Year 2: 1. Paid the outstanding balance for the inventory purchased in Year 1. 2. Paid the outstanding wages payable balance. 3. Sold the remaining inventory for $30,000 cash. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 151 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 151 4. Received full payment on the outstanding accounts receivable. 5. Incurred and paid wages of $12,000. 6. Returned the cash balance to the owners and shut down operations. a. Prepare an income statement and a statement of cash flows for both Year 1 and Year 2. b. Complete a chart like the following. Performance Measure Year 1 Year 2 Total Net income Net cash flow from operating activities REAL DATA E420 Assessing economic consequences Condensed balance sheets for 2005 and 2006 and the 2006 income statement for Goodyear, the world's largest tire company, are as follows (dollars in millions). 2006 2005 Current assets Long-term assets Total assets Current liabilities Long-term liabilities Shareholders' equity Total liabilities and shareholders' equity Revenues Expenses Net loss $ 10,179 6,850 $ 17,029 $ 4,666 13,121 (758) $ 17,029 $ 20,258 20,588 $ (330) $ 8,616 6,989 $15,605 $ 5,441 10,091 73 $15,605 a. Early in 2007, assume that Goodyear is considering the following transactions. Treat each separately and compute how it would affect the company's ratios of current assets divided by current liabilities and total liabilities divided by total shareholder's equity. 1. Purchase $1,000 in inventory on account. 2. Issue common stock for $2,000 cash. 3. Refinance a $500 short-term liability with a $500 long-term liability. 4. Purchase equipment in exchange for a $400 long-term note payable. 5. Pay a $1,000 short-term debt with cash. b. Assume that the terms of Goodyear's long-term debt require the company to maintain a ratio of current assets divided by current liabilities of 2.0. Is this covenant restriction relevant to whether the company should enter into any of the above transactions? Explain. c. How much cash could Goodyear pay for a long-term investment and still be in compliance with the covenant? E421 Appendix 4A: T-account analysis Excerpts from the financial statements of Dunbar Manufacturing are provided below. Wages Cash payments for wages during 2009 Wages payable as of December 31, 2009 Wage expense on the 2009 income statement Rent $35,000 17,000 39,000 Prepaid rent as of December 31, 2008 Prepaid rent as of December 31, 2009 Rent expense on the 2009 income statement $12,000 15,000 21,000 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 152 TEAM-B 204:JWCL006:ch04: 152 Part 2 Measurement, Mechanics, and Use of Financial Statements Accounts Receivable Cash collected from customers during 2009 Accounts receivable as of December 31, 2008 Sales revenue on the 2009 income statement $38,000 14,000 45,000 a. Compute the wages payable as of December 31, 2008. b. Compute the cash payments for rent during 2009. c. Compute the accounts receivable as of December 31, 2009. PROBLEMS P41 Journal entries and the accounting equation Below are several transactions entered into by Vulcan Metal Corporation during 2009. Unless otherwise noted, all transactions involve cash. 1. 2. 3. 4. 5. 6. 7. 8. Purchased equipment for $150,000. Paid employees $30,000 in wages. Collected $15,000 from customers as payments on open accounts. Provided services for $24,000: $16,000 received in cash and the remainder on open account. Paid $50,000 on an outstanding note payable: $10,000 for interest and $40,000 to reduce the principal. Purchased a one-month ad in the local newspaper for $5,000. Purchased a building valued at $250,000 in exchange for $130,000 cash and a long-term note payable. Sold investments with a cost of $20,000 for $35,000. REQUIRED: Prepare journal entries for each transaction and explain how each affects the accounting equation. P42 T-accounts and the accounting equation The following T-accounts reflect seven different transactions that Rodman Container Company entered into during 2009: Cash Accounts Receivable Equipment (a) (f) (g) 7,000 5,000 25,000 (c) (d) (e) 2,000 20,000 1,200 (a) 21,000 (f) 5,000 (d) 50,000 Inventory Accounts Payable Notes Payable (b) 6,000 Common Stock (c) 2,000 (b) 6,000 (d) Rent Expense 30,000 Sales Revenue (g) 25,000 (a) 28,000 (e) 1,200 REQUIRED: For each transaction, describe what occurred and how it affected the accounting equation. P43 Journal entries and preparing the four financial statements Ryan Hope, controller of Hope, Inc., provides you with the following information concerning Hope during 2009. (Hope, Inc., began operations on January 1, 2009.) 1. Issued 1,000 shares of common stock at $95 per share. 2. Paid $2,600 per month to rent office and warehouse space. The rent was paid on the last day of each month. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 153 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 153 3. 4. 5. 6. 7. 8. 9. Made total sales for services of $190,000: $65,000 for cash and $125,000 on account. Purchased land for $32,000. Borrowed $75,000 on December 31. The note payable matures in two years. Salaries totaling $80,000 were paid during the year. Other expenses totaling $40,000 were paid during the year. $56,000 was received from customers as payment on account. Declared and paid a dividend of $26,000. REQUIRED: a. Prepare journal entries for these transactions. b. Establish T-accounts for each account, and post the journal entries to these T-accounts. c. Prepare an income statement, statement of shareholders' equity, a December 31, 2009 balance sheet, and statement of cash flows for 2009. P44 Preparing the four financial statements The December 31, 2008 balance sheet for Morrison Home Services is summarized below. Assets Liabilities and Shareholders' Equity Cash Receivables Long-term assets Total assets $10,000 4,000 10,000 $24,000 Liabilities Contributed capital Retained earnings Total liabilities and shareholders' equity $ 6,000 10,000 8,000 $24,000 During January of 2009, the following transactions were entered into: 1. 2. 3. 4. 5. 6. Services were performed for $7,000 cash. $3,000 cash was received from customers on outstanding accounts receivable. $3,000 cash was paid for outstanding liabilities. Long-term assets were purchased in exchange for a $6,000 note payable. Expenses of $4,000 were paid in cash. A dividend of $800 was issued to the owners. REQUIRED: a. Provide a journal entry for each transaction. b. Treat each transaction independently and describe how each would affect the ratios of current assets divided by current liabilities, net income divided by shareholders' equity, and total liabilities divided by shareholders' equity; Morrison's current ratio, return on equity, and debt/equity ratio, respectively. c. Prepare the income statement, statement of shareholders' equity, the January 31 balance sheet, and the statement of cash flows for January. P45 Comprehensive problem The December 31, 2008 balance sheet of Tybee Corporation is provided below (in millions). Assets Liabilities and Shareholders' Equity Cash Accounts receivable Supplies Prepaid insurance Equipment Less: Acc. dep. (12) Land Total $ 24 15 6 12 50 38 10 $105 Accounts payable Interest payable Unearned revenue Other short-term payables Long-term note payable Contributed capital Retained earnings Total $ 4 3 12 4 50 20 12 $105 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 154 TEAM-B 204:JWCL006:ch04: 154 Part 2 Measurement, Mechanics, and Use of Financial Statements Transactions during January 2009: Paid $5 for employee wages. Collected $10 cash from customers for work previously performed and billed. Purchased equipment for $5 cash. Purchased $2 of supplies for cash. Paid $3 to a vendor for supplies previously purchased on credit in December 2008. Paid the interest owed as of December 31, 2008. Completed $18 in services for customers, receiving 50 percent payment in cash and billing the remainder. Paid $15 to reduce outstanding long-term note payable. Collected $5 for the issuance of common shares. As of 1/31/09: Had performed 25 percent of the services for which it had been paid in advance. Owes $1 for interest that will be paid next month. Depreciated equipment in the amount of $4. Physical count of supplies reveals $3 on hand. Declared and paid a cash dividend in the amount of 50 percent of January's net income. REQUIRED: Prepare a complete set of financial statements as of January 31, 2009. P46 Effects of transactions on the income statement and statement of cash flows Ten transactions are listed below. Net Income Net Operating Cash Flow Transaction Accounts Direction 1. Issued ownership securities for cash. Cash Contributed Capital NE NE 2. Purchased inventory on account. 3. Sold a service on account. 4. Received cash payments from customers on previously recorded sales. 5. Purchased equipment for cash. 6. Paid cash to reduce the wages payable account. 7. Sold a service for cash. 8. Paid off a long-term loan. 9. Made a cash interest payment. 10. Sold land for an amount greater than its cost. REQUIRED: For each one, indicate what specific accounts are affected as well as the direction (increase or decrease) of the effect. Also indicate whether the transaction would increase or decrease both net income (revenues minus expenses) on the income statement and net cash flow from operations (operating cash inflows minus operating cash outflows) on the statement of cash flows. Use the following key: increase ( ), decrease ( ), and no effect (NE). The first one has been completed for you. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 155 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 155 P47 The effects of adjusting journal entries on the accounting equation Beta Alloys made the following adjusting journal entries on December 31, 2008. 1. Wage Expense Wages Payable 2. Insurance Expense Prepaid Insurance 3. Interest Receivable Interest Revenue 4. Unearned Rent Revenue Rent Revenue 5. Depreciation Expense Accumulated Depreciation 6. Supplies Expense Supplies Inventory 7. Unearned Subscription Revenue Subscription Revenue 10,000 10,000 5,000 5,000 1,000 1,000 6,000 6,000 20,000 20,000 8,000 8,000 2,000 2,000 REQUIRED: Classify each adjusting entry as either an accrual adjustment (A) or a cost expiration adjustment (C), and indicate whether each entry increases ( ), decreases ( ), or has no effect (NE) on assets, liabilities, shareholders' equity, revenues, and expenses. Organize your answer in the following way. The first journal entry has been done for you. Entry Classification Assets Liabilities Shareholders' Equity Revenues Expenses (1) A NE NE P48 Preparing adjusting journal entries The following information is available for M&M Johnson, Inc.: a. The December 31, 2008, supplies inventory balance is $85,000. A count of supplies reveals that the company actually has $30,000 of supplies on hand. b. As of December 31, 2008, Johnson, Inc. had not paid the rent for December. The monthly rent is $2,400. c. On December 20, 2008, Johnson collected $18,000 in customer advances for the subsequent performance of a service. Johnson recorded the $18,000 as unearned revenue, and as of December 31 two-thirds of the service had been performed. d. The total cost of Johnson's fixed assets is $500,000. Johnson estimates that the assets have a useful life of ten years and uses the straight-line method of depreciation. e. Johnson borrowed $10,000 at an annual rate of 12 percent on July 1, 2008. The first interest payment will be made on January 1, 2009. f. Johnson placed several ads in local newspapers during December. On December 31, the company received a $28,000 bill for the ads, which was not recorded at that time. g. On July 1, 2008, Johnson paid the premium for a one-year life insurance policy. The $350 cost of the premium was capitalized when paid. REQUIRED: Prepare the adjusting journal entries necessary on December 31, 2008. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 156 TEAM-B 204:JWCL006:ch04: 156 Part 2 Measurement, Mechanics, and Use of Financial Statements P49 Inferring adjusting journal entries from changes in T-account balances The following information is available for Derrick Company: Account T-Account Balance before Adjustments T-Account Balance after Adjustments Prepaid Rent Prepaid Insurance Accumulated Depreciation Salaries Payable Unearned Revenues Fees Earned Rent Expense Insurance Expense Depreciation Expense Salary Expense 14,500 8,500 36,000 1,300 800 87,600 6,500 5,500 0 3,500 11,800 7,800 38,400 2,500 600 87,800 9,200 6,200 2,400 4,700 REQUIRED: Prepare the adjusting journal entries that gave rise to the changes indicated. Burkholder Corporation borrowed $28,000 from its bank on January 1, 2008, at an annual interest rate of 10 percent. The $28,000 principal is to be paid as a lump sum at the end of the period of the loan, which is after December 31, 2009. This is the only interest-bearing debt held by Burkholder. P410 Reconciling accrual and cash flow dollar amounts REQUIRED: The following chart below contains six independent cases, each related to the Burkholder Corporation. Compute the missing amount in each case, assuming that the loan described is Burkholder's only outstanding loan. Case 1 Case 2 Case 3 Case 4 Case 5 Case 6 12/31/08 interest payable balance Cash interest payments--2003 12/31/09 interest payable balance 400 3,000 ? 800 ? 300 400 2,300 ? ? 2,600 200 200 ? 400 ? 2,500 0 P411 Revenue recognition, cost expiration, and cash flows Prustate Insurance Company collected $240,000 from Jacobs Printing Corporation for a twoyear fire insurance policy on May 31, 2008. The policy is in effect from June 1, 2008, to May 31, 2009. REQUIRED: a. Assume that Prustate Insurance Company recorded the $240,000 cash collection as a liability on May 31, 2008. 1. Prepare the entry to record the cash collection. 2. Prepare the adjusting entry necessary on December 31, 2008. 3. What was the purpose of the adjusting journal entry on December 31, 2008? 4. Complete a chart like the following: 2008 2009 Total Insurance revenue Cash receipts associated with insurance b. Assume that Jacobs Printing Corporation recorded the $240,000 cash payment as an asset on May 31, 2008. 1. Prepare the entry to record the cash payment. 2. Prepare the adjusting entry necessary on December 31, 2008. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 157 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 157 3. What was the purpose of the adjusting journal entry on December 31, 2008? 4. Complete a chart like the following: 2008 2009 Total Insurance expense Cash payments associated with insurance REAL DATA P412 The effects of transactions on financial ratios The balance sheet of Walgreens, a leading chain drugstore, as of August 31, 2006, appears as follows (dollars in millions): Assets Liabilities and Shareholders' Equity Cash Accounts receivable Inventory Other noncurrent assets Total assets $ 1,335 2,063 6,050 7,683 $17,131 Accounts payable Other short-term payables Long-term payable Shareholders' equity Total liabilities and shareholders' equity $ 4,039 1,716 1,260 10,116 $17,131 REQUIRED: Assume that the following eight transactions occurred the next year (dollars in millions). Indicate the effect of each transaction on net income (revenues minus expenses), the current ratio (current assets divided by current liabilities), working capital (current assets minus current liabilities), and the debt/equity ratio (total liabilities divided by total shareholders' equity) of Walgreens. Use the following key: increase ( ), decrease ( ), no effect (NE). Treat each transaction independently. Transaction Net Income Current Ratio Working Capital Debt/Equity Ratio 1. Issued ownership shares for $100 cash. 2. Purchased equipment costing $95 for cash. 3. Paid off a $200 long-term liability 4. Sold inventory costing $500 for $685 cash. 5. Declared a $152 dividend but have not paid. 6. Paid $200 in wages payable. 7. Received $75 from customers on account. 8. Incurred and paid $30 in interest on short-term payables. P413 Effects of different forms of financing on financial ratios The following condensed balance sheet for December 31, 2009, comes from the records of Buzz and Associates: Assets Liabilities and Shareholders' Equity Cash Other current assets Property, plant, and equipment $ 10,000 40,000 70,000 Total assets $120,000 Current liabilities Long-term notes payable Contributed capital Retained earnings Total liabilities and shareholders' equity $ 20,000 20,000 30,000 50,000 $120,000 JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 158 TEAM-B 204:JWCL006:ch04: 158 Part 2 Measurement, Mechanics, and Use of Financial Statements Buzz and Associates is considering the purchase of a new piece of equipment for $30,000. The company does not have enough cash to purchase it outright, so it is considering alternative ways of financing. As management sees it, there are three basic options: (1) issue 3,000 ownership shares for $10 per share, (2) take out a long-term loan (12 percent annual interest) for $30,000 from the bank, or (3) purchase the equipment on open account (must be paid in full in thirty days). Presently Buzz has 12,000 ownership shares outstanding. REQUIRED: a. Compute the present current ratio (current assets/current liabilities), the debt/equity ratio (total liabilities/shareholders' equity), and the book value of Buzz's outstanding ownership shares: (total assets minus total liabilities) divided by number of shares outstanding. b. Compute the current ratio, debt/equity ratio, and book value per share under each of the three financing alternatives, and express your answers in the following format: Financing Alternative Current Ratio Debt/Equity Ratio Book Value per Share 1. Share issuance 2. Long-term note 3. Open account c. Discuss some of the pros and cons associated with each of the three financing options. d. The chairman of the board of directors stated at a recent board meeting that with $50,000 in Retained Earnings, the company should be able to purchase the $30,000 piece of equipment. Comment on the chairman's statement. REAL DATA P414 Effects of events on financial ratios The following balances were taken from the October 31, 2006 balance sheet of HewlettPackard (dollars in millions). Current assets Long-term assets Current liabilities Long-term liabilities Shareholders' equity $48,264 33,717 35,850 7,987 38,144 Early in fiscal 2007, Hewlett-Packard considered the financial effects of several events. REQUIRED: For each of the five events listed here, indicate how they would affect the financial ratios listed by completing the following chart. Assume that financial statements are prepared immediately after each event. Treat each event independently, and use the following key: Increase ( ), Decrease ( ), and No Effect (NE). Net Income Shareholders' Equity Current Assets Current Liabilities Total Liabilities Shareholders' Equity 1. Purchase inventory on account. 2. Sell assets for cash at a gain. 3. Provide services to customers, receiving cash in return. 4. Make a principal payment on an outstanding longterm liability. 5. Issue common stock for cash. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 159 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 159 REAL DATA P415 Effects of events on financial ratios The following balances were taken from the December 31, 2006 balance sheet of Manpower, Inc., a world-leading workforce provider (dollars in millions): Current assets Long-term assets Current liabilities Long-term liabilities Shareholders' equity $4,682 1,832 2,882 1,158 2,474 Early in 2007, Manpower considered the financial effects of several events. REQUIRED: For each of the five events listed here, indicate how each event would affect the financial ratios listed by completing the following chart. Assume that financial statements are prepared immediately after each event. Treat each event independently, and use the following key: Increase ( ), Decrease ( ), and No Effect (NE). Net Income Sales Current Assets Current Liabilities Total Liabilities Shareholders' Equity 1. Purchase equipment for cash. 2. Purchase machinery in exchange for a longterm note payable. 3. Pay salaries, which have not been accrued, to employees. 4. Declare a dividend. 5. Issue common stock to satisfy a current obligation. REAL DATA P416 Effects of events on financial ratios The following balances were taken from the December 31, 2006 balance sheet of Time Warner (dollars in millions): Current assets Long-term assets Current liabilities Long-term liabilities Shareholders' equity $ 10,851 120,818 12,780 58,500 60,389 Early in 2007, Time Warner considered the financial effects of several events. REQUIRED: For each of the five events listed here, indicate how they would affect the financial ratios listed by completing the following chart. Assume that financial statements are prepared immediately after each event. Treat each event independently, and use the following key: Increase ( ), Decrease ( ), and No Effect (NE). Net Income Total Assets Current Assets Current Liabilities 1. Purchase equipment in exchange for a note payable. 2. Pay cash for marketing its services. (Continued) JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 160 TEAM-B 204:JWCL006:ch04: 160 Part 2 Measurement, Mechanics, and Use of Financial Statements Net Income Total Assets Current Assets Current Liabilities 3. Sell equipment for an amount less than its book value. 4. Pay wages that were accrued in a previous period. 5. Provide a service for which cash was collected in a previous period. P417 Comprehensive problem The following balance sheet is presented for J.D.F. Company as of December 31, 2008. J.D.F. Company Balance Sheet December 31, 2008 ASSETS Cash Accounts receivable Merchandise inventory Prepaid insurance Supplies inventory Long-term investments Equipment Less: Accumulated depreciation Machinery Less: Accumulated depreciation Patent Total assets LIABILITIES AND SHAREHOLDERS' EQUITY $ 170,000 188,000 200,000 74,000 40,000 160,000 $480,000 98,000 $950,000 230,000 382,000 720,000 75,000 $2,009,000 Accounts payable Wages payable Mortgage payable Bonds payable Contributed capital Retained earnings Total liabilities and shareholders' equity $ 220,000 73,000 300,000 500,000 500,000 416,000 $2,009,000 During 2009, J.D.F. entered into the following transactions. 1. Made credit sales of $1,350,000 and cash sales of $350,000. The cost of the inventory sold was $700,000. 2. Purchased $820,000 of merchandise inventory on account. 3. Made cash payments of $400,000 to employees for salaries. This amount includes the wages due employees as of December 31, 2008. 4. Purchased $110,000 of supplies inventory by issuing a six-month note that matures on March 12, 2010. 5. Collected $850,000 from customers in payment of open accounts receivable. 6. Paid suppliers $870,000 for payment of open accounts payable. 7. Sold a long-term investment for $37,000. The investment had been purchased for $30,000. 8. Paid $148,000 in cash for miscellaneous operating expenses. 9. Issued additional common stock for $120,000 cash. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 161 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 161 10. On September 30, 2009, a customer gave the company a note due on May 1, 2010, in payment of a $72,000 account receivable. 11. The company declared and paid a cash dividend of $50,000. 12. The company purchased stock in Microsoft as a long-term investment for $50,000. J.D.F. used the following information to prepare adjusting journal entries on December 31, 2009. (a) Forty percent of the prepaid insurance on January 1 was still in effect as of December 31, 2009. (b) A physical count of the supplies inventory indicated that the company had $40,000 on hand as of December 31, 2009. (c) A review of the company's advertising campaign indicates that of the expenditures made during 2009 for miscellaneous operating expenses, $25,000 applies to promotions to be undertaken during 2010. (d) The company is charged at a rate of $3,500 per month for certain operating expenses. It paid $36,000 for these expenses during the year. (e) The company owes employees $43,000 for wages as of December 31, 2009. (f) The $72,000 note receivable accepted in payment of an account receivable (see [10] above) specifies an annual interest rate of 9 percent. (g) Equipment has an estimated useful life of ten years, and machinery has an estimated useful life of twenty years. The patent originally cost $125,000 and had an estimated useful life of ten years. The company uses the straight-line method to depreciate and amortize all property, plant, equipment, and intangibles. (h) The note issued by the company (see [4] above) has a stated rate of 10 percent and was issued on September 12, 2009. REQUIRED: Prepare an income statement, a statement of shareholders' equity, a balance sheet, and a statement of cash flows using the direct form of presentation. P418 Appendix 4A: T-account analysis Excerpts from the financial statements of Tree Tops Services are as follows. 2009 2008 Balance sheet: Accounts receivable Unearned revenue Income statement: Revenues from services Statement of cash flows: Net cash from operations $ 2,500 1,300 54,700 62,400 $ 3,100 2,600 49,800 58,700 Note: Net cash from operations consists of two components: (1) cash collections from services rendered and (2) cash payments due to operating activities. REQUIRED: For 2009, compute (1) cash collections from services rendered and (2) cash payments due to operating activities. P419 Appendix 4A: T-account analysis Mayberry Enterprises has two sources of revenue. It sells advertising displays to retail firms and provides a consulting service on how to mount and use these displays. You represent a large manufacturing company that is considering purchasing Mayberry. You have reviewed Mayberry's most recent financial statements, excerpts of which are provided below and are concerned about which of the two revenue sources is growing in importance for Mayberry. Mayberry's customers always pay for the consulting services in advance, indicating that the accounts receivable balance is associated only with sales of advertising displays. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 162 TEAM-B 204:JWCL006:ch04: 162 Part 2 Measurement, Mechanics, and Use of Financial Statements 2009 2008 2007 Income statement: Revenues Balance sheet: Accounts receivable Statement of cash flows: Collections from display sales $89,500 29,500 43,500 $76,000 32,200 41,500 $67,000 35,000 39,500 REQUIRED: Which of the two revenue sources is growing in importance for Mayberry? Support your conclusion with calculations. P420 Appendix 4A: T-account analysis You are a credit analyst for First American Bank, and Badger Business has applied for a loan. The company claims to have more than tripled profits from 2008 to 2009 and believes that it should be given prime credit terms. In addition, you note that Badger has expanded its operations, recently paying $37,000 for new equipment that replaced older equipment, which was sold that same year. No other transactions affected the company's equipment account. Excerpts from the company's 2009 financial statements are provided below. 2009 2008 Balance sheet: Equipment Accumulated depreciation Income statement: Net income Depreciation expense Statement of cash flows: Proceeds from equipment sale $97,400 (26,400) 5,200 8,700 23,400 $84,800 (24,300) 1,500 7,600 0 REQUIRED: Reconstruct the journal entry to record the sale of equipment, and comment on Badger's claim that profits more than tripled in 2009. ISSUES FOR DISCUSSION REAL DATA ID41 A transaction and its effect on the accounting equation and balance sheet When MCI Communications Corporation (now part of Verizon Communications) purchased Satellite Business Systems (SBS) from International Business Machines Corporation (IBM), it issued common stock to IBM, valued at $376 million, and signed a note payable for $104 million. MCI received miscellaneous assets valued at $52 million and the SBS system. REQUIRED: Respond to the following: a. b. c. d. At what dollar amount was the SBS system recorded on MCI's balance sheet? Describe how this transaction affected the accounting equation from MCI's point of view. Describe how this transaction affected MCI's balance sheet. Identify the financial statement accounts affected, the direction of the effect, and the dollar amount of the effect on each account. e. Prepare the journal entry MCI recorded when the transaction took place. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 163 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 163 REAL DATA ID42 The effect of a transaction on the basic accounting equation When Campbell Soup purchased the European culinary business from Unilever, the acquisition was funded with available cash and a short-term notes payable. The $920 million purchase price was allocated: $100 million to fixed assets and inventory; $490 million to identifiable intangible assets (e.g. trademarks), and $330 represented the excess of the purchase price over the fair value of the individual assets acquired (goodwill). REQUIRED: a. b. c. d. REAL DATA How did the transaction affect the accounting equation from Campbell Soup's perspective? How did the transaction affect the accounting equation from Unilever's perspective? Describe how the transaction affected Campbell Soup's balance sheet. Prepare the journal entry made by Campbell Soup to record the transaction. ID43 The effects of transactions on the accounting equation In the late 1990s the Internet explosion sent the share values of well-known Internet companies soaring. Many of these companies took advantage of the high prices by making major share issuances and using the funds as their major source of financing. Lycos collected $111 million from a 1998 issuance; Yahoo! collected over $800 million over a three-year period; and America Online topped them all, collecting over $1 billion. While each company used the proceeds a little differently, they all used some of it to reduce debt, update equipment, and increase current assets. REQUIRED: a. Describe how the issuance of stock to reduce debt, update equipment, and increase current assets affects the fundamental accounting equation. b. Explain how the issuance of stock could increase a company's credit rating. REAL DATA ID44 Cash flows and business failures The W.T. Grant Company was the nation's largest retailer until it filed for bankruptcy only one year after it had reported profits of over $20 million for more than ten consecutive years. Yet cash flow provided by operations started dipping several years earlier and remained negative until the company's collapse. REQUIRED: a. What kind of items might account for such a divergence between net income and cash flow provided by operations? b. What information on the financial statements could have provided some warning of the company's failure? REAL DATA ID45 Corporate frauds and the auditor In "Behind the Wave of Corporate Fraud: A Change in How Auditors Work," the Wall Street Journal (March 25, 2004) details several of the recent accounting scandals and the techniques management used to deceive both the auditors and the investing public. The article focused on audit techniques that contributed to the ability of management to undertake deceptive practices. For example, WorldCom reclassified ordinary expenses as assets, which the auditors missed because there was "no supporting documentation"; Tyco International, charged with inflating profits by over $1 billion, left "warning signs" that were not followed up on by auditors; and HealthSouth Corporation pulled it off by inflating the dollar amounts of a large number of small revenue recognition transactions because they "knew the auditors did not look at increases of less than $5,000." REQUIRED: a. Explain how WorldCom showed higher profits in the current period by inaccurately classifying expenses as assets. How would this technique affect the profits of future periods? b. Explain why management may be tempted to inflate profits in the current period. c. Explain why auditors might not check transactions below a certain dollar amount. d. How could high-quality internal controls have helped in avoiding these frauds? JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 164 TEAM-B 204:JWCL006:ch04: 164 REAL DATA Part 2 Measurement, Mechanics, and Use of Financial Statements ID46 Watch cash flow Herbert S. Bailey, Jr. published the following poem in Publishers Weekly (Jan. 13, 1975), which was written in the meter of Edgar Allan Poe's famous poem, The Raven. Though my bottom line is black, I am flat upon my back. My cash flows out and customers pay slow. The growth of my receivables is almost unbelievable; The result is certain--unremitting woe! And I hear the banker utter an ominous low mutter, "Watch cash flow." REQUIRED: Explain Mr. Bailey's message. REAL DATA ID47 Income statement classification and International Financial Reporting Standards In January 2004, Munich-based automaker BMW switched how it classified certain expenses to match what it anticipates to be the format approved by International Financial Reporting Standards (IFRS). Previously, BMW classified these expenses as part of operating profit, and now it has decided to move them to the nonoperating section of the income statement in line with IFRS. As reported in the Wall Street Journal, a Goldman Sachs analyst commented that BMW's action would significantly boost its operating income, and "if GM took BMW's approach, it would boost operating income by over $7 billion." REQUIRED: a. How would the change made by BMW affect net income, that is, its "bottom line"? b. Provide several reasons why BMW might be interested in making this change. c. Why would an analyst from Goldman Sachs be concerned about how operating profits are measured by BMW and GM? d. Would BMW be allowed to make this change if it wished to issue stock on the New York Share Exchange? Discuss. REAL DATA ID48 Problems with the federal government's accounting systems The Associated Press reported: The military's money managers last year made almost $7 trillion in adjustments to their financial ledgers in an attempt to make them add up, the Pentagon's inspector general said in a report released yesterday. The Pentagon could not show receipts of $2.3 trillion of those changes, and half a trillion dollars of it was just corrections of mistakes made in earlier adjustments. . . . The magnitude of accounting entries required to compile the financial statements highlights the significant problems [the Pentagon] has producing accurate and reliable financial statements with existing systems and processes . . . the military can't measure the results of closing a base; can't rationally decide whether to contract out a service or keep it in government hands; and may inaccurately peg the cost of programs under debate, from national missile defense to retirees' health care. REQUIRED: Discuss problems that might arise due to the significant weaknesses of the Pentagon's accounting systems. REAL DATA ID49 Debt transactions and the basic accounting equation Within one week in March 2007 the Wall Street Journal reported two separate articles that detailed companies borrowing money to pay dividends. The March 20, 2007 edition of the Journal reported that the private equity firm Apollo Management purchased Rexnord Corporation and then within months Rexnord borrowed $450 million to pay a special dividend to Apollo. Attractive conditions in the debt markets were cited as the motivation behind the borrowing. The March 27, 2007 Wall Street Journal reported that Scotts Miracle-Gro Company pursued a similar plan. Scotts borrowed $775 million and returned $750 million to shareholders in the form of a special dividend and a stock buyback program. JWCL006_c04_106-165.qxd 3/18/08 11:40 PM Page 165 TEAM-B 204:JWCL006:ch04: Chapter 4 The Mechanics of Financial Accounting 165 REQUIRED: Discuss how the above transactions affect the basic accounting equation for the companies involved. What risks are posed when a company pursues such a strategy? What are the benefits of such a decision? REAL DATA ID410 Real-time accounting According to The Internal Auditor (April 2000): In the past, credible financial reports could be produced, audited, and published only on a periodic basis, because the information needed to generate such reports was either impossible or too costly to obtain on a real-time basis. However, a growing number of important items on financial statements have come under real-time management, as information technology has made such practices both economically feasible and competitively necessary for survival. REQUIRED: What does it mean that information can be obtained on a real-time basis? What items on the financial statements do you think have come under real-time management, and what advantages might real-time accounting create? REAL DATA ID411 The annual report of PepsiCo The annual report of PepsiCo is reproduced in Appendix C. REQUIRED: Review the PepsiCo annual report, and answer the following questions. a. In terms of the basic accounting equation, explain how PepsiCo accounts for prepaid expenses. What is the dollar value of prepaid expenses on the 2006 and 2005 balance sheets? b. In terms of the basic accounting equation, explain how PepsiCo accounts for costs related to the acquisition and development of software. c. How much cash did PepsiCo spend for capital expenditures and dividends during the year ended December 31, 2006. How did these transactions affect the basic accounting equation? How much cash was collected from share issuances through stock options, and how did these transactions affect the basic accounting equation? d. What is the balance of other accrued taxes on PepsiCo's December 31, 2006 balance sheet, and how did it get there? e. What does PepsiCo's management say in its management letter about its system of internal controls?

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'Imperial''Parkay''BlueBonnet''Chiffon''Mazola''Fleischmanns'14.112.813.513.216.818.113.612.513.412.717.217.214.413.414.112.616.418.714.31314.313.917.318.412.318
Minnesota - STAT - 3022
'Hormone1''Hormone2''Hormone3''Hormone4''Hormone5'132118761713141111720171815141721108
Minnesota - STAT - 3022
'Rate 350''Rate 440''Rate 515'166176177109126136140155156
Minnesota - STAT - 3022
'I''II''III''IV'62.587.55070.3505054.759.493.892.287.587.596.976.670.365.656.35045.356.3
Minnesota - STAT - 3022
'Ramiha''Konini''Wainui'1.2910.4217.111.7321.0823.6917.6331.3732.88
Minnesota - STAT - 3022
'Method1''Method2''Method3''Method4''Method5'3.32.52.82.51.93.623.62.42.34.23.43.83.13.13.42.42.91.61.73.81.32.821.62.21.52.71.51.93.52.12.82.12.23.61.32.81.71.82.61.42.41.31.6
Minnesota - STAT - 3022
'Pocket1''Pocket2''Pocket3''Pocket4''Pocket5'10.29.910.11010.210109.99.79.89.89.99.89.99.910.410.19.99.79.710109.79.69.8
Minnesota - STAT - 3022
'Galactose''Glucose'.59.25.3.03.44.13.18.02.22.07.230.120.13.01
Minnesota - STAT - 3022
'Brand1''Brand2''Brand3'453950384446525043475448454857424644434048
Minnesota - STAT - 3022
'Brand1''Brand2''Brand3''Brand4'101713141414182258151212918168121017
Michigan State University - SESSION - 825
Cellular Automata as a Paradigm for Ecological ModelingP. HogewegBioinfnmutica Paduulaan 8 Utrecht, The NetherlandsABSTRACT We review cellular automata as a modeling formalism and discuss how it can be used for modeling (spatial) ecological proc
Michigan State University - SESSION - 825
e c o l o g i c a l m o d e l l i n g 2 1 0 ( 2 0 0 8 ) 7184available at www.sciencedirect.comjournal homepage: www.elsevier.com/locate/ecolmodelDesign and implementation of an integrated GIS-based cellular automata model to characterize forest
UNC - TOXC - 707
Lecture Schedule for Advanced Toxicology TOXC 707/PHCO 707/ ENVR 731 Fall Semester 2007 9:00-9:50AM MWF (Room 235 Rosenau Hall) Course Director: Dr. James A. Swenberg Phone: 966-6139, Fax: 966-6123 jswenber@email.unc.edu DATE AUGUST 22 (W) 24 (F) 27
Duke - STA - 244
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Duke - STA - 244
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Duke - STA - 244
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Duke - STA - 244
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Duke - STA - 244
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Duke - STA - 244
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Duke - STA - 244
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Duke - STA - 244
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N.C. State - MA - 242
N.C. State - MA - 242
N.C. State - MA - 242
N.C. State - MA - 242
University of Florida - COP - 6726
PAGESIZE 8192BUFFPAGES 1024
McGill - METEO - 04011707
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McGill - METEO - 03110207
YUL 716270 MONTREAL/DORVAL QB CN 4547 -7375 36 0
East Los Angeles College - OPEN - 7162
Spaces of Democracy Geography and Democracy An Introduction1Clive Barnett and Murray LowWhere is Democracy? Amidst debates about globalization, neo-liberalism, and anti-capitalism, it is easy to forget that probably the most significant global
UCSD - ATT - 0118
Developmental Work Research10095Developmental work research is an innovative approach to the study and reshaping of work and learning. It expands culturalhistorical activity theory by bringing it to the domains of work, technology and organizat
Bowling Green - CSC - 1010
ASSIGNMENT2 ASSIGNMENT2ShanGao CSC1010 MWF12:0012:50pm 10/11/2006Y=4*X+1 Y=4*X+1Y=X 5 Y=X3Comparison Comparison