Intermediate Acct Sol Manual

Intermediate Acct Sol Manual - CONTENTS Preface to the...

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Unformatted text preview: CONTENTS Preface to the Instructor Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 Chapter 24 Financial Accounting and Accounting Standards Conceptual Framework Underlying Financial Accounting The Accounting Information System Income Statement and Related Information Balance Sheet and Statement of Cash Flows Accounting and the Time Value of Money Cash and Receivables Valuation of Inventories: A Cost Basis Approach Inventories: Additional Valuation Issues Acquisition and Disposition of Property, Plant, and Equipment Depreciation, Impairments, and Depletion Intangible Assets Current Liabilities and Contingencies Long-Term Liabilities Stockholders’ Equity Dilutive Securities and Earnings Per Share Investments Revenue Recognition Accounting for Income Taxes Accounting for Pensions and Postretirement Benefits Accounting for Leases Accounting Changes and Error Analysis Statement of Cash Flows Full Disclosure in Financial Reporting iii PREFACE—TO THE INSTRUCTOR The presentation of the subject matter in each of the chapters in I ntermediate Accounting, 12e is followed by questions, brief exercises, exercises, problems, and concepts for analysis. Another section entitled “Using Your Judgment” is also provided (financial reporting, financial statement analysis, comparative analysis, research, international reporting, professional research and professional simulation). Note that writing, group, and ethics cases have been integrated into the exercises, problems, and concepts for analysis and are identified with icons in the text margins. This manual contains complete solutions to all exercises, problems, and cases in the “Using Your Judgment” section as well as suggested answers to the questions and concepts for analysis. Assignment Classification Table (Topic and Learning Objective). A unique feature of our Solutions Manual is a table that categorizes four types of end-of-chapter items (questions, exercises, problems, and concepts for analysis) by key topics in the chapter. New to Intermediate Accounting, 12e is a classification table organizing solutions by textbook learning objective. Assignment Characteristics Table. Each chapter of this manual contains a table offering: (1) a short description of each exercise, problem, and case, (2) an indication of the level of difficulty (simple, moderate, or complex), and (3) the estimated time in minutes. An estimated average minimum and maximum time (in minutes) is given for each exercise, problem, and case in the text. Although many of the estimated times are based on actual classroom experience, it should be recognized that they are only averages. On any given problem or case even a superior student may encounter difficulty because of a mechanical error or misinterpretation of the problem and spend more time than on other problems of similar difficulty. The estimated time to complete each exercise is also indicated at the right of each exercise number. For problems and cases the estimated time also appears with the list of “purposes” that precedes each set of problems and each set of cases. We hope these classifications, descriptions, and times will prove helpful to instructors in tailoring homework assignments to the capacities of their students and to the time available. Purpose. A statement of the purpose of each problem and each case appears in a list preceding the sets of problems and cases in each chapter. Questions. The questions at the end of the chapter provide a basis for classroom discussion of the topics presented in the chapter and serve as an aid to the students in testing their understanding of the text material. They deal with both conceptual and procedural matters. The sequence of questions generally corresponds to the topical coverage in the text. Full and complete answers to these questions are presented in this manual. Brief Exercises. Each brief exercise focuses on one concept or procedure. Because these brief exercises are straightforward and simple, they build the student’s confidence and test basic skills. Exercises. Generally, the exercises cover a specific topic and require less time and effort to solve than the problems. In addition to serving as supplemental assignment material, the exercises may be used for class discussion and for examination purposes. iv Problems. Whereas the goal of the exercises is brevity of solution time and coverage of essential principles or methodology with minimum difficulty, the problems are designed to develop a professional level of achievement and, therefore, are generally more challenging to solve. We have arranged the problems, as much as possible, from least to most difficult in the same order as the discussion in the chapter. Some of the problems are routine and can be solved by following procedures that are illustrated in the textbook. The more difficult problems may blend a diversity of principles into a single situation requiring a series of steps, computations, or solutions and demand interpretation, analysis, and judgment. Many of the problems (indicated by AICPA, CMA, or CIA Adapted) have been adapted from the Uniform CPA, CMA, or CIA Examinations. In most instances, the solutions to these problems include all the information from the unofficial CPA, CMA, or CIA examination solution. Generally, the students will not furnish a solution in the same detail. Additionally, a far greater number of problems has been provided than the instructor can reasonably use in a single offering of the course. Concepts For Analysis. The concepts for analysis, many of which are adoptions from the Uniform CPA Examination, generally require essay as opposed to quantitative solutions. They are intended to confront the student with situations, frequently unstructured, calling for in-depth analysis and the exercise of judgment in identifying problems and evaluating alternatives. Using Your Judgment. This section of assignment material has been greatly expanded and revised for this 12th edition. The financial reporting problems have been adapted to the Annual Report financial information found in the text. Many of the financial statement analysis cases (using real-world companies), the comparative analysis cases, and the research cases (many of which require either library research or Internet research), have been updated for this edition. This edition also includes updated and expanded international reporting cases and a new feature called “Professional Research”. The professional simulations are patterned after the computerized CPA exam, which was introduced in 2004. SUMMARY The solutions have been painstakingly prepared, reviewed, and tested to provide instructors error-free materials. To the extent that we have not, we invite the users of our textbook to inform us directly of the reactions and suggested improvements. All solutions manuals are available at no cost for use by instructors adopting the textbook. ACKNOWLEDGMENTS We sincerely thank the following individuals for their expert assistance in reviewing and checking the material contained in this Solutions Manual: John Borke, University of Wisconsin—Platteville; Jack Cathey, University of North Carolina – Charlotte; Robert Derstine, Villanova University; Gregory Dold, Southwestern College; James M. Emig, Villanova University; Larry Falcetto, Emporia State University; Paul Robertson, Henderson State University; Alice Sineath, Forsyth Technical Community College; Dick Wasson, Southwestern College. We thank development editor, Ann Torbert, Ed Brislin of John Wiley & Sons, and Alicia Gmeiner of Elm Street Publishing Services for preparing this manual for publication. Donald E. Kieso Jerry J. Weygandt Terry D. Warfield v CHAPTER 1 Financial Accounting and Accounting Standards ASSIGNMENT CLASSIFICATION TABLE Topics 1. Subject matter of accounting. 2. Environment of accounting. 3. Role of principles, objectives, standards, and accounting theory. 4. Historical development of accounting standards. 5. Authoritative pronouncements and standards-setting bodies. 6. Role of pressure groups. 7. International accounting. 8. Ethical issues. Questions 1 2, 3, 4 5, 6, 7 8, 9, 10, 11 12, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22, 23 23, 24, 25, 26, 27, 28 29, 30 31 Cases 1 3, 4 2 5, 16 6, 7, 8, 9, 10, 11, 12, 15 17, 18 14 13, 16 1-1 ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty Simple Moderate Simple Simple Simple Simple Simple Complex Simple Moderate Simple Simple Complex Moderate Moderate Moderate Moderate Moderate Time (minutes) 15–20 20–25 10–15 15–20 20–25 20–25 10–15 30–40 15–20 30–40 15–20 10–15 20–25 30–40 25–35 25–35 25–35 25–35 Item CA1-1 CA1-2 CA1-3 CA1-4 CA1-5 CA1-6 CA1-7 CA1-8 CA1-9 CA1-10 CA1-11 CA1-12 CA1-13 CA1-14 CA1-15 CA1-16 CA1-17 CA1-18 Description Financial accounting. Objectives of financial reporting. Accounting numbers and the environment. Need for accounting standards. AICPA’s role in standards setting. FASB role in standards setting. Government role in standards setting. Politicalization of standards setting. Models for setting accounting standards. Standards-setting terminology. Accounting organizations and documents issued. Accounting pronouncements. Issues involving standards setting. Securities and Exchange Commission. Standards-setting process. History of standards-setting organizations. Economic consequences. Standards-setting process, economic consequences. 1-2 ANSWERS TO QUESTIONS 1. Financial accounting measures, classifies, and summarizes in report form those activities and that information which relate to the enterprise as a whole for use by parties both internal and external to a business enterprise. Managerial accounting also measures, classifies, and summarizes in report form enterprise activities, but the communication is for the use of internal, managerial parties, and relates more to subsystems of the entity. Managerial accounting is management decision oriented and directed more toward product line, division, and profit center reporting. Financial statements generally refer to the four basic financial statements: balance sheet, income statement, statement of cash flows, and statement of changes in owners’ or stockholders’ equity. Financial reporting is a broader concept; it includes the basic financial statements and any other means of communicating financial and economic data to interested external parties. Examples of financial reporting other than financial reports are annual reports, prospectuses, reports filed with the government, news releases, management forecasts or plans, and descriptions of an enterprise’s social or environmental impact. If a company’s financial performance is measured accurately, fairly, and on a timely basis, the right managers and companies are able to attract investment capital. To provide unreliable and irrelevant information leads to poor capital allocation which adversely affects the securities market. Some major challenges facing the accounting profession relate to the following items: Non-financial measurement – how to report significant key performance measurements such as customer satisfaction indexes, backlog information and reject rates on goods purchased. Forward-looking information – how to report more future oriented information. Soft assets – how to report on intangible assets, such as market know-how, market dominance, and well-trained employees. Timeliness – how to report more real-time information. In general, the objectives of financial reporting are to provide (1) information that is useful in investment and credit decisions, (2) information that is useful in assessing cash flow prospects, and (3) information about enterprise resources, claims to those resources, and changes in them. More specifically these objectives state that financial reporting should provide information: a. that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. b. to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. Since investors and creditors’ cash flows are related to enterprise cash flows, financial reporting should provide information to help investors, creditors, and other users assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise. c. about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities), owners’ equity, and the effects of transactions, events, and circumstances that change its resources and claims to those resources. A common set of standards applied by all businesses and entities provides financial statements which are reasonably comparable. Without a common set of standards, each enterprise could, and would, develop its own theory structure and set of practices, resulting in noncomparability among enterprises. 2. 3. 4. 5. 6. 1-3 Questions Chapter 1 (Continued) 7. General-purpose financial statements are not likely to satisfy the specific needs of all interested parties. Since the needs of interested parties such as creditors, managers, owners, governmental agencies, and financial analysts vary considerably, it is unlikely that one set of financial statements is equally appropriate for these varied uses. The SEC has the power to prescribe, in whatever detail it desires, the accounting practices and principles to be employed by the companies that fall within its jurisdiction. Because the SEC receives audited financial statements from nearly all companies that issue securities to the public or are listed on the stock exchanges, it is greatly interested in the content, accuracy, and credibility of the statements. For many years the SEC relied on the AICPA to regulate the profession and develop and enforce accounting principles. Lately, the SEC has assumed a more active role in the development of accounting standards, especially in the area of disclosure requirements. In December 1973, in ASR No. 150, the SEC said the FASB’s statements would be presumed to carry substantial authoritative support and anything contrary to them to lack such support. It thereby supports the development of accounting principles in the private sector. The Committee on Accounting Procedure was a special committee of the American Institute of CPAs that, between the years of 1939 and 1959, issued 51 Accounting Research Bulletins dealing with a wide variety of timely accounting problems. These bulletins provided solutions to immediate problems and narrowed the range of alternative practices. But, the Committee’s problem-by-problem approach failed to provide a well-defined and well-structured body of accounting theory that was so badly needed. The Committee on Accounting Procedure was replaced in 1959 by the Accounting Principles Board. 8. 9. 10. The creation of the Accounting Principles Board was intended to advance the written expression of accounting principles, to determine appropriate practices, and to narrow the differences and inconsistencies in practice. To achieve its basic objectives, its mission was to develop an overall conceptual framework to assist in the resolution of problems as they became evident and to do substantive research on individual issues before pronouncements were issued. 11. Accounting Research Bulletins were pronouncements on accounting practice issued by the Committee on Accounting Procedure between 1939 and 1959; since 1964 they have been recognized as accepted accounting practice unless superseded in part or in whole by an opinion of the APB or an FASB standard. APB Opinions were issued by the Accounting Principles Board during the years 1959 through 1973 and, unless superseded by FASB Statements, are recognized as accepted practice and constitute the requirements to be followed by all business enterprises. FASB Statements are pronouncements of the Financial Accounting Standards Board and currently represent the accounting profession’s authoritative pronouncements on financial accounting and reporting practices. 12. The explanation should note that generally accepted accounting principles or standards have “substantial authoritative support.” They consist of accounting practices, procedures, theories, concepts, and methods which are recognized by a large majority of practicing accountants as well as other members of the business and financial community. Bulletins issued by the Committee on Accounting Procedure, opinions rendered by the Accounting Principles Board, and statements issued by the Financial Accounting Standards Board constitute “substantial authoritative support.” 13. It was believed that FASB Statements would carry greater weight than APB Opinions because of significant differences between the FASB and the APB, namely: (1) The FASB has a smaller membership of full-time compensated members; (2) the FASB has greater autonomy and increased independence; and (3) the FASB has broader representation than the APB. 14. The technical staff of the FASB conducts research on an identified accounting topic and prepares a “discussion memorandum” that is released by the Board for public reaction. The Board analyzes and evaluates the public response to the discussion memorandum, deliberates on the issues, and 1-4 Questions Chapter 1 (Continued) issues an “exposure draft” for public comment. The discussion memorandum merely presents all facts and alternatives related to a specific topic or problem, whereas the exposure draft is a tentative “statement.” After studying the public’s reaction to the exposure draft, the Board may reevaluate its position, revise the draft, and vote on the issuance of a final statement. 15. Statements of financial accounting standards constitute generally accepted accounting principles and dictate acceptable financial accounting and reporting practices as promulgated by the FASB. The first standards statement was issued by the FASB in 1973. Statements of financial accounting concepts do not establish generally accepted accounting principles. Rather, the concepts statements set forth fundamental objectives and concepts that the FASB intends to use as a basis for developing future standards. The concepts serve as guidelines in solving existing and emerging accounting problems in a consistent, sound manner. Both the standards statements and the concepts statements may develop through the same process from discussion memorandum, to exposure draft, to a final approved statement. 16. Rule 203 of the Code of Professional Conduct prohibits a member of the AICPA from expressing an opinion that financial statements conform with GAAP if those statements contain a material departure from an accounting principle promulgated by the FASB, or its predecessors, the APB and the CAP, unless the member can demonstrate that because of unusual circumstances the financial statements would otherwise have been misleading. Failure to follow Rule 203 can lead to a loss of a CPA’s license to practice. This rule is extremely important because it requires auditors to follow FASB standards. 17. FASB Standards, FASB Technical Bulletins, AICPA Practice Bulletins. 18. The chairman of the FASB was indicating that too much attention is put on the bottom line and not enough on the development of quality products. Managers should be less concerned with shortterm results and be more concerned with the long-term results. In addition, short-term tax benefits often lead to long-term problems. The second part of his comment relates to accountants being overly concerned with following a set of rules, so that if litigation ensues, they will be able to argue that they followed the rules exactly. The problem with this approach is that accountants want more and more rules with less reliance on professional judgment. Less professional judgment leads to inappropriate use of accounting procedures in difficult situations. In the accountants’ defense, recent legal decisions have imposed vast new liability on accountants. The concept of accountant’s liability that has emerged in these cases is broad and expansive; the number of classes of people to whom the accountant is held responsible are almost limitless. 19. FASB Staff Positions (FSP) are used to provide interpretive guidance and to make minor amendments to existing standards. The due process used to issue a FSP is the same used to issue a new standard. 20. The Emerging Issues Task Force often arrives at consensus conclusions on certain financial reporting issues. These consensus conclusions are then looked upon as GAAP by practitioners because the SEC has indicated that it will view consensus solutions as preferred accounting and will require persuasive justification for departing from them. Thus, at least for public companies which are subject to SEC oversight, consensus solutions developed by the Emerging Issues Task Force are followed unless subsequently overturned by the FASB. It should be noted that the FASB took greater direct ownership of GAAP established by the EITF by requiring that consensus positions be ratified by the FASB. 1-5 Questions Chapter 1 (Continued) 21. The Governmental Accounting Standards Board, under the oversight of the Financial Accounting Foundation, was created in 1984 to address state and local governmental reporting issues. The new board has replaced a number of organizations that set rules for government accounting. The National Council on Governmental Accounting, a voluntary body affiliated with the Municipal Finance Officers Association, was the primary standard setter for about 100,000 government units. But many other organizations also offered guidance for government accounting. The new GASB will consolidate the rules into one body. 22. Possible reasons might be: 1. The objectives of financial reporting for other types of enterprises (government, railroads, etc.) are not sufficiently different from those established by the FASB to warrant a separate standard-setting structure. 2. The existence of competing standard-setting bodies would create serious jurisdictional conflicts. 3 . The framework is already in place within the existing structure to enforce the standards promulgated by the FASB. 4. The FASB already has significant support from user groups of external financial reports. Uncertainty exists concerning the ability of any other standard-setting body to gain such support. 23. The sources of pressure are innumerable, but the most intense and continuous pressure to change or influence accounting principles or standards come from individual companies, industry associations, governmental agencies, practicing accountants, academicians, professional accounting organizations, and public opinion. 24. Economic consequences means the impact of accounting reports on the wealth positions of issuers and users of financial information and the decision-making behavior resulting from that impact. In other words, accounting information impacts various users in many different ways which leads to wealth transfers among these various groups. If politics plays an important role in the development of accounting standards, standards will be subject to manipulation for the purpose of furthering whatever policy prevails at the moment. No matter how well intentioned the standards setter may be, if information is designed to indicate that investing in a particular enterprise involves less risk than it actually does, or is designed to encourage investment in a particular segment of the economy, financial reporting will suffer an irreplaceable loss of credibility. 25. No one particular proposal is expected in answer to this question. The students’ proposals, however, should be defensible relative to the following criteria: 1. The method must be efficient, responsive, and expeditious. 2. The method must be free of bias and be above or insulated from pressure groups. 3. The method must command widespread support if it does not have legislative authority. 4. The method must produce sound yet practical accounting principles or standards. The students’ proposals might take the form of alterations of the existing methodology, an accounting court (as proposed by Leonard Spacek), or governmental device. 26. Concern exists about fraudulent financial reporting because it can undermine the entire financial reporting process. Failure to provide information to users that is accurate can lead to inappropriate allocations of resources in our economy. In addition, failure to detect massive fraud can lead to additional governmental oversight of the accounting profession. 27. The expectations gap is the difference between what people think accountants should be doing and what accountants think they can do. It is a difficult gap to close. The accounting profession recognizes it must play an important role in narrowing this gap. To meet the needs of society, the profession is continuing its efforts in developing accounting standards, such as numerous pronouncements issued by the FASB, to serve as guidelines for recording and processing business transactions in the changing economic environment. 1-6 Questions Chapter 1 (Continued) 28. The following are some of the key provisions of the Sarbanes-Oxley Act: • Establishes an oversight board for accounting practices. The Public Company Accounting Oversight Board (PCAOB) has oversight and enforcement authority and establishes auditing, quality control, and independence standards and rules. • Implements stronger independence rules for auditors. Audit partners, for example, are required to rotate every five years and auditors are prohibited from offering certain types of consulting services to corporate clients. • Requires CEOs and CFOs to personally certify that financial statements and disclosures are accurate and complete and requires CEOs and CFOs to forfeit bonuses and profits when there is an accounting restatement. • Requires audit committees to be comprised of independent members and members with financial expertise. • Requires codes of ethics for senior financial officers. In addition, Section 404 of the Sarbanes-Oxley Act requires public companies to attest to the effectiveness of their internal controls over financial reporting. 29. Some of the reasons for difference are: 1. The objectives of financial reporting are often different in foreign countries. 2. The institutional structures are often not comparable. 3. Strong national tendencies are pervasive and therefore there is reluctance to adopt any one country’s approach. 30. Relevant and reliable financial information is a necessity for viable capital markets. Unfortunately, financial statements from companies outside the United States are often prepared using different financial statements than US GAAP. As a result, international companies have to develop financial information in different ways. Beyond the additional costs these companies incur, users of financial statements are often forced to understand at least two sets of GAAP. It is not surprising that there is a growing demand for one set of high quality international standards. 31. Accountants must perceive the moral dimensions of some situations because GAAP does not define or cover all specific features that are to be reported in financial statements. In these instances accountants must choose among alternatives. These accounting choices influence whether particular stakeholders may be harmed or benefited. Moral decision-making involves awareness of potential harm or benefit and taking responsibility for the choices. 1-7 TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 1-1 (Time 15–20 minutes) Purpose to provide the student with an opportunity to distinguish between financial accounting and managerial accounting, identify major financial statements, and differentiate financial statements and financial reporting. CA 1-2 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to explain the basic objectives of financial reporting. CA 1-3 (Time 10–15 minutes) Purpose—to provide the student with an opportunity to describe how reported accounting numbers might affect an individual’s perceptions and actions. CA 1-4 (Time 15–20 minutes) Purpose to provide the student with an opportunity to evaluate the viewpoint of removing mandatory accounting standards and allowing each company to voluntarily disclose the information it desired. CA 1-5 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to explain the evolution of accounting standardssetting organizations and the role of the AICPA in the standards-setting environment. CA 1-6 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to identify the sponsoring organization of the FASB, the method by which the FASB arrives at a decision, and the types and the purposes of documents issued by the FASB. CA 1-7 (Time 10–15 minutes) Purpose—to provide the student with an opportunity to identify the governmental entity that oversees the FASB and indicate its role in the standards-setting process. CA 1-8 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to focus on the types of organizations involved in the standards-setting process, what impact accounting has on the environment, and the environment’s influence on accounting. CA 1-9 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to focus on what type of standards-setting environment exists in the United States. In addition, this CA explores why user groups are interested in the nature of financial reporting standards and why some groups wish to issue their own standards. CA 1-10 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to identify and define acronyms appearing in the first chapter. Some are self-evident, others are not so. CA 1-11 (Time 15–20 minutes) Purpose to provide the student with an opportunity to identify the various documents issued by different accounting organizations. The CA should help the student to better focus on the more important documents issued in the financial reporting area. CA 1-12 (Time 10–15 minutes) Purpose—to provide the student with an opportunity to match the descriptions of a number of authoritative pronouncements issued by standards-setting bodies to the pronouncements. 1-8 Time and Purpose of Concepts for Analysis (Continued) CA 1-13 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to consider the ethical dimensions of implementation of a new accounting standard. CA 1-14 (Time 30–40 minutes) Purpose—to provide the student with an assignment that explores the role and function of the Securities and Exchange Commission. CA 1-15 (Time 25–35 minutes) Purpose—to provide the student with an assignment that explores the role of the FASB and the standards-setting process. CA 1-16 (Time 25–35 minutes) Purpose—to provide the student with a writing assignment on the evolution of accounting standardssetting organizations. CA 1-17 (Time 25–35 minutes) Purpose—to provide the student with the opportunity to discuss the role of Congress in accounting standards-setting as well as to discuss the core standards project related to international accounting. CA 1-18 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to comment on a letter sent by business executives to the FASB and Congress on the accounting for derivatives. 1-9 SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 1-1 (a) Financial accounting is the process that culminates in the preparation of financial reports relative to the enterprise as a whole for use by parties both internal and external to the enterprise. In contrast, managerial accounting is the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of financial information used by the management to plan, evaluate, and control within an organization and to assure appropriate use of, and accountability for, its resources. (b) The financial statements most frequently provided are the balance sheet, the income statement, the statement of cash flows, and the statement of changes in owners’ or stockholders’ equity. (c) Financial statements are the principal means through which financial information is communicated to those outside an enterprise. As indicated in (b), there are four major financial statements. However, some financial information is better provided, or can be provided only, by means of financial reporting other than formal financial statements. Financial reporting (other than financial statements and related notes) may take various forms. Examples include the company president’s letter or supplementary schedules in the corporate annual reports, prospectuses, reports filed with government agencies, news releases, management’s forecasts, and descriptions of an enterprise’s social or environmental impact. CA 1-2 (a) In accordance with Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting by Business Enterprises,” the objectives of financial reporting are to provide information to investors, creditors, and others 1. that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. 2. to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. Since investors’ and creditors’ cash flows are related to enterprise cash flows, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise. 3. about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners’ equity), and the effects of transactions, events, and circumstances that change its resources and claims to those resources. (b) Statement of Financial Accounting Concepts No. 1 established standards to meet the information needs of large groups of external users such as investors, creditors, and their representatives. Although the level of sophistication related to business and financial accounting matters varies both within and between these user groups, users are expected to possess a reasonable understanding of accounting concepts, financial statements, and business and economic activities and are expected to be willing to study and interpret the information with reasonable diligence. 1-10 CA 1-3 Accounting numbers affect investing decisions. Investors, for example, use the financial statements of different companies to enhance their understanding of each company’s financial strength and operating results. Because these statements follow generally accepted accounting principles, investors can make meaningful comparisons of different financial statements to assist their investment decisions. Accounting numbers also influence creditors’ decisions. A commercial bank usually looks into a company’s financial statements and past credit history before deciding whether to grant a loan and in what amount. The financial statements provide a fair picture of the company’s financial strength (for example, short-term liquidity and long-term solvency) and operating performance for the current period and over a period of time. The information is essential for the bank to ensure that the loan is safe and sound. CA 1-4 It is not appropriate to abandon mandatory accounting standards and allow each company to voluntarily disclose the type of information it considered important. Without a coherent body of accounting theory and standards, each accountant or enterprise would have to develop its own theory structure and set of practices, and readers of financial statements would have to familiarize themselves with every company’s peculiar accounting and reporting practices. As a result, it would be almost impossible to prepare statements that could be compared. In addition, voluntary disclosure may not be an efficient way of disseminating information. A company is likely to disclose less information if it has the discretion to do so. Thus, the company can reduce its cost of assembling and disseminating information. However, an investor wishing additional information has to pay to receive additional information desired. Different investors may be interested in different types of information. Since the company may not be equipped to provide the requested information, it would have to spend additional resources to fulfill such needs; or the company may refuse to furnish such information if it’s too costly to do so. As a result, investors may not get the desired information or they may have to pay a significant amount of money for it. Furthermore, redundancy in gathering and distributing information occurs when different investors ask for the same information at different points in time. To the society as a whole, this would not be an efficient way of utilizing resources. CA 1-5 (a) One of the committees that the AICPA established prior to the establishment of the FASB was the Committee on Accounting Procedures (CAP). The CAP, during its existence from 1939 to 1959, issued 51 Accounting Research Bulletins (ARB). In 1959, the AICPA created the Accounting Principles Board (APB) to replace the CAP. Before being replaced by the FASB, the APB released 31 official pronouncements, called APB Opinions. (b) Although the ARBs issued by the CAP helped to narrow the range of alternative practices to some extent, the CAP’s problem-by-problem approach failed to provide the well-defined, structured body of accounting principles that was both needed and desired. As a result, the CAP was replaced by the APB. The APB had more authority and responsibility than did the CAP. Unfortunately, the APB was beleaguered throughout its 14-year existence. It came under fire early, charged with lack of productivity and failing to act promptly to correct alleged accounting abuses. The APB also met a lot of industry and CPA firm opposition and occasional governmental interference when tackling numerous thorny accounting issues. In fear of governmental rule-making, the accounting profession investigated the ineffectiveness of the APB and replaced it with the FASB. 1-11 CA 1-5 (Continued) Learning from prior experiences, the FASB has several significant differences from the APB. The FASB has: (1) smaller membership, (2) full-time, compensated membership, (3) greater autonomy, (4) increased independence, and (5) broader representation. In addition, the FASB has its own research staff and relies on the expertise of various task force groups formed for various projects. These features form the bases for the expectations of success and support from the public. In addition, the due process taken by the FASB in establishing financial accounting standards gives interested persons ample opportunity to make their views known. Thus, the FASB is responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession. (c) The AICPA has supplemented the FASB’s efforts in the present standard-setting environment. The issue papers, which are prepared by the Accounting Standards Executive Committee (AcSEC), identify current financial reporting problems for specific industries and present alternative treatments of the issue. These papers provide the FASB with an early warning device to insure timely issuance of FASB standards, Interpretations, and Staff Positions. In situations where the FASB avoids the subject of an issue paper, AcSEC may issue a Statement of Position to provide guidance for the reporting issue. AcSEC also issues Practice Bulletins which indicate how the AICPA believes a given transaction should be reported. Recently, the role of the AICPA in standard-setting has diminished. The FASB and the AICPA agreed, that after a transition period, the AICPA and AcSEC no longer will issue authoritative accounting guidance for public companies. CA 1-6 (a) The Financial Accounting Foundation (FAF) is the sponsoring organization of the FASB. The FAF selects the members of the FASB and its Advisory Council, funds their activities, and generally oversees the FASB’s activities. The FASB follows a due process in establishing a typical FASB Statement of Financial Accounting Standards. The following steps are usually taken: (1) A topic or project is identified and placed on the Board’s agenda. (2) A task force of experts from various sectors is assembled to define problems, issues, and alternatives related to the topic. (3) Research and analysis are conducted by the FASB technical staff. (4) A discussion memorandum is drafted and released. (5) A public hearing is often held, usually 60 days after the release of the memorandum. (6) The Board analyzes and evaluates the public response. (7) The Board deliberates on the issues and prepares an exposure draft for release. (8) After a 30-day (minimum) exposure period for public comment, the Board evaluates all of the responses received. (9) A committee studies the exposure draft in relation to the public responses, reevaluates its position, and revises the draft if necessary. (10) The full Board gives the revised draft final consideration and votes on issuance of a Standards Statement. The passage of a new accounting standard in the form of an FASB Statement requires the support of five of the seven Board members. (b) The FASB issues three major types of pronouncements: Standards and Interpretations, Financial Accounting Concepts, and Technical Bulletins. Financial accounting standards issued by the FASB are considered GAAP. In addition, the FASB also issues interpretations that represent modifications or extensions of existing standards and APB Opinions. These interpretations have the same authority as standards and APB Opinions in guiding current accounting practices. The Statements of Financial Accounting Concepts (SFAC) help the FASB to avoid the “problemby-problem approach.” These statements set forth fundamental objectives and concepts that the Board will use in developing future standards of financial accounting and reporting. They are intended to form a cohesive set of interrelated concepts, a body of theory or a conceptual framework, that will serve as tools for solving existing and emerging problems in a consistent, sound manner. 1-12 CA 1-6 (Continued) The FASB may issue a technical bulletin when there is a need for guidelines on implementing or applying FASB Standards or Interpretations, APB Opinions, Accounting Research Bulletins, or emerging issues. A technical bulletin is issued only when (1) it is not expected to cause a major change in accounting practice for a number of enterprises, (2) its cost of implementation is low, and (3) the guidance provided by the bulletin does not conflict with any broad fundamental accounting principle. In addition, the FASB’s Emerging Issues Task Force (EITF) issues statements to provide guidance on how to account for new and unusual financial transactions that have the potential for creating diversity in reporting practices. The EITF identifies controversial accounting problems as they arise and determines whether they can be quickly resolved or whether the FASB should become involved in solving them. In essence, it becomes a “problem filter” for the FASB. Thus, it is hoped that the FASB will be able to work on more pervasive long-term problems, while the EITF deals with shortterm emerging issues. CA 1-7 The Securities and Exchange Commission (SEC) is the governmental entity that provides oversight over the accounting standards-setting process. Until the 1960s, the SEC acted with remarkable restraint in the area of developing accounting standards. Generally, it relied on the AICPA to regulate the accounting profession and develop and enforce accounting standards. During the APB era, however, the SEC took a more active interest in the development of accounting standards, pressing for quicker action, specific pronouncements, and eventually for the demise of the APB. Recently, the SEC has interacted with the FASB as both a supporter and a prodder. Because it confronts the financial accounting and reporting practices of U.S. business on a daily basis, the SEC frequently identifies emerging problems for the FASB to address. The Commission communicates these problems to the FASB, responds to FASB drafts and exposures, and provides the FASB with counsel and advice upon request. The SEC has reaffirmed its support for the FASB, indicating that “financial statements conforming to standards set by the FASB will be presumed to have authoritative support.” In short, the SEC requires public companies to adhere to GAAP. CA 1-8 (a) CAP. The Committee on Accounting Procedure, CAP, which was in existence from 1939 to 1959, was a natural outgrowth of AICPA committees which were in existence during the period 1933 to 1938. The committee was formed in direct response to the criticism received by the accounting profession during the financial crisis of 1929 and the years thereafter. The authorization to issue pronouncements on matters of accounting principles and procedures was based on the belief that the AICPA had the responsibility to establish practices that would become generally accepted by the profession and by corporate management. As a general rule, the CAP directed its attention, almost entirely, to resolving specific accounting problems and topics rather than to the development of generally accepted accounting principles. The committee voted on the acceptance of specific Accounting Research Bulletins published by the committee. A two-thirds majority was required to issue a particular research bulletin. The CAP did not have the authority to require acceptance of the issued bulletins by the general membership 1-13 CA 1-8 (Continued) of the AICPA, but rather received its authority only upon general acceptance of the pronouncement by the members. That is, the bulletins set forth normative accounting procedures that “should be” followed by the accounting profession, but were not “required” to be followed. It was not until well after the demise of the CAP, in 1964, that the Council of the AICPA adopted recommendations that departures from effective CAP Bulletins should be disclosed in financial statements or in audit reports of members of the AICPA. The demise of the CAP could probably be traced to four distinct factors: (1) the narrow nature of the subjects covered by the bulletins issued by the CAP, (2) the lack of any theoretical groundwork in establishing the procedures presented in the bulletins, (3) the lack of any real authority by the CAP in prescribing adherence to the procedures described by the bulletins, and (4) the lack of any formal representation on the CAP of interest groups such as corporate managers, governmental agencies, and security analysts. APB. The objectives of the APB were formulated mainly to correct the deficiencies of the CAP as described above. The APB was thus charged with the responsibility of developing written expression of generally accepted accounting principles through consideration of the research done by other members of the AICPA in preparing Accounting Research Studies. The committee was in turn given substantial authoritative standing in that all opinions of the APB were to constitute substantial authoritative support for generally accepted accounting principles. If an individual member of the AICPA decided that a principle or procedure outside of the official pronouncements of the APB had substantial authoritative support, the member had to disclose the departure from the official APB opinion in the financial statements of the firm in question. The membership of the committee comprising the APB was also extended to include representation from industry, government, and academe. The opinions were also designed to include minority dissents by members of the board. Exposure drafts of the proposed opinions were readily distributed. The demise of the APB occurred primarily because the purposes for which it was created were not being accomplished. Broad generally accepted accounting principles were not being developed. The research studies supposedly being undertaken in support of subsequent opinions to be expressed by the APB were often ignored. The committee in essence became a simple extension of the original CAP in that only very specific problem areas were being addressed. Interest groups outside of the accounting profession questioned the appropriateness and desirability of having the AICPA directly responsible for the establishment of GAAP. Politicization of the establishment of GAAP had become a reality because of the far-reaching effects involved in the questions being resolved. FASB. The formal organization of the FASB represents an attempt to vest the responsibility of establishing GAAP in an organization representing the diverse interest groups affected by the use of GAAP. The FASB is independent of the AICPA. It is independent, in fact, of any private or governmental organization. Individual CPAs, firms of CPAs, accounting educators, and representatives of private industry will now have an opportunity to make known their views to the FASB through their membership on the Board. Independence is facilitated through the funding of the organization and payment of the members of the Board. Full-time members are paid by the organization and the organization itself is funded solely through contributions. Thus, no one interest group has a vested interest in the FASB. Conclusion. The evolution of the current FASB certainly does represent “increasing politicization of accounting standards setting.” Many of the efforts extended by the AICPA can be directly attributed to the desire to satisfy the interests of many groups within our society. The FASB represents, perhaps, just another step in this evolutionary process. 1-14 CA 1-8 (Continued) (b) Arguments for politicalization of the accounting rule-making process: 1 . Accounting depends in large part on public confidence for its success. Consequently, the critical issues are not solely technical, so all those having a bona fide interest in the output of accounting should have some influence on that output. 2. There are numerous conflicts between the various interest groups. In the face of this, compromise is necessary, particularly since the critical issues in accounting are value judgments, not the type which are solvable, as we have traditionally assumed, using deterministic models. Only in this way (reasonable compromise) will the financial community have confidence in the fairness and objectivity of accounting rule-making. 3. Over the years, accountants have been unable to establish, on the basis of technical accounting elements, rules which would bring about the desired uniformity and acceptability. This inability itself indicates rule-setting is primarily consensual in nature. 4. The public accounting profession, through bodies such as the Accounting Principles Board, made rules which business enterprises and individuals “had” to follow. For many years, these businesses and individuals had little say as to what the rules would be, in spite of the fact that their economic well-being was influenced to a substantial degree by those rules. It is only natural that they would try to influence or control the factors that determine their economic well-being. (c) Arguments against the politicalization of the accounting rule-making process: 1. Many accountants feel that accounting is primarily technical in nature. Consequently, they feel that substantive, basic research by objective, independent and fair-minded researchers ultimately will result in the best solutions to critical issues, such as the concepts of income and capital, even if it is accepted that there isn’t necessarily a single “right” solution. 2. Even if it is accepted that there are no “absolute truths” as far as critical issues are concerned, many feel that professional accountants, taking into account the diverse interests of the various groups using accounting information, are in the best position, because of their independence, education, training, and objectivity, to decide what generally accepted accounting principles ought to be. 3 . The complex situations that arise in the business world require that trained accountants develop the appropriate accounting principles. 4. The use of consensus to develop accounting principles would decrease the professional status of the accountant. 5. This approach would lead to “lobbying” by various parties to influence the establishment of accounting principles. CA 1-9 (a) The public/private mixed approach appears to be the way standards are established in the United States. In many respects, the FASB is a quasi-governmental agency in that its standards are required to be followed because the SEC has provided support for this approach. The SEC has the ultimate power to establish standards but has chosen to permit the private sector to develop these standards. By accepting the standards established by the FASB as authoritative, it has granted much power to the FASB. (It might be useful to inform the students that not all countries follow this model. For example, the purely political approach is used in France and West Germany. The private, professional approach is employed in Australia, Canada, and the United Kingdom.) (b) Publicly reported accounting numbers influence the distribution of scarce resources. Resources are channeled where needed at returns commensurate with perceived risk. Thus, reported accounting numbers have economic effects in that resources are transferred among entities and individuals as a consequence of these numbers. It is not surprising then that individuals affected by these numbers will be extremely interested in any proposed changes in the financial reporting environment. 1-15 CA 1-9 (Continued) (c) The Accounting Standards Executive Committee (AcSEC of the AICPA), among other groups, has presented a potential challenge to the exclusive right of the FASB to establish accounting principles. Also, Congress has been attempting to legislate certain accounting practices, particularly to help struggling industries. Some possible reasons why other groups might wish to establish standards are: 1. As indicated in the previous answer, standards have economic effects and therefore certain groups would prefer to make their own standards to ensure that they receive just treatment. 2. Some believe the FASB does not act quickly to resolve accounting matters, either because it is not that interested in the subject area or because it lacks the resources to do so. 3. Some argue that the FASB does not have the competence to legislate standards in certain areas. For example, many have argued that the FASB should not legislate standards for not-for-profit enterprises because the problems are unique and not well known by the FASB. CA 1-10 (a) AICPA. American Institute of Certified Public Accountants. The national organization of practicing certified public accountants. (b) CAP. Committee on Accounting Procedure. A committee of practicing CPAs which issued 51 Accounting Research Bulletins between 1939 and 1959 and is a predecessor of the FASB. (c) ARB. Accounting Research Bulletins. Official pronouncements of the Committee on Accounting Procedure which, unless superseded, remain a primary source of GAAP. (d) APB. Accounting Principles Board. A committee of public accountants, industry accountants and academicians which issued 31 Opinions between 1959 and 1973. The APB replaced the CAP and was itself replaced by the FASB. Its opinions, unless superseded, remain a primary source of GAAP. (e) FAF. Financial Accounting Foundation. An organization whose purpose is to select members of the FASB and its Advisory Councils, fund their activities, and exercise general oversight. (f) FASAC. Financial Accounting Standards Advisory Council. An organization whose purpose is to consult with the FASB on issues, project priorities, and select task forces. (g) SOP. Statements of Position. Statements issued by the AICPA (through the Accounting Standards Executive Committee of its Accounting Standards Division) which are generally devoted to emerging problems not addressed by the FASB or the SEC. (h) GAAP. Generally accepted accounting principles. A common set of standards, principles, and procedures which have substantial authoritative support and have been accepted as appropriate because of universal application. (i) CPA. Certified public accountant. An accountant who has fulfilled certain education and experience requirements and passed a rigorous examination. Most CPAs offer auditing, tax, and management consulting services to the general public. FASB. Financial Accounting Standards Board. The primary body which currently establishes and improves financial accounting and reporting standards for the guidance of issuers, auditors, users, and others. SEC. Securities and Exchange Commission. An independent regulatory agency of the United States government which administers the Securities Acts of 1933 and 1934 and other acts. 1-16 (j) (k) CA 1-10 (Continued) (l) IASB. International Accounting Standards Board. An international group, formed in 1973, that is actively developing and issuing accounting standards that will have international appeal and hopefully support. (m) GASB. Governmental Accounting Standards Board. The primary body that currently establishes accounting and reporting standards for state and local governments. CA 1-11 1. 2. 3. 4. (b), (e) (a) (c) (d) CA 1-12 1. 2. 3. 4. 5. 6. (d) (f) (c) (e) (a) (b) CA 1-13 (a) Inclusion or omission of information that materially affects net income harms particular stakeholders. Accountants must recognize that their decision to implement (or delay) reporting requirements will have immediate consequences for some stakeholders. (b) Yes. Because the FASB standard results in a fairer representation, it should be implemented as soon as possible—regardless of its impact on net income. SEC Staff Bulletin No. 74 (December 30, 1987) requires a statement as to what the expected impact of the standard will be. (c) The accountant’s responsibility is to provide financial statements that present fairly the financial condition of the company. By advocating early implementation, Popovich fulfills this task. (d) Potential lenders and investors, who read the financial statements and rely on their fair representation of the financial condition of the company, have the most to gain by early implementation. A stockholder who is considering the sale of stock may be harmed by early implementation that lowers net income (and may lower the value of the stock). CA 1-14 (a) The Securities and Exchange Commission (SEC) is an independent federal agency that receives its authority from federal legislation enacted by Congress. The Securities and Exchange Act of 1934 created the SEC. (b) As a result of the Securities and Exchange Act of 1934, the SEC has legal authority relative to accounting practices. The U.S. Congress has given the SEC broad regulatory power to control accounting principles and procedures in order to fulfill its goal of full and fair disclosure. 1-17 CA 1-14 (Continued) (c) There is no direct relationship as the SEC was created by Congress and the Financial Accounting Standards Board (FASB) was created by the private sector. However, the SEC historically has followed a policy of relying on the private sector to establish financial accounting and reporting standards known as generally accepted accounting principles (GAAP). The SEC does not necessarily agree with all of the pronouncements of the FASB. In cases of unresolved differences, the SEC rules take precedence over FASB rules for companies within SEC jurisdiction. CA 1-15 (a) The process by which a topic is selected or identified as appropriate for study by the Financial Accounting Standards Board (FASB) is described below. • Problems or issues come to the attention of the FASB from – the Emerging Issues Task Force which may identify significant emerging accounting issues that it feels the FASB should address. – the Financial Accounting Standards Advisory Council which addresses the FASB on the priority of problems and encourages the FASB to undertake new projects. – the Research and Technical Activities Staff of the FASB, which monitors business periodicals for stories concerning unusual transactions or events and may detect an emerging problem. – the close contact it maintains with various business, industry, government, professional financial groups, and the SEC. – its staff which may learn of emerging problems as it responds to technical inquiries received from preparers and auditors. • • • • Topics are then placed on the FASB agenda. The plan for major technical agenda projects is given prompt public notice in the FASB’s newsletter “Status Report.” A task force of experts from various sectors is assembled to define problems, issues, and alternatives related to the topic. The task force inputs are submitted to the FASB’s Technical Activities Division for research and analysis. (b) Once a topic is considered appropriate for consideration by the FASB, major steps in the process leading to the issuance of a Statement of Financial Accounting Standards include the following: • • • • Research and analysis is conducted by the FASB Technical Staff. A discussion memorandum is drafted and released for written comments. Written comments are submitted and a public hearing is held approximately 60 days after the memorandum is released. The Board analyzes and evaluates the public responses. 1-18 CA 1-15 (Continued) • • • • (c) The Board deliberates on the issues and prepares an exposure draft which is released for public comment. After a 30-day (minimum) exposure period and possible public hearings from industry groups, the Board evaluates all comments received. A committee studies the exposure draft in relation to the public responses, reevaluates its position, and revises the draft if necessary. The full Board gives the revised final draft consideration and votes on the issuance of a Standards Statement. At least three other organizations who can influence the setting of generally accepted accounting principles include the • • • American Institute of Certified Public Accountants. Securities and Exchange Commission. Financial Executives Institute. CA 1-16 (a) The ethical issue in this case relates to making questionable entries to meet expected earnings forecasts. As indicated in this chapter, businesses’ concentration on “maximizing the bottom line,” “facing the challenges of competition,” and “stressing short-term results” places accountants in an environment of conflict and pressure. (b) Given that Normand has pleaded guilty, he certainly acted improperly. Doing the right thing, making the right decision, is not always easy. Right is not always obvious, and the pressures to “bend the rules,” “to play the game,” “to just ignore it” can be considerable. (c) No doubt, Normand was in a difficult position. I am sure that he was concerned that if he failed to go along, it would affect his job performance negatively or that he might be terminated. These job pressures, time pressures, peer pressures often lead individuals astray. Can it happen to you? One individual noted that at a seminar on ethics sponsored by the CMA Society of Southern California, attendees were asked if they had ever been pressured to make questionable entries. This individual noted that to the best of his recollection, everybody raised a hand, and more than one had eventually chosen to resign. (d) Major stakeholders are: (1) Troy Normand, (2) present and potential stockholders and creditors of WorldCom, (3) employees, and (4) family. Recognize that WorldCom is the largest bankruptcy in United States history, so many individuals are affected. CA 1-17 a. Considering the economic consequences of many accounting standards, it is not surprising that special interest groups become vocal and critical (some supporting, some opposing) when standards are being formulated. The FASB’s derivative accounting standard is no exception. Many from the banking industry, for example, criticized the standard as too complex and leading to unnecessary earnings volatility. They also indicated that the proposal may discourage prudent risk management activities and in some cases could present misleading financial information. 1-19 CA 1-17 (Continued) As a result, Congress is often approached to put pressure on the FASB to change its rulings. In the stock option controversy, industry was quite effective in going to Congress to force the FASB to change its conclusions. In the derivative controversy, Rep. Richard Baker introduced a bill which would force the SEC to formally approve each standard issued by the FASB. Not only would this process delay adoption, but could lead to additional politicalization of the standards-setting process. Dingell commented that Congress should stay out of the standards-setting process and defended the FASB’s approach to establishing generally accepted accounting standards. b. Attempting to set standards by a political process will probably lead to the following consequences: (a) Too many alternatives. (b) Lack of clarity that will lead to inconsistent application. (c) Lack of disclosure that reduces transparency. (d) Not comprehensive in scope. Without an independent process, standards will be based on political compromise. A classic illustration is what happened in the savings and loan industry. Applying generally accepted accounting principles to the S&L industry would have forced regulators to restrict activities of many S&Ls. Unfortunately, accounting principles were overridden by regulatory rules and the resulting lack of transparency masked the problems. William Siedman, former FDIC Chairman noted later that it was “the worst mistake in the history of government.” Another indication of the problem of government intervention is shown in the accounting standards used by some countries around the world. Completeness and transparency of information needed by investors and creditors is not available in order to meet or achieve other objectives. CA 1-18 (a) The “due process” system involves the following: (1) Identifying topics and placing them on the Board’s agenda. (2) Research and analysis is conducted and discussion memorandum of pros and cons issued. (3) A public hearing is often held. (4) Board evaluates research and public responses and issues exposure draft. (5) Board evaluates responses and changes exposure draft, if necessary. Final statement is then issued. (b) Economic consequences mean the impact of accounting reports on the wealth positions of issuers and users of financial information and the decision-making behavior resulting from that impact. (c) Economic consequences indicated in the letter are: (1) concerns related to the potential impact on the capital markets, the weakening of companies’ ability to manage risk, and the adverse control implications of implementing costly and complex new rules imposed at the same time as other major initiatives, including the Year 2000 issues and a single European currency. The principal point of this letter is to delay the finalization of the derivatives standard. As indicated in the letter, the authors of this letter urge the FASB to expose its new proposal for public comment, following the established due process procedures that are essential to acceptance of its standards and providing sufficient time for affected parties to understand and assess the new approach. (Authors note: The FASB indicated in a follow-up letter that all due process procedures had been followed and all affected parties had more than ample time to comment. In addition, the FASB issued a follow-up standard, which delayed the effective date of the standard, in part to give companies more time to develop the information systems needed for implementation of the standard.) The reason why the letter was sent to Congress was to put additional pressure on the FASB to delay or drop the issuance of a standard on derivatives. Unfortunately, in too many cases, when the business community does not like the answer proposed by the FASB, it resorts to lobbying members of Congress. The lobbying efforts usually involve developing some type of legislation that will negate the standard. In some cases, efforts involve challenging the FASB’s authority to develop rules in certain areas with additional Congressional oversight. 1-20 (d) (e) FINANCIAL REPORTING PROBLEM (a) The key organizations involved in standard setting in the U.S. are the AICPA, FASB, and SEC. See also (c). (b) Different authoritative literature pertaining to methods recording accounting transactions exists today. Some authoritative literature has received more support from the profession than other literature. The literature that has substantial authoritative support is the one most supported by the profession and should be followed when recording accounting transactions. These standards and procedures are called generally accepted accounting principles (GAAP). There are four different levels, and the first level is the one with the most authoritative support. It consists of FASB Standards Interpretations and Staff Positions, APB Opinions and Interpretations, and CAP Accounting Research Bulletins. The second level consists of AICPA Industry Audit and Accounting Guides, AICPA Statements of Position, and FASB Technical Bulletins. The third level consists of AICPA Practice Bulletins and EITF documents, Concepts Statements, and other authoritative pronouncements. The fourth level (least authoritative) involves AICPA Accounting Interpretations, prevalent industry practices and FASB Implementation Guides. (c) Standards setting in the U.S. has evolved through the work of the following organizations: 1 . American Institute of Certified Public Accountants (AICPA)—it is the national professional organization of practicing Certified Public Accountants (CPAs). Outgrowths of the AICPA have been the Committee on Accounting Procedure (CAP) which issued Accounting Research Bulletins and the Accounting Principles Board (APB) whose major purposes were to advance written expression of accounting principles, determine appropriate practices, and narrow the areas of difference and inconsistency in practice. 2. Financial Accounting Standards Board (FASB)—the mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, which includes issuers, auditors, and users of the financial information. 1-21 FINANCIAL REPORTING PROBLEM (Continued) 3. Securities and Exchange Commission (SEC)—the SEC is an independent regulatory agency of the United States government which administers the Securities Act of 1933, the Securities Exchange Act of 1934, and several other acts. The SEC has broad power to prescribe the accounting practices and standards to be employed by companies that fall within its jurisdiction. (d) The SEC and the AICPA have been the authority for compliance with GAAP. The SEC has indicated that financial statements conforming to standards set by the FASB will be presumed to have authoritative support. The AICPA, in Rule 203 of the Code of Professional Ethics, requires that members prepare financial statements in accordance with GAAP. Failure to follow Rule 203 can lead to the loss of a CPA’s license to practice. 1-22 INTERNATIONAL REPORTING PROBLEM (a) The International Accounting Standards Board is an independent, privately funded accounting standards setter based in London, UK. The Board is committed to developing, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements. In addition, the Board cooperates with national accounting standards setters to achieve convergence in accounting standards around the world. (b) In summary, the following groups might gain most from harmonization of financial reporting: • Investors, investment analysts and stockbrokers: to facilitate international comparisons for investment decisions. • Credit grantors: for similar reasons to bullet point above. • Multinational companies: as preparers, investors, appraisers of products or staff, and as movers of staff around the globe; also, as raisers of finance on international markets (this also applies to some companies that are not multinationals). • Governments: as tax collectors and hosts of multinationals; also interested are securities markets regulators and governmental and nongovernmental rule makers. (c) The fundamental argument against harmonization is that, to the extent that international differences in accounting practices result from underlying economic, legal, social, and other environmental factors, harmonization may not be justified. Different accounting has grown up to serve the different needs of different users; this might suggest that the existing accounting practice is “correct” for a given nation and should not be changed merely to simplify the work of multinational companies or auditors. There does seem to be strength in this point particularly for smaller companies with no significant multinational activities or connections. To foist upon a small private family company in Luxembourg lavish disclosure requirements and the need to report a “true and fair” view may be an expensive and unnecessary piece of harmonization. 1-23 INTERNATIONAL REPORTING PROBLEM (Continued) The most obvious obstacle to harmonization is the sheer size and deeprootedness of the differences in accounting. These differences have grown up over the previous century because of differences in users, legal systems, and so on. Thus, the differences are structural rather than cosmetic, and require revolutionary action to remove them. Note to instructor: For a more complete treatment of international accounting standards, students should read Appendix 24B, “International Accounting Standards.” 1-24 PROFESSIONAL RESEARCH: ACCOUNTING AND FINANCIAL REPORTING (a) Three ways: a. Use the main menu following Original Pronouncements and then Statement of Financial Accounting Concepts. b. Query: “CON 1”, “Objectives of Financial Reporting” c. Search: Search within a single OP document type, Document title: Statement of accounting concepts, Query for: No. 1 or 1 CON 1, Par. 7. Financial reporting includes not only financial statements but also other means of communicating information that relates, directly or indirectly, to the information provided by the accounting system—that is, information about an enterprise’s resources, obligations, earnings, etc. Management may communicate information to those outside an enterprise by means of financial reporting other than formal financial statements either because the information is required to be disclosed by authoritative pronouncement, regulatory rule, or custom or because management considers it useful to those outside the enterprise and discloses it voluntarily. Information communicated by means of financial reporting other than financial statements may take various forms and relate to various matters. Corporate annual reports, prospectuses, and annual reports filed with the Securities and Exchange Commission are common examples of reports that include financial statements, other financial information, and nonfinancial information. News releases, management’s forecasts or other descriptions of its plans or expectations, and descriptions of an enterprise’s social or environmental impact are examples of reports giving financial information other than financial statements or giving only nonfinancial information. CON 1, Par, 24 and 25: 24. Many people base economic decisions on their relationships to and knowledge about business enterprises and thus are potentially interested in the information provided by financial reporting. Among the potential users are owners, lenders, suppliers, potential investors and creditors, employees, management, directors, customers, financial analysts and advisors, brokers, underwriters, stock exchanges, lawyers, economists, taxing authorities, regulatory authorities, legislators, financial press and reporting agencies, labor unions, trade associations, business researchers, teachers and students, and the public. Members and potential members of some groups—such as owners, creditors, and employees—have or contemplate having direct economic interests in particular business enterprises. Managers and directors, who are charged with managing the enterprise in the interest of owners (paragraph 12), also have a direct interest. Members of other groups—such as financial analysts and advisors, regulatory authorities, and labor unions—have derived or indirect interests because they advise or represent those who have or contemplate having direct interests. Potential users of financial information most directly concerned with a particular business enterprise are generally interested in its ability to generate favorable cash flows because their decisions relate to amounts, timing, and uncertainties of expected cash flows. To investors, lenders, suppliers, and employees, a business enterprise is a source of cash in the form of dividends or interest and perhaps appreciated market prices, repayment of borrowing, payment for goods or services, or salaries or wages. They invest cash, goods, or services in an enterprise and expect to obtain sufficient cash in return to make the investment worthwhile. They are directly concerned with the ability of the enterprise to generate favorable cash flows and may also be concerned with how the market’s perception of that ability affects the relative prices of its securities. To customers, a business enterprise is a source of goods or services, but only by obtaining sufficient cash to pay for the resources it uses and to meet its other obligations can the enterprise provide those goods (b) (c) 1-25 ACCOUNTING AND FINANCIAL REPORTING (Continued) or services. To managers, the cash flows of a business enterprise are a significant part of their management responsibilities, including their accountability to directors and owners. Many, if not most, of their decisions have cash flow consequences for the enterprise. Thus, investors, creditors, employees, customers, and managers significantly share a common interest in an enterprise’s ability to generate favorable cash flows. Other potential users of financial information share the same interest, derived from investors, creditors, employees, customers, or managers whom they advise or represent or derived from an interest in how those groups (and especially stockholders) are faring. 1-26 PROFESSIONAL SIMULATION (a) The term “accounting principles” in the auditor’s report includes not only accounting principles but also the practices and the methods of applying them. Although the term quite naturally emphasizes the primary or fundamental character of some principles, it includes general rules adopted or professed as guides to action in practice. The term does not connote, however, rules from which there can be no deviation. In some cases the question is which of several partially relevant principles are applicable. Neither is the term “accounting principles” necessarily synonymous with accounting theory. Accounting theory is the broad area of inquiry devoted to the definition of objectives to be served by accounting, the development and elaboration of relevant concepts, the promotion of consistency through logic, the elimination of faulty reasoning, and the evaluation of accounting practice. Generally accepted accounting principles are those principles (whether or not they have only limited usage) that have substantial authoritative support. Whether a given principle has authoritative support is a question of fact and a matter of judgment. The CPA is responsible for collecting the available evidence of authoritative support and judging whether it is sufficient to bring the practice within the bounds of generally accepted accounting principles. Opinions of the Accounting Principles Board, pronouncements of the Committee on Accounting Procedure, statements of the Financial Accounting Standards Board, and releases of the Securities and Exchange Commission (if there are any on the subject in question) would be given greater weight than other single sources. Opinions of the Accounting Principles Board and statements and interpretations of the FASB constitute substantial authoritative support, and the evidence would tend to be conclusive if the Securities and Exchange Commission has issued an affirmative opinion on the same subject. Other support for generally accepted accounting principles can come from AICPA Industry Audit and Accounting Guides, AICPA Statements of Position, and FASB Technical Bulletins (Level Two). In addition, AICPA Practice Bulletins and FASB Emerging Issues Task Force Statements are identified as Level Three type documents. (b) 1-27 PROFESSIONAL SIMULATION (Continued) Note that other evidence of authoritative support may be found in the published opinions of the committees of the American Accounting Association and the affirmative opinions of practitioners and academicians in articles, textbooks, and expert testimony. Similarly, the views of stock exchanges, commercial and investment bankers, and regulatory commissions influence the general acceptance of accounting principles and, hence, are considered in determining whether an accounting principle has substantial authoritative support. Business practice also is a source of evidence. Finally, because they influence business practice, the tax code and state laws are sources of evidence too. 1-28 CHAPTER 2 Conceptual Framework Underlying Financial Accounting ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. 2. 3. 4. 5. 6. Conceptual framework–general. Objectives of financial reporting. Qualitative characteristics of accounting. Elements of financial statements. Basic assumptions. Basic principles: a. Historical cost. b. Revenue recognition. c. Expense matching. d. Full disclosure. Accounting principles–comprehensive. Constraints. Comprehensive assignments on assumptions, principles, and constraints. 23, 24, 25, 26 6, 7 8 Questions 1, 21 2, 5 3, 4, 6, 24 7, 8, 9 10, 11, 12 13, 14, 15 16, 17, 18 19 20, 21, 22 1, 2 3, 9, 10 4 5 1, 2 3 4, 5 4, 5 5 4, 5 4, 5, 6 7, 8 1 4, 5 12 5, 6 5, 6, 7, 8, 9, 10, 11 Brief Exercises Exercises Concepts for Analysis 1, 2 3 4 7. 8. 9. 2-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives 1. 2. 3. 4. 5. 6. 7. 8. Describe the usefulness of a conceptual frame work. Describe the FASB’s efforts to construct a conceptual framework. Understand the objectives of financial reporting. Identify the qualitative characteristics of accounting information. Describe the basic elements of financial statements. Describe the basic assumptions of accounting. Explain the application of the basic principles of accounting. Describe the impact that constraints have on reporting accounting information. 1, 2 3, 10 4, 8, 9 5, 9 6, 7, 9 1, 2 3 4, 5 4, 5, 6, 7, 8 1, 4, 5 Brief Exercises Exercises 2-2 ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty Moderate Simple Simple Simple Moderate Complex Moderate Moderate Simple Simple Moderate Moderate Complex Moderate Complex Moderate Moderate Moderate Moderate Moderate Time (minutes) 25–30 15–20 15–20 15–20 20–25 20–25 20–25 20–25 20–25 25–35 25–35 30–35 25–30 30–35 20–25 20–25 20–30 20–30 20–25 30–35 Item E2-1 E2-2 E2-3 E2-4 E2-5 E2-6 E2-7 E2-8 C2-1 C2-2 C2-3 C2-4 C2-5 C2-6 C2-7 C2-8 C2-9 C2-10 C2-11 C2-12 Description Qualitative characteristics. Qualitative characteristics. Elements of financial statements. Assumptions, principles, and constraints. Assumptions, principles, and constraints. Full disclosure principle. Accounting principles–comprehensive. Accounting principles–comprehensive. Conceptual framework–general. Conceptual framework–general. Objectives of financial reporting. Qualitative characteristics. Revenue recognition and matching principle. Revenue recognition and matching principle. Matching principle. Matching principle. Matching principle. Qualitative characteristics. Matching–ethics Cost/Benefit 2-3 ANSWERS TO QUESTIONS 1. A conceptual framework is a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements. A conceptual framework is necessary in financial accounting for the following reasons: 1. It will enable the FASB to issue more useful and consistent standards in the future. 2. New issues will be more quickly soluble by reference to an existing framework of basic theory. 3. It will increase financial statement users’ understanding of and confidence in financial reporting. 4. It will enhance comparability among companies’ financial statements. The primary objectives of financial reporting are as follows: 1. Provide information useful in investment and credit decisions for individuals who have a reasonable understanding of business. 2. Provide information useful in assessing future cash flows. 3. Provide information about enterprise resources, claims to these resources, and changes in them. “Qualitative characteristics of accounting information” are those characteristics which contribute to the quality or value of the information. The overriding qualitative characteristic of accounting information is usefulness for decision making. Relevance and reliability are the two primary qualities of useful accounting information. For information to be relevant, it should have predictive value or feedback value, and it must be presented on a timely basis. Relevant information has a bearing on a decision and is capable of making a difference in the decision. Relevant information helps users to make predictions about the outcomes of past, present, and future events, or to confirm or correct prior expectations. Reliable information can be depended upon to represent the conditions and events that it is intended to represent. Reliability stems from representational faithfulness, neutrality, and verifiability. In providing information to users of financial statements, the Board relies on general-purpose financial statements. The intent of such statements is to provide the most useful information possible at minimal cost to various user groups. Underlying these objectives is the notion that users need reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This point is important: it means that in the preparation of financial statements a level of reasonable competence can be assumed; this has an impact on the way and the extent to which information is reported. Comparability facilitates comparisons between information about two different enterprises at a particular point in time. Consistency facilitates comparisons between information about the same enterprise at two different points in time. At present, the accounting literature contains many terms that have peculiar and specific meanings. Some of these terms have been in use for a long period of time, and their meanings have changed over time. Since the elements of financial statements are the building blocks with which the statements are constructed, it is necessary to develop a basic definitional framework for them. Distributions to owners differ from expenses and losses in that they represent transfers to owners, and they do not arise from activities intended to produce income. Expenses differ from losses in that they arise from the entity’s ongoing major or central operations. Losses arise from peripheral or incidental transactions. 2. 3. 4. 5. 6. 7. 8. 2-4 Questions Chapter 2 (Continued) 9. Investments by owners differ from revenues and gains in that they represent transfers by owners to the entity, and they do not arise from activities intended to produce income. Revenues differ from gains in that they arise from the entity’s ongoing major or central operations. Gains arise from peripheral or incidental transactions. 10. The four basic assumptions that underlie the financial accounting structure are: 1. An economic entity assumption. 2. A going concern assumption. 3. A monetary unit assumption. 4. A periodicity assumption. 11. (a) In accounting it is generally agreed that any measures of the success of an enterprise for periods less than its total life are at best provisional in nature and subject to correction. Measurement of progress and status for arbitrary time periods is a practical necessity to serve those who must make decisions. It is not the result of postulating specific time periods as measurable segments of total life. (b) The practice of periodic measurement has led to many of the most difficult accounting problems such as inventory pricing, depreciation of long-term assets, and the necessity for revenue recognition tests. The accrual system calls for associating related revenues and expenses. This becomes very difficult for an arbitrary time period with incomplete transactions in process at both the beginning and the end of the period. A number of accounting practices such as adjusting entries or the reporting of corrections of prior periods result directly from efforts to make each period’s calculations as accurate as possible and yet recognizing that they are only provisional in nature. 12. The monetary unit assumption assumes that the unit of measure (the dollar) remains reasonably stable so that dollars of different years can be added without any adjustment. When the value of the dollar fluctuates greatly over time, the monetary unit assumption loses its validity. The FASB in Concept No. 5 indicated that it expects the dollar unadjusted for inflation or deflation to be used to measure items recognized in financial statements. Only if circumstances change dramatically will the Board consider a more stable measurement unit. 13. Some of the arguments which might be used are outlined below: 1. Cost is definite and reliable; other values would have to be determined somewhat arbitrarily and there would be considerable disagreement as to the amounts to be used. 2. Amounts determined by other bases would have to be revised frequently. 3. Comparison with other companies is aided if cost is employed. 4. The costs of obtaining replacement values could outweigh the benefits derived. 14. Revenue is generally recognized when (1) realized or realizable, and (2) earned. The adoption of the sale basis is the accountant’s practical solution to the extremely difficult problem of measuring revenue under conditions of uncertainty as to the future. The revenue is equal to the amount of cash that will be received due to the operations of the current accounting period, but this amount will not be definitely known until such cash is collected. The accountant, under these circumstances, insists on having “objective evidence,” that is, evidence external to the firm itself, on which to base an estimate of the amount of cash that will be received. The sale is considered to be the earliest point at which this evidence is available in the usual case. Until the sale is made, any estimate of the value of inventory is based entirely on the opinion of the management of the firm. When the sale is made, however, an outsider, the buyer, has corroborated the estimate of management and a value can now be assigned based on this transaction. The sale 2-5 Questions Chapter 2 (Continued) also leads to a valid claim against the buyer and gives the seller the full support of the law in enforcing collection. In a highly developed economy where the probability of collection is high, this gives additional weight to the sale in the determination of the amount to be collected. Ordinarily there is a transfer of control as well as title at the sales point. This not only serves as additional objective evidence but necessitates the recognition of a change in the nature of assets. The sale, then, has been adopted because it provides the accountant with objective evidence as to the amount of revenue that will be collected, subject of course to the bad debts estimated to determine ultimate collectibility. 15. Revenues should be recognized when they are realized or realizable and earned. The most common time at which these two conditions are met is when the product or merchandise is delivered or services are rendered to customers. Therefore, revenue for Magnus Eatery should be recognized at the time the luncheon is served. 16. Revenues are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. Revenues are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash. Readily convertible assets have (1) interchangeable (fungible) units and (2) quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price. 17. Each deviation depends on either the existence of earlier objective evidence other than the sale or insufficient evidence of sale. Objective evidence is the key. (a) In the case of installment sales the probability of uncollectibility may be great due to the nature of the collection terms. The sale itself, therefore, does not give an accurate basis on which to estimate the amount of cash that will be collected. It is necessary to adopt a basis which will give a reasonably accurate estimate. The installment sales method is a modified cash basis; income is recognized as cash is collected. A cash basis is preferable when no earlier estimate of revenue is sufficiently accurate. (b) The opposite is true in the case of certain agricultural products. Since there is a ready buyer and a quoted price, a sale is not necessary to establish the amount of revenue to be received. In fact, the sale is an insignificant part of the whole operation. As soon as it is harvested, the crop can be valued at its selling price less the cost of transportation to the market and this valuation gives an extremely accurate measure of the amount of revenue for the period without the need of waiting until the sale has been made to measure it. In other words, the sale proceeds are readily realizable and earned, so revenue recognition should occur. (c) In the case of long-term contracts, the use of the “sales basis” would result in a distortion of the periodic income figures. A shift to a “percentage of completion basis” is warranted if objective evidence of the amount of revenue earned in the periods prior to completion is available. The accountant finds such evidence in the existence of a firm contract, from which the ultimate realization can be determined, and estimates of total cost which can be compared with cost incurred to estimate percentage-of-completion for revenue measurement purposes. In general, when estimates of costs to complete and extent of progress toward completion of long-term contracts are reasonably dependable, the percentage-of-completion method is preferable to the completed-contract method. 18. The president means that the “gain” should be recorded in the books. This item should not be entered in the accounts, however, because it has not been realized. 19. The cause and effect relationship can seldom be conclusively demonstrated, but many costs appear to be related to particular revenues and recognizing them as expenses accompanies recognition of the revenue. Examples of expenses that are recognized by associating cause and effect are sales commissions and cost of products sold or services provided. 2-6 Questions Chapter 2 (Continued) Systematic and rational allocation means that in the absence of a direct means of associating cause and effect, and where the asset provides benefits for several periods, its cost should be allocated to the periods in a systematic and rational manner. Examples of expenses that are recognized in a systematic and rational manner are depreciation of plant assets, amortization of intangible assets, and allocation of rent and insurance. Some costs are immediately expensed because the costs have no discernible future benefits or the allocation among several accounting periods is not considered to serve any useful purpose. Examples include officers’ salaries, most selling costs, amounts paid to settle lawsuits, and costs of resources used in unsuccessful efforts. 20. The four characteristics are: 1. Definitions–The item meets the definition of an element of financial statements. 2. Measurability–It has a relevant attribute measurable with sufficient reliability. 3. Relevance–The information is capable of making a difference in user decisions. 4. Reliability–The information is representationally faithful, verifiable, and neutral. 21. (a) To be recognized in the main body of financial statements, an item must meet the definition of an element. In addition the item must have been measured, recorded in the books, and passed through the double-entry system of accounting. (b) Information provided in the notes to the financial statements amplifies or explains the items presented in the main body of the statements and is essential to an understanding of the performance and position of the enterprise. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element. (c) Supplementary information includes information that presents a different perspective from that adopted in the financial statements. It also includes management’s explanation of the financial information and a discussion of the significance of that information. 22. The general guide followed with regard to the full disclosure principle is to disclose in the financial statements any facts of sufficient importance to influence the judgment of an informed reader. The fact that the amount of outstanding common stock doubled in January of the subsequent reporting period probably should be disclosed because such a situation is of importance to present stockholders. Even though the event occurred after December 31, 2007, it should be disclosed on the balance sheet as of December 31, 2007, in order to make adequate disclosure. (The major point that should be emphasized throughout the entire discussion on full disclosure is that there is normally no “black” or “white” but varying shades of grey and it takes experience and good judgment to arrive at an appropriate answer.) 23. Accounting information is subject to two constraints: cost/benefit considerations, and materiality. Information is not worth providing unless the benefits it provides exceed the costs of preparing it. Information that is immaterial is irrelevant, and consequently, not useful. If its inclusion or omission would have no impact on a decision maker, the information is immaterial. 24. The costs of providing accounting information are paid primarily to highly trained accountants who design and implement information systems, retrieve and analyze large amounts of data, prepare financial statements in accordance with authoritative pronouncements, and audit the information presented. These activities are time-consuming and costly. The benefits of providing accounting information are experienced by society in general, since informed financial decisions help allocate scarce resources to the most effective enterprises. Occasionally new accounting standards require presentation of information that is not readily assembled by the accounting systems of most companies. A determination should be made as to whether the incremental or additional costs of providing the proposed information exceed the incremental benefits to be obtained. This determination requires careful judgment since the benefits of the proposed information may not be readily apparent. 2-7 Questions Chapter 2 (Continued) 25. The concept of materiality refers to the relative significance of an amount, activity, or item to informative disclosure and a proper presentation of financial position and the results of operations. Materiality has qualitative and quantitative aspects; both the nature of the item and its relative size enter into its evaluation. An accounting misstatement is said to be material if knowledge of the misstatement will affect the decisions of the average informed reader of the financial statements. Financial statements are misleading if they omit a material fact or include so many immaterial matters as to be confusing. In the examination, the auditor concentrates efforts in proportion to degrees of materiality and relative risk and disregards immaterial items. The relevant criteria for assessing materiality will depend upon the circumstances and the nature of the item and will vary greatly among companies. For example, an error in current assets or current liabilities will be more important for a company with a flow of funds problem than for one with adequate working capital. The effect upon net income (or earnings per share) is the most commonly used measure of materiality. This reflects the prime importance attached to net income by investors and other users of the statements. The effects upon assets and equities are also important as are misstatements of individual accounts and subtotals included in the financial statements. The auditor will note the effects of misstatements on key ratios such as gross profit, the current ratio, or the debt/equity ratio and will consider such special circumstances as the effects on debt agreement covenants and the legality of dividend payments. There are no rigid standards or guidelines for assessing materiality. The lower bound of materiality has been variously estimated at 5% to 20% of net income, but the determination will vary based upon the individual case and might not fall within these limits. Certain items, such as a questionable loan to a company officer, may be considered material even when minor amounts are involved. In contrast a large misclassification among expense accounts may not be deemed material if there is no misstatement of net income. 26. (a) To the extent that warranty costs can be estimated accurately, they should be matched against the related sales revenue. Acceptable if reasonably accurate estimation is possible. (b) Not acceptable. Most accounts are collectible or the company will be out of business very soon. Hence sales can be recorded when made. Also, other companies record sales when made rather than when collected, so if accounts for Joan Osborne Co. are to be compared with other companies, they must be kept on a comparable basis. However, estimates for uncollectible accounts should be recorded if there is a reasonably accurate basis for estimating bad debts. (c) Not acceptable. A provision for the possible loss can be made through an appropriation of retained earnings but until judgment has been rendered on the suit or it is otherwise settled, entry of the loss usually represents anticipation. Recording it earlier is probably unwise legal strategy as well. For the loss to be recognized at this point, the loss would have to be probable and reasonably estimable. (See FASB No. 5 for additional discussion if desired.) Note disclosure is required if the loss is not recorded. (d) Acceptable because lower of cost or market is in accordance with generally accepted accounting principles. 2-8 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 2-1 (a) If the company changed its method for inventory valuation, the consistency, and therefore the comparability, of the financial statements have been affected by a change in the method of applying the accounting principles employed. The change would require comment in the auditor’s report in an explanatory paragraph. If the company disposed of one of its two subsidiaries that had been included in its consolidated statements for prior years, no comment as to consistency needs to be made in the CPA’s audit report. The comparability of the financial statements has been affected by a business transaction, but there has been no change in any accounting principle employed or in the method of its application. (The transaction would probably require informative disclosure in the financial statements.) If the company reduced the estimated remaining useful life of plant property because of obsolescence, the comparability of the financial statements has been affected. The change is not a matter of consistency; it is a change in accounting estimate required by altered conditions and involves no change in accounting principles employed or in their method of application. The change would probably be disclosed by a note in the financial statements; if commented upon in the CPA’s report, it would be as a matter of disclosure rather than consistency. If the company is using a different inventory valuation method from all other companies in its industry, no comment as to consistency need be made in the CPA’s audit report. Consistency refers to a given company following consistent accounting principles from one period to another; it does not refer to a company following the same accounting principles as other companies in the same industry. (b) (c) (d) BRIEF EXERCISE 2-2 1. 2. 3. 4. Verifiability Comparability Consistency Timeliness 2-9 BRIEF EXERCISE 2-3 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) Equity Revenues Equity Assets Expenses Losses Liabilities Distributions to owners Gains Investments by owners BRIEF EXERCISE 2-4 (a) (b) (c) (d) Periodicity Monetary unit Going concern Economic entity BRIEF EXERCISE 2-5 (a) (b) (c) (d) Revenue recognition Matching Full disclosure Historical cost BRIEF EXERCISE 2-6 (a) (b) (c) (d) Industry practices Conservatism Cost-benefit relationship Materiality 2-10 BRIEF EXERCISE 2-7 Companies and their auditors for the most part have adopted the general rule of thumb that anything under 5% of net income is considered not material. Recently, the SEC has indicated that it is okay to use this percentage for the initial assessment of materiality, but other factors must be considered. For example, companies can no longer fail to record items in order to meet consensus analyst’s earnings numbers; preserve a positive earnings trend; convert a loss to a profit or vice versa; increase management compensation, or hide an illegal transaction like a bribe. In other words, both quantitative and qualitative factors must be considered in determining when an item is material. (a) (b) (c) Because the change was used to create a positive trend in earnings, the change is considered material. Each item must be considered separately and not netted. Therefore each transaction is considered material. In general, companies that follow an “expense all capital items below a certain amount” policy are not in violation of the materiality concept. Because the same practice has been followed from year to year, Seliz’s actions are acceptable. BRIEF EXERCISE 2-8 (a) (b) (c) (d) (e) Net realizable value. Would not be disclosed. Liabilities would be disclosed in the order to be paid. Would not be disclosed. Depreciation would be inappropriate if the going concern assumption no longer applies. Net realizable value. Net realizable value (i.e. redeemable value). BRIEF EXERCISE 2-9 (a) (b) (c) (d) Conservatism Full disclosure Matching principle Historical cost 2-11 BRIEF EXERCISE 2-10 (a) (b) Should be debited to the Land account, as it is a cost incurred in acquiring land. As an asset, preferably to a Land Improvements account. The driveway will last for many years, and therefore it should be capitalized and depreciated. Probably an asset, as it will last for a number of years and therefore will contribute to operations of those years. If the fiscal year ends December 31, this will all be an expense of the current year that can be charged to an expense account. If statements are to be prepared on some date before December 31, part of this cost would be expense and part asset. Depending upon the circumstances, the original entry as well as the adjusting entry for statement purposes should take the statement date into account. Should be debited to the Building account, as it is a part of the cost of that plant asset which will contribute to operations for many years. As an expense, as the service has already been received; the contribution to operations occurred in this period. (c) (d) (e) (f) 2-12 SOLUTIONS TO EXERCISES EXERCISE 2-1 (20–30 minutes) (a) (b) (c) (d) (e) Feedback Value. Cost/Benefit and Materiality. Neutrality. Consistency. Neutrality. (f) (g) (h) (i) (j) Relevance and Reliability. Timeliness. Relevance. Comparability. Verifiability. EXERCISE 2-2 (15–20 minutes) (a) (b) (c) (d) (e) Comparability. Feedback Value. Consistency. Neutrality. Verifiability. (f) (g) (h) (i) (j) Relevance. Comparability and Consistency. Reliability. Relevance and Reliability. Timeliness. EXERCISE 2-3 (15–20 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) Gains, losses. Liabilities. Investments by owners, comprehensive income. (also possible would be revenues and gains). Distributions to owners. (Note to instructor: net effect is to reduce equity and assets). Comprehensive income (also possible would be revenues and gains). Assets. Comprehensive income. Revenues, expenses. Equity. Revenues. Distributions to owners. Comprehensive income. 2-13 EXERCISE 2-4 (15–20 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) 6. 5. 7. 2. 11. 1. 4. 10. 9. 3. Matching principle. Historical cost principle. Full disclosure principle. Going concern assumption. Conservatism. Economic entity assumption. Periodicity assumption. Industry practices. Materiality. Monetary unit assumption. EXERCISE 2-5 (20–25 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) Historical cost principle. Conservatism. Full disclosure principle. Matching principle. Materiality. Industry practices. Economic entity assumption. Full disclosure principle. Revenue recognition principle. (j) (k) (l) (m) (n) (o) (p) (q) (r) Full disclosure principle. Matching principle. Economic entity assumption. Periodicity assumption. Matching principle. Materiality. Historical cost principle. Conservatism. Matching principle. EXERCISE 2-6 (a) It is well established in accounting that revenues and cost of goods sold must be disclosed in an income statement. It might be noted to students that such was not always the case. At one time, only net income was reported but over time we have evolved to the present reporting format. The proper accounting for this situation is to report the equipment as an asset and the notes payable as a liability on the balance sheet. Offsetting is permitted in only limited situations where certain assets are contractually committed to pay off liabilities. 2-14 (b) EXERCISE 2-6 (Continued) (c) According to GAAP, the basis upon which inventory amounts are stated (lower of cost or market) and the method used in determining cost (LIFO, FIFO, average cost, etc.) should also be reported. The disclosure requirement related to the method used in determining cost should be emphasized, indicating that where possible alternatives exist in financial reporting, disclosure in some format is required. Consistency requires that disclosure of changes in accounting principles be made in the financial statements. To do otherwise would result in financial statements that are misleading. Financial statements are more useful if they can be compared with similar reports for prior years. (d) EXERCISE 2-7 (a) This entry violates the economic entity assumption. This assumption in accounting indicates that economic activity can be identified with a particular unit of accountability. In this situation, the company erred by charging this cost to the wrong economic entity. The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost. If we were to select sales value, for example, we would have an extremely difficult time in attempting to establish a sales value for a given item without selling it. It should further be noted that the revenue recognition principle provides the answer to when revenue should be recognized. Revenue should be recognized when (1) realized or realizable and (2) earned. In this situation, an earnings process has definitely not taken place. Probably the company is too conservative in its accounting for this transaction. The matching principle indicates that expenses should be allocated to the appropriate periods involved. In this case, there appears to be a high uncertainty that the company will have to pay. FASB Statement No. 5 requires that a loss should be accrued only (1) when it is probable that the company would lose the suit and (2) the amount of the loss can be reasonably estimated. (Note to instructor: The student will probably be unfamiliar with FASB Statement No. 5. The purpose of this question is to develop some decision framework when the probability of a future event must be assumed.) (b) (c) 2-15 EXERCISE 2-7 (Continued) (d) At the present time, accountants do not recognize price-level adjustments in the accounts. Hence, it is misleading to deviate from the cost principle because conjecture or opinion can take place. It should also be noted that depreciation is not so much a matter of valuation as it is a means of cost allocation. Assets are not depreciated on the basis of a decline in their fair market value, but are depreciated on the basis of systematic charges of expired costs against revenues. (Note to instructor: It might be called to the students’ attention that the FASB does encourage supplemental disclosure of price-level information.) Most accounting methods are based on the assumption that the business enterprise will have a long life. Acceptance of this assumption provides credibility to the historical cost principle, which would be of limited usefulness if liquidation were assumed. Only if we assume some permanence to the enterprise is the use of depreciation and amortization policies justifiable and appropriate. Therefore, it is incorrect to assume liquidation as Fresh Horses, Inc. has done in this situation. It should be noted that only where liquidation appears imminent is the going concern assumption inapplicable. The answer to this situation is the same as (b). (e) (f) EXERCISE 2-8 (a) Depreciation is an allocation of cost, not an attempt to value assets. As a consequence, even if the value of the building is increasing, costs related to this building should be matched with revenues on the income statement, not as a charge against retained earnings. A gain should not be recognized until the inventory is sold. Accountants follow the historical cost approach and write-ups of assets are not permitted. It should also be noted that the revenue recognition principle states that revenue should not be recognized until it is realized or realizable and is earned. (b) 2-16 EXERCISE 2-8 (Continued) (c) Assets should be recorded at the fair market value of what is given up or the fair market value of what is received, whichever is more clearly evident. It should be emphasized that it is not a violation of the historical cost principle to use the fair market value of the stock. Recording the asset at the par value of the stock has no conceptual validity. Par value is merely an arbitrary amount usually set at the date of incorporation. The gain should be recognized at the point of sale. Deferral of the gain should not be permitted, as it is realized and is earned. To explore this question at greater length, one might ask what justification other than the controller’s might be used to justify the deferral of the gain. For example, the rationale provided in APB Opinion No. 29, noncompletion of the earnings process, might be discussed. It appears from the information that the sale should be recorded in 2007 instead of 2006. Regardless of whether the terms are f.o.b. shipping point or f.o.b. destination, the point is that the inventory was sold in 2007. It should be noted that if the company is employing a perpetual inventory system in dollars and quantities, a debit to Cost of Goods Sold and a credit to Inventory is also necessary in 2007. (d) (e) 2-17 TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 2-1 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to comment on the purpose of the conceptual framework. In addition, a discussion of the Concepts Statements issued by the FASB is required. CA 2-2 (Time 25–35 minutes) Purpose—to provide the student with the opportunity to identify and discuss the benefits of the conceptual framework. In addition, the most important quality of information must be discussed, as well as other key characteristics of accounting information. CA 2-3 (Time 25–35 minutes) Purpose—to provide the student with some familiarity with Statement of Financial Accounting Concepts No. 1. The student is asked to indicate the broad objectives of accounting, and to discuss how this statement might help to establish accounting standards. CA 2-4 (Time 30–35 minutes) Purpose—to provide the student with some familiarity with Statement of Financial Accounting Concepts No. 2. The student is asked to describe various characteristics of useful accounting information and to identify possible trade-offs among these characteristics. CA 2-5 (Time 25–30 minutes) Purpose—to provide the student with the opportunity to indicate and discuss different points at which revenues can be recognized. The student is asked to discuss the “crucial event” that triggers revenue recognition. CA 2-6 (Time 30–35 minutes) Purpose—to provide the student with familiarity with an economic concept of income as opposed to the GAAP approach. Also, factors to be considered in determining when net revenue should be recognized are emphasized. CA 2-7 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to assess different points to report costs as expenses. Direct cause and effect, indirect cause and effect, and rational and systematic approaches are developed. CA 2-8 (Time 20–25 minutes) Purpose—to provide the student with familiarity with the matching principle in accounting. Specific items are then presented to indicate how these items might be reported using the matching principle. CA 2-9 (Time 20–30 minutes) Purpose—to provide the student with a realistic case involving association of costs with revenues. The advantages of expensing costs as incurred versus spreading costs are examined. Specific guidance is asked on how allocation over time should be reported. CA 2-10 (Time 20–30 minutes) Purpose—to provide the student with the opportunity to discuss the relevance and reliability of financial statement information. The student must write a letter on this matter so the case does provide a good writing exercise for the students. CA 2-11 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to discuss the ethical issues related to expense recognition. CA 2-12 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to discuss the cost/benefit constraint. 2-18 SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 2-1 (a) A conceptual framework is like a constitution. Its objective is to provide a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements. A conceptual framework is necessary so that standard setting is useful, i.e., standard setting should build on and relate to an established body of concepts and objectives. A well-developed conceptual framework should enable the FASB to issue more useful and consistent standards in the future. Specific benefits that may arise are: 1. A coherent set of standards and rules should result. 2 . New and emerging practical problems should be more quickly soluble by reference to an existing framework. 3 . It should increase financial statement users’ understanding of and confidence in financial reporting. 4. It should enhance comparability among companies’ financial statements. 5. It should help determine the bounds for judgment in preparing financial statements. 6. It should provide guidance to the body responsible for establishing accounting standards. (b) The FASB has issued six Statements of Financial Accounting Concepts (SFAC) that relate to business enterprises. Their titles and brief description of the focus of each Statement are as follows: 1. SFAC No. 1, “ Objectives of Financial Reporting by Business Enterprises,” presents the goals and purposes of accounting. 2. SFAC No. 2, “Qualitative Characteristics of Accounting Information,” examines the characteristics that make accounting information useful. 3. SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” provides definitions of the broad classifications of items found in financial statements. 4. SFAC No. 5, “Recognition and Measurement in Financial Statements,” sets forth fundamental recognition criteria and guidance on what information should be formally incorporated into financial statements and when. In addition, this concept statement addresses certain measurement issues that are closely related to recognition. 5. SFAC No. 6, “Elements of Financial Statements,” replaces SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” and expands its scope to include not-for-profit organizations. 6. SFAC No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements,” provides a framework for using expected future cash flows and present value as a basis for measurement. CA 2-2 (a) FASB’s conceptual framework study should provide benefits to the accounting community such as: 1. guiding the FASB in establishing accounting standards on a consistent basis. 2. determining bounds for judgment in preparing financial statements by prescribing the nature, functions and limits of financial accounting and reporting. 3. increasing users’ understanding of and confidence in financial reporting. 2-19 CA 2-2 (Continued) (b) Statement of Financial Accounting Concepts No. 2 identifies the most important quality for accounting information as usefulness for decision making. Relevance and reliability are the primary qualities leading to this decision usefulness. Usefulness is the most important quality because, without usefulness, there would be no benefits from information to set against its costs. (c) The number of key characteristics or qualities that make accounting information desirable are described in the Statement of Financial Accounting Concepts No. 2. The importance of three of these characteristics or qualities are discussed below. 1 . Understandability–information provided by financial reporting should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. Financial information is a tool and, like most tools, cannot be of much direct help to those who are unable or unwilling to use it, or who misuse it. 2 . Relevance–the accounting information is capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations. 3. Reliability–the reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has representational quality. (Note to instructor: Other qualities might be discussed by the student, such as secondary qualities. All of these qualities are defined in the textbook.) CA 2-3 (a) The basic objectives in Statement of Financial Accounting Concepts No. 1 are to: 1. provide information useful in investment and credit decisions for individuals who have a reasonable understanding of business. 2. provide information useful in assessing future cash flows. 3. provide information about economic resources, claims to those resources, and changes in them. (b) The purpose of this statement is to set forth fundamentals on which financial accounting and reporting standards may be based. Without some basic set of objectives that everyone can agree to, inconsistent standards will be developed. For example, some believe that accountability should be the primary objective of financial reporting. Others argue that prediction of future cash flows is more important. It follows that individuals who believe that accountability is the primary objective may arrive at different financial reporting standards than others who argue for prediction of cash flow. Only by establishing some consistent starting point can accounting ever achieve some underlying consistency in establishing accounting principles. It should be emphasized to the students that the Board itself is likely to be the major user and thus the most direct beneficiary of the guidance provided by this pronouncement. However, knowledge of the objectives and concepts the Board uses should enable all who are affected by or interested in financial accounting standards to better understand the content and limitations of information provided by financial accounting and reporting, thereby furthering their ability to use that information effectively and enhancing confidence in financial accounting and reporting. That knowledge, if used with care, may also provide guidance in resolving new or emerging problems of financial accounting and reporting in the absence of applicable authoritative pronouncements. 2-20 CA 2-4 (a) (1) Relevance is one of the two primary decision-specific characteristics of useful accounting information. Relevant information is capable of making a difference in a decision. Relevant information helps users to make predictions about the outcomes of past, present, and future events, or to confirm or correct prior expectations. Information must also be timely in order to be considered relevant. (2) Reliability is one of the two primary decision-specific characteristics of useful accounting information. Reliable information can be depended upon to represent the conditions and events that it is intended to represent. Reliability stems from representational faithfulness and verifiability. Representational faithfulness is correspondence or agreement between accounting information and the economic phenomena it is intended to represent. Verifiability provides assurance that the information is free from bias. (3) Understandability is a user-specific characteristic of information. Information is understandable when it permits reasonably informed users to perceive its significance. Understandability is a link between users, who vary widely in their capacity to comprehend or utilize the information, and the decision-specific qualities of information. (4) Comparability means that information about enterprises has been prepared and presented in a similar manner. Comparability enhances comparisons between information about two different enterprises at a particular point in time. (5) Consistency means that unchanging policies and procedures have been used by an enterprise from one period to another. Consistency enhances comparisons between information about the same enterprise at two different points in time. (b) (Note to instructor: There are a multitude of answers possible here. The suggestions below are intended to serve as examples.) (1) Forecasts of future operating results and projections of future cash flows may be highly relevant to some decision makers. However, they would not be as reliable as historical cost information about past transactions. (2) Proposed new accounting methods may be more relevant to many decision makers than existing methods. However, if adopted, they would impair consistency and make trend comparisons of an enterprise’s results over time difficult or impossible. (3) There presently exists much diversity among acceptable accounting methods and procedures. In order to facilitate comparability between enterprises, the use of only one accepted accounting method for a particular type of transaction could be required. However, consistency would be impaired for those firms changing to the new required methods. (4) Occasionally, relevant information is exceedingly complex. Judgment is required in determining the optimum trade-off between relevance and understandability. Information about the impact of general and specific price changes may be highly relevant but not understandable by all users. (c) Although trade-offs result in the sacrifice of some desirable quality of information, the overall result should be information that is more useful for decision making. CA 2-5 (a) The various accepted times of recognizing revenue in the accounts are as follows: 1. Time of sale. This time is currently acceptable when the costs and expenses related to the particular transaction are reasonably determinable at the time of sale and when the collection of the sales price is reasonably certain. 2-21 CA 2-5 (Continued) 2. At completion. This time is currently acceptable in extractive industries where the salability of the product at a quoted price is likely and in the agricultural industry where there is a quoted price for the product and only Iow additional costs of delivery to the market remain. 3. During production. This time is currently acceptable when the revenue is known from the contract and total cost can be estimated to determine percentage of completion. 4. At collection. This time is currently acceptable when collections are received in installments, when there are substantial “after costs” that unless anticipated would have the effect of overstating income on a sales basis in the period of sale, and when collection risks are high. (b) (1) The “crucial event”–that is, the most difficult task in the cycle of a complete transaction–in the process of earning revenue may or may not coincide with the rendering of service to the subscriber. The new director suggests that they do not coincide in the magazine business and that revenue from subscription sales and advertising should be recognized in the accounts when the difficult task of selling is accomplished and not when the magazines are published to fill the subscriptions or to carry the advertising. The director’s view that there is a single crucial event in the process of earning revenue in the magazine business is questionable even though the amount of revenue is determinable when the subscription is sold. Although the firm cannot prosper without good advertising contracts and while advertising rates depend substantially on magazine sales, it also is true that readers will not renew their subscriptions unless the content of the magazine pleases them. Unless subscriptions are obtained at prices that provide for the recovery in the first subscription period of all costs of selling and filling those subscriptions, the editorial and publishing activities are as crucial as the sale in the earning of the revenue. Even if the subscription rate does provide for the recovery of all associated costs within the first period, however, the editorial and publishing activities still would be important since the firm has an obligation (in the amount of the present value of the costs expected to be incurred in connection with the editorial and publication activities) to produce and deliver the magazine. Not until this obligation is fulfilled should the revenue associated with it be recognized in the accounts since the revenue is the result of accomplishing two difficult economic tasks (selling and filling subscriptions) and not just the first one. The director’s view also presumes that the cost of publishing the magazines can be computed accurately at or close to the time of the subscription sale despite uncertainty about possible changes in the prices of the factors of production and variations in efficiency. Hence, only a portion–not most–of the revenue should be recognized in the accounts at the time the subscription is sold. (2) Recognizing in the accounts all the revenue in equal portions with the publication of the magazine every month is subject to some of the same criticism from the standpoint of theory as the suggestion that all or most of the revenue be recognized in the accounts at the time the subscription is sold. Although the journalistic efforts of the magazine are important in the process of earning revenue, the firm could not prosper without magazine sales and the advertising that results from paid circulation. Hence, some revenue should be recognized in the accounts at the time of the subscription sale. This alternative, even though it does not recognize revenue in the accounts quite as fast as it is earned, is preferable to the first alternative because a greater proportion of the process of earning revenue is associated with the monthly publication of the magazine than with the subscription sale. For this reason, and because the task of estimating the amount of revenue associated with the subscription sale often has been considered subjective, recognizing revenue in the accounts with the monthly publication of the magazine has received support even though it does not meet the tests of revenue recognition as well as the next alternative. 2-22 CA 2-5 (Continued) (3) Recognizing in the accounts a portion of the revenue at the time a cash subscription is obtained and a portion each time an issue is published meets the tests of revenue recognition better than the other two alternatives. A portion of the net income is recognized in the accounts at the time of each major or crucial event. Each crucial event is clearly discernible and is a time of interaction between the publisher and subscriber. A legal sale is transacted before any revenue is recognized in the accounts. Prior to the time the revenue is recognized in the accounts, it already has been received in distributable form. Finally, the total revenue is measurable with more than the usual certainty, and the revenue attributable to each crucial event is determinable using reasonable (although sometimes conceptually unsatisfactory) assumptions about the relationship between revenue and costs when the costs are indirect. (Note to instructor: CA 2-5 might also be assigned in conjunction with Chapter 18.) CA 2-6 (a) The economist views business income in terms of wealth of the entity as a whole resulting from an accretion attributable to the whole process of business activity. The accountant must measure the “wealth” of the entity in terms of its component parts, that is, individual assets and liabilities. The events must be identified which cause changes in financial condition of the entity and the resulting changes should be assigned to specific accounting periods. To achieve this identification of such events, accountants employ the revenue recognition principle in the measurement of periodic income. (b) Revenue recognition results from the accomplishment of economic activity involving the transfer of goods and services giving rise to a claim. To warrant recognition there must be a change in assets that is capable of being objectively measured and that involves an exchange transaction. This refers to the presence of an arm’s-length transaction with a party external to the entity. The existence and terms of the transaction may be defined by operation of law, by established trade practice, or may be stipulated in a contract. Note that an item should meet four fundamental recognition criteria to be recognized. Those criteria are: 1. Definitions—The item meets the definition of an element of financial statements. 2. Measurability—It has a relevant attribute measurable with sufficient reliability. 3. Relevance—The information is capable of making a difference in user decisions. 4. Reliability—The information is representationally faithful, verifiable, and neutral. In the context of revenue recognition, recognition involves consideration of two factors, (a) being realized or realizable and (b) being earned, with sometimes one and sometimes the other being the more important consideration. Events that can give rise to recognition of revenue are: the completion of a sale; the performance of a service; the production of a standard interchangeable good with a guaranteed market, a determinable market value and only minor costs of marketing, such as precious metals and certain agricultural commodities; and the progress of a construction project, as in shipbuilding. The passing of time may be the “event” that establishes the recognition of revenue, as in the case of interest revenue or rental income. As a practical consideration, there must be a reasonable degree of certainty in measuring the amount of revenue recognized. Problems of measurement may arise in estimating the degree of completion of a contract, the net realizable value of a receivable or the value of a nonmonetary asset received in an exchange transaction. In some cases, while the revenue may be readily measured, it may be impossible to estimate reasonably the related expenses. In such instances revenue recognition must be deferred until proper periodic income measurement can be achieved through the matching process. 2-23 CA 2-6 (Continued) (c) No. The factor apparently relied upon by Sulu Associates is that revenue is recognized as the services giving rise to it are performed. The firm has completed the construction of the building, obtained financing for the project, and secured tenants for most of the space. Management of the project is yet to be rendered and Sulu did not accrue revenue for this service. However, another factor must be considered. Since the fee for Sulu’s services has as its source the future profits of the project, on May 31, 2007, there is no way to measure objectively the amount of the fee. Setting the amount at the commercial value of the services might be a reasonable approach were it not for the contingent nature of the source of the fees. That an asset, contracts receivable, exists as a result of this activity is outweighed by the inability to measure it objectively. Revenue recognition at this time is unwarranted because of the contingent nature of the revenue and the likelihood of overstating the assets. Thus, revenue recognition at this point would not be in accordance with generally accepted accounting principles. Because revenue cannot be recognized, the related expenses should be deferred so that they can be amortized over the respective periods of revenue recognition. With a reasonable expectation of future benefit, the deferred costs conform to the accounting concept of assets. CA 2-7 (a) Some costs are recognized as expenses on the basis of a presumed direct association with specific revenue. This presumed direct association has been identified both as “associating cause and effect” and as the “matching concept.” Direct cause-and-effect relationships can seldom be conclusively demonstrated, but many costs appear to be related to particular revenue, and recognizing them as expenses accompanies recognition of the revenue. Generally, the matching concept requires that the revenue recognized and the expenses incurred to produce the revenue be given concurrent periodic recognition in the accounting records. Only if effort is properly related to accomplishment will the results, called earnings, have useful significance concerning the efficient utilization of business resources. Thus, applying the matching principle is a recognition of the cause-and-effect relationship that exists between expense and revenue. Examples of expenses that are usually recognized by associating cause and effect are sales commissions, freight-out on merchandise sold, and cost of goods sold or services provided. (b) Some costs are assigned as expenses to the current accounting period because 1. their incurrence during the period provides no discernible future benefits; 2. they are measures of assets recorded in previous periods from which no future benefits are expected or can be discerned; 3. they must be incurred each accounting year, and no build-up of expected future benefits occurs; 4. by their nature they relate to current revenues even though they cannot be directly associated with any specific revenues; 5. the amount of cost to be deferred can be measured only in an arbitrary manner or great uncertainty exists regarding the realization of future benefits, or both; 6. and uncertainty exists regarding whether allocating them to current and future periods will serve any useful purpose. Thus, many costs are called “period costs” and are treated as expenses in the period incurred because they have neither a direct relationship with revenue earned nor can their occurrence be directly shown to give rise to an asset. The application of this principle of expense recognition results in charging many costs to expense in the period in which they are paid or accrued for payment. Examples of costs treated as period expenses would include officers’ salaries, advertising, research and development, and auditors’ fees. 2-24 CA 2-7 (Continued) (c) A cost should be capitalized, that is, treated as a measure of an asset when it is expected that the asset will produce benefits in future periods. The important concept here is that the incurrence of the cost has resulted in the acquisition of an asset, a future service potential. If a cost is incurred that resulted in the acquisition of an asset from which benefits are not expected beyond the current period, the cost may be expensed as a measure of the service potential that expired in producing the current period’s revenues. Not only should the incurrence of the cost result in the acquisition of an asset from which future benefits are expected, but also the cost should be measurable with a reasonable degree of objectivity, and there should be reasonable grounds for associating it with the asset acquired. Examples of costs that should be treated as measures of assets are the costs of merchandise on hand at the end of an accounting period, costs of insurance coverage relating to future periods, and the cost of self-constructed plant or equipment. (d) In the absence of a direct basis for associating asset cost with revenue and if the asset provides benefits for two or more accounting periods, its cost should be allocated to these periods (as an expense) in a systematic and rational manner. Thus, when it is impractical, or impossible, to find a close cause-and-effect relationship between revenue and cost, this relationship is often assumed to exist. Therefore, the asset cost is allocated to the accounting periods by some method. The allocation method used should appear reasonable to an unbiased observer and should be followed consistently from period to period. Examples of systematic and rational allocation of asset cost would include depreciation of fixed assets, amortization of intangibles, and allocation of rent and insurance. (e) A cost should be treated as a loss when no revenue results. The matching of losses to specific revenue should not be attempted because, by definition, they are expired service potentials not related to revenue produced. That is, losses result from events that are not anticipated as necessary in the process of producing revenue. There is no simple way of identifying a loss because ascertaining whether a cost should be a loss is often a matter of judgment. The accounting distinction between an asset, expense, loss, and prior period adjustment is not clear-cut. For example, an expense is usually voluntary, planned, and expected as necessary in the generation of revenue. But a loss is a measure of the service potential expired that is considered abnormal, unnecessary, unanticipated, and possibly nonrecurring and is usually not taken into direct consideration in planning the size of the revenue stream. CA 2-8 (a) Costs should be recognized as expiring in a given period if they are not chargeable to a prior period and are not applicable to future periods. Recognition in the current period is required when any of the following conditions or criteria are present: 1. A direct identification of association of charges with revenue of the period, such as goods shipped to customers. 2. An indirect association with the revenue of the period, such as fire insurance or rent. 3. A period charge where no association with revenue in the future can be made so the expense is charged this period, such as officers’ salaries. 4. A measurable expiration of asset costs during the period, even though not associated with the production of revenue for the current period, such as a fire or casualty loss. (b) (1) Although it is generally agreed that inventory costs should include all costs attributable to placing the goods in a salable state, receiving and handling costs are often treated as cost expirations in the period incurred because they are irregular or are not in uniform proportion to sales. 2-25 CA 2-8 (Continued) The portion of the receiving and handling costs attributable to the unsold goods processed during the period should be inventoried. These costs might be more readily apportioned if they are assigned by some device such as an applied rate. Abnormally high receiving and handling costs should be charged off as a period cost. (2) The valuation of inventories at the lower of cost or market has been widely adopted as a conservative method of valuing inventories. This method results in recording losses but not gains prior to the sale of the inventory. Where there is not an attendant drop in sales prices, costs and revenues are mismatched to the extent that the present period’s reported net income is reduced and the next period’s reported net income is increased. Such mismatching has been justified on the grounds that the next period should receive a “fresh start” and its position be the same as though the inventory has been purchased at current market prices. This argument, it might be noted, is contrary to the “going concern” concept. Where the writedown is of a substantial amount, it has been suggested that the cost of goods sold be reported in terms of original cost. The writedown would be excluded from the cost of goods sold section and shown separately. In addition to matching costs with revenues, this procedure shows normal and abnormal operating results on the income statement for comparative purposes. (3) Cash discounts on purchases are treated as “other revenues” in some financial statements in violation of the matching concept. Revenue is not recognized when goods are purchased or cash disbursed. Furthermore, inventories valued at gross invoice price are recorded at an amount greater than their cash outlay resulting in misstatement of inventory cost in the current period and inventory cost expirations in future periods. Close adherence to the matching concept requires that cash discounts be recorded as a reduction of the cost of purchases and that inventories be priced at net invoice prices. Where inventories are priced at gross invoice prices for expediency, however, there is a slight distortion of the financial statements if the beginning and ending inventories vary little in amount. CA 2-9 (a) The preferable treatment of the costs of the sample display houses is expensing them over more than one period. These sample display houses are assets because they represent rights to future service potentials or economic benefits. According to the matching concept, the costs of service potentials should be amortized as the benefits are received. Thus, costs of the sample display houses should be matched with the revenue from the sale of the houses which is receivable over a period of more than one year. As the sample houses are left on display for three to seven years, Carlos Rodriguez apparently expects to benefit from the displays for at least that length of time. The alternative of expensing the costs of sample display houses in the period in which the expenditure is made is based primarily upon the concept of conservatism. These costs are of a promotional nature. Promotional costs often are considered expenses of the period in which the expenditures occur due to the uncertainty in determining the time periods benefited. It is likely that no decision is made concerning the life of a sample display house at the time it is erected. Past experience may provide some guidance in determining the probable life. A decision to tear down or alter a house probably is made when sales begin to lag or when a new model with greater potential becomes available. 2-26 CA 2-9 (Continued) There is uncertainty not only as to the life of a sample display house but also as to whether a sample display house will be torn down or altered. If it is altered rather than torn down, a portion of the cost of the original house may be attributable to the new model. (b) If all of the shell houses are to be sold at the same price, it may be appropriate to allocate the costs of the display houses on the basis of the number of shell houses sold. This allocation would be similar to the units-of-production method of depreciation and would result in a good matching of costs with revenues. On the other hand, if the shell houses are to be sold at different prices, it may be preferable to allocate costs on the basis of the revenue contribution of the shell houses sold. There is uncertainty regarding the number of homes of a particular model which will be sold as a result of the display sample. The success of this amortization method is dependent upon accurate estimates of the number and selling price of shell houses to be sold. The estimate of the number of units of a particular model which will be sold as a result of a display model should include not only units sold while the model is on display but also units sold after the display house is torn down or altered. Cost amortization solely on the basis of time may be preferable when the life of the models can be estimated with a great deal more accuracy than can the number of units which will be sold. If unit sales and selling prices are uniform over the life of the sample, a satisfactory matching of costs and revenues may be achieved if the straight-line amortization procedure is used. 2-27 CA 2-10 Date Dear Uncle Waldo, I received the information on Cricket Corp. and appreciate your interest in sharing this venture with me. However, I think that basing an investment decision on these financial statements would be unwise because they are neither relevant nor reliable. One of the most important characteristics of accounting information is that it is relevant, i.e., it will make a difference in my decision. To be relevant, this information must be timely. Because Cricket’s financial statements are a year old, they have lost their ability to influence my decision: a lot could have changed in that one year. Another element of relevance is predictive value. Once again, Cricket’s accounting information proves irrelevant. Shown without reference to other years’ profitability, it cannot help me predict future profitability because I cannot see any trends developing. Closely related to predictive value is feedback value. These financial statements do not provide feedback on any strategies which the company may have used to increase profits. These financial statements are also not reliable. In order to be reliable, their assertions must be verifiable by several independent parties. Because no independent auditor has verified these amounts, there is no way of knowing whether or not they are represented faithfully. For instance, I would like to believe that this company earned $2,424,240, and that it had a very favorable debt-to-equity ratio. However, unaudited financial statements do not give me any reasonable assurance about these claims. Finally, the fact that Mrs. Cricket herself prepared these statements indicates a lack of neutrality. Because she is not a disinterested third party, I cannot be sure that she did not prepare the financial statements in favor of her husband’s business. I do appreciate the trouble you went through to get me this information. Under the circumstances, however, I do not wish to invest in the Cricket bonds and would caution you against doing so. Before you make a decision in this matter, please call me. Sincerely, Your Nephew 2-28 CA 2-11 (a) The stakeholders are investors, creditors, etc.; i.e., users of financial statements, current and future. (b) Honesty and integrity of financial reporting, job protection, profit. (c) Applying the matching principle and recording expense during the plant’s life, or not applying it. That is, record the mothball costs in the future. (d) The major question may be whether or not the expense of mothballing can be estimated properly so that the integrity of financial reporting is maintained. Applying the matching principle will result in lower profits and possibly higher rates for consumers. Could this cost anyone his or her job? Will investors and creditors have more useful information? On the other hand, failure to apply the matching principle means higher profits, lower rates, and greater potential job security. (e) Students’ recommendations will vary. Note: Other stakeholders possibly affected are present and future consumers of electric power. Delay in allocating the expense will benefit today’s consumers of electric power at the expense of future consumers. CA 2-12 1. Information about competitors might be useful for benchmarking the company’s results but if management does have expertise in providing the information, it could lack reliability. In addition, it is likely very costly for management to gather sufficiently reliable information of this nature. While users of financial statements might benefit from receiving internal information, such as company plans and budgets, competitors might also be able to use this information to gain a competitive advantage relative to the disclosing company. In order to produce forecasted financial statements, management would have to make numerous assumptions and estimates, which would be costly in terms of time and data collection. Because of the subjectivity involved, the forecasted statements would lack reliability, thereby detracting from any potential benefits. In addition, while management’s forecasts of future profitability or balance sheet amounts could be of benefit, companies could be subject to shareholder lawsuits, if the amounts in the forecasted statements are not realized. It would be excessively costly for companies to gather and report information that is not used in managing the business. Flexible reporting allows companies to “fine-tune” their financial reporting to meet the information needs of its varied users. In this way, they can avoid the cost of providing information that is not demanded by its users. Similar to number 3, concerning forecasted financial statements, if managers report forwardlooking information, the company could be exposed to liability if investors unduly rely on the information in making investment decisions. Thus, if companies get protection from unwarranted lawsuits (called a safe harbor), then they might be willing to provide potentially beneficial forwardlooking information. 2. 3. 4. 5. 6. 2-29 FINANCIAL REPORTING PROBLEM (a) From Note 1. Revenue Recognition—Sales are recognized when revenue is realized or realizable and has been earned. Most revenue transactions represent sales of inventory, and the revenue recorded includes shipping and handling costs, which generally are included in the list price to the customer. The Company’s policy is to recognize revenue when title to the product, ownership and risk of loss transfer to the customer, which generally is on the date of shipment. A provision for payment discounts and product return allowances is recorded as a reduction of sales in the same period that the revenue is recognized. Trade promotions, consisting primarily of customer pricing allowances, merchandising funds and consumer coupons, are offered through various programs to customers and consumers. Sales are recorded net of trade promotion spending, which is recognized as incurred, generally at the time of the sale. Most of these arrangements have terms of approximately one year. Accruals for expected payouts under these programs are included as accrued marketing and promotion in the accrued and other current liabilities line in the Consolidated Balance Sheets. (b) Most of the information presented in P&G’s financial statements is reported on an historical cost basis. Examples are: Property, Plant, and Equipment, Inventories (which is not in excess of market), Goodwill, and Intangible Assets. Regarding the use of fair value, all of the company’s marketable investments are reported at fair value (quoted market prices). In addition, the fair value of the company’s financial instruments and the fair value of pension assets are disclosed. Examination of the auditor’s report. Also, P&G indicated that no new accounting pronouncements issued or effective during the fiscal year have had or are expected to have a material impact on the financial statements. Certain reclassifications of prior years’ amounts have been made to conform to the current year presentation. Selling, general and administrative expense primarily includes marketing expenses, including the cost of media, advertising and related costs; selling expenses; research and development costs; administrative and other indirect overhead costs; and other miscellaneous operating items. 2-30 (c) (d) FINANCIAL STATEMENT ANALYSIS CASE (a) 1. In the year of the change, Wal-Mart will reverse the revenue recognized in prior periods for layaway sales that are not complete. This will reduce income in the year of the change. 2. In subsequent years, after the adjustment in the year of the change, as long as Wal-Mart continues to make layaway sales at the same levels, income levels should return to prior levels (except for growth). That is, the accounting change only changes the timing of the recognition, not the overall amount recognized. (b) By recognizing the revenue before delivery, Wal-Mart was recognizing revenue before the earnings process was complete. In addition, if customers did not pay the remaining balance owed, the realizability criterion is not met either. While Wal-Mart likely could estimate expected deliveries and payments, it is not apparent that this was done. Even if all retailers used the same policy, it still might be difficult to compare the results for layaway transactions. For example what if retailers have different policies as to how much customers have to put down in order for the retailer to set aside the merchandise. Note that the higher (lower) the amount put down, the more (less) likely the customer will complete the transaction. The concern under the prior rules is that retailers might give very generous layaway terms in order to accelerate revenue recognition. Investors would be in for a surprise if customers do not complete the transactions and the revenue recorded earlier must be reversed, thereby lowering reported income. (c) 2-31 COMPARATIVE ANALYSIS CASE (a) Coca-Cola indicates its business is nonalcoholic beverages, principally soft drinks, but also a variety of noncarbonated beverages. It notes that it is the world’s leading manufacturer, marketer and distributor of soft-drink beverage concentrates and syrups as well as the world’s largest marketer and distributor of juice and juice-drink products. In its segment supporting note to the financial statements, however, it does not provide a breakdown of beverage drinks into soft drinks and noncarbonated beverages. Rather segments are defined based on the following geographic areas: the North American Group (including The Minute Maid Company); the Africa Group; the Europe and Eurasia Group and the Middle East Group; the Latin America Group; the Asia Group; and Corporate. The North America Group includes the United States, Canada, and Puerto Rico. PepsiCo views itself as a leading, global snack and beverage company. It manufactures, markets, and sells a variety of salty, sweet and grainbased snacks, carbonated and noncarbonated beverages and foods. It is organized in four divisions: • • • • Frito-Lay North America, PepsiCo Beverages North America, PepsiCo International, and Quaker Foods North America. The North American divisions operate in the United States and Canada. The international divisions operate in over 200 countries, with our largest operations in Mexico and the United Kingdom. (b) Coca-Cola’s net operating revenues for 2004 was $21,962 million which was comprised principally of beverage sales. PepsiCo reported net sales of $29,261 million of which soft drinks is an estimated $18,175 ($8,313 + $9,862) million. The remainder is related to sales in the Frito-Lay and Quaker Foods segments. Based on these amounts, Coca-Cola has the dominant position in beverage sales. 2-32 COMPARATIVE ANALYSIS CASE (Continued) (c) Coca-Cola values inventory at the lower of cost or market. In general, cost is determined on the basis of average cost or first-in first-out methods. PepsiCo also values its inventory at the lower of cost or market. Approximately 16% in 2004 and 10% in 2003 of the inventory cost was computed using the LIFO method. The differences between LIFO and FIFO methods of valuing these inventories are not material. Because PepsiCo uses LIFO for part of its inventory, if material, it would be necessary to adjust as best as possible to FIFO. An additional problem is that both use the average cost for some of their inventory, but information related to its percentage use is not provided. (d) Both PepsiCo and Coca-Cola were affected by the promulgation of new accounting standards by the FASB in 2004. Description of these standard adoptions is discussed below. Coca-Cola New Accounting Standards Effective January 1, 2003, the Company adopted SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS No. 146 requires that a liability for a cost associated with an exit or disposal plan be recognized when the liability is incurred. SFAS No. 146 establishes that fair value is the objective for initial measurement of the liability. In cases where employees are required to render service beyond a minimum retention period until they are terminated in order to receive termination benefits, a liability for termination benefits is recognized ratably over the future service period. Under EITF Issue No. 94-3, a liability for the entire amount of the exit cost was recognized at the date that the entity met the four criteria described above. Refer to Note 17. 2-33 COMPARATIVE ANALYSIS CASE (Continued) Effective January 1, 2003, our Company adopted the recognition and measurement provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“Interpretation 45”). This interpretation elaborates on the disclosures to be made by a guarantor in interim and annual financial statements about the obligations under certain guarantees. Interpretation 45 also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. We do not currently provide significant guarantees on a routine basis. As a result, this interpretation has not had a material impact on our consolidated financial statements. During 2004, the FASB issued FASB Staff Position 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-2”). FSP 106-2 relates to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) signed into law in December 2003. The Act introduced a prescription drug benefit under Medicare known as “Medicare Part D.” The Act also established a federal subsidy to sponsors of retiree health care plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. During the second quarter of 2004, our Company adopted the provisions of FSP 106-2 retroactive to January 1, 2004. The adoption of FSP 106-2 did not have a material impact on our consolidated financial statements. Refer to Note 14. In October 2004, the American Jobs Creation Act of 2004 (the “Jobs Creation Act”) was signed into law. The Jobs Creation Act includes a temporary incentive for U.S. multinationals to repatriate foreign earnings at an effective 5.25 percent tax rate. Such repatriations must occur in either an enterprise’s last tax year that began before the enactment date, or the first tax year that begins during the one-year period beginning on the date of enactment. 2-34 COMPARATIVE ANALYSIS CASE (Continued) FASB Staff Position 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” (“FSP 109-2”), indicates that the lack of clarification of certain provisions within the Jobs Creation Act and the timing of the enactment necessitate a practical exception to the SFAS No. 109, “Accounting for Income Taxes,” (“SFAS No. 109”) requirement to reflect in the period of enactment the effect of a new tax law. Accordingly, an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Creation Act on its plan for reinvestment or repatriation of foreign earnings. FSP 109-2 requires that the provisions of SFAS No. 109 be applied as an enterprise decides on its plan for reinvestment or repatriation of its unremitted foreign earnings. In 2004, our Company recorded an income tax benefit of approximately $50 million as a result of the realization of certain tax credits related to certain provisions of the Jobs Creation Act not related to repatriation provisions. Our Company is currently evaluating the details of the Jobs Creation Act and any impact it may have on our income tax expense in 2005. Refer to Note 15. In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of Accounting Research Bulletin No. 43, Chapter 4.” SFAS No. 151 requires that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) be recorded as current period charges and that the allocation of fixed production overheads to inventory be based on the normal capacity of the production facilities. SFAS No. 151 is effective for our Company on January 1, 2006. The Company does not believe that the adoption of SFAS No. 151 will have a material impact on our consolidated financial statements. PepsiCo PepsiCo reported no effects from the adoption of new accounting standards in 2004. 2-35 RESEARCH CASE Answers will vary by the article and the company selected. 2-36 INTERNATIONAL REPORTING CASE The IASB and FASB frameworks are strikingly similar. This is not surprising, given that the IASB framework was adopted after the FASB developed its framework (the IASB framework was approved in April 1989). In addition, the IASC, the predecessor to the IASB, was formed to facilitate harmonization of accounting standards across countries. This objective could be aided by adopting a similar conceptual framework. Specific similarities include: (a) Primary Components—Both frameworks include elements addressing objectives, assumptions, qualitative characteristics, elements of financial statements, and constraints. The objectives for both frameworks focus on information about financial position, performance and changes in performance that is decisionuseful. Relevance and reliability are identified as key qualitative characteristics of useful information. Both frameworks adopt similar definitions for assets and liabilities and define equity as the residual of assets minus liabilities. Both frameworks assume some level of understandability by users of financial statements. (b) (c) (d) (e) Some differences include: (a) Terminology—The IASB framework contains some terms not found in the FASB’s. For example, prudence, listed under reliability in the IASB framework corresponds to the notion of conservatism in the FASB framework. Assumptions—The IASB does not specifically address assumptions about the monetary unit or economic entity. Note that the accrual basis assumption, in combination with the timeliness constraint can be viewed as subsuming the periodicity assumption in the FASB framework. 2-37 (b) INTERNATIONAL REPORTING CASE (Continued) (c) Elements—The IASB defines just five elements without specific definitions for Investments by and Distributions to Owners or Comprehensive Income. There is no distinction in the IASB framework between gains and revenues and losses and expenses. Note to Instructors—These differences may be resolved as the FASB and IASB work on their performance reporting projects. (d) Qualitative Characteristics—The IASB does not make a distinction between primary (relevance and reliability) and secondary qualitative factors (comparability), although many of the same qualitative factors are apparent in each framework. Recognition and Measurement Principles—The IASB Framework, as presented in the Overview does not address measurement principles related to Historical Cost, Revenue Recognition and Matching. These likely are discussed in the context of Accrual Basis and True and Fair Presentation. 2-38 PROFESSIONAL RESEARCH: ACCOUNTING AND FINANCIAL REPORTING Search Strings: concept statement, “materiality”, “articulation”, “CON 2”, “CON 3” a) According to Concepts Statement 2 (CON 2): Qualitative Characteristics of Accounting Information, “Glossary”: “Materiality is defined as the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.” b) CON 2, Appendix C—See Table 1—refers to several SEC cases which apply materiality. Students might also research SEC literature (e.g. Staff Accounting Bulletin No. 99), although SEC literature is not in the FARS database. SFAC No. 2, 128. provides the following examples of screens that might be used to determine materiality: “ a. An accounting change in circumstances that puts an enterprise in danger of being in breach of covenant regarding its financial condition may justify a lower materiality threshold than if its position were stronger. A failure to disclose separately a nonrecurrent item of revenue may be material at a lower threshold than would otherwise be the case if the revenue turns a loss into a profit or reverses the trend of earnings from a downward to an upward trend. A misclassification of assets that would not be material in amount if it affected two categories of plant or equipment might be material if it changed the classification between a noncurrent and a current asset category. Amounts too small to warrant disclosure or correction in normal circumstances may be considered material if they arise from abnormal or unusual transactions or events.” b. c. d. However, according to CON 2, Pars. 129, 131 the FASB notes that more than magnitude must be considered in evaluating materiality: Almost always, the relative rather than the absolute size of a judgment item determines whether it should be considered material in a given situation. Losses from bad debts or pilferage that could be shrugged off as routine by a large business may threaten the continued existence of a small one. An error in inventory valuation may be material in a small enterprise for which it cut earnings in half but immaterial in an enterprise for which it might make a barely perceptible ripple in the earnings. Some of the empirical investigations referred to in Appendix C throw light on the considerations that enter into materiality judgments. SFAC No. 2, Par. 131. Some hold the view that the Board should promulgate a set of quantitative materiality guides or criteria covering a wide variety of situations that preparers could look to for authoritative support. That appears to be a minority view, however, on the basis of representations made to the Board in response to the Discussion Memorandum, Criteria for Determining Materiality. The predominant view is that materiality judgments can properly be made only by those who have all the facts. The Board’s present position is that no general standards of materiality could be formulated to take into account all the considerations that enter into an experienced human judgment. 2-39 ACCOUNTING AND FINANCIAL REPORTING (Continued) c) SFAC No. 3, Par. 15. The two classes of elements are related in such a way that (a) assets, liabilities, and equity are changed by elements of the other class and at any time are their cumulative result and (b) an increase (decrease) in an asset cannot occur without a corresponding decrease (increase) in another asset or a corresponding increase (decrease) in a liability or equity. Those relationships are sometimes collectively referred to as “articulation.” They result in financial statements that are fundamentally interrelated so that statements that show elements of the second class depend on statements that show elements of the first class and vice versa. 2-40 PROFESSIONAL SIMULATION Explanation 1. Most accounting methods are based on the assumption that the business enterprise will have a long life. Acceptance of this assumption provides credibility to the historical cost principle, which would be of limited usefulness if liquidation were assumed. Only if we assume some permanence to the enterprise is the use of depreciation and amortization policies justifiable and appropriate. Therefore, it is incorrect to assume liquidation as the company has done in this situation. It should be noted that only where liquidation appears imminent is the going concern assumption inapplicable. Probably the company is too conservative in its accounting for this transaction. The matching principle indicates that expenses should be allocated to the appropriate periods involved. In this case, there appears to be a high uncertainty that the company will have to pay. FASB Statement No. 5 requires that a loss should be accrued only (1) when it is probable that the company would lose the suit and (2) the amount of the loss can be reasonably estimated. (Note to instructor: The student will probably be unfamiliar with FASB Statement No. 5. The purpose of this question is to develop some decision framework when the probability of a future event must be assumed.) This entry violates the economic entity assumption. This assumption in accounting indicates that economic activity can be identified with a particular unit of accountability. In this situation, the company erred by charging this cost to the wrong economic entity. 2. 3. Research According to Concepts Statement 2 (CON 2): Qualitative Characteristics of Accounting Information, “Glossary”: “Materiality is defined as the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.” 2-41 PROFESSIONAL SIMULATION (Continued) According to the “SUMMARY OF PRINCIPAL CONCLUSIONS”: “Materiality is a pervasive concept that relates to the qualitative characteristics, especially relevance and reliability. Materiality and relevance are both defined in terms of what influences or makes a difference to a decision maker, but the two terms can be distinguished. A decision not to disclose certain information may be made, say, because investors have no need for that kind of information (it is not relevant) or because the amounts involved are too small to make a difference (they are not material). Magnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, will not generally be a sufficient basis for a materiality judgment. The Board’s present position is that no general standards of materiality can be formulated to take into account all the considerations that enter into an experienced human judgment. Quantitative materiality criteria may be given by the Board in specific standards in the future, as in the past, as appropriate.” Expanded discussion of materiality is found at paragraphs 123–132 and in Appendix C of CON 2. 2-42 CHAPTER 3 The Accounting Information System ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. 2. 3. 4. 5. 6. 7. 8. *9. *10. *11. Transaction identification. Nominal accounts. Trial balance. Adjusting entries. Financial statements Closing. Inventory and cost of goods sold. Comprehensive accounting cycle. Cash vs. Accrual Basis Reversing entries. Worksheet 18, 19, 20 21 22 13 14 20, 21 22 23, 24, 25 11 15 9, 10, 11, 12 12 11 Questions 1, 2, 3, 5 4, 7 6, 13 8, 14, 16, 17 3, 4, 5, 6, 7, 8, 9, 10 2, 3, 4 5, 6, 7, 8, 9, 10, 22 11, 12, 25, 26 13, 14, 18 12, 14, 15, 16 1, 2, 6, 11 10 1, 2, 7 1, 2, 3, 4, 5, 6, 7, 8, 9, 11 1, 2, 4, 6 1, 4, 8, 9, 11 Brief Exercises 1, 2 Exercises 1, 2, 3, 4, 19 Problems 1 *These topics are dealt with in the Appendix to the Chapter. 3-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives 1. 2. 3. 4. 5. 6. 7. 8. *9. *10. *11. Understand basic accounting terminology. Explain double-entry rules. Identify steps in accounting cycle. Record transactions in journals, post to ledger accounts, and prepare a trial balance. Explain the reasons for preparing adjusting entries. Prepare financial statements from the adjusted trail balance. Prepare closing entries. Explain how to adjust inventory accounts at year-end. Differentiate the cash basis of accounting from the accrual basis of accounting. Identify adjusting entries that may be reversed. Prepare a 10-column worksheet. 12 11 13 14 1, 2, 3, 4, 5, 6, 7 3, 4, 5, 6, 7, 8, 9, 10 1, 2, 3, 4, 19 5, 6, 7, 8, 9, 10, 22 11, 12 13, 14, 18 15, 16, 17 20, 21 22 23, 24, 25 11 10 1, 4, 8, 9 2, 3, 4, 5, 6, 7, 8, 9, 11 1, 2, 4, 6, 7, 8, 9, 11 1, 4, 8, 9, 11 Brief Exercises Exercises Problems *These topics are dealt with in the Appendix to the Chapter. 3-2 ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty Simple Simple Simple Simple Moderate Moderate Complex Moderate Moderate Complex Moderate Moderate Simple Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Complex Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex Time (minutes) 15–20 10–15 15–20 10–15 10–15 15–20 15–20 10–15 15–20 25–30 20–25 20–25 10–15 10–15 10–15 20–25 10–15 10–15 10–15 15–20 10–15 20–25 10–15 20–25 10–15 25–35 35–40 25–30 40–50 15–20 25–35 25–35 30–40 30–35 35–40 40–50 Item E3-1 E3-2 E3-3 E3-4 E3-5 E3-6 E3-7 E3-8 E3-9 E3-10 E3-11 E3-12 E3-13 E3-14 E3-15 E3-16 E3-17 E3-18 E3-19 *E3-20 *E3-21 *E3-22 *E3-23 *E3-24 *E3-25 P3-1 P3-2 P3-3 P3-4 P3-5 P3-6 P3-7 *P3-8 *P3-9 *P3-10 *P3-11 Description Transaction analysis–service company. Corrected trial balance. Corrected trial balance. Corrected trial balance. Adjusting entries. Adjusting entries. Analyze adjusted data. Adjusting entries. Adjusting entries. Adjusting entries. Prepare financial statements. Prepare financial statements. Closing entries. Closing entries. Missing amounts. Find missing amounts–periodic inventory. Cost of goods sold–periodic inventory. Closing entries for a corporation. Transactions of a corporation, including investment and dividend. Cash to accrual basis. Cash to accrual basis. Adjusting and reversing entries. Worksheet. Worksheet and balance sheet presentation. Partial worksheet preparation. Transactions, financial statements–service company. Adjusting entries and financial statements. Adjusting entries. Financial statements, adjusting and closing entries. Adjusting entries. Adjusting entries and financial statements. Adjusting entries and financial statements. Adjusting and closing. Adjusting and closing. Cash and accrual basis. Worksheet, balance sheet, adjusting and closing entries. 3-3 ANSWERS TO QUESTIONS 1. Examples are: (a) Payment of an accounts payable. (b) Collection of an accounts receivable from a customer. (c) Transfer of an accounts payable to a note payable. Transactions (a), (b), (d) are considered business transactions and are recorded in the accounting records because a change in assets, liabilities, or equities has been effected as a result of a transfer of values from one party to another. Transactions (c) and (e) are not business transactions because a transfer of values has not resulted, nor can the event be considered financial in nature and capable of being expressed in terms of money. Transaction (a): Transaction (b): Transaction (c): Transaction (d): Accounts Receivable (debit), Service Revenue (credit). Cash (debit), Accounts Receivable (credit). Office Supplies (debit), Accounts Payable (credit). Delivery Expense (debit), Cash (credit). 2. 3. 4. Revenue and expense accounts are referred to as temporary or nominal accounts because each period they are closed out to Income Summary in the closing process. Their balances are reduced to zero at the end of the accounting period; therefore, the term temporary or nominal is sometimes given to these accounts. The double-entry system means that for every debit amount there must be a credit amount and viceversa. At least two accounts are affected. It does not mean that each transaction must be recorded twice. Although it is not absolutely necessary that a trial balance be taken periodically, it is customary and desirable. The trial balance accomplishes two principal purposes: (1) It tests the accuracy of the entries in that it proves that debits and credits of an equal amount are in the ledger. (2) It provides a list of ledger accounts and their balances which may be used in preparing the financial statements and in supplying financial data about the concern. (a) Real account; balance sheet. (b) Real account; balance sheet. (c) Merchandise inventory is generally considered a real account appearing on the balance sheet. It has the elements of a nominal account when the periodic inventory system is used. It may appear on the income statement when the multiple-step format is used. (d) Real account; balance sheet. (e) Real account; balance sheet. (f) Nominal account; income statement. (g) Nominal account; income statement. (h) Real account; balance sheet. At December 31, the three days’ wages due to the employees represent a current liability. The related expense must be recorded in this period to properly reflect the expense incurred. (a) In a service company, revenues are service revenues and expenses are operating expenses. In a merchandising company, revenues are sales revenues and expenses consist of cost of goods sold plus operating expenses. (b) The measurement process in a merchandising company consists of comparing the sales price of the merchandise inventory to the cost of goods sold and operating expenses. 5. 6. 7. 8. 9. 3-4 Questions Chapter 3 (Continued) 10. The purpose of the Cost of Goods Sold account is to act as a clearing account for bringing together those items directly affecting cost of goods sold for this period. Example of items that would appear in this account are: (1) Purchases, (2) Purchase Discounts, (3) Purchase Returns, (4) Purchase Allowances, (5) Transportation-in, (6) Inventory (beginning), and (7) Inventory (ending). The ending balance represents the cost of goods sold. 11. The purpose of the Cost of Goods Sold account is to accumulate the costs of issuances from inventory. In a perpetual inventory system, when inventory is sold, Cost of Goods Sold is debited and Inventory is credited. At the end of the period, Cost of Goods Sold is closed to Income Summary. 12. On the balance sheet, the effect of the error is (1) the equipment account is understated, and (2) the Capital account (proprietorship–partnership) or Retained Earnings (Corporation) is understated. On the income statement, (1) purchases and cost of goods sold are overstated and (2) net income is understated. (Note to instructor: The instructor should also be ready to discuss the effect that the omission of the depreciation charge on the computer might have.) 13. (a) (b) (c) (d) No change. Before closing, balances exist in these accounts; after closing, no balances exist. Before closing, balances exist in these accounts; after closing, no balances exist. Before closing, a balance exists in this account exclusive of any dividends or the income or loss for the period; after closing, the balance is increased or decreased by the amount of net income or net loss, and decreased by dividends declared. (e) No change. 14. Adjusting entries are prepared prior to the preparation of financial statements in order to bring the accounts up to date and are necessary (1) to achieve a proper matching of revenues and expenses in measuring income and (2) to achieve an accurate presentation of assets, liabilities and stockholders’ equity. 15. Closing entries are prepared to transfer the balances of nominal accounts to capital (retained earnings) after the adjusting entries have been recorded and the financial statements prepared. Closing entries are necessary to reduce the balances in nominal accounts to zero in order to prepare the accounts for the next period’s transactions. 16. Cost – Salvage Value = Depreciable Cost: $3,000 – $0 = $3,000. Depreciable Cost ÷ Useful Life = Depreciation Expense For One Year $3,000 ÷ 5 years = $600 per year. The asset was used for 6 months (7/1 – 12/31), therefore 1/2-year of depreciation expense should be reported. Annual depreciation X 6/12 = amount to be reported on 2007 income statement: $600 X 6/12 = $300. 17. December 31 Interest Receivable............................................................................................................. 10,000 Interest Revenue........................................................................................................ (To record accrued interest revenue on loan) 10,000 Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on the books of one company is an accrued revenue to another company. *18. Under the cash basis of accounting, revenue is recorded only when cash is received and expenses are recorded only when paid. Under the accrual basis of accounting, revenue is recognized when it is earned and expenses are recognized when incurred, without regard to the time of the receipt or payment of cash. A cash basis balance sheet and income statement are incomplete and inaccurate in comparison to accrual basis financial statements. The accrual basis matches effort (expenses) with accomplishment (revenues) in the income statement while the cash basis only presents cash receipts and cash disbursements. The accrual basis balance sheet contains receivables, payables, accruals, prepayments, and deferrals while a cash basis balance sheet shows none of these. 3-5 Questions Chapter 3 (Continued) *19. Wages paid during the year will include the payment of any wages attributable to the prior year but unpaid at the end of the prior year. This amount is an expense of the prior year and not of the current year, and thus should be subtracted in determining wages expense. Similarly, wages paid during the year will not include any wages attributable to hours worked during the current year but not actually paid until the following year. This should be added in determining wages expense. *20. Although similar to the strict cash basis, the modified cash basis of accounting requires that expenditures for capital items be charged against income over all the periods to be benefited. This is done through conventional accounting methods, such as depreciation and amortization. Under the strict cash basis, expenditures would be recognized as expense in the period in which the corresponding cash disbursement is made. *21. Reversing entries are made at the beginning of the period to reverse the accrued items and some prepaid items. Reversing entries are not required. They are made to simplify the recording of certain transactions that will occur later in the period. The same results will be attained whether or not reversing entries are recorded. *22. A work sheet is not a permanent accounting record and its use is not required in the accounting cycle. The work sheet is an informal device for accumulating and sorting information needed for the financial statements. Its use is optional in helping to prepare financial statements. 3-6 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 3-1 May 1 Cash ............................................................................... Common Stock .................................................. 3 Equipment.................................................................... Accounts Payable ............................................. Rent Expense.............................................................. Cash....................................................................... 21 Accounts Receivable................................................ Service Revenue................................................ 500 500 1,100 1,100 400 400 3,000 3,000 13 BRIEF EXERCISE 3-2 Aug. 2 Cash................................................................................. Equipment ..................................................................... Brett Favre, Capital ............................................ 7 Supplies ......................................................................... Accounts Payable .............................................. Cash................................................................................. Accounts Receivable ................................................. Service Revenue ................................................. 400 400 1,300 670 1,970 12,000 2,500 14,500 12 3-7 BRIEF EXERCISE 3-2 (Continued) 15 Rent Expense............................................................... Cash ....................................................................... 19 Supplies Expense....................................................... Supplies ($400 – $270) ..................................... 130 130 600 600 BRIEF EXERCISE 3-3 July 1 Prepaid Insurance ...................................................... Cash ....................................................................... Insurance Expense .................................................... Prepaid Insurance.............................................. ($18,000 X 1/2 X 1/3) 18,000 18,000 3,000 3,000 Dec. 31 BRIEF EXERCISE 3-4 July 1 Cash ................................................................................ Unearned Insurance Revenue ....................... Unearned Insurance Revenue................................ Insurance Revenue............................................ ($18,000 X 1/2 X 1/3) 18,000 18,000 3,000 3,000 Dec. 31 3-8 BRIEF EXERCISE 3-5 Feb. 1 Prepaid Insurance....................................................... 840,000 Cash ........................................................................ June 30 Insurance Expense..................................................... 175,000 Prepaid Insurance .............................................. ($840,000 X 5/24) 840,000 175,000 BRIEF EXERCISE 3-6 Nov. 1 Cash................................................................................. Unearned Rent Revenue .................................. Dec. 31 Unearned Rent Revenue........................................... Rent Revenue ...................................................... ($2,700 X 2/3) 1,800 1,800 2,700 2,700 BRIEF EXERCISE 3-7 Dec. 31 Salaries Expense......................................................... Salaries Payable ................................................. ($6,000 X 3/5) Jan. 2 Salaries Payable .......................................................... Salaries Expense......................................................... Cash ........................................................................ 3,600 2,400 6,000 3,600 3,600 3-9 BRIEF EXERCISE 3-8 Dec. 31 Interest Receivable .................................................... Interest Revenue ................................................ Feb. 1 Cash ................................................................................ Notes Receivable ............................................... Interest Receivable............................................ Interest Revenue ................................................ 10,400 10,000 300 100 300 300 BRIEF EXERCISE 3-9 Dec. 31 Interest Expense ......................................................... Interest Payable.................................................. Accounts Receivable ................................................ Service Revenue ................................................ 31 Salaries Expense ........................................................ Salaries Payable................................................. Bad Debt Expense...................................................... Allowance for Doubtful Accounts ................ 700 700 900 900 400 400 1,400 1,400 31 31 BRIEF EXERCISE 3-10 Depreciation Expense.................................................................... Accumulated Depreciation—Equipment......................... Equipment.......................................................................................... Less: Accumulated depreciation—equipment ...................... 3-10 3,000 3,000 $30,000 3,000 $27,000 BRIEF EXERCISE 3-11 Beginning inventory Purchases Less: Purchase returns Purchase discounts Net purchases Add: Freight-in Cost of goods purchased Cost of goods available for sale Ending inventory Cost of goods sold $540,000 $5,800 5,000 10,800 529,200 16,200 545,400 626,400 70,200 $556,200 $ 81,000 BRIEF EXERCISE 3-12 Sales........................................................................................... Interest Revenue .................................................................... Income Summary........................................................... Income Summary ................................................................... Cost of Goods Sold....................................................... Operating Expenses ..................................................... Income Tax Expense .................................................... Income Summary ................................................................... Retained Earnings......................................................... Retained Earnings ................................................................. Dividends ......................................................................... 18,900 18,900 62,100 62,100 780,300 556,200 189,000 35,100 828,900 13,500 842,400 3-11 *BRIEF EXERCISE 3-13 (a) Cash receipts ....................................................................... + Increase in accounts receivable................................. ($18,600 – $13,000) Service revenue................................................................... (b) Payments for operating expenses ................................ – Increase in prepaid expenses ..................................... ($23,200 – $17,500) Operating expenses........................................................... $152,000 5,600 $157,600 $ 97, 000 (5,700) ________ $ 91,300 *BRIEF EXERCISE 3-14 (a) Salaries Payable.................................................................. Salaries Expense........................................................ Salaries Expense ................................................................ Cash................................................................................ (c) Salaries Payable.................................................................. Salaries Expense ................................................................ Cash................................................................................ 3,600 2,400 6,000 3,600 3,600 6,000 6,000 (b) 3-12 SOLUTIONS TO EXERCISES EXERCISE 3-1 (15–20 minutes) Apr. 2 Cash................................................................................. Equipment ..................................................................... Beverly Crusher, Capital .................................. 2 3 No entry—not a transaction. Supplies ......................................................................... Accounts Payable .............................................. 7 Rent Expense ............................................................... Cash ........................................................................ Accounts Receivable ................................................. Service Revenue ................................................. 12 Cash................................................................................. Unearned Service Revenue............................. Cash................................................................................. Service Revenue ................................................. 21 Insurance Expense..................................................... Cash ........................................................................ Salaries Expense......................................................... Cash ........................................................................ 110 110 1,160 1,160 3,200 3,200 2,300 2,300 600 600 1,100 1,100 700 700 32,000 14,000 46,000 11 17 30 3-13 EXERCISE 3-1 (Continued) 30 Supplies Expense....................................................... Supplies ................................................................ 30 Equipment..................................................................... Beverly Crusher, Capital ................................. 6,100 6,100 120 120 EXERCISE 3-2 (10–15 minutes) Wanda Landowska Company Trial Balance April 30, 2007 Debit Cash ................................................................................... Accounts Receivable.................................................... Prepaid Insurance ($700 + $100) .............................. Equipment........................................................................ Accounts Payable ($4,500 – $100) ........................... Property Tax Payable ................................................... Wanda Landowska, Capital ($11,200 + $1,500)......... Wanda Landowska, Drawing ..................................... Service Revenue ............................................................ Salaries Expense ........................................................... Advertising Expense ($1,100 + $300)...................... Property Tax Expense ($800 + $100)....................... 1,500 6,690 4,200 1,400 900 $24,350 $24,350 $ 4,800 2,750 800 8,000 $ 4,400 560 12,700 Credit 3-14 EXERCISE 3-3 (15–20 minutes) The ledger accounts are reproduced below, and corrections are shown in the accounts. Cash Bal. (1) 5,912 (4) 450 190 Accounts Payable Bal. 7,044 Accounts Receivable Bal. 5,240 (1) 450 Common Stock Bal. 8,000 Supplies on Hand Bal. 2,967 Retained Earnings Bal. 2,000 Furniture and Equipment Bal. (2) 6,100 3,200 Service Revenue Bal. (3) (5) 5,200 2,025 80 Office Expense Bal. 4,320 (2) 3,200 3-15 EXERCISE 3-3 (Continued) Blues Traveler Corporation Trial Balance (corrected) April 30, 2007 Debit Cash ................................................................................... Accounts Receivable.................................................... Supplies on Hand .......................................................... Furniture and Equipment............................................ Accounts Payable.......................................................... Common Stock............................................................... Retained Earnings......................................................... Service Revenue ............................................................ Office Expense ............................................................... 1,120 $24,349 $24,349 $ 6,172 4,790 2,967 9,300 $ 7,044 8,000 2,000 7,305 Credit 3-16 EXERCISE 3-4 (15–20 minutes) Watteau Co. Trial Balance June 30, 2007 Debit Cash ($2,870 + $180 – $65 – $65) .................................................. $ 2,920 Accounts Receivable ($3,231 – $180).......................................... Supplies ($800 – $500)...................................................................... Equipment ($3,800 + $500).............................................................. Accounts Payable ($2,666 – $206 – $260).................................. Unearned Service Revenue ($1,200 – $325).............................. Common Stock ................................................................................... Dividends .............................................................................................. Retained Earnings ............................................................................. Service Revenue ($2,380 + $801 + $325) .................................... Wages Expense ($3,400 + $670 – $575)...................................... Office Expense.................................................................................... 3,495 940 $15,581 $15,581 575 3,000 3,506 3,051 300 4,300 $ 2,200 875 6,000 Credit EXERCISE 3-5 (10–15 minutes) 1. Depreciation Expense ($250 X 3)......................................... Accumulated Depreciation—Equipment .................. Unearned Rent Revenue ($9,300 X 1/3) ............................. Rent Revenue .................................................................... 3. Interest Expense ....................................................................... Interest Payable ................................................................ 500 500 750 750 3,100 3,100 2. 3-17 EXERCISE 3-5 (Continued) 4. Supplies Expense .................................................................... Supplies ($2,800 – $850)................................................ 5. Insurance Expense ($300 X 3).............................................. Prepaid Insurance ........................................................... 900 900 1,950 1,950 EXERCISE 3-6 (10–15 minutes) 1. Accounts Receivable .............................................................. Service Revenue .............................................................. Utilities Expense....................................................................... Utilities Payable ............................................................... 3. Depreciation Expense............................................................. Accumulated Depreciation – Dental Equipment ... Interest Expense....................................................................... Interest Payable ............................................................... 4. Insurance Expense ($12,000 X 1/12) .................................. Prepaid Insurance ........................................................... Supplies Expense ($1,600 – $500) ...................................... Supplies .............................................................................. 1,000 1,000 1,100 1,100 400 400 500 500 750 750 520 520 2. 5. 3-18 EXERCISE 3-7 (15–20 minutes) (a) Ending balance of supplies Add: Adjusting entry Deduct: Purchases Beginning balance of supplies $700 950 850 800 (b) Total prepaid insurance Amount used (6 X $400) Present balance $4,800 2,400 2,400 ($400 X 12) The policy was purchased six months ago (August 1, 2006) (c) The entry in January to record salary expense was Salaries Expense ........................................................... Salaries Payable ............................................................ Cash............................................................................ 1,800 700 2,500 The “T” account for salaries payable is Salaries Payable Paid January End Bal. 800 700 Beg. Bal. ? The beginning balance is therefore Ending balance of salaries payable Plus: Reduction of salaries payable Beginning balance of salaries payable $ 800 700 $1,500 3-19 EXERCISE 3-7 (Continued) (d) Service revenue Cash received Unearned revenue reduced $2,000 1,600 $ 400 Ending unearned revenue January 31, 2007 Plus: Unearned revenue reduced Beginning unearned revenue December 31, 2006 $ 750 400 $1,150 EXERCISE 3-8 (10–15 minutes) 1. Wages Expense ........................................................................ Wages Payable ................................................................. Utilities Expense....................................................................... Accounts Payable............................................................ 3. Interest Expense ($30,000 X 8% X 1/12)............................ Interest Payable ............................................................... Telephone Expense................................................................. Accounts Payable............................................................ 200 200 117 117 1,900 1,900 600 600 2. 4. 3-20 EXERCISE 3-9 (15–20 minutes) (a) 10/15 Salaries Expense ....................................................... Cash....................................................................... (To record payment of October 15 payroll) Accounts Receivable................................................ Service Revenue................................................ (To record revenue for services performed for which payment has not yet been received) Cash ............................................................................... Unearned Service Revenue ........................... (To record receipt of cash for services not yet performed) Supplies Expense...................................................... Supplies................................................................ (To record the use of supplies during October) Accounts Receivable................................................ Service Revenue................................................ (To record revenue for services performed for which payment has not yet been received) Salaries Expense ....................................................... Salaries Payable ................................................ (To record liability for accrued payroll) Unearned Service Revenue .................................... Service Revenue................................................ (To reduce the Unearned Service Revenue account for service that has been performed) 800 800 10/17 2,400 2,400 10/20 650 650 (b) 10/31 470 470 10/31 1,650 1,650 10/31 600 600 10/31 400 400 3-21 EXERCISE 3-10 (25–30 minutes) (a) 1. Aug. 31 Insurance Expense ($4,500 X 3/12) ............. Prepaid Insurance .................................... 2. Aug. 31 Supplies Expense ($2,600 – $450)............... Supplies....................................................... 3. Aug. 31 Depreciation Expense—Cottages ............... Accumulated Depreciation— Cottages................................................... ($120,000 – $12,000 = $108,000; $108,000 X 4% = $4,320 per year; $4,320 X 1/4 = $1,080) Aug. 31 Depreciation Expense—Furniture ............... Accumulated Depreciation— Furniture .................................................. ($16,000 – $1,600 = $14,400; $14,400 X 10% = $1,440; $1,440 X 1/4 = $360) 4. Aug. 31 Unearned Rent Revenue................................. Rent Revenue ............................................ 5. Aug. 31 Salaries Expense............................................... Salaries Payable ....................................... 6. Aug. 31 Accounts Receivable....................................... Rent Revenue ............................................ 7. Aug. 31 Interest Expense ............................................... Interest Payable ........................................ [($60,000 X 8%) X 1/4] 1,125 1,125 2,150 2,150 1,080 1,080 360 360 3,800 3,800 375 375 800 800 1,200 1,200 3-22 EXERCISE 3-10 (Continued) (b) Greco Resort Adjusted Trial Balance August 31, 2007 Debit Cash.................................................................................... Accounts Receivable .................................................... Prepaid Insurance ($4,500 – $1,125) ........................ Supplies ($2,600 – $2,150)........................................... Land.................................................................................... Cottages ............................................................................ Accumulated Depreciation—Cottages.................... Furniture............................................................................ Accumulated Depreciation—Furniture ................... Accounts Payable .......................................................... Unearned Rent Revenue ($4,600 – $3,800) ............ Salaries Payable ............................................................. Interest Payable .............................................................. Mortgage Payable .......................................................... Common Stock ............................................................... Retained Earnings ......................................................... Dividends .......................................................................... Rent Revenue ($76,200 + $3,800 + $800)................ Salaries Expense ($44,800 + $375)........................... Utilities Expense............................................................. Repair Expense............................................................... Insurance Expense ........................................................ Supplies Expense .......................................................... Depreciation Expense—Cottages............................. Depreciation Expense—Furniture ............................ Interest Expense............................................................. $ 19,600 800 3,375 450 20,000 120,000 $ 16,000 360 4,500 800 375 1,200 60,000 91,000 9,000 5,000 80,800 45,175 9,200 3,600 1,125 2,150 1,080 360 1,200 $249,115 1,080 Credit $249,115 3-23 EXERCISE 3-11 (20–25 Minutes) (a) ANDERSON COOPER CO. Income Statement For the Year Ended December 31, 2007 Revenues Service revenue ......................................................... Expenses Salaries expense ....................................................... Rent expense.............................................................. Depreciation expense .............................................. Interest expense ........................................................ Net Income............................................................................... $6,840 2,260 145 83 9,328 $ 2,262 $11,590 (b) ANDERSON COOPER CO. Statement of Retained Earnings For the Year Ended December 31, 2007 Retained earnings, January 1...................................................................... Add: Net income .............................................................................................. Less: Dividends ............................................................................................... Retained earnings, December 31 ............................................................... $11,310 2,262 13,572 3,000 $10,572 3-24 EXERCISE 3-11 (Continued) (c) ANDERSON COOPER CO. Balance Sheet December 31, 2007 Assets Current Assets Cash................................................................................ Accounts receivable.................................................. Prepaid rent.................................................................. Total current assets............................................ Property, plant, and equipment Equipment..................................................................... Less Accumulated depreciation............................ Total assets ................................................................................... $18,050 (4,895) 13,155 $41,827 $19,472 6,920 2,280 28,672 Liabilities and Stockholders’ Equity Current liabilities Accounts payable....................................................... Interest payable .......................................................... Notes payable.............................................................. Total current liabilities ....................................... Stockholders’ equity Common Stock............................................................ Retained Earnings...................................................... Total liabilities and stockholders’ equity ............................ $20,000 10,572* 30,572 $41,827 $ 5,472 83 5,700 11,255 *Beg. Balance + Net Income – Dividends = Ending Balance $11,310 + $2,262 – $3,000 = $10,572 3-25 EXERCISE 3-12 (20–25 Minutes) (a) SANTO DESIGN AGENCY Income Statement For the Year Ended December 31, 2007 Revenues Advertising revenue ................................................ Expenses Salaries expense ...................................................... Depreciation expense ............................................. Rent expense............................................................. Art supplies expense .............................................. Insurance expense................................................... Interest expense ....................................................... Total expenses.................................................. Net income.............................................................................. $11,300 7,000 4,000 3,400 850 500 27,050 $34,450 $61,500 SANTO DESIGN AGENCY Statement of Retained Earnings For the Year Ended December 31, 2007 Retained earnings, January 1...................................................................... Add: Net income .............................................................................................. Retained earnings, December 31 ............................................................... $ 3,500 34,450 $37,950 3-26 EXERCISE 3-12 (Continued) (a) Continued SANTO DESIGN AGENCY Balance Sheet December 31, 2007 Assets Cash................................................................................................... Accounts receivable .................................................................... Art supplies..................................................................................... Prepaid insurance......................................................................... Printing equipment ....................................................................... Less: Accumulated depreciation—printing equipment......... Total assets ......................................................................... $60,000 35,000 25,000 $65,000 $11,000 21,500 5,000 2,500 Liabilities and Stockholders’ Equity Liabilities Notes payable ..................................................................... Accounts payable.............................................................. Interest payable.................................................................. Unearned advertising revenue...................................... Salaries payable................................................................. Total liabilities ............................................................ Stockholders’ equity Common stock ................................................................... Retained earnings ............................................................. Total liabilities and stockholders’ equity .......... $10,000 37,950 47,950 $65,000 $ 5,000 5,000 150 5,600 1,300 $17,050 (b) (1) Based on interest payable at December 31, 2007, interest is $25 per month or .5% of the note payable. .5% X 12 = 6% interest per year. (2) Salaries Expense, $11,300 less Salaries Payable 12/31/07, $1,300 = $10,000. Total Payments, $17,500 – $10,000 = $7,500 Salaries Payable 12/31/06. 3-27 EXERCISE 3-13 (10–15 Minutes) (a) Sales ....................................................................................... Less: Sales returns and allowances............................ Sales discount......................................................... Net sales................................................................................ (b) Sales ....................................................................................... Income Summary....................................................... Income Summary ............................................................... Sales Returns and Allowances ............................. Sales Discounts ......................................................... 800,000 800,000 39,000 24,000 15,000 $24,000 15,000 $800,000 39,000 $761,000 EXERCISE 3-14 (10–15 minutes) Sales ....................................................................................... Sales Returns and Allowances ............................. Sales Discounts ......................................................... Income Summary....................................................... Income Summary ............................................................... Cost of Goods Sold................................................... Freight-out ................................................................... Insurance Expense.................................................... Rent Expense.............................................................. Salary Expense........................................................... Income Summary ............................................................... Retained Earnings..................................................... 21,000 21,000 308,000 208,000 7,000 12,000 20,000 61,000 350,000 13,000 8,000 329,000 3-28 EXERCISE 3-15 (10–15 minutes) (a) $9,000 (b) $25,000 (c) $10,000 (d) $100,000 (e) $57,000 EXERCISE 3-16 (20–25 minutes) (a) Sales *Sales returns Net sales (b) Beginning inventory Purchases Purchase returns Goods available for sale *Ending inventory Cost of goods sold (c) *Sales Sales returns Net sales $78,000 (4,000) $74,000 $16,000 88,000 (6,000) 98,000 (34,000) $64,000 $99,000 (5,000) $94,000 (d) *Beginning inventory Purchases Purchase returns Goods available for sale Ending inventory Cost of goods sold $ 30,000 100,000 (10,000) 120,000 (48,000) $ 72,000 3-29 EXERCISE 3-16 (Continued) (e) Beginning inventory *Purchases Purchase returns Goods available for sale Ending inventory Cost of goods sold $ 44,000 108,000 (8,000) 144,000 (30,000) $114,000 from (f) below (f) Net sales *Cost of goods sold Gross profit $132,000 (114,000) $ 18,000 (g) Sales Sales returns *Net sales $100,000 (9,000) $ 91,000 (h) Beginning inventory Purchases *Purchase returns Goods available for sale Ending inventory Cost of goods sold (i) Net sales Cost of goods sold *Gross profit $ 24,000 85,000 (9,000) 100,000 (28,000) $ 72,000 $91,000 (72,000) $19,000 3-30 EXERCISE 3-17 (10–15 minutes) Inventory, September 1, 2006 ........................................ Purchases ............................................................................ Less: Purchase returns and allowances.................... Net purchases..................................................................... Add: Freight-in.................................................................... Cost of goods purchased ............................................... Cost of goods available for sale ................................... Inventory, August 31, 2007............................................. Cost of goods sold ................................................... $149,400 2,000 147,400 4,000 151,400 168,900 25,000 $143,900 $ 17,500 EXERCISE 3-18 (10–15 minutes) Sales....................................................................................... Cost of Goods Sold .................................................. Sales Returns and Allowances............................. Sales Discounts......................................................... Selling Expenses....................................................... Administrative Expenses........................................ Income Tax Expense................................................ Income Summary ...................................................... (or) Sales....................................................................................... Income Summary ...................................................... 410,000 410,000 410,000 225,700 12,000 15,000 16,000 38,000 30,000 73,300 3-31 EXERCISE 3-18 (Continued) Income Summary ............................................................... Cost of Goods Sold................................................... Sales Returns and Allowances ............................. Sales Discounts ......................................................... Selling Expense ......................................................... Administrative Expense .......................................... Income Tax Expense ................................................ Income Summary ............................................................... Retained Earnings..................................................... Retained Earnings ............................................................. Dividends ..................................................................... 18,000 18,000 73,300 73,300 336,700 225,700 12,000 15,000 16,000 38,000 30,000 3-32 EXERCISE 3-19 (10–15 minutes) J1 Date Mar. 1 Cash Common Stock (Investment of cash in business) 3 Land Building Equipment Cash (Purchased Michelle Wie’s Golf Land) 5 Advertising Expense Cash (Paid for advertising) 6 Prepaid Insurance Cash (Paid for one-year insurance policy) 10 Equipment Accounts Payable (Purchased equipment on account) 18 Cash Service Revenue (Received cash for services performed) 25 Dividends Cash (Declared and paid a $500 cash dividend) 30 Wages Expense Cash (Paid wages expense) 30 Accounts Payable Cash (Paid creditor on account) 31 Cash Service Revenue (Received cash for services performed) 500 500 10,000 22,000 6,000 38,000 Account Titles and Explanation Ref. Debit 50,000 50,000 Credit 1,600 1,600 1,480 1,480 2,500 2,500 1,200 1,200 900 900 2,500 2,500 750 750 3-33 *EXERCISE 3-20 (15–20 minutes) Jill Accardo, M.D. Conversion of Cash Basis to Accrual Basis For the Year 2007 Excess of cash collected over cash disbursed ($142,600˚–˚$55,470) Add increase in accounts receivable ($9,250 – $15, 927) Deduct increase in unearned service revenue ($2,840 – $4,111) Add decrease in accrued liabilities ($3,435 – $2,108) Add increase in prepaid expenses ($1,917 – $3,232) Net income on an accrual basis $87,130 6,677 (1,271) 1,327 1,315 $95,178 Alternate solution: Jill Accardo, M.D. Conversion of Income Statement Data from Cash Basis to Accrual Basis For the Year 2007 Cash Adjustments Basis Collections from customers: –Accounts receivable, Jan. 1 +Accounts receivable, Dec. 31 +Unearned service revenue, Jan. 1 –Unearned service revenue, Dec. 31 Service revenue Disbursements for expenses: –Accrued liabilities, Jan. 1 +Accrued liabilities, Dec. 31 +Prepaid expenses, Jan. 1 –Prepaid expenses, Dec. 31 Operating expenses Net income—cash basis Net income—accrual basis $142,600 $9,250 $15,927 2,840 4,111 $148,006 55,470 3,435 2,108 1,917 3,232 $ 87,130 52,828 $ 95,178 Add Deduct Accrual Basis 3-34 *EXERCISE 3-21 (10–15 minutes) (a) Wayne Rogers Corp. Income Statement (Cash Basis) For the Year Ended December 31, 2006 Sales Expenses Net income (b) Wayne Rogers Corp. Income Statement (Accrual Basis) For the Year Ended December 31, 2006 Sales* Expenses** Net income *2006: 2007: **2006: 2007: $295,000 + $160,000 + $30,000 = $485,000 $355,000 + $90,000 = $445,000 $185,000 + $67,000 + $25,000 = $277,000 $40,000 + $160,000 + $55,000 = $255,000 $485,000 277,000 $208,000 2007 $445,000 255,000 $190,000 $295,000 225,000 $ 70,000 2007 $515,000 272,000 $243,000 3-35 *EXERCISE 3-22 (20–25 minutes) (a) Adjusting Entries: 1. Insurance Expense ($5,280 X 5/24).............................. Prepaid Insurance..................................................... Rental Revenue ($1,800 X 1/3)....................................... Unearned Rental Revenue ..................................... 3. Advertising Materials ....................................................... Advertising Expense................................................ Interest Expense ................................................................ Interest Payable......................................................... 290 290 770 770 1,100 1,100 600 600 2. 4. (b) Reversing Entries: 1. 2. No reversing entry required. Unearned Rental Revenue.............................................. Rental Revenue.......................................................... Advertising Expense ........................................................ Advertising Materials............................................... 4. Interest Payable ................................................................. Interest Expense ....................................................... 770 770 600 600 290 290 3. 3-36 *EXERCISE 3-23 (10–15 minutes) Adjusted Trial Accounts Balance Dr. Cash Merchandise Inventory Sales Sales Returns and Allowances Sales Discounts Cost of Goods Sold 9,000 80,000 450,000 10,000 5,000 250,000 10,000 5,000 250,000 450,000 Cr. Income Statement Dr. Cr. Balance Sheet Dr. 9,000 80,000 Cr. 3-37 *EXERCISE 3-24 (20–25 minutes) Ed Bradley Co. Worksheet (partial) For the Month Ended April 30, 2007 Adjusted Trial Balance Account Titles Cash Accounts receivable Prepaid rent Equipment Accum. depreciation Notes payable Accounts payable Bradley, capital Bradley, drawing Services revenue Salaries expense Rent expense Depreciation expense Interest expense Interest payable Totals Net income Totals 62,700 6,650 11,590 6,840 2,260 145 83 83 62,700 6,840 2,260 145 83 9,328 2,262 11,590 11,590 53,372 11,590 53,372 83 51,110 2,262 53,372 11,590 Dr. 19,472 6,920 2,280 18,050 4,895 5,700 5,472 34,960 6,650 Cr. Income Statement Dr. Cr. Balance Sheet Dr. 19,472 6,920 2,280 18,050 4,895 5,700 5,472 34,960 Cr. 3-38 EXERCISE 3-24 (Continued) Ed Bradley Co. Balance Sheet April 30, 2007 Assets Current Assets Cash............................................................................ Accounts receivable ............................................. Prepaid rent.............................................................. Total current assets.................................... Property, plant, and equipment Equipment ................................................................ Less Accumulated depreciation ....................... Total assets ................................................................................... $18,050 (4,895) 13,155 $41,827 $19,472 6,920 2,280 28,672 Liabilities and Owner’s Equity Current liabilities Accounts payable .................................................. Interest payable ...................................................... Notes payable.......................................................... Total current liabilities............................... Owner’s equity Bradley, Capital ...................................................... Total liabilities and owner’s equity........................................ $ 5,472 83 5,700 11,255 30,572* $41,827 *Beg. Balance – Drawings + Net Income = Ending Balance $34,960 – $6,650 + $2,262 = $30,572 3-39 *EXERCISE 3-25 (10–15 minutes) Jurassic Park Co. Worksheet (partial) For Month Ended February 28, 2007 Adjusted Trial Balance Account Titles Supplies Accumulated depreciation Interest payable Supplies expense Depreciation expense Interest expense (c) 50 50 50 (b) 257 257 257 (a) 1,041 1,041 1,041 150 (c) 50 200 200 6,939 (b) 257 7,196 7,196 Dr. 1,756 Cr. Adjustments Dr. Cr. (a) 1,041 Trial Balance Dr. 715 Cr. Income Statement Dr. Cr. Balance Sheet Dr. 715 Cr. The following accounts and amounts would be shown in the February income statement: Supplies expense Depreciation expense Interest expense $1,041 257 50 3-40 TIME AND PURPOSE OF PROBLEMS Problem 3-1 (Time 25–35 minutes) Purpose—to provide an opportunity for the student to post daily transactions to a “T” account ledger, take a trial balance, prepare an income statement, a balance sheet and a statement of owner’s equity, close the ledger, and take a post-closing trial balance. The problem deals with routine transactions of a professional service firm and provides a good integration of the accounting process. Problem 3-2 (Time 35–40 minutes) Purpose—to provide an opportunity for the student to prepare adjusting entries, and prepare financial statements (income statement, balance sheet, and statement of retained earnings). The student also is asked to analyze two transactions to find missing amounts. Problem 3-3 (Time 25–30 minutes) Purpose—to provide an opportunity for the student to prepare adjusting entries. The adjusting entries are fairly complex in nature. Problem 3-4 (Time 40–50 minutes) Purpose—to provide an opportunity for the student to prepare adjusting entries and an adjusted trail balance and then prepare an income statement, retained earnings statement, and a balance sheet. In addition, closing entries must be made and a post-closing trial balance prepared. Problem 3-5 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to determine what adjusting entries need to be made to specific accounts listed in a partial trial balance. The student is also required to determine the amounts of certain revenue and expense items to be reported in the income statement. Problem 3-6 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to prepare year-end adjusting entries from a trial balance and related information presented. The problem also requires the student to prepare an income statement, a balance sheet, and a statement of owner’s equity. The problem covers the basics of the endof-period adjusting process. Problem 3-7 (Time 25–35 minutes) Purpose—to provide an opportunity for the student to figure out the year-end adjusting entries that were made from a trial balance and an adjusted trial balance. The student is also required to prepare an income statement, a statement of retained earnings, and a balance sheet. In addition, the student needs to answer a number of questions related to specific accounts. Problem 3-8 (Time 30–40 minutes) Purpose—to provide an opportunity for the student to prepare adjusting, closing, and reversing entries. This problem presents basic adjustments including a number of accruals and deferrals. It provides the student with an integrated flow of the year-end accounting process. Problem 3-9 (Time 30–35 minutes) Purpose—to provide an opportunity for the student to prepare adjusting and closing entries from a trial balance and related information. The student is also required to post the entries to “T” accounts. *Problem 3-10 (Time 35–40 minutes) Purpose—to provide an opportunity for the student to prepare and compare (a) cash basis and accrual basis income statements, (b) cash basis and accrual basis balance sheets, and (c) to discuss the weaknesses of cash basis accounting. *Problem 3-11 (Time 40–50 minutes) Purpose—to provide an opportunity for the student to complete a worksheet and then prepare a classified balance sheet. In addition, adjusting and closing entries must be made and a post-closing trial balance prepared. 3-41 SOLUTIONS TO PROBLEMS PROBLEM 3-1 (a) (Explanations are omitted.) and (d) Cash Sept. 1 8 20 20,000 Sept. 4 1,690 5 980 10 18 19 30 30 30 Bal 12,533 Accounts Receivable Sept. 14 25 Bal. 30 5,120 Sept. 20 2,110 6,250 Rent Expense Sept. 4 680 Sept. 30 680 Service Revenue 330 Sept. 30 8,920 Sept. 8 14 25 8,920 Miscellaneous Office Expense Sept. 10 30 430 Sept. 85 515 30 515 515 Accumulated Depreciation Sept. 30 288 1,690 5,120 2,110 8,920 980 Accounts Payable Sept. 18 3,600 Sept. Bal. 2 30 17,280 13,680 680 942 430 3,600 3,000 1,400 85 Sept. Furniture and Equipment 2 17,280 Shigeki Muruyama, Capital Sept. 19 3,000 Sept. Bal. 1 30 30 20,000 5,707 22,707 Supplies on Hand Sept. Bal. 5 30 942 Sept. 612 30 Office Salaries Expense Sept. 30 1,400 Sept. 30 1,400 Supplies Expense Sept. 30 330 Sept. 30 330 3-42 PROBLEM 3-1 (Continued) Depreciation Expense Sept. 30 288 Sept. 30 288 Sept. Income Summary 30 30 30 30 30 30 Inc. 680 Sept. 515 1,400 330 288 5,707 8,920 30 8,920 8,920 (b) Shigeki Muruyama, D.D.S. Trial Balance September 30 Debit Credit Cash.................................................................................................... Accounts Receivable .................................................................... Supplies on Hand........................................................................... Furniture and Equipment............................................................. Accumulated Depreciation.......................................................... Accounts Payable .......................................................................... Shigeki Muruyama, Capital ......................................................... Service Revenue............................................................................. Rent Expense .................................................................................. Miscellaneous Office Expense .................................................. Office Salaries Expense............................................................... Supplies Expense .......................................................................... Depreciation Expense .................................................................. Totals ..................................................................................... 12,533 6,250 612 17,280 288 13,680 17,000 8,920 680 515 1,400 330 288 39,888 39,888 3-43 PROBLEM 3-1 (Continued) (c) Shigeki Muruyama, D.D.S. Income Statement For the Month of September Service revenue........................................................................... Expenses: Office salaries expense.................................................. Rent expense..................................................................... Supplies expense............................................................. Depreciation expense ..................................................... Miscellaneous office expense...................................... Total expenses ....................................................... Net income .................................................................................... $1,400 680 330 288 515 $8,920 3,213 $5,707 Shigeki Muruyama, D.D.S. Balance Sheet As of September 30 Assets Cash ........................................ $12,533 Accounts receivable .......... Supplies on Hand................ Furniture and equip............ Accum. depreciation......... 6,250 612 17,280 (288) Total liabilities and owner’s equity.......................... $36,387 Liabilities and Owner’s Equity Accounts payable ....................... $13,680 Shigeki Muruyama, Capital ......... 22,707 Total assets................... $36,387 3-44 PROBLEM 3-1 (Continued) Shigeki Muruyama, D.D.S. Statement of Owner’s Equity For the Month of September Muruyama, Capital September 1........................................................ Add: Net income for September......................................................... Less: Withdrawal by owner ................................................................. Muruyama, Capital September 30...................................................... $20,000 5,707 25,707 3,000 $22,707 (e) Shigeki Muruyama, D.D.S. Post-closing Trial Balance September 30 Debit Credit Cash.................................................................................... Accounts Receivable .................................................... Supplies on Hand........................................................... Furniture and Equipment............................................. Accumulated Depreciation.......................................... Accounts Payable .......................................................... Shigeki Muruyama, Capital ......................................... Totals ..................................................................... 12,533 6,250 612 17,280 288 13,680 22,707 36,675 36,675 3-45 PROBLEM 3-2 (a) Dec. 31 Accounts Receivable .............................................. Advertising Revenue ...................................... 31 Unearned Advertising Revenue .......................... Advertising Revenue ...................................... 31 Art Supplies Expense ............................................. Art Supplies....................................................... 31 Depreciation Expense ............................................ Accumulated Depreciation........................... 31 Interest Expense....................................................... Interest Payable ............................................... 31 Insurance Expense .................................................. Prepaid Insurance ........................................... 31 Salaries Expense...................................................... Salaries Payable .............................................. 1,500 1,500 1,400 1,400 3,400 3,400 7,000 7,000 150 150 850 850 1,300 1,300 3-46 PROBLEM 3-2 (Continued) (b) YOUNT ADVERTISING AGENCY Income Statement For the Year Ended December 31, 2007 Revenues Advertising revenue............................................. Expenses Salaries expense................................................... Depreciation expense.......................................... Rent expense ......................................................... Art supplies expense........................................... Insurance expense ............................................... Interest expense.................................................... Total expenses .............................................. Net income .......................................................................... $11,300 7,000 4,000 3,400 850 500 27,050 $34,450 $61,500 YOUNT ADVERTISING AGENCY Statement of Retained Earnings For the Year Ended December 31, 2007 Retained earnings, January 1 ..................................................................... Add: Net income.............................................................................................. Retained earnings, December 31............................................................... $ 3,500 34,450 $37,950 3-47 PROBLEM 3-2 (Continued) YOUNT ADVERTISING AGENCY Balance Sheet December 31, 2007 Assets Cash .................................................................................................. Accounts receivable.................................................................... Art supplies .................................................................................... Prepaid insurance ........................................................................ Printing equipment ...................................................................... Less: Accumulated depreciation—printing equipment... Total assets......................................................................... $60,000 35,000 25,000 $65,000 $11,000 21,500 5,000 2,500 Liabilities and Stockholders’ Equity Liabilities Notes payable..................................................................... Accounts payable ............................................................. Interest payable ................................................................. Unearned advertising revenue ..................................... Salaries payable ................................................................ Total liabilities............................................................ Stockholders’ equity Common stock................................................................... Retained earnings............................................................. Total liabilities and stockholders’ equity.......... $10,000 37,950 47,950 $65,000 $ 5,000 5,000 150 5,600 1,300 $17,050 (c) (1) Interest is $50 per month or 1% of the note payable. 1% X 12 = 12% interest per year. (3) Salaries Expense, $11,300 less Salaries Payable 12/31/07, $1,300 = $10,000. Total Payments, $13,500 – $10,000 = $3,500 Salaries Payable 12/31/06. 3-48 PROBLEM 3-3 1. Dec. 31 Salaries Expense ..................................................... Salaries Payable .............................................. (5 X $700 X 2/5) = $1,400 (3 X $500 X 2/5) = 600 Total accrued salaries $2,000 31 Unearned Rent Revenue ....................................... Rent Revenue ................................................... (5 X $4,000 X 2) = $40,000 (4 X $8,500 X 1) = 34,000 Total rent earned $74,000 31 Advertising Expense .............................................. Prepaid Advertising........................................ (A650 – $500 per month for 8 months) = $4,000 (B974 – $300 per month for 3 months) = 900 Total advertising expense $4,900 31 Interest Expense ...................................................... Interest Payable ............................................... ($80,000 X 12% X 7/12) 2,000 2,000 2. 74,000 74,000 3. 4,900 4,900 4. 5,600 5,600 3-49 PROBLEM 3-4 (a) Nov. 30 Store Supplies Expense................................ Store Supplies ......................................... 30 Depr. Expense—Store Equipment............ Accumulated Depreciation— Store Equipment ................................ 30 Depr. Expense—Delivery Equipment ...... Accumulated Depreciation— Delivery Equipment........................... 30 Interest Expense.............................................. Interest Payable ...................................... 2,000 2,000 9,000 9,000 7,000 7,000 11,000 11,000 3-50 PROBLEM 3-4 (Continued) (b) DAPHNE MAIN FASHION CENTER Adjusted Trial Balance November 30, 2007 Dr. 26,700 33,700 45,000 3,500 85,000 Cr. Cash ........................................................................................... Accounts Receivable ........................................................... Merchandise Inventory ........................................................ Store Supplies ........................................................................ Store Equipment .................................................................... Accumulated Depr.— Store Equipment................................................................. Delivery Equipment .............................................................. 48,000 Accumulated Depr.— Delivery Equipment ........................................................... Notes Payable......................................................................... Accounts Payable ................................................................. Common Stock....................................................................... Retained Earnings................................................................. Sales .......................................................................................... Sales Returns and Allowances........................................................................... 4,200 Cost of Goods Sold .............................................................. 497,400 Salaries Expense ................................................................... 140,000 Advertising Expense ............................................................ 26,400 Utilities Expense .................................................................... 14,000 Repair Expense ...................................................................... 12,100 Delivery Expense................................................................... 16,700 Rent Expense.......................................................................... 24,000 Store Supplies Expense...................................................... 2,000 Depreciation Expense— Store Equipment................................................................. 9,000 Depreciation Expense— Delivery Equipment ........................................................... 7,000 Interest Expense .................................................................... 11,000 Interest Payable ..................................................................... ________ Totals .................................................................................. 1,005,700 27,000 13,000 51,000 48,500 90,000 8,000 757,200 11,000 1,005,700 3-51 PROBLEM 3-4 (Continued) (c) DAPHNE MAIN FASHION CENTER Income Statement For the Year Ended November 30, 2007 $757,200 4,200 753,000 497,400 255,600 Sales revenue Sales ................................................................ Less: Sales returns and allowances..... Net sales......................................................... Cost of goods sold.................................................. Gross profit ............................................................... Operating expenses Selling expenses Salaries expense .............................. ($140,000 X 70%) Advertising expense........................ Rent expense ..................................... ($24,000 X 80%) Delivery expense .............................. Utilities expense ............................... ($14,000 X 80%) Depr. exp.—store equipment....... Depr. exp.—deliv. equipment ..... Stores supplies expense................ Total selling expenses........... Administrative expenses Salaries expense .............................. ($140,000 X 30%) Repair expense ................................. Rent expense ..................................... ($24,000 X 20%) Utilities expense ............................... ($14,000 X 20%) Total admin. expenses ......... Total oper. expenses..... Income from operations ...................................... Other expenses and losses Interest expense .......................................... Net loss ..................................................................... $98,000 26,400 19,200 16,700 11,200 9,000 7,000 2,000 $189,500 42,000 12,100 4,800 2,800 61,700 251,200 4,400 11,000 $ 6,600 3-52 PROBLEM 3-4 (Continued) DAPHNE MAIN FASHION CENTER Retained Earnings Statement For the Year Ended November 30, 2007 Retained earnings, December 1, 2006................................. Less: Net loss.............................................................................. Retained earnings, November 30, 2007 .............................. $8,000 6,600 $1,400 DAPHNE MAIN FASHION CENTER Balance Sheet November 30, 2007 Assets Current assets Cash ............................................................... Accounts receivable ................................. Merchandise inventory ............................ Store supplies............................................. Total current assets ....................... Property, plant, and equipment Store equipment......................................... $85,000 Accum. depr.—store equipment.......... 27,000 Delivery equipment ................................... 48,000 Accum. depr.—delivery equipment .... 13,000 Total assets....................................... Liabilities and Stockholders’ Equity Current liabilities Notes payable due next year ...................................... Accounts payable ........................................................... Interest payable............................................................... Total current liabilities........................................ Long-term liabilities Notes payable .................................................................. Total liabilities....................................................... Stockholders’ equity Common Stock ................................................................ Retained Earnings .......................................................... Total liabilities and stockholders’ equity ..... $26,700 33,700 45,000 3,500 $108,900 $58,000 35,000 93,000 $201,900 $30,000 48,500 11,000 $ 89,500 21,000 110,500 90,000 1,400 91,400 $201,900 3-53 PROBLEM 3-4 (Continued) (d) Nov. 30 Sales.................................................................... Income Summary.................................... 30 Income Summary ............................................ Sales Returns and Allowances .......... Cost of Goods Sold................................ Salaries Expense .................................... Advertising Expense ............................. Utilities Expense ..................................... Repair Expense ....................................... Delivery Expense.................................... Rent Expense........................................... Store Supplies Expense ....................... Depreciation Expense—Store Equipment ............................................ Depreciation Expense—Delivery Equipment ............................................ Interest Expense ..................................... 30 Retained Earnings .......................................... Income Summary.................................... 757,200 757,200 763,800 4,200 497,400 140,000 26,400 14,000 12,100 16,700 24,000 2,000 9,000 7,000 11,000 6,600 6,600 3-54 PROBLEM 3-4 (Continued) (e) DAPHNE MAIN FASHION CENTER Post-Closing Trial Balance November 30, 2007 Debit Credit Cash.................................................................................... Accounts Receivable .................................................... Merchandise Inventory................................................. Store Supplies................................................................. Store Equipment............................................................. Accumulated Depreciation—Store Equipment .... Delivery Equipment ....................................................... Accumulated Depreciation—Delivery Equipment.................................................................... Notes Payable ................................................................. Accounts Payable .......................................................... Interest Payable .............................................................. Common Stock ............................................................... Retained Earnings ......................................................... $ 26,700 33,700 45,000 3,500 85,000 $ 27,000 48,000 13,000 51,000 48,500 11,000 90,000 $241,900 1,400 $241,900 3-55 PROBLEM 3-5 (a) -1Depreciation Expense....................................................... Accumulated Depreciation—Equipment ........... (1/16 X $152,000) -2Interest Expense................................................................. Interest Payable ......................................................... ($90,000 X 10% X 72/360) -3Admissions Revenue........................................................ Unearned Admissions Revenue ........................... (2,000 X $25) -4Prepaid Advertising........................................................... Advertising Expense ................................................ -5Salaries Expense................................................................ Salaries Payable......................................................... 9,500 9,500 1,800 1,800* 50,000 50,000 1,100 1,100 4,700 4,700 (b) (1) (2) (3) (4) Interest expense, $3,200 ($1,400 + $1,800). Admissions revenue, $330,000 ($380,000 – $50,000). Advertising expense, $12,580 ($13,680 – $1,100). Salaries expense, $62,300 ($57,600 + $4,700). *Note to instructor: If 30 day months are assumed, interest expense = $1,750 ($90,000 X 10% X 70/360). 3-56 PROBLEM 3-6 (a) -1Service Revenue ........................................................................ Unearned Service Revenue........................................... -2Accounts Receivable................................................................ Service Revenue ............................................................... -3Bad Debt Expense ..................................................................... Allowance for Doubtful Accounts............................... -4Insurance Expense.................................................................... Unexpired Insurance ....................................................... -5Depreciation Expense—Furniture and Equipment.......... Accum. Depr.—Furniture and Equipment................ ($25,000 X .125) -6Interest Expense ......................................................................... Interest Payable.................................................................. ($7,200 X .10 X 30/360) -7Prepaid Rent ................................................................................. Rent Expense...................................................................... -8Office Salaries Expense............................................................ Salaries Payable................................................................. 6,900 6,900 4,900 4,900 1,430 1,430 480 480 3,125 3,125 60 60 750 750 2,510 2,510 3-57 PROBLEM 3-6 (Continued) (b) Carlos Beltran, Consulting Engineer Income Statement For the Year Ended December 31, 2007 Service revenue ($100,000 – $6,900 + $4,900)....................... Expenses Office salaries expense ($28,500 + $2,510) .................. Heat, light, and water expense ......................................... Rent expense ($9,750 – $750) ........................................... Insurance expense ............................................................... Bad debt expense ................................................................. Depreciation expense.......................................................... Miscellaneous office expense........................................... Interest expense .................................................................... Total expenses ................................................................. Net income........................................................................................ $31,010 1,080 9,000 480 1,430 3,125 720 60 $98,000 46,905 $51,095 3-58 PROBLEM 3-6 (Continued) Carlos Beltran, Consulting Engineer Balance Sheet December 31, 2007 Assets Current assets Cash ..................................................................... $31,500 Accounts receivable ....................................... $54,500 ($49,600 + $4,900) Less: Allowance for doubtful accounts........................ (2,180)* 52,320 Engineering supplies inventory.................. 1,960 Unexpired insurance ...................................... 620 ($1,100 – $480) Prepaid rent ....................................................... 750 Total current assets ................................ $ 87,150 Furniture and equipment....................................... 25,000 Less: Accum. depreciation ........................ (9,375)** 15,625 Total assets ............................................... $102,775 Liabilities and Owner’s Equity Current liabilities Unearned service revenue............................ Interest payable................................................ Salaries payable............................................... Notes payable ................................................... Carlos Beltran, Capital........................................... ($35,010 + $51,095) Total liabilities and owner’s equity........ *($750 + $1,430) **($6,250 + $3,125) $6,900 60 2,510 7,200 $ 16,670 86,105 $102,775 3-59 PROBLEM 3-6 (Continued) Carlos Beltran, Consulting Engineer Statement of Owner’s Equity For the Year Ended December 31, 2007 Carlos Beltran, Capital, January 1 .............................................................. Add: Net income................................................................................................ Less: Withdrawals ............................................................................................ Carlos Beltran, Capital, December 31 ........................................................ a $ 52,010a 51,095 103,105 (17,000) $ 86,105 Carlos Beltran, Capital—trial balance ..................... Withdrawals during the year ...................................... Carlos Beltran, Capital, as of January 1, 2007......... $35,010 17,000 $52,010 3-60 PROBLEM 3-7 (a) Dec. 31 Account Receivable ....................................... Service Revenue..................................... 31 Unearned Service Revenue......................... Service Revenue..................................... 31 Art Supplies Expense.................................... Art Supplies ............................................. 31 Depreciation Expense ................................... Accumulated Depreciation— Printing Equipment........................... 31 Interest Expense ............................................. Interest Payable ...................................... 31 Insurance Expense......................................... Prepaid Insurance.................................. 31 Salaries Expense ............................................ Salaries Payable ..................................... 3,000 3,000 1,400 1,400 3,000 3,000 6,750 6,750 150 150 750 750 1,500 1,500 3-61 PROBLEM 3-7 (Continued) (b) ANA ALICIA ADVERTISING CORPORATION Income Statement For the Year Ended December 31, 2007 Revenues Service revenue ........................................................... Expenses Salaries expense ......................................................... Art supplies expense ................................................. Depreciation expense ................................................ Rent expense................................................................ Insurance expense...................................................... Interest expense .......................................................... Total expenses.................................................... Net income................................................................................. $11,500 8,000 6,750 4,000 750 500 31,500 $31,500 $63,000 ANA ALICIA ADVERTISING CORPORATION Statement of Retained Earnings For the Year Ended December 31, 2007 Retained earnings, January 1........................................................................... Add: Net income ................................................................................................... Retained earnings, December 31 .................................................................... $ 4,500 31,500 $36,000 3-62 PROBLEM 3-7 (Continued) ANA ALICIA ADVERTISING CORPORATION Balance Sheet December 31, 2007 Assets Cash.................................................................................................... Accounts receivable ..................................................................... Art supplies...................................................................................... Prepaid insurance.......................................................................... Printing equipment ........................................................................ Less: Accum. depr.—printing equipment............................. Total assets ......................................................................... Liabilities and Stockholders’ Equity Liabilities Accounts payable .............................................................. Interest payable.................................................................. Notes payable ..................................................................... Unearned service revenue.............................................. Salaries payable................................................................. Total liabilities.......................................................... Stockholders’ equity Common Stock ................................................................... Retained Earnings ............................................................. Total stockholders’ equity ................................... Total liabilities and stockholders’ equity............ 10,000 36,000 46,000 $63,250 $ 5,000 150 5,000 5,600 1,500 $17,250 $60,000 33,750 26,250 $63,250 $ 7,000 22,000 5,500 2,500 3-63 PROBLEM 3-7 (Continued) (c) (1) Total depreciable cost = $6,750 X 8 = $54,000. Salvage value = cost $60,000 less depreciable cost $54,000 = $6,000 (2) Based on the balance in interest payable, interest is $50 per month or 1% of the note payable. 1% X 12 = 12% interest per year. (3) Salaries Expense, $11,500 less Salaries Payable 12/31/07, $1,500 = $10,000. Total payments, $12,500 – $10,000 = $2,500 Salaries Payable 12/31/06. 3-64 *PROBLEM 3-8 (a), (b), (d) Cash Bal. 15,000 Bal. Prepaid Insurance 9,000 Adj. 5,500 Common Stock Bal. Accounts Receivable Bal. 13,000 400,000 Maintenance Expense Bal. 24,000 Close 24,000 3,500 Bal. Adj. Salaries Expense 80,000 Close 3,600 83,600 83,600 83,600 Retained Earnings Bal. Inc. 82,000 30,250 112,250 Allow. for Doubtful Accts. Bal. Adj. 1,100 850 1,950 Adj. Cls. Dues Revenue 8,900 Bal. 191,100 200,000 Rev. 200,000 200,000 8,900 Depr. Expense—Buildings Adj. 4,800 Close 4,800 Land Bal. 350,000 Buildings Bal. 120,000 Close Close Green Fee Revenue 8,100 Bal. Rental Revenue 16,800 Bal. _____ Adj. 16,800 1,400 15,400 1,400 16,800 8,100 Depr. Expense—Equipment Adj. 15,000 Close 15,000 Accum. Depr.Equipment Bal. Adj. 70,000 15,000 Rev. Accum. Depr. of Buildings Bal. 38,400 Adj. 4,800 43,200 Rent Receivable Adj. $1,400 Rev. 1,400 Adj. Bal. Utilities Expense 54,000 Close 54,000 Adj. Insurance Expense 3,500 Close 3,500 Bad Debt Expense 850 Close 850 Exp. Inc. Income Summary 185,750 Rev. 30,250 216,000 216,000 216,000 3-65 PROBLEM 3-8 (Continued) Salaries Payable Adj. Equipment Bal. 150,000 3,600 Unearned Dues Revenue Adj. 8,900 (b) -1Depreciation Expense—Buildings ............................... Accumulated Depreciation—Buildings.............. (1/25 X $120,000) -2Depreciation Expense—Equipment............................. Accumulated Depreciation—Equipment ........... (10% X $150,000) -3Insurance Expense............................................................ Prepaid Insurance ..................................................... -4Rent Receivable.................................................................. Rental Revenue.......................................................... (1/11 X $15,400) -5Bad Debts Expense........................................................... Allowance for Doubtful Accounts........................ [($13,000 X 15%) – $1,100] -6Salaries Expense ............................................................... Salaries Payable ........................................................ -7Dues Revenue ..................................................................... Unearned Dues Revenue ........................................ 3-66 4,800 4,800 15,000 15,000 3,500 3,500 1,400 1,400 850 850 3,600 3,600 8,900 8,900 PROBLEM 3-8 (Continued) (c) Platteville Golf Club, Inc. Adjusted Trial Balance December 31, XXXX Dr. Cr. Cash........................................................................................... $ 15,000 Accounts Receivable ........................................................... 13,000 Allowance for Doubtful Accounts ................................... Prepaid Insurance................................................................. Land........................................................................................... Building .................................................................................... Accum. Depreciation—Buildings..................................... Accum. Depreciation—Equipment .................................. Rent Receivable..................................................................... Salaries Payable .................................................................... Equipment ............................................................................... Common Stock ...................................................................... Retained Earnings ................................................................ Dues Revenue ........................................................................ Green Fee Revenue .............................................................. Rental Revenue...................................................................... Utilities Expense.................................................................... Bad Debts Expense .............................................................. Unearned Dues Revenue .................................................... Salaries Expense................................................................... Maintenance Expense ......................................................... Depreciation Expense—Buildings .................................. Depreciation Expense—Equipment................................ Insurance Expense ............................................................... 54,000 850 8,900 83,600 24,000 4,800 15,000 3,500 $840,650 1,400 3,600 150,000 400,000 82,000 191,100 8,100 16,800 $ 5,500 350,000 120,000 43,200 85,000 1,950 Totals ............................................................................ $840,650 3-67 PROBLEM 3-8 (Continued) (d) -Dec. 31Dues Revenue ..................................................................... Green Fee Revenue........................................................... Rental Revenue .................................................................. Income Summary ...................................................... -31Income Summary ............................................................... Utilities Expense........................................................ Bad Debt Expense..................................................... Salaries Expense....................................................... Maintenance Expense.............................................. Depreciation Expense—Buildings....................... Depreciation Expense—Equipment .................... Insurance Expense ................................................... -31Income Summary ............................................................... Retained Earnings..................................................... 30,250 30,250 185,750 54,000 850 83,600 24,000 4,800 15,000 3,500 191,100 8,100 16,800 216,000 3-68 *PROBLEM 3-9 (a), (b), (c) Cash Bal. 18,500 Bal. Accounts Receivable 42,000 Allow. for Doubtful Accts. Bal. Adj. 700 1,400 Inventory Bal. 80,000 Bal. Furniture & Equipment 84,000 Accum. Depr. of F. & E. Bal. Adj. 35,000 14,000 Prepaid Insurance Bal. 5,100 Adj. Common Stock Bal. 80,600 Cls. 2,550 Notes Payable Bal. Sales 600,000 Bal. 600,000 28,000 Admin. Salaries Expense Bal. 65,000 Cls. 65,000 Insurance Expense Adj. 2,550 Cls. Interest Expense 700 6,000 6,700 Adj. 3,360 Close 3,360 2,550 Sales Salaries Expense Bal. Adj. 50,000 Cls. 2,400 52,400 52,400 52,400 Bal. Advertising Expense 6,700 Adj. Close 6,700 Office Expense Bal. 5,000 Adj. Close 5,000 1,500 3,500 5,000 Bad Debt Expense Adj. 1,400 Cls. 1,400 Prepaid Advertising Expense Adj. 700 Interest Payable Adj. 3,360 Depr. Exp.—Furn. & Equip. Adj. 14,000 Cls. 14,000 Exp. Inc. Income Summary 546,210 Sales 53,790 600,000 600,000 600,000 Office Supplies Adj. 1,500 Salaries Payable Adj. 2,400 Retained Earnings Bal. Inc. Bal. 10,000 53,790 63,790 Bal. Cost of Goods Sold 398,000 Cls. 398,000 3-69 PROBLEM 3-9 (Continued) (b) -1Bad Debts Expense........................................................... Allowance for Doubtful Accounts........................ -2Depreciation Expense—Furniture and Equipment ($84,000 ÷ 6).............................................. Accum. Depr.—Furniture and Equipment......... -3Insurance Expense............................................................ Prepaid Insurance ..................................................... -4Interest Expense ................................................................ Interest Payable ......................................................... -5Sales Salaries Expense ................................................... Salaries Payable ........................................................ -6Prepaid Advertising Expense ........................................ Advertising Expense ................................................ -7Office Supplies ................................................................... Office Expense ........................................................... 14,000 14,000 1,400 1,400 2,550 2,550 3,360 3,360 2,400 2,400 700 700 1,500 1,500 3-70 PROBLEM 3-9 (Continued) (c) Dec. 31 Sales ...................................................................................... Income Summary ...................................................... 600,000 600,000 Dec. 31 Income Summary............................................................... Cost of Goods Sold.................................................. Advertising Expense................................................ Administrative Salaries Expense......................... Sales Salaries Expense .......................................... Office Expense........................................................... Insurance Expense................................................... Bad Debt Expense .................................................... Depreciation Expense—Furniture and Equipment............................................................... Interest Expense ....................................................... 546,210 398,000 6,000 65,000 52,400 3,500 2,550 1,400 14,000 3,360 Dec. 31 Income Summary............................................................... Retained Earnings .................................................... 53,790 53,790 3-71 *PROBLEM 3-10 (a) Razorback Sales and Services Income Statement For the Month Ended January 31, 2007 (1) Cash Basis (2) Accrual Basis $105,750* Revenues............................................................................ $ 75,000 Expenses Cost of computers & printers: Purchased and paid..................................... Cost of goods sold ...................................... Salaries................................................................... Rent.......................................................................... Other Expenses ................................................... 89,250** 9,600 6,000 8,400 63,750*** 12,600 2,000 10,400 88,750 $ 17,000 Total expenses............................................ 113,250 Net income (loss)............................................................. $(38,250) * ($2,550 X 30) + ($4,500 X 4) + ($750 X 15) ** ($1,500 X 40) + ($3,000 X 6) + ($450 X 25) *** ($1,500 X 30) + ($3,000 X 4) + ($450 X 15) 3-72 *PROBLEM 3-10 (Continued) (b) Razorback Sales and Services Balance Sheet As of January 31, 2007 (1) Cash Basis (2) Accrual Basis $ 51,750a 30,750 25,500b 4,000 $112,000 Assets Cash ....................................................................... Accounts Receivable........................................ Inventory............................................................... Prepaid rent ......................................................... Total assets ................................................... Liabilities and Owners’ Equity Accounts payable .............................................. Salaries payable................................................. Owners’ equity.................................................... Total liabilities and owners’ equity............ $51,750a $51,750 $51,750c $51,750 2,000 3,000 107,000d $112,000 $ a Original investment Cash sales Cash purchases Rent paid Salaries paid Other expenses Cash balance Jan. 31 $ 90,000 75,000 (89,250) (6,000) (9,600) (8,400) $ 51,750 b (10 @ $1,500) + (2 @ $3,000) + (10 @ $450). c Initial investment minus net loss: $90,000 – $38,250. Initial investment plus net income: $90,000 + $17,000. d 3-73 *PROBLEM 3-10 (Continued) (c) 1. The $30,750 in receivables from customers is an asset and a future cash flow resulting from sales that is ignored. The cash basis understates the amount of revenues and inflow of assets in January from the sale of computers and printers by $30,750. The cost of computers and printers sold in January is overstated by $25,500. The unsold computers and printers are an asset of $25,500 in the form of inventory. The cash basis ignores $3,000 of the salaries that have been earned by the employees in January and will be paid in February. Rent expense on the cash basis is overstated by $4,000 under the cash basis. This prepayment is an asset in the form of two months’ future right to the use of office, showroom, and repair space and should appear on the balance sheet. Other operating expenses on a cash basis are understated by $2,000 as is the liability for the unpaid portion of these expenses incurred in January. 2. 3. 4. 5. 3-74 (a) NOAH’S ARK Worksheet For the Year Ended September 30, 2007 Account Titles Trial Balance Dr. 37,400 18,600 31,900 80,000 120,000 (b) (a) 17,400 28,000 (c) (d) 1,000 43,000 14,600 1,700 50,000 109,700 14,000 278,500 109,000 30,500 9,400 16,900 18,000 (e) ______ (f) 6,000 491,700 (a) (b) (c) 28,000 17,400 (f) 6,800 _____ 62,200 (e) 3,000 62,200 6,000 6,800 ______ 507,500 3,000 507,500 28,000 17,400 6,000 6,800 ______ 251,000 28,500 279,500 ______ 279,500 ______ 279,500 28,000 17,400 3,000 6,000 491,700 (d) 1,000 109,000 30,500 9,400 16,900 21,000 12,000 279,500 109,000 30,500 9,400 16,900 21,000 12,000 279,500 36,200 14,600 2,700 50,000 109,700 14,000 6,800 37,400 1,200 3,900 80,000 120,000 Cr. Dr. Cr. Dr. Cr. Dr. Cr. Adjustments Adjusted Trial Balance Dr. Income Statement Balance Sheet Cr. 37,400 1,200 3,900 80,000 120,000 43,000 14,600 1,700 50,000 109,700 14,000 *PROBLEM 3-11 3-75 Cash Supplies Prepaid Insurance Land Equipment Accum. Depreciation Accounts Payable Unearned Ad. Rev. Mortgage Payable N. Y. Berge, Capital N. Y. Berge, Drawing Admissions Revenue Salaries Expense Repair Expense Advertising Expense Utilities Expense Prop. Taxes Expense Interest Expense Totals Insurance Expense Supplies Expense Interest Payable Depreciation Expense 6,000 ______ 256,500 ______ 256,500 3,000 228,000 28,500 256,500 Prop. Taxes Payable Totals Net Income Totals Key: (a) Expired Insurance; (b) Supplies Used; (c) Depreciation Expensed; (d) Admission Revenue Earned; (e) Accrued Property Taxes; (f) Accrued Interest Payable. *PROBLEM 3-11 (Continued) (b) NOAH’S ARK Balance Sheet September 30, 2007 Assets Current assets Cash .............................................................. Supplies........................................................ Prepaid insurance..................................... Total current assets....................... Property, plant, and equipment Land .............................................................. Equipment ................................................... Less: Accum. depreciation................... Total assets ...................................... $120,000 43,000 77,000 157,000 $199,500 $37,400 1,200 3,900 $ 42,500 80,000 Liabilities and Owner’s Equity Current liabilities Current maturity of long-term debt ............................ Accounts payable ............................................................ Unearned admissions revenue.................................... Interest payable ................................................................ Property taxes payable .................................................. Total current liabilities......................................... Long-term liabilities Mortgage payable............................................................. Total liabilities ........................................................ Owner’s equity N.Y. Berge, Capital ($109,700 + $28,500 – $14,000) Total liabilities and owner’s equity.................. $10,000 14,600 1,700 6,000 3,000 $ 35,300 40,000 75,300 124,200 $199,500 3-76 *PROBLEM 3-11 (Continued) (c) Sep. 30 Insurance Expense......................................... Prepaid Insurance.................................. 30 Supplies Expense........................................... Supplies .................................................... 30 Depreciation Expense ................................... Accum. Depreciation ........................... 30 Unearned Admissions Revenue ................ Admissions Revenue............................ 30 Property Taxes Expense .............................. Property Taxes Payable ....................... 30 Interest Expense ............................................. Interest Payable ...................................... 28,000 28,000 17,400 17,400 6,800 6,800 1,000 1,000 3,000 3,000 6,000 6,000 279,500 279,500 251,000 109,000 30,500 28,000 21,000 17,400 16,900 12,000 9,400 6,800 (d) Sep. 30 Admissions Revenue .................................... Income Summary ................................... 30 Income Summary............................................ Salaries Expense.................................... Repair Expense....................................... Insurance Expense ................................ Property Taxes Expense...................... Supplies Expense .................................. Utilities Expense..................................... Interest Expense..................................... Advertising Expense............................. Depreciation Expense .......................... 3-77 *PROBLEM 3-11 (Continued) 30 Income Summary ............................................ N. Y. Berge, Capital ................................ 30 N. Y. Berge, Capital......................................... N. Y. Berge, Drawing ............................. 14,000 14,000 28,500 28,500 (e) NOAH’S ARK Post-Closing Trial Balance September 30, 2007 Debit Credit Cash ................................................................................... Supplies............................................................................ Prepaid Insurance ......................................................... Land ................................................................................... Equipment........................................................................ Accumulated Depreciation......................................... Accounts Payable.......................................................... Unearned Admissions Revenue ............................... Interest Payable ............................................................. Property Taxes Payable .............................................. Mortgage Payable.......................................................... N. Y. Berge, Capital ....................................................... $ 37,400 1,200 3,900 80,000 120,000 $ 43,000 14,600 1,700 6,000 3,000 50,000 124,200 $242,500 $242,500 3-78 FINANCIAL REPORTING PROBLEM (a) June 30, 2004 total assets: $57,048 million. June 30, 2003 total assets: $43,706 million. June 30, 2004 cash and cash equivalents: $5,469 million. 2002 research and development costs: $1,601 million. 2004 research and development costs: $1,802 million. 2002 net sales: $40,238 million. 2004 net sales: $51,407 million. An adjusting entry for prepayments is necessary when the receipt/ disbursement precedes the recognition in the financial statements. Accounts such as prepaid insurance and prepaid rent may be included in the Prepaid expenses and other receivables section ($1,803 million at June 30, 2004). Both of these accounts would require an adjusting entry to recognize the proper amount of expense incurred during the period. In addition, depreciation expense is an adjusting entry related to a prepayment. An adjusting entry for an accrual is necessary when recognition in the financial statements precedes the cash receipt/disbursement, such as interest or taxes payable. Other adjusting entries probably made by P&G include interest revenue and expense and interest receivable and interest payable. P&G reports $7,689 million of Accrued and other liabilities at June 30, 2004. (f) 2002 Depreciation and amortization expense: $1,693 million 2003 Depreciation and amortization expense: $1,703 million 2004 Depreciation and amortization expense: $1,733 million (From the Statement of Cash Flows) (b) (c) (d) (e) 3-79 FINANCIAL STATEMENT ANALYSIS CASE (a) 2003 Sales Gross Profit % Operating Profit Net Cash Flow less Capital Expenditures Net Earnings $8,811.50 44.40 1,544.10 923.80 787.10 2002 $8,304.10 45.50 1,508.10 746.40 720.90 2001 $7,548.40 44.20 1,167.90 855.50 473.60 % Change 2003 6.11% –2.42% 2.39% 23.77% 9.18% % Change 2002 10.01% 2.94% 29.13% –12.75% 52.22% (b) Except for a slight decrease in gross profit %, Kellogg has reported good performance in 2003 compared to 2002. The net cash flow measure showed strong improvement in 2003 after a dip in 2002, compared to 2001. Sales also showed a steady, although slowing, growth in 2003. There appears to be a leveling off of performance in operating profits and earnings in 2003, compared to 2002. This likely reflects exceptionally strong performance in 2002, as the economy improved relative to 2000–2001. The steady, positive trends are all supportive of Kellogg achieving its objective of sustainable growth. 3-80 COMPARATIVE ANALYSIS CASE (a) The Coca-Cola Company percentage increase is 14.6% computed as follows: Total assets (December 31, 2004)..................................................... Total assets (December 31, 2003)..................................................... Difference.................................................................................................. $3,985 ÷ $27,342 = $14.6% PepsiCo, Inc.’s percentage increase is computed as follows: Total assets (December 25, 2004)..................................................... Total assets (December 27, 2003)..................................................... Difference.................................................................................................. $2,660 ÷ $25,327 = $10.5% Coca-Cola Company had the larger increase. (b) 5-Year Growth Rate Net sales Income from continuing operations (c) The Coca-Cola Company 5.5% 7.4% PepsiCo, Inc. 5.7% 10.4% $27,987 $25,327 $ 2,660 $31,327 $27,342 $ 3,985 The Coca-Cola Company had depreciation and amortization expense of $893,000,000; PepsiCo, Inc. had depreciation and amortization expense of $1,264,000,000. PepsiCo has substantially more property, plant, and equipment and intangible assets than does Coca-Cola. PepsiCo is engaged in three different types of businesses: soft drinks, snack-food, and juices. As a result, it has more tangible fixed assets. In addition, PepsiCo has substantial intangible 3-81 COMPARATIVE ANALYSIS CASE (Continued) assets. Amortizable intangible assets for Coke and Pepsi increase the amount of amortization expense recorded in income. The amount of property, plant, and equipment and amortizable intangible assets reported for these two companies is as follows: The Coca-Cola Company Property, plant, and equipment (net) Amortizable intangible assets (net) $6,091,000,000 702,000,000 $6,793,000,000 PepsiCo, Inc. $8,149,000,000 598,000,000 $8,747,000,000 3-82 RESEARCH CASE (a) Per page 15, SIC codes are assigned on the basis of a firm’s “primary activity,” which is determined by the principal product or group of products produced or distributed, or service rendered. 12 = Coal mining; 271 = Newspapers; 3571 = Electronic computers; 7033 = Trailer parks and campsites; 75 = Auto repair, services, and parking; 872 = Accounting, auditing, and bookkeeping. (1) 3949, (2) 0279, (3) 3951, (4) 5722, (5) 7311 Major group = 45. Industry group = 451. Industry = 4512 Per 2004 Wards directory: (1) America West Holdings Corp. ($22,545 B) (2) AMR Corp. ($17,400 B) (3) United Airlines ($16,138 B) (4) Delta Airlines Corp. ($13,303) (5) Northwest Airlines Corp. ($9,510 B) (Note: Subsidiaries of AMR, UAL, and Northwest are included in the listing. The question asks about parent companies.) (b) (c) (d) 3-83 PROFESSIONAL RESEARCH: ACCOUNTING AND FINANCIAL REPORTING (a) The three essential characteristics of assets. Search String: asset and characteristics. CON6, Par26. An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others’ access to it, and (c) the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred. (b) Three essential characteristics of liabilities. Search String: liability and characteristic. CON6, Par36. A liability has three essential characteristics: (a) it embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand, (b) the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice, and (c) the transaction or other event obligating the entity has already happened. (c) Uncertainty, and its effects on financial statements. Search Strings: “uncertainty”, effect% of uncertainty. CON6, Par44. Uncertainty about economic and business activities and results is pervasive, and it often clouds whether a particular item qualifies as an asset or a liability of a particular entity at the time the definitions are applied. The presence or absence of future economic benefit that can be obtained and controlled by the entity or of the entity’s legal, equitable, or constructive obligation to sacrifice assets in the future can often be discerned reliably only with hindsight. As a result, some items that with hindsight actually qualified as assets or liabilities of the entity under the definitions may, as a practical matter, have been recognized as expenses, losses, revenues, or gains or remained unrecognized in its financial statements because of uncertainty about whether they qualified as assets or liabilities of the entity or because of recognition and measurement considerations stemming from uncertainty at the time of assessment. Conversely, some items that with hindsight did not qualify under the definitions may have been included as assets or liabilities because of judgments made in the face of uncertainty at the time of assessment. CON6, Par45. An effect of uncertainty is to increase the costs of financial reporting in general and the costs of recognition and measurement in particular. Some items that qualify as assets or liabilities under the definitions may therefore be recognized as expenses, losses, revenues, or gains or remain unrecognized as a result of cost and benefit analyses indicating that their formal incorporation in financial statements is not useful enough to justify the time and effort needed to do it. It may be possible, for example, to make the information more reliable in the face of uncertainty by exerting greater effort or by spending more money, but it also may not be worth the added cost. 3-84 ACCOUNTING AND FINANCIAL REPORTING (Continued) (d) The difference between realization and recognition Search String: realization, recognition. CON6, Par143. Realization in the most precise sense means the process of converting noncash resources and rights into money and is most precisely used in accounting and financial reporting to refer to sales of assets for cash or claims to cash. The related terms realized and unrealized therefore identify revenues or gains or losses on assets sold and unsold, respectively. Those are the meanings of realization and related terms in the Board’s conceptual framework. Recognition is the process of formally recording or incorporating an item in the financial statements of an entity. Thus, as asset, liability, revenue, expense, gain, or loss may be recognized (recorded) or unrecognized (unrecorded). Realization and recognition are not used as synonyms, as they sometimes are in accounting and financial literature. 3-85 PROFESSIONAL SIMULATION Journal Entries Dec. 31 Accounts Receivable................................................ Advertising Revenue........................................ 31 Unearned Advertising Revenue............................ Advertising Revenue........................................ 31 Art Supplies Expense............................................... Art Supplies ........................................................ 31 Depreciation Expense .............................................. Accumulated Depreciation............................. 31 Salaries Expense ....................................................... Salaries Payable ................................................ 1,500 1,500 1,400 1,400 3,400 3,400 7,000 7,000 1,300 1,300 Financial Statements Nalezny Advertising Agency Income Statement For the Year Ended December 31, 2007 Revenues Advertising revenue........................................................... Expenses Salaries expense ................................................................. Depreciation expense........................................................ Rent expense........................................................................ Art supplies expense ......................................................... Total expenses .......................................................... Net income...................................................................................... $61,500 $11,300 7,000 4,000 3,400 25,700 $35,800 3-86 PROFESSIONAL SIMULATION (Continued) Nalezny Advertising Agency Balance Sheet December 31, 2007 Assets Cash............................................................................................. Accounts receivable .............................................................. Art supplies............................................................................... Printing equipment ................................................................. Less: Accumulated depreciation— printing equipment.................................................... Total Assets............................................................. Liabilities and Stockholders’ Equity Liabilities Accounts payable.......................................................... Unearned advertising revenue.................................. Salaries payable............................................................. Total liabilities ........................................................ Stockholders’ equity Common stock ............................................................... Retained earnings ......................................................... Total liabilities and stockholders’ equity............ *Retained earnings, Jan. 1, 2007 Add: Net income Retained earnings, Dec. 31, 2007 $ 4,800 35,800 $40,600 $11,000 21,500 5,000 $60,000 35,000 25,000 $62,500 $5,000 5,600 1,300 $11,900 $10,000 40,600* 50,600 $62,500 Explanation Following preparation of financial statements (see Illustration 3-6), Nalezny would prepare closing entries to reduce the temporary accounts to zero. Some companies prepare a post-closing trial balance and reversing entries. 3-87 CHAPTER 4 Income Statement and Related Information ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. Income measurement concepts. Questions 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 18, 28, 31, 32, 33 1 1, 2, 7 Brief Exercises Exercises Problems Concepts for Analysis 3, 4, 5, 6, 8 2. Computation of net income from balance sheets and selected accounts. Single-step income statements; earnings per share. Multiple-step income statements. Extraordinary items; accounting changes; discontinued operations; prior period adjustments; errors. Retained earnings statement. Intraperiod tax allocation. Comprehensive income. Disposal of a component (discontinued operations). 11, 19, 23, 24 17, 18, 19 13, 14, 15, 16, 27, 29 3. 2, 8 3, 4, 6, 7, 10, 15, 16 4, 5, 6, 8 5, 7, 9, 10, 12, 13 2, 3, 4, 5 1, 2, 7 4. 5. 3 4, 5, 6, 7 1, 4 3, 4, 5, 6, 7 4, 6, 7, 8 6. 7. 8. 9. 30 21, 22, 25, 26, 27 34 29, 35 9, 10 8, 10, 11, 12, 16 8 1, 2, 4, 5, 6 11 14, 15, 16 9 4-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives 1. 2. 3. 4. 5. 6. 7. 8. Understand the uses and limitations of an income statement. Prepare a single-step income statement. Prepare a multiple-step income statement. Explain how to report irregular items. Explain intraperiod tax allocation. Identify where to report earnings per share information. Prepare a retained earnings statement. Explain how to report other comprehensive income. 1, 2 3, 4 4, 5, 6, 7, 10 5, 6, 7 8 9, 10 11 1, 2, 3, 4, 6, 7, 16 4, 5, 6, 8, 10, 14 5, 7, 8, 10, 12, 13, 16 8, 12, 13, 16 7, 8, 9, 10, 12, 13, 16 8, 11, 15, 16 14, 15, 16 2 1, 4 1, 3, 4, 5, 6, 7 1, 3, 5, 6, 7 1, 2, 3, 4, 5, 7 1, 2, 4, 5, 6 Brief Exercises Exercises Problems 4-2 ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty Simple Simple Moderate Simple Moderate Moderate Simple Simple Simple Moderate Simple Moderate Moderate Simple Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate Moderate Simple Simple Moderate Moderate Simple Moderate Moderate Moderate Simple Time (minutes) 18–20 25–35 20–25 30–35 30–35 30–40 15–20 30–35 20–25 20–25 20–25 15–20 15–20 15–20 15–20 30–35 30–35 25–30 30–40 45–55 20–25 25–35 25–35 20–25 10–15 25–35 20–25 15–20 30–35 30–40 20–25 10–15 Item E4-1 E4-2 E4-3 E4-4 E4-5 E4-6 E4-7 E4-8 E4-9 E4-10 E4-11 E4-12 E4-13 E4-14 E4-15 E4-16 P4-1 P4-2 P4-3 P4-4 P4-5 P4-6 P4-7 C4-1 C4-2 C4-3 C4-4 C4-5 C4-6 C4-7 C4-8 C4-9 Description Computation of net income. Income statement items. Single-step income statement. Multiple-step and single-step. Multiple-step and extraordinary items. Multiple-step and single-step. Income Statement, EPS. Multiple-step statement with retained earnings. Earnings per share. Condensed income statement—periodic inventory method. Retained earnings statement. Earnings per share. Change in accounting principle. Comprehensive income. Comprehensive income. Various reporting formats. Multi-step income, retained earnings. Single-step income, retained earnings, periodic inventory. Irregular items. Multiple- and single-step income, retained earnings. Irregular items. Retained earnings statement, prior period adjustments. Income statement, irregular items. Identification of income statement deficiencies. Income reporting deficiencies. Extraordinary items. Earnings management. Earnings management Income reporting items. Identification of income statement weaknesses. Classification of income statement items. Comprehensive income. 4-3 ANSWERS TO QUESTIONS 1. The income statement is important because it provides investors and creditors with information that helps them predict the amount, timing, and uncertainty of future cash flows. It helps investors and creditors predict future cash flows in a number of different ways. First, investors and creditors can use the information on the income statement to evaluate the past performance of the enterprise. Second, the income statement helps users of the financial statements to determine the risk (level of uncertainty) of income—revenues, expenses, gains, and losses—and highlights the relationship among these various components. It should be emphasized that the income statement is used by parties other than investors and creditors. For example, customers can use the income statement to determine a company’s ability to provide needed goods or services, unions examine earnings closely as a basis for salary discussions, and the government uses the income statements of companies as a basis for formulating tax and economic policy. 2. Information on past transactions can be used to identify important trends that, if continued, provide information about future performance. If a reasonable correlation exists between past and future performance, predictions about future earnings and cash flows can be made. For example, a loan analyst can develop a prediction of future performance by estimating the rate of growth of past income over the past several periods and project this into the next period. Additional information about current economic and industry factors can be used to adjust the trend rate based on historical information. Some situations in which changes in value are not recorded in income are: a) b) c) d) Unrealized gains or losses on available-for-sale investments, Changes in the market values of long-term liabilities, such as bonds payable, Changes (increases) in value of property, plant and equipment, such as land, natural resources, or equipment, Changes (increases) in the values of intangible assets such as customer goodwill, brand value, or intellectual capital. 3. Note that some of these omissions arise because the items (e.g., brand value) are not recognized in financial statements, while others (value of land) are recorded in financial statements but measurement is at historical cost. 4. Some situations in which application of different accounting methods or estimates lead to comparison problems include: a. b. c. d. e. f. 5. Inventory methods—LIFO vs. FIFO, Depreciation Methods—straight-line vs. accelerated, Accounting for long-term contracts—percentage-of-completion vs. completed-contract, Estimates of useful lives or salvage values for depreciable assets, Estimates of bad debts, Estimates of warranty returns. The transaction approach focuses on the activities that have occurred during a given period and instead of presenting only a net change, a description of the components that comprise the change is included. In the capital maintenance approach, only the net change (income) is reflected whereas the transaction approach not only provides the net change (income) but the components of income (revenues and expenses). The final net income figure should be the same under either approach given the same valuation base. 4-4 Questions Chapter 4 (Continued) 6. Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales before they are complete in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves, which are established, by using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses, and warranty returns. Earnings management has a negative effect on the quality of earnings if it distorts the information in a way that is less useful for predicting future cash flows. Within the Conceptual Framework, useful information is both relevant and reliable. However, earnings management reduces the reliability of income, because the income measure is biased (up or down) and/or the reported income is not representationally faithful to that which it is supposed to report (e.g., volatile earnings are made to look more smooth). Caution should be exercised because many assumptions and estimates are made in accounting and the income figure is a reflection of these assumptions. If for any reason the assumptions are not well-founded, distortions will appear in the income reported. The objectives of the application of generally accepted accounting principles to the income statement are to measure and report the results of operations as they occur for a specified period without recognizing any artificial exclusions or modifications. The term “quality of earnings” refers to the credibility of the earnings number reported. Companies that use aggressive accounting policies report higher income numbers in the short-run. In such cases, we say that the quality of earnings is low. Similarly, if higher expenses are recorded in the current period, in order to report higher income in the future, then the quality of earnings is considered low. 7. 8. 9. 10. The major distinction between revenues and gains (or expenses and losses) depends on the typical activities of the enterprise. Revenues can occur from a variety of different sources, but these sources constitute the entity’s ongoing major or central operations. Gains also can arise from many different sources, but these sources occur from peripheral or incidental transactions of an entity. The same type of distinction is made between an expense and a loss. 11. The advantages of the single-step income statement are: (1) simplicity and conciseness, (2) probably better understood by the layperson, (3) emphasis on total costs and expenses, and net income, and (4) does not imply priority of one revenue or expense over another. The disadvantages are that it does not show the relationship between sales and cost of goods sold and it does not show other important relationships and information, such as income from operations, income before taxes, etc. 12. Operating items are the expenses and revenues which relate directly to the principal activity of the concern; they are revenues realized from, or expenses which contribute to, the sale of goods or services for which the company was organized. The nonoperating items result from secondary activities of the company. They are not directly related to the principal activity of the company but arise from incidental activities. 13. The current operating performance income statement contains only the revenues and usual expenses of the current year, with all unusual gains or losses or material corrections of prior periods’ revenues and expenses appearing in the retained earnings statement. The modified allinclusive income statement includes most items including irregular ones, as part of net income. The retained earnings statement then would include only the beginning balance (adjusted for the effects of errors and changes in accounting principles), the net amount transferred from income summary, dividends, and transfers to and from appropriated retained earnings. 4-5 Questions Chapter 4 (Continued) In APB Opinion No. 9, the APB recommended a modified all-inclusive income statement, excluding from the income statement only those items, few in number, which meet the criteria for prior period adjustments and which would thus appear as adjustments to the beginning balance in the retained earnings statement. Subsequently a number of pronouncements have reinforced this position. Recently, changes in accounting principle are also adjusted through the beginning retained earnings balance. 14. Items considered corrections of errors should be charged or credited to the opening balance of retained earnings. 15. (a) This might be shown in the income statement as an extraordinary item if it is a material, unusual, and infrequent gain realized during the year. However, in general and in accordance with APB Opinion No. 30, this transaction would normally not be considered extraordinary, but would be shown in the nonoperating section of a multiple-step income statement. If unusual or infrequent but not both, it should be separately disclosed in the income statement. (b) The bonus should be shown as an operating expense in the income statement. Although the basis of computation is a percentage of net income, it is an ordinary operating expense to the company and represents a cost of the service received from employees. (c) If the amount is immaterial, it may be combined with the depreciation expense for the year and included as a part of the depreciation expense appearing in the income statement. If the amount is material, it should be shown in the retained earnings statement as an adjustment to the beginning balance of retained earnings. (d) This should be shown in the income statement. One treatment would be to show it in the statement as a deduction from the rent expense, as it reduces an operating expense and therefore is directly related to operations. Another treatment is to show it in the other revenues and gains section of the income statement. (e) Assuming that a provision for the loss had not been made at the time the patent infringement suit was instituted, the loss should be recognized in the current period in computing net income. It may be reported as an unusual loss. (f) This should be reported in the income statement, but not as an extraordinary item because it relates to usual business operations of the firm. 16. (a) The remaining book value of the equipment should be depreciated over the remainder of the five-year period. The additional depreciation ($425,000) is not a correction of an error and is not shown as an adjustment to retained earnings. It is considered a change in estimate. (b) The loss should be shown as an extraordinary item, assuming that it is unusual and infrequent. (c) Should be shown either as other expenses or losses or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. It should not be shown as an extraordinary item. (d) Assuming that a receivable had not been recorded in the previous period, the gain should be recognized in the current period in computing net income, but not as an extraordinary item. (e) A correction of an error should be considered a prior period adjustment and the beginning balance of Retained Earnings should be restated. (f) The cumulative effect of the change is reported as an adjustment to beginning retained earnings. Prior years ’ s tatements are recast on a basis consistent with the new standard. 17. (a) Other expenses or losses section or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. (b) Operating expense section or other expenses and losses section or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. APB Opinion No. 30 specifically states that the effect of a strike does not constitute an extraordinary item. (c) Operating expense section, as a selling expense, but sometimes reflected as an administrative expense. (d) Separate section after income from continuing operations, entitled discontinued operations. (e) Other revenues and gains section or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. (f) Other revenues and gains section. 4-6 Questions Chapter 4 (Continued) (g) Operating expense section, normally administrative. If a manufacturing concern, may be included in cost of goods sold. (h) Other expenses or losses section or in separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. 18. Bonds and Glavine should not report the sales in a similar manner. This type of transaction appears to be typical of Bonds’ central operations. Therefore, Bonds should report revenues of $160,000 and expenses of $100,000 ($70,000 + $30,000). However, Glavine’s transaction appears to be a peripheral or incidental activity not related to its central operations. Thus, Glavine should report a gain of $60,000 ($160,000 – $100,000). Note that although the classification is different, the effect on net income is the same ($60,000 increase). 19. You should tell Rex that a company’s reported net income is the same whether the single-step or multiple-step format is used. Either way, the company has the same revenues, gains, expenses, and losses; they are simply organized in a different format. 20. Both formats are acceptable. The amount of detail reported in the income statement is left to the judgment of the company, whose goal in making this decision should be to present financial statements which are most useful to decision makers. We want to present a simple, understandable statement so that a reader can easily discover the facts of importance; therefore, a single amount for selling expenses might be preferable. However, we also want to fully disclose the results of all activities; thus, a separate listing of expenses may be preferred. Note that if the condensed version is used, it should be accompanied by a supporting schedule of the eight components in the notes to the financial statements. 21. Intraperiod tax allocation should not affect the reporting of an unusual gain. The FASB specifically prohibits a “net-of-tax” treatment for such items to insure that users of financial statements can easily differentiate extraordinary items from material items that are unusual or infrequent, but not both. “Net-of-tax” treatment is reserved for discontinued operations, extraordinary items, and prior period adjustments. 22. Intraperiod tax allocation has no effect on reported net income, although it does affect the amounts reported for various components of income. The effects on these components offset each other so net income remains the same. Intraperiod tax allocation merely takes the total tax expense and allocates it to the various items which affect the tax amount. 23. If Letterman has preferred stock outstanding, the numerator in its computation may be incorrect. A better description of “earnings per share” is “earnings per common share.” The numerator should include only the earnings available to common shareholders. Therefore, the numerator should be: net income less preferred dividends. The denominator is also incorrect if Letterman had any common stock transactions during the year. Since the numerator represents the results for the entire year, the denominator should reflect the weighted average number of common shares outstanding during the year, not the shares outstanding at one point in time (year-end). 24. The earnings per share trend is not favorable. Extraordinary items are one-time occurrences which are not expected to be reported in the future. Therefore, earnings per share on income before extraordinary items is more useful because it represents the results of ordinary business activity. Considering this EPS amount, EPS has decreased from $7.21 to $6.40. 25. Tax allocation within a period is the practice of allocating the income tax for a period to such items as income before extraordinary items, extraordinary items, and prior period adjustments. The justification for tax allocation within a period is to produce financial statements which disclose an appropriate relationship, for example, between income tax expense and (a) income before extraordinary items, (b) extraordinary items, and (c) prior period adjustments (or of the opening balance of retained earnings). 4-7 Questions Chapter 4 (Continued) 26. Tax allocation within a period (intraperiod) becomes necessary when a firm encounters such items as discontinued operations, extraordinary items, or corrections of errors. Such allocation is necessary to bring about an appropriate relationship between income tax expense and income from continuing operations, discontinued operations, income before extraordinary items, extraordinary items, etc. Tax allocation within a period is handled by first computing the tax expense attributable to income before extraordinary items, assuming no discontinued operations. This is simply computed by ascertaining the income tax expense related to revenue and expense transactions entering into the determination of such income. Next, the remaining income tax expense attributable to other items is determined by the tax consequences of transactions involving these items. The applicable tax effect of these items (extraordinary, prior period adjustments) should be disclosed separately because of their materiality. 27. Natsume Sozeki Company Partial Income Statement For the Year Ended December 31, 2007 Income before taxes and extraordinary item Income taxes Income before extraordinary item Extraordinary item—gain on sale of plant (condemnation) Less: Applicable income tax Net income $1,000,000 340,000 660,000 $450,000 135,000 315,000 $ 975,000 28. The damages would probably be reported in Pierogi Corporation’s financial statements in the other expenses or losses section. If the damages are unusual in nature, the damage settlement might be reported as an unusual item. The damages would not be reported as a correction of an error (prior period adjustment). 29. The assets, cash flows, results of operations, and activities of the plants closed would not appear to be clearly distinguishable, operationally or for financial reporting purposes, from the assets, results of operations, or activities of the Tiger Paper Company. Therefore, disposal of these assets is not considered to be a disposal of a component of a business that would receive special reporting. 30. The major items reported in the retained earnings statement are: (1) adjustments of the beginning balance for corrections of errors or changes in accounting principle, (2) the net income or loss for the period, (3) dividends for the year, and (4) restrictions (appropriations) of retained earnings. It should be noted that the retained earnings statement is sometimes composed of two parts, unappropriated and appropriated. 31. Generally accepted accounting principles are ordinarily concerned only with a “fair presentation” of business income. In contrast, taxable income is a statutory concept which defines the base for raising tax revenues by the government, and any method of accounting which meets the statutory definition will “clearly reflect” taxable income as defined by the Internal Revenue Code. It should be noted that the Code prohibits use of the cash receipts and disbursements method as a method which will clearly reflect income in accounting for purchases and sales if inventories are involved. The cash receipts and disbursements method will not usually fairly present income because: 1. The completed transaction, not receipt or disbursement of cash, increases or diminishes income. Thus, a sale on account produces revenue and increases income, and the incurrence of expense reduces income without regard to the time of payment of cash. 2. The matching principle requires that costs be matched against related revenues produced. In most situations the cash receipts and disbursements method will violate the matching principle. 4-8 Questions Chapter 4 (Continued) 3. Consistency requires that accountable events receive the same accounting treatment from accounting period to accounting period. The cash receipts and disbursements method permits manipulation of the timing of revenues and expenses and may result in treatments which are not consistent, detracting from the usefulness of comparative statements. 32. Problems arise both from the revenue side and from the expense side. There sometimes may be doubt as to the amount of revenue under our common rules of revenue recognition. However, the more difficult problem is the determination of costs expired in the production of revenue. During a single fiscal period it often is difficult to determine the expiration of certain costs which may benefit several periods. Business is continuous and estimates have to be made of the future if we are to systematically apportion costs to fiscal periods. Examples of items which present serious obstacles include such items as institutional advertising costs. Accountants have established certain rules for handling revenues and costs which are applied consistently and in a systematic manner. From period to period, application of these rules generally results in a satisfactory matching of costs and revenues unless there are large changes from one period to another. These rules, influenced by conservatism in the face of the uncertainties involved, tend to charge costs to expense earlier than might be ideally desirable if we had more knowledge of the future. Costs or expenses of the types mentioned above, by their very nature, defy any attempt to relate them to revenues of a specific period or periods. Although it is known that institutional advertising will yield benefits beyond the present, both the amount of such benefits and when they will be enjoyed are shrouded in uncertainty. The degree of certainty with which their time distribution can be forecast is so small and the results, therefore, so unreliable that the accountant writes them off as applicable to the period or periods in which the expense was incurred. 33. Elements are the basic ingredients which comprise the income statement; that is, revenues, gains, expenses, and losses. Items are descriptions of the elements such as rent revenue, rent expense, etc. In order to predict the future, the amounts of individual items may have to be reported. For example, if “income from continuing operations” is significantly lower this year and is reported as a single amount, users would not know whether to attribute the decrease to a temporary increase in an expense item (for example, an unusually large bad debt), a structural change (for example, a change in the relationship between variable and fixed expenses), or some other factor. Another example is income data that are distorted because of large discretionary expenses. 34. Other comprehensive income must be displayed (reported) in one of three ways: (1) a second separate income statement, (2) a combined income statement of comprehensive income, or (3) as part (separate columns) of the statement of stockholders’ equity. 35. The results of continuing operations should be reported separately from discontinued operations, and any gain or loss from disposal of a component of a business should be reported with the related results of discontinued operations and not as an extraordinary item. The following format illustrates the proper disclosure: Income from continuing operations before income tax Income tax Income from continuing operations Discontinued operations Gain (loss) on disposal of Division X less applicable income taxes of $— Net income $XXX XXX XXX XXX $XXX 4-9 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 4-1 Tim Allen Co. Income Statement For the Year 2007 Revenues Sales .................................................................................... Expenses Cost of goods sold ......................................................... Wage expense .................................................................. Other operating expenses............................................ Income tax expense ....................................................... Total expenses ...................................................... Net income..................................................................................... Earnings per share...................................................................... $320,000 120,000 10,000 25,000 475,000 $65,000 $0.65* $540,000 *$65,000 ÷ 100,000 shares. Note: The increase in value of the company reputation and the unrealized gain on the value of patents are not reported. 4-10 BRIEF EXERCISE 4-2 Turner Corporation Income Statement For the Year Ended December 31, 2007 Revenues Net sales .......................................................................... Interest revenue ............................................................ Total revenues...................................................... Expenses Cost of goods sold....................................................... Selling expenses........................................................... Administrative expenses............................................ Interest expense............................................................ Income tax expense* ................................................... Total expenses .................................................... $1,250,000 280,000 212,000 45,000 193,200 1,980,200 $2,400,000 31,000 2,431,000 Net income................................................................................. $ 450,800 Earnings per share** .............................................................. $6.44 *($2,431,000 – $1,250,000 – $280,000 – $212,000 – $45,000) X 30% = $193,200. **$450,800 ÷ 70,000 shares. 4-11 BRIEF EXERCISE 4-3 Turner Corporation Income Statement For the Year Ended December 31, 2007 Net sales ........................................................................... Cost of goods sold........................................................ Gross profit ......................................................... Selling expenses............................................................ Administrative expenses ............................................ Income from operations .............................................. Other revenue and gains Interest revenue................................................. Other expenses and losses Interest expense ................................................ Income before income tax .......................................... Income tax........................................................................ Net income....................................................................... Earnings per share........................................................ 45,000 14,000 644,000 193,200 $ 450,800 $6.44* 31,000 $280,000 212,000 492,000 658,000 $2,400,000 1,250,000 1,150,000 *$450,800 ÷ 70,000 shares. 4-12 BRIEF EXERCISE 4-4 Income from continuing operations Discontinued operations Loss from operation of discontinued restaurant division (net of tax) Loss from disposal of restaurant division (net of tax) Net income Earnings per share Income from continuing operations Discontinued operations, net of tax Net income *Rounded BRIEF EXERCISE 4-5 189,000 $315,000 $12,600,000 504,000 $12,096,000 $1.26 (.05)* $1.21 Income before income tax and extraordinary item Income tax Income before extraordinary item Extraordinary item—loss from casualty Less: Applicable income tax Net income Earnings per share Income before extraordinary item Extraordinary loss, net of tax Net income *Rounded $1.02* (.11)* $ .91 $770,000 231,000 539,000 $4,571,000 $7,300,000 2,190,000 5,110,000 4-13 BRIEF EXERCISE 4-6 2007 Income before income tax Income tax (30%) Net Income $190,000 57,000 $133,000 2006 $145,000 43,500 $101,500 2005 $170,000 51,000 $119,000 BRIEF EXERCISE 4-7 Kingston would not report any cumulative effect because a change in estimate is not handled retroactively. Kingston would report bad debt expense of $120,000 in 2007. BRIEF EXERCISE 4-8 $1,200,000 – $250,000 190,000 = $5.00 per share 4-14 BRIEF EXERCISE 4-9 Lincoln Corporation Retained Earnings Statement For the Year Ended December 31, 2007 Retained earnings, January 1 ................................................. Add: Net income.......................................................................... Less: Cash dividends ................................................................ Retained earnings, December 31........................................... $ 675,000 2,400,000 3,075,000 75,000 $3,000,000 BRIEF EXERCISE 4-10 Lincoln Corporation Retained Earnings Statement For the Year Ended December 31, 2007 Retained earnings, January 1, as reported ........................ Correction for overstatement of expenses in prior period (net of tax)................................................. Retained earnings, January 1, as adjusted ........................ Add: Net income.......................................................................... Less: Cash dividends ................................................................ Retained earnings, December 31........................................... $ 675,000 80,000 755,000 2,400,000 3,155,000 75,000 $3,080,000 4-15 BRIEF EXERCISE 4-11 (a) (b) Net income (Dividend revenue) Net income Unrealized holding gain Comprehensive income $3,000 $3,000 5,000 $8,000 (c) Unrealized holding gain (Other comprehensive income) $5,000 (d) Accumulated other comprehensive income, January 1, 2007 Unrealized holding gain Accumulated other comprehensive income, December 31, 2007 $ 0 5,000 $5,000 4-16 SOLUTIONS TO EXERCISES EXERCISE 4-1 (18–20 minutes) Computation of net income Change in assets: Change in liabilities: Change in stockholders’ equity: Change in stockholders’ equity accounted for as follows: Net increase Increase in common stock Increase in additional paid-in capital Decrease in retained earnings due to dividend declaration Net increase accounted for Increase in retained earnings due to net income $ 54,000 $125,000 13,000 (19,000) 119,000 $173,000 $79,000 + $45,000 + $127,000 – $47,000 = $204,000 Increase $ 82,000 – $51,000 = 31,000 Increase $173,000 Increase 4-17 EXERCISE 4-2 (25–35 minutes) (a) Total net revenue: Sales Less: Sales discounts Sales returns Net sales Dividend revenue Rental revenue Total net revenue (b) Net income: Total net revenue (from a) Expenses: Cost of goods sold Selling expenses Administrative expenses Interest expense Total expenses Income before income tax Income tax Net income (c) Dividends declared: Ending retained earnings Beginning retained earnings Net increase Less: Net income Dividends declared 184,400 99,400 82,500 12,700 379,000 68,300 31,000 $ 37,300 $447,300 $390,000 $ 7,800 12,400 20,200 369,800 71,000 6,500 $447,300 $134,000 114,400 19,600 (37,300) $ 17,700 4-18 EXERCISE 4-2 (Continued) ALTERNATE SOLUTION Beginning retained earnings Add: Net income Less: Dividends declared Ending retained earnings $114,400 37,300 151,700 ? $134,000 Dividends declared must be $17,700 ($151,700 – $134,000) EXERCISE 4-3 (20–25 minutes) LeRoi Jones Inc. Income Statement For Year Ended December 31, 2007 Revenues Net sales ($1,250,000(b) – $17,000)............................ Expenses Cost of goods sold........................................................ Selling expenses............................................................ Administrative expenses............................................. Interest expense............................................................. Total expenses ..................................................... Income before income tax....................................................... Income tax........................................................................ Net income .................................................................................. Earnings per share .................................................................... *Rounded 4-19 $1,233,000 500,000 400,000(c) 100,000(a) 20,000 1,020,000 213,000 63,900 $ 149,100 $ 7.46* EXERCISE 4-3 (Continued) Determination of amounts (a) Administrative expenses = 20% of cost of good sold = 20% of $500,000 = $100,000 (b) Gross sales X 8% = administrative expenses = $100,000 ÷ 8% = $1,250,000 (c) Selling expenses = four times administrative expenses. (operating expenses consist of selling and administrative expenses; since selling expenses are 4/5 of operating expenses, selling expenses are 4 times administrative expenses.) = 4 X $100,000 = $400,000 Earnings per share $7.46 ($149,100 ÷ 20,000) Note: An alternative income statement format is to show income tax a part of expenses, and not as a separate item. In this case, total expenses are $1,083,900. 4-20 EXERCISE 4-4 (30–35 minutes) (a) Multiple-Step Form P. Bride Company Income Statement For the Year Ended December 31, 2007 (In thousands, except earnings per share) $96,500 60,570 35,930 Sales.............................................................................. Cost of goods sold ................................................... Gross profit on sales ............................................... Operating Expenses Selling expenses Sales commissions..................................... Depr. of sales equipment.......................... Transportation-out...................................... Administrative expenses Officers’ salaries.......................................... Depr. of office furn. and equip................ Income from operations..................... Other Revenues and Gains Rental revenue .................................................... Other Expenses and Losses Interest expense ................................................. Income before income tax...................................... Income tax ............................................................ Net income .................................................................. Earnings per share ($16,220 ÷ 40,550) ............... $7,980 6,480 2,690 4,900 3,960 $17,150 8,860 26,010 9,920 17,230 27,150 1,860 25,290 9,070 $16,220 $.40 4-21 EXERCISE 4-4 (Continued) (b) Single-Step Form P. Bride Company Income Statement For the Year Ended December 31, 2007 (In thousands, except earnings per share) Revenues Net sales ...................................................................................... Rental revenue........................................................................... Total revenues .................................................................... Expenses Cost of goods sold................................................................... Selling expenses....................................................................... Administrative expenses........................................................ Interest expense........................................................................ Total expenses.................................................................... Income before income tax ............................................................ Income tax.......................................................................................... Net income .................................................................................. Earnings per share.......................................................................... $ 96,500 17,230 113,730 60,570 17,150 8,860 1,860 88,440 25,290 9,070 $ 16,220 $.40 Note: An alternative income statement format for the single-step form is to show income tax a part of expenses, and not as a separate item. (c) Single-step: 1. Simplicity and conciseness. 2. Probably better understood by users. 3. Emphasis on total costs and expenses and net income. 4. Does not imply priority of one revenue or expense over another. 4-22 EXERCISE 4-4 (Continued) Multiple-step: 1. Provides more information through segregation of operating and nonoperating items. 2. Expenses are matched with related revenue. Note to instructor: Students’ answers will vary due to the nature of the question; i.e., it asks for an opinion. However, the discussion supporting the answer should include the above points. EXERCISE 4-5 (30–35 minutes) Maria Conchita Alonzo Corp. Income Statement For the Year Ended December 31, 2007 Sales Revenue Sales ..................................................................................... Less: Sales returns and allowances.......................... Sales discounts.................................................... Net sales revenue............................................................. Cost of goods sold .......................................................... Gross profit on sales ............................................................. Operating Expenses Selling expenses .......................................................... Admin. and general expenses ................................. Income from operations........................................................ 194,000 97,000 291,000 273,000 $150,000 45,000 $1,380,000 195,000 1,185,000 621,000 564,000 4-23 EXERCISE 4-5 (Continued) Other Revenues and Gains Interest revenue .................................................................. Other Expenses and Losses Interest expense ................................................................. Income before tax and extraordinary item.......................... Income tax ($299,000 X .34) ............................................ Income before extraordinary item.......................................... Extraordinary item—loss from earthquake damage ............ Less: Applicable tax reduction ($150,000 X .34)........... Net income..................................................................................... Per share of common stock: Income before extraordinary item ($197,340 ÷ 100,000) ...................................................... Extraordinary item (net of tax) ....................................... Net income ($98,340 ÷ 100,000) ..................................... *Rounded $1.97* (.99) $ .98 150,000 51,000 $ 99,000 98,340 60,000 299,000 101,660 197,340 86,000 359,000 4-24 EXERCISE 4-6 (30–40 minutes) (a) Multiple-Step Form Whitney Houston Shoe Co. Income Statement For the Year Ended December 31, 2007 $980,000 496,000 484,000 Net sales.................................................................. Cost of goods sold .............................................. Gross profit on sales .......................................... Operating Expenses Selling expenses Wages and salaries................................ $114,800 Depr. exp. (70% X $65,000).................. 45,500 Materials and supplies.......................... 17,600 Administrative expenses Wages and salaries................................ 135,900 51,700 Other admin. expenses ........................ Depr. exp. (30% X $65,000).................. Income from operations..................................... Other Revenues and Gains Rental revenue ............................................... Other Expenses and Losses Interest expense ............................................ Income before income tax................................. Income tax ....................................................... Net income ............................................................. Earnings per share ($72,600 ÷ 20,000) .......... 19,500 $177,900 207,100 385,000 99,000 29,000 128,000 18,000 110,000 37,400 $ 72,600 $3.63 4-25 EXERCISE 4-6 (Continued) (b) Single-Step Form Whitney Houston Shoe Co. Income Statement For the Year Ended December 31, 2007 Revenues Net sales ...................................................................................... Rental revenue........................................................................... Total revenues .................................................................... Expenses Cost of goods sold................................................................... Selling expenses....................................................................... Administrative expenses ....................................................... Interest expense........................................................................ Total expenses ................................................................... Income before income tax ............................................................ Income tax................................................................................... Net income......................................................................................... Earnings per share ($72,600 ÷ 20,000) ..................................... $ 980,000 29,000 1,009,000 496,000 177,900 207,100 18,000 899,000 110,000 37,400 $ 72,600 $3.63 Note: An alternative income statement format for the single-step form is to show income tax as part of expense, and not as a separate item. (c) Single-step: 1. Simplicity and conciseness. 2. Probably better understood by users. 3. Emphasis on total costs and expenses and net income. 4. Does not imply priority of one revenue or expense over another. 4-26 EXERCISE 4-6 (Continued) Multiple-step: 1. Provides more information through segregation of operating and nonoperating items. 2. Expenses are matched with related revenue. Note to instructor: Students’ answers will vary due to the nature of the question, i.e., it asks for an opinion. However, the discussion supporting the answer should include the above points. EXERCISE 4-7 (15–20 minutes) (a) Net sales Less: Cost of goods sold Administrative expenses Selling expenses Discontinued operations-loss Income before income tax Income tax ($110,000 X .30) Net income (b) Income from continuing operations before income tax Income tax ($150,000 X .30) Income from continuing operations Discontinued operations, less applicable income tax of $12,000 Net income *$110,000 + $40,000 Earnings per share: Income from continuing operations ($105,000 ÷ 10,000) Loss on discontinued operations, net of tax Net Income ($77,000 ÷ 10,000) $ 540,000 (210,000) (100,000) (80,000) (40,000) 110,000 33,000 $ 77,000 $150,000* 45,000 105,000 (28,000) $ 77,000 $10.50 (2.80) $ 7.70 4-27 EXERCISE 4-8 (30–35 minutes) (a) Ivan Calderon Corp. Income Statement For the Year Ended December 31, 2007 Sales Revenue Net sales ................................................................................ Cost of goods sold............................................................. Gross profit on sales ............................................ Operating Expenses Selling expenses ........................................................... $65,000 Administrative expenses ............................................ 48,000 Income from operations .......................................................... Other Revenues and Gains Dividend revenue .......................................................... Interest revenue............................................................. Other Expenses and Losses Write-off of inventory due to obsolescence............... Income before income tax and extraordinary item............... Income tax ....................................................................... Income before extraordinary item........................................ Extraordinary item Casualty loss........................................................ Less: Applicable tax reduction ...................... Net income................................................................................... Per share of common stock: Income before extraordinary item ($233,640 ÷ 60,000) ................................................... Extraordinary item, net of tax.................................... Net income ($200,640 ÷ 60,000)................................ *Rounded 4-28 $1,300,000 780,000 520,000 113,000 407,000 20,000 7,000 27,000 434,000 80,000 354,000 120,360 233,640 50,000 17,000 33,000 $ 200,640 $3.89* (.55) $3.34 EXERCISE 4-8 (Continued) (b) Ivan Calderon Corp. Retained Earnings Statement For the Year Ended December 31, 2007 Retained earnings, Jan. 1, as reported.............................................. Correction for overstatement of net income in prior period (depreciation error) (net of $18,700 tax)................................ Retained earnings, Jan. 1, as adjusted.............................................. Add: Net income........................................................................................ Less: Dividends declared....................................................................... Retained earnings, Dec. 31 .................................................................... $ 980,000 (36,300) 943,700 200,640 1,144,340 45,000 $1,099,340 EXERCISE 4-9 (20–25 minutes) Computation of net income: 2007 net income after tax ...................................... 2007 net income before tax [$33,000,000 ÷ (1 – .34)] ..................................... Add back major casualty loss.............................. Income from operations.................................. Income taxes (34% X $68,000,000) ..................... Income before extraordinary item ...................... Extraordinary item: Casualty loss ...................................................... $18,000,000 Less: Applicable income tax reduction ......... Net income.................................................................. 6,120,000 11,880,000 $33,000,000 50,000,000 18,000,000 68,000,000 23,120,000 44,880,000 $33,000,000 4-29 EXERCISE 4-9 (Continued) Net income......................................................................................... Less: Provision for preferred dividends (8% of $4,500,000) ................................................................ Income available to common stockholders..................... Common stock shares............................................................ Earnings per share................................................................... Income statement presentation Per share of common stock: Income before extraordinary item................................ Extraordinary item, net of tax ........................................ Net income ........................................................................... $4.45a (1.19)b $3.26 $33,000,000 360,000 32,640,000 ÷10,000,000 $3.26* a $44,880,000 – $360,000 10,000,000 b = $4.45* $11,880,000 10,000,000 = $1.19* *Rounded 4-30 EXERCISE 4-10 (20–25 minutes) Spock Corporation Income Statement For the Year Ended December 31, 2007 Net sales(a)............................................................................ Cost of goods sold(b) ........................................................ Gross profit .................................................................. Selling expenses(c) ............................................................ Administrative expenses(d) ............................................. Income from operations........................................... Other revenue..................................................................... Other expense .................................................................... Income before income tax.............................................. Income tax ($434,000 X .34) .................................... Income before extraordinary item ............................... Extraordinary loss ............................................................ Less: Applicable income tax .................................. Net income .......................................................................... $4,162,000 2,665,000 1,497,000 $636,000 491,000 240,000 (176,000) 1,127,000 370,000 64,000 434,000 147,560 286,440 46,200 $ 240,240 $ 70,000 23,800 Earnings per share ($900,000 ÷ $10 par value = 90,000 shares) Income before extraordinary item ($286,440 ÷ 90,000)............ Extraordinary item, net of tax........................................................... Net income.............................................................................................. *Rounded Supporting computations (a) Net sales: $4,275,000 – $34,000 – $79,000 = $4,162,000 $3.18* (.51)* $2.67 (b) Cost of goods sold: $535,000 + ($2,786,000 + $72,000 – $27,000 – $15,000) – $686,000 = $2,665,000 (c) Selling expenses: $284,000 + $83,000 + $69,000 + $54,000 + $93,000 + $36,000 + $17,000 = $636,000 (d) Administrative expenses: $346,000 + $33,000 + $24,000 + $48,000 + $32,000 + $8,000 = $491,000 4-31 EXERCISE 4-11 (20–25 minutes) (a) Eddie Zambrano Corporation Retained Earnings Statement For the Year Ended December 31, 2007 $225,000* (15,000) (21,000) 189,000 144,000** 333,000 100,000 $233,000 Balance, January 1, as reported...................................................... Correction for depreciation error (net of $10,000 tax).............. Cumulative decrease in income from change in inventory methods (net of $14,000 tax) ............................ Balance, January 1, as adjusted...................................................... Add: Net income ................................................................................... Less: Dividends declared .................................................................. Balance, December 31 ........................................................................ *($40,000 + $125,000 + $160,000) – ($50,000 + $50,000) **[$240,000 – (40% X $240,000)] (b) Total retained earnings would still be reported as $233,000. A restriction does not affect total retained earnings; it merely labels part of the retained earnings as being unavailable for dividend distribution. Retained earnings would be reported as follows: Retained earnings: Appropriated Unappropriated Total $ 70,000 163,000 $233,000 4-32 EXERCISE 4-12 (15–20 minutes) Net income: Income from continuing operations before income tax.................................................. Income tax (35% X $23,650,000)............................ Income from continuing operations .................... Discontinued operations Loss before income tax..................................... $3,225,000 Less: Applicable income tax (35%) ............... Net income.................................................................... Preferred dividends declared: ...................................... Weighted average common shares outstanding........ Earnings per share Income from continuing operations .................... Discontinued operations, net of tax..................... Net income.................................................................... *($15,372,500 – $1,075,000) ÷ 4,000,000. (Rounded) **$2,096,250 ÷ 4,000,000. (Rounded) ***($13,276,250 – $1,075,000) ÷ 4,000,000. 1,128,750 2,096,250 $13,276,250 $ 1,075,000 4,000,000 $23,650,000 8,277,500 15,372,500 $3.57* (.52)** $3.05*** 4-33 EXERCISE 4-13 (15–20 minutes) (a) Income before income tax Income tax (35%) Net Income (b) Cumulative effect for years prior to 2007. Weighted Average $370,000 390,000 Tax Rate (35%) Net Effect FIFO Difference $395,000 $25,000 430,000 40,000 Total $65,000 $22,750 $42,250 2007 2006 2005 $450,000 $430,000 $395,000 157,500 150,500 138,250 $292,500 $279,500 $256,750 2007 $450,000 157,500 $292,500 Year 2005 2006 (c) Income before income tax Income tax (35%) Net income EXERCISE 4-14 (15–20 minutes) Roxanne Carter Corporation Income Statement and Comprehensive Income Statement For the Year Ended December 31, 2007 Sales ........................................................................................................ Cost of goods sold.............................................................................. Gross profit ........................................................................................... Selling and administrative expenses............................................ Net income............................................................................................. Net income............................................................................................. Unrealized holding gain .................................................................... Comprehensive income .................................................................... $1,200,000 750,000 450,000 320,000 $ 130,000 $ 130,000 18,000 $ 148,000 4-34 EXERCISE 4-15 (15–20 minutes) C. Reither Co. Statement of Stockholders’ Equity For the Year Ended December 31, 2007 Accumulated Comprehensive Total Beginning balance Comprehensive income Net income* Other comprehensive income Unrealized holding loss Comprehensive income Dividends Ending balance (10,000) $570,000 (60,000) (60,000) $ 60,000 (10,000) $200,000 $20,000 $350,000 (60,000) 120,000 $120,000 120,000 $520,000 Income Retained Earnings $ 90,000 Other Comprehensive Income $80,000 Common Stock $350,000 *($700,000 – $500,000 – $80,000). EXERCISE 4-16 (30–35 minutes) (a) Roland Carlson Inc. Income Statement For the Year Ended December 31, 2007 Revenues Sales.......................................................................................................... Rent revenue........................................................................................... Total revenues ........................................................................... Expenses Cost of goods sold................................................................... Selling expenses....................................................................... Administrative expenses........................................................ Total expenses ................................................................ 4-35 $1,900,000 40,000 1,940,000 850,000 300,000 240,000 $1,390,000 EXERCISE 4-16 (Continued) Income from continuing operations before income tax.............................................................................. Income tax........................................................................ Income from continuing operations................................... Discontinued operations Loss on discontinued operations ............................ Less: Applicable income tax reduction.................. Income before extraordinary items .................................... Extraordinary items: Extraordinary gain......................................................... Less: Applicable income tax...................................... Extraordinary loss ......................................................... Less: Applicable income tax reduction.................. Net income.................................................................................. 550,000 187,000 363,000 $75,000 25,500 49,500 313,500 95,000 32,300 60,000 20,400 62,700 376,200 39,600 $ 336,600 Per share of common stock: Income from continuing operations ($363,000 ÷ 100,000) ......... Loss on discontinued operations, net of tax............................ Income before extraordinary items ($313,500 ÷ 100,000)........... Extraordinary gain, net of tax ........................................................ Extraordinary loss, net of tax ........................................................ Net income ($336,600 ÷ 100,000) ................................................. (b) Roland Carlson Inc. Retained Earnings Statement For the Year Ended December 31, 2007 $3.63 (.49) 3.14 .63 (.40) $3.37 Retained earnings, January 1................................................................... Add: Net income ........................................................................................... Less: Dividends declared .......................................................................... Retained earnings, December 31 ............................................................ $600,000 336,600 $936,600 150,000 $786,600 4-36 EXERCISE 4-16 (Continued) (c) Roland Carlson Inc. Comprehensive Income Statement For the Year Ended December 31, 2007 Net income ............................................................................................ Other comprehensive income Unrealized holding gain ............................................................. Comprehensive income .................................................................... 15,000 $351,600 $336,600 4-37 TIME AND PURPOSE OF PROBLEMS Problem 4-1 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to prepare an income statement and a retained earnings statement. A number of special items such as loss from discontinued operations, unusual items, and ordinary gains and losses are presented in the problem for analysis purposes. Problem 4-2 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to prepare a single-step income statement and a retained earnings statement. The student must determine through analysis the ending balance in retained earnings. Problem 4-3 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to analyze a number of transactions and to prepare a partial income statement. The problem includes discontinued operations, an extraordinary item, and the cumulative effect of a change in accounting principle. Problem 4-4 (Time 45–55 minutes) Purpose—to provide the student with the opportunity to prepare a multiple-step and single-step income statement and a retained earnings statement from the same underlying information. A substantial number of operating expenses must be reported in this problem unlike Problem 4-1. As a consequence, the problem is time-consuming and emphasizes the differences between the multiple-step and singlestep income statement. Problem 4-5 (Time 20–25 minutes) Purpose—to provide the student with a problem on the income statement treatment of (1) a usual but infrequently occurring charge, (2) an extraordinary item and its related tax effect, (3) a correction of an error, and (4) earnings per share. The student is required not only to identify the proper income statement treatment but also to provide the rationale for such treatment. Problem 4-6 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to prepare a retained earnings statement. A number of special items must be reclassified and reported in the income statement. This problem illustrates the fact that ending retained earnings is unaffected by the choice of disclosing items in the income statement or the retained earnings statement, although the income reported would be different. Problem 4-7 (Time 25–35 minutes) Purpose—to provide the student with a problem to determine the reporting of several items, which may get special treatment as irregular items. This is a good problem for a group assignment. 4-38 SOLUTIONS TO PROBLEMS PROBLEM 4-1 American Horse Company Income Statement For the Year Ended December 31, 2007 Sales........................................................................................ Cost of goods sold ............................................................. Gross profit ........................................................................... Selling and administrative expenses ........................... Income from operations.................................................... Other revenues and gains Interest revenue ...................................................... Gain on the sale of investments ........................ Other expenses and losses Write-off of goodwill .............................................. Income from continuing operations before income tax......................................................................... Income tax ............................................................................. Income from continuing operations ............................. Discontinued operations Loss on operations, net of tax ........................... Loss on disposal, net of tax................................ Income before extraordinary item ................................. Extraordinary item—loss from flood damage, net of tax............................................................................ Net income ............................................................................ $ 90,000 440,000 530,000 1,225,000 390,000 835,000 2,660,000 905,000 1,755,000 820,000 $ 70,000 110,000 180,000 $25,000,000 17,000,000 8,000,000 4,700,000 3,300,000 4-39 PROBLEM 4-1 (Continued) Earnings per share: Income from continuing operations ......................... Discontinued operations Loss on operations, net of tax......................... Loss on disposal, net of tax ............................. Income before extraordinary item............................. Extraordinary loss, net of tax ..................................... Net income ........................................................................ $( .30) (1.47) (1.77) 3.85b (1.30) $ 2.55c $ 5.62a American Horse Company Retained Earnings Statement For the Year Ended December 31, 2007 Retained earnings, January 1....................................... Add: Net income ............................................................... Less: Dividends Preferred stock...................................................... Common stock ...................................................... Retained earnings, December 31 ................................ 980,000 835,000 1,815,000 $ 70,000 250,000 320,000 $ 1,495,000 a $1,755,000 – $70,000 300,000 shares = $5.62 b $1,225,000 – $70,000 300,000 shares = $3.85 c $835,000 – $70,000 300,000 shares = $2.55 4-40 PROBLEM 4-2 Mary J. Blige Corporation Income Statement For the Year Ended December 31, 2007 Revenues Net sales ($1,000,000 – $14,500 – $17,500)........... Gain on sale of land ................................................. Rent revenue .............................................................. Total revenues ................................................ Expenses Cost of goods sold* ................................................. Selling expenses....................................................... Administrative expenses........................................ Total expenses................................................ Income before income tax.................................................. Income tax................................................................... Net income (per common share $2.05) .......................... Earnings per share ($61,500 ÷ 30,000) ........................... *Cost of goods sold: Merchandise inventory, Jan. 1.................................... Purchases .......................................................................... $610,000 Less: Purchase discounts............................................ 10,000 Net purchases .................................................................. 600,000 Add: Freight-in ................................................................. 20,000 Merchandise available for sale ................................... Less: Merchandise inventory, Dec. 31 ..................... Cost of goods sold ...................................................... 4-41 $ 968,000 30,000 18,000 1,016,000 585,000 232,000 99,000 916,000 100,000 38,500 $ 61,500 $2.05 $ 89,000 620,000 709,000 124,000 $585,000 PROBLEM 4-2 (Continued) Mary J. Blige Corporation Retained Earnings Statement For the Year Ended December 31, 2007 Retained earnings, January 1....................................................... Add: Net income ............................................................................... Less: Cash dividends...................................................................... Retained earnings, December 31 ................................................ $260,000 61,500 321,500 45,000 $276,500 4-42 PROBLEM 4-3 Tony Rich Inc. Income Statement (Partial) For the Year Ended December 31, 2007 Income from continuing operations before income tax ...................................................... Income tax.................................................................... Income from continuing operations ................................ Discontinued operations Loss from disposal of recreational division .......... $115,000 Less: Applicable income tax reduction.............. Income before extraordinary item .................................... Extraordinary item: Major casualty loss ................................................... Less: Applicable income tax reduction.............. Net income ............................................................................... 80,000 36,800 43,200 $454,450 34,500 80,500 497,650 $798,500* 220,350** 578,150 Per share of common stock: Income from continuing operations.................... Discontinued operations, net of tax .................... Income before extraordinary items ..................... Extraordinary item, net of tax ................................ Net income ($454,450 ÷ 80,000)............................. *Rounded $7.23* (1.01)* 6.22 (.54) $5.68 4-43 PROBLEM 4-3 (Continued) *Computation of income from cont. operations before taxes: As previously stated Loss on sale of securities Gain on proceeds of life insurance policy ($110,000 – $46,000) Error in computation of depreciation As computed ($54,000 ÷ 6) Corrected ($54,000 – $9,000) ÷ 6 As restated $9,000 (7,500) 1,500 $798,500 $790,000 (57,000) 64,000 **Computation of income tax: Income from continuing operations before taxes Nontaxable income (gain on life insurance) Taxable income Tax rate Income tax expense $798,500 (64,000) 734,500 X .30 $220,350 Note: No adjustment is needed for the inventory method change, since the new method is reported in 2007 income. The cumulative effect on prior years of retroactive application of new inventory method will be recorded in retained earnings. 4-44 PROBLEM 4-4 (a) J. R. Reid Corporation Income Statement For the Year Ended June 30, 2007 Sales Revenue Sales ............................................................................... Less: Sales discounts .............................................. Sales returns................................................... Net sales........................................................................ Cost of goods sold ........................................................... Gross profit ......................................................................... Operating Expenses Selling expenses Sales commissions............................ $97,600 Sales salaries....................................... 56,260 Travel expense .................................... 28,930 Entertainment expense..................... 14,820 Freight-out ............................................ 21,400 Telephone and internet exp. .......... 9,030 Depr. of sales equipment ................. 4,980 Building expense................................ 6,200 Bad debt expense............................... 4,850 Misc. selling expense........................ 4,715 $1,678,500 $31,150 62,300 93,450 1,585,050 896,770 688,280 248,785 4-45 PROBLEM 4-4 (Continued) Administrative Expenses Real estate and other local taxes .......... Building expense ........................................ Depreciation of office furniture and equipment ...................... Office supplies used.................................. Telephone and internet expense ........... Miscellaneous office expenses.............. Income from operations .................................. Other Revenues and Gains Dividend revenue........................................ Other Expenses and Losses Bond interest expense.............................. Income before income tax .............................. Income tax..................................................... Net income........................................................... Earnings per common share [($290,525 – $9,000) ÷ 80,000]................. *Rounded 7,320 9,130 7,250 3,450 2,820 6,000 35,970 284,755 403,525 38,000 441,525 18,000 423,525 133,000 $ 290,525 $3.52* 4-46 PROBLEM 4-4 (Continued) J. R. Reid Corporation Retained Earnings Statement For the Year Ended June 30, 2007 Retained earnings, July 1, 2006, as reported .................. Correction of depreciation understatement, net of tax ........ Retained earnings, July 1, 2006, as adjusted .................. Add: Net income........................................................................ Less: Dividends declared on preferred stock ...................... Dividends declared on common stock ....................... Retained earnings, June 30, 2007........................................ 9,000 32,000 41,000 $568,825 $337,000 17,700 319,300 290,525 609,825 4-47 PROBLEM 4-4 (Continued) (b) J. R. Reid Corporation Income Statement For the Year Ended June 30, 2007 Revenues Net sales.................................................................................... Dividend revenue ................................................................... Total revenues .............................................................. Expenses Cost of goods sold ................................................................ Selling expenses .................................................................... Administrative expenses ..................................................... Bond interest expense ......................................................... Total expenses ............................................................. Income before income tax ............................................................... Income tax ................................................................................ Net income............................................................................................ Earnings per common share .......................................................... 896,770 248,785 35,970 18,000 1,199,525 423,525 133,000 $ 290,525 $3.52 $1,585,050 38,000 1,623,050 4-48 PROBLEM 4-4 (Continued) J. R. Reid Corporation Retained Earnings Statement For the Year Ended June 30, 2007 Retained earnings, July 1, 2006, as reported ................ Correction of depreciation understatement (net of tax) ............................................................................. Retained earnings, July 1, 2006 as adjusted ................. Add: Net income...................................................................... Less: Dividends declared on preferred stock............... Dividends declared on common stock................ Retained earnings, June 30, 2007...................................... 9,000 32,000 41,000 $568,825 $337,000 17,700 $319,300 290,525 609,825 4-49 PROBLEM 4-5 1. The usual but infrequently occurring charge of $10,500,000 should be disclosed separately, assuming it is material. This charge is shown above income before extraordinary items and would not be reported net of tax. This item should be separately disclosed to inform the users of the financial statements that this item is nonrecurring and therefore may not impact next year’s results. Furthermore, trend comparisons may be misleading if such an item is not highlighted and adjustments made. The item should not be considered extraordinary because it is usual in nature. The extraordinary item of $9,000,000 should be reported net of tax in a separate section for extraordinary items. An adjustment should be made to income taxes to report this amount at $22,400,000. The $3,000,000 tax effect of this extraordinary item should be reported with the extraordinary item. The reason for the separate disclosure is much the same as that given above for the separate disclosure of the usual, but infrequently occurring item. Readers must be informed that certain revenue and expense items may be unusual and infrequent, and that their likelihood for affecting operations again in the future is unlikely. The adjustment required for correction of an error is inappropriately labeled and also should not be reported in the retained earnings statement. Changes in estimate should be handled in current and future periods through the income statement. Catch-up adjustments are not permitted. To restate financial statements every time a change in estimate occurred would be extremely costly. In addition, adjusting the beginning balance of retained earnings is inappropriate as the increased charge in this case affects current and future income statements. 2. 3. 4-50 PROBLEM 4-5 (Continued) 4. Earnings per share should be reported on the face of the income statement and not in the notes to the financial statements. Because such importance is ascribed to this statistic, the profession believes it necessary to highlight the earnings per share figure. In this case the company should report both income before extraordinary item and net income on a per share basis. 4-51 PROBLEM 4-6 (a) LeClair Corp. Retained Earnings Statement For the Year Ended December 31, 2007 Retained earnings, January 1, as reported......................................... Correction of error from prior period (net of tax) ............................. Adjust for change in accounting principle (net of tax) ................... Retained earnings, January 1, as adjusted......................................... Add: Net income .......................................................................................... Less: Cash dividends declared .............................................................. Retained earnings, December 31 ........................................................... *$62,300 = ($84,500 + $41,200 + $21,600 – $25,000 – $60,000) $257,600 25,400 (18,200) 264,800 62,300* 32,000 $295,100 (b) 1. Gain on sale of investments—body of income statement. This gain should not be shown net of tax on the income statement. 2. Refund on litigation with government—body of income statement, possibly unusual item. This refund should not be shown net of tax on the income statement. 3. Loss on discontinued operations—body of the income statement, following the caption, “Income from continuing operations.” 4. Write-off of goodwill—body of income statement, possibly unusual item. The write-off should not be shown net of tax on the income statement. 4-52 PROBLEM 4-7 Rap Corp. Income Statement (Partial) For the Year Ended December 31, 2007 Income from continuing operations before income tax ........................................ Income tax ............................................... Income from continuing operations .......... Discontinued operations Loss from operations of discontinued subsidiary................. $ 90,000 Less: Applicable income tax reduction ............................. Loss from disposal of subsidiary......... Less: Applicable income tax reduction ............................. Income before extraordinary item .............. Extraordinary item: Gain on condemnation ........................ Less: Applicable income tax ............. Net income ......................................................... Per share of common stock: Income from continuing operations ......................................... Discontinued operations, net of tax.......................................... Income before extraordinary item ............................................. Extraordinary item, net of tax...................................................... Net income ($716,920 ÷ 100,000)................................................ *Rounded 4-53 $1,206,000* 458,280** 747,720 34,200 100,000 38,000 $ 55,800 62,000 117,800 629,920 145,000 58,000 87,000 $ 716,920 $7.48* (1.18)* 6.30 .87 $7.17 PROBLEM 4-7 (Continued) *Computation of income from continuing operations before income tax: As previously stated Loss on sale of equipment [$40,000 – ($80,000 – $36,000)] Restated $1,210,000 (4,000) $1,206,000 **Computation of income tax expense: $1,206,000 X .38 = $458,280 Note: The error related to the intangible asset was correctly charged to retained earnings. 4-54 TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 4-1 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to comment on deficiencies in an income statement format. The student is required to comment on such items as inappropriate heading, incorrect classification of special items, proper net of tax treatment, and presentation of per share data. CA 4-2 (Time 10–15 minutes) Purpose—to provide the student a real company context to identify factors that make income statement information useful. The focus is on overly-aggregated information in a condensed income statement. Additional detail would seem to be warranted either on the face of the statement or with reference to the notes. CA 4-3 (Time 20–25 minutes) Purpose—to provide the student with an understanding of conditions where extraordinary item classification is appropriate. In this case, it should be emphasized that in situations where extraordinary item classification is not permitted, a classification as an unusual item may still be employed. CA 4-4 (Time 20–25 minutes) Purpose—to provide the student an illustration of how earnings can be managed. The case allows students to see the effects of warranty expense timing on the trend of income and illustrates the potential use of accruals to smooth earnings. CA 4-5 (Time 20–25 minutes) Purpose—to provide the student an illustration of how earnings can be managed by how losses are reported, including ethical issues. CA 4-6 (Time 25–30 minutes) Purpose—to provide the student with an unstructured case to comment on the reporting of discontinued operations and extraordinary items. In addition, the student is asked to comment on materiality considerations and earnings per share implications. CA 4-7 (Time 30–40 minutes) Purpose—to provide the student with the opportunity to comment on deficiencies in an income statement. This case includes discussion of extraordinary items, discontinued items, and ordinary gains and losses. The case is complete and therefore provides a broad overview to a number of items discussed in the textbook. CA 4-8 (Time 20–25 minutes) Purpose—to provide the student with a variety of situations involving classification of special items. This case is different from CA 4-7 in that an income statement is not presented. Instead, short factual situations are described. A good comprehensive case for discussing the presentation of special items. CA 4-9 (Time 10–15 minutes) Purpose—to provide the student with an opportunity to show how comprehensive income should be reported. 4-55 SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 4-1 The deficiencies of John Amos Corporation’s income statement are as follows: 1. 2. 3. 4. 5. 6. 7. 8. The heading is inappropriate. The heading should include the name of the company and the period of time for which the income statement is presented. Gain on recovery of insurance proceeds should be classified as an extraordinary item in a separate section of the income statement. Cost of goods sold is usually listed as the first expense, followed by selling, administrative, and other expenses. Advertising expense is a selling expense and should usually be classified as such, unless this expense is unusually different from previous periods. Loss on obsolescence of inventories might be classified as an unusual item and separately disclosed if it is unusual or infrequent but not both. Loss on discontinued operations requires a separate classification after income from continuing operations and before presentation of income before extraordinary items. Intraperiod income tax allocation is required to relate income tax expense to income from continuing operations, loss on discontinued operations, and the extraordinary item. Per share data is a required presentation for income from continuing operations, discontinued operations, income before extraordinary item, extraordinary item, and net income. CA 4-2 (a) The main deficiency in the Boeing income statement is that important information is being aggregated, particularly in the “Costs and expenses” line item. More detail likely could be found in Boeing’s SEC Form 10K. However, the condensed income statement may be the one that investors and creditors rely upon. Also, earnings per share should be reported. Boeing could provide additional details on the expenses included in Costs and expenses on the face of the income statement. Alternatively, the company could provide the information in the notes to the financial statements, which could be referenced on the face of the income statement. (b) CA 4-3 1. 2. 3. 4. 5. Classify as an extraordinary item because the two conditions of an extraordinary item, unusual in nature and infrequent in occurrence, are met. Classify as a loss, but not extraordinary. Such losses would not be considered unusual for a business enterprise. Classify as an extraordinary loss because the two conditions of an extraordinary item, unusual in nature and infrequent in occurrence, are met. Classify as gain or loss, but not extraordinary. Because the company maintains a portfolio of such securities, the gain or loss would not be considered unusual in nature. Classify as a gain or loss, but not extraordinary. Company practices indicate such sales are not unusual or infrequent in occurrence. 4-56 CA 4-3 (Continued) 6. 7. 8. Material losses on extinguishment of debt should not be classified as extraordinary items. Classify as a loss, but not extraordinary. The loss is not an infrequent occurrence taking into account the environment in which the entity operates. Classify as an extraordinary item if the two conditions of an extraordinary item, unusual in nature and infrequent in occurrence, are met. Conditions do not appear met in this case. CA 4-4 (a) Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales before they are complete in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves, which are established, by using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses, and warranty returns. (b) Proposed Accounting Income before warranty expense Warranty expense Income 2004 2005 2006 2007 $43,000 8,000 $35,000 2008 $43,000 2,000 $41,000 $20,000 $25,000 $30,000 Assuming the same income before warranty expense for both 2007 and 2008 and total warranty expense over the 2-year period of $10,000, this proposed accounting results in steadily increasing income over the two-year period. (c) Appropriate Accounting Income before warranty expense Warranty expense Income 2004 2005 2006 2007 $43,000 5,000 $38,000 2008 $43,000 5,000 $38,000 $20,000 $25,000 $30,000 The appropriate accounting would be to record $5,000 of warranty expense in 2007, resulting in income of $38,000. However, with the same amount of warranty expense in 2008, Grace no longer shows an increasing trend in income. Thus, by taking more expense in 2007, Grace can save some income (a classic case of “cookie-jar” reserves) and maintain growth in income. 4-57 CA 4-5 (a) The ethical issues involved are integrity and honesty in financial reporting, full disclosure, accountant’s professionalism, and job security for Arthur. (b) If Arthur believes the losses are relevant information important to users of the income statement, he should disclose the losses separately. If they are considered incidental to the company’s normal activities—i.e., the major activities of the Salem Corporation do not include selling equipment—the transactions should be reported among any gains and losses that occurred during the year. CA 4-6 (a) It appears that the sale of the Casino Royale Division would qualify as a discontinued operation. The operation of gambling facilities appears to meet the criteria for discontinued operations for Woody Allen Corp. and, therefore, the accounting requirements related to discontinued operations should be followed. Although the financial vice-president might be correct theoretically, professional pronouncements require that such a segregation be made. The controller is incorrect in stating that the disposal of the Casino Royale Division should be reported as an extraordinary item. A separate classification is required for disposals meeting the requirements of discontinued operations. If this disposal did not meet the requirements for disposal of a component of a business, extraordinary item treatment might be considered appropriate. (b) The “walkout” or strike should not be reported as an extraordinary item. Events of this nature are a general risk that any business enterprise takes and should not warrant extraordinary item treatment. APB Opinion No. 30 specifically indicates that the effects of a strike should not be reported as an extraordinary item. (c) The financial vice-president is incorrect in his/her observations concerning the materiality of extraordinary items. The materiality of each extraordinary item must be considered individually. It is not appropriate to consider only the materiality of the net effect. Each extraordinary item must be reported separately on the income statement. (d) Earnings per share for income from continuing operations, discontinued operations, income before extraordinary items, extraordinary items, and net income must be reported on the face of the income statement. 4-58 CA 4-7 The income statement of Cynthia Taylor Corporation contains the following weaknesses in classification and disclosure: 1. Sales taxes. Sales taxes have been erroneously included in both gross sales and cost of goods sold on the income statement of Cynthia Taylor Corporation. Failure to deduct these taxes directly from customer billings results in a deceptive inflation of the amount of sales. These taxes should be deducted from gross sales because the corporation acts as an agent in collecting and remitting such taxes to the state government. Purchase discounts. Purchase discounts should not be treated as revenue by being lumped with other revenues such as dividends and interest. A purchase discount is more logically a reduction of the cost of purchases because revenue is not created by purchasing goods and paying for them. In a cash transaction, cost is measured by the amount of the cash consideration. In a credit transaction, however, cost is measured by the amount of cash required to settle immediately the obligation incurred. The discount should reduce the cost of goods sold to the amount of cash that would be required to settle the obligation immediately. Recoveries of amounts written off in prior years. These collections should be credited to the allowance for doubtful accounts unless the direct write-off method was used in accounting for bad debt expense. Generally, the direct write-off method is not allowed. Freight-in and freight-out. Although freight-out is an expense of selling and is therefore reported properly in the statement, freight-in is an inventoriable cost and should have been included in the computation of cost of goods sold. The value assigned to inventory should represent the value of the economic resources given up in obtaining goods and readying them for sale. Loss on discontinued styles. This type of loss, though often substantial, should not be treated as an extraordinary item because it is apparently typical of the customary business activity of the corporation. It should be reported in “Costs and expenses” as an operating expense. Loss on sale of marketable securities. This item should be reported as a separate component of income from continuing operations and not as an extraordinary item. The conditions of unusual in nature and infrequent in occurrence are not met. Loss on sale of warehouse. This type of item is specifically excluded by APB Opinion No. 30 from treatment as an extraordinary item unless such a loss is the direct result of a major casualty, an expropriation, or a prohibition under a newly enacted law or regulation. This item should be separately disclosed as an unusual item, if either unusual in nature or infrequent in occurrence. Federal Income taxes. The provision for federal income taxes and intraperiod tax allocation are not presented in the income statement. 2. 3. 4. 5. 6. 7. 8. This omission implies that the federal income tax is a distribution of net income instead of an operating expense and a determinant of net income. This assumption is not as relevant to the majority of financial statement users as the concept of net income to investors, stockholders, or residual equity holders. Also, by law the corporation must pay federal income taxes whether the benefits it receives from the government are direct or indirect. Finally, those who base their decisions upon financial statements are thought to look to net income as being a more relevant measure of income than income before taxes. 4-59 CA 4-8 Classification 1. No disclosure. Rationale Error has “washed out”; that is, subsequent income statement compensated for the error. However, prior year income statements should be restated. Material, unusual in nature, and infrequent in occurrence. Material item, but change in estimated useful life is considered part of normal business activity. Change in estimate, considered part of normal business activity. Sale does not meet criteria for either the disposal of a component of the business or an extraordinary item. A change in inventory methods is a change in accounting principle and prior periods are adjusted. Loss on preparation of such proposals is not considered extraordinary in nature. Strikes are not considered extraordinary in nature. Corrections of errors are shown as prior period adjustments. Material, unusual in nature, and infrequent in occurrence. Division’s assets, results of operations, and activities are clearly distinguishable physically, operationally, and for financial reporting purposes. 2. 3. 4. 5. Extraordinary item section. Depreciation expense in body of income statement, based on new useful life. No separate disclosure unless material. Reported in body of the income statement, possibly as an unusual item. Adjustment to the beginning balance of retained earnings. Reported in body of the income statement, possibly as an unusual item. Reported in body of the income statement, possibly as an unusual item. Prior period adjustment, adjust beginning retained earnings. Extraordinary item section. Discontinued operations section. 6. 7. 8. 9. 10. 11. 4-60 CA 4-9 (a) Separate Statement Net income........................................................................................ Statement of Comprehensive Income Net income........................................................................................ Unrealized gains .............................................................................. Comprehensive income ................................................................. (b) Combined Format …income components… Net income........................................................................................ Other comprehensive income Unrealized gains .............................................................................. Comprehensive income ................................................................. (c) Current Year $400,000 Prior Year $410,000 $400,000 20,000 $420,000 $410,000 _______ $410,000 $400,000 20,000 $420,000 $410,000 _______ $410,000 Arthur can choose either approach, according to SFAS No. 130 or report the unrealized gains in stockholders’ equity. The method chosen should be based on which one provides the most useful information. For example, Arthur should not choose the combined format because the gains result in an increasing trend in comprehensive income, while net income is declining. 4-61 FINANCIAL REPORTING PROBLEM (a) P&G uses the multiple-step income statement because it separates operating from nonoperating activities. A multiple-step income statement is used to recognize additional relationships related to revenues and expenses. P&G recognizes a separation of operating transactions from nonoperating transactions. As a result, trends in income from continuing operations should be easier to understand and analyze. Disclosure of operating income may assist in comparing different companies and assessing operating efficiencies. P&G operates in the consumer products market. The company separates its operations into five segments: (sales by segment) Fabric and Home Care, 27% Beauty Care, 33% Baby and Family Care, 20% Health Care, 13% Snacks and Beverages, 7% (c) P&G’s gross profit (Net Sales – Cost of Products Sold) was $26,331 million in 2004, $21,236 million in 2003, and $19,249 million in 2002. P&G’s gross profit increased by 24% in 2004 compared to 2003. The increase in the gross profit in 2004 is due primarily to increased sales from growth in market share (see MD&A). P&G probably makes a distinction between operating and nonoperating revenue for the reasons mentioned in the solution to Part (a). Interest expense increased in 2004 compared to 2003. By separating out these revenue and expense items, the statement reader can see the separate impacts of operating and financing activities. P&G reports the following ratios in its 9-year “Financial Summary” section: Net earnings margin and Earnings and Dividends per share. The Financial Summary also reports income statement items, such as advertising and research and development expenses and operating income. 4-62 (b) (d) (e) FINANCIAL STATEMENT ANALYSIS CASE 1 (a) Depending on the company chosen, student answers will vary. Given the ready availability, the analysis for Walgreens is provided below: Z-Score Analysis Z= Working Capital Total Assets X 1.2 + Retained Earnings Total Assets X 1.4 + EBIT Total Assets X 3.3 + Sales Total Assets X .99 + MV Equity Total Liabilities X 0.6 Walgreens ($000,000) Z-Score 2004 Total Assets Current Assets Current Liabilities Working Capital Working Capital/Assets Retained Earnings Retained Earnings/ Assets EBIT EBIT/Assets Sales Sales/Assets MV Equity Total Liabilities MV Equity*/Total Liabilities 7.175 X 0.6 = Total = *Market Price X Shares Outstanding Market Price Shares Outstanding Total Equity $36.45 1,023 $8,139.70 $32.57 1025 $7,117.80 4.301 8.736 7.355 X 0.6 = Total = 4.413 8.768 0.562 $2,159.70 0.162 $37,508.20 2.811 $37,288.35 5,202.40 X 0.99 = 2.783 X 3.3 = 0.534 X 1.4 = 0.787 0.544 $1,871.70 0.161 $32,505.40 2.789 $33,384.25 4,539.00 X 0.99 = 2.761 X 3.3 = 0.530 X 1.4 = 0.761 $13,342.10 7,764.40 4,077.90 3,686.50 0.276 $7,503.30 X 1.2 = 0.332 Weights 2004 2003 $11,656.80 6,609.00 3,671.40 2,937.60 0.252 $6,339.90 X 1.2 = 0.302 Weights Z-Score 2003 4-63 FINANCIAL STATEMENT ANALYSIS CASE 1 (Continued) (b) Walgreens’ Z-score in 2004 has declined slightly but is still above the cutoff score for companies that are unlikely to fail. The company has improved in just about all areas in 2004, compared to 2003. Note to instructors—as an extension, students could be asked to conduct the analysis on companies which are in financial distress (e.g., Xerox, Enron) to examine whether their financial distress could have been predicted in advance. (c) EBIT is an operating income measure. By adding back items less relevant to predicting future operating results (interest, taxes), it is viewed as a better indicator of future profitability. 4-64 FINANCIAL STATEMENT ANALYSIS CASE 2 Earnings (loss) per common share Earnings from continuing operations ($97,700,000 ÷ 177,636,000).................................................... Discontinued operations, net of tax ............................................. Earnings before extraordinary item.............................................. Extraordinary items, net of tax ....................................................... Net earnings ($56,100,000 ÷ 177,636,000).......................... *$.01 rounding difference. $0.55 (0.20) 0.35 (0.03)* $ .32 4-65 FINANCIAL STATEMENT ANALYSIS CASE 3 (a) Assumptions, estimates related to items such as bad debt expense, warranties, or the useful lives or residual values for fixed assets could result in income being overstated. See the table below. Average Price $34.63 55.54 Sales per Share $ 8.06 17.45 (b) December 31, 2004 Tootsie Roll Hershey (c) EPS $1.23 2.38 P/E 28.15 23.34 PSR 4.30 3.18 Tootsie Roll has a higher P/E relative to Hershey by 21%. But Tootsie’s PSR is 35% higher than that for Hershey. Thus, it would appear that the Tootsie Roll’s Stock is overpriced, and by a bigger margin when using the sales-based PSR. This may suggest a lower quality of earnings for Tootsie Roll. 4-66 COMPARATIVE ANALYSIS CASE (a) Both companies are using the multiple-step format in presenting income statement information. Companies use the multiple-step income statement to recognize additional relationships related to revenues and expenses. Both companies distinguish between operating and nonoperating transactions. As a result, trends in income from continuing operations should be easier to understand and analyze. Disclosure of operating income may assist in comparing different companies and assessing operating efficiencies. The Coca-Cola Company shows an additional intermediate component of income—gross profit. PepsiCo does not report this information on its income statement. (b) The gross profit, operating profit, and net income for these two companies are as follows: 2004 $29,261 13,406 $15,855 $5,259 $4,212 2004 $21,962 7,638 $14,324 $5,698 $4,847 2003 $26,971 12,379 $14,592 $4,781 $3,568 2003 $21,044 7,762 $13,282 $5,221 $4,347 2002 $25,112 11,497 $13,615 $4,295 $3,000 2002 $19,564 7,105 $12,459 $5,458 $3,050 % Change 16.52% 16.60% 16.45% 22.44% 40.40% % Change 12.26% 7.50% 14.97% 4.40% 58.92% PepsiCo Sales................................. Cost of sales .................. Gross profit .................... Operating profit ............ Net income ..................... Coca-Cola Sales................................. Cost of sales .................. Gross profit .................... Operating income......... Net income ..................... 4-67 COMPARATIVE ANALYSIS CASE (Continued) As shown in the table above, the two companies report almost similar net incomes in 2004 and significant growth in income from 2002 to 2004. However, while PepsiCo’s sales, gross profit and operating income shows stronger growth, both companies are doing well. (c) Coca-Cola and PepsiCo have reported gains on the equity transactions related to bottling operations. PepsiCo reported gains on its equity investments. Also, PepsiCo reported impairments, restructurings and merger-related costs during the past 3 years, which affected its income those years and make year-to-year comparisons of net income distorted—PepsiCo’s income growth would have been even higher without the effects of these one-time items. These items are significant for both companies because they have contributed to bottom line net income in prior years but there is uncertainty about whether these items will recur in the future. Coca-Cola provided the following adjustments to arrive at “adjusted net income”: 2004 Net income before cumulative effect of accounting change Add: Interest expense Less: Effective tax rate benefit of interest expense $4,847 196 (43) 2003 $4,347 178 (37) 2002 $3,976 199 (55) (d) Coca-Cola’s management believes that these financial measures provide investors and analysts useful additional insight into the Company’s financial position and performance. Management also uses these financial measures to evaluate the Company’s performance and to make certain decisions relating to the Company’s optimal capital structure and allocation of resources. They note that non-GAAP financial measures should not be considered substitutes for performance measures presented in Coke’s consolidated financial statements in accordance with GAAP. In addition, they caution that the methodologies for the calculation of non-GAAP financial measures may vary from company to company and, therefore, non-GAAP financial measures that Coke presents may not be comparable to similarly-named non-GAAP financial measures reported by other companies. 4-68 RESEARCH CASE 1 (a) There are a number of differences: (1) Northrop uses a multi-step format, while Goodyear uses a single-step format. Northrop provides more detail on components of revenue and expenses. Note that Goodyear references the notes to the financial statements for additional detail on Income items. Northrop reports a discontinued operation in 2004, 2003, and 2002. Goodyear reports “Rationalizations”, which are described in Note 3 as arising from various actions to reduce capacity, eliminate redundancies, and reduce costs. Both companies report depreciation expense as an adjustment to net income in determining cash flow from operations in the statement of cash flow. Depends on preference for conciseness versus detail. Most would agree that Northrop has the more useful income statement in terms of detail provided and understandability. For example, only by reading note 3 does the statement reader understand that the “Rationalizations” in Goodyear’s income statement are reductions from income. (b) (c) (d) 4-69 RESEARCH CASE 2 (a) The second income statement would report comprehensive income, which includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Under current GAAP, many income items bypass the traditional income statement and are reported directly in equity. As a result, equity is becoming “a dumpster for an amorphous and growing mass of important information.” The alternatives identified include: (1) providing two separate income statements, (2) creating a single statement which reports traditional income as a subtotal and comprehensive income as the bottom line, and (3) creating a three-column statement of stockholders’ equity. (b) (c) 4-70 INTERNATIONAL REPORTING CASE (a) Some of the differences are: 1. The title of the statement is different. 2. Units of currency—Avon reports in pounds sterling and earnings per share is 5.7 pence (loss). 3. Terminology—The term used for sales is “Turnover”. Interest revenue and expense are referred to as receivables and payables. 4. Avon separates out components between exceptional items and before exceptional items. The profit for the year was 5,974 higher before exceptional items. The “Loss on the disposal of fixed assets” is an example of an irregular item. As in the U.S., these items are included in the measurement of income but they are separate from “Operating Profit”, likely due to their non-recurring nature. British companies also report interest revenue and expense under a separate heading in the income statement. This distinguishes income from the operating and financing activities of the company. (b) 4-71 FINANCIAL ACCOUNTING RESEARCH Search Strings: “Comprehensive income,” “reclassification adjustment”, “comprehensive”, “other comprehensive income” (a) (b) FAS130 Reporting Comprehensive Income (Issued June, 1997). FAS130, Par8. Comprehensive income is defined in Concepts Statement 6 as “the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners” (paragraph 70). FAS130, Par16. Items included in net income are displayed in various classifications. Those classifications can include income from continuing operations, discontinued operations, extraordinary items, and cumulative effects of changes in accounting principle. This Statement does not change those classifications or other requirements for reporting results of operations. FAS130, Par17. Items included in other comprehensive income shall be classified based on their nature. For example, under existing accounting standards, other comprehensive income shall be classified separately into foreign currency items, minimum pension liability adjustments, and unrealized gains and losses on certain investments in debt and equity securities. Additional classifications or additional items within current classifications may result from future accounting standards. FAS130, Par18. Adjustments shall be made to avoid double counting in comprehensive income items that are displayed as part of net income for a period that also had been displayed as part of other comprehensive income in that period or earlier periods. For example, gains on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains in the period in which they arose must be deducted through other comprehensive income of the period in which they are included in net income to avoid including them in comprehensive income twice. Those adjustments are referred to in this Statement as reclassification adjustments. (c) (d) (e) 4-72 PROFESSIONAL SIMULATION Explanation As indicated in the income statement below, the loss on abandonment is reported as an “other expense and loss.” The gain on disposal of a business component is reported as part of discontinued operations, net of tax. The change in inventory costing from FIFO to average cost is a change in accounting principle. The cumulative effect of a change in accounting principle is adjusted through the beginning balance of retained earnings. Gross profit is $1,550,000, income from operations is $930,000; income from continuing operations before taxes is $900,000; net income is $665,000; and earnings per share (on net income) is $6.65. Measurement Jude Law Corporation Income Statement For the Year Ended December 31, 2007 Sales....................................................................................... Cost of goods sold ............................................................ Gross profit .......................................................................... Selling expenses ................................................................ $340,000 Administrative expenses ................................................. 280,000 Income from operations................................................... Other revenues and gains Interest revenue.................................................................. 10,000 Other expenses and losses Loss from plant abandonment ...................................... 40,000 Income from continuing operations before income tax ...................................................... Income tax (30% X 900,000)............................................ Income from continuing operations ............................ Discontinued operations Gain on disposal of component of business............ 90,000 Less: Applicable income tax......................................... 27,000 4-73 $3,200,000 1,650,000 1,550,000 (a) 620,000 930,000 (b) 30,000 900,000 (c) 270,000 630,000 63,000 PROFESSIONAL SIMULATION (Continued) Income before extraordinary item.................................... Extraordinary item Loss from earthquake.......................................................... Less: Applicable income tax ............................................. Net income............................................................................... Per share of common stock Income from continuing operations................................ Discontinued operations, net of tax................................ Income before extraordinary item.................................... Extraordinary item, loss from earthquake, net of tax...... Net income............................................................................... 40,000 12,000 693,000 (28,000) $665,000 (d) $6.30 0.63 6.93 (0.28) $6.65 (e) Note to instructor: The change for inventory costing is reflected in the current years cost of goods sold. If comparative statements are presented, prior year’s would be recast as under the new method. The cumulative effect of the change in accounting principle is shown as an adjustment to beginning retained earnings. 4-74 CHAPTER 5 Balance Sheet and Statement of Cash Flows ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. Disclosure principles, uses of the balance sheet, financial flexibility. Classification of items in the balance sheet and other financial statements. Preparation of balance sheet; issues of format, terminology, and valuation. Statement of cash flows. Questions 1, 2, 3, 4, 5, 6, 7, 10, 18, 22, 23, 25 11, 12, 13, 14, 15, 16, 18, 19 4, 7, 8, 9, 16, 17, 20, 21, 24 25, 26, 27, 28, 29, 30, 31, 32 12, 13, 14, 15, 16 Brief Exercises 1 Exercises Problems Concepts for Analysis 4, 5 2. 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11 1, 2, 3, 4, 6, 7, 8, 9, 10 1, 2, 3 3. 4, 5, 6, 7, 11, 12 1, 2, 3, 4, 5 3, 4, 5 4. 13, 14, 15, 16, 17, 18 6, 7 6 5-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives 1. 2. 3. Explain the uses and limitations of a balance sheet. Identify the major classifications of the balance sheet. Prepare a classified balance sheet using the report and account formats. Determine which balance sheet information requires supplemental disclosure. Describe the major disclosure techniques for the balance sheet. Indicate the purpose of the statement of cash flows. Identify the content of the statement of cash flows. Prepare a statement of cash flows. Understand the usefulness of the statement of cash flows. 12, 13, 14, 15 16 13 14, 15, 16, 17, 18 15, 16, 18 6, 7 6, 7 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11 1, 2, 3, 4, 6, 8, 9 1, 2, 3, 4, 5, 6, 7, 9, 10, 11, 12, 17 10 1, 2, 3, 4, 5, 6, 7 4 Brief Exercises Exercises Problems 7 4. 5. 6. 7. 8. 9. 5-2 ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty Simple Simple Simple Simple Simple Complex Moderate Moderate Complex Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex Complex Complex Complex Moderate Moderate Moderate Simple Simple Complex Time (minutes) 15–20 15–20 15–20 30–35 30–35 30–35 15–20 10–15 30–35 15–20 25–30 30–35 15–20 25–35 25–35 25–35 30–35 25–35 30–35 35–40 40–45 40–45 40–50 35–45 40–50 25–30 30–35 20–25 25–30 20–25 40–50 Item E5-1 E5-2 E5-3 E5-4 E5-5 E5-6 E5-7 E5-8 E5-9 E5-10 E5-11 E5-12 E5-13 E5-14 E5-15 E5-16 E5-17 E5-18 P5-1 P5-2 P5-3 P5-4 P5-5 P5-6 P5-7 Description Balance sheet classifications. Classification of balance sheet accounts. Classification of balance sheet accounts. Preparation of a classified balance sheet. Preparation of a corrected balance sheet. Corrections of a balance sheet. Current assets section of the balance sheet. Current vs. long-term liabilities. Current assets and current liabilities. Current liabilities. Balance sheet preparation. Preparation of a balance sheet. Statement of cash flows—classifications. Preparation of a statement of cash flows. Preparation of a statement of cash flows. Preparation of a statement of cash flows. Preparation of a statement of cash flows and a balance sheet. Preparation of a statement of cash flows, analysis. Preparation of a classified balance sheet, periodic inventory. Balance sheet preparation. Balance sheet adjustment and preparation. Preparation of a corrected balance sheet. Balance sheet adjustment and preparation. Preparation of a statement of cash flows and a balance sheet. Preparation of a statement of cash flows and a balance sheet. Reporting for financial effects of varied transactions. Current asset and liability classification. Identifying balance sheet deficiencies. Critique of balance sheet format and content. Presentation of property, plant, and equipment. Cash flow analysis. C5-1 C5-2 C5-3 C5-4 C5-5 C5-6 5-3 ANSWERS TO QUESTIONS 1. The balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to enterprise creditors, and the owners’ equity in net enterprise resources. That information not only complements information about the components of income, but also contributes to financial reporting by providing a basis for (1) computing rates of return, (2) evaluating the capital structure of the enterprise, and (3) assessing the liquidity and financial flexibility of the enterprise. Solvency refers to the ability of an enterprise to pay its debts as they mature. For example, when a company carries a high level of long-term debt relative to assets, it has lower solvency. Information on long-term obligations, such as long-term debt and notes payable, in comparison to total assets can be used to assess resources that will be needed to meet these fixed obligations (such as interest and principal payments). Financial flexibility is the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities. An enterprise with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities. Generally, the greater the financial flexibility, the lower the risk of enterprise failure. Some situations in which estimates affect amounts reported in the balance sheet include: a) allowance for doubtful accounts. b) depreciable lives and estimated salvage values for plant and equipment. c) warranty returns. d) determining the amount of revenues that should be recorded as unearned. When estimates are required, there is subjectivity in determining the amounts. Such subjectivity can impact the usefulness of the information by reducing the reliability of the measures, either because of bias or lack of verifiability. 5. An increase in inventories increases current assets, which is in the numerator of the current ratio. Therefore, inventory increases will increase the current ratio. In general, an increase in the current ratio indicates a company has better liquidity, since there are more current assets relative to current liabilities. Note to instructors—When inventories increase faster than sales, this may not be a good signal about liquidity. That is, inventory can only be used to meet current obligations when it is sold (and converted to cash). That is why some analysts use a liquidity ratio—the acid test ratio—that excludes inventories from current assets in the numerator. 6. Liquidity describes the amount of time that is expected to elapse until an asset is converted into cash or until a liability has to be paid. The ranking of the assets given in order of liquidity is: (1) (d) Short-term investments. (2) (e) Accounts receivable. (3) (b) Inventories. (4) (c) Buildings. (5) (a) Goodwill. The major limitations of the balance sheet are: (1) The values stated are generally historical and not at fair value. (2) Estimates have to be used in many instances, such as in the determination of collectibility of receivables or finding the approximate useful life of long-term tangible and intangible assets. (3) Many items, even though they have financial value to the business, presently are not recorded. One example is the value of a company’s human resources. 2. 3. 4. 7. 5-4 Questions Chapter 5 (Continued) 8. Some items of value to technology companies such as Intel or IBM are the value of research and development (new products that are being developed but which are not yet marketable), the value of the “intellectual capital” of its workforce (the ability of the companies’ employees to come up with new ideas and products in the fast changing technology industry), and the value of the company reputation or name brand (e.g., the “Intel Inside” logo). In most cases, the reasons why the value of these items are not recorded in the balance sheet concern the lack of reliability of the estimates of the future cash flows that will be generated by these “assets” (for all three types) and the ability to control the use of the asset (in the case of employees). Being able to reliably measure the expected future benefits and to control the use of an item are essential elements of the definition of an asset, according to the Conceptual Framework. Classification in financial statements helps users by grouping items with similar characteristics and separating items with different characteristics. Current assets are expected to be converted to cash within one year or one operating cycle, whichever is longer—property, plant and equipment will provide cash inflows over a longer period of time. Thus, separating long-term assets from current assets facilitates computation of useful ratios such as the current ratio. 9. 10. Separate amounts should be reported for accounts receivable and notes receivable. The amounts should be reported gross, and an amount for the allowance for doubtful accounts should be deducted. The amount and nature of any nontrade receivables, and any amounts designated or pledged as collateral, should be clearly identified. 11. Available-for-sale securities should be reported as a current asset only if management expects to convert them into cash as needed within one year or the operating cycle, whichever is longer. If available-for-sale securities are not held with this expectation, they should be reported as longterm investments. 12. The relationship between current assets and current liabilities is that current liabilities are those obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities. 13. The total selling price of the season tickets is $20,000,000 (10,000 X $2,000). Of this amount, $9,000,000 has been earned by 12/31/07 (18/40 X $20,000,000). The remaining $11,000,000 should be reported as unearned revenue, a current liability in the 12/31/07 balance sheet (22/40 X $20,000,000). 14. Working capital is the excess of total current assets over total current liabilities. This excess is sometimes called net working capital. Working capital represents the net amount of a company’s relatively liquid resources. That is, it is the liquidity buffer available to meet the financial demands of the operating cycle. 15. (a) (b) (c) (d) (e) (f) (g) (h) Stockholders’ Equity. “Treasury stock (at cost).” Note: This is a reduction of total stockholders’ equity. Current Assets. Included in “Cash.” Investments. “Land held as an investment.” Investments. “Sinking fund.” Long-term debt (adjunct account to bonds payable). “Unamortized premium on bonds payable.” Intangible Assets. “Copyrights.” Investments. “Employees’ pension fund,” with subcaptions of “Cash” and “Securities” if desired. (Assumes that the company still owns these assets.) Stockholders’ Equity. “Premium on capital stock” or “Additional paid-in capital in excess of par value.” 5-5 Questions Chapter 5 (Continued) (i) 16. (a) (b) (c) (d) (e) (f) (g) (h) (i) 17. (a) (b) (c) (d) (e) Investments. Nature of investments should be given together with parenthetical information as follows: “pledged to secure loans payable to banks.” Allowance for doubtful accounts receivable should be deducted from accounts receivable. Merchandise held on consignment should not appear on the consignee’s balance sheet except possibly as a note to the financial statements. Advances received on sales contract are normally a current liability and should be shown as such in the balance sheet. Cash surrender value of life insurance should be shown as a long-term investment. Land should be reported in property, plant, and equipment unless held for investment. Merchandise out on consignment should be shown among current assets under the heading of inventories. Franchises should be itemized in a section for intangible assets. Accumulated depreciation of plant and equipment should be deducted from the plant and equipment accounts. Materials in transit should not be shown on the balance sheet of the buyer, if purchased f.o.b. destination. Trade accounts receivable should be stated at their estimated amount collectible, often referred to as net realizable value. The method most generally followed is to deduct from the total accounts receivable the amount of the allowance for doubtful accounts. Land is generally stated in the balance sheet at cost. Inventories are generally stated at the lower of cost or market. Trading securities (consisting of common stock of other companies) are stated at fair value. Prepaid expenses should be stated at cost less the amount apportioned to and written off over the previous accounting periods. 18. Assets are defined as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. If a building is leased, the future economic benefits of using the building are controlled by the lessee (tenant) as the result of a past event (the signing of a lease agreement). 19. Agazzi is incorrect. Retained earnings is a source of assets, but is not an asset itself. For example, even though the funds obtained from issuing a note payable are invested in the business, the note payable is not reported as an asset. It is a source of assets, but it is reported as a liability because the company has an obligation to repay the note in the future. Similarly, even though the earnings are invested in the business, retained earnings is not reported as an asset. It is reported as part of stockholders’ equity because it is, in effect, an investment by owners which increases the ownership interest in the assets of an entity. 20. The notes should appear as long-term liabilities with full disclosure as to their terms. Each year, as the profit is determined, notes of an amount equal to two-thirds of the year’s profits should be transferred from the long-term liabilities to current liabilities until all of the notes have been liquidated. 21. Some of the techniques of disclosure for the balance sheet are: 1. Parenthetical explanations. 2. Notes to the financial statements. 3. Cross references and contra items. 4. Supporting schedules. 5-6 Questions Chapter 5 (Continued) 22. A note entitled “Summary of Significant Accounting Policies” would indicate the basic accounting principles used by that enterprise. This note should be very useful from a comparative standpoint, since it should be easy to determine whether the company uses the same accounting policies as other companies in the same industry. 23. General debt obligations, lease contracts, pension arrangements and stock option plans are four items for which disclosure is mandatory in the financial statements. The reason for disclosing these contractual situations is that these commitments are of a long-term nature, are often significant in amount, and are very important to the company’s well-being. 24. The profession has recommended that the use of the word “surplus” be discontinued in balance sheet presentations of owners’ equity. This term has a connotation outside accounting that is quite different from its meaning in the accounts or in the balance sheet. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing to the nonaccountant and leads to misinterpretation. 25. The purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. It differs from the balance sheet and the income statement in that it reports the sources and uses of cash by operating, investing, and financing activity classifications. While the income statement and the balance sheet are accrual basis statements, the statement of cash flows is a cash basis statement—noncash items are omitted. 26. The difference between these two amounts may be due to increases in current assets (e.g., an increase in accounts receivable from a sale on account would result in an increase in revenue and net income but have no effect yet on cash). Similarly a cash payment that results in a decrease in an existing current liability (e.g., accounts payable would decrease cash provided by operations without affecting net income.) 27. The difference between these two amounts could be due to noncash charges that appear in the income statement. Examples of noncash charges are depreciation, depletion, and amortization of intangibles. Expenses recorded but unpaid (e.g., increase in accounts payable) and collection of previously recorded sales on credit (i.e. now decreasing accounts receivable) also would cause cash provided by operating activities to exceed net income. 28. Operating activities involve the cash effects of transactions that enter into the determination of net income. Investing activities include making and collecting loans and acquiring and disposing of debt and equity instruments; property, plant, and equipment and intangibles. Financing activities involve liability and owners’ equity items and include obtaining capital from owners and providing them with a return on (dividends) and a return of their investment and borrowing money from creditors and repaying the amounts borrowed. 29. (a) (b) Net income is adjusted downward by deducting $7,000 from $90,000 and reporting cash provided by operating activities as $83,000. The issuance of the preferred stock is a financing activity. The issuance is reported as follows: Cash flows from financing activities Issuance of preferred stock $1,150,000 5-7 Questions Chapter 5 (Continued) (c) Net income is adjusted as follows: Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Premium amortization Net cash provided by operating activities $90,000 14,000 (5,000) $99,000 (d) The increase of $20,000 reflects an investing activity. The increase in Land is reported as follows: Cash flows from investing activities: Investment in Land $(20,000) 30. The company appears to have good liquidity and reasonable financial flexibility. Its current cash $900,000 , which indicates that it can pay off its current liabilities in debt coverage ratio is .90 $1,000,000 a given year from its operations. In addition, its cash debt coverage ratio is also good at $900,000 , which indicates that it can pay off approximately 60% of its debt out of current .60 $1, 500,000 operations. 31. Free cash flow = $860,000 – $75,000 – $20,000 = $765,000. 32. Free cash flow is net cash provided by operating activities less capital expenditures and dividends. The purpose of free cash flow analysis is to determine the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity. 5-8 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 5-1 Current assets Cash................................................................................. Accounts receivable................................................... Less: Allowance for doubtful accounts......... Inventories..................................................................... Prepaid insurance....................................................... Total current assets...................................... $27,000 $110,000 (8,000) 102,000 290,000 9,500 $428,500 BRIEF EXERCISE 5-2 Current assets Cash................................................................................. Trading securities ....................................................... Accounts receivable................................................... Less: Allowance for doubtful accounts......... Inventory ........................................................................ Prepaid insurance....................................................... Total current assets...................................... $90,000 (4,000) $ 7,000 11,000 86,000 34,000 5,200 $143,200 BRIEF EXERCISE 5-3 Long-term investments Held-to-maturity securities ...................................... Land held for investment.......................................... Long-term note receivables..................................... Total investments................................................. 5-9 $ 61,000 39,000 42,000 $142,000 BRIEF EXERCISE 5-4 Property, plant, and equipment Land ................................................................................ Buildings ....................................................................... Less: Accumulated depreciation..................... Equipment..................................................................... Less: Accumulated depreciation.................... Timberland.................................................................... Total property, plant, and equipment ....... $ 61,000 $207,000 (45,000) $190,000 (19,000) 162,000 171,000 70,000 $464,000 BRIEF EXERCISE 5-5 Intangible assets Goodwill......................................................................... Patents ........................................................................... Franchises .................................................................... Total intangibles .................................................. $150,000 220,000 110,000 $480,000 BRIEF EXERCISE 5-6 Intangible assets Goodwill......................................................................... Franchises .................................................................... Patents ........................................................................... Trademarks................................................................... Total intangible assets....................................... $40,000 47,000 33,000 10,000 $130,000 5-10 BRIEF EXERCISE 5-7 Current liabilities Accounts payable ....................................................... Accrued salaries.......................................................... Notes payable............................................................... Income taxes payable ................................................ Total current liabilities................................. $72,000 4,000 12,500 7,000 $95,500 BRIEF EXERCISE 5-8 Current liabilities Accounts payable ....................................................... Advances from customers....................................... Wages payable............................................................. Interest payable ........................................................... Income taxes payable ................................................ Total current liabilities................................. $240,000 41,000 27,000 12,000 29,000 $349,000 BRIEF EXERCISE 5-9 Long-term liabilities Bonds payable ............................................................. Less: Discount on bonds payable.................. Pension liability ........................................................... Total long-term liabilities ............................ $400,000 24,000 $376,000 375,000 $751,000 5-11 BRIEF EXERCISE 5-10 Stockholders’ equity Common stock ............................................................ Additional paid-in capital ......................................... Retained earnings ...................................................... Accumulated other comprehensive loss............ Total stockholders’ equity ................................. $700,000 200,000 120,000 (150,000) $870,000 BRIEF EXERCISE 5-11 Stockholders’ equity Preferred stock............................................................ Common stock ............................................................ Additional paid-in capital ......................................... Retained earnings ...................................................... Total stockholders’ equity ................................. $172,000 55,000 174,000 114,000 $515,000 BRIEF EXERCISE 5-12 Cash Flow Statement Operating Activities Net income.................................................................... Increase in accounts receivable............................ Increase in accounts payable................................. Depreciation expense ............................................... Net cash provided by operating activities........ $40,000 (10,000) 5,000 4,000 39,000 5-12 BRIEF EXERCISE 5-12 (Continued) Investing Activities Purchase of equipment ............................................. Financing Activities Issue notes payable ................................................... Dividends ....................................................................... Net cash flow from financing activities ........ Net change in cash ($39,000 – $8,000 + $15,000) ......... (8,000) 20,000 (5,000) 15,000 $46,000 Free Cash Flow = $39,000 (Net cash provided by operating activities) – $8,000 (Purchase of equipment) – $5,000 (Dividends) = $26,000. BRIEF EXERCISE 5-13 Cash flows from operating activities Net income..................................................................... Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense ......................................... Increase in accounts payable .......................... Increase in accounts receivable...................... Net cash provided by operating activities .......... $39,000 9,500 (13,000) 35,500 $186,500 $151,000 BRIEF EXERCISE 5-14 Sale of land and building................................................. Purchase of land ................................................................ Purchase of equipment .................................................... Net cash provided by investing activities........... 5-13 $181,000 (37,000) (53,000) $ 91,000 BRIEF EXERCISE 5-15 Issuance of common stock ............................................ Purchase of treasury stock ............................................ Payment of cash dividend .............................................. Retirement of bonds......................................................... Net cash used by financing activities.................. $147,000 (40,000) (85,000) (100,000) $ (78,000) BRIEF EXERCISE 5-16 Free Cash Flow Analysis Net cash provided by operating activities ................ Less: Purchase of equipment ..................................... Purchase of land* ............................................... Dividends .............................................................. Free cash flow .................................................................... $400,000 (53,000) (37,000) (85,000) $225,000 *If the land were purchased as an investment, it would be excluded in the computation of free cash flow. 5-14 SOLUTIONS TO EXERCISES EXERCISE 5-1 (15–20 minutes) (a) If the investment in preferred stock is readily marketable and held primarily for sale in the near term to generate income on short-term price differences, then the account should appear as a current asset and be included with trading securities. If, on the other hand, the preferred stock is not a trading security, it should be classified as available for sale. Available for sale securities are classified as current or noncurrent depending upon the circumstances. (b) If the company accounts for the treasury stock on the cost basis, the account should properly be shown as a reduction of total stockholders’ equity. (c) Stockholders’ equity. (d) Current liability. (e) Property, plant, and equipment (as a deduction). (f) If the warehouse in process of construction is being constructed for another party, it is properly classified as an inventory account in the current asset section. This account will be shown net of any billings on the contract. On the other hand, if the warehouse is being constructed for the use of this particular company, it should be classified as a separate item in the property, plant, and equipment section. (g) Current asset. (h) Current liability. (i) Retained earnings. 5-15 EXERCISE 5-1 (Continued) (j) Current asset. (k) Current liability. (l) Current liability. (m) Current asset (inventory). (n) Current liability. EXERCISE 5-2 (15–20 minutes) 1. 2. 3. 4. 5 6. 7. 8. 9. 10. h. d. f. f. c. a. f. g. a. a. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. b. f. a. h. c. b. a. a. g. f. 5-16 EXERCISE 5-3 (15–20 minutes) 1. 2. 3. 4. 5 6. 7. 8. 9. a. b. f. a. f. h. i. d. a. 10. 11. 12. 13. 14. 15. 16. 17. 18. f. a. f. a. or e. (preferably a.) c. and N. f. X. f. c. 5-17 EXERCISE 5-4 (30–35 minutes) Denis Savard Inc. Balance Sheet December 31, 20– Assets Current assets Cash ....................................................................... Less: Cash restricted for plant expansion .................................................. Accounts receivable ......................................... Less: Allowance for doubtful accounts..................................................... Notes receivable ................................................ Receivables—officers ...................................... Inventories Finished goods............................................ Work in process .......................................... Raw materials............................................... Total current assets ............................ Long-term investments Preferred stock investments.......................... Land held for future plant site....................... Cash restricted for plant expansion............ Total long-term investments ............ Property, plant, and equipment Buildings .............................................................. Less: Accum. depreciation— buildings..................................................... Intangible assets Copyrights ........................................................... Total assets ................................................. $XXX XXX XXX XXX $XXX XXX XXX XXX XXX XXX XXX XXX $XXX XXX XXX XXX XXX XXX XXX XXX XXX $XXX 5-18 EXERCISE 5-4 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accrued salaries payable ..................................... Notes payable, short-term.................................... Unearned subscriptions revenue ...................... Unearned rent revenue.......................................... Total current liabilities.................................... Long-term debt Bonds payable, due in four years...................... Less: Discount on bonds payable..................... Total liabilities ................................................... Stockholders’ equity Capital stock: Common stock .................................................. Additional paid-in capital: Premium on common stock.......................... Total paid-in capital .................................. Retained earnings................................................... Total paid-in capital and retained earnings ................................... Less: Treasury stock, at cost...................... Total stockholders’ equity...................... Total liabilities and stockholders’ equity ........................................ $XXX XXX XXX XXX $XXX $XXX (XXX) XXX XXX XXX XXX XXX XXX XXX (XXX) XXX $XXX Note to instructor: An assumption made here is that cash included the cash restricted for plant expansion. If it did not, then a subtraction from cash would not be necessary or the cash balance would be “grossed up” and then the cash restricted for plant expansion deducted. 5-19 EXERCISE 5-5 (30–35 minutes) Uhura Company Balance Sheet December 31, 2007 Assets Current assets Cash .................................................................. Trading securities—at fair value ............. Accounts receivable .................................... $357,000 Less: Allowance for doubtful accounts................................................ Inventories, at lower of average cost or market ............................................ Prepaid expenses ......................................... Total current assets .............................. Long-term investments Land held for future use............................. Cash surrender value of life insurance ..................................................... Property, plant, and equipment Building............................................................ $730,000 Less: Accum. depr.—building........... Office equipment .......................................... Less: Accum. depr.—office equipment ............................................. Intangible assets Goodwill........................................................... Total assets ............................................ 5-20 $230,000 120,000 17,000 340,000 401,000 12,000 $1,103,000 175,000 90,000 265,000 160,000 265,000 105,000 570,000 160,000 730,000 80,000 $2,178,000 EXERCISE 5-5 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable ........................................ Notes payable (due next year) ................. Rent payable .................................................. Total current liabilities......................... Long-term liabilities Bonds payable .............................................. $500,000 Add: Premium on bonds payable ........... Pension obligation....................................... Total liabilities ........................................ Stockholders’ equity Common stock, $1 par, authorized 400,000 shares, issued 290,000 shares ........................................................... Additional paid-in capital........................... Retained earnings........................................ Total stockholders’ equity.................. Total liabilities and stockholders’ equity .................................... *$2,178,000 – $944,000 – $450,000 290,000 160,000 450,000 784,000* 1,234,000 $2,178,000 53,000 $553,000 82,000 635,000 944,000 $ 135,000 125,000 49,000 $309,000 5-21 EXERCISE 5-6 (30–35 minutes) Geronimo Company Balance Sheet July 31, 2007 Assets Current assets Cash .................................................................. Accounts receivable .................................... $46,700** Less: Allowance for doubtful accounts................................................ Inventories ...................................................... Total current assets .............................. Long-term investments Bond sinking fund........................................ Property, plant, and equipment Equipment....................................................... Less: Accumulated depreciation— equipment..................................... Intangible assets Patents ............................................................. Total assets ............................................ *($69,000 – $15,000 + $6,000) **($52,000 – $5,300) ***($60,000 + $5,300) 21,000 $288,500 112,000 28,000 84,000 15,000 3,500 $60,000* 43,200 65,300*** $168,500 5-22 EXERCISE 5-6 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes and accounts payable............................... Taxes payable........................................................... Total current liabilities.................................... Long-term liabilities ...................................................... Total liabilities ................................................... Stockholders’ equity ..................................................... Total liabilities and stockholders’ equity ............................................... ****($44,000 + $8,000) $288,500 $ 52,000**** 6,000 58,000 75,000 133,000 155,500 5-23 EXERCISE 5-7 (15–20 minutes) Current assets Cash ............................................................................... Less: Cash restricted for plant expansion........ Trading securities at fair value (cost, $31,000) ..................................................................... Accounts receivable (of which $50,000 is pledged as collateral on a bank loan) ............. Less: Allowance for doubtful accounts ............. Interest receivable [($40,000 X 6%) X 8/12] ....... Inventories at lower of cost (determined using LIFO) or market Finished goods.................................................... Work-in-process.................................................. Raw materials....................................................... Total current assets .................................... 52,000 34,000 207,000 293,000 $509,600 161,000 (12,000) 149,000 1,600 $ 87,000* (50,000) $ 37,000 29,000 *An acceptable alternative is to report cash at $37,000 and simply report the cash restricted for plant expansion in the investments section. 5-24 EXERCISE 5-8 (10–15 minutes) 1. Dividends payable of $2,375,000 will be reported as a current liability [(1,000,000 – 50,000) X $2.50]. Bonds payable of $25,000,000 and interest payable of $3,000,000 ($100,000,000 X 12% X 3/12) will be reported as a current liability. Bonds payable of $75,000,000 will be reported as a long-term liability. 3. Customer advances of $17,000,000 will be reported as a current liability ($12,000,000 + $30,000,000 – $25,000,000). 2. 5-25 EXERCISE 5-9 (30–35 minutes) (a) Allessandro Scarlatti Company Balance Sheet (Partial) December 31, 2007 Current assets Cash ................................................................... Accounts receivable ..................................... Less: Allowance for doubtful accounts......................................... Inventories ....................................................... Prepaid expenses .......................................... Total current assets ............................... *Cash balance Add: Cash disbursement after discount [$39,000 X 98%)] Less: Cash sales in January ($30,000 – $21,500) Cash collected on account Bank loan proceeds ($35,324 – $23,324) Adjusted cash **Accounts receivable balance Add: Accounts reduced from January collection ($23,324 ÷ 98%) Deduct: Accounts receivable in January Adjusted accounts receivable ***Inventories Less: Inventory received on consignment Adjusted inventory $ 34,396* $ 91,300** 7,000 84,300 159,000*** 9,000 $286,696 $ 40,000 38,220 78,220 (8,500) (23,324) (12,000) $ 34,396 $ 89,000 23,800 112,800 (21,500) $ 91,300 $171,000 12,000 $159,000 5-26 EXERCISE 5-9 (Continued) Current liabilities Accounts payable ................................................... Notes payable........................................................... Total current liabilities.................................... a $115,000a 55,000b $170,000 $61,000 $39,000 15,000 54,000 $115,000 $ 67,000 12,000 $ 55,000 Accounts payable balance Add: Cash disbursements Purchase invoice omitted ($27,000 – $12,000) Adjusted accounts payable b Notes payable balance Less: Proceeds of bank loan Adjusted notes payable (b) Adjustment to retained earnings balance: Add: January sales discounts [($23,324 ÷ 98%) X .02]................................ Deduct: January sales ............................................... January purchase discounts ($39,000 X 2%) ......................................... December purchases................................ Consignment inventory ........................... Change (decrease) to retained earnings .............. 780 15,000 12,000 (57,780) $(57,304) $ $30,000 476 5-27 EXERCISE 5-10 (15–20 minutes) (a) In order for a liability to be reported for threatened litigation, the amount must be probable and payment reasonably estimable. Since these conditions are not met an accrual is not required. A current liability of $150,000 should be recorded. A current liability for accrued interest of $4,000 ($600,000 X 8% X 1/2) should be reported. Also, the $600,000 note payable should be a current liability if payable in one year. Otherwise, the $600,000 note payable would be a long-term liability. Although bad debts expense of $300,000 should be debited and the allowance for doubtful accounts credited for $300,000, this does not result in a liability. The allowance for doubtful accounts is a valuation account (contra asset) and is deducted from accounts receivable on the balance sheet. A current liability of $80,000 should be reported. The liability is recorded on the date of declaration. Customer advances of $110,000 ($160,000 – $50,000) will be reported as a current liability. (b) (c) (d) (e) (f) 5-28 EXERCISE 5-11 (25–30 minutes) Kelly Corporation Balance Sheet December 31, 2007 Assets Current assets Cash.................................................................................. Office supplies .............................................................. Prepaid insurance........................................................ Total current assets ............................................ Equipment ............................................................................. Less: Accumulated depreciation ................................... Intangible assets—trademark ......................................... Total assets............................................................ Liabilities and Stockholders’ Equity Current liabilities Accounts payable ........................................................ Wages payable.............................................................. Unearned service revenue ........................................ Total current liabilities ...................................... Long-term liabilities Bonds payable .............................................................. Total liabilities ............................................................... Stockholders’ equity Common stock.............................................................. Retained earnings ($25,000 – $2,500*) .................. Total stockholders’ equity.................................. Total liabilities and stockholders’ equity............ *[$10,000 – ($9,000 + $1,400 + $1,200 + $900)] 5-29 $ 6,850 1,200 1,000 $ 9,050 48,000 4,000 44,000 950 $54,000 $10,000 500 2,000 $12,500 9,000 21,500 10,000 22,500 32,500 $54,000 EXERCISE 5-12 (30–35 minutes) John Nalezny Corporation Balance Sheet December 31, 2007 Assets Current assets Cash ................................................................ Trading securities....................................... Accounts receivable .................................. $435,000 Less: Allowance for doubtful accounts ........................................... (25,000) Inventories .................................................... Total current assets........................... $197,000 153,000 410,000 597,000 1,357,000 Long-term investments Investments in bonds................................ Investments in stocks ............................... Total long-term investments.......... Property, plant, and equipment Land ................................................................ Buildings ....................................................... 1,040,000 Less: Accum. depreciation............... (152,000) Equipment.................................................... 600,000 Less: Accum. depreciation............... (60,000) Total property, plant, and equipment.......................................... 299,000 277,000 576,000 260,000 888,000 540,000 1,688,000 Intangible assets Franchise.................................................................. Patent.............................................................. Total intangible assets....................... Total assets .......................................... 160,000 195,000 355,000 $3,976,000 5-30 EXERCISE 5-12 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable ................................. Short-term notes payable................... Dividends payable ................................ Accrued liabilities ................................. Total current liabilities ............... Long-term debt Long-term notes payable.................... Bonds payable ....................................... Total long-term liabilities .............. Total liabilities ................................. Stockholder’s equity Paid-in capital Common stock ($5 par)................ $1,000,000 Additional paid-in capital............. 80,000 Retained earnings* ............................... Total paid-in capital and retained earnings...................... Less: Treasury stock ........................... Total stockholders’ equity ........ Total liabilities and stockholders’ equity................ $ 455,000 90,000 136,000 96,000 $ 777,000 900,000 1,000,000 1,900,000 2,677,000 1,080,000 410,000 1,490,000 (191,000) 1,299,000 $3,976,000 5-31 EXERCISE 5-12 (Continued) *Computation of Retained Earnings: Sales Investment revenue Extraordinary gain Cost of goods sold Selling expenses Administrative expenses Interest expense Net income Beginning retained earnings Net income Ending retained earnings Or ending retained earnings can be computed as follows: Total stockholders’ equity Add: Treasury stock Less: Paid-in capital Ending retained earnings $1,299,000 191,000 1,080,000 $ 410,000 $8,100,000 63,000 80,000 (4,800,000) (2,000,000) (900,000) (211,000) $ 332,000 $ 78,000 332,000 $410,000 Note to instructor: There is no dividends account. Thus, the 12/31/07 retained earnings balance already reflects any dividends declared. EXERCISE 5-13 (15–20 minutes) (a) (b) (c) (d) (e) 4. 3. 4. 3. 1. (f) (g) (h) (i) (j) 1. 5. 4. 5. 4. 5-32 (k) (l) 1. 2. (m) 2. EXERCISE 5-14 (25–35 minutes) Constantine Cavamanlis Inc. Statement of Cash Flows For the Year Ended December 31, 2007 Cash flows from operating activities Net income...................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense .......................................... Increase in accounts receivable....................... Increase in accounts payable ........................... Net cash provided by operating activities ........... Cash flows from investing activities Purchase of equipment .............................................. Cash flows from financing activities Issuance of common stock....................................... Payment of cash dividends ...................................... Net cash used by financing activities ................... Net increase in cash........................................................... Cash at beginning of year ................................................ Cash at end of year............................................................. 20,000 (23,000) (3,000) 32,000 13,000 $45,000 $ 6,000 (3,000) 5,000 8,000 52,000 (17,000) $44,000 5-33 EXERCISE 5-15 (25–35 minutes) (a) Zubin Mehta Corporation Statement of Cash Flows For the Year Ended December 31, 2007 Cash flows from operating activities Net income...................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense........................................... Loss on sale of investments.............................. Decrease in accounts receivable ..................... Decrease in current liabilities............................ Net cash provided by operating activities............ Cash flows from investing activities Sale of investments ..................................................... [($74,000 – $52,000) – $10,000] Purchase of equipment .............................................. Net cash used by investing activities .................... Cash flows from financing activities Payment of cash dividends....................................... Net increase in cash ........................................................... Cash at beginning of year................................................. Cash at end of year ............................................................. (b) Free Cash Flow Analysis $175,000 (58,000) (30,000) $ 87,000 (30,000) 99,000 78,000 $177,000 (58,000) (46,000) 12,000 $17,000 10,000 5,000 (17,000) 15,000 175,000 $160,000 Net cash provided by operating activities .................. Less: Purchase of equipment ........................................ Dividends................................................................... Free cash flow ...................................................................... 5-34 EXERCISE 5-16 (20–25 minutes) (a) Shabbona Corporation Statement of Cash Flows For the Year Ended December 31, 2007 Cash flows from operating activities Net income........................................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ............................................ Increase in accounts receivable......................... Decrease in inventory............................................ Decrease in accounts payable............................ Net cash provided by operating activities ............. Cash flows from investing activities Sale of land....................................................................... Purchase of equipment ................................................ Net cash used by investing activities...................... Cash flows from financing activities Payment of cash dividends ........................................ Net increase in cash............................................................. Cash at beginning of year .................................................. Cash at end of year............................................................... Noncash investing and financing activities Issued common stock to retire $50,000 of bonds outstanding 39,000 (60,000) (21,000) (60,000) 51,000 22,000 $ 73,000 $27,000 (16,000) 9,000 (13,000) 7,000 132,000 $125,000 5-35 EXERCISE 5-16 (Continued) (b) Current cash debt coverage ratio = Net cash provided by operating activities = Average current liabilities $132,000 ($34,000 + $47,000) / 2 3.26 to 1 = = Cash debt coverage ratio = Net cash provided by operating activities Average total liabilities $184,000 + $247,000 2 = $132,000 ÷ = .61 to 1 Free Cash Flow Analysis Net cash provided by operating activities .............................. Less: Purchase of equipment .................................................... Dividends............................................................................... Free cash flow .................................................................................. $132,000 (60,000) (60,000) $ 12,000 Shabbona has excellent liquidity. Its financial flexibility is good. It might be noted that it substantially reduced its long-term debt in 2007 which will help its financial flexibility. 5-36 EXERCISE 5-17 (30–35 minutes) (a) Grant Wood Corporation Statement of Cash Flows For the Year Ended December 31, 2007 Cash flows from operating activities Net income.......................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of equipment..................................... $ 2,000* Depreciation expense .............................................. 13,000 Patent amortization................................................... 2,500 Increase in current liabilities ................................. 13,000 Increase in current assets (other than cash) ........ (29,000) Net cash provided by operating activities ............... Cash flows from investing activities Sale of equipment ............................................................ 10,000 Addition to building......................................................... (27,000) Investment in stock ......................................................... (16,000) Net cash used by investing activities........................ Cash flows from financing activities Issuance of bonds ........................................................... 50,000 Payment of dividends ..................................................... (30,000) Purchase of treasury stock........................................... (11,000) Net cash provided by financing activities................ Net increase in cash............................................................... $55,000 1,500 56,500 (33,000) 9,000 $32,500a *[$10,000 – ($20,000 – $8,000)] a An additional proof to arrive at the increase in cash is provided as follows: Total current assets—end of period Total current assets—beginning of period Increase in current assets during the period Increase in current assets other than cash Increase in cash during year 5-37 $296,500 [from part (b)] 235,000 61,500 29,000 $ 32,500 EXERCISE 5-17 (Continued) (b) Grant Wood Corporation Balance Sheet December 31, 2007 $296,500b 16,000 Assets Current assets .......................................................... Long-term investments ......................................... Property, plant, and equipment Land ...................................................................... $ 30,000 Building ($120,000 + $27,000)....................... $147,000 Less: Accum. depreciation ($30,000 + $4,000).......................................... (34,000) 113,000 Equipment ($90,000 – $20,000) .................... 70,000 Less: Accum. depreciation ($11,000 – $8,000 + $9,000) ........................ (12,000) 58,000 Total property, plant, and equipment ........ Intangible assets—patents ($40,000 – $2,500).......................................... Total assets ................................................ Liabilities and Stockholders’ Equity Current liabilities ($150,000 + $13,000) .......................... Long-term liabilities Bonds payable ($100,000 + $50,000)........................ Total liabilities........................................................... Stockholders’ equity Common stock ................................................................ Retained earnings ($44,000 + $55,000 – $30,000) ......... Total paid-in capital and retained earnings......... Less: Cost of treasury stock....................................... Total stockholders’ equity .................................... Total liabilities and stockholders’ equity......... b 201,000 37,500 $551,000 $163,000 150,000 313,000 $180,000 69,000 249,000 (11,000) 238,000 $551,000 The amount determined for current assets could be computed last and then is a “plug” figure. That is, total liabilities and stockholders’ equity is computed because information is available to determine this amount. Because the total assets amount is the same as total liabilities and stockholders’ equity amount, the amount of total assets is determined. Information is available to compute all the asset amounts except current assets and therefore current assets can be determined by deducting the total of all the other asset balances from the total asset balance (i.e., $551,000 – $37,500 – $201,000 – $16,000). Another way to compute this amount, given the information, is that beginning current assets plus the $29,000 increase in current assets other than cash plus the $32,500 increase in cash equals $296,500. 5-38 EXERCISE 5-18 (25–35 minutes) (a) Madrasah Corporation Statement of Cash Flows For the Year Ended December 31, 2007 $44,000 Cash flows from operating activities Net income...................................................................... Adjustment to reconcile net income to net cash provided by operating activities: Depreciation................................................................... Increase in accounts payable .................................. Increase in accounts receivable ............................. Net cash provided by operating activities ........... Cash flows from Investing activities Purchase of equipment .............................................. Cash flows from financing activities Issuance of stock ......................................................... Payment of dividends ................................................. Net cash used by financing activities ................... Net increase in cash........................................................... Cash at beginning of year ................................................ Cash at end of year............................................................. $ 6,000 5,000 (18,000) (7,000) 37,000 (17,000) 20,000 (33,000) (13,000) $ 7,000 13,000 $20,000 2007 6.3 $126,000 $ 20,000 2006 6.73 $101,000 $ 15,000 (b) Current ratio Free Cash Flow Analysis Net cash provided by operating activities ................................. Less: Purchase of equipment....................................................... Pay dividends ......................................................................... Free cash flow ..................................................................................... $ 37,000 (17,000) (33,000) $ (13,000) (c) Although, Madrasah’s current ratio has declined from 2006 to 2007, it is still in excess of 6. It appears the company has good liquidity and financial flexibility. 5-39 TIME AND PURPOSE OF PROBLEMS Problem 5-1 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to prepare a balance sheet, given a set of accounts. No monetary amounts are to be reported. Problem 5-2 (Time 35–40 minutes) Purpose—to provide the student with the opportunity to prepare a complete balance sheet, involving dollar amounts. A unique feature of this problem is that the student must solve for the retained earnings balance. Problem 5-3 (Time 40–45 minutes) Purpose—to provide an opportunity for the student to prepare a balance sheet in good form. Emphasis is given in this problem to additional important information that should be disclosed. For example, an inventory valuation method, bank loans secured by long-term investments, and information related to the capital stock accounts must be disclosed. Problem 5-4 (Time 40–45 minutes) Purpose—to provide the student with the opportunity to analyze a balance sheet and correct it where appropriate. The balance sheet as reported is incomplete, uses poor terminology, and is in error. A challenging problem. Problem 5-5 (Time 40–45 minutes) Purpose—to provide the student with the opportunity to prepare a balance sheet in good form. Additional information is provided on each asset and liability category for purposes of preparing the balance sheet. A challenging problem. Problem 5-6 (Time 35–45 minutes) Purpose—to provide the student with an opportunity to prepare a complete statement of cash flows. A condensed balance sheet is also required. The student is also required to explain the usefulness of the statement of cash flows. Because the textbook does not explain in Chapter 5 all of the steps involved in preparing the statement of cash flows, assignment of this problem is dependent upon additional instruction by the teacher or knowledge gained in elementary financial accounting. Problem 5-7 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to prepare a balance sheet in good form and a more complex cash flow statement. 5-40 SOLUTIONS TO PROBLEMS PROBLEM 5-1 Company Name Balance Sheet December 31, 20XX Assets Current assets Cash on hand (including petty cash) Cash in bank Trading securities Accounts receivable Less: Allowance for doubtful accounts Interest receivable Advances to employees Inventory (ending) Prepaid rent Total current assets Long-term investments Bond sinking fund Cash surrender value of life insurance Land for future plant site Total long-term investments Property, plant, and equipment Land Buildings Less: Accum. depreciation—buildings Equipment Less: Accum. depreciation—equipment Total property, plant, and equipment Intangible assets Copyright Patent Total intangible assets Total assets 5-41 $XXX XXX XXX XXX $XXX XXX XXX XXX XXX XXX XXX $XXX $XXX XXX XXX $XXX $XXX $XXX XXX XXX XXX XXX XXX XXX $XXX XXX XXX $XXX PROBLEM 5-1 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable Payroll taxes payable Accrued wages Dividends payable Unearned subscriptions revenue Total current liabilities Long-term debt Bonds payable Add: Premium on bonds payable Pension obligations Total long-term liabilities Total liabilities Stockholders’ equity Capital stock Preferred stock (description) Common stock (description) Additional paid-in capital Premium on preferred stock Total paid-in capital Retained earnings Total paid-in capital and retained earnings Less: Treasury stock (description) Total stockholders’ equity Total liabilities and stockholders’ equity $XXX XXX XXX XXX XXX $XXX $XXX XXX XXX XXX XXX XXX $XXX XXX XXX XXX XXX XXX XXX (XXX) XXX $XXX 5-42 PROBLEM 5-2 Letterman, Inc. Balance Sheet December 31, 2007 Assets Current assets Cash............................................................. Trading securities ................................... Notes receivable...................................... Income taxes receivable ....................... Inventories................................................. Prepaid expenses.................................... Total current assets......................... Property, plant, and equipment Land............................................................. $ 480,000 Building ...................................................... $1,640,000 Less: Accum. depreciation— building ............................................ Equipment ................................................. Less: Accum. depreciation— equipment........................................ Intangible assets Goodwill ..................................................... Total assets ........................................ 170,200 1,470,000 292,000 1,178,000 3,127,800 1,469,800 $ 360,000 121,000 545,700 97,630 239,800 87,920 $1,452,050 125,000 $4,704,850 5-43 PROBLEM 5-2 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable..................................... Notes payable to banks .......................... Payroll taxes payable .............................. Taxes payable ............................................ Rent payable............................................... Total current liabilities ..................... $ 590,000 265,000 177,591 98,362 45,000 $1,175,953 Long-term liabilities Unsecured notes payable (long-term).............................................. $1,600,000 Bonds payable........................................... $300,000 Less: Discount on bonds payable .............................................. 15,000 285,000 Long-term rental obligations ............... 480,000 Total liabilities..................................... Stockholders’ equity Capital stock Preferred stock, $10 par; 20,000 shares authorized, 15,000 shares issued .................................. $150,000 Common stock, $1 par; 400,000 shares authorized, 200,000 issued................................. 200,000 Retained earnings ($1,163,897 – $350,000) ....................... Total stockholders’ equity ($4,704,850 – $3,540,953) ............. Total liabilities and stockholders’ equity...................... 2,365,000 3,540,953 $350,000 813,897 1,163,897 $4,704,850 5-44 PROBLEM 5-3 Side Kicks Company Balance Sheet December 31, 2007 Assets Current assets Cash................................................................. $ 41,000 Accounts receivable................................... $163,500 Less: Allowance for doubtful accounts .............................................. 8,700 154,800 Inventory—at LIFO cost ............................ 308,500 Prepaid insurance....................................... 5,900 Total current assets............................. Long-term investments Investments in stocks and bonds, of which investments of $120,000 have been pledged as security for notes payable—at fair value................. Property, plant, and equipment Cost of uncompleted plant facilities Land .......................................................... Building in process of construction ....................................... Equipment ..................................................... Less: Accum. depreciation ............... Intangible assets Patents—at cost less amortization ....... Total assets ............................................ $ 510,200 339,000 85,000 124,000 400,000 140,000 209,000 260,000 469,000 36,000 $1,354,200 5-45 PROBLEM 5-3 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable, secured by investments of $120,000.......................... Accounts payable....................................... Accrued expenses...................................... Total current liabilities ....................... Long-term liabilities 8% bonds payable, due January 1, 2018 ........................................ Less: Unamortized discount on bonds payable......................................... Total liabilities....................................... Stockholders’ equity Common stock Authorized 600,000 shares of $1 par value; issued and outstanding, 500,000 shares ........... $500,000 Premium on common stock .................... 45,000 Retained earnings ...................................... Total liabilities and stockholders’ equity........................ $ 94,000 148,000 49,200 $ 291,200 400,000 20,000 380,000 671,200 545,000 138,000 683,000 $1,354,200 5-46 PROBLEM 5-4 Russell Crowe Corporation Balance Sheet December 31, 2007 Assets Current assets Cash............................................................... Accounts receivable................................. Inventories................................................... Total current assets........................... Long-term investments Assets allocated to trustee for expansion: Cash in bank ............................................... U.S. Treasury notes, at fair value......... Property, plant, and equipment Land............................................................... Buildings ...................................................... $1,070,000a Less: Accum. depreciation— buildings ............................................ 410,000 Total assets .......................................... $175,900 170,000 312,100 $658,000 70,000 138,000 208,000 750,000 660,000 1,410,000 $2,276,000 Liabilities and Stockholders’ Equity Current liabilities Notes payable—current installment....... Federal income taxes payable .............. Total current liabilities...................... $100,000 75,000 $ 175,000 5-47 PROBLEM 5-4 (Continued) Long-term liabilities Notes payable ............................................... Total liabilities......................................... Stockholders’ equity Common stock, no par; 1,000,000 shares authorized and issued; 950,000 shares outstanding................... Retained earnings ........................................ Less: Treasury stock, at cost (50,000 shares) .......................................................... Total stockholders’ equity .................. Total liabilities and stockholders’ equity.......................... 500,000b 675,000 $1,150,000 538,000c 1,688,000 (87,000) 1,601,000 $2,276,000 $1,640,000 – $570,000 (to eliminate the excess of appraisal value over cost from the Buildings account. Note that the appreciation capital account is also deleted.) b a $600,000 – $100,000 (to reclassify the currently maturing portion of the notes payable as a current liability.) $658,000 – $120,000 (to remove the value of goodwill from retained earnings. Note 2 indicates that retained earnings was credited. Note that the goodwill account is also deleted.) Note: As an alternate presentation, the cash restricted for plant expansion would be added to the general cash account and then subtracted. The amount reported in the investments section would not change. c 5-48 PROBLEM 5-5 Stephen King Corporation Balance Sheet December 31, 2007 Assets Current assets Cash............................................................... Trading securities—at fair value .......... Accounts receivable................................. $ 170,000 Less: Allowance for doubtful accounts ............................................ 10,000 Inventories, at lower of cost (determined using FIFO) or market....... Total current assets........................... Long-term investments Investments in common stock (available for sale)—at fair value ...... Bond sinking fund..................................... Cash surrender value of life insurance.................................................. Land held for future use ......................... Property, plant, and equipment Land............................................................... Buildings ...................................................... Less: Accum. depreciation— building .............................................. Equipment ................................................... Less: Accum. depreciation— equipment.......................................... Intangible assets Franchise ..................................................... Goodwill ....................................................... Total assets .......................................... $114,000 80,000 160,000 180,000 $ 534,000 270,000 250,000 40,000 270,000 830,000 500,000 1,040,000 360,000 450,000 180,000 680,000 270,000 1,450,000 165,000 100,000 265,000 $3,079,000 5-49 PROBLEM 5-5 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable...................................... Notes payable ............................................. Taxes payable ............................................. Unearned revenue ..................................... Total current liabilities ....................... $ 104,000 80,000 40,000 5,000 $ 229,000 Long-term liabilities Notes payable ............................................. $ 120,000 7% bonds payable, due 2015 ................ $1,000,000 Less: Discount on bonds payable........ 40,000 960,000 Total liabilities....................................... Stockholders’ equity Capital stock Preferred stock, no par value; 200,000 shares authorized, 70,000 issued and outstanding....... Common stock, $1 par value; 400,000 shares authorized, 100,000 issued and outstanding .......... Paid-in capital in excess of par on common stock (100,000 X [$10.00 – $1.00)] ...................................... Retained earnings ..................................... Total stockholders’ equity ................ Total liabilities and stockholders’ equity........................ 1,080,000 1,309,000 450,000 100,000 900,000 1,450,000 320,000 1,770,000 $3,079,000 5-50 PROBLEM 5-6 (a) Alistair Cooke, Inc. Statement of Cash Flows For the Year Ended December 31, 2007 Cash flows from operating activities Net income...................................................................... Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense .......................................... Gain on sale of investments.............................. Increase in account receivable ($41,600 – $21,200) ............................................ Net cash provided by operating activities ........... Cash flows from investing activities Sale of investments..................................................... Purchase of land .......................................................... Net cash used by investing activities.................... Cash flows from financing activities Issuance of common stock....................................... Retirement of notes payable .................................... Payment of cash dividends ...................................... Net cash used by financing activities ................... Net increase in cash........................................................... Cash at beginning of year ................................................ Cash at end of year............................................................. $32,000 12,000 (3,400) (20,400) (11,800) 20,200 17,000 (18,000) (1,000) 24,000 (16,000) (8,200) (200) 19,000 20,000 $39,000 Noncash investing and financing activities Land purchased through issuance of $30,000 of bonds 5-51 PROBLEM 5-6 (Continued) (b) Alistair Cooke Inc. Balance Sheet December 31, 2007 Assets Cash Accounts receivable Investments Plant assets (net) Land $39,000 41,600 18,400 (1) 69,000 (2) 88,000 (3) $256,000 Liabilities and Stockholders’ Equity Accounts payable Long-term notes payable Bonds payable Common stock Retained earnings $30,000 25,000 30,000 124,000 47,000 $256,000 (4) (5) (6) (7) (1) $32,000 – ($17,000 – $3,400) (2) $81,000 – $12,000 (3) $40,000 + $18,000 + $30,000 (4) $41,000 – $16,000 (5) $0 + $30,000 (6) $100,000 + $24,000 (7) $23,200 + $32,000 – $8,200 (c) Cash flow information is useful for assessing the amount, timing, and uncertainty of future cash flows. For example, by showing the specific inflows and outflows from operating activities, investing activities, and financing activities, the user has a better understanding of the liquidity and financial flexibility of the enterprise. Similarly, these reports are useful in providing feedback about the flow of enterprise resources. This information should help users make more accurate predictions of future cash flow. In addition, some individuals have expressed concern about the quality of the earnings because the measurement of the income depends on a number of accruals and estimates which may be somewhat subjective. As a result, the higher the ratio of cash provided by operating activities to net income, the more comfort some users have in the reliability of the earnings. In this problem the ratio of cash provided by operating activities to net income is 63% ($20,200 ÷ $32,000). 5-52 PROBLEM 5-6 (Continued) An analysis of Cooke’s free cash flow indicates it is negative as shown below: Free Cash Flow Analysis Net cash provided by operating activities ................................. Less: Purchase of land .................................................................. Dividends ............................................................................... Free cash flow ..................................................................................... $20,200 (18,000) (8,200) $ (6,000) $20,200 Its current cash debt coverage ratio is .67 to 1 and its cash debt $30,000 $71,000 + $85,000 coverage ratio is .26 to 1 $20,200 ÷ , which are reasonable. 2 Overall, it appears that its liquidity position is average and overall financial flexibility should be improved. 5-53 PROBLEM 5-7 (a) Jay Leno Inc. Statement of Cash Flows For the Year Ended December 31, 2007 Cash flows from operating activities Net income...................................................................... Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense........................................... Loss on sale of investments.............................. Increase in accounts payable ($40,000 – $30,000) ......................................... Increase in accounts receivable ($42,000 – $21,200) ......................................... Net cash provided by operating activities............ Cash flows from investing activities Sale of investments ..................................................... Purchase of land........................................................... Net cash used by investing activities .................... Cash flows from financing activities Issuance of common stock ....................................... Payment of cash dividends....................................... Net cash provided by financing activities............ Net increase in cash ........................................................... Cash at beginning of year................................................. Cash at end of year ............................................................. $35,000 $12,000 3,000 10,000 (20,800) 4,200 39,200 29,000 (38,000) (9,000) 26,000 (10,000) 16,000 46,200 20,000 $66,200 Noncash investing and financing activities Land purchased through issuance of $30,000 of bonds 5-54 PROBLEM 5-7 (Continued) (b) Jay Leno Inc. Balance Sheet December 31, 2007 Assets Liabilities and Stockholders’ Equity $66,200 42,000 69,000 (1) 108,000 (2) $285,200 Accounts payable Bonds payable Common stock Retained earnings $40,000 71,000 (3) 126,000 (4) 48,200 (5) $285,200 Cash Accounts receivable Plant assets (net) Land (1) $81,000 – $12,000 (2) $40,000 + $38,000 + $30,000 (3) $41,000 + $30,000 (4) $100,000 + $26,000 (5) $23,200 + $35,000 – $10,000 (c) An analysis of Leno’s free cash flow indicates it is negative as shown below: Free Cash Flow Analysis Net cash provided by operating activities .................................. Less: Purchase of land ................................................................... Dividends ................................................................................ Free cash flow ...................................................................................... $39,200 (38,000) (10,000) $( 8,800) 5-55 PROBLEM 5-7 (Continued) $39,200 Its current cash debt coverage is 1.12 to 1 . Overall, it appears $35,000* that its liquidity position is average and overall financial flexibility should be improved. *($30,000 + $40,000) ÷ 2 (d) This type of information is useful for assessing the amount, timing, and uncertainty of future cash flows. For example, by showing the specific inflows and outflows from operating activities, investing activities, and financing activities, the user has a better understanding of the liquidity and financial flexibility of the enterprise. Similarly, these reports are useful in providing feedback about the flow of enterprise resources. This information should help users make more accurate predictions of future cash flow. In addition, some individuals have expressed concern about the quality of the earnings because the measurement of the income depends on a number of accruals and estimates which may be somewhat subjective. As a result, the higher the ratio of cash provided by operating activities to net income, the more comfort some users have in the reliability of the earnings. 5-56 TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 5-1 (Time 20–25 minutes) Purpose—to provide a varied number of financial transactions and then determine how each of these items should be reported in the financial statements. Accounting changes, additional assessments of income taxes, prior period adjustments, and changes in estimates are some of the financial transactions presented. CA 5-2 (Time 25–30 minutes) Purpose—to present the student with the opportunity to determine whether certain accounts should be classified as current asset and current liability items. Borderline cases are included in which the student is required to state the reasons for the questionable classifications. The number of items to be classified is substantial and provides a good review to assess whether students understand what items should be classified in the current section of the balance sheet. CA 5-3 (Time 30–35 minutes) Purpose—to present the asset section of a partial balance sheet that must be analyzed to assess its deficiencies. Items such as improper classifications, terminology, and disclosure must be considered. CA 5-4 (Time 20–25 minutes) Purpose—to present a balance sheet that must be analyzed to assess its deficiencies. Items such as improper classification, terminology, and disclosure must be considered. CA 5-5 (Time 20–25 minutes) Purpose—to present the student an ethical issue related to the presentation of balance sheet information. The reporting involves “net presentation” of property, plant and equipment. CA 5-6 (Time 40–50 minutes) Purpose—to present a cash flow statement that must be analyzed to explain differences in cash flow and net income, and sources and uses of cash flow and ways to improve cash flow. 5-57 SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 5-1 1. The new estimate would be used in computing depreciation expense for 2007. No adjustment of the balance in accumulated depreciation at the beginning of the year would be made. Instead, the remaining depreciable cost would be divided by the estimated remaining life. This is a change in an estimate and is accounted for prospectively (in the current and future years). Disclosure in the notes to the financial statements is appropriate, if material. The additional assessment should be shown on the current period’s income statement. If material it should be shown separately; if immaterial it could be included with the current year’s tax expense. This transaction does not represent a prior period adjustment. The effect of the error at December 31, 2006, should be shown as an adjustment of the beginning balance of retained earnings on the retained earnings statement. The current year’s expense should be adjusted (if necessary) for the possible carryforward of the error into the 2007 expense computation. Generally, an entry is made for a cash dividend on the date of declaration. The appropriate entry would be a debit to Retained Earnings (or Dividends) for the amount to be paid, with a corresponding credit to Dividends Payable. Dividends payable is reported as a current liability. 2. 3. 4. CA 5-2 Current Assets Interest accrued on U.S. government securities. Notes receivable. Petty cash fund. U.S. government securities. Cash in bank. Inventory of operating parts and supplies. Inventory of raw materials. Accounts receivable. U.S. government contracts. Regular (less allowance for doubtful accounts). Installments—due next year. Inventory of finished goods. Inventory of work in process. Current Liabilities Preferred cash dividend, payable Nov. 1, 2007. Federal income taxes payable. Customers’ advances (on contracts to be completed next year). Premium on bonds redeemable in 2007. Officers’ 2007 bonus accrued. Accrued payroll. Notes payable. Accrued interest on bonds. Accounts payable. Accrued interest on notes payable. 8% First mortgage bonds to be redeemed in 2007. 5-58 CA 5-2 (Continued) Borderline cases that have been classified on the basis of assumptions are: 1. 2. 3. 4. Notes receivable are assumed to be collectible within one year or the operating cycle. U.S. government securities are assumed to be a temporary investment of current funds. Accounts receivable—government contracts are assumed to be collectible within one year or the operating cycle. Notes payable are assumed to be due within one year or the operating cycle. (Note to instructor: Allowance for doubtful accounts receivable is not a current asset. It, however, would appear in the current asset section.) CA 5-3 (1) Unclaimed payroll checks should be shown as a current liability if these are claims by employees. (2) Trading securities should be reported at fair value, not cost. (3) Bad Debt Reserve is an improper terminology; Allowance for Doubtful Accounts is considered more appropriate. The amount of estimated uncollectibles should be disclosed. (4) Next-in, First-out (NIFO) is not an acceptable inventory valuation method. (5) Heading “Tangible assets” should be changed to “Property, Plant and Equipment” also label for corresponding $630,000 should be changed to “net property, plant, and equipment.” (6) Land should not be depreciated. (7) Buildings and equipment and their related accumulated depreciation balances should be separately disclosed. (8) The valuation basis for stocks should be disclosed (fair value or equity) and the description should be Available for Sale Securities or Investment in X Company. (9) Treasury stock is not an asset and should be shown in the stockholders’ equity section as a deduction. (10) Discount on bonds payable is not an asset and should be shown as a deduction from bonds payable. (11) Sinking fund should be reported in the long-term investments section. CA 5-4 Criticisms of the balance sheet of the Bellemy Brothers Corporation: (1) The basis for the valuation of marketable securities should be shown. Marketable securities are valued at fair value. In addition, they should be classified as either trading securities, available-forsale securities, or held-to-maturity securities. (2) An allowance for doubtful accounts receivable is not indicated. 5-59 CA 5-4 (Continued) (3) The basis for the valuation and the method of pricing for Merchandise Inventory are not indicated. (4) A stock investment in a subsidiary company is not ordinarily held to be sold within one year or the operating cycle, whichever is longer. As such, this account should not be classified as a current asset, but rather should be included under the heading “Investments.” The basis of valuation of the investment should be shown. (5) Treasury stock is not an asset. It should be presented as a deduction in the stockholders’ equity section of the balance sheet. The class of stock, number of shares, and basis of valuation should be indicated. (6) Buildings and land should be segregated. The Reserve for Depreciation should be shown as a subtraction from the Buildings account only. Also, the term “reserve for” should be replaced by “accumulated.” (7) Cash Surrender Value of Life Insurance would be more appropriately shown under the heading of “Investments.” (8) Reserve for Income Taxes should appropriately be entitled Income Taxes Payable. (9) Customers’ Accounts with Credit Balances is an immaterial amount. As such, this account need not be shown separately. The $1,000 credit could readily be netted against Accounts Receivable without any material misstatement. (10) Unamortized Premium on Bonds Payable should be appropriately shown as an addition to the related Bonds Payable in the long-term liability section. The use of the term deferred credits is inappropriate. (11) Bonds Payable are inadequately disclosed. The interest rate, interest payment dates, and maturity date should be indicated. (12) Additional disclosure relative to the Common Stock account is needed. This disclosure should include the number of shares authorized, issued, and outstanding. (13) Earned Surplus should appropriately be entitled Retained Earnings. Also, a separate heading should be shown for this account; it should not be shown under the heading “Capital Stock.” A more appropriate heading would be “Stockholders’ Equity.” (14) Cash Dividends Declared should be disclosed on the retained earnings statement as a reduction of retained earnings. Dividends Payable, in the amount of $8,000, should be shown on the balance sheet among the current liabilities, assuming payment has not occurred. CA 5-5 (a) The ethical issues involved are integrity and honesty in financial reporting, full disclosure, and the accountant’s professionalism. (b) While presenting property, plant, and equipment net of depreciation on the balance sheet may be acceptable under GAAP, it is inappropriate to attempt to hide information from financial statement users. Information must be useful, and the presentation Pafko is considering would not be. Users would not grasp the age of plant assets and the company’s need to concentrate its future cash outflows on replacement of these assets. This information could be provided in a note disclosure. 5-60 CA 5-5 (Continued) Because of the significant impact on the financial statements of the depreciation method(s) used, the following disclosures should be made. a. b. c. d. Depreciation expense for the period. Balances of major classes of depreciable assets, by nature and function. Accumulated depreciation, either by major classes of depreciable assets or in total. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. CA 5-6 Date James Spencer, III, CEO James Spencer Corporation 125 Wall Street Middleton, Kansas 67458 Dear Mr. Spencer: I have good news and bad news about the financial statements for the year ended December 31, 2007. The good news is that net income of $100,000 is close to what we predicted in the strategic plan last year, indicating strong performance this year. The bad news is that the cash balance is seriously low. Enclosed is the Statement of Cash Flows, which best illustrates how both of these situations occurred simultaneously. If you look at the operating activities, you can see that no cash was generated by operations due to the increase in accounts receivable and inventory and reduction in accounts payable. In effect, these events caused net cash flow provided by operating activities to be lower than net income, they reduced your cash balance by $116,000. The corporation made significant investments in equipment and land. These were paid from cash reserves. These purchases used 75% of the company’s cash. In addition, the redemption of the bonds improved the equity of the corporation and reduced interest expense. However, it also used 25% of the corporation’s cash. It is normal to use cash for investing and financing activities. But when cash is used, it must also be replenished. Operations normally provide the cash for investing and financing activities. Since there is a finite amount of assets to sell and funds to borrow or raise from the sale of capital stock, operating activities are the only renewable source of cash. That is why it is important to keep the operating cash flows positive. Cash management requires careful and continuous planning. There are several possible remedies for the current cash problem. First, prepare a detailed analysis of monthly cash requirements for the next year. Second, investigate the changes in accounts receivable and inventory and work to return them to more normal levels. Third, look for more favorable terms with suppliers to allow the accounts payable to increase without loss of discounts or other costs. Finally, since the land represents a long-term commitment without immediate plans for use, consider shopping for a low interest loan to finance the acquisition for a few years and return the cash balance to a more normal level. If you have additional questions or need one of our staff to address this problem, please contact me at your convenience. Sincerely yours, Partner in Charge 5-61 FINANCIAL REPORTING PROBLEM (a) P&G could use the account form or report form. P&G uses the report form. (b) The techniques of disclosing pertinent information include (1) parenthetical explanations, (2) notes, (3) cross-reference and contra items, and (4) supporting schedules. P&G uses parenthetical explanations and notes (see notes to financial statements section) and supporting schedules. (c) Investments are reported on P&G’s balance sheet as current assets. Note 1 (Significant Accounting Policies) states that Investments are readily available marketable debt and equity securities. These securities are reported at fair value. Unrealized gains and losses on trading securities are recognized in income. Unrealized gains and losses relating to investments classified as available-for-sale are recorded as a component of accumulated other comprehensive income in stockholders’ equity. As of June 30, 2004, P&G had negative working capital (current assets less than current liabilities) of $5,032,000,000. At June 30, 2003, P&G’s positive working capital was $2,862,000,000. (d) The following table summarizes P&G’s cash flows from operating, investing, and financing activities in the 2002–2004 time period (in millions). 2004 $ 9,362 (9,391) (368) 2003 $ 8,700 (1,507) (5,095) 2002 $ 7,742 (6,835) 197 Net cash provided by operating activities Net cash used in investing activities Net cash used in financing activities P&G’s net cash provided by operating activities increased by 12% from 2002 to 2003, and by 8% from 2003 to 2004. When accounts payable, accrued and other liabilities increase, cost of goods sold and operating expenses are higher on an accrued basis than they are on a cash basis. To convert to net cash provided by operating activities, the increase in accounts payable, accrued and other liabilities must be added to net income. 5-62 FINANCIAL REPORTING PROBLEM (Continued) (e) (1) Net Cash Provided by Operating Activities ÷ Average Current Liabilities = Current Cash Debt Ratio $9,362 ÷ ($22,147 + $12,358) 2 = .54:1 (2) Net Cash Provided by Operating Activities ÷ Average Total Liabilities = Cash Debt Coverage Ratio $9,362 ÷ ($39,770 + $27,520) 2 = .28:1 (3) Net cash provided by operating activities less capital expenditures and dividends Net cash provided by operating activities Less: Capital expenditures Dividends Free cash flow $9,362 $2,024 2,539 4,563 $4,799 Note that P&G also used cash ($4,070 million) to repurchase common stock, which reduces its free cash flow to $729 million. P&G’s financial position appears adequate. Over 25% of its total liabilities can be covered by the current year’s operating cash flow and its free cash flow position indicates it is easily meeting its capital investment and financing demands from current free cash flow. 5-63 FINANCIAL STATEMENT ANALYSIS CASE 1 (a) T he raw materials price increase is not a required disclosure. However, the company might well want to inform shareholders in the management discussion and analysis section, especially as a means for company management to point out an area of success. If the company had not been able to successfully meet the challenge, then the reporting in the discussion and analysis section would be for the purpose of explaining poorer than expected operating results. The information in item (2) should be reported as follows: The $4,000,000 outstanding should, of course, be included in the balance sheet as a part of liabilities (short- or long-term, depending on the terms of the loan). The fact that an additional $11,000,000 or so is available for borrowing should be disclosed in the notes to the financial statements, as also should the fact that the loan is based on the accounts receivable. (b) 5-64 FINANCIAL STATEMENT ANALYSIS CASE 2 (a) These accounts are shown in the order in which Sherwin-Williams actually presented the accounts. The order shown may be modified somewhat; however, cash should certainly be listed first and other current assets last within the current asset category; common stock should be listed first and retained earnings last in the shareholders’ equity category. For the remaining items, the order may be different than that shown. CURRENT ASSETS Cash and cash equivalents Short-term investments Accounts receivable, less allowance Finished goods inventories Work in process and raw materials inventories Other current assets LONG-TERM ASSETS Land Buildings Machinery and equipment Intangibles and other assets CURRENT LIABILITIES Accounts payable Employee compensation payable Taxes payable Other accruals Accrued taxes LONG-TERM LIABILITIES Long-term debt Postretirement benefits other than pensions Other long-term liabilities 5-65 FINANCIAL STATEMENT ANALYSIS CASE 2 (Continued) SHAREHOLDERS’ EQUITY Common stock Other capital Retained earnings (b) There is some latitude for judgment in this question. The general answer is that the assets and liabilities specific to the automotive division will decrease and that cash will increase. Some students may be aware that retained earnings will increase or decrease, depending upon whether the assets were sold above or below historical cost. ♦ Cash and cash equivalents—increase from the sale of the assets ♦ Accounts receivable, less allowance—decrease from the sale of the Automotive Division’s receivables ♦ Finished goods inventories—decrease ♦ Work in process and raw materials inventories—decrease ♦ Land—decrease ♦ Buildings—decrease ♦ Machinery and equipment—decrease ♦ Long-term debt—decrease ♦ Retained earnings—increase or decrease, depending on whether the assets were sold above or below cost 5-66 FINANCIAL STATEMENT ANALYSIS CASE 3 a. Working Capital, Current Ratio Without Contractual Obligations Working Capital $17,855 – $7,888 = $9,997 With contractual Obligations* Off-balance sheet current obligations = $2,351 ($2,274 + $75 + $2) Working Capital $17,855 – ($7,888 + $2,351) = $7,616 Current Ratio $17,855 ÷ $7,888 = 2.27 Current Ratio $17,855 ÷ ($7,888 + $2,351) = 1.74 *Note: The Total debt of $3,458 is included in the current liabilities on the balance sheet. Without information on contractual obligations, an analyst would overstate Deere’s liquidity, as measured by working capital and the current ratio. b. 1) Based on the analysis in part a., Deere has a pretty good liquidity cushion. It would be able to pay a loan of up $7.6 billion, if due in one year. 2) Additional contractual obligations of $4,839 in years 1–3 and $1,610 in years 3–5 are relevant to assessing whether Deere can repay a loan maturing in 5 years. In evaluating a longer term loan, an analyst would need to develop a prediction of Deere’s cash flows over the next 5 years that would be used to repay a longer term loan. In summary, the schedule of contractual obligations provides information about off-balance sheet obligations—both the amounts and when due. This helps the analyst assess both liquidity and solvency of a company. 5-67 FINANCIAL STATEMENT ANALYSIS CASE 4 (a) ($ in millions) Current assets Total assets Current liabilities Total liabilities (1) Cash provided by operations (2) Capital expenditures (3) Dividends paid Net Income (loss) Sales Free Cash Flow (1) – (2) – (3) 2003 $1,821 2,162 1,253 3,198 392 46 0 35 5,264 346 2002 $1,616 1,990 1,066 3,343 174 39 0 (149) 3,933 135 As indicated above, Amazon’s free cash flow in 2003 and 2002 was $346 million and $135 million respectively. Amazon shows a positive trend in profitability and cash flow from operations. Depending on the investment required to build the warehouses, it appears they could finance the warehouses with internal funds. (b) Cash from operations has increased in 2003 relative to 2002 by $218 million. This is due in part to increased profitability (increase of $184 million) from a loss of $149 in 2002 to its first profit in 2003. If the company can turn in another year like this in 2004, it would appear they are on the way to more stable performance. Prior to 2003, most would agree that Amazon was over-priced. It is hard to justify high market valuations in the face of operating losses and barely positive cash flow from operations. However, the results posted in 2003 indicate that Amazon may have turned the corner financially. However, it may be awhile before investors can expect any dividends. (c) 5-68 COMPARATIVE ANALYSIS CASE (a) The Coca-Cola Company uses the account form; PepsiCo, Inc. uses the report form. The Coca-Cola Company had a working capital of $1,123,000,000 ($12,094,000,000 – $10,971,000,000); PepsiCo, Inc. has working capital of $1,877,000,000 ($8,639,000,000 – $6,752,000,000). The Coca-Cola Company indicates in its management discussion and analysis section that its global presence and strong capital position afford it easy access to key financial markets around the world, enabling it to raise funds with a low effective cost. This posture, coupled with active management of its short-term and long-term debt, results in a lower overall cost of borrowing. As a result, its debt management policies, in conjunction with its share repurchase program and investment activity, can result in current liabilities exceeding current assets. PepsiCo has a similar strategy (see discussion in “Liquidity and Capital Resources.”) The most significant difference relates to intangible assets. The CocaCola Company has Trademarks, Goodwill, and Other Intangible Assets of $3,836 million; PepsiCo, Inc. has Intangible Assets, net of amortization of $5,440,000,000. PepsiCo, Inc. has substantial intangible assets due to the reacquiring of franchise rights and trademarks. In addition, a substantial amount of goodwill is recorded in these reacquisitions which represents the residual purchase price after allocation to all identifiable assets. In addition, PepsiCo carries higher levels of property, plant, and equipment (29.1% of assets), while Coca-Cola’s property, plant, and equipment is just 19% of assets. Coca-Cola has much higher investments in unconsolidated subsidiaries (20%* > 11.7% of assets). *($9,306 – $3,054) ÷ $31,327 (b) (c) 5-69 COMPARATIVE ANALYSIS CASE (Continued) (d) Total assets The Coca-Cola Company PepsiCo, Inc. Long-term debt The Coca-Cola Company PepsiCo, Inc. (e) (54.0%) 40.8% 38.6% (20.3%) Annual 14.6% 10.5% Five-Year 50.4% 34.8% The Coca-Cola Company has increased net cash provided by operating activities from 2002 to 2004 by $1,226 million or 25.9%. PepsiCo, Inc. has increased net cash provided by operating activities by $427 million or 9.2%. Both companies have favorable trends in the generation of internal funds from operations. The Coca-Cola Company Current Cash Debt Ratio $10,971 + $7,886 2 (f) $5,968 ÷ = .63:1 Cash Debt Coverage Ratio $15,392 + $13,252 2 $5,968 ÷ = .42:1 5-70 COMPARATIVE ANALYSIS CASE (Continued) Free cash flow Net cash provided by operating activities Less: Business reinvestment Free cash flow $5,968,000,000 755,000,000 $5,213,000,000 The Coca-Cola Company defines free cash flow as the cash remaining from operations after satisfying business reinvestment opportunities. We have defined it to also reduce dividends. In that case, the CocaCola Company’s free cash flow would be reduced by an additional $2,429,000,000, which would reduce its free cash flow to $2,784,000,000. Note that Coca-Cola is also using cash to repurchase shares ($1,739 million in 2004). PepsiCo, Inc. Current Cash Debt Ratio $5,054 ÷ $6,752 + $6,415 2 = .77:1 Cash Debt Coverage Ratio $5,054 ÷ $14,464 + $13,453 = .36:1 2 Free cash flow Net cash provided by operating activities Less: Capital spending Dividends Free cash flow $5,054,000,000 $1,387,000,000 1,329,000,000 2,716,000,000 $2,338,000,000 PepsiCo also is using significant cash balances to repurchase shares ($3.1 billion in 2004). Both companies have strong liquidity and financial flexibility. 5-71 COMPARATIVE ANALYSIS CASE (Continued) (g) The Coca-Cola Company uses the following ratios: Net debt to net capital; interest coverage ratio; and ratio of earnings to fixed charges. PepsiCo, Inc. does not use any ratios to explain its financial position related to debt financing. Thus, users must construct their own ratios for this purpose. 5-72 RESEARCH CASE 1 (a) Ford Motor Co. = 0000037996 Wisconsin Electric = 0000107815 Ford separately presents the assets and liabilities of its automotive and financial services operations due to their heterogeneity. Wisconsin Electric presents its plant assets first due to their importance. Note that common equity is listed before liabilities for Wisconsin Electric, which is a common practice for utilities. (b) 5-73 INTERNATIONAL REPORTING CASE (a) Some of the differences are: 1. Report form and subtotals—Tomkins uses a modified report form with current liabilities deducted from current assets to determine net current assets and remaining liabilities deducted from total assets less current liabilities to arrive at “net assets”. This amount balances with total “Capital and Reserves”. Classifications—the classifications are not arranged according to decreasing liquidity. For example, “Fixed assets” are listed first, then “Current assets”. Cash is not listed as the first current asset. Terminology—For example, “Stock” is used instead of inventory. The term “Debtors” is used instead of accounts receivable. Contributed capital is referred to as “Called up share capital” and “Share premium”, rather than Common Stock and Additional paid-in capital. “Profit and loss account” is used instead of Retained Earnings. Units of currency—Tomkins reports in pounds sterling. 2. 3. 4. (b) Although there are differences in terminology and some groupings and subtotals are different, the British balance sheet does group assets and liabilities with similar characteristics together (Fixed assets, Current assets and current liabilities). For the most part, the classifications are similar in that they are related to the liquidity of the balance sheet items. By netting liabilities against assets, a measure of solvency is provided. Note to instructors: A final difference not mentioned above is the “Capital redemption reserve” account in the Capital and reserves section of Tomkins’ Balance sheet. This account in the U.K. corresponds to “Additional Paid-in Capital—Treasury Stock in the U.S. setting. 5-74 PROFESSIONAL RESEARCH: ACCOUNTING AND FINANCIAL REPORTING Search string: “accounting policies” and disclosure (a) (b) APB 22: Disclosure of Accounting Policies. 6. The accounting policies of a reporting entity are the specific accounting principles and the methods of applying those principles that are judged by the management of the entity to be the most appropriate in the circumstances to present fairly financial position, changes in financial position, and results of operations in accordance with generally accepted accounting principles and that, accordingly, have been adopted for preparing the financial statements. 12. Disclosure of accounting policies should identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, changes in financial position, or results of operations. In general, the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it should encompass those accounting principles and methods that involve any of the following: a. A selection from existing acceptable alternatives; b. Principles and methods peculiar to the industry in which the reporting entity operates, even if such principles and methods are predominantly followed in that industry; c. Unusual or innovative applications of generally accepted accounting principles (and, as applicable, of principles and methods peculiar to the industry in which the reporting entity operates). (d) Examples of disclosures by a business entity commonly required with respect to accounting policies would include, among others, those relating to basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, accounting for research and development costs (including basis for amortization), translation of foreign currencies, recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. This list of examples is not all-inclusive. (c) 5-75 PROFESSIONAL SIMULATION Financial Statement Lance Livestrong Company Balance Sheet December 31, 2007 Assets Current assets Cash ($50,000 – $20,000)............................................ Accounts receivable ($38,500 + $13,500).............. Less: Allowance for doubtful accounts ........... Inventories ...................................................................... Total current assets................................................ Long-term investments Plant expansion fund................................................... Property, plant, and equipment Equipment ....................................................................... Less: Accumulated depreciation— equipment ............................................................ Intangible assets Patents.............................................................................. Total assets ............................................................... $30,000 $ 52,000 13,500 38,500 65,300 133,800 20,000 132,000 28,000 104,000 20,000 $277,800 5-76 PROFESSIONAL SIMULATION (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable......................................................... Taxes payable................................................................ Note payable .................................................................. Total current liabilities........................................... Long-term liabilities Bonds payable (9%, due June 30, 2015)............... Total liabilities.......................................................... Stockholders’ equity Common stock ($1 par) .............................................. Additional paid in capital ........................................... Retained earnings ........................................................ Total liabilities and stockholders’ equity.............. 50,000 55,000 20,800 125,800 $277,800 100,000 152,000 $32,000 3,000 17,000 $ 52,000 Analysis Z= Working capital Retained earnings X 1.2 + X 1.4 + Total assets Total assets + Sales Total assets X 0.99 + EBIT Total assets X 3.3 MV equity X 0.6 Total liabilities = ($133,800 – $52,000) $20,800 X 1.2 + X 1.4 $277,800 $277,800 + + $14,000 X 3.3 $277,800 $210,000 $225,000 X 0.99 + X 0.6 $277,800 $152,000 = .3533 + .1048 + .1663 + .7484 + .8882 = 2.2610 5-77 PROFESSIONAL SIMULATION (Continued) Livestrong’s Z-Score is above the “likely-to-fail” level of 1.81 but also below the unlikely-to-fail value of 3.0. Livestrong should be concerned about his company’s situation. Research Search string: “accounting policies” and disclosure APB 22: Disclosure of Accounting Policies 12. Disclosure of accounting policies should identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, changes in financial position, or results of operations. In general, the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it should encompass those accounting principles and methods that involve any of the following: a. b. A selection from existing acceptable alternatives; Principles and methods peculiar to the industry in which the reporting entity operates, even if such principles and methods are predominantly followed in that industry; Unusual or innovative applications of generally accepted accounting principles (and, as applicable, of principles and methods peculiar to the industry in which the reporting entity operates). c. Examples of disclosures by a business entity commonly required with respect to accounting policies would include, among others, those relating to basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, accounting for research and development costs (including basis for amortization), translation of foreign currencies, recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. This list of examples is not all-inclusive. 5-78 CHAPTER 6 Accounting and the Time Value of Money ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. 2. 3. Present value concepts. Use of tables. Present and future value problems: a. Unknown future amount. b. Unknown payments. c. Unknown number of periods. d. Unknown interest rate. e. Unknown present value. 4. Value of a series of irregular deposits; changing interest rates. Valuation of leases, pensions, bonds; choice between projects. Deferred annuity. Expected Cash Flows. Uses of a calculator. 6 15 10, 12, 13, 14, 15 15, 18 8, 19 7, 19 10, 11, 12 1, 5, 13 6, 12, 17 4, 9 3, 11, 16 2, 7, 8, 10, 14 2, 4, 6, 7, 11 7, 16, 17 8, 15 7, 9, 14 2, 3, 4, 5, 6, 8, 12, 17, 18, 19 2, 6 2 2, 7 1, 4, 7, 13, 14 3, 5, 8 Questions 1, 2, 3, 4, 5, 9, 17 13, 14 8 1 Brief Exercises Exercises Problems 5. 3, 5, 6, 8, 9, 10, 13, 14 7 6. 7. *8. 16 20, 21 22, 23, 24 13, 14 15, 16, 17 6-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives 1. 2. 3. 4. 5. Identify accounting topics where the time value of money is relevant. Distinguish between simple and compound interest. Use appropriate compound interest tables. Identify variables fundamental to solving interest problems. Solve future and present value of problems. 1, 2, 3, 4, 7, 8 5, 6, 9, 13 10, 11, 12, 14, 16, 17 15 2, 3, 6, 9, 10, 12, 15, 18, 19 3, 4, 5, 6, 12, 15, 16 3, 4, 5, 6, 11, 12, 16, 17, 18, 19 7, 8, 13, 14 20, 21 22, 23, 24 1, 2, 3, 5, 7, 9, 10 1, 2, 3, 4, 5, 7, 8, 9, 10 1, 2, 3, 4, 5, 7, 8, 9, 10, 13, 14 5, 6, 11, 12 13, 14 15, 16, 17 2 1 Brief Exercises Exercises Problems 6. 7. Solve future value of ordinary and annuity due problems. Solve present value of ordinary and annuity due problems. Solve present value problems related to deferred annuities and bonds. Apply expected cash flows to present value measurement. Use a financial calculator to solve time value of money problems. 8. *9. *10. 6-2 ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty Simple Simple Simple Moderate Simple Moderate Moderate Simple Moderate Simple Moderate Simple Moderate Moderate Moderate Simple Simple Simple Simple Simple Moderate Simple Simple Simple Moderate Moderate Moderate Moderate Moderate Moderate Complex Moderate Complex Complex Complex Moderate Moderate Moderate Moderate Moderate Moderate Time (minutes) 5–10 5–10 10–15 15–20 10–15 15–20 12–17 10–15 5–10 10–15 10–15 10–15 15–20 15–20 15–20 10–15 10–15 10–15 10–15 5–10 15–20 3–5 3–5 3–5 15–20 15–20 20–30 20–30 20–25 25–30 30–35 20–30 30–35 30–35 25–30 20–25 20–25 20–25 10–15 10–15 10–15 Item E6-1 E6-2 E6-3 E6-4 E6-5 E6-6 E6-7 E6-8 E6-9 E6-10 E6-11 E6-12 E6-13 E6-14 E6-15 E6-16 E6-17 E6-18 E6-19 E6-20 E6-21 *E6-22 *E6-23 *E6-24 P6-1 P6-2 P6-3 P6-4 P6-5 P6-6 P6-7 P6-8 P6-9 P6-10 P6-11 P6-12 P6-13 P6-14 *P6-15 *P6-16 *P6-17 Description Using interest tables. Simple and compound interest computations. Computation of future values and present values. Computation of future values and present values. Computation of present value. Future value and present value problems. Computation of bond prices. Computations for a retirement fund. Unknown rate. Unknown periods and unknown interest rate. Evaluation of purchase options. Analysis of alternatives. Computation bond liability. Computation of pension liability. Investment decision. Retirement of debt. Computation of amount of rentals. Least costly payoff—ordinary annuity. Least costly payoff—annuity due. Expected cash flows. Expected cash flows and present value. Determine the interest rate (with a calculator). Determine the interest rate (with a calculator). Determine the interest rate (with a calculator). Various time value situations. Various time value situations. Analysis of alternatives. Evaluating payment alternatives. Analysis of alternatives. Purchase price of a business (deferred annuities). Time value concepts applied to solve business problems. Analysis of alternatives. Analysis of business problems. Analysis of lease versus purchase. Pension funding, deferred annuity. Pension funding—ethics Expected cash flows and present value. Expected cash flows and present value. Various time value of money situations. Various time value of money situations. Various time value of money situations. 6-3 ANSWERS TO QUESTIONS 1. Money has value because with it one can acquire assets and services and discharge obligations. The holding, borrowing or lending of money can result in costs or earnings. And the longer the time period involved, the greater the costs or the earnings. The cost or earning of money as a function of time is the time value of money. Accountants must have a working knowledge of compound interest, annuities, and present value concepts because of their application to numerous types of business events and transactions which require proper valuation and presentation. These concepts are applied in the following areas: (1) sinking funds, (2) installment contracts, (3) pensions, (4) long-term assets, (5) leases, (6) notes receivable and payable, (7) business combinations, and (8) amortization of premiums and discounts. 2. Some situations in which present value measures are used in accounting include: (a) Notes receivable and payable—these involve single sums (the face amounts) and may involve annuities, if there are periodic interest payments. (b) Leases—involve measurement of assets and obligations, which are based on the present value of annuities (lease payments) and single sums (if there are residual values to be paid at the conclusion of the lease). (c) Pensions and other deferred compensation arrangements—involve discounted future annuity payments that are estimated to be paid to employees upon retirement. (d) Bond pricing—the price of bonds payable is comprised of the present value of the principal or face value of the bond plus the present value of the annuity of interest payments. (e) Long-term assets—evaluating various long-term investments or assessing whether an asset is impaired requires determining the present value of the estimated cash flows (may be single sums and/or an annuity). Interest is the payment for the use of money. It may represent a cost or earnings depending upon whether the money is being borrowed or loaned. The earning or incurring of interest is a function of the time, the amount of money, and the risk involved (reflected in the interest rate). Simple interest is computed on the amount of the principal only, while compound interest is computed on the amount of the principal plus any accumulated interest. Compound interest involves interest on interest while simple interest does not. 4. The interest rate generally has three components: (1) Pure rate of interest—This would be the amount a lender would charge if there were no possibilities of default and no expectation of inflation. (2) Expected inflation rate of interest—Lenders recognize that in an inflationary economy, they are being paid back with less valuable dollars. As a result, they increase their interest rate to compensate for this loss in purchasing power. When inflationary expectations are high, interest rates are high. (3) Credit risk rate of interest—The government has little or no credit risk (i.e., risk of nonpayment) when it issues bonds. A business enterprise, however, depending upon its financial stability, profitability, etc. can have a low or a high credit risk. Accountants must have knowledge about these components because these components are essential in identifying an appropriate interest rate for a given company or investor at any given moment. 5. (a) (b) (c) (d) Present value of an ordinary annuity at 8% for 10 periods (Table 6-4). Future value of 1 at 8% for 10 periods (Table 6-1). Present value of 1 at 8% for 10 periods (Table 6-2). Future value of an ordinary annuity at 8% for 10 periods (Table 6-3). 6-4 3. Questions Chapter 6 (Continued) 6. He should choose quarterly compounding, because the balance in the account on which interest will be earned will be increased more frequently, thereby resulting in more interest earned on the investment. As shown in the following calculation: Semiannual compounding, assuming the amount is invested for 2 years: n=4 $1,000 X 1.16986 = $1,169.86 i=4 Quarterly compounding, assuming the amount is invested for 2 years: n=8 $1,000 X 1.17166 = $1,171.66 i=2 Thus, with quarterly compounding, Bill could earn $1.80 more. 7. 8. 9. $24,208.02 = $18,000 X 1.34489 (future value of 1 at 21/2 for 12 periods). $27,919.50 = $50,000 X .55839 (present value of 1 at 6% for 10 periods). An annuity involves (1) periodic payments or receipts, called rents, (2) of the same amount, (3) spread over equal intervals, (4) with interest compounded once each interval. Rents occur at the end of the intervals for ordinary annuities while the rents occur at the beginning of the intervals for annuities due. 10. Amount paid each year = $30,000 3.03735 (present value of an ordinary annuity at 12% for 4 years). Amount paid each year = $9,877.03. 11. Amount deposited each year = $160,000 (future value of an ordinary annuity at 10% for 4 years). 4.64100 Amount deposited each year = $34,475.33. 12. Amount deposited each year = $160,000 [future value of an annuity due at 10% for 4 years 5.10510 (4.64100 X 1.10)]. Amount deposited each year = $31,341.21. 13. The process for computing the future value of an annuity due using the future value of an ordinary annuity interest table is to multiply the corresponding future value of the ordinary annuity by one plus the interest rate. For example, the factor for the future value of an annuity due for 4 years at 12% is equal to the factor for the future value of an ordinary annuity times 1.12. 14. The basis for converting the present value of an ordinary annuity table to the present value of an annuity due table involves multiplying the present value of an ordinary annuity factor by one plus the interest rate. 6-5 Questions Chapter 6 (Continued) 15. Present value = present value of an ordinary annuity of $25,000 for 20 periods at ? percent. $210,000 = present value of an ordinary annuity of $25,000 for 20 periods at ? percent. $210,000 $25,000 = 8.4. Present value of an ordinary annuity for 20 periods at ? percent = The factor 8.4 is closest to 8.51356 in the 10% column (Table 6-4). 16. 4.96764 Present value of ordinary annuity at 12% for eight periods. 2.40183 Present value of ordinary annuity at 12% for three periods. 2.56581 Present value of ordinary annuity at 12% for eight periods, deferred three periods. The present value of the five rents is computed as follows: 2.56581 X $10,000 = $25,658.10. 17. (a) (b) (c) (d) Present value of an annuity due. Present value of 1. Future value of an annuity due. Future value of 1. 18. $27,000 = PV of an ordinary annuity of $6,900 for five periods at ? percent. $27,000 $6,900 = PV of an ordinary annuity for five periods at ? percent. 3.91304 = PV of an ordinary annuity for five periods at ?. 3.91304 = approximately 9%. 19. The IRS argues that the future reserves should be discounted to present value. The result would be smaller reserves and therefore less of a charge to income. As a result, income would be higher and income taxes may therefore be higher as well. 6-6 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 6-1 8% annual interest i = 8% PV = $10,000 FV = ? 0 1 n=3 2 3 FV = $10,000 (FVF3, 8%) FV = $10,000 (1.25971) FV = $12,597.10 8% annual interest, compounded semiannually i = 4% PV = $10,000 FV = ? 0 1 2 3 n=6 4 5 6 FV = $10,000 (FVF6, 4%) FV = $10,000 (1.26532) FV = $12,653.20 6-7 BRIEF EXERCISE 6-2 12% annual interest i = 12% PV = ? FV = $20,000 0 1 2 n=4 3 4 PV = $20,000 (PVF4, 12%) PV = $20,000 (.63552) PV = $12,710.40 12% annual interest, compounded quarterly i = 3% PV = ? FV = $20,000 0 1 2 n = 16 6 7 8 PV = $20,000 (PVF16, 3%) PV = $20,000 (.62317) PV = $12,463.40 6-8 BRIEF EXERCISE 6-3 i=? PV = $30,000 FV = $222,000 0 1 2 n = 21 19 20 21 FV = PV (FVF21, i) OR $222,000 = $30,000 (FVF21, i) FVF21, i = 7.40000 i = 10% PV = FV (PVF21, i) $30,000 = $222,000 (PVF21, i) PVF21, i = .13514 i = 10% BRIEF EXERCISE 6-4 i = 5% PV = $10,000 FV = $13,400 0 n=? FV = PV (FVFn, 5%) OR $13,400 = $10,000 (FVFn, 5%) FVFn, 5% = 1.34000 n = 6 years 6-9 ? PV = FV (PVFn, 5%) $10,000 = $13,400 (PVFn, 5%) PVFn, 5% = .74627 n = 6 years BRIEF EXERCISE 6-5 First payment today i = 12% R= $5,000 $5,000 $5,000 FV–AD = $5,000 $5,000 ? 0 1 2 n = 20 18 19 20 FV–AD = $5,000 (FVF–OA20, 12%) 1.12 FV–AD = $5,000 (72.05244) 1.12 FV–AD = $403,494 First payment at year-end i = 12% FV–OA = ? $5,000 $5,000 $5,000 $5,000 $5,000 0 1 2 n = 20 18 19 20 FV–OA = $5,000 (FVF–OA20, 12%) FV–OA = $5,000 (72.05244) FV–OA = $360,262 6-10 BRIEF EXERCISE 6-6 i = 11% R=? ? ? ? FV–OA = $200,000 0 1 2 n = 10 8 9 10 $200,000 = R (FVF–OA10, 11%) $200,000 = R (16.72201) $200,000 16.72201 =R R = $11,960 BRIEF EXERCISE 6-7 12% annual interest i = 12% PV = ? FV = $350,000 0 1 2 n=5 3 4 5 PV = $350,000 (PVF5, 12%) PV = $350,000 (.56743) PV = $198,600.50 6-11 BRIEF EXERCISE 6-8 With quarterly compounding, there will be 20 quarterly compounding periods, at 1/4 the interest rate: PV = $350,000 (PVF20, 3%) PV = $350,000 (.55368) PV = $193,788 BRIEF EXERCISE 6-9 i = 10% FV–OA = R= $12,961 $12,961 $100,000 $12,961 0 1 2 n=? n $100,000 = $12,961 (FVF–OAn, 10%) $100,000 = 7.71545 FVF–OAn, 10% = 12,961 Therefore, n = 6 years 6-12 BRIEF EXERCISE 6-10 First withdrawal at year-end i = 8% PV–OA = R = ? $20,000 $20,000 $20,000 $20,000 $20,000 0 1 2 n = 10 8 9 10 PV–OA = $20,000 (PVF–OA10, 8%) PV–OA = $20,000 (6.71008) PV–OA = $134,202 First withdrawal immediately i = 8% PV–AD = ? R= $20,000 $20,000 $20,000 $20,000 $20,000 0 1 2 n = 10 8 9 10 PV–AD = $20,000 (PVF–AD10, 8%) PV–AD = $20,000 (7.24689) PV–AD = $144,938 6-13 BRIEF EXERCISE 6-11 i=? PV = R= $1,124.40 $75 $75 $75 $75 $75 0 1 2 n = 18 $1,124.40 = $75 (PVF–OA18, i) PVF18, i = $1,124.40 75 16 17 18 = 14.992 Therefore, i = 2% per month BRIEF EXERCISE 6-12 i = 8% PV = $200,000 R = ? ? ? ? ? 0 1 2 n = 20 18 19 20 $200,000 = R (PVF–OA20, 8%) $200,000 = R (9.81815) R = $20,370 6-14 BRIEF EXERCISE 6-13 i = 12% R= $20,000 $20,000 $20,000 $20,000 $20,000 12/31/06 12/31/07 12/31/08 n=8 12/31/12 12/31/13 12/31/14 FV–OA = $20,000 (FVF–OA8, 12%) FV–OA = $20,000 (12.29969) FV–OA = $245,994 BRIEF EXERCISE 6-14 i = 8% PV–OA = ? R= $20,000 $20,000 $20,000 $20,000 0 1 2 n=4 3 4 5 6 n=8 11 12 PV–OA = $20,000 (PVF–OA12–4, 8% ) OR PV–OA = $20,000 (7.53608 – 3.31213) PV–OA = $20,000 (PVF–OA8, 8%)(PVF4, 8%) PV–OA = $20,000 (5.74664)(.73503) PV–OA = $84,479 PV–OA = $84,479 6-15 BRIEF EXERCISE 6-15 i = 8% PV = ? PV–OA = R = ? $70,000 $70,000 $1,000,000 $70,000 $70,000 $70,000 0 1 2 n = 10 8 9 10 $1,000,000 (PVF10, 8%) = $1,000,000 (.46319) = $463,190 70,000 (PVF–OA10, 8%) = $70,000 (6.71008) 469,706 $932,896 BRIEF EXERCISE 6-16 PV–OA = $20,000 $4,864.51 $4,864.51 $4,864.51 $4,864.51 0 1 $20,000 (PV–OA6, i%) (PV–OA6, i%) Therefore, i% 2 5 = $4,864.51 (PV–OA6, i%) = $20,000 ÷ $4,864.51 = 4.11141 = 12 6 6-16 BRIEF EXERCISE 6-17 PV–AD = $20,000 $? $? $? $? 0 1 2 5 6 $20,000 = Payment (PV–AD6, 12%) $20,000 ÷ (PV–AD6, 12%) = Payment $20,000 ÷ 4.60478 = $4,343.31 6-17 SOLUTIONS TO EXERCISES EXERCISE 6-1 (5–10 minutes) (a) Rate of Interest 9% 3% 5% 9% 5% 3% (b) Number of Periods 9 20 30 25 30 28 1. a. b. c. 2. a. b. c. EXERCISE 6-2 (510 minutes) (a) Simple interest of $1,600 per year X 8 Principal Total withdrawn Interest compounded annually—Future value of 1 @ 8% for 8 periods Total withdrawn (c) Interest compounded semiannually—Future value of 1 @ 4% for 16 periods Total withdrawn EXERCISE 6-3 (10–15 minutes) (a) (b) (c) (d) $7,000 X 1.46933 = $10,285.31. $7,000 X .43393 = $3,037.51. $7,000 X 31.77248 = $222,407.36. $7,000 X 12.46221 = $87,235.47. 6-18 $12,800 20,000 $32,800 (b) 1.85093 X $20,000 $37,018.60 1.87298 X $20,000 $37,459.60 EXERCISE 6-4 (15–20 minutes) (a) Future value of an ordinary annuity of $4,000 a period for 20 periods at 8% Factor (1 + .08) Future value of an annuity due of $4,000 a period at 8% Present value of an ordinary annuity of $2,500 for 30 periods at 10% Factor (1 + .10) Present value of annuity due of $2,500 for 30 periods at 10% Future value of an ordinary annuity of $2,000 a period for 15 periods at 10% Factor (1 + 10) Future value of an annuity due of $2,000 a period for 15 periods at 10% Present value of an ordinary annuity of $1,000 for 6 periods at 9% Factor (1 + .09) Present value of an annuity date of $1,000 for 6 periods at 9% $183,047.84 ($4,000 X 45.76196) X 1.08 $197,691.67 (b) $23,567.28 ($2,500 X 9.42691) X 1.10 $25,924.00 (Or see Table 6-5 which gives $25,924.03) (c) $63,544.96 ($2,000 X 31.77248) X 1.10 $69,899.46 (d) $4,485.92 ($1,000 X 4.48592) X 1.09 $4,889.65 (Or see Table 6-5) EXERCISE 6-5 (10–15 minutes) (a) (b) (c) $30,000 X 4.96764 = $149,029.20. $30,000 X 8.31256 = $249,376.80. ($30,000 X 3.03735 X .50663 = $46,164.38. or (5.65022 – 4.11141) X $30,000 = $46,164.30 (difference of $.08 due to rounding). 6-19 EXERCISE 6-6 (15–20 minutes) (a) (b) Future value of $12,000 @ 10% for 10 years ($12,000 X 2.59374) = Future value of an ordinary annuity of $600,000 at 10% for 15 years ($600,000 X 31.77248) Deficiency ($20,000,000 – $19,063,488) $31,124.88 $19,063,488.00 $936,512.00 (c) $70,000 discounted at 8% for 10 years: $70,000 X .46319 = $32,423.30 Accept the bonus of $40,000 now. (Also, consider whether the 8% is an appropriate discount rate since the president can probably earn compound interest at a higher rate without too much additional risk.) EXERCISE 6-7 (12–17 minutes) (a) $50,000 X .31524 + $5,000 X 8.55948 = $15,762.00 = 42,797.40 $58,559.40 = $11,969.50 = 38,030.40 $49,999.90 (b) $50,000 X .23939 + $5,000 X 7.60608 The answer should be $50,000; the above computation is off by 10¢ due to rounding. (c) $50,000 X .18270 + $5,000 X 6.81086 = $ 9,135.00 = 34,054,30 $43,189.30 6-20 EXERCISE 6-8 (10–15 minutes) (a) Present value of an ordinary annuity of 1 for 4 periods @ 8% Annual withdrawal Required fund balance on June 30, 2013 Fund balance at June 30, 2013 Future value of an ordinary annuity at 8% for 4 years $66,242.60 4.50611 3.31213 X $20,000 $66,242.60 = $14,700.62 (b) Amount of each of four contributions is $14,700.62 EXERCISE 6-9 (10 minutes) The rate of interest is determined by dividing the future value by the present value and then finding the factor in the FVF table with n = 2 that approximates that number: $123,210 = $100,000 (FVF2, i%) $123,210 ÷ $100,000 = (FVF2, i%) 1.2321 = (FVF2, i%)—reading across the n = 2 row reveals that i = 11%. EXERCISE 6-10 (10–15 minutes) (a) The number of interest periods is calculated by first dividing the future value of $1,000,000 by $92,296, which is 10.83471—the value $1.00 would accumulate to at 10% for the unknown number of interest periods. The factor 10.83471 or its approximate is then located in the Future Value of 1 Table by reading down the 10% column to the 25-period line; thus, 25 is the unknown number of years Mike must wait to become a millionaire. The unknown interest rate is calculated by first dividing the future value of $1,000,000 by the present investment of $182,696, which is 5.47357—the amount $1.00 would accumulate to in 15 years at an unknown interest rate. The factor or its approximate is then located in the Future Value of 1 Table by reading across the 15-period line to the 12% column; thus, 12% is the interest rate Venus must earn on her investment to become a millionaire. 6-21 (b) EXERCISE 6-11 (10–15 minutes) (a) Total interest = Total payments—Amount owed today $162,745.30 (10 X $16,274.53) – $100,000 = $62,745.30. Sosa should borrow from the bank, since the 9% rate is lower than the manufacturer’s 10% rate determined below. PV–OA10, i% = $100,000 ÷ $16,274.53 = 6.14457—Inspection of the 10 period row reveals a rate of 10%. (b) EXERCISE 6-12 (10–15 minutes) Building A—PV = $600,000. Building B— Rent X (PV of annuity due of 25 periods at 12%) = PV $69,000 X 8.78432 = PV $606,118.08 = PV Building C— Rent X (PV of ordinary annuity of 25 periods at 12%) = PV $7,000 X 7.84314 = PV $54,901.98 = PV Cash purchase price PV of rental income Net present value $650,000.00 – 54,901.98 $595,098.02 Answer: Lease Building C since the present value of its net cost is the smallest. 6-22 EXERCISE 6-13 (15–20 minutes) Time diagram: PV = ? PV–OA = ? Lance Armstrong, Inc. i = 5% Principal $2,000,000 interest $110,000 $110,000 $110,000 $110,000 $110,000 $110,000 0 1 2 3 n = 30 28 29 30 Formula for the interest payments: PV–OA = R (PVF–OAn, i) PV–OA = $110,000 (PVF–OA30, 5%) PV–OA = $110,000 (15.37245) PV–OA = $1,690,970 Formula for the principal: PV = FV (PVFn, i) PV = $2,000,000 (PVF30, 5%) PV = $2,000,000 (0.23138) PV = $462,760 The selling price of the bonds = $1,690,970 + $462,760 = $2,153,730. 6-23 EXERCISE 6-14 (15–20 minutes) Time diagram: i = 8% R= PV–OA = ? $700,000 $700,000 $700,000 0 1 2 n = 15 15 16 n = 10 24 25 Formula: PV–OA = R (PVF–OAn, i) PV–OA = $700,000 (PVF–OA25–15, 8%) PV–OA = $700,000 (10.67478 – 8.55948) PV–OA = $700,000 (2.11530) PV–OA = $1,480,710 OR Time diagram: i = 8% R= PV–OA = ? $700,000 $700,000 $700,000 0 1 FV(PVn, i) 2 15 16 (PV–OAn, i) 24 25 6-24 EXERCISE 6-14 (Continued) (i) Present value of the expected annual pension payments at the end of the 10th year: PV–OA = R (PVF–OAn, i) PV–OA = $700,000 (PVF–OA10, 8%) PV–OA = $700,000 (6.71008) PV–OA = $4,697,056 (ii) Present value of the expected annual pension payments at the beginning of the current year: PV = FV (PVFn, i) PV = $4,697,056 (PVF15,8%) PV = $4,697,056 (0.31524) PV = $1,480,700* *$10 difference due to rounding. The company’s pension obligation (liability) is $1,480,700. 6-25 EXERCISE 6-15 (15–20 minutes) (a) i = 8% PV = $1,000,000 FV = $1,999,000 0 1 2 n=? FVF(n, 8%) = $1,999,000 ÷ $1,000,000 = 1.999 reading down the 8% column, 1.999 corresponds to 9 periods. (b) By setting aside $300,000 now, Andrew can gradually build the fund to an amount to establish the foundation. PV = $300,000 FV = ? 0 FV 1 2 8 9 = $300,000 (FVF9, 8%) = $300,000 (1.999) = $599,700—Thus, the amount needed from the annuity: $1,999,000 – $599,700 = $1,399,300. $? $? $? FV = $1,399,300 0 1 2 8 9 Payments = FV ÷ (FV–OA9, 8%) = $1,399,300 ÷ 12.48756 = $112,055.52. 6-26 EXERCISE 6-16 (10–15 minutes) Amount to be repaid on March 1, 2015. Time diagram: i = 6% per six months PV = $70,000 FV = ? 3/1/05 3/1/06 3/1/07 3/1/13 3/1/14 3/1/15 n = 20 six-month periods Formula: FV = PV (FVFn, i) FV = $70,000 (FVF20, 6%) FV = $70,000 (3.20714) FV = $224,500 Amount of annual contribution to retirement fund. Time diagram: R R=? R ? i = 10% R R ? ? R ? FV–AD = $224,500 3/1/10 3/1/11 3/1/12 3/1/13 3/1/14 3/1/15 6-27 EXERCISE 6-16 (Continued) 1. 2. 3. 4. Future value of ordinary annuity of 1 for 5 periods at 10% Factor (1 + .10) Future value of an annuity due of 1 for 5 periods at 10% Periodic rent ($224,500 ÷ 6.71561) 6.10510 X 1.10000 6.71561 $33,430 EXERCISE 6-17 (10–15 minutes) Time diagram: i = 11% R PV–OA = $365,755 R ? R ? ? 0 1 n = 25 24 25 Formula: PV–OA = R (PV–OAn, i) $365,755 = R (PVF–OA25, 11%) $365,755 = R (8.42174) R = $365,755 ÷ 8.42174 R = $43,429.86 6-28 EXERCISE 6-18 (10–15 minutes) Time diagram: i = 8% PV–OA = ? $300,000 $300,000 $300,000 $300,000 $300,000 0 1 2 n = 15 13 14 15 Formula: PV–OA = R (PVF–OAn, i) PV–OA = $300,000 (PVF–OA15, 8%) PV–OA = $300,000 (8.55948) R = $2,567,844 The recommended method of payment would be the 15 annual payments of $300,000, since the present value of those payments ($2,567,844) is less than the alternative immediate cash payment of $2,600,000. 6-29 EXERCISE 6-19 (10–15 minutes) Time diagram: i = 8% PV–AD = ? R= $300,000 $300,000 $300,000 $300,000 $300,000 0 Formula: Using Table 6-4 1 2 n = 15 13 14 15 Using Table 6-5 PV–AD = R (PVF–ADn, i) PV–AD = $300,000 (PVF–AD15, 8%) PV–AD = $300,000 (9.24424) PV–AD = $2,773,272 PV–AD = R (PVF–OAn, i) PV–AD = $300,000 (8.55948 X 1.08) PV–AD = $300,000 (9.24424) PV–AD = $2,773,272 The recommended method of payment would be the immediate cash payment of $2,600,000, since that amount is less than the present value of the 15 annual payments of $300,000 ($2,773,272). 6-30 EXERCISE 6-20 (5–10 minutes) Expected Probability Cash Assessment = Flow 20% $ 760 50% 3,150 30% 2,250 Total Expected Value $ 6,160 30% 50% 20% Total Expected Value 10% 80% 10% Total Expected Value $ 1,620 3,600 1,680 $ 6,900 $ –100 1,600 500 $ 2,000 Cash Flow Estimate X (a) $ 3,800 6,300 7,500 (b) $ 5,400 7,200 8,400 (c) $(1,000) 2,000 5,000 EXERCISE 6-21 (10–15 minutes) Estimated Cash Outflow X $ 200 450 550 750 Probability Assessment = Expected Cash Flow 10% $ 20 30% 135 50% 275 10% 75 X PV Factor, n = 2, I = 6% $ 505 X 0.89 Present Value $ 449.45 6-31 *EXERCISE 6-22 10 ? –19,000 0 49,000 N I/YR. 9.94% PV PMT FV *EXERCISE 6-23 10 ? 42,000 6,500 0 N I/YR. 8.85% PV PMT FV *EXERCISE 6-24 40 ? 178,000 14,000 0 N I/YR. 7.49% (semiannual) PV PMT FV 6-32 TIME AND PURPOSE OF PROBLEMS Problem 6-1 (Time 15–20 minutes) Purpose—to present an opportunity for the student to determine how to use the present value tables in various situations. Each of the situations presented emphasizes either a present value of 1 or a present value of an ordinary annuity situation. Two of the situations will be more difficult for the student because a noninterest-bearing note and bonds are involved. Problem 6-2 (Time 15–20 minutes) Purpose—to present an opportunity for the student to determine solutions to four present and future value situations. The student is required to determine the number of years over which certain amounts will accumulate, the rate of interest required to accumulate a given amount, and the unknown amount of periodic payments. The problem develops the student’s ability to set up present and future value equations and solve for unknown quantities. Problem 6-3 (Time 20–30 minutes) Purpose—to present the student with an opportunity to determine the present value of the costs of competing contracts. The student is required to decide which contract to accept. Problem 6-4 (Time 20–30 minutes) Purpose—to present the student with an opportunity to determine the present value of two lottery payout alternatives. The student is required to decide which payout option to choose. Problem 6-5 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to determine which of four insurance options results in the largest present value. The student is required to determine the present value of options which include the immediate receipt of cash, an ordinary annuity, an annuity due, and an annuity of changing amount. The student must also deal with interest compounded quarterly. This problem is a good summary of the application of present value techniques. Problem 6-6 (Time 25–30 minutes) Purpose—to present an opportunity for the student to determine the present value of a series of deferred annuities. The student must deal with both cash inflows and outflows to arrive at a present value of net cash inflows. A good problem to develop the student’s ability to manipulate the present value table factors to efficiently solve the problem. Problem 6-7 (Time 30–35 minutes) Purpose—to present the student an opportunity to use time value concepts in business situations. Some of the situations are fairly complex and will require the student to think a great deal before answering the question. For example, in one situation a student must discount a note and in another must find the proper interest rate to use in a purchase transaction. Problem 6-8 (Time 20–30 minutes) Purpose—to present the student with an opportunity to determine the present value of an ordinary annuity and annuity due for three different cash payment situations. The student must then decide which cash payment plan should be undertaken. 6-33 Time and Purpose of Problems (Continued) Problem 6-9 (Time 30–35 minutes) Purpose—to present the student with the opportunity to work three different problems related to time value concepts: purchase versus lease, determination of fair value of a note, and appropriateness of taking a cash discount. Problem 6-10 (Time 30–35 minutes) Purpose—to present the student with the opportunity to assess whether a company should purchase or lease. The computations for this problem are relatively complicated. Problem 6-11 (Time 25–30 minutes) Purpose—to present the student an opportunity to apply present value to retirement funding problems, including deferred annuities. Problem 6-12 (Time 20–25 minutes) Purpose—to provide the student an opportunity to explore the ethical issues inherent in applying time value of money concepts to retirement plan decisions. Problem 6-13 (Time 20–25 minutes) Purpose—to present the student an opportunity to compute expected cash flows and then apply present value techniques to determine a warranty liability. Problem 6-14 (Time 20–25 minutes) Purpose—to present the student an opportunity to compute expected cash flows and then apply present value techniques to determine the fair value of an asset. *Problems 6-15, 6-16, 6-17 (Time 10–15 minutes each) Purpose—to present the student an opportunity to use a financial calculator to solve time value of money problems. 6-34 SOLUTIONS TO PROBLEMS PROBLEM 6-1 (a) Given no established value for the building, the fair market value of the note would be estimated to value the building. Time diagram: i = 9% PV = ? FV = $275,000 1/1/07 1/1/08 n=3 1/1/09 1/1/10 Formula: PV = FV (PVFn, i) PV = $275,000 (PVF3, 9%) PV = $275,000 (.77218) PV = $212,349.50 Cash equivalent price of building Less: Book value ($250,000 – $100,000) Gain on disposal of the building $212,349.50 150,000.00 $ 62,349.50 6-35 PROBLEM 6-1 (Continued) (b) Time diagram: i = 11% Principal $200,000 Interest $18,000 PV–OA = ? $18,000 $18,000 $18,000 1/1/07 1/1/08 1/1/09 n = 10 1/1/2016 1/1/2017 Present value of the principal FV (PVF10, 11%) = $200,000 (.35218) Present value of the interest payments R (PVF–OA10, 11%) = $18,000 (5.88923) Combined present value (purchase price) (c) Time diagram: i = 8% PV–OA = ? $4,000 $4,000 $4,000 $4,000 $4,000 = $ 70,436.00 = 106,006.14 $176,442.14 0 1 2 n = 10 8 9 10 Formula: PV–OA = R (PVF–OAn,i) PV–OA = $4,000 (PVF–OA10, 8%) PV–OA = $4,000 (6.71008) PV–OA = $26,840.32 (cost of machine) 6-36 PROBLEM 6-1 (Continued) (d) Time diagram: i = 12% PV–OA = ? $20,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 0 1 2 3 4 n=8 5 6 7 8 Formula: PV–OA = R (PVF–OAn,i) PV–OA = $5,000 (PVF–OA8, 12%) PV–OA = $5,000 (4.96764) PV–OA = $24,838.20 Cost of tractor = $20,000 + $24,838.20 = $44,838.20 (e) Time diagram: i = 11% PV–OA = ? $100,000 $100,000 $100,000 $100,000 0 1 2 n=9 8 9 Formula: PV–OA = R (PVF–OAn, i) PV–OA = $100,000 (PVF–OA9, 11%) PV–OA = $100,000 (5.53705) PV–OA = $553,705 6-37 PROBLEM 6-2 (a) Time diagram: i = 8% R R=? R ? R ? R ? R ? R ? FV – OA = $70,000 R ? R ? 0 1 2 3 4 n=8 5 6 7 8 Formula: FV–OA = R (FVF–OAn,i) $70,000 = R (FVF–OA8, 8%) $70,000 = R (10.63663) R = $70,000 ÷ 10.63663 R = $6,581.03 (b) Time diagram: i = 12% R R=? R ? R ? R ? FV–AD = 500,000 40 41 42 n = 25 64 65 6-38 PROBLEM 6-2 (Continued) 1. 2. 3. 4. Future value of an ordinary annuity of 1 for 25 periods at 12% Factor (1 + .12) Future value of an annuity due of 1 for 25 periods at 12% Periodic rent ($500,000 ÷ 149.33393) 133.33387 1.1200 149.33393 $3,348.20 (c) Time diagram: i = 9% PV = $20,000 FV = $56,253 0 1 2 3 n Present value approach PV = FV (PVFn, i) or $20,000 = $56,253 (PVFn, 9%) PVFn, 9% = $20,000 ÷ $56,253 = .35554 Future value approach FV = PV (FVFn, i) $56,253 = $20,000 (FVFn, 9%) FVFn, 9% = $56,253 ÷ $20,000 = 2.81265 2.81265 is approximately the value of $1 invested at 9% for 12 years. .35554 is approximately the present value of $1 discounted at 9% for 12 years. 6-39 PROBLEM 6-2 (Continued) (d) Time diagram: i=? PV = $18,181 FV = $27,600 0 1 2 n=4 3 4 Future value approach FV = PV (FVFn, i) or $27,600 = $18,181 (FVF4, i) = $27,600 ÷ $18,181 = 1.51807 Present value approach PV = FV (PVFn, i) $18,181 = $27,600 (PVF4, i) = $18,181 ÷ $27,600 = .65873 FVF4, i PVF4, i 1.51807 is the value of $1 invested at 11% for 4 years. .65873 is the present value of $1 discounted at 11% for 4 years. 6-40 PROBLEM 6-3 Time diagram (Bid A): i = 9% $63,000 PV–OA = R = ? 2,400 2,400 2,400 2,400 63,000 2,400 2,400 2,400 2,400 0 0 1 2 3 4 5 n=9 6 7 8 9 10 Present value of initial cost 12,000 X $5.25 = $63,000 (incurred today) Present value of maintenance cost (years 1–4) 12,000 X $.20 = $2,400 R (PVF–OA4, 9%) = $2,400 (3.23972) Present value of resurfacing FV (PVF5, 9%) = $63,000 (.64993) Present value of maintenance cost (years 6–9) R (PVF–OA9–5, 9%) = $2,400 (5.99525 – 3.88965) Present value of outflows for Bid A 6-41 $ 63,000.00 7,775.33 40,945.59 5,053.44 $116,774.36 PROBLEM 6-3 (Continued) Time diagram (Bid B): i = 9% $114,000 PV–OA = R = ? 1,080 1,080 1,080 1,080 1,080 1,080 1,080 1,080 1,080 0 0 1 2 3 4 5 n=9 6 7 8 9 10 Present value of initial cost 12,000 X $9.50 = $114,000 (incurred today) Present value of maintenance cost 12,000 X $.09 = $1,080 R (PV–OA9, 9%) = $1,080 (5.99525) Present value of outflows for Bid B Bid A should be accepted since its present value is the lower. 6,474.87 $120,474.87 $114,000.00 6-42 PROBLEM 6-4 Lump sum alternative: Present Value = $900,000 X (1 – .46) = $486,000. Annuity alternative: Payments = $62,000 X (1 – .25) = $46,500. Present Value = Payments (PV–AD20, 8%) = $46,500 (10.60360) = $493,067.40. O’Malley should choose the annuity payout; its present value is $7,067.40 greater. 6-43 PROBLEM 6-5 (a) (b) The present value of $55,000 cash paid today is $55,000. Time diagram: i = 21/2% per quarter PV–OA = ? R= $3,700 $3,700 $3,700 $3,700 $3,700 0 1 2 n = 20 quarters 18 19 20 Formula: PV–OA = R (PVF–OAn, i) PV–OA = $3,700 (PVF–OA20, 21/2%) PV–OA = $3,700 (15.58916) PV–OA = $57,679.89 (c) Time diagram: i = 21/2% per quarter $18,000 PV–AD = R = $1,600 $1,600 $1,600 $1,600 $1,600 0 1 2 n = 40 quarters 38 39 40 Formula: PV–AD = R (PVF–ADn, i) PV–AD = $1,600 (PVF–AD40, 21/2%) PV–AD = $1,600 (25.73034) PV–AD = $41,168.54 The present value of option (c) is $18,000 + $41,168.54, or $59,168.54. 6-44 PROBLEM 6-5 (Continued) (d) Time diagram: i = 21/2% per quarter PV–OA = ? PV–OA = R= ? $4,000 R= $1,200 $4,000 $4,000 $1,200 $1,200 $1,200 0 1 11 12 13 14 n = 25 quarters 36 37 n = 12 quarters Formulas: PV–OA = R (PVF–OAn,i) PV–OA = $4,000 (PVF–OA12, 21/2%) PV–OA = $4,000 (10.25776) PV–OA = $41,031.04 PV–OA = R (PVF–OAn,i) PV–OA = $1,200 (PVF–OA37–12, 21/2%) PV–OA = $1,200 (23.95732 – 10.25776) PV–OA = $16,439.47 The present value of option (d) is $41,031.04 + $16,439.47, or $57,470.51. Present values: (a) (b) (c) (d) $55,000. $57,679.89. $59,168.54. $57,470.51. Option (c) is the best option, based upon present values alone. 6-45 Time diagram: i = 12% ($36,000) $23,000 23,000 $63,000 $63,000 $63,000 $63,000 $43,000 $43,000 $43,000 PV–OA = ? R = ($36,000) 0 n=5 ($60,000 – $27,000 – $10,000) ($100,000 – $27,000 – $10,000) 1 n=5 n = 20 n = 10 ($80,000 – $27,000 – $10,000) 5 6 10 11 12 29 30 31 39 40 (0 – $27,000 – $9,000) Formulas: PV–OA = R (PVF–OAn, i) 12% PV–OA = R (PVF–OAn, i) ) PV–OA = $23,000 (PVF–OA10-5, 12% 12% PV–OA = R (PVF–OAn, i) ) PV–OA = $63,000 (2.40496) PV–OA = $151,512.48 PV–OA = $63,000 (PVF–OA30–10, ) PV–OA =R (PVF–OAn, i) PV–OA = $43,000 (PVF–OA40–30, PV–OA = $43,000 (.18860) PV–OA = $8,109.80 12% PV–OA = ($36,000)(PVF–OA5, PV–OA = $23,000 (2.04544) PV–OA = $47,045.12 ) PV–OA = ($36,000)(3.60478) PV–OA = $23,000 (5.65022 – 3.60478) PV – OA = $63,000 (8.05518 – 5.65022) PV – OA = $43,000 (8.24378 – 8.05518) PROBLEM 6-6 PV–OA =($129,772.08) Present value of future net cash inflows: $(129,772.08) 47,045.12 151,512.48 8,109.80 $ 76,895.32 Nicole Bobek should accept no less than $76,895.32 for her vineyard business. PROBLEM 6-7 (a) Time diagram (alternative one): i=? PV–OA = $572,000 R= $80,000 $80,000 $80,000 $80,000 $80,000 0 1 2 n = 12 10 11 12 Formulas: PV–OA = R (PVF–OAn, i) $572,000 = $80,000 (PVF–OA12, i) PVF–OA12, i = $572,000 ÷ $80,000 PVF–OA12, i = 7.15 7.15 is present value of an annuity of $1 for 12 years discounted at approximately 9%. Time diagram (alternative two): i=? PV = $572,000 FV = $1,900,000 n = 12 6-47 PROBLEM 6-7 (Continued) Future value approach FV = PV (FVFn, i) or $1,900,000 = $572,000 (FVF12, i) FVF12, I FVF12, I = $1,900,000 ÷ $572,000 = 3.32168 $572,000 = $1,900,000 (PVF12, i) PVF12, i = $572,000 ÷ $1,900,000 PVF12, i = .30105 .30105 is the present value of $1 discounted at between 10% and 11% for 12 years. Present value approach PV = FV (PVFn, i) 3.32168 is the future value of $1 invested at between 10% and 11% for 12 years. Lee should choose alternative two since it provides a higher rate of return. (b) Time diagram: i=? ($824,150 – $200,000) PV–OA = R= $624,150 $76,952 $76,952 $76,952 $76,952 0 1 8 9 10 n = 10 six-month periods 6-48 PROBLEM 6-7 (Continued) Formulas: PV–OA = R (PVF–OAn, i) $624,150 = $76,952 (PVF–OA10, i) PV–OA10, i = $624,150 ÷ $76,952 PV–OA10, i = 8.11090 8.11090 is the present value of a 10-period annuity of $1 discounted at 4%. The interest rate is 4% semiannually, or 8% annually. (c) Time diagram: i = 5% per six months PV = ? PV–OA = R= ? $24,000 $24,000 $24,000 $24,000 $24,000 ($600,000 X 8% X 6/12) 0 1 2 8 9 10 n = 10 six-month periods [(7 – 2) X 2] Formulas: PV–OA = R (PVF–OAn, i) PV–OA = $24,000 (PVF–OA10, 5%) PV–OA = $24,000 (7.72173) PV–OA = $185,321.52 PV = FV (PVFn, i) PV = $600,000 (PVF10, 5%) PV = $600,000 (.61391) PV = $368,346 Combined present value (amount received on sale of note): $185,321.52 + $368,346 = $553,667.52 6-49 PROBLEM 6-7 (Continued) (d) Time diagram (future value of $300,000 deposit) i = 21/2% per quarter PV = $300,000 FV = ? 12/31/07 12/31/08 12/31/16 12/31/17 n = 40 quarters Formula: FV = PV (FVFn, i) FV = $300,000 (FVF40, 2 1/2%) FV = $300,000 (2.68506) FV = $805,518 Amount to which quarterly deposits must grow: $1,300,000 – $805,518 = $494,482. Time diagram (future value of quarterly deposits) i = 21/2% per quarter R R=? R ? R ? R ? R ? R ? R ? R ? R ? 12/31/07 12/31/08 12/31/16 12/31/17 n = 40 quarters 6-50 PROBLEM 6-7 (Continued) Formulas: FV–OA = R (FVF–OAn, i) $494,482 = R (FVF–OA40, 2 1/2%) $494,482 = R (67.40255) R = $494,482 ÷ 67.40255 R = $7,336.25 6-51 PROBLEM 6-8 Vendor A: $15,000 X 6.14457 $ 92,168.55 + 45,000.00 + 10,000.00 $147,168.55 payment (PV of ordinary annuity 10%, 10 periods) down payment maintenance contract total cost from Vendor A Vendor B: $8,000 semiannual payment 18.01704 (PV of annuity due 5%, 40 periods) $144,136.32 $1,000 X 3.79079 (PV of ordinary annuity of 5 periods, 10%) $ 3,790.79 PV of first 5 years of maintenance $2,000 [PV of ordinary annuity 15 per., 10% (7.60608) – X 3.81529 PV of ordinary annuity 5 per., 10% (3.79079)] $ 7,630.58 PV of next 10 years of maintenance $3,000 [(PV of ordinary annuity 20 per., 10% (8.51356) – X .90748 PV of ordinary annuity 15 per., 10% (7.60608)] $ 2,722.44 PV of last 5 years of maintenance Vendor C: Total cost of press and maintenance Vendor C: $125,000.00 cash purchase price 3,790.79 maintenance years 1–5 7,630.58 maintenance years 6–15 2,722.44 maintenance years 16–20 $139,143.81 The press should be purchased from Vendor C, since the present value of the cash outflows for this option is the lowest of the three options. 6-52 PROBLEM 6-9 (a) Time diagram for the first ten payments: i = 10% PV–AD = ? R= $800,000 $800,000 $800,000 $800,000 $800,000 $800,000 $800,000 $800,000 0 1 2 3 7 8 9 10 n = 10 Formula for the first ten payments: PV–AD = R (PVF–ADn, i) PV–AD = $800,000 (PVF–AD10, 10%) PV–AD = $800,000 (6.75902) PV–OA = $5,407,216 Time diagram for the last ten payments: i = 10% R= PV–OA = ? $300,000 $300,000 $300,000 $300,000 0 1 n=9 2 10 11 n = 10 18 19 20 6-53 PROBLEM 6-9 (Continued) Formula for the last ten payments: PV–OA = R (PVF–OAn, i) PV–OA = $300,000 (PVF–OA19 – 9, 10%) PV–OA = $300,000 (8.36492 – 5.75902) PV–OA = $300,000 (2.6059) PV–OA = $781,770 Note: The present value of an ordinary annuity is used here, not the present value of an annuity due. The total cost for leasing the facilities is: $5,407,216 + $781,770 = $6,188,986. OR Time diagram for the last ten payments: i = 10% PV = ? R= $300,000 $300,000 $300,000 $300,000 0 FVF (PVFn, i) 1 2 9 10 17 18 19 R (PVF–OAn, i) 6-54 PROBLEM 6-9 (Continued) Formulas for the last ten payments: (i) Present value of the last ten payments: PV–OA = R (PVF–OAn, i) PV–OA = $300,000 (PVF–OA10, 10%) PV–OA = $300,000 (6.14457) PV–OA = $1,843,371 (ii) Present value of the last ten payments at the beginning of current year: PV = FV (PVFn, i) PV = $1,843,371 (PVF9, 10%) PV = $1,843,371 (.42410) PV = $781,774* *$4 difference due to rounding. Cost for leasing the facilities $5,407,216 + $781,774 = $6,188,990 Since the present value of the cost for leasing the facilities, $6,188,990, is less than the cost for purchasing the facilities, $7,200,000, Starship Enterprises should lease the facilities. 6-55 PROBLEM 6-9 (Continued) (b) Time diagram: i = 11% PV–OA = ? R= $12,000 $12,000 $12,000 $12,000 $12,000 $12,000 $12,000 0 1 2 3 6 7 8 9 n=9 Formula: PV–OA = R (PVF–OAn, i) PV–OA = $12,000 (PVF–OA9, 11%) PV–OA = $12,000 (5.53705) PV–OA = $66,444.60 The fair value of the note is $66,444.60. (c) Time diagram: Amount paid = $784,000 0 10 30 Amount paid = $800,000 6-56 PROBLEM 6-9 (Continued) Cash discount = $800,000 (2%) = $16,000 Net payment = $800,000 – $16,000 = $784,000 If the company decides not to take the cash discount, then the company can use the $784,000 for an additional 20 days. The implied interest rate for postponing the payment can be calculated as follows: (i) Implied interest for the period from the end of discount period to the due date: Cash discount lost if not paid within the discount period Net payment being postponed = $16,000/$784,000 = 0.0204 (ii) Convert the implied interest rate to annual basis: Daily interest = 0.0204/20 = 0.00102 Annual interest = 0.00102 X 365 = 37.23% Since Starship’s cost of funds, 10%, is less than the implied interest rate for cash discount, 37.23%, it should continue the policy of taking the cash discount. 6-57 PROBLEM 6-10 1. Purchase. Time diagrams: Installments i = 10% PV–OA = ? R= $300,000 $300,000 $300,000 $300,000 $300,000 0 1 2 3 n=5 4 5 Property taxes and other costs i = 10% PV–OA = ? R= $56,000 $56,000 $56,000 $56,000 $56,000 $56,000 0 1 2 9 10 11 12 n = 12 6-58 PROBLEM 6-10 (Continued) Insurance i = 10% PV–AD = ? R= $27,000 $27,000 $27,000 $27,000 $27,000 $27,000 0 1 2 9 10 11 12 n = 12 Salvage Value PV = ? FV = $500,000 0 1 2 9 10 11 12 n = 12 Formula for installments: PV–OA = R (PVF–OAn, i) PV–OA = $300,000 (PVF–OA5, 10%) PV–OA = $300,000 (3.79079) PV–OA = $1,137,237 6-59 PROBLEM 6-10 (Continued) Formula for property taxes and other costs: PV–OA = R (PVF–OAn, i) PV–OA = $56,000 (PVF–OA12, 10%) PV–OA = $56,000 (6.81369) PV–OA = $381,567 Formula for insurance: PV–AD = R (PVF–ADn, i) PV–AD = $27,000 (PVF–AD12, 10%) PV–AD = $27,000 (7.49506) PV–AD = $202,367 Formula for salvage value: PV = FV (PVFn, i) PV = $500,000 (PVF12, 10%) PV = $500,000 (0.31863) PV = $159,315 6-60 PROBLEM 6-10 (Continued) Present value of net purchase costs: Down payment Installments Property taxes and other costs Insurance Total costs Less: Salvage value Net costs $ 400,000 1,137,237 381,567 202,367 $2,121,171 159,315 $1,961,856 2. Lease. Time diagrams: Lease payments i = 10% PV–AD = ? R= $240,000 $240,000 $240,000 $240,000 $240,000 0 1 2 10 11 12 n = 12 Interest lost on the deposit i = 10% PV–OA = ? R= $10,000 $10,000 $10,000 $10,000 $10,000 0 1 2 10 11 12 n = 12 6-61 PROBLEM 6-10 (Continued) Formula for lease payments: PV–AD = R (PVF–ADn, i) PV–AD = $240,000 (PVF–AD12, 10%) PV–AD = $240,000 (7.49506) PV–AD = $1,798,814 Formula for interest lost on the deposit: Interest lost on the deposit per year = $100,000 (10%) = $10,000 PV–OA = R (PVF–OAn, i) PV–OA = $10,000 (PVF–OA12, 10%) PV–OA = $10,000 (6.81369) PV–OA = $68,137* Cost for leasing the facilities = $1,798,814 + $68,137 = $1,866,951 Rijo Inc. should lease the facilities because the present value of the costs for leasing the facilities, $1,866,951, is less than the present value of the costs for purchasing the facilities, $1,961,856. *OR: $100,000 – ($100,000 X .31863) = $68,137 6-62 PROBLEM 6-11 (a) Annual retirement benefits. Maugarite–current salary $ 40,000.00 X 2.56330 (future value of 1, 24 periods, 4%) 102,532.00 annual salary during last year of work X .50 retirement benefit % $ 51,266.00 annual retirement benefit Kenny–current salary $30,000.00 X 3.11865 (future value of 1, 29 periods, 4%) 93,559.50 annual salary during last year of work X .40 retirement benefit % $37,424.00 annual retirement benefit $15,000.00 X 2.10685 (future value of 1, 19 periods, 4%) 31,602.75 annual salary during last year of work X .40 retirement benefit % $12,641.00 annual retirement benefit $15,000.00 X 1.73168 (future value of 1, 14 periods, 4%) 25,975.20 annual salary during last year of work X .40 retirement benefit % $10,390.00 annual retirement benefit Anita–current salary Willie–current salary 6-63 PROBLEM 6-11 (Continued) (b) Fund requirements after 15 years of deposits at 12%. Maugarite will retire 10 years after deposits stop. $ 51,266.00 annual plan benefit [PV of an annuity due for 30 periods – PV of an X 2.69356 annuity due for 10 periods (9.02181 – 6.32825)] $138,088.00 Kenny will retire 15 years after deposits stop. $37,424.00 annual plan benefit X 1.52839 [PV of an annuity due for 35 periods – PV of an annuity due for 15 periods (9.15656 – 7.62817)] $57,198.00 Anita will retire 5 years after deposits stop. $12,641.00 annual plan benefit X 4.74697 [PV of an annuity due for 25 periods – PV of an annuity due for 5 periods (8.78432 – 4.03735)] $60,006.00 Willie will retire the beginning of the year after deposits stop. $10,390.00 annual plan benefit X 8.36578 (PV of an annuity due for 20 periods) $86,920.00 6-64 PROBLEM 6-11 (Continued) $138,088.00 Maugarite 57,198.00 Kenny 60,006.00 Anita 86,920.00 Willie $342,212.00 Required fund balance at the end of the 15 years of deposits. (c) Required annual beginning-of-the-year deposits at 12%: Deposit X (future value of an annuity due for 15 periods at 12%) = FV Deposit X (37.27972 X 1.12) = $342,212.00 Deposit = $342,212.00 ÷ 41.75329 Deposit = $8,196.00. 6-65 PROBLEM 6-12 (a) The time value of money would suggest that NET Life’s discount rate was substantially higher than First Security’s. The actuaries at NET Life are making different assumptions about inflation, employee turnover, life expectancy of the work force, future salary and wage levels, return on pension fund assets, etc. NET Life may operate at lower gross and net margins and it may provide fewer services. As the controller of KBS, Qualls assumes a fiduciary responsibility to the present and future retirees of the corporation. As a result, he is responsible for ensuring that the pension assets are adequately funded and are adequately protected from most controllable risks. At the same time, Qualls is responsible for the financial condition of KBS. In other words, he is obligated to find ethical ways of increasing the profits of KBS, even if it means switching pension funds to a less costly plan. At times, Qualls’ role to retirees and his role to the corporation can be in conflict, especially if Qualls is a member of a professional group such as CPAs or CMAs. If KBS switched to NET Life The primary beneficiaries of Qualls’ decision would be the corporation and its many stockholders by virtue of reducing 8 million dollars of annual pension costs. The present and future retirees of KBS may be negatively affected by Qualls’ decision because the chance of losing a future benefit may be increased by virtue of higher risks (as reflected in the discount rate and NET Life’s weaker reputation). If KBS stayed with First Security In the short run, the primary beneficiaries of Qualls’ decision would be the employees and retirees of KBS given the lower risk pension asset plan. KBS and its many stakeholders could be negatively affected by Qualls’ decision to stay with First Security because of the company’s inability to trim 8 million dollars from its operating expenses. (b) (c) 6-66 PROBLEM 6-13 Cash Flow Probability Estimate X Assessment = Expected Cash Flow 2008 $ 2,000 20% $ 400 4,000 60% 2,400 5,000 20% 1,000 X PV Factor, n = 1, I = 5% Present Value $ 3,800 0.95238 $ 3,619.04 2009 $ 2,500 5,000 6,000 30% 50% 20% $ 750 2,500 1,200 $ 4,450 2010 $ 3,000 6,000 7,000 30% 40% 30% $ 900 2,400 2,100 X PV Factor, n = 2, I = 5% 0.90703 Present Value $ 4,036.28 X PV Factor, n = 3, I = 5% Present Value $ 5,400 0.86384 $ 4,664.74 Total Estimated Liability $ 12,320.06 6-67 PROBLEM 6-14 Cash Flow Probability Estimate X Assessment = Expected Cash Flow 2008 $ 6,000 40% $ 2,400 8,000 60% 4,800 X PV Factor, n = 1, I = 6% Present Value $ 7,200 0.9434 $ 6,792.48 2009 $ (500) 2,000 3,000 20% 60% 20% $ (100) 1,200 600 $ 1,700 Scrap Value Received at the End of 2009 X PV Factor, n = 2, I = 6% 0.89 Present Value $ 1,513.00 $ 500 700 50% 50% $ X PV Factor, n = 2, I = 6% $ 600 0.89 Estimated Fair Value 250 350 Present Value $ 534.00 $ 8,839.48 6-68 *PROBLEM 6-15 (a) Inputs: 8 7.25 0 ? 70,000 N Answer: (b) Note—set to begin mode. Inputs: 25 I PV PMT –6,761.57 FV 9.65 0 ? 500,000 N Answer: (c) Inputs: 4 I PV PMT –4,886.59 FV ? –17,000 0 26,000 N Answer: I 11.21 PV PMT FV 6-69 *PROBLEM 6-16 (a) Inputs: 15 ? –150,000 20,000 0 N Answer: (b) Inputs: 7 I 10.25 PV PMT FV 7.35 ? –16,000 0 N Answer: (c) Inputs: 10 I PV 85,186.34 PMT FV 10.65 ? 16,000 200,000 N Answer: I PV –168,323.64 PMT FV 6-70 *PROBLEM 6-17 (a) Inputs: 20 5.25 –180,000 ? 0 N Answer: I PV PMT –14.751.41 FV (b) Note—set payments at 12 per year. Inputs: 96 9.1 35,000 ? 0 N Answer: I PV PMT –514.57 FV (c) Note—set to begin mode. Inputs: 5 8.25 8,000 ? 0 N Answer: I PV PMT –1,863.16 FV (d) Note—set back to end mode. Inputs: 5 8.25 8,000 ? 0 N Answer: I PV PMT –2,016.87 FV 6-71 FINANCIAL REPORTING PROBLEM (a) 1. Long-lived assets, goodwill For impairment of goodwill and long-lived assets, fair value is determined using a discounted cash flow analysis. 2. 3. 4. (b) Debt Weighted-Average Effective Interest Rate At December 31 Short-Term Long-Term 2004 1.5% 4.0% 2003 3.6% 3.7% 1. Short-term and long-term debt Postretirement benefit plans Employee stock ownership plans The following rates are disclosed in the accompanying notes: 6-72 FINANCIAL REPORTING PROBLEM (Continued) Benefit Plans Pension Benefits United States 2004 2003 Weighted average assumptions Discount rate Expected return on assets Other Retiree Benefits 2004 2003 5.2% 7.4% 5.1% 7.7% 6.1% 9.5% 5.8% 9.5% Stock-Based Compensation Assumptions Risk-free interest rate Used in Black-Scholes model. 2. 2004 3.8% Annual 2003 3.9% 2002 5.4% There are different rates for various reasons: 1. 2. The maturity dates—short-term vs. long-term. The security or lack of security for debts—mortgages and collateral vs. unsecured loans. Fixed rates and variable rates. Issuances of securities at different dates when differing market rates were in effect. Different risks involved or assumed. Foreign currency differences—some investments and payables are denominated in different currencies. 3. 4. 5. 6. 6-73 FINANCIAL STATEMENT ANALYSIS CASE (a) Cash inflows of $350,000 less cash outflows of $125,000 = Net cash flows of $225,000. $225,000 X 2.48685 (PVF-OA3, 10%) = $559,541.25 (b) Cash inflows of $275,000 less cash outflows of $175,000 = Net cash flows of $100,000. $100,000 X 2.48685 (PVF-OA3,10%) = $248,685.00 (c) The estimate of future cash flows is very useful. It provides an understanding of whether the value of gas and oil properties is increasing or decreasing from year to year. Although it is an estimate, it does provide an understanding of the direction of change in value. Also, it can provide useful information to record a write-down of the assets. 6-74 RESEARCH CASE 1 (a) The Form 10-K items include: (1) Business, (2) Properties, (3) Legal Proceedings, (4) Submission of Matters to a Vote of Security Holders, (5) Market for Registrant’s Common Equity and Related Stockholder Matters, (6) Selected Financial Data, (7) Management’s Discussion and Analysis of Financial Condition and Results of Operations, (8) Financial Statements and Supplemental Data, (9) Changes in and Disagreements with Accountants on Accounting and Financial Disclosure, (10) Directors and Executive Officers of the Registrant, (11) Executive Compensation, (12) Security Ownership of Certain Beneficial Owners and Management, (13) Certain Relationships and Related Transactions, and (14) Exhibits, Financial Statement Schedules, and Reports on Form 8-K. If financials are not included, they have been “incorporated by reference” from the annual report to shareholders. Depends on firm selected. (b) (c) 6-75 RESEARCH CASE 2 (a) FASB pronouncements usually provoke some controversy, and Concepts Statements are no exception. The principle objections raised in recent Exposure Drafts are largely the same objections raised when the Board was deliberating Concepts Statement 7. They focus on three areas: Use of the expected-cash-flow approach in developing present value measurements Use of fair value as the objective for measurements on initial recognition and subsequent fresh-start measurements that employ present value. Inclusion of the entity’s credit standing in the measurement of its liabilities. Prior to Concepts Statement 7, many accounting pronouncements used the term best estimate to describe the target for estimated cash flows. The term was never defined, but its contexts seem to suggest that an accounting best estimate is: Unbiased In a range of possible outcomes, the most likely amount A single amount or point estimate. 1. 2. 3. (b) 1. 2. 3. 6-76 RESEARCH CASE 2 (Continued) Few other professions follow the accounting practice of equating best estimate a nd most likely. Statisticians, actuaries, scientists and engineers tend to avoid the term best estimate. When they use it, they do so to describe the expected value—the probability-weighted average. But accountants have grown used to the most-likely meaning for best estimate. The Board has long recognized that present values can be changed by altering either cash flows or discount rates. Still, the Board’s early deliberations took the traditional path of developing a best estimate of cash flows and then selecting an appropriate interest rate. Over time, the Board found that a focus on finding the “right” interest rate was unproductive. Any positive interest rate would make the discounted number smaller than the undiscounted best estimate, but there had to be more to present value than that. Moreover, it became clear that intuitions built on contractual cash flows and interest rates don’t always work when applied to assets and liabilities that don’t have contractual amounts and payment dates. Moving the reference point from contractual to estimated cash flows disrupts the conventional relationships that apply to contractual cash flows. What is the “rate commensurate with the risk” when actual cash flows may be higher or lower than the best estimate? Is the rate higher or lower than risk free? By how much? Does the answer change if the item is a liability rather than an asset? What are the proper cash flows and interest rate when timing is uncertain? The traditional approach doesn’t provide ready answers to those questions. In a sense, the drafters of Opinion 21 had it right. If a single bestestimate of future cash flows and a single interest rate are the only tools for computing present value, then the technique cannot be reasonably applied to a broader range of measurement problems. 6-77 RESEARCH CASE 2 (Continued) (c) The Board was looking at two sets of principles: the elements of economic value and the practical principles of present value. The elements of economic value (paragraphs 23 and 39) are: a. An estimate of the future cash flow, or in more complex cases, series of future cash flows at different times Expectations about possible variations in the amount or timing of those cash flows The time value of money, represented by the risk-free rate of interest The price for bearing the uncertainty inherent in the asset or liability Other, sometimes unidentifiable, factors including illiquidity and market imperfections. b. c. d. e. The practical principles, stated simply, are: a. b. Don’t leave anything out. (But see item e.) Use consistent assumptions and don’t count the same thing twice. Keep your finger off the scale. Aim for the average of a range, rather than a single most-likely, minimum or maximum amount. Don’t make up what you don’t know. c. d. e. (d) Most accounting estimates use nominal amounts; the estimate includes the effect of inflation. The focus here is on Practical Principle (b)—Use consistent assumptions. If the estimated cash flows do not include inflation, if instead they are real amounts, then the discount rate should not include inflation. Nominal cash flows are discounted at a nominal rate, and real cash flows at a real rate. 6-78 PROFESSIONAL RESEARCH: ACCOUNTING AND FINANCIAL REPORTING Search strings: “present value”, present and value, Present value$, “best estimate”, “estimated cash flow”, “expected cash flow”, “fresh-start measurement”, “interest methods of allocation” (a) Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements (FASB 2000). See Appendix B: APPLICATIONS OF PRESENT VALUE IN FASB STATEMENTS AND APB OPINIONS, CON7, Par. 119 119. . . . The accompanying table is presented to assist readers in understanding the differences between the conclusions reached in this Statement and those found in FASB Statements and APB Opinions that employ present value techniques in recognition, measurement, or amortization (period-to-period allocation) of assets and liabilities in the statement of financial position. Some example are: ∑ ∑ ∑ ∑ ∑ Debt payable and related premium or discount Asset acquired by incurring liabilities in a business combination—“An asset acquired by incurring liabilities is recorded at cost—that is, at the present value of the amounts to be paid” (paragraph 67(b)). APB Opinion No. 21, Interest on Receivables and Payables—Note exchanged for property, goods, or services. Capital lease or operating lease— . . . The lessee’s incremental borrowing rate is used unless (a) the lessor’s implicit rate can be determined and (b) the implicit rate is less than the incremental borrowing rate. FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Lease . . . Origination fees and costs are reflected over the life of the loan as an adjustment of the yield on the net investment in the loan. FASB Statement No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions . . . Effective settlement rate “. . . as opposed to ‘settling’ the obligation, which incorporates the insurer’s risk factor, ‘effectively settling’ the obligation focuses only on the time value of money and ignores the insurer’s cost for assuming the risk of experience losses” (paragraph 188). FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for LongLived Assets to Be Disposed Of . . . The objective is to estimate the fair value of the impaired asset. . . . The objective is to estimate fair value. (b) ∑ ∑ (c) 1. CON7, Glossary of terms: Best estimate: The single most-likely amount in a range of possible estimated amounts; in statistics, the estimated mode. In the past, accounting pronouncements have used the term best estimate in a variety of contexts that range in meaning from “unbiased” to “most likely.” This Statement uses best estimate in the latter meaning, as distinguished from the expected amounts described below. 2. CON7, Glossary of terms: Estimated Cash Flow and Expected Cash Flow: In the past, accounting pronouncements have used the terms estimated cash flow and expected cash flow interchangeably. In this Statement: Estimated cash flow refers to a single amount to be received or paid in the future. Expected cash flow refers to the sum of probability-weighted amounts in a range of possible estimated amounts; the estimated mean or average. 6-79 ACCOUNTING AND FINANCIAL REPORTING (Continued) 3. CON7, Glossary of terms: Fresh-Start Measurements: Measurements in periods following initial recognition that establishes a new carrying amount unrelated to previous amounts and accounting conventions. Some fresh-start measurements are used every period, as in the reporting of some marketable securities at fair value under FASB Statement No.115, Accounting for Certain Investments in Debt and Equity Securities. In other situations, freshstart measurements are prompted by an exception or “trigger,” as in a remeasurement of assets under FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. 4. CON7, Glossary of terms: Interest Methods of Allocation: Reporting conventions that use present value techniques in the absence of a fresh-start measurement to compute changes in the carrying amount of an asset or liability from one period to the next. Like depreciation and amortization conventions, interest methods are grounded in notions of historical cost. The term interest methods of allocation refers both to the convention for periodic reporting and to the several approaches to dealing with changes in estimated future cash flows. 6-80 PROFESSIONAL SIMULATION Measurement i = 12% Principal $100,000 Interest $10,000 PV–OA = ? $10,000 $10,000 $10,000 $10,000 0 1 2 3 n=5 4 5 Present value of the principal FV (PVF5, 12%) = $100,000 (.56743) Present value of the interest payments R (PVF–OA5, 12%) = $10,000 (3.60478) Combined present value (purchase price) i = 8% Principal $100,000 Interest $10,000 = $56,743.00 = 36,047.80 $92,790.80 PV–OA = ? $10,000 $10,000 $10,000 $10,000 0 1 2 3 n=5 4 5 Present value of the principal FV (PVF5, 8%) = $100,000 (.68058) Present value of the interest payments R (PVF–OA5, 8%) = $10,000 (3.99271) Combined present value (Proceeds) 6-81 = $ 68,058.00 = 39,927.10 $107,985.10 PROFESSIONAL SIMULATION (Continued) 12% Inputs: 5 12 ? –10000 –10000 N Answer: 8% Inputs: I PV 92,790.45 PMT FV 5 8 ? –10000 –10000 N Answer: Valuation A 1 2 3 Bond Amortization Schedule B I PV 107,985.42 PMT FV C D E F G Carrying Interest 4 5 6 7 8 9 10 11 12 13 14 15 The following formula is entered in the cells in this column: =+E5*0.12. Bond Discount Amortization Value of Bonds $92,790.45 Date Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cash Interest Expense The following formula is entered in the cells in this column: =+C6-B6. 10,000.00 10,000.00 10,000.00 10,000.00 10,000.00 $11,134.85 11,271.04 11,423.56 11,594.39 11,785.71 $1,134.85 1,271.04 1.423.56 1,594.39 1,785.71 93,925.30 95,196.34 96,619.90 98,214.29 100,000.00 The following formula is entered in the cells in this column: =+E5+D6 6-82 CHAPTER 7 Cash and Receivables ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. 2. Accounting for cash. Accounting for accounts receivable, bad debts, other allowances. Accounting for notes receivable. Assignment and factoring of accounts receivable. Analysis of receivables. Petty cash and bank reconciliations. Questions 1, 2, 3, 4, 21 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15 14, 15 16, 17, 18, 19 20 22 Brief Exercises 1 2, 3, 4, 5 Concepts Exercises 1, 2 3, 4, 5, 6, 7, 8, 9, 10, 11, 12 18, 19 12, 13, 14, 15, 16, 17, 21 20, 21 22, 23, 24, 25 Problems 1 2, 3, 4, 5, 6 8, 9, 10 7, 11, 12, 13 1 12, 13, 14 1, 2, 3, 4, 5, 10, 11 6, 7, 8, 9 6, 8 for Analysis 3. 4. 6, 7 8, 9, 10, 11, 12 13 14, 15, 16 5. *6. *This material is covered in an Appendix to the chapter. 7-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives 1. 2. 3. 4. 5. 6. 7. 8. 9. *10. Identify items considered as cash. Indicate how to report cash and related items. Define receivables and identify the different types of receivables. Explain accounting issues related to recognition of accounts receivable. Explain accounting issues related to valuation of accounts receivable. Explain accounting issues related to recognition of notes receivable. Explain accounting issues related to valuation of notes receivable. Explain accounting issues related to disposition of accounts and notes receivable. Describe how to report and analyze receivables. Explain common techniques employed to control cash. 9, 10, 11, 12 13 14, 15, 16 2, 3, 4 5 6, 7, 8 3, 4 3, 4, 5, 6, 12 7, 8, 9, 10, 11, 12 18, 19 18, 19 13, 14, 15, 16, 17, 21 20 22, 23, 24, 25 Brief Exercises 1 Exercises 1, 2 1 6 6 2, 3, 4, 5, 6 8, 9, 10 10 7, 11 11 12, 13, 14 Problems 7-2 ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty Moderate Moderate Simple Simple Simple Moderate Moderate Simple Simple Simple Simple Simple Simple Simple Simple Moderate Simple Simple Moderate Moderate Moderate Simple Simple Moderate Simple Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex Moderate Moderate Moderate Moderate Time (minutes) 10–15 10–15 10–15 10–15 15–20 5–10 10–15 5–10 8–10 10–12 8–10 15–20 10–15 15–18 10–15 15–20 10–15 10–15 20–25 10–15 10–15 5–10 10–15 15–20 15–20 20–25 20–25 20–30 25–35 20–30 25–35 25–30 30–35 30–35 40–50 20–25 20–25 20–30 20–30 Item E7-1 E7-2 E7-3 E7-4 E7-5 E7-6 E7-7 E7-8 E7-9 E7-10 E7-11 E7-12 E7-13 E7-14 E7-15 E7-16 E7-17 E7-18 E7-19 E7-20 E7-21 *E7-22 *E7-23 *E7-24 *E7-25 P7-1 P7-2 P7-3 P7-4 P7-5 P7-6 P7-7 P7-8 P7-9 P7-10 P7-11 *P7-12 *P7-13 *P7-14 Description Determining cash balance. Determine cash balance. Financial statement presentation of receivables. Determine ending accounts receivable. Record sales gross and net. Recording sales transactions. Recording bad debts. Recording bad debts. Computing bad debts and preparing journal entries. Bad debt reporting. Bad debts—aging. Journalizing various receivable transactions. Assigning accounts receivable. Journalizing various receivable transactions. Transfer of receivables with recourse. Transfer of receivables with recourse. Transfer of receivables without recourse. Notes transactions at unrealistic interest rates. Notes receivable with unrealistic interest rate. Analysis of receivables. Transfer of receivables. Petty cash. Petty cash. Bank reconciliation and adjusting entries. Bank reconciliation and adjusting entries. Determine proper cash balance. Bad debt reporting. Bad debt reporting—aging. Bad debt reporting. Bad debt reporting. Journalize various accounts receivable transactions. Assigned accounts receivable—journal entries. Notes receivable with realistic interest rate. Notes receivable journal entries. Comprehensive receivables problem. Income effects of receivables transactions. Petty cash, bank reconciliation. Bank reconciliation and adjusting entries. Bank reconciliation and adjusting entries. 7-3 ASSIGNMENT CHARACTERISTICS TABLE (Continued) CA7-1 CA7-2 CA7-3 CA7-4 CA7-5 CA7-6 CA7-7 CA7-8 CA7-9 CA7-10 CA7-11 Bad debt accounting. Various receivable accounting issues. Bad debt reporting issues. Basic note and accounts receivable transactions. Bad debt reporting issues. Sale of notes receivable. Zero-interest-bearing note receivable. Reporting of notes receivable, interest, and sale of receivables. Accounting for zero-interest-bearing note. Receivables management. Bad debt reporting, ethics. Simple Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate 10–15 15–20 25–30 25–30 25–30 20–25 20–30 25–30 25–30 25–30 25–30 7-4 ANSWERS TO QUESTIONS 1. Cash normally consists of coins and currency on hand, bank deposits, and various kinds of orders for cash such as bank checks, money orders, travelers’ checks, demand bills of exchange, bank drafts, and cashiers’ checks. Balances on deposit in banks which are subject to immediate withdrawal are properly included in cash. Money market funds that provide checking account privileges may be classified as cash. There is some question as to whether deposits not subject to immediate withdrawal are properly included in cash or whether they should be set out separately. Savings accounts, time certificates of deposit, and time deposits fall in this latter category. Unless restrictions on these kinds of deposits are such that they cannot be converted (withdrawn) within one year or the operating cycle of the entity, whichever is longer, they are properly classified as current assets. At the same time, they may well be presented separately from other cash and the restrictions as to convertibility reported. (a) (b) (c) (d) (e) (f) Cash Trading securities. Temporary investments. Accounts receivable. Accounts receivable, a loss if uncollectible. Other assets if not expendable, cash if expendable for goods and services in the foreign country. (g) Receivable if collection expected within one year; otherwise, other asset. (h) (i) (j) (k) (l) (m) Investments, possibly other assets. Cash. Trading securities. Cash. Cash. Postage expense, or prepaid expense, or office supplies inventory. (n) Receivable from employee if the company is to be reimbursed; otherwise, prepaid expense. 2. 3. A compensating balance is that portion of any cash deposit maintained by an enterprise which constitutes support for existing borrowing arrangements with a lending institution. A compensating balance representing a legally restricted deposit held against short-term borrowing arrangements should be stated separately among the cash and cash-equivalent items. A restricted deposit held as a compensating balance against long-term borrowing arrangements should be separately classified as a noncurrent asset in either the investments or other assets section. 4. Restricted cash for debt redemption would be reported in the long-term asset section, probably in the investments section. Another alternative is the other assets section. Given that the debt is long term, the restricted cash should also be reported as long term. The seller normally uses trade discounts to avoid frequent changes in its catalogs, to quote different prices for different quantities purchased, and to hide the true invoice price from competitors. Trade discounts are not recorded in the accounts because the price finally quoted is generally an accurate statement of the fair market value of the product on that date. In addition, no subsequent changes can occur to affect this value from an accounting standpoint. With a cash discount, the buyer receives a choice and events subsequent to the original transaction dictate that additional entries may be needed. Two methods of recording accounts receivable are: 1. Record receivables and sales gross. 2. Record receivables and sales net. 5. 6. 7-5 Questions Chapter 7 (Continued) The net method is desirable from a theoretical standpoint because it values the receivable at its net realizable value. In addition, recording the sales at net provides a better assessment of the revenue that was earned from the sale of the product. If the purchasing company fails to take the discount, then the company should reflect this amount as income. The gross method for receivables and sales is used in practice normally because it is expedient and its use does not generally have any significant effect on the presentation of the financial statements. 7. The basic problems that relate to the valuation of receivables are (1) the determination of the face value of the receivable, (2) the probability of future collection of the receivable, and (3) the length of time the receivable will be outstanding. The determination of the face value of the receivable is a function of the trade discount, cash discount, and certain allowance accounts such as the Allowance for Sales Returns and Allowances. The theoretical superiority of the allowance method over the direct write-off method of accounting for bad debts is two-fold. First, since revenue is considered to be recognized at the point of sale on the assumption that the resulting receivables are valid liquid assets merely awaiting collection, periodic income will be overstated to the extent of any receivables that eventually become uncollectible. The proper matching of revenue and expense requires that gross sales in the income statement be partially offset by a charge to bad debt expense that is based on an estimate of the receivables arising from gross sales that will not be converted into cash. Second, accounts receivable on the balance sheet should be stated at their estimated net realizable value. The allowance method accomplishes this by deducting from gross receivables the allowance for doubtful accounts. The latter is derived from the charges for bad debt expense on the income statement. 9. The percentage-of-sales method. U nder this method Bad Debt Expense is debited and Allowance for Doubtful Accounts is credited with a percentage of the current year’s credit or total sales. The rate is determined by reference to the relationship between prior years’ credit or total sales and actual bad debts arising therefrom. Consideration should also be given to changes in credit policy and current economic conditions. Although the rate should theoretically be based on and applied to credit sales, the use of total sales is acceptable if the ratio of credit sales to total sales does not vary significantly from year to year. The percentage-of-sales method of providing for estimated uncollectible receivables is intended to charge bad debt expense to the period in which the corresponding sales are recorded and is, therefore, designed for the preparation of a fair income statement. Due to annually insignificant but cumulatively significant errors in the experience rate which may result in either an excessive or inadequate balance in the allowance account, however, this method may not accurately report accounts receivable in the balance sheet at their estimated net realizable value. This can be prevented by periodically reviewing and, if necessary, adjusting the balance in the allowance account. The materiality of any such adjustment would govern its treatment for reporting purposes. The necessity of such adjustments of the allowance account indicates that bad debt expenses have not been accurately matched against related sales. Further, even when the experience rate does not result in an excessive or inadequate balance in the allowance account, this method tends to have a smoothing effect on reported periodic income due to year-to-year differences between the amounts of bad debt write-offs and estimated bad debts. 8. 7-6 Questions Chapter 7 (Continued) The aging method. With this method each year’s debit to the expense account and credit to the allowance account are determined by an evaluation of the collectibility of open accounts receivable at the close of the year. An analysis of the accounts according to their due dates is the usual procedure. For each of the age categories established in the analysis, average percentage rates may be developed on the basis of past experience and applied to the accounts in the respective age categories. This method may also utilize individual analysis for some accounts, especially those that are considerably past due, in arriving at estimated uncollectible receivables. On the basis of the foregoing analysis the balance in the valuation account is then adjusted to the amount estimated to be uncollectible. This method of providing for uncollectible accounts is quite accurate for purposes of reporting accounts receivable at their estimated net realizable value in the balance sheet. From the standpoint of the income statement, however, the aging method may not match accurately bad debt expenses with the sales which caused them because the charge to bad debt expense is not based on sales. The accuracy of both the charge to bad debt expense and the reported value of receivables depends on the current estimate of uncollectible accounts. The accuracy of the expense charge, however, is additionally dependent upon the timing of actual write-offs. 10. A major part of accounting is the measurement of financial data. Changes in values should be recognized as soon as they are measurable in objective terms in order for accounting to provide useful information on a periodic basis. The very existence of accounts receivable is based on the decision that a credit sale is an objective indication that revenue should be recognized. The alternative is to wait until the debt is paid in cash. If revenue is to be recognized and an asset recorded at the time of a credit sale, the need for fairness in the statements requires that both expenses and the asset be adjusted for the estimated amounts of the asset that experience indicates will not be collected. The argument may be persuasive that the evidence supporting write-offs permits a more accurate decision than that which supports the allowance method. The latter method, however, is “objective” in the sense in which accountants use the term and is justified by the need for fair presentation of receivables and income. The direct write-off method is not wholly objective; it requires the use of judgment in determining when an account has become uncollectible. 11. Because estimation of the allowance requires judgment, management could either over-estimate or under-estimate the amount of uncollectible accounts depending on whether a higher or lower earnings number is desired. For example, Sun Trust bank (referred to in the chapter) was having a very profitable year. By over-estimating the amount of bad debts, Sun Trust could record a higher allowance and expense, thereby reducing income in the current year. In a subsequent year, when earnings are low, they could under-estimate the allowance, record less expense and get a boost to earnings. 12. The receivable due from Kishwaukee Company should be written off to an appropriately named loss account and reported in the income statement as part of income from operations. Note that the profession specifically excludes write-offs of receivables from being extraordinary. In this case, classification as an unusual item would seem appropriate. The loss may properly be reduced by the portion of the allowance for doubtful accounts at the end of the preceding year that was allocable to the Kishwaukee Company account. Estimates for doubtful accounts are based on a firm’s prior bad debt experience with due consideration given to changes in credit policy and forecasted general or industry business conditions. 7-7 Questions Chapter 7 (Continued) The purpose of the allowance method is to anticipate only that amount of bad debt expense which can be reasonably forecasted in the normal course of events; it is not intended to anticipate bad debt losses which are abnormal and nonrecurring in nature. 13. If the direct write-off method is used, the only alternative is to debit Cash and credit a revenue account entitled Uncollectible Amounts Recovered. If the allowance method is used, then the accountant may debit Accounts Receivable and credit the Allowance for Doubtful Accounts. An entry is then made to credit the customer’s account and debit Cash upon receipt of the remittance. 14. The journal entry on John Singer’s books would be: Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Discount on Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 380,000 620,000* *Assumes that seller is a dealer in this property. If not, the property might be credited, and a loss on sale of $70,000 would be recognized. 15. Imputed interest is the interest ascribed or attributed to a situation or circumstance which is void of a stated or otherwise appropriate interest factor. Imputed interest is the result of a process of interest rate estimation called imputation. An interest rate is imputed for notes receivable when (1) no interest rate is stated for the transaction, or (2) the stated interest rate is unreasonable, or (3) the stated face amount of the note is materially different from the current cash price for the same or similar items or from the current market value of the debt instrument. In imputing an appropriate interest rate, consideration should be given to the prevailing interest rates for similar instruments of issuers with similar credit ratings, the collateral, and restrictive covenants. 16. A company might sell receivables because money is tight and access to normal credit is not available or prohibitively expensive. Also, a company may have to sell its receivables, instead of borrowing, to avoid violating existing lending arrangements. In addition, billing and collection of receivables are often time-consuming and costly. 17. A financial components approach is used when receivables are sold but there is continuing involvement by the seller in the receivable. Examples of continuing involvement are recourse provisions or continuing rights to service the receivable. A transfer of receivables should be recorded as a sale when the following three conditions are met: (a) The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors). (b) The transferees have obtained the right to pledge or exchange either the transferred assets or beneficial interests in the transferred assets. (c) The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity. 18. Recourse is a guarantee from Hale that if any of the sold receivables are uncollectible, Hale will pay the factor for the amount of the uncollectible account. This recourse obligation represents continuing involvement by Hale after the sale. Under the financial components model, the estimated fair value of the recourse obligation will be reported as a liability on Hale’s balance sheet. 7-8 Questions Chapter 7 (Continued) 19. Several acceptable solutions are possible depending upon assumptions made as to whether certain items are collectible within the operating cycle or not. The following illustrates one possibility: Current Assets Accounts receivable—Trade (of which accounts in the amount of $75,000 have been assigned as security for loans payable) ($523,000 + $75,000) Federal income tax refund receivable Advance payments on purchases Investments Advance to subsidiary Other Assets Travel advance to employee Notes receivable past due plus accrued interest $598,000 15,500 61,000 45,500 22,000 27,000 20. The accounts receivable turnover ratio is computed by dividing net sales by average net receivables outstanding during the year. This ratio is used to assess the liquidity of the receivables. It measures the number of times, on average, receivables are collected during the period. It provides some indication of the quality of the receivables and how successful the company is in collecting its outstanding receivables. 21. Because the restricted cash can not be used by Hawthorn to meet current obligations, it should not be reported as a current asset – it should be reported in investments or other assets. Thus, although this item has cash in its label, it should not be reflected in liquidity measures, such as the current or acid-test ratios. *22. (1) (2) (3) The general checking account is the principal bank account of most companies and frequently the only bank account of small companies. Most if not all transactions are cycled through the general checking account, either directly or on an imprest basis. Imprest bank accounts are used to disburse cash (checks) for a specific purpose, such as dividends, payroll, commissions, or travel expenses. Money is deposited in the imprest fund from the general fund in an amount necessary to cover a specific group of disbursements. Lockbox accounts are local post office boxes to which a multi-location company instructs its customers to mail remittances. A local bank is authorized to empty the box daily and credit the company’s accounts for collections. 7-9 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 7-1 Cash in bank—savings account Cash on hand Checking account balance Cash to be reported $63,000 9,300 17,000 $89,300 BRIEF EXERCISE 7-2 June 1 Accounts Receivable ............................... Sales ................................................... June 12 Cash .............................................................. Sales Discounts ........................................ Accounts Receivable .................... *$40,000 – ($40,000 X .03) = $38,800 38,800* 1,200 40,000 40,000 40,000 BRIEF EXERCISE 7-3 June 1 Accounts Receivable ............................... Sales ................................................... June 12 Cash .............................................................. Accounts Receivable .................... *$40,000 – ($40,000 X .03) = $38,800 7-10 38,800* 38,800 38,800 38,800 BRIEF EXERCISE 7-4 Bad Debt Expense........................................................... Allowance for Doubtful Accounts ................... ($1,200,000 X 2% = $24,000) 24,000 24,000 BRIEF EXERCISE 7-5 (a) Bad Debt Expense ................................................. Allowance for Doubtful Accounts ......... [(10% X $250,000) – $2,100] (b) Bad Debt Expense ................................................. Allowance for Doubtful Accounts ......... ($24,600 – $2,100) 22,500 22,500 22,900 22,900 BRIEF EXERCISE 7-6 11/1/07 Notes Receivable ........................................ Sales ..................................................... 12/31/07 Interest Receivable ..................................... Interest Revenue............................... ($20,000 X 6% X 2/12) 5/1/08 Cash ................................................................ Notes Receivable.............................. Interest Receivable .......................... Interest Revenue............................... ($400 = $20,000 X 6% X 4/12) 7-11 20,000 20,000 200 200 20,600 20,000 200 400 BRIEF EXERCISE 7-7 Notes Receivable ............................................................ Discount on Notes Receivable ........................ Cash.......................................................................... Discount on Notes Receivable ................................... Interest Revenue .................................................. $15,944 X 12% = $1,913 Discount on Notes Receivable ................................... Interest Revenue .................................................. ($15,944 + $1,913) X 12% = $2,143 Cash .................................................................................... Notes Receivable.................................................. 20,000 20,000 2,143 2,143 1,913 1,913 20,000 4,056 15,944 BRIEF EXERCISE 7-8 Akira, Inc. Cash .................................................................................... Finance Charge ($1,000,000 X 2%)............................ Notes Payable........................................................ Alisia National Bank Notes Receivable ............................................................ Cash.......................................................................... Financing Revenue ($1,000,000 X 2%) .......... 700,000 680,000 20,000 680,000 20,000 700,000 7-12 BRIEF EXERCISE 7-9 CRC Cash .................................................................................... Due from Factor ............................................................... Loss on Sale of Receivables ....................................... Accounts Receivable........................................... *6% X $100,000 = $6,000 **2% X $100,000 = $2,000 Fredrick Accounts Receivable ..................................................... Due to CRC ............................................................. Financing Revenue .............................................. Cash .......................................................................... 100,000 6,000 2,000 92,000 92,000 6,000* 2,000** 100,000 BRIEF EXERCISE 7-10 CRC Cash .................................................................................... Due from Factor ............................................................... Loss on Sale of Receivables ....................................... Accounts Receivable........................................... Recourse Obligation............................................ *6% X $100,000 = $6,000 **2% X $100,000 = $2,000 + $7,500 92,000 6,000* 9,500** 100,000 7,500 7-13 BRIEF EXERCISE 7-11 Cash $200,000 – [$200,000 X (.05 + .04)] ................. Due from Factor ($200,000 X .04)............................... Loss on Sale of Receivables....................................... Accounts Receivable .......................................... Recourse Obligation ........................................... *($200,000 X .05) + $8,000 182,000 8,000 18,000* 200,000 8,000 BRIEF EXERCISE 7-12 The entry for the sale now would be: Cash $200,000 – [($200,000 X (.05 + .04)]................ Due from Factor ($200,000 X .04)............................... Loss on Sale of Receivables....................................... Account Receivable ............................................ Recourse Obligation ........................................... *($200,000 X .05) + $4,000 This lower estimate for the recourse obligation reduces the amount of the loss—this will result in higher income in the year of the sale. Keyser’s liabilities will be lower by $4,000. 182,000 8,000 14,000* 200,000 4,000 BRIEF EXERCISE 7-13 The accounts receivable turnover ratio is computed as follows: Net Sales $5,416,000,000 = 17.61 times = Average Trade Receivables (net) $277,300,000 + $337,800,000 2 7-14 BRIEF EXERCISE 7-13 (Continued) The average collection period for accounts receivable in days is 365 days Accounts Receivable Turnover 365 17.61 = = 20.73 days As indicated from these ratios, General Mills’ accounts receivable turnover ratio appears quite strong. *BRIEF EXERCISE 7-14 Petty Cash..................................................................................... Cash ..................................................................................... Office Supplies ............................................................................ Miscellaneous Expense............................................................ Cash Over and Short................................................................. Cash ($200 – $17)............................................................. 94 87 2 183 200 200 *BRIEF EXERCISE 7-15 (a) (b) (c) (d) (e) Added to balance per bank statement (1) Added to balance per books (3) Deducted from balance per books (4) Deducted from balance per bank statement (2) Deducted from balance per books (4) 7-15 *BRIEF EXERCISE 7-16 (b) Cash...................................................................................... Interest Revenue.................................................... Office Expense—Bank Charges .................................. Cash ........................................................................... (e) Accounts Receivable ...................................................... Cash ........................................................................... 377 377 31 31 25 25 (c) Thus, all “Balance per Books” adjustments in the reconciliation require a journal entry. 7-16 SOLUTIONS TO EXERCISES EXERCISE 7-1 (10–15 minutes) (a) Cash includes the following: 1. Commercial savings account— First National Bank of Yojimbo 1. Commercial checking account— First National Bank of Yojimbo 2. Money market fund—Volonte 5. Petty cash 11. Commercial Paper (cash equivalent) 12. Currency and coin on hand Cash reported on December 31, 2007, balance sheet (b) Other items classified as follows: 3. 4. Travel advances (reimbursed by employee)* should be reported as receivable—employee in the amount of $180,000. Cash restricted in the amount of $1,500,000 for the retirement of long-term debt should be reported as a noncurrent asset identified as “Cash restricted for retirement of long-term debt.” An IOU from Marianne Koch should be reported as a receivable in the amount of $190,000. The bank overdraft of $110,000 should be reported as a current liability.** Certificates of deposits of $500,000 each should be classified as temporary investments. Postdated check of $125,000 should be reported as an accounts receivable. The compensating balance requirement does not affect the balance in cash. A note disclosure indicating the arrangement and the amounts involved should be described in the notes. 7-17 $ 600,000 900,000 5,000,000 1,000 2,100,000 7,700 $8,608,700 6. 7. 8. 9. 10. EXERCISE 7-1 (Continued) *If not reimbursed, charge to prepaid expense. **If cash is present in another account in the same bank on which the overdraft occurred, offsetting is required. EXERCISE 7-2 (10–15 minutes) 1. Cash balance of $925,000. Only the checking account balance should be reported as cash. The certificates of deposit of $1,400,000 should be reported as a temporary investment, the cash advance to subsidiary of $980,000 should be reported as a receivable, and the utility deposit of $180 should be identified as a receivable from the gas company. Cash balance is $584,650 computed as follows: Checking account balance Overdraft Petty cash Coin and currency $600,000 (17,000) 300 1,350 $584,650 Cash held in a bond sinking fund is restricted. Assuming that the bonds are noncurrent, the restricted cash is also reported as noncurrent. 2. 7-18 EXERCISE 7-2 (Continued) 3. Cash balance is $599,800 computed as follows: Checking account balance Certified check from customer $590,000 9,800 $599,800 The postdated check of $11,000 should be reported as a receivable. Cash restricted due to compensating balance should be described in a note indicating the type of arrangement and amount. Postage stamps on hand are reported as part of office supplies inventory or prepaid expenses. 4. Cash balance is $85,000 computed as follows: Checking account balance Money market mutual fund $37,000 48,000 $85,000 The NSF check received from customer should be reported as a receivable. 5. Cash balance is $700,900 computed as follows: Checking account balance Cash advance received from customer $700,000 900 $700,900 Cash restricted for future plant expansion of $500,000 should be reported as a noncurrent asset. Short-term Treasury bills of $180,000 should be reported as a temporary investment. Cash advance received from customer of $900 should also be reported as a liability; cash advance of $7,000 to company executive should be reported as a receivable; refundable deposit of $26,000 paid to federal government should be reported as a receivable. 7-19 EXERCISE 7-3 (10–15 minutes) Current assets Accounts receivable Customers Accounts (of which accounts in the amount of $40,000 have been pledged as security for a bank loan) Installment accounts collectible due in 2007 Installment accounts collectible due after December 31, 2007* Other** ($2,640 + $1,500) Investments Advance to subsidiary company 81,000 34,000 $136,000 4,140 $140,140 $79,000 23,000 *This classification assumes that these receivables are collectible within the operating cycle of the business. **These items could be separately classified, if considered material. EXERCISE 7-4 (10–15 minutes) Computation of cost of goods sold: Merchandise purchased Less: Ending inventory Cost of goods sold $320,000 90,000 $230,000 7-20 EXERCISE 7-4 (Continued) Selling price = 1.4 (Cost of good sold) = 1.4 ($230,000) = $322,000 Sales on account Less: Collections Uncollected balance Balance per ledger Apparent shortage $322,000 198,000 124,000 82,000 $ 42,000 —Enough for a new car EXERCISE 7-5 (15–20 minutes) (a) (1) June 3 Accounts Receivable—Chester...................... Sales ............................................................. June 12 Cash......................................................................... Sales Discounts ($3,000 X 2%) ....................... Accounts Receivable—Chester ........... (2) June 3 Accounts Receivable—Chester...................... Sales ($3,000 X 98%) ............................... June 12 Cash......................................................................... Accounts Receivable—Chester ........... 2,940 2,940 3,000 3,000 2,940 60 3,000 2,940 2,940 7-21 EXERCISE 7-5 (Continued) (b) July 29 Cash .................................................................... Accounts Receivable—Chester....... Sales Discounts Forfeited ................. 3,000 2,940 60 (Note to instructor: Sales discounts forfeited could have been recognized at the time the discount period lapsed. The company, however, would probably not record this forfeiture until final cash settlement.) EXERCISE 7-6 (5–10 minutes) July 1 Accounts Receivable......................................... Sales ............................................................ Cash ........................................................................ Sales Discounts .................................................. Accounts Receivable ............................. *$20,000 – (.03 X $20,000) = $19,400 July 17 Accounts Receivable......................................... 200,000 Sales ............................................................ July 30 Cash ........................................................................ 200,000 Accounts Receivable ............................. 200,000 20,000 20,000 19,400* 600 20,000 July 10 200,000 7-22 EXERCISE 7-7 (10–15 minutes) (a) Bad Debt Expense ................................................. Allowance for Doubtful Accounts ......... *.01 X ($900,000 – $50,000) = $8,500 (b) Bad Debt Expense ................................................. Allowance for Doubtful Accounts ......... 3,000 3,000* 8,500 8,500* *Step 1: Step 2: .05 X $100,000 = $5,000 (desired credit balance in Allowance account) $5,000 – $2,000 = $3,000 (required credit entry to bring allowance account to $5,000 credit balance) EXERCISE 7-8 (15–20 minutes) (a) Allowance for Doubtful Accounts ......................... Accounts Receivable ...................................... (b) Accounts Receivable Less: Allowance for Doubtful Accounts Net realizable value (c) Accounts Receivable Less: Allowance for Doubtful Accounts Net realizable value 6,000 6,000 $800,000 40,000 $760,000 $794,000 34,000 $760,000 7-23 EXERCISE 7-9 (8–10 minutes) (a) Bad Debt Expense....................................................... Allowance for Doubtful Accounts............... ($90,000 X 4%) + $1,750 = $5,350 (b) Bad Debt Expense....................................................... Allowance for Doubtful Accounts............... $680,000 X 1% = $6,800 6,800 6,800 5,350 5,350 EXERCISE 7-10 (10–12 minutes) (a) The direct write-off approach is not theoretically justifiable even though required for income tax purposes. The direct write-off method does not match expenses with revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet. Bad Debt Expense – 2% of Sales = $44,000 ($2,200,000 X 2%) Bad Debt Expense – Direct Write-Off = $31,330 ($7,800 + $6,700 + $7,000 + $9,830) Net income would be $12,670 ($44,000 – $31,330) lower under the percentage-of-sales approach. (b) 7-24 EXERCISE 7-11 (8–10 minutes) Balance 1/1 ($700 – $155) 4/12 (#2412) ($1,710 – $1,000 – $300*) 11/18 (#5681) ($2,000 – $1,250) $ 545 Over one year 410 Eight months and 19 days 750 One month and 13 days $1,705 *($790 – $490) Inasmuch as later invoices have been paid in full, all three of these amounts should be investigated in order to determine why Hopkins Co. has not paid them. The amounts in the beginning balance and #2412 should be of particular concern. EXERCISE 7-12 (15–20 minutes) 7/1 Accounts Receivable—Harding Co. ................ Sales ($8,000 X 98%) .................................. 7/5 Cash [$9,000 X (1 – .09)] ...................................... Loss on Sale of Receivables.............................. Accounts Receivable ($9,000 X 98%) ... Sales Discounts Forfeited........................ 8,190 810 8,820 180 7,840 7,840 (Note: It is possible that the company already recorded the Sales Discounts Forfeited. In this case, the credit to Accounts Receivable would be for $9,000. The same point applies to the next entry as well.) 7-25 EXERCISE 7-12 (Continued) 7/9 Accounts Receivable ........................................... Sales Discounts Forfeited ($9,000 – 2%)............................................ Cash .......................................................................... Finance Charge ($6,000 X 6%) .......................... Notes Payable.............................................. 7/11 Account Receivable—Harding Co................... Sales Discounts Forfeited ....................... ($8,000 X 2%) 180 180 5,640 360 6,000 160 160 This entry may be made at the next time financial statements are prepared. Also, it may occur on 12/29 when Harding Company’s receivable is adjusted. 12/29 Allowance for Doubtful Accounts.................... Accounts Receivable—Harding Co. ........ [$7,840 + $160 = $8,000; $8,000 – (10% X $8,000) = $7,200] 7,200 7,200 EXERCISE 7-13 (10–15 minutes) (a) Cash .............................................................................. Finance Charge.......................................................... Notes Payable.................................................. 192,000 8,000* 200,000 *2% X $400,000 = $8,000 (b) Cash .............................................................................. Accounts Receivable..................................... 7-26 350,000 350,000 EXERCISE 7-13 (Continued) (c) Notes Payable ......................................................... Interest Expense .................................................... Cash................................................................. *10% X $200,000 X 3/12 = $5,000 EXERCISE 7-14 (15–18 minutes) 1. Cash ............................................................................ Loss on Sale of Receivables ............................... ($25,000 X 10%) Accounts Receivable .................................. 2. Cash ............................................................................ Finance Charge ($55,000 X 8%).......................... Notes Payable................................................ 3. Bad Debt Expense .................................................. Allowance for Doubtful Accounts........... [($82,000 X 5%) + $2,120] 4. Bad Debt Expense .................................................. Allowance for Doubtful Accounts........... ($430,000 X 1.5%) EXERCISE 7-15 (10–15 minutes) Computation of net proceeds: Cash received Less: Recourse liability Net proceeds 7-27 200,000 5,000* 205,000 22,500 2,500 25,000 50,600 4,400 55,000 6,220 6,220 6,450 6,450 $160,000 1,000 $159,000 EXERCISE 7-15 (Continued) Computation of gain or loss: Carrying value Net proceeds Loss on sale of receivables The following journal entry would be made: Cash................................................................................ Loss on Sale of Receivables .................................. Recourse Liability............................................. Accounts Receivable....................................... EXERCISE 7-16 (15–20 minutes) (a) To be recorded as a sale, all of the following conditions would be met: (1) The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors). (2) The transferees have obtained the right to pledge or to exchange either the transferred assets or beneficial interests in the transferred assets. (3) The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity. (b) Computation of net proceeds: Cash received ($175,000 X 94%) Due from factor ($175,000 X 4%) Less: Recourse obligation Net proceeds 7-28 $200,000 159,000 $ 41,000 $160,000 41,000 1,000 200,000 $164,500 7,000 $171,500 2,000 $169,500 EXERCISE 7-16 (Continued) Computation of gain or loss: Carrying value Net proceeds Loss on sale of receivables The following journal entry would be made: Cash ....................................................................... Due from Factor ................................................. Loss on Sale of Receivables.......................... Recourse Liability .................................... Accounts Receivable .............................. $ $175,000 169,500 5,500 $164,500 7,000 5,500 2,000 175,000 EXERCISE 7-17 (10–15 minutes) (a) July 1 Cash ................................................................. Due from Factor............................................ Loss on Sale of Receivables .................... Accounts Receivable........................ **(4% X $300,000) = $12,000 **(1 1/2% X $300,000) = $4,500 (b) July 1 Accounts Receivable .................................. Due to JFK Corp. ............................... Financing Revenue ........................... Cash ....................................................... 300,000 12,000 4,500 283,500 283,500 12,000* 4,500** 300,000 7-29 EXERCISE 7-18 (10–15 minutes) 1. 7/1/07 Notes Receivable....................................... 1,101,460.00 Discount on Notes Receivable... Land .................................................... Gain on Sale of Land ..................... ($700,000 – $590,000) Computation of the discount $1,101,460 Face value of note .63552 Present value of 1 for 4 periods at 12% $ 700,000 Present value of note 1,101,460 Face value of note $ 401,460 Discount on note receivable 2. 7/1/07 Notes Receivable....................................... 400,000.00 Discount on Notes Receivable... Service Revenue ............................. Computation of the present value of the note: Maturity value Present value of $400,000 due in 8 years at 12%—$400,000 X .40388 Present value of $12,000 payable annually for 8 years at 12% annually—$12,000 X 4.96764 Present value of the note Discount on note receivable 59,611.68 221,163.68 $178,836.32 $161,552.00 401,460.00 590,000.00 110,000.00 178,836.32 221,163.68 $400,000.00 7-30 EXERCISE 7-19 (20–25 minutes) (a) Notes Receivable ..................................................... Discount on Notes Receivable .................. Consulting Revenue .................................... *Computation of present value of note: PV of $200,000 due in 2 years at 10% $200,000 X .82645 = $165,290 (b) Discount on Notes Receivable............................. Interest Revenue ........................................... *$165,290 X 10% = $16,529 (c) Discount on Notes Receivable............................. Interest Revenue ............................................ *$34,710 – $16,529 Cash .............................................................................. Notes Receivable .......................................... 200,000 200,000 18,181* 18,181 16,529 16,529* 200,000 34,710 165,290* EXERCISE 7-20 (10–15 minutes) (a) Accounts Receivable ................................................. Sales ..................................................................... Cash................................................................................. Accounts Receivable....................................... 100,000 100,000 70,000 70,000 7-31 EXERCISE 7-20 (Continued) (b) Accounts Receivable Turnover = Net Sales Average Trade Receivables (net) Net Sales $100,000 = 3.33 times = Average Trade Receivables (net) ($15,000 + $45,000*)/2 *$15,000 + $100,000 – $70,000 Average number of days to collect 365 = 110 days = receivables 3.33 (c) Jones Company’s turnover ratio has declined significantly. That is, it is turning receivables 3.33 times a year and collections on receivables took 110 days. In the prior year, the turnover ratio was almost double (6.0) and collections took only 61 days. This is a bad trend in liquidity. Jones should consider offering early payment discounts and/or tightened credit and collection policies. EXERCISE 7-21 (a) Cash [$25,000 X (1 – .09)]......................................... Due from Factor .......................................................... Loss on Sale of Accounts Receivable ................. Accounts Receivable ...................................... Recourse Obligation ....................................... Computation of cash received Accounts receivable ......................................... Less: Due from factor (5% X $25,000) ......... Finance charge (4% X $25,000)......... Cash received.............................................. Computation of net proceeds (cash and other assets received, less any liabilities incurred) Cash received...................................................... Due from factor................................................... Less: Recourse liability ................................... Net proceeds ............................................... 7-32 22,750 1,250 2,200 25,000 1,200 $25,000 1,250 1,000 $22,750 $22,750 1,250 $24,000 1,200 $22,800 EXERCISE 7-21 (Continued) Computation of loss Carrying (Book) value ...................................... Less: Net proceeds ........................................... Loss on sale of receivables ................... (b) Accounts Receivable Turnover = $25,000 22,800 $ 2,200 Net Sales Average Trade Receivables (net) Net Sales $100,000 = 5.71 times = Average Trade Receivables (net) ($15,000 + $20,000*)/2 *($15,000 + $100,000 – $70,000 – $25,000) Average number of days to collect = 365 = 63.92 days 5.71 With the factoring transaction, Jones Company’s turnover ratio still declines but by less than in the earlier exercise. While Jones’ collections have slowed, by factoring the receivables, Jones is able to convert them to cash. The cost of this approach to converting receivables to cash is captured in the Loss on Sale of Accounts Receivable account. 7-33 *EXERCISE 7-22 (5–10 minutes) 1. April 1 Petty Cash.................................................... Cash .................................................... April 10 Transportation-In....................................... Supplies Expense...................................... Postage Expense....................................... Accounts Receivable—Employees ..... Miscellaneous Expense........................... Cash Over and Short................................ Cash ($200 – $27)............................ 3. April 20 Petty Cash.................................................... Cash .................................................... 100 100 200 200 60 25 33 17 36 2 173 2. *EXERCISE 7-23 (10–15 minutes) Accounts Receivable—Employees............................ ($40.00 + $34.00) Nick Fonzarelli, Drawings*............................................ Repair Expense................................................................. Postage Expense ($20.00 – $2.90).............................. Office Supplies ................................................................. Cash Over and Short ...................................................... Cash ($300.00 – $15.20)....................................... *Note: This debit might also be made to the capital account. 74.00 170.00 14.35 17.10 2.90 6.45 284.80 7-34 *EXERCISE 7-24 (15–20 minutes) (a) Angela Lansbury Company Bank Reconciliation July 31 $8,650 2,350a (1,100)b $9,900 $9,250 1,000 $ 15 335 (350) $9,900 Balance per bank statement, July 31 Add: Deposits in transit Deduct: Outstanding checks Correct cash balance, July 31 Balance per books, July 31 Add: Collection of note Less: Bank service charge NSF check Corrected cash balance, July 31 Computation of deposits in transit Deposits per books Deposits per bank in July Less deposits in transit (June) Deposits mailed and received in July Deposits in transit, July 31 a b $5,810 $5,000 (1,540) (3,460) $2,350 Computation of outstanding checks Checks written per books Checks cleared by bank in July $4,000 Less outstanding checks (June)* (2,000) Checks written and cleared in July Outstanding checks, July 31 *Assumed to clear bank in July $3,100 (2,000) $1,100 7-35 *EXERCISE 7-24 (Continued) (b) Cash ................................................................................ Office Expenses—Bank Service Charge............. Accounts Receivable................................................. Notes Receivable ............................................. *EXERCISE 7-25 (15–20 minutes) (a) Logan Bruno Company Bank Reconciliation, August 31, 2007 County National Bank Balance per bank statement, August 31, 2007 Add: Cash on hand Deposits in transit Deduct: Outstanding checks Correct cash balance Balance per books, August 31, 2007 ($10,050 + $35,000 – $34,903) Add: Note ($1,000) and interest ($40) collected Deduct: Bank service charges Understated check for supplies Correct cash balance (b) Cash ........................................................................................ Notes Receivable ..................................................... Interest Revenue ...................................................... (To record collection of note and interest) 7-36 650 15 335 1,000 $ 8,089 $ 310 3,800 4,110 12,199 1,050 $11,149 $10,147 1,040 11,187 $ 20 18 38 $11,149 1,040 1,000 40 *EXERCISE 7-25 (Continued) Office Expense—Bank Service Charges ..................... Cash .............................................................................. (To record August bank charges) Supplies Expense................................................................ Cash .............................................................................. (To record error in recording check for supplies) (c) The corrected cash balance of $11,149 would be reported in the August 31, 2007, balance sheet. 18 18 20 20 7-37 TIME AND PURPOSE OF PROBLEMS Problem 7-1 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the balance sheet effect that occurs when the cash book is left open. In addition, the student is asked to adjust the present balance sheet to an adjusted balance sheet, reflecting the proper cash presentation. Problem 7-2 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to determine various items related to accounts receivable and the allowance for doubtful accounts. Five independent situations are provided. Problem 7-3 (Time 20–30 minutes) Purpose—to provide a short problem related to the aging of accounts receivable. The appropriate balance for doubtful accounts must be determined. In addition, the manner of reporting accounts receivable on the balance sheet must be shown. Problem 7-4 (Time 25–35 minutes) Purpose—the student prepares an analysis of the changes in the allowance for doubtful accounts and supports it with an aging schedule. The adjusting entry is prepared. Problem 7-5 (Time 20–30 minutes) Purpose—a short problem that must be analyzed to make the necessary correcting entries. It is not a pencil-pushing problem but requires a great deal of conceptualization. A good problem for indicating the types of adjustments that might occur in the receivables area. Problem 7-6 (Time 25–35 minutes) Purpose—to provide the student with a number of business transactions related to notes and accounts receivable that must be journalized. Recoveries of receivables, and write-offs are the types of transactions presented. The problem provides a good cross section of a number of accounting issues related to receivables. Problem 7-7 (Time 25–30 minutes) Purpose—a short problem involving the reporting problems associated with the assignment of accounts receivable. The student is required to make the journal entries necessary to record an assignment. A straightforward problem. Problem 7-8 (Time 30–35 minutes) Purpose—to provide the student with a problem in the imputation of interest. Our hope is that a good conceptual discussion can develop, related to the proper accounting for this item. Problem 7-9 (Time 30–35 minutes) Purpose—to provide the student with another problem requiring the imputation of interest. The student is required to make journal entries on a series of dates when note installments are collected. A relatively straightforward problem. Problem 7-10 (Time 40–50 minutes) Purpose—the student calculates the current portion of long-term receivables and interest receivable, and prepares the long-term receivables section of the balance sheet. Then the student prepares a schedule showing interest income. The problem includes interest-bearing and zero-interest-bearing notes and an installment receivable. Problem 7-11 (Time 20–25 minutes) Purpose—to provide the student the opportunity to record the sales of receivables with and without recourse and determine the income effects. 7-38 Time and Purpose of Problems (Continued) *Problem 7-12 (Time 20–25 minutes) Purpose—to provide the student the opportunity to do the accounting for petty cash and a bank reconciliation. *Problem 7-13 (Time 20–30 minutes) Purpose—to provide the student with the opportunity to prepare a bank reconciliation which is reconciled to a corrected balance. Traditional types of adjustments are presented. Journal entries are also required. *Problem 7-14 (Time 20–30 minutes) Purpose—to provide the student with the opportunity to prepare a bank reconciliation which goes from balance per bank to corrected balance. Traditional types of adjustments are presented such as deposits in transit, bank service charges, NSF checks, and so on. Journal entries are also required. 7-39 SOLUTIONS TO PROBLEMS PROBLEM 7-1 (a) December 31 Accounts Receivable ($17,640 + $360).................. Sales.................................................................................. Cash........................................................................ Sales Discounts.................................................. December 31 Cash .................................................................................. Purchase Discounts..................................................... Accounts Payable .............................................. 18,000 22,000 39,640 360 26,200 250 26,450 After Adjustment $ 25,560 60,000 67,000 152,560 (b) Current assets Cash ($39,000 – $39,640 + $26,200) Receivables ($42,000 + $18,000) Inventories Total Current liabilities Accounts payable ($45,000 + $26,450) Other current liabilities Total Working capital Current ratio Per balance sheet $ 39,000 42,000 67,000 (1) 148,000 45,000 14,200 (2) 59,200 (1) – (2) $ 88,800 (1) ÷ (2) 2.5 to 1 71,450 14,200 85,650 $ 66,910 1.78 to 1 7-40 PROBLEM 7-2 1. Net sales Percentage Bad debt expense 2. Accounts receivable Amounts estimated to be uncollectible Net realizable value 3. Allowance for doubtful accounts 1/1/07 Establishment of accounts written off in prior years Customer accounts written off in 2007 Bad debt expense for 2007 ($2,100,000 X 3%) Allowance for doubtful accounts 12/31/07 4. Bad debt expense for 2007 Customer accounts written off as uncollectible during 2006 Allowance for doubtful accounts balance 12/31/07 Accounts receivable, net of allowance for doubtful Accounts Allowance for doubtful accounts balance 12/31/07 Accounts receivable, before deducting allowance for doubtful accounts 5. Accounts receivable Percentage Bad debt expense, before adjustment Allowance for doubtful accounts (debit balance) Bad debt expense, as adjusted 7-41 $1,500,000 1 1/2% $ 22,500 $1,750,000 (180,000) $1,570,000 $17,000 8,000 (30,000) 63,000 $58,000 $ 84,000 (24,000) 60,000 $ $ 950,000 60,000 $1,010,000 $410,000 3% 12,300 14,000 $ 26,300 PROBLEM 7-3 (a) The Allowance for Doubtful Accounts should have a balance of $50,000 at year-end. The supporting calculations are shown below: Expected Percentage Uncollectible .02 .10 .15 .25 .60 Days Account Outstanding 0–15 days 16–30 days 31–45 days 46–60 days 61–75 days Amount $300,000 100,000 80,000 40,000 20,000 Estimated Uncollectible $ 6,000 10,000 12,000 10,000 12,000 $50,000 Balance for Allowance for Doubtful Accounts The accounts which have been outstanding over 75 days ($15,000) and have zero probability of collection would be written off immediately by a debit to allowance for Doubtful Accounts for $15,000 and a credit to Amounts Receivable for $15,000. It is not considered when determining the proper amount for the Allowance for Doubtful Accounts. (b) Accounts receivable ($555,000 – $15,000) ................. Less: Allowance for doubtful accounts ...................... Accounts receivable (net) ................................................ (c) $540,000 50,000 $490,000 The year-end bad debt adjustment would decrease before-tax income $30,000 as computed below: Estimated amount required in the Allowance for Doubtful Accounts Balance in the account after write-off of uncollectible accounts but before adjustment ($35,000 – $15,000) Required charge to expense 7-42 $50,000 20,000 $30,000 PROBLEM 7-4 (a) Blaise Pascal Corporation Analysis of Changes in the Allowance for Doubtful Accounts For the Year Ended December 31, 2007 $154,000 180,000 15,000 349,000 155,000 194,000 60,600 $254,600 Balance at January 1, 2007 Provision for doubtful accounts ($9,000,000 X 2%) Recovery in 2007 of bad debts written off previously Deduct write-offs for 2007 ($95,000 + $60,000) Balance at December 31, 2007 before change in accounting estimate Increase due to change in accounting estimate during 2007 ($254,600 – $194,000) Balance at December 31, 2007 adjusted (Schedule 1) Schedule 1 Computation of Allowance for Doubtful Accounts at December 31, 2007 Aging category Nov–Dec 2007 July–Oct Jan–Jun Prior to 1/1/07 Balance $1,080,000 650,000 420,000 90,000 (a) % 2 10 25 70 Doubtful accounts $ 21,600 65,000 105,000 63,000 $254,600 (a) $150,000 – $60,000 7-43 PROBLEM 7-4 (Continued) (b) The journal entry to record this transaction is as follows: Bad Debt Expense ................................................. Allowance for Doubtful Accounts................ (To increase the allowance for doubtful accounts at December 31, 2007, resulting from a change in accounting estimate) $60,600 $60,600 7-44 PROBLEM 7-5 Bad Debt Expense .............................................................. Accounts Receivable .............................................. (To correct bad debt expense and write off accounts receivable) Accounts Receivable ......................................................... Advance on Sales Contract .................................. (To reclassify credit balance in accounts receivable) Allowance for Doubtful Accounts ................................. Accounts Receivable .............................................. (To write off $4,200 of uncollectible accounts) 2,740.00 2,740.00 4,840.00 4,840.00 4,200.00 4,200.00 (Note to instructor: Many students will not make this entry at this point. Because $4,200 is totally uncollectible, a write-off immediately seems most appropriate. The remainder of the solution therefore assumes that the student made this entry.) Allowance for Doubtful Accounts ................................. Bad Debt Expense.................................................... (To reduce allowance for doubtful account balance) Balance ($8,750 + $18,620 – $2,740 – $4,200) Corrected balance (see below) Adjustment 7,374.64 7,374.64 $20,430.00 13,055.36 $ 7,374.64 Aging Schedule 1% 3% 6% 25% $ 1,723.42 4,239.90 2,231.04 4,861.00 $13,055.36 Age Under 60 days 61–90 days 91–120 days Over 120 days Balance $172,342 141,330 ($136,490 + $4,840) 37,184 ($39,924 – $2,740) 19,444 ($23,644 – $4,200) 7-45 PROBLEM 7-5 (Continued) If the student did not make the entry to record the $4,200 write-off earlier, the following would change in the problem. After the adjusting entry for $7,374.64, an entry would have to be made to write off the $4,200. Balance ($8,750 + $18,620 – $2,740) Corrected balance (see below) Adjustment $24,630.00 17,255.36 $ 7,374.64 Aging Schedule 1% 3% 6% — $ 1,723.42 4,239.90 2,231.04 9,061.00* $17,255.36 Age Under 60 days 61–90 days 91–120 days Over 120 days Balance $172,342 141,330 37,184 23,644 *$4,200 + (25% X $19,444) 7-46 PROBLEM 7-6 -1Cash......................................................................................... Sales Discounts ................................................................... Accounts Receivable............................................... *[$138,000 – ($40,000 X 2%)] -2Accounts Receivable ......................................................... Allowance for Doubtful Accounts....................... Cash......................................................................................... Accounts Receivable............................................... -3Allowance for Doubtful Accounts.................................. Accounts Receivable............................................... -4Bad Debt Expense............................................................... Allowance for Doubtful Accounts....................... ($17,300 + $6,300 – $17,500 = $6,100; $20,000 – $6,100 = $13,900) 13,900 13,900 17,500 17,500 6,300 6,300 6,300 6,300 137,200* 800 138,000 7-47 PROBLEM 7-7 July 1, 2007 Cash ......................................................................................... Finance Charge (.005 X $100,000) .................................. Notes Payable (80% X $100,000).......................... July 31, 2007 Notes Payable ....................................................................... Accounts Receivable ............................................... Finance Charge .................................................................... Finance Charge Payable (.005 X $45,000)......... August 31, 2007 Notes Payable ....................................................................... Cash*........................................................................................ Finance Charge (.005 X [$100,000 – $55,000 – $30,000])..................... Finance Charge Payable.................................................... Accounts Receivable ............................................... 25,000 4,700 75 225 30,000 225 225 79,500 500 80,000 55,000 55,000 *Total cash collection Less: Finance charge payable (from previous entry) Finance charge (current month) [(.005 X ($100,000 – $55,000 – $30,000)] Note payable (balance) ($80,000 – $55,000) Cash collected $30,000 (225) (75) (25,000) $ 4,700 7-48 PROBLEM 7-8 10/1/07 Notes Receivable .......................................... Sales ....................................................... 100,000 100,000 2,000* 2,000 12/31/07 Interest Receivable....................................... Interest Revenue ................................ *$100,000 X .08 X 3/12 = $2,000 10/1/08 Cash .................................................................. Interest Receivable ............................ Interest Revenue................................. *$100,000 X .08 = $8,000 **$100,000 X .08 X 9/12 = $6,000 12/31/08 Interest Receivable....................................... Interest Revenue................................. Cash .................................................................. Interest Receivable ............................ Interest Revenue................................. Cash .................................................................. Notes Receivable................................ 100,000 100,000 2,000 2,000 8,000 2,000 6,000 8,000* 2,000 6,000** 10/1/09 Note: Entries at 10/1/08 and 10/1/09 assumes reversing entries were not made on January 1, 2008 and January 1, 2009. 7-49 PROBLEM 7-9 (a) December 31, 2007 Cash ................................................................................... Notes Receivable ........................................................... Discount on Notes Receivable ....................... Revenue from Services..................................... To record revenue at the present value of the note plus the immediate cash payment: PV of $18,000 annuity @ 11% for 4 years ($18,000 X 3.10245) $55,844.10 Down payment 36,000.00 Capitalized value of services $91,844.10 36,000.00 72,000.00 16,155.90 91,844.10 (b) December 31, 2008 Cash ......................................................................................... 18,000.00 Notes Receivable ...................................................... 18,000.00 Discount on Notes Receivable ........................................ Interest Revenue ....................................................... 6,142.85 6,142.85 Schedule of Note Discount Amortization Cash Received — $18,000.00 18,000.00 18,000.00 18,000.00 Interest Revenue — $6,142.85a 4,838.56 3,390.81 1,783.68c Carrying Amount of Note $55,844.10 43,986.95b 30,825.51 16,216.32 — Date 12/31/07 12/31/08 12/31/09 12/31/10 12/31/11 a $6,142.85 = $55,844.10 X 11% $43,986.95 = $55,844.10 + $6,142.85 – $18,000.00 cRounded by $.12 b 7-50 PROBLEM 7-9 (Continued) (c) December 31, 2009 Cash....................................................................... Notes Receivable .................................... Discount on Notes Receivable...................... Interest Revenue..................................... 18,000.00 18,000.00 4,838.56 4,838.56 (d) December 31, 2010 Cash....................................................................... Notes Receivable .................................... Discount on Notes Receivable...................... Interest Revenue..................................... 3,390.81 3,390.81 18,000.00 18,000.00 (e) December 31, 2011 Cash....................................................................... Notes Receivable .................................... Discount on Notes Receivable...................... Interest Revenue..................................... 18,000.00 18,000.00 1,783.68 1,783.68 7-51 PROBLEM 7-10 (a) Connecticut Inc. Long-Term Receivables Section of Balance Sheet December 31, 2007 9% note receivable from sale of division, due in annual installments of $600,000 to May 1, 2009, less current installment 8% note receivable from officer, due Dec. 31, 2009, collateralized by 10,000 shares of Connecticut, Inc., common stock with a fair value of $450,000 Zero-interest-bearing note from sale of patent, net of 12% imputed interest, due April 1, 2009 Installment contract receivable, due in annual installments of $45,125 to July 1, 2011, less current installment Total long-term receivables (b) Connecticut Inc. Selected Balance Sheet Balances December 31, 2007 $ 600,000 (1) 400,000 173,746 (2) 110,275 $1,284,021 (3) Current portion of long-term receivables: Note receivable from sale of division Installment contract receivable Total current portion of long-term receivables Accrued interest receivable: Note receivable from sale of division Installment contract receivable Total accrued interest receivable $600,000 29,725 $629,725 (1) (3) 72,000 7,700 $79,700 (4) (5) 7-52 PROBLEM 7-10 (Continued) (c) Connecticut Inc. Interest Revenue from Long-Term Receivables For the Year Ended December 31, 2007 Interest income: Note receivable from sale of division Note receivable from sale of patent Note receivable from officer Installment contract receivable from sale of land Total interest income for year ended 12/31/07 Explanation of Amounts (1) $126,000 14,346 32,000 7,700 $180,046 (6) (2) (7) (5) Long-term Portion of 9% Note Receivable at 12/31/07 Face amount, 5/1/06 Less: Installment received 5/1/07 Balance, 12/31/07 Less: Installment due 5/1/08 Long-term portion, 12/31/07 $1,800,000 600,000 1,200,000 600,000 $ 600,000 (2) Zero-interest-bearing Note, Net of Imputed Interest at 12/31/07 Face amount 4/1/07 Less: Imputed interest [$200,000 – ($200,000 X 0.797)] Balance, 4/1/07 Add: Interest earned to 12/31/07 ($159,400 X 12% X 9/12) Balance, 12/31/07 $ 200,000 40,600 159,400 14,346 $ 173,746 7-53 PROBLEM 7-10 (Continued) (3) Long-term Portion of Installment Contract Receivable at 12/31/07 Contract selling price, 7/1/07 Less: Down payment, 7/1/07 Balance, 12/31/07 Less: Installment due, 7/1/08 [$45,125 – ($140,000 X 11%)] Long-term portion, 12/31/07 $ 200,000 60,000 140,000 29,725 $ 110,275 (4) Accrued Interest—Note Receivable, Sale of Division at 12/31/07 Interest accrued from 5/1 to 12/31/07 ($1,200,000 X 9% X 8/12) $ 72,000 (5) Accrued Interest—Installment Contract at 12/31/07 Interest accrued from 7/1 to 12/31/07 ($140,000 X 11% X 1/2) $ 7,700 (6) Interest Revenue—Note Receivable, Sale of Division, for 2007 Interest earned from 1/1 to 5/1/2007 ($1,800,000 X 9% X 4/12) Interest earned from 5/1 to 12/31/07 ($1,200,000 X 9% X 8/12) Interest income $ 54,000 72,000 $ 126,000 (7) Interest Revenue—Note Receivable, Officer, for 2007 Interest earned 1/1/ to 12/31/07 ($400,000 X 8%) 7-54 $ 32,000 PROBLEM 7-11 Radisson Company INCOME STATEMENT EFFECT For the Year Ended December 31, 2007 Expenses resulting from accounts receivable assigned (Schedule 1) Loss resulting from accounts receivable sold ($300,000 – $250,000) Total expenses Schedule 1 Computation of Expense for Accounts Receivable Assigned Assignment expense: Accounts receivable assigned Advance by Stickum Finance Company Interest expense Total expenses 50,000 $72,920 $22,920 $400,000 X 85% 340,000 X 3% $10,200 12,720 $22,920 7-55 *PROBLEM 7-12 (a) Petty Cash............................................................................ Cash ............................................................................ Postage Expense............................................................... Supplies................................................................................ Accounts Receivable—Employees ............................. Shipping Expense ............................................................. Advertising Expense ........................................................ Misc. Expense .................................................................... Cash ($250.00 – $16.40) ........................................ Petty Cash............................................................................ Cash ............................................................................ (b) Balances per bank: Add: Cash on hand Deposit in transit Deduct Checks outstanding Correct cash balance, May 31 Balance per books: Add: Note receivable (collected with interest) Deduct Service Charge Correct cash balance, May 31 *($9,150 + $31,000 – $31,835) Cash....................................................................................... Note Receivable ...................................................... Interest Revenue..................................................... Office Expense—Bank Charges ................................... Cash ............................................................................ (c) $9,218 + $300 = $9,518. 7-56 250.00 250.00 33.00 75.00 30.00 57.45 22.80 15.35 233.60 50.00 50.00 $6,522 $ 246 3,000 3,246 9,768 (550) $9,218 $8,315* 930 9,245 (27) $9,218 930 900 30 27 27 *PROBLEM 7-13 (a) Jose Orozco Co. Bank Reconciliation June 30, 2007 $4,150.00 2,890.00 (2,136.05) $4,903.95 $3,969.85 $ 30.00 523.80 936.00 453.20 72.00 30.50 Balance per bank, June 30 Add: Deposits in transit Deduct: Outstanding checks Correct cash balance, June 30 Balance per books, June 30 Add: Error in recording deposit ($90 – $60) Error on check no. 747 ($582.00 – $58.20) Note collection ($900 + $36) Deduct: NSF check Error on check no. 742 ($491 – $419) Bank service charges ($25 + $5.50) Correct cash balance, June 30 (b) Cash.......................................................................... Accounts Receivable ................................... Accounts Payable ......................................... Notes Receivable........................................... Interest Revenue ........................................... Accounts Receivable .......................................... Accounts Payable ................................................ Office Expense—Bank Charges...................... Cash................................................................... *Assumes sale was on account and not a cash sale. 1,489.80 1,489.80 5,459.65 (555.70) $4,903.95 30.00* 523.80** 900.00 36.00 453.20 72.00*** 30.50 555.70 **Assumes that the purchase of the equipment was recorded at its proper price. If a straight cash purchase, then Equipment should be credited instead of Accounts Payable. ***If a straight cash purchase, then Equipment should be debited instead of Accounts Payable. 7-57 *PROBLEM 7-14 (a) Tanizaki Inc. Bank Reconciliation November 30 $56,274.20 1,915.40 58,189.60 Balance per bank statement, November 30 Add: Cash on hand, not deposited Deduct: Outstanding checks #1224 #1230 #1232 #1233 Correct cash balance, Nov. 30 Balance per books, November 30 Add: Bond interest collected by bank Deduct: Bank charges not recorded in books Customer’s check returned NSF Correct cash balance, Nov. 30 *Computation of balance per books, November 30 Balance per books, October 31 Add receipts for November Deduct disbursements for November Balance per books, November 30 7-58 $1,635.29 2,468.30 3,625.15 482.17 8,210.91 $49,978.69 $49,178.22* 1,400.00 50,578.22 $ 27.40 572.13 599.53 $49,978.69 $ 41,847.85 173,523.91 215,371.76 166,193.54 $ 49,178.22 *PROBLEM 7-14 (Continued) (b) November 30 Cash.............................................................................. Interest Revenue............................................ November 30 Office Expense—Bank Charges .......................... Cash ................................................................... November 30 Accounts Receivable .............................................. Cash ................................................................... 1,400.00 1,400.00 27.40 27.40 572.13 572.13 7-59 TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 7-1 (Time 10–15 minutes) Purpose—to provide the student with the opportunity to discuss the deficiencies of the direct write-off method, the justification for two allowance methods for estimating bad debts, and to explain the accounting for the recoveries of accounts written off previously. CA 7-2 (Time 15–20 minutes) Purpose—to provide the student with the opportunity to discuss the accounting for cash discounts, trade discounts, and the factoring of accounts receivable. CA 7-3 (Time 25–30 minutes) Purpose—to provide the student with the opportunity to discuss the advantages and disadvantages of handling reporting problems related to the Allowance for Doubtful Accounts balance. Recommendations must be made concerning whether some type of allowance approach should be employed, how collection expenses should be handled, and finally, the appropriate accounting treatment for recoveries. A very complete case which should elicit a good discussion of this issue. CA 7-4 (Time 25–30 minutes) Purpose—to ask the student to discuss when interest revenue from a note receivable is reported. In Part 2, the student is asked to contrast the estimation of bad debts based on credit sales with that based on the balance in receivables, and to describe the reporting of the allowance and the bad debts expense. CA 7-5 (Time 25–30 minutes) Purpose—the student prepares an accounts receivable aging schedule, computes the amount of the adjustment, and prepares the journal entry to adjust the allowance. Then the student is asked to identify steps to improve collection and evaluate each step in terms of risks and costs involved. CA 7-6 (Time 20–25 minutes) Purpose—to provide the student with a discussion problem related to notes receivable sold without and with recourse. CA 7-7 (Time 20–30 minutes) Purpose—a zero-interest-bearing note is exchanged for a unique machine. The student must consider valuation, financial statement disclosure, and factoring the note. CA 7-8 (Time 25–30 minutes) Purpose—the student calculates interest revenue on an interest-bearing note and a zero-interestbearing note, and tells how the notes should be reported on the balance sheet. The student discusses how to account for collections on assigned accounts receivable and how to account for factored accounts receivable. CA 7-9 (Time 25–30 minutes) Purpose—to provide the student with a case related to the imputation of interest. One company has overstated its income by not imputing an interest element on the zero-interest-bearing note receivable that it received in the transaction. We have presented a short analysis to indicate what the proper solution should be. It is unlikely that the students will develop a journal entry with dollar amounts, but they should be encouraged to do so. CA 7-10 (Time 25–30 minutes) Purpose—to provide the student with a case to analyze receivables irregularities, including a shortage. This is a good writing assignment. CA 7-11 (Time 25–30 minutes) Purpose—to provide the student with a case to analyze ethical issues inherent in bad debt judgments. 7-60 SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 7-1 (a) The direct write-off method overstates the trade accounts receivable on the balance sheet by reporting them at more than their net realizable value. Furthermore, because the write-off often occurs in a period after the revenues were generated, the direct write-off method does not match bad debts expense with the revenues generated by sales in the same period. (b) One allowance method estimates bad debts based on credit sales. The method focuses on the income statement and attempts to match bad debts with the revenues generated by the sales in the same period. The other allowance method estimates bad debts based on the balance in the trade accounts receivable account. The method focuses on the balance sheet and attempts to value the accounts receivable at their net realizable value. (c) The company should account for the collection of the specific accounts previously written off as uncollectible as follows: ∑ Reinstatement of accounts by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts. ∑ Collection of accounts by debiting Cash and crediting Accounts Receivable. CA 7-2 (a) 1. Archer should account for the sales discounts at the date of sale using the net method by recording accounts receivable and sales revenue at the amount of sales less the sales discounts available. Revenues should be recorded at the cash-equivalent price at the date of sale. Under the net method, the sale is recorded at an amount that represents the cash-equivalent price at the date of exchange (sale). 2. There is no effect on Archer’s sales revenues when customers do not take the sales discounts. Archer’s net income is increased by the amount of interest (discount) earned when customers do not take the sales discounts. (b) Trade discounts are neither recorded in the accounts nor reported in the financial statements. Therefore, the amount recorded as sales revenues and accounts receivable is net of trade discounts and represents the cash-equivalent price of the asset sold. (c) To account for the accounts receivable factored on August 1, 2007, Archer should decrease accounts receivable by the amount of accounts receivable factored, increase cash by the amount received from the factor, and record a loss. Factoring of accounts receivable on a without recourse basis is equivalent to a sale. The difference between the cash received and the carrying amount of the receivables is a loss. (d) Archer should report the face amount of the interest-bearing notes receivable and the related interest receivable for the period from October 1 through December 31 on its balance sheet as noncurrent assets. Both assets are due on September 30, 2009, which is more than one year from the date of the balance sheet. 7-61 CA 7-2 (Continued) Archer should report interest revenue from the notes receivable on its income statement for the year ended December 31, 2007. Interest revenue is equal to the amount accrued on the notes receivable at the appropriate rate for three months. Interest revenue is realized with the passage of time. Accordingly, interest revenue should be accounted for as an element of income over the life of the notes receivable. CA 7-3 (1) Allowances and charge-offs. Method (a) is recommended. In the case of this company which has a large number of relatively small sales transactions, it is practicable to give effect currently to the probable bad debt expense. Whenever practicable, it is advisable to accrue probable bad debt charges and apply them in the accounting periods in which the related sales are credited. If the percentage is based on actual long-run experience, the allowance balance is usually adequate to bring the accounts receivable in the balance sheet to realizable values. However, the method does not preclude a periodic review of the accounts receivable for the purpose of estimating probable losses in relation to the allowance balance and adjustment for an inadequate or excessive allowance. Therefore method (b) is technically not wrong, but perhaps could be used in conjunction with method (a). Method (b) does not seem as appropriate here because of the probable large number of accounts involved and therefore a percentage of sales basis should provide a better “matching” of expenses with revenues. (2) Collection expenses. Method (a) or (b) is recommended. In the case of this company, one strong argument for method (a) is that it is advisable to have the bad debt expense account show the full amount of expense relating to efforts to collect and failure to collect balances receivable. On the other hand, an argument can be made to debit the allowance balance on the theory that bad debts (including related expenses) are established at the time the allowance is first established. As a result, the allowance balance already has anticipated these expenses and therefore as they occur they should be charged against the allowance account. It should be noted that there is no “right answer” to this question. It would seem that alternatives (c) and (d) are not good alternatives because the expense is not identified with bad debts, which it should be. (3) Recoveries. Method (c) is recommended. This method treats the recovery as a correction of a previous write-off. It produces an allowance account that reflects the net experience with bad debts. Method (a) might be acceptable if the provision for bad debts were based on experience with losses without considering recoveries, but in this case it would be advisable to use one account with a specific designation rather than the broad designation “other revenue.” As indicated in the textbook, recoveries are usually handled by reestablishing the receivable and allowance account. The receivable is then written off. Method (c) is basically that approach. CA 7-4 Part 1 Since John Depp Company is a calendar-year company, six months of interest should be accrued on 12/31/07. The remaining interest revenue should be recognized on 6/30/08 when the note is collected. The rationale for this treatment is: the accrual basis of accounting provides more useful information than does the cash basis. Therefore, since interest accrues with the passage of time, interest earned on John Depp’s note receivable should be recognized over the life of the note, regardless of when the cash is received. 7-62 CA 7-4 (Continued) Part 2 (a) The use of the allowance method based on credit sales to estimate bad debts is consistent with the matching principle because bad debts arise from and are a function of making credit sales. Therefore, bad debt expense for the current period should be matched with current credit sales. This is an income statement approach because the balance in the allowance for doubtful accounts is ignored when computing bad debt expense. The allowance method based on the balance in accounts receivable is not consistent with the matching principle. This method attempts to value accounts receivable at the amount expected to be collected. The method is facilitated by preparing an aging schedule of accounts receivable and plugging bad debt expense with the adjustment necessary to bring the allowance account to the required balance. Alternatively, the ending balance in accounts receivable can be used to determine the required balance in the allowance account without preparing an aging schedule by using a composite percentage. Bad debt expense is determined in the same manner as when an aging schedule is used. However, neither of these approaches associates bad debt expense with the period of sale, especially for sales made in the last month or two of the period. (b) On John Depp’s balance sheet, the allowance for doubtful accounts is presented as a contra account to accounts receivable with the resulting difference representing the net accounts receivable (i.e., their net realizable value). Bad debt expense would generally be included on John Depp’s income statement with the other operating (selling/general and administrative) expenses for the period. However, theoretical arguments can be made for (1) reducing sales revenue by the bad debts adjustment in the same manner that sales returns and allowances and trade discounts are considered reductions of the amount to be received from sales of products or (2)˚classifying the bad debts expense as a financial expense. CA 7-5 (a) Rosita Arenas Company Accounts Receivable Aging Schedule May 31, 2007 Estimated Proportion of Total Not yet due Less than 30 days past due 30 to 60 days past due 61 to 120 days past due 121 to 180 days past due Over 180 days past due .680 .150 .080 .050 .025 .015 1.000 Amount in Category $1,088,000 240,000 128,000 80,000 40,000 24,000 $1,600,000 Probability of Non-Collection .010 .035 .050 .090 .300 .800 Uncollectible Amount $10,880 8,400 6,400 7,200 12,000 19,200 $64,080 7-63 CA 7-5 (Continued) (b) Rosita Arenas Company Analysis of Allowance for Doubtful Accounts May 31, 2007 $ 43,300 160,000 203,300 145,000 58,300 64,080 $ 5,780 5,780 5,780 June 1, 2006 balance Bad debt expense accrual ($4,000,000 X .04) Balance before write-offs of bad accounts Write-offs of bad accounts Balance before year-end adjustment Estimated uncollectible amount Additional allowance needed Bad Debt Expense................................................................. Allowance for Doubtful Accounts......................... (c) (1) Steps to Improve Accounts Receivable Situation Establish more selective creditgranting policies, such as more restrictive credit requirements or more thorough credit investigations. (2) Risks and Costs Involved T his policy could result in los t sales and increased costs of credit evaluation. The company may be a ll but forced to adhere to th e prevailing credit-granting policies of the office equipment and supplies industry. T his policy may offend curren t c ustomers and thus risk futur e sales. Increased collection costs could result from this policy. Establish a more rigorous collection policy either through external collection agencies or by its own personnel. Charge interest on overdue ac- T his policy could result in los t counts. Insist on cash on deliv- sales and increased administrative ery (COD) or cash on order costs. (COO) for new customers or poor credit risks. 7-64 CA 7-6 (a) The appropriate valuation basis of a note receivable at the date of sale is its discounted present value of the future amounts receivable for principal and interest using the customer’s market rate of interest, if known or determinable, at the date of the equipment’s sale. (b) Luzov should increase the carrying amount of the note receivable by the effective interest revenue earned for the period February 1 to May 1, 2007. Luzov should account for the sale of the note receivable without recourse by increasing cash for the proceeds received, eliminating the carrying amount of the note receivable, and recognizing a loss (gain) for the resulting difference. This reporting is appropriate since the note’s carrying amount is correctly recorded at the date it was sold and the sale of a note receivable without recourse has occurred. Thus the difference between the cash received and the carrying amount of the note at the date it is sold is reported as a loss (gain). (c) 1. For notes receivable not sold, Luzov should recognize a bad debt expense. The expense equals the adjustment required to bring the balance of the allowance for doubtful accounts equal to the estimated uncollectible amounts less the fair values of recoverable equipment. 2. For notes receivable sold with recourse, at the time of sale, Luzov would have recorded a recourse obligation. This obligation measures the estimated bad debts at the time of the sale and increases the loss on the sale. CA 7-7 (a) 1. It was not possible to determine the machine’s fair value directly, so the sales price of the machine is reported at the note’s September 30, 2006, fair value. The note’s September 30, 2006, fair value equals the present value of the two installments discounted at the buyer’s September 30, 2006, market rate of interest. 2. Tiger reports 2006 interest revenue determined by multiplying the note’s carrying amount at September 30, 2006, times the buyer’s market rate of interest at the date of issue, times threetwelfths. Tiger should recognize that there is an interest factor implicit in the note, and this interest is earned with the passage of time. Therefore, interest revenue for 2006 should include three months’ revenue. The rate used should be the market rate established by the original present value, and this is applied to the carrying amount of the note. (b) To report the sale of the note receivable with recourse, Tiger should decrease notes receivable by the carrying amount of the note, increase cash by the amount received, record a recourse liability for possible customer defaults and report the difference as a loss or gain as part of income from continuing operations. (c) Tiger should decrease cash, increase notes (accounts) receivable past due for all payments caused by the note’s dishonor and eliminate the recourse liability. The note (account) receivable should be written down to its estimated recoverable amount (or an allowance for uncollectibles established), and a loss on uncollectible notes should be recorded for the excess of this difference over the amount of the recourse obligation previously recorded. 7-65 CA 7-8 (a) 1. For the interest-bearing note receivable, the interest revenue for 2007 should be determined by multiplying the principal (face) amount of the note by the note’s rate of interest by one half (July 1, 2007 to December 31, 2007). Interest accrues with the passage of time, and it should be accounted for as an element of revenue over the life of the note receivable. 2 . For the zero-interest-bearing note receivable, the interest revenue for 2007 should be determined by multiplying the carrying value of the note by the prevailing rate of interest at the date of the note by one third (September 1, 2007 to December 31, 2007). The carrying value of the note at September 1, 2007 is the face amount discounted for two years at the prevailing interest rate from the maturity date of August 31, 2009 back to the issuance date of September 1, 2007. Interest, even if unstated, accrues with the passage of time, and it should be accounted for as an element of revenue over the life of the note receivable. (b) The interest-bearing note receivable should be reported at December 31, 2007, as a current asset at its principal (face) amount. The zero-interest-bearing note receivable should be reported at December 31, 2007, as a noncurrent asset at its face amount less the unamortized discount on the note at December 31, 2007. (c) Because the trade accounts receivable are assigned, Sondergaard should account for the subsequent collections on the assigned trade accounts receivable by debiting Cash and crediting Accounts Receivable. The cash collected should then be remitted to Irene Dunne Finance until the amount advanced by Irene Dunne Finance is settled. The payments to Irene Dunne Finance consist of both principal and interest with interest computed at the rate of 8% on the balance outstanding. (d) Because the trade accounts receivable were factored on a without recourse basis, the factor is responsible for collection. On November 1, 2007, Sondergaard should credit Accounts Receivable for the amount of trade accounts receivable factored, debit Cash for the amount received from the factor, debit a Receivable from Factor for 5% of the trade accounts receivable factored, and debit Loss on Sale of Receivables for 3% of the trade accounts receivable factored. CA 7-9 The controller of Engone Company cannot justify the manner in which the company has accounted for the transaction in terms of sound financial accounting principles. Several problems are inherent in the sale of Rocketeer Enterprises stock to Campbell Inc. First, the issue of whether an arm’s-length transaction has occurred may be raised. The controller stated that the stock has not been marketable for the past six years. Thus, the recognition of revenue is highly questionable in view of the limited market for the stock; i.e., has an exchange occurred? Secondly, the collectibility of the note from Campbell is open to question. Campbell appears to have a liquidity problem due to its current cash squeeze. The lack of assurance about collectibility raises the question of whether revenue should be recognized. Central to the transaction is the issue of imputed interest. If we assume that an arm’s-length exchange has taken place, then the zero-interest-bearing feature masks the question of whether a gain, no gain or loss, or a loss occurred. 7-66 CA 7-9 (Continued) For a gain to occur, the interest imputation must result in an interest rate of about 5% or less. To illustrate: Present value of an annuity of $1 at 5% for 10 years = 7.72173; thus the present value of ten payments of $400,000 is $3,088,692. The cost of the investment is $3,000,000; thus, only an $88,692 gain is recognized at 5%. Selecting a more realistic interest rate (in spite of the controller’s ill-founded statements about “no cost” money since he/she is ignoring the opportunity cost) of 8% finds the present value of the annuity of $400,000 for ten periods equal to $2,684,032 ($400,000 X 6.71008). In this case a loss of $315,968 must be recognized as illustrated by the following journal entry: Notes Receivable.......................................................................................... Loss on Disposal of Rocketeer Stock....................................................... Investment in Rocketeer Stock ................................................. Discount on Notes Receivable.................................................. 4,000,000 315,968 3,000,000 1,315,968 CA 7-10 To: From: Date: Subject: John Castle, Branch Manager Accounting Major October 3, 2007 Shortage in the Accounts Receivable Ledger While performing a routine test on accounts receivable balances today, I discovered a $48,000 shortage. I believe that this matter deserves your immediate attention. To compute the shortage, I determined that the accounts receivable balance should have been based on the amount of inventory which has been sold. When we opened for business this year, we purchased $360,000 worth of merchandise inventory, and this morning, the balance in this account was $90,000. The $270,000 difference times the 40% markup indicates that sales on account totalled $378,000 [$270,000 + ($270,000 X .40)] to date. I subtracted the payments of $198,000 made on account this year and calculated the ending balance to be $180,000. However, the ledger shows a balance of only $132,000. I realize that this situation is very sensitive and that we should not accuse any one individual without further evidence. However, in order to protect the company’s assets, we must begin an immediate investigation of this disparity. Aside from me, the only other employee who has access to the accounts receivable ledger is Percy Shelley, the receivables clerk. I will supervise Shelley more closely in the future but suggest that we also employ an auditor to check into this situation. 7-67 CA 7-11 (a) No, the controller should not be concerned with Santo Company’s growth rate in estimating the allowance. The accountant’s proper task is to make a reasonable estimate of bad debt expense. In making the estimate, the controller should consider the previous year’s write-offs and also anticipate economic factors which might affect the company’s industry and influence Santo’s current write-off. (b) Yes, the controller’s interest in disclosing financial information completely and fairly conflicts with the president’s economic interest in manipulating income to avoid undesirable demands from the parent company. Such a conflict of interest is an ethical dilemma. The controller must recognize the dilemma, identify the alternatives, and decide what to do. 7-68 FINANCIAL REPORTING PROBLEM (a) Under “Cash Equivalents” in its notes to the consolidated financial statements, P&G indicates: “Highly liquid investments with maturities of three months or less when purchased are considered cash equivalents and recorded at cost.” (b) P&G has $5,469 million in cash and cash equivalents. As disclosed in the Consolidated Statement of Cash Flows, P&G indicates that in 2004 cash was used for capital expenditures ($ 2,024 million) and acquisitions ($7,476 million). Cash dividends were paid ($2,539 million), longterm debt was reduced ($1,188 million), and treasury stock was purchased ($4,070). As indicated in Note 1, the company’s products are sold primarily through retail operations including mass merchandisers, grocery stores, membership club stores, and drug stores. In fact, in it segment note (Note 12), P&G indicates that 17% of its sales in 2004 were to a single large customer – Wal-mart. Thus, to the extent that its customers have credit profiles similar to Wal-mart, it is reasonable that bad debt expense might not be material. (c) 7-69 FINANCIAL STATEMENT ANALYSIS CASE 1 (a) Cash may consist of funds on deposit at the bank, negotiable instruments such as money orders, certified checks, cashier’s checks, personal checks, bank drafts, and money market funds that provide checking account privileges. Cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash, and (b) so near their maturity that they present insignificant risk from changes in interest rates. Generally, only investments with original maturities of 3 months or less qualify. Examples of cash equivalents are Treasury bills, commercial paper, and money market funds. A compensating balance is that portion of any cash deposit maintained by an enterprise which constitutes support for existing borrowing arrangements with a lending institution. A compensating balance representing a legally restricted deposit held against short-term borrowing arrangements should be stated separately among cash and cash equivalent items. A restricted deposit held as a compensating balance against long-term borrowing arrangements should be separately classified as a noncurrent asset in either the investments or other assets section. (b) (c) (d) Cash equivalents are short-term, highly liquid investments that are both (1) readily convertible to known amounts of cash, and (2) so near their maturity that they represent insignificant risk of changes in interest rates. Generally, only investments with original maturities of 3 months or less qualify under these definitions. Examples of cash equivalents are Treasury bills, commercial paper, and money market funds purchased with cash that are in excess of immediate needs. Short-term investments are the investments held temporarily in place of cash and can be readily converted to cash when current financing needs make such conversion desirable. Examples of short-term investments include stock, Treasury notes, and other short-term securities. 7-70 FINANCIAL STATEMENT ANALYSIS CASE 1 (Continued) The major differences between cash equivalents and short-term investments are (1) cash equivalents typically have shorter maturity (less than three months) whereas short-term investments either have a longer maturity (e.g., short-term bonds) or no maturity date (e.g., stock), and (2) cash equivalents are readily convertible to known amounts of cash whereas a company may have a gain or loss when selling its short-term investments. Occidental received $345 million from selling its receivables. (e) Occidental would record a loss of $30,000,000 as revealed in the following entry to record the transaction: Cash .................................................................................. 345,000,000 Loss on Sale of Receivables .................................... 30,000,000* Accounts Receivable........................................ Recourse Liability.............................................. (f) 360,000,000 15,000,000 The transaction in (e) will decrease Occidental’s liquidity position. Current assets decrease by $15,000,000 and current liabilities are increased by the $15,000,000 (for the recourse liability). 7-71 FINANCIAL STATEMENT ANALYSIS CASE 2 Part 1 (a) Cash equivalents are short-term, highly liquid investments that can be converted into specific amounts of cash. They include money market funds, commercial paper, bank certificates of deposit, and Treasury bills. Cash equivalents differ in that they are extremely liquid (that is, easily turned into cash) and have very low risk of declining in value while held. (b) (in millions) (1) Current ratio (2) Working capital Microsoft $70,566 $14,969 = 4.7 $11,336 $4,272 Oracle = 2.7 $70,566 – $14,969 = $55,597 $11,336 – $4,272 = $7,064 Microsoft’s current ratio and working capital are both significantly higher than Oracle’s. Based on these measures, Microsoft is much more liquid than Oracle. (c) Yes, a company can have too many liquid assets. Liquid assets earn little or no return. Microsoft’s investors are accustomed to returns of 30% on their investment. Thus, Microsoft’s large amount of liquid assets may eventually create a drag on its ability to meet investor expectations. 7-72 FINANCIAL STATEMENT ANALYSIS CASE 2 (Continued) Part 2 2004 (a) Receivable Turnover $36,835 = $36,835 = 6.65 times ($5,890 + $5,196)/2 $5,543 Or a collection period of 55 days (365 ÷ 6.65). (b) Bad Debt Expense ......................................................... Allowance for Doubtful Accounts.................. Allowance for Doubtful Accounts ............................ Accounts Receivable ......................................... (c) 44 44 120 120 Accounts receivable is reduced by the amount of bad debts in the allowance account. This makes the denominator of the turnover ratio lower, resulting in a higher turnover ratio. 7-73 COMPARATIVE ANALYSIS CASE (a) Cash and cash equivalents: Coca-Cola, 12/31/04 $6,707,000,000 PepsiCo, 12/25/04 $1,280,000,000 Coca-Cola classifies cash equivalents as “marketable securities that are highly liquid and have maturities of three months or less at the date of purchase.” PepsiCo classifies cash equivalents as “funds temporarily invested (with maturities three months or less). (b) Accounts receivable (net): Coca-Cola, 12/31/04 $2,171,000,000 Allowance for doubtful accounts receivable: Coca-Cola, 12/31/04 Balance, $69,000,000 Percent of receivables, 3.08% (c) PepsiCo, 12/25/04 Balance, $97,000,000 Percent of receivables, 3.13% PepsiCo, 12/25/04 $2,999,000,000 Receivables turnover ratio and days outstanding for receivables: Coca-Cola $21,962 = 10.3 times $2,171 + $2,091 2 365 ÷ 10.3 = 35.4 days PepsiCo $29,261 $2,999 + $2,830 2 = 10 times 365 ÷ 10 = 36.5 days Coca-Cola’s turnover ratio is slightly higher, resulting in fewer days in receivables. It is likely that these companies use similar receivables management practices. 7-74 RESEARCH CASES CASE 1 (a) The 2004 edition reported 138 firms selling receivables, and 17 firms collateralizing receivables. The answer depends on the companies selected. (b) CASE 2 (a) Analysts say Americredit’s revised accounting method still doesn’t give investors a true picture of the company’s earnings. This is because gain-on-sale accounting is a very aggressive revenuerecognition policy and it makes a sub-prime lender look a lot better than it really is. Americredit uses gain-on-sale accounting, a method under which companies immediately record expected revenue and profit from their loan sales. But even though the gains are posted on the company’s books upfront, they materialize only gradually. So, much of the profits booked in this way are only estimates of expected future profits. The method has drawn fierce criticism in recent months by investors who say it encourages companies to book lots of loans, with little regard for their quality, as a way to increase profits. What’s more, these critics say, the assumptions used to calculate expected future profits—such as anticipated default rates—vary widely and are difficult to predict. (b) The Securities and Exchange Commission has indicated that the most aggressive form of gain-on-sale accounting, the “cash-in” method would no longer be permissible. That decision led Americredit, which employed the “cash-in” method, to change its procedure. Under the “cash-in method,” companies use a shorter time period to measure 7-75 RESEARCH CASES (Continued) the value of expected revenue streams. Americredit executives moved last week to convert to a “cash-out” method of gain-on-sale accounting, in which those values are calculated over longer periods of time, tending to result in lower earnings and revenues. Analysts indicate that although the “cash-out” method is not as aggressive as the “cash-in method,” it still increases the potential for gross overstatements of revenue and earnings. They say abandoning gain-on-sale accounting altogether for future securitizations and booking revenue and earnings gradually as actual cash revenue comes in would paint a truer picture of a company’s earnings. (c) Earnings reports that indicate that problem loans—defined as loans in which a customer is more than one month behind on interest payments—climbed to 9.7% of all managed receivables in the first quarter from 8.9% in the fiscal fourth quarter. Thus, analysts look at how Americredit deals with customers that miss payments. For example, Americredit allows a customer who misses a monthly car payment to defer principal payments twice until year end, without being declared delinquent. These deferred loans should be counted as problem loans and Americredit’s percentage of problem loans for the first quarter would have been much higher. 7-76 PROFESSIONAL RESEARCH: ACCOUNTING AND FINANCIAL REPORTING Search strings: “transfer”, “recourse”, “collateral”, “accounting for transfers” (a) Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (September 2000). The prior standard was Statement of Financial Accounting Standards No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS No. 140, Appendix E (para. 364) contains a glossary with definitions for the following terms. 1. Transfer: The conveyance of a noncash financial asset by and to someone other than the issuer of that financial asset. Thus, a transfer includes selling a receivable, putting it into a securitization trust, or posting it as collateral but excludes the origination of that receivable, the settlement of that receivable, or the restructuring of that receivable into a security in a troubled debt restructuring. 2. Recourse: The right of a transferee of receivables to receive payment from the transferor of those receivables for (a) failure of debtors to pay when due, (b) the effects of prepayments, or (c) adjustments resulting from defects in the eligibility of the transferred receivables. 3. Collateral: Personal or real property in which a security interest has been given. (c) SFAS No. 140, Par.2. “Transfers of financial assets take many forms. Accounting for transfers in which the transferor has no continuing involvement with the transferred assets or with the transferee has not been controversial. However, transfers of financial assets often occur in which the transferor has some continuing involvement either with the assets transferred or with the transferee. Examples of continuing involvement are recourse, servicing, agreements to reacquire, options written or held, and pledges of collateral.” (b) 7-77 PROFESSIONAL SIMULATION Measurement Trade Accounts Receivable Beginning balance $ 40,000 Credit sales during 2007 550,000 Collections during 2007 (500,000) Factored receivables (40,000) Ending balance $ 50,000 Financial Statements Current assets Cash* Trade accounts receivable Allowance for doubtful accounts Customer receivable (post-dated checks) Interest receivable** Due from factor*** Note receivable Inventories Prepaid postage Total current assets *($15,000 – $2,000 – $100) **($50,000 X 11% X 1/2) ***($40,000 X 6%) Analysis 2006 Current ratio = ($139,500* ÷ $80,000) Receivables turnover = 10.37 times *($20,000 + $40,000 – $5,500 + $85,000) Both ratios indicate that Horn’s liquidity has improved relative to the prior year. 2007 ($192,550 ÷ $86,000) $550,000 ($34,500 + $42,400)/2 Allowance for Doubtful Accounts Beginning balance $5,500 Charge-offs (2,300) 2007 provision (0.8% X $550,000) 4,400 Ending balance $7,600 $ 12,900 $50,000 (7,600) 42,400 2,000 2,750 2,400 50,000 80,000 100 $192,550 = 1.74 = 2.24 = 14.3 times 7-78 PROFESSIONAL SIMULATION (Continued) Explanation With a secured borrowing, the receivables would stay on Horn’s books and Horn would record a note payable. This would reduce the current ratio and receivables turnover ratio. 7-79 CHAPTER 8 Valuation of Inventories: A Cost-Basis Approach ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. Inventory accounts; determining quantities, costs, and items to be included in inventory; the inventory equation; balance sheet disclosure. Perpetual vs. periodic. Recording of discounts. Inventory errors. Flow assumptions. 10, 11 7 12, 13, 16, 18, 20 4 5, 6, 7 Questions 1, 2, 3, 4, 5, 6, 8, 9 Brief Exercises 1, 3 Exercises 1, 2, 3, 4, 5, 6, 10 Problems 1, 2, 3 Concepts for Analysis 1, 2, 3, 5, 11 2. 3. 4. 5. 2 9, 13, 14, 17 7, 8 2, 3, 4, 5, 10, 11, 12 13, 14, 15, 16, 17, 18, 19, 20, 21, 22 18 4, 5, 6 3 2 1, 4, 5, 6, 7 5, 6, 7, 8 4 6. 7. Inventory accounting changes. Dollar-value LIFO methods. 14, 15, 17, 18, 19 8, 9 7 1, 8, 9, 10, 11 6, 7, 10 8, 9 23, 24, 25, 26 8-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives 1. 2. 3. 4. 5. Identify major classifications of inventory. Distinguish between perpetual and periodic inventory systems. Identify the effects of inventory errors on the financial statements. Understand the items to include as inventory cost. Describe and compare the cost flow assumptions used to account for inventories. Explain the significance and use of a LIFO reserve. Understand the effect of LIFO liquidations. Explain the dollar-value LIFO method. Identify the major advantages and disadvantages of LIFO. Understand why companies select given inventory methods. 8, 9 22, 23, 24, 25, 26 1, 8, 9, 10, 11 Brief Exercises 1 2 4 1, 3 5, 6, 7 4, 9, 13, 16, 17, 18, 20 5, 10, 11, 12 1, 2, 3, 4, 5, 6, 7, 8 13, 14, 15, 16, 17, 18, 19, 20, 22 21 1, 2, 3 1, 4, 5, 6, 7 4, 5, 6 Exercises Problems 6. 7. 8. 9. 10. 8-2 ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty Moderate Moderate Simple Simple Moderate Simple Simple Simple Moderate Simple Simple Moderate Moderate Moderate Moderate Moderate Simple Simple Moderate Simple Moderate Moderate Simple Simple Moderate Moderate Moderate Moderate Simple Complex Complex Moderate Moderate Moderate Time (minutes) 15–20 10–15 10–15 10–15 15–20 10–20 10–15 20–25 15–25 10–15 10–15 15–20 15–20 20–25 15–20 15–20 10–15 15–20 15–20 10–15 10–15 25–30 5–10 15–20 20–25 15–20 30–40 25–35 20–25 40–55 40–55 25–35 30–40 30–40 Item E8-1 E8-2 E8-3 E8-4 E8-5 E8-6 E8-7 E8-8 E8-9 E8-10 E8-11 E8-12 E8-13 E8-14 E8-15 E8-16 E8-17 E8-18 E8-19 E8-20 E8-21 E8-22 E8-23 E8-24 E8-25 E8-26 P8-1 P8-2 P8-3 P8-4 P8-5 P8-6 P8-7 P8-8 Description Inventoriable costs. Inventoriable costs. Inventoriable costs. Inventoriable costs—perpetual. Inventoriable costs—error adjustments. Determining merchandise amounts—periodic. Purchases recorded net. Purchases recorded, gross method. Periodic versus perpetual entries. Inventory errors, periodic. Inventory errors. Inventory errors. FIFO and LIFO—periodic and perpetual. FIFO, LIFO and average cost determination. FIFO, LIFO, average cost inventory. Compute FIFO, LIFO, average cost—periodic. FIFO and LIFO; periodic and perpetual. FIFO and LIFO; income statement presentation. FIFO and LIFO effects. FIFO and LIFO—periodic. LIFO effect. Alternate inventory methods—comprehensive. Dollar-value LIFO. Dollar-value LIFO. Dollar-value LIFO. Dollar-value LIFO. Various inventory issues. Inventory adjustments. Purchases recorded gross and net. Compute FIFO, LIFO, and average cost—periodic and perpetual. Compute FIFO, LIFO, and average cost—periodic and perpetual. Compute FIFO, LIFO, and average cost—periodic and perpetual. Financial statement effects of FIFO and LIFO. Dollar-value LIFO. 8-3 ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item P8-9 P8-10 P8-11 CA8-1 CA8-2 CA8-3 CA8-4 CA8-5 CA8-6 CA8-7 CA8-8 CA8-9 CA8-10 CA8-11 Description Internal indexes—dollar-value LIFO. Internal indexes—dollar-value LIFO. Dollar-value LIFO. Inventoriable costs. Inventoriable costs. Inventoriable costs. Accounting treatment of purchase discounts. General inventory issues. LIFO inventory advantages. Average cost, FIFO, and LIFO. LIFO application and advantages. Dollar-value LIFO issues. FIFO and LIFO. LIFO Choices—Ethical Issues Level of Difficulty Moderate Complex Moderate Moderate Moderate Moderate Simple Moderate Simple Simple Moderate Moderate Moderate Moderate Time (minutes) 25–35 30–35 40–50 15–20 15–25 25–35 15–25 20–25 15–20 15–20 25–30 25–30 30–35 20–25 8-4 ANSWERS TO QUESTIONS 1. In a retailing concern, inventory normally consists of only one category, that is the product awaiting resale. In a manufacturing enterprise, inventories consist of raw materials, work in process, and finished goods. Sometimes a manufacturing or factory supplies inventory account is also included. (a) Inventories are unexpired costs and represent future benefits to the owner. A statement of financial position includes a listing of all unexpired costs (assets) at a specific point in time. Because inventories are assets owned at the specific point in time for which a statement of financial position is prepared, they must be included in order that the owners’ financial position will be presented fairly. (b) Beginning and ending inventories are included in the computation of net income only for the purpose of arriving at the cost of goods sold during the period of time covered by the statement. Goods included in the beginning inventory which are no longer on hand are expired costs to be matched against revenues earned during the period. Goods included in the ending inventory are unexpired costs to be carried forward to a future period, rather than expensed. 3. In a perpetual inventory system, data are available at any time on the quantity and dollar amount of each item of material or type of merchandise on hand. A physical inventory means that inventory is periodically counted (at least once a year) but that up-to-date records are not necessarily maintained. Discrepancies often occur between the physical count and the perpetual records because of clerical errors, theft, waste, misplacement of goods, etc. 4. No. Mariah Carey, Inc. should not report this amount on its balance sheet. As consignee, it does not own this merchandise and therefore it is inappropriate for it to recognize this merchandise as part of its inventory. Product financing arrangements are essentially off-balance-sheet financing devices. These arrangements make it appear that a company has sold its inventory or never taken title to it so they can keep loans off their balance sheet. A product financing arrangement should not be recorded as a sale. Rather, the inventory and related liability should be reported on the balance sheet. (a) (b) (c) (d) (e) (f) Inventory. Not shown, possibly in a note to the financial statements if material. Inventory. Inventory, separately disclosed as raw materials. Not shown, possibly a note to the financial statements. Inventory or manufacturing supplies. 2. 5. 6. 7. This omission would have no effect upon the net income for the year, since the purchases and the ending inventory are understated in the same amount. With respect to financial position, both the inventory and the accounts payable would be understated. Materiality would be a factor in determining whether an adjustment for this item should be made as omission of a large item would distort the amount of current assets and the amount of current liabilities. It, therefore, might influence the current ratio to a considerable extent. Cost, which has been defined generally as the price paid or consideration given to acquire an asset, is the primary basis for accounting for inventories. As applied to inventories, cost means the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. These applicable expenditures and charges include all acquisition and production costs but exclude all selling expenses and that portion of general and administrative expenses not clearly related to production. Freight charges applicable to the product are considered a cost of the goods. 8-5 8. Questions Chapter 8 (Continued) 9. By their nature, product costs “attach” to the inventory and are recorded in the inventory account. These costs are directly connected with the bringing of goods to the place of business of the buyer and converting such goods to a salable condition. Such charges would include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. Period costs are not considered to be directly related to the acquisition or production of goods and therefore are not considered to be a part of inventories. Conceptually, these expenses are as much a cost of the product as the initial purchase price and related freight charges attached to the product. While selling expenses are generally considered as more directly related to the cost of goods sold than to the unsold inventory, in most cases, though, the costs, especially administrative expenses, are so unrelated or indirectly related to the immediate production process that any allocation is purely arbitrary. Interest costs are considered a cost of financing and are generally expensed as incurred, when related to getting inventories ready for sale. 10. Cash discounts (purchase discounts) should not be accounted for as financial income when payments are made. Income should be recognized when the earning process is complete (when the company sells the inventory). Furthermore, a company does not earn revenue from purchasing goods. Cash discounts should be considered as a reduction in the cost of the items purchased. 11. $100.00, $105.00, $103.00. (Transportation-In not included for discount.) 12. Arguments for the specific identification method are as follows: (1) It provides an accurate and ideal matching of costs and revenues because the cost is specifically identified with the sales price. (2) The method is realistic and objective since it adheres to the actual physical flow of goods rather than an artificial flow of costs. (3) Inventory is valued at actual cost instead of an assumed cost. Arguments against the specific identification method include the following: (1) (2) (3) (4) The cost of using it restricts its use to goods of high unit value. The method is impractical for manufacturing processes or cases in which units are commingled and identity lost. It allows an artificial determination of income by permitting arbitrary selection of the items to be sold from a homogeneous group. It may not be a meaningful method of assigning costs in periods of changing price levels. 13. The first-in, first-out method approximates the specific identification method when the physical flow of goods is on a FIFO basis. When the goods are subject to spoilage or deterioration, FIFO is particularly appropriate. In comparison to the specific identification method, an attractive aspect of FIFO is the elimination of the danger of artificial determination of income by the selection of advantageously priced items to be sold. The basic assumption is that costs should be charged in the order in which they are incurred. As a result, the inventories are stated at the latest costs. Where the inventory is consumed and valued in the FIFO manner, there is no accounting recognition of 8-6 Questions Chapter 8 (Continued) unrealized gain or loss. A criticism of the FIFO method is that it maximizes the effects of price fluctuations upon reported income because current revenue is matched with the oldest costs which are probably least similar to current replacement costs. On the other hand, this method produces a balance sheet value for the asset close to current replacement costs. It is claimed that FIFO is deceptive when used in a period of rising prices because the reported income is not fully available since a part of it must be used to replace inventory at higher cost. The results achieved by the weighted average method resemble those of the specific identification method where items are chosen at random or there is a rapid inventory turnover. Compared with the specific identification method, the weighted average method has the advantage that the goods need not be individually identified; therefore accounting is not so costly and the method can be applied to fungible goods. The weighted average method is also appropriate when there is no marked trend in price changes. In opposition, it is argued that the method is illogical. Since it assumes that all sales are made proportionally from all purchases and that inventories will always include units from the first purchases, it is argued that the method is illogical because it is contrary to the chronological flow of goods. In addition, in periods of price changes there is a lag between current costs and costs assigned to income or to the valuation of inventories. If it is assumed that actual cost is the appropriate method of valuing inventories, last-in, first-out is not theoretically correct. In general, LIFO is directly adverse to the specific identification method because the goods are not valued in accordance with their usual physical flow. An exception is the application of LIFO to piled coal or ores which are more or less consumed in a LIFO manner. Proponents argue that LIFO provides a better matching of current costs and revenues. During periods of sharp price movements, LIFO has a stabilizing effect upon reported income figures because it eliminates paper income and losses on inventory and smooths the impact of income taxes. LIFO opponents object to the method principally because the inventory valuation reported in the balance sheet could be seriously misleading. The profit figures can be artificially influenced by management through contracting or expanding inventory quantities. Temporary involuntary depletion of LIFO inventories would distort current income by the previously unrecognized price gains or losses applicable to the inventory reduction. 14. A company may obtain a price index from an outside source (external index)—the government, a trade association, an exchange—or by computing its own index (internal index) using the double extension method. Under the double extension method the ending inventory is priced at both base-year costs and at current-year costs, with the total current cost divided by the total base cost to obtain the current year index. 15. Under the double extension method, LIFO inventory is priced at both base-year costs and currentyear costs. The total current-year cost of the inventory is divided by the total base-year cost to obtain the current-year index. The index for the LIFO pool consisting of product A and product B is computed as follows: Base-Year Cost Product Units Unit Total A 25,500 $10.20 $260,100 B 10,350 $37.00 382,950 December 31, 2007 inventory $643,050 Current-Year Cost Base-Year Cost = $956,460 $643,050 Current-Year Cost Unit Total $19.00 $484,500 $45.60 471,960 $956,460 = 148.74, index at 12/31/07. 8-7 Questions Chapter 8 (Continued) 16. The LIFO method results in a smaller net income because later costs, which are higher than earlier costs, are matched against revenue. Conversely, in a period of falling prices, the LIFO method would result in a higher net income because later costs in this case would be lower than earlier costs, and these later costs would be matched against revenue. 17. The dollar-value method uses dollars instead of units to measure increments, or reductions in a LIFO inventory. After converting the closing inventory to the same price level as the opening inventory, the increases in inventories, priced at base-year costs, is converted to the current price level and added to the opening inventory. Any decrease is subtracted at base-year costs to determine the ending inventory. The principal advantage is that it requires less record-keeping. It is not necessary to keep records nor make calculations of opening and closing quantities of individual items. Also, the use of a base inventory amount gives greater flexibility in the makeup of the base and eliminates many detailed calculations. The unit LIFO inventory costing method is applied to each type of item in an inventory. Any type of item removed from the inventory base (e.g., magnets) and replaced by another type (e.g., coils) will cause the old cost (magnets) to be removed from the base and to be replaced by the more current cost of the other item (coils). The dollar-value LIFO costing method treats the inventory base as being composed of a base of cost in dollars rather than of units. Therefore a change in the composition of the inventory (less magnets and more coils) will not change the cost of inventory base so long as the amount of the inventory stated in base-year dollars does not change. 18. (a) LIFO layer—a LIFO layer (increment) is formed when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices. (b) LIFO reserve—the difference between the inventory method used for internal purposes and LIFO. (c) LIFO effect—the change in the LIFO reserve (Allowance to Reduce Inventory to LIFO) from one period to the next. 19. December 31, 2007 inventory at December 31, 2006 prices, $1,026,000 ÷ 1.08 Less: Inventory, December 31, 2006 Increment added during 2007 at base prices Increment added during 2007 at December 31, 2007 prices, $150,000 X 1.08 Add: Inventory at December 31, 2006 Inventory, December 31, 2007, under dollar-value LIFO method $950,000 800,000 $150,000 $162,000 800,000 $962,000 20. Phantom inventory profits occur when the inventory costs matched against sales are less than the replacement cost of the inventory. The costs of goods sold therefore is understated and profit is considered overstated. Phantom profits are said to occur when FIFO is used during periods of rising prices. High inventory profits through involuntary liquidation occur if a company is forced to reduce its LIFO base or layers. If the base or layers of old costs are eliminated, strange results can occur because old, irrelevant costs can be matched against current revenues. A distortion in reported income for a given period may result, as well as consequences that are detrimental from an income tax point of view. 8-8 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 8-1 Billie Joel Company Balance Sheet (Partial) December 31 Current assets Cash .............................................................................. Receivables (net) ...................................................... Inventories Finished goods ................................................ Work in process............................................... Raw materials ................................................... Prepaid insurance .................................................... Total current assets........................................ $150,000 200,000 335,000 685,000 41,000 $1,316,000 $ 190,000 400,000 BRIEF EXERCISE 8-2 Inventory (150 X $30).......................................................... Accounts Payable..................................................... Accounts Payable (6 X $30) ............................................. Inventory...................................................................... Accounts Receivable (125 X $50)................................... Sales.............................................................................. Cost of Goods Sold (125 X $30)...................................... Inventory...................................................................... 8-9 4,500 4,500 180 180 6,250 6,250 3,750 3,750 BRIEF EXERCISE 8-3 December 31 inventory per physical count Goods-in-transit purchased FOB shipping point Goods-in-transit sold FOB destination December 31 inventory $200,000 15,000 22,000 $237,000 BRIEF EXERCISE 8-4 Cost of goods sold as reported Overstatement of 12/31/06 inventory Overstatement of 12/31/07 inventory Corrected cost of goods sold 12/31/07 retained earnings as reported Overstatement of 12/31/07 inventory Corrected 12/31/07 retained earnings $1,400,000 (110,000) 45,000 $1,335,000 $5,200,000 (45,000) $5,155,000 BRIEF EXERCISE 8-5 $11,850 1,000 Weighted average cost per unit Ending inventory 300 X $11.85 = Cost of goods available for sale Deduct ending inventory Cost of goods sold (700 X $11.85) = $11.85 $3,555 $11,850 3,555 $ 8,295 8-10 BRIEF EXERCISE 8-6 Ending inventory (April 23) 300 X $13 = $3,900 $11,850 3,900 $ 7,950 Cost of goods available for sale Deduct ending inventory Cost of goods sold BRIEF EXERCISE 8-7 April 1 April 15 Ending inventory Cost of goods available for sale Deduct ending inventory Cost of goods sold 250 X $10 = 50 X $12 = $2,500 600 $3,100 $11,850 3,100 $ 8,750 BRIEF EXERCISE 8-8 2005 2006 $123,200 ÷ 1.10 = $112,000 $100,000 X 1.00 $12,000* X 1.10 *$112,000 – $100,000 2007 $134,560 ÷ 1.16 = $116,000 $100,000 X 1.00 $12,000 X 1.10 $4,000** X 1.16 **$116,000 – $112,000 8-11 $100,000 $100,000 13,200 $113,200 $100,000 13,200 4,640 $117,840 BRIEF EXERCISE 8-9 2006 inventory at base amount ($21,708 ÷ 1.08) 2005 inventory at base amount Increase in base inventory 2006 inventory under LIFO Layer one Layer two $19,750 X 1.00 $ 350 X 1.08 $19,750 378 $20,128 2007 inventory at base amount ($25,935 ÷ 1.14) 2006 inventory at base amount Increase in base inventory 2007 inventory under LIFO Layer one Layer two Layer three $19,750 X 1.00 $ 350 X 1.08 $ 2,650 X 1.14 $19,750 378 3,021 $23,149 $22,750 20,100 $ 2,650 $20,100 (19,750) $ 350 8-12 SOLUTIONS TO EXERCISES EXERCISE 8-1 (15–20 minutes) Items 1, 3, 5, 8, 11, 13, 14, 16, and 17 would be reported as inventory in the financial statements. The following items would not be reported as inventory: 2. Cost of goods sold in the income statement. 4. Not reported in the financial statements. 6. Cost of goods sold in the income statement. 7. Cost of goods sold in the income statement. 9. Interest expense in the income statement. 10. Advertising expense in the income statement. 12. Office supplies in the current assets section of the balance sheet. 15. Not reported in the financial statements. 18. Short-term investments in the current asset section of the balance sheet. EXERCISE 8-2 (10–15 minutes) Inventory per physical count Goods in transit to customer, f.o.b. destination Goods in transit from vendor, f.o.b. seller Inventory to be reported on balance sheet $441,000 + 38,000 + 51,000 $530,000 The consigned goods of $61,000 are not owned by Jose Oliva and were properly excluded. The goods in transit to a customer of $46,000, shipped f.o.b. shipping point, are properly excluded from the inventory because the title to the goods passed when they left the seller (Oliva) and therefore a sale and related cost of goods sold should be recorded in 2007. The goods in transit from a vendor of $83,000, shipped f.o.b. destination, are properly excluded from the inventory because the title to the goods does not pass to Oliva until the buyer (Oliva) receives them. 8-13 EXERCISE 8-3 (10–15 minutes) 1. 2. 3. Include. Merchandise passes to customer only when it is shipped. Do not include. Title did not pass until January 3. Include in inventory. Product belonged to Harlowe Inc. at December 31, 2007. 4. Include in inventory. Under invoice terms, title passed when goods were shipped. Do not include. Goods received on consignment remain the property of the consignor. 5. EXERCISE 8-4 (10–15 minutes) 1. Raw Materials Inventory ...................................... Accounts Payable ....................................... 2. Raw Materials Inventory ...................................... Accounts Payable ....................................... No adjustment necessary. Accounts Payable .................................................. Raw Materials Inventory............................ 5. Raw Materials Inventory ...................................... Accounts Payable ....................................... 19,800 19,800 7,500 7,500 28,000 28,000 8,100 8,100 3. 4. 8-14 EXERCISE 8-5 (15–20 minutes) (a) Inventory December 31, 2007 (unadjusted) Transaction 2 Transaction 3 Transaction 4 Transaction 5 Transaction 6 Transaction 7 Transaction 8 Inventory December 31, 2007 (adjusted) (b) Transaction 3 Sales.......................................................................... Accounts Receivable ................................ (To reverse sale entry in 2007) Transaction 4 Purchases (Inventory) ......................................... Accounts Payable ...................................... (To record purchase of merchandise in 2007) Transaction 8 Sales Returns and Allowances......................... Accounts Receivable ................................ 2,600 2,600 15,630 15,630 $234,890 13,420 -0-08,540 (10,438) (10,520) 1,500 $237,392 12,800 12,800 8-15 EXERCISE 8-6 (10–20 minutes) 2005 Sales Sales Returns Net Sales Beginning Inventory Ending Inventory Purchases Purchase Returns and Allowances Transportation-in Cost of Good Sold Gross Profit $290,000 11,000 279,000 20,000 32,000* 242,000 5,000 8,000 233,000 46,000 2006 $360,000 13,000 347,000 32,000 37,000 260,000 8,000 9,000 256,000 91,000 2007 $410,000 20,000 390,000 37,000** 44,000 298,000 10,000 12,000 293,000 97,000 *This was given as the beginning inventory for 2006. **This was calculated as the ending inventory for 2006. EXERCISE 8-7 (10–15 minutes) (a) May 10 Purchases ................................................ Accounts Payable ....................... ($15,000 X .98) May 11 Purchases ................................................ Accounts Payable ....................... ($13,200 X .99) May 19 Accounts Payable.................................. Cash................................................. May 24 Purchases ................................................ Accounts Payable ($11,500 X .98)............................ 8-16 14,700 14,700 13,068 13,068 14,700 14,700 11,270 11,270 EXERCISE 8-7 (Continued) (b) May 31 Purchase Discounts Lost ............................... Accounts Payable ($13,200 X .01) ...................................... (Discount lost on purchase of May 11, $13,200, terms 1/15, n/30) EXERCISE 8-8 (a) Feb. 1 Inventory [$10,800 – ($10,800 X 10%)]........ Accounts Payable................................... Feb. 4 Accounts Payable [$2,500 – ($2,500 X 10%)] ............................................... Inventory.................................................... Feb. 13 Accounts Payable ($9,720 – $2,250) ........... Inventory (3% X $7,470) ........................ Cash ............................................................ (b) Feb. 1 Purchases [$10,800 – ($10,800 X 10%)] ..... Accounts Payable................................... Feb. 4 Accounts Payable [$2,500 – ($2,500 X 10%)] .................................................................. Purchase Returns and Allowances ...... Feb. 13 Accounts Payable ($9,720 – $2,250) ........... Purchase Discounts (3% X $7,470)....... Cash ............................................................ 8-17 132 132 9,720 9,720 2,250 2,250 7,470 224.10 7,245.90 9,720 9,720 2,250 2,250 7,470 224.10 7,245.90 EXERCISE 8-8 (Continued) (c) Purchase price (list) Less: Trade discount (10% X $10,800) Price on which cash discount based Less: Cash discount (3% X $9,720) Net price EXERCISE 8-9 (15–25 minutes) (a) Jan. 4 Accounts Receivable............................ Sales (80 X $8).............................. Jan. 11 Purchases ($150 X $6).......................... Accounts Payable ....................... Accounts Receivable............................ Sales (120 X $8.75)...................... Jan. 20 Purchases (160 X $7) ............................ Accounts Payable ....................... Accounts Receivable............................ Sales (100 X $9) ........................... Jan. 31 Inventory ($7 X 110) .............................. Cost of Goods Sold............................... Purchases ($900 + $1,120) ....... Inventory (100 X $5).................... *($500 + $2,020 – $770) 770 1,750* 2,020 500 1,120 1,120 900 900 900 900 1,050 1,050 640 640 $10,800 1,080 9,720 291.60 $ 9,428.40 Jan. 13 Jan. 27 8-18 EXERCISE 8-9 (Continued) (b) Sales ($640 + $1,050 + $900) Cost of goods sold Gross profit Jan. 4 $2,590 1,750 $ 840 640 640 400 400 900 900 1,050 1,050 700 700 1,120 1,120 900 900 650 650 (c) Accounts Receivable ................................ Sales (80 X $8) .................................. Cost of Goods Sold ................................... Inventory (80 X $5) .......................... Jan. 11 Inventory ....................................................... Accounts Payable (150 X $6)......... Accounts Receivable ................................ Sales (120 X $8.75) .......................... Cost of Goods Sold ................................... Inventory ([(20 X $5) + (100 X $6)] ....................................... Jan. 13 Jan. 20 Inventory ....................................................... Accounts Payable (160 X $7) ....... Accounts Receivable ................................ Sales (100 X $9)................................ Cost of Goods Sold ................................... Inventory [(50 X $6) + (50 X $7)] ......................................... Jan. 27 (d) Sales Cost of goods sold ($400 + $700 +$650) Gross profit 8-19 $2,590 1,750 $ 840 EXERCISE 8-10 (10–15 minutes) Current Year Overstated Overstated Overstated Overstated No effect Overstated* No effect No effect Overstated Overstated Overstated Overstated Subsequent Year No effect No effect No effect Understated No effect No effect No effect No effect No effect No effect No effect Understated 1. Working capital Current ratio Retained earnings Net income Working capital Current ratio Retained earnings Net income Working capital Current ratio Retained earnings Net income 2. 3. *Assume that the correct current ratio is greater than one. EXERCISE 8-11 (10–15 minutes) (a) $370,000 = 1.85 to 1 $200,000 $370,000 + $22,000 – $13,000 + $3,000 $382,000 = = 2.06 to 1 $200,000 – $15,000 $185,000 Adjust Income Increase (Decrease) $22,000 15,000 (13,000) (b) (c) 1. 2. 3. 4. Event Understatement of ending inventory Overstatement of purchases Overstatement of ending inventory Overstatement of advertising expense; understatement of cost of goods sold Effect of Error Decreases net income Decreases net income Increases net income 0 $24,000 8-20 EXERCISE 8-12 (15–20 minutes) Errors in Inventories Net Income Year 2002 2003 2004 2005 2006 2007 Per Books $ 50,000 52,000 54,000 56,000 58,000 60,000 $330,000 2,000 8,000 $3,000 9,000 $11,000 2,000 Add Overstatement Jan. 1 Deduct Understatement Jan. 1 Deduct OverstateAdd UnderstateCorrected Net Income $ 47,000 46,000 $11,000 74,000 45,000 60,000 50,000 $322,000 ment Dec. 31 ment Dec. 31 $3,000 9,000 EXERCISE 8-13 (15–20 minutes) (a) (1) Cost of Goods Sold LIFO 500 @ $13 = 500 @ $12 = $ 6,500 6,000 $12,500 $ 3,000 8,400 $11,400 Ending Inventory 300 @ $10 = 300 @ $12 = $3,000 3,600 $6,600 $6,500 1,200 $7,700 (2) FIFO 300 @ $10 = 700 @ $12 = 500 @ $13 = 100 @ $12 = (b) LIFO 100 @ $10 = 300 @ $12 = 200 @ $13 = $ 1,000 3,600 2,600 $ 7,200 8-21 EXERCISE 8-13 (Continued) (c) Sales Cost of Goods Sold Gross Profit (FIFO) $25,400 = ($24 X 200) + ($25 X 500) + ($27 X 300) 11,400 $14,000 Note: FIFO periodic and FIFO perpetual provide the same gross profit and inventory value. (d) LIFO matches more current costs with revenue. When prices are rising (as is generally the case), this results in a higher amount for cost of goods sold and a lower gross profit. As indicated in this exercise, prices were rising and cost of goods sold under LIFO was higher. EXERCISE 8-14 (20–25 minutes) (a) (1) LIFO 600 @ $6.00 = $3,600 100 @ $6.08 = 608 $4,208 (2) Average cost Total cost Total units $33,655* 5,300 = = $6.35 average cost per unit 700 @ $6.35 = $4,445 8-22 EXERCISE 8-14 (Continued) *Units 600 1,500 800 1,200 700 500 5,300 (b) (1) FIFO 500 @ $6.79 = $3,395 200 @ $6.60 = 1,320 $4,715 (2) LIFO 100 @ $6.00 = $ 600 100 @ $6.08 = 608 500 @ $6.79 = 3,395 $4,603 (c) Total merchandise available for sale Less inventory (FIFO) Cost of goods sold $33,655 4,715 $28,940 @ @ @ @ @ @ Price $6.00 $6.08 $6.40 $6.50 $6.60 $6.79 = = = = = = Total Cost $ 3,600 9,120 5,120 7,800 4,620 3,395 $33,655 (d) FIFO. 8-23 EXERCISE 8-15 (15–20 minutes) (a) Shania Twain Company COMPUTATION OF INVENTORY FOR PRODUCT BAP UNDER FIFO INVENTORY METHOD March 31, 2007 Units 600 800 200 1,600 Unit Cost $12.00 11.00 10.00 Total Cost $ 7,200 8,800 2,000 $18,000 March 26, 2007 February 16, 2007 January 25, 2007 (portion) March 31, 2007, inventory (b) Shania Twain Company COMPUTATION OF INVENTORY FOR PRODUCT BAP UNDER LIFO INVENTORY METHOD March 31, 2007 Units 600 1,000 1,600 Unit Cost $8.00 9.00 Total Cost $ 4,800 9,000 $13,800 Beginning inventory January 5, 2007 (portion) March 31, 2007, inventory (c) Shania Twain Company COMPUTATION OF INVENTORY FOR PRODUCT BAP UNDER WEIGHTED AVERAGE INVENTORY METHOD March 31, 2007 Units 600 1,200 1,300 800 600 4,500 Unit Cost $ 8.00 9.00 10.00 11.00 12.00 Total Cost $ 4,800 10,800 13,000 8,800 7,200 $44,600 Beginning inventory January 5, 2007 January 25, 2007 February 16, 2007 March 26, 2007 Weighted average cost ($44,600 ÷ 4,500) March 31, 2007, inventory *Rounded off. 1,600 $ 9.91* $ 9.91 $15,856 8-24 EXERCISE 8-16 (15–20 minutes) (a) (1) 2,100 units available for sale – 1,400 units sold = 700 units in the ending inventory. 500 @ $4.58 = $2,290 200 @ 4.60 = 920 700 $3,210 Ending inventory at FIFO cost. (2) 100 @ $4.10 = 600 @ 4.20 = 700 $ 410 2,520 $2,930 Ending inventory at LIFO cost. (3) $9,240 cost of goods available for sale ÷ 2,100 units available for sale = $4.40 weighted-average unit cost. 700 units X $4.40 = $3,080 Ending inventory at weighted-average cost. (b) (1) LIFO will yield the lowest gross profit because this method will yield the highest cost of goods sold figure in the situation presented. The company has experienced rising purchase prices for its inventory acquisitions. In a period of rising prices, LIFO will yield the highest cost of goods sold because the most recent purchase prices (which are the higher prices in this case) are used to price cost of goods sold while the older (and lower) purchase prices are used to cost the ending inventory. (2) LIFO will yield the lowest ending inventory because LIFO uses the oldest costs to price the ending inventory units. The company has experienced rising purchase prices. The oldest costs in this case are the lower costs. 8-25 EXERCISE 8-17 (10–15 minutes) (a) (1) 400 @ $30 = 160 @ $25 = $12,000 4,000 $16,000 $ 8,000 4,000 $12,000 (b) (1) (2) FIFO LIFO $16,000 [same as (a)] 100 @ $20 = 60 @ $25 = 400 @ $30 = $ 2,000 1,500 12,000 $15,500 (2) 400 @ $20 = 160 @ $25 = 8-26 EXERCISE 8-18 (15–20 minutes) First-in, first-out Sales Cost of goods sold: Inventory, Jan. 1 Purchases Cost of goods available Inventory, Dec. 31 Cost of goods sold Gross profit Operating expenses Net income $120,000 592,000* 712,000 235,000** 477,000 573,000 200,000 $ 373,000 $1,050,000 $120,000 592,000 712,000 164,000*** 548,000 502,000 200,000 $ 302,000 Last-in, first-out $1,050,000 *Purchases 6,000 @ $22 = 10,000 @ $25 = 7,000 @ $30 = $132,000 250,000 210,000 $592,000 **Computation of inventory, Dec. 31: First-in, first-out: 7,000 units @ $30 = 1,000 units @ $25 = $210,000 25,000 $235,000 ***Last-in, first-out: 6,000 units @ $20 = 2,000 units @ $22 = $120,000 44,000 $164,000 8-27 EXERCISE 8-19 (20–25 minutes) Sandy Alomar Corporation SCHEDULES OF COST OF GOODS SOLD For the First Quarter Ended March 31, 2007 Schedule 1 First-in, First-out Beginning inventory Plus purchases Cost of goods available for sale Less ending inventory Cost of goods sold $ 40,000 146,200* 186,200 61,300 $124,900 Schedule 2 Last-in, First-out $ 40,000 146,200 186,200 56,800 $129,400 *($33,600 + $25,500 + $38,700 + $48,400) Schedules Computing Ending Inventory Units Beginning inventory Plus purchases Units available for sale Less sales ($150,000 ÷ 5) Ending inventory 10,000 34,000 44,000 30,000 14,000 The unit computation is the same for both assumptions, but the cost assigned to the units of ending inventory are different. First-in, First-out (Schedule 1) 11,000 3,000 14,000 at $4.40 = at $4.30 = $48,400 12,900 $61,300 Last-in, First-out (Schedule 2) 10,000 at $4.00 = 4,000 at $4.20 = 14,000 $40,000 16,800 $56,800 8-28 EXERCISE 8-20 (10–15 minutes) (a) FIFO Ending Inventory 12/31/07 $ 827.64 76 @ $10.89* = 24 @ $11.88** = 285.12 $1,112.76 *[$11.00 – .01 ($11.00)] **[$12.00 – .01 ($12.00)] (b) LIFO Cost of Goods Sold—2007 76 @ $10.89 = $ 827.64 84 @ $11.88 = 997.92 90 @ $14.85* = 1,336.50 15 @ $15.84** = 237.60 $3,399.66 *[$15.00 – .01 ($15)] **[$16.00 – .01 ($16)] (c) FIFO matches older costs with revenue. When prices are declining, as in this case, this results in a higher amount for cost of goods sold. Therefore, it is recommended that FIFO be used by Howie Long Shop to minimize taxable income. EXERCISE 8-21 (10–15 minutes) (a) The difference between the inventory used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO or the LIFO reserve. The change in the allowance balance from one period to the next is called the LIFO effect (or as shown in this example, the LIFO adjustment). LIFO subtracts inflation from inventory costs by charging the items purchased recently to cost of goods sold. As a result, ending inventory (assuming increasing prices) will be lower than FIFO or average cost. 8-29 (b) EXERCISE 8-21 (Continued) (c) Cash flow was computed as follows: Revenue $3,200,000 Cost of goods sold (2,800,000) Operating expenses (150,000) Income taxes (75,600) Cash flow $ 174,400 If the company has any sales on account or payables, then the cash flow number is incorrect. It is assumed here that the cash basis of accounting is used. (d) The company has extra cash because its taxes are less. The reason taxes are lower is because cost of goods sold (in a period of inflation) is higher under LIFO than FIFO. As a result, net income is lower which leads to lower income taxes. If prices are decreasing, the opposite effect results. EXERCISE 8-22 (25–30 minutes) (a) (1) Ending inventory—Specific Identification Date No. Units Unit Cost December 2 July 20 100 50 150 $30 25 Total Cost $3,000 1,250 $4,250 (2) Ending inventory—FIFO Date No. Units December 2 September 4 100 50 150 Unit Cost $30 28 Total Cost $3,000 1,400 $4,400 (3) Ending inventory—LIFO Date No. Units January 1 March 15 100 50 150 Unit Cost $20 24 Total Cost $2,000 1,200 $3,200 8-30 EXERCISE 8-22 (Continued) (4) Ending inventory—Average Cost Date January 1 March 15 July 20 September 4 December 2 Explanation Beginning inventory Purchase Purchase Purchase Purchase No. Units 100 300 300 200 100 1,000 Unit Cost $20 24 25 28 30 Total Cost $ 2,000 7,200 7,500 5,600 3,000 $25,300 $25,300 ÷ 1,000 = $25.30 Ending Inventory—Average Cost No. Units 150 (b) Unit Cost $25.30 Total Cost $3,795 Double Extension Method Base-Year Costs Current Costs Total $3,000 Units 100 50 Current-Year Cost Per Unit $30 $28 Total $3,000 1,400 $4,400 Units 150 Base-Year Cost Per Unit $20 Ending Inventory for the Period at Current Cost Ending Inventory for the Period at Base-Year Cost = $4,400 = 1.4667 $3,000 $3,000 2,000 1,000 1.4667 1,467 2,000 $3,467 Ending inventory at base-year prices ($4,400 ÷ 1.4667) Base layer (100 units at $20) Increment in base-year dollars Current index Increment in current dollars Base layer (100 units at $20) Ending inventory at dollar-value LIFO 8-31 EXERCISE 8-23 (5–10 minutes) $97,000 – $92,000 = $5,000 increase at base prices. $98,350 – $92,600 = $5,750 increase in dollar-value LIFO value. $5,000 X Index = $5,750. Index = $5,750 ÷ $5,000. Index = 115 EXERCISE 8-24 (15–20 minutes) (a) 12/31/07 inventory at 1/1/07 prices, $140,000 ÷ 1.12 Inventory 1/1/07 Inventory decrease at base prices Inventory at 1/1/07 prices Less decrease at 1/1/07 prices Inventory 12/31/07 under dollar-value LIFO method (b) 12/31/08 inventory at base prices, $172,500 ÷ 1.15 12/31/07 inventory at base prices Inventory increment at base prices Inventory at 12/31/07 Increment added during 2008 at 12/31/08 prices, $25,000 X 1.15 Inventory 12/31/08 $125,000 160,000 $ 35,000 $160,000 35,000 $125,000 $150,000 125,000 $ 25,000 $125,000 28,750 $153,750 EXERCISE 8-25 (20–25 minutes) Change from Prior Year — $+30,000 (20,000) +4,000 +16,000 +12,000 Current $ 2004 2005 2006 2007 2008 2009 $ 80,000 115,500 108,000 122,200 154,000 176,900 Price Index 1.00 1.05 1.20 1.30 1.40 1.45 8-32 Base Year $ $ 80,000 110,000 90,000 94,000 110,000 122,000 EXERCISE 8-25 (Continued) Ending Inventory—Dollar-value LIFO: 2004 2005 $80,000 $80,000 @ 1.00 = 30,000 @ 1.05 = $ 80,000 31,500 $111,500 2006 $80,000 @ 1.00 = 10,000 @ 1.05 = $ 80,000 10,500 $ 90,500 2007 $80,000 @ 1.00 = 10,000 @ 1.05 = 4,000 @ 1.30 = $ 80,000 10,500 5,200 $ 95,700 2009 $80,000 @ 1.00 = 10,000 @ 1.05 = 4,000 @ 1.30 = 16,000 @ 1.40 = 12,000 @ 1.45 = 2008 $80,000 @ 1.00 = 10,000 @ 1.05 = 4,000 @ 1.30 = 16,000 @ 1.40 = $ 80,000 10,500 5,200 22,400 $118,100 $ 80,000 10,500 5,200 22,400 17,400 $135,500 EXERCISE 8-26 (15–20 minutes) Change from Prior Year — $+16,000 (4,000) +6,000 (8,000) Date Dec. 31, 2003 Dec. 31, 2004 Dec. 31, 2005 Dec. 31, 2006 Dec. 31, 2007 Current $ $ 70,000 90,300 95,120 105,600 100,000 Price Index 1.00 1.05 1.16 1.20 1.25 Base-Year $ $70,000 86,000 82,000 88,000 80,000 8-33 EXERCISE 8-26 (Continued) Ending Inventory—Dollar-value LIFO: Dec. 31, 2003 $70,000 Dec. 31, 2004 $70,000 @ 1.00 = 16,000 @ 1.05 = $70,000 16,800 $86,800 Dec. 31, 2005 $70,000 @ 1.00 = 12,000 @ 1.05 = $70,000 12,600 $82,600 Dec. 31, 2006 $70,000 @ 1.00 = 12,000 @ 1.05 = 6,000 @ 1.20 = $70,000 12,600 7,200 $89,800 Dec. 31, 2007 $70,000 @ 1.00 = 10,000 @ 1.05 = $70,000 10,500 $80,500 8-34 TIME AND PURPOSE OF PROBLEMS Problem 8-1 (Time 30–40 minutes) Purpose—to provide a multipurpose problem with trade discounts, goods in transit, computing internal price indexes, dollar-value LIFO, comparative FIFO, LIFO, and average cost computations, and inventoriable cost identification. Problem 8-2 (Time 25–35 minutes) Purpose—to provide the student with eight different situations that require analysis to determine their impact on inventory, accounts payable, and net sales. Problem 8-3 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to prepare general journal entries to record purchases on a gross and net basis. Problem 8-4 (Time 40–55 minutes) Purpose—to provide a problem where the student must compute the inventory using a FIFO, LIFO, and average cost assumption. These inventory value determinations must be made under two differing assumptions: (1) perpetual inventory records are kept in units only and (2) perpetual records are kept in dollars. Many detailed computations must be made in this problem. Problem 8-5 (Time 40–55 minutes) Purpose—to provide a problem where the student must compute the inventory using a FIFO, LIFO, and average cost assumption. These inventory value determinations must be made under two differing assumptions: (1) perpetual inventory records are kept in units only and (2) perpetual records are kept in dollars. This problem is very similar to Problem 8-4, except that the differences in inventory values must be explained. Problem 8-6 (Time 25–35 minutes) Purpose—to provide a problem where the student must compute cost of goods sold using FIFO, LIFO, and weighted average, under both a periodic and perpetual system. Problem 8-7 (Time 30–40 minutes) Purpose—to provide a problem where the student must identify the accounts that would be affected if LIFO had been used rather than FIFO for purposes of computing inventories. Problem 8-8 (Time 30–40 minutes) Purpose—to provide a problem which covers the use of inventory pools for dollar-value LIFO. The student is required to compute ending inventory, cost of goods sold, and gross profit using dollar-value LIFO, first with one inventory pool and then with three pools. Problem 8-9 (Time 25–35 minutes) Purpose—the student computes the internal conversion price indexes for a LIFO inventory pool and then computes the inventory amounts using the dollar-value LIFO method. Problem 8-10 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to compute inventories using the dollar-value approach. An index must be developed in this problem to price the new layers. This problem will prove difficult for the student because the indexes are hidden. Problem 8-11 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to write a memo on how a dollar-value LIFO pool works. In addition, the student must explain the step-by-step procedure used to compute dollar value LIFO. 8-35 SOLUTIONS TO PROBLEMS PROBLEM 8-1 1. $150,000 – ($150,000 X .20) = $120,000; $120,000 – ($120,000 X .10) = $108,000, cost of goods purchased $1,100,000 + $69,000 = $1,169,000. The $69,000 of goods in transit on which title had passed on December 24 (f.o.b. shipping point) should be added to 12/31/06 inventory. The $29,000 of goods shipped (f.o.b. shipping point) on January 3, 2007, should remain part of the 12/31/06 inventory. Because no date was associated with the units issued or sold, the periodic (rather than perpetual) inventory method must be assumed. FIFO inventory cost: 1,000 units at $24 1,100 units at 23 Total 1,500 units at $21 600 units at 22 Total 1,500 at $21 2,000 at 22 3,500 at 23 1,000 at 24 8,000 $ 24,000 25,300 $ 49,300 $ 31,500 13,200 $ 44,700 $ 31,500 44,000 80,500 24,000 $180,000 2. 3. LIFO inventory cost: Average cost: Totals $180,000 ÷ 8,000 = $22.50 Ending inventory (2,100 X $22.50) is $47,250. 8-36 PROBLEM 8-1 (Continued) 4. Computation of price indexes: 12/31/06 $252,000 = 105 $240,000 $286,720 = 112 $256,000 12/31/07 Dollar-value LIFO inventory 12/31/06: Increase $240,000 – $200,000 = 12/31/06 price index Increase in terms of 105 Base inventory Dollar-value LIFO inventory $ 40,000 X 1.05 42,000 2006 Layer 200,000 $242,000 Dollar-value LIFO inventory 12/31/07: Increase $256,000 – $240,000 = 12/31/07 price index Increase in terms of 112 2006 layer Base inventory Dollar-value LIFO inventory 5. $ 16,000 X 1.12 17,920 2007 Layer 42,000 200,000 $259,920 The inventoriable costs for 2007 are: Merchandise purchased Add: Freight-in Deduct: Purchase returns Purchase discounts Inventoriable cost $16,500 6,800 $909,400 22,000 931,400 23,300 $908,100 8-37 PROBLEM 8-2 James T. Kirk Company Schedule of Adjustments December 31, 2007 Inventory Initial amounts Adjustments: 1. 2. 3. 4. 5. 6. 7. 8. Total adjustments Adjusted amounts 1. $1,520,000 NONE 71,000 30,000 32,000 21,000 27,000 NONE 3,000 184,000 $1,704,000 Accounts Payable $1,200,000 NONE 71,000 NONE NONE NONE NONE 56,000 6,000 133,000 $1,333,000 Net Sales $8,150,000 (40,000) NONE NONE (47,000) NONE NONE NONE NONE (87,000) $8,063,000 The $31,000 of tools on the loading dock were properly included in the physical count. The sale should not be recorded until the goods are picked up by the common carrier. Therefore, no adjustment is made to inventory, but sales must be reduced by the $40,000 billing price. The $71,000 of goods in transit from a vendor to James T. Kirk were shipped f.o.b. shipping point on 12/29/07. Title passes to the buyer as soon as goods are delivered to the common carrier when sold f.o.b. shipping point. Therefore, these goods are properly includable in Kirk’s inventory and accounts payable at 12/31/07. Both inventory and accounts payable must be increased by $71,000. The work-in-process inventory sent to an outside processor is Kirk’s property and should be included in ending inventory. Since this inventory was not in the plant at the time of the physical count, the inventory column must be increased by $30,000. 8-38 2. 3. PROBLEM 8-2 (Continued) 4. The tools costing $32,000 were recorded as sales ($47,000) in 2007. However, these items were returned by customers on December 31, so 2007 net sales should be reduced by the $47,000 return. Also, $32,000 has to be added to the inventory column since these goods were not included in the physical count. The $21,000 of Kirk’s tools shipped to a customer f.o.b. destination are still owned by Kirk while in transit because title does not pass on these goods until they are received by the buyer. Therefore, $21,000 must be added to the inventory column. No adjustment is necessary in the sales column because the sale was properly recorded in 2008 when the customer received the goods. The goods received from a vendor at 5:00 p.m. on 12/31/07 should be included in the ending inventory, but were not included in the physical count. Therefore, $27,000 must be added to the inventory column. No adjustment is made to accounts payable, since the invoice was included in 12/31/07 accounts payable. The $56,000 of goods received on 12/26/07 were properly included in the physical count of inventory; $56,000 must be added to accounts payable since the invoice was not included in the 12/31/07 accounts payable balance. Since one-half of the freight-in cost ($6,000) pertains to merchandise properly included in inventory as of 12/31/07, $3,000 should be added to the inventory column. The remaining $3,000 debit should be reflected in cost of goods sold. The full $6,000 must be added to accounts payable since the liability was not recorded. 5. 6. 7. 8. 8-39 PROBLEM 8-3 (a) (1) 8/10 Purchases...................................................................... Accounts Payable ............................................ 8/13 Accounts Payable....................................................... Purchase Returns and Allowances ............ 8/15 Purchases...................................................................... Accounts Payable ............................................ 8/25 Purchases...................................................................... Accounts Payable ............................................ 8/28 Accounts Payable....................................................... Cash ...................................................................... 9,000 9,000 1,200 1,200 12,000 12,000 15,000 15,000 12,000 12,000 (2) Purchases—addition in cost of goods sold section of income statement. Purchase returns and allowances—deduction from purchases in cost of goods sold section of the income statement. Accounts payable—current liability in the current liabilities section of the balance sheet. 8/10 Purchases...................................................................... Accounts Payable ($9,000 X .98) ................. 8/13 Accounts Payable....................................................... Purchase Returns and Allowances ............ ($1,200 X .98) 8-40 (b) (1) 8,820 8,820 1,176 1,176 PROBLEM 8-3 (Continued) 8/15 Purchases ....................................................................... Accounts Payable ($12,000 X .99)................. 8/25 Purchases ....................................................................... Accounts Payable ($15,000 X .98)................. 8/28 Accounts Payable......................................................... Purchase Discounts Lost........................................... Cash........................................................................ 2. 8/31 Purchase Discounts Lost........................................... Accounts Payable .............................................. (.02 X [$9,000 – $1,200]) 11,880 11,880 14,700 14,700 11,880 120 12,000 156 156 3. Same as part (a) (2) except: Purchase Discounts Lost—treat as financial expense in income statement. (c) The second method is better theoretically because it results in the inventory being carried net of purchase discounts, and purchase discounts not taken are shown as an expense. The first method is normally used, however, for practical reasons. 8-41 PROBLEM 8-4 (a) Purchases Total Units April 1 (balance on hand) April 4 April 11 April 18 April 26 April 30 Total units Total units sold Total units (ending inventory) 100 400 300 200 500 200 1,700 1,400 300 Sales Total Units April 5 April 12 April 27 April 28 Total units 300 200 800 100 1,400 Assuming costs are not computed for each withdrawal: (1) First-in, first-out. Date of Invoice April 30 April 26 No. Units 200 100 Unit Cost $5.80 5.60 Total Cost $1,160 560 $1,720 (2) Last-in, first-out. Date of Invoice April 1 April 4 No. Units 100 200 Unit Cost $5.00 5.10 Total Cost $ 500 1,020 $1,520 8-42 PROBLEM 8-4 (Continued) (3) Average cost. Cost of Part X available. Date of Invoice No. Units April 1 April 4 April 11 April 18 April 26 April 30 Total Available 100 400 300 200 500 200 1,700 Unit Cost $5.00 5.10 5.30 5.35 5.60 5.80 Total Cost $ 500 2,040 1,590 1,070 2,800 1,160 $9,160 Average cost per unit = $9,160 ÷ 1,700 = $5.39. Inventory, April 30 = 300 X $5.39 = $1,617. (b) Assuming costs are computed for each withdrawal: (1) First-in, first out. The inventory would be the same in amount as in part (a), $1,720. 8-43 PROBLEM 8-4 (Continued) (2) Last-in, first-out. Purchased Date April 1 April 4 April 5 April 11 300 5.30 No. of units 100 400 Unit cost $5.00 5.10 300 $5.10 No. of units Sold Unit cost No. of units 100 100 400 100 100 100 100 300 April 12 200 5.30 100 100 100 April 18 200 5.35 100 100 100 200 April 26 500 5.60 100 100 100 200 500 April 27 800 500 @ 200 @ 100 @ April 28 April 30 200 5.80 100 5.60 5.35 5.30 5.10 100 100 100 100 200 5.00 5.10 5.00 5.00 5.80 1,010 500 1,660 Balance* Unit cost $5.00 5.00 5.10 5.00 5.10 5.00 5.10 5.30 5.00 5.10 5.30 5.00 5.10 5.30 5.35 5.00 5.10 5.30 5.35 5.60 5,410 2,610 1,540 2,600 Amount $ 500 2,540 1,010 Inventory April 30 is $1,660. *The balance on hand is listed in detail after each transaction. 8-44 PROBLEM 8-4 (Continued) (3) Average cost. Purchased Date April 1 April 4 April 5 April 11 April 12 April 18 April 26 April 27 April 28 April 30 200 5.80 200 500 5.35 5.60 800 100 5.4336 5.4336 300 5.30 200 5.2120 No. of units 100 400 Unit cost $5.00 5.10 300 $5.0800 No. of units Sold Unit cost No. of units 100 500 200 500 300 500 1,000 200 100 300 Balance Unit cost* $5.0000 5.0800 5.0800 5.2120 5.2120 5.2672 5.4336 5.4336 5.4336 5.6779 Amount $ 500.00 2,540.00 1,016.00 2,606.00 1,563.60 2,633.60 5,433.60 1,086.72 543.36 1,703.36 Inventory April 30 is $1,703. *Four decimal places are used to minimize rounding errors. 8-45 PROBLEM 8-5 (a) A ssuming costs are not computed for each withdrawal (units received, 5,600, minus units issued, 4,700, equals ending inventory at 900 units): (1) First-in, first-out. Date of Invoice No. Units Jan. 28 900 Unit Cost $3.60 Total Cost $3,240 (2) Last-in, first-out. Date of Invoice No. Units Jan. 2 (3) 900 Unit Cost $3.00 Total Cost $2,700 Average cost. Cost of goods available: Date of Invoice No. Units Jan. 2 Jan. 10 Jan. 18 Jan. 23 Jan. 28 Total Available 1,200 600 1,000 1,300 1,500 5,600 Unit Cost $3.00 3.20 3.30 3.40 3.60 Total Cost $ 3,600 1,920 3,300 4,420 5,400 $18,640 Average cost per unit = $18,640 ÷ 5,600 = $ 3.33 Cost of inventory Jan. 31 = 900 X $3.33 = $2,997 (b) Assuming costs are computed at the time of each withdrawal: Under FIFO—Yes. The amount shown as ending inventory would be the same as in (a) above. In each case the units on hand would be assumed to be part of those purchased on Jan. 28. Under LIFO—No. During the month the available balance dropped below the ending inventory quantity so that the layers of oldest costs were partially liquidated during the month. 8-46 PROBLEM 8-5 (Continued) Under Average Cost—No. A new average cost would be computed each time a withdrawal was made instead of only once for all items purchased during the year. The calculations to determine the inventory on this basis are given below. (1) First-in, first-out. The inventory would be the same in amount as in part (a), $3,240. Last-in, first-out. Received Date Jan. 2 Jan. 7 Jan. 10 Jan. 13 Jan. 18 1,000 3.30 600 3.20 500 300 3.20 3.30 No. of units 1,200 Unit cost $3.00 700 $3.00 Issued No. of units Unit cost No. of units 1,200 500 500 600 500 100 500 100 700 Jan. 20 700 100 300 Jan. 23 Jan. 26 Jan. 28 1,500 3.60 1,300 3.40 800 3.40 3.30 3.20 3.00 200 200 1,300 200 500 200 500 1,500 Jan. 31 1,300 3.60 200 500 200 3.00 3.00 3.40 3.00 3.40 3.00 3.40 3.60 3.00 3.40 3.60 3,020 7,700 600 5,020 2,300 Balance Unit cost* $3.00 3.00 3.00 3.20 3.00 3.20 3.00 3.20 3.30 4,130 Amount $3,600 1,500 3,420 1,820 (2) Inventory, January 31 is $3,020. 8-47 PROBLEM 8-5 (Continued) (3) Average cost. Received Date Jan. 2 Jan. 7 Jan. 10 Jan. 13 Jan. 18 Jan. 20 Jan. 23 Jan. 26 Jan. 28 Jan. 31 1,500 3.60 1,300 3.5291 1,300 3.40 800 3.3773 1,000 3.30 600 3.20 500 300 1,100 3.1091 3.2281 3.2281 No. of units 1,200 Unit cost $3.00 700 $3.0000 Issued No. of units Unit cost No. of units 1,200 500 1,100 600 1,300 200 1,500 700 2,200 900 Balance Unit cost* $3.0000 3.0000 3.1091 3.1091 3.2281 3.2281 3.3773 3.3773 3.5291 3.5291 Amount $3,600 1,500 3,420 1,865 4,197 646 5,066 2,364 7,764 3,176 Inventory, January 31 is $3,176. *Four decimal places are used to minimize rounding errors. 8-48 PROBLEM 8-6 (a) Beginning inventory Purchases (2,000 + 3,000) Units available for sale Sales (2,500 + 2,000) Goods on hand Periodic FIFO 1,000 X $12 = 2,000 X $18 = 1,500 X $23 = 4,500 1,000 5,000 6,000 4,500 1,500 $12,000 36,000 34,500 $82,500 (b) Perpetual FIFO Same as periodic: Periodic LIFO 3,000 X $23 = 1,500 X $18 = 4,500 Perpetual LIFO Purchased $82,500 (c) $69,000 27,000 $96,000 (d) Date 1/1 2/4 2/20 4/2 11/4 Sold Balance 1,000 X $12 = } $12,000 $48,000 2,000 X $18 = $36,000 2,000 X $18 500 X $12 3,000 X $23 = $69,000 2,000 X $23 = $46,000 ______ $88,000 1,000 X $12 2,000 X $18 } $42,000 500 X $12 500 X $12 3,000 X $23 500 X $12 1,000 X $23 = } } $ 6,000 $75,000 $29,000 8-49 PROBLEM 8-6 (Continued) (e) Periodic weighted-average 1,000 X $12 = $ 12,000 2,000 X $18 = 36,000 3,000 X $23 = 69,000 $117,000 ÷ 6,000 = $19.50 4,500 X $19.50 $87,750 (f) Perpetual moving average Date 1/1 2/4 2/20 4/2 11/4 3,000 X $23 = $69,000 2,000 X $22 = 44,000 $84,000 a Purchased Sold Balance 1,000 X $12 = $12,000 2,000 X $18 = $36,000 2,500 X $16 = $40,000 3,000 X $16 = 500 X $16 = 3,500 X $22 = 1,500 X $22 = a 48,000 8,000 77,000 33,000 500 X $16 = $ 8,000 3,000 X $23 = 69,000 3,500 $77,000 ($77,000 ÷ 3,500 = $22) 8-50 PROBLEM 8-7 The accounts in the 2008 financial statements which would be affected by a change to LIFO and the new amount for each of the accounts are as follows: Account Cash Inventory Retained earnings Cost of goods sold Income taxes New amount for 2008 $165,600 120,000 215,600 810,000 94,400 (1) (2) (3) (4) (5) The calculations for both 2007 and 2008 to support the conversion to LIFO are presented below. Income for the Years Ended Sales Less: Cost of goods sold Other expenses Income before taxes Income taxes (40%) Net income Cost of Good Sold and Ending Inventory for the Years Ended Beginning inventory Purchases Cost of goods available Ending inventory Cost of goods sold Determination of Cash at Income taxes under FIFO Income taxes as calculated under LIFO Increase in cash Adjust cash at 12/31/08 for 2007 tax difference Total increase in cash Cash balance under FIFO Cash balance under LIFO (40,000 X $3.00) (150,000 X $3.50) (40,000 X $3.00) 12/31/07 $900,000 525,000 205,000 730,000 170,000 68,000 $102,000 12/31/08 $1,350,000 810,000 304,000 1,114,000 236,000 94,400 $ 141,600 12/31/07 $120,000 525,000 645,000 120,000 $525,000 12/31/07 $ 76,000 68,000 8,000 — 8,000 130,000 $138,000 8-51 (40,000 X $3.00) (180,000 X $4.50) (40,000 X $3.00) 12/31/08 $120,000 810,000 930,000 120,000 $810,000 12/31/08 $110,400 94,400 16,000 8,000 24,000 141,600 $165,600 PROBLEM 8-7 (Continued) Determination of Retained Earnings at Net income under FIFO Net income under LIFO Reduction in retained earnings Adjust retained earnings at 12/31/08 for 2007 reduction Total reduction in retained earnings Retained earnings under FIFO Retained earnings under LIFO 12/31/07 $114,000 102,000 12,000 — 12,000 200,000 $188,000 12/31/08 $165,600 141,600 24,000 12,000 36,000 251,600 $215,600 8-52 PROBLEM 8-8 (a) 1. Ending inventory in units Portable 6,000 + 15,000 – 14,000 = Midsize 8,000 + 20,000 – 24,000 = Flat-screen 3,000 + 10,000 – 6,000 = 7,000 4,000 7,000 18,000 2. Ending inventory at current cost Portable 7,000 X $120 = Midsize 4,000 X $300 = Flat-screen 7,000 X $460 = $ 840,000 1,200,000 3,220,000 $5,260,000 3. Ending inventory at base-year cost Portable 7,000 X $100 = Midsize 4,000 X $250 = Flat-screen 7,000 X $400 = $ 700,000 1,000,000 2,800,000 $4,500,000 4. Price index $5,260,000 ÷ $4,500,000 = 1.1689 Ending inventory $3,800,000 X 1.0000 = 700,000* X 1.1689 = *($4,500,000 – $3,800,000 = $700,000) 5. $3,800,000 818,230 $4,618,230 6. Cost of goods sold Beginning inventory Purchases [(15,000 X $120) + (20,000 X $300) + (10,000 X $460)] Cost of goods available Ending inventory Cost of goods sold 8-53 $ 3,800,000 12,400,000 16,200,000 4,618,230 $11,581,770 PROBLEM 8-8 (Continued) 7. Gross profit Sales [(14,000 X $150) + (24,000 X $405) + (6,000 X $600)] Cost of goods sold Gross profit $15,420,000 11,581,770 $ 3,838,230 (b) 1. Ending inventory at current cost restated to base cost Portable $ 840,000 ÷ 1.20 = $ 700,000 Midsize 1,200,000 ÷ 1.20 = $1,000,000 Flat-screen 3,220,000 ÷ 1.15 = $2,800,000 Ending inventory Portable $ 600,000 X 1.00 = 100,000 X 1.20 = Midsize 1,000,000 X 1.00 = Flat-screen 1,200,000 X 1.00 = 1,600,000 X 1.15 = 2. $ 600,000 120,000 1,000,000 1,200,000 1,840,000 $4,760,000 3. Cost of good sold Cost of good available Ending inventory Cost of goods sold Gross profit Sales Cost of goods sold Gross profit $16,200,000 4,760,000 $11,440,000 4. $15,420,000 11,440,000 $ 3,980,000 8-54 PROBLEM 8-9 (a) Adis Abeba Wholesalers Inc. Computation of Internal Conversion Price Index for Inventory Pool No. 1 Double Extension Method 2006 $595,000 234,000 $829,000 2007 $520,000 320,000 $840,000 Current inventory at current-year cost Product A Product B Current inventory at base cost Product A Product B 17,000 X $35 = 9,000 X $26 = 13,000 X $40 = 10,000 X $32 = 17,000 X $30 = 9,000 X $25 = $510,000 225,000 $735,000 13,000 X $30 = 10,000 X $25 = $390,000 250,000 $640,000 Conversion price index $829,000 ÷ $735,000 = 1.13 $840,000 ÷ $640,000 = 1.31 (b) Adis Abeba Wholesalers Inc. Computation of Inventory Amounts under Dollar-Value LIFO Method for Inventory Pool No. 1 at December 31, 2006 and 2007 Current Inventory at base cost Conversion price index 1.00 1.13 (a) Inventory at LIFO cost $525,000 237,300 $762,300 December 31, 2006 Base inventory 2006 layer ($735,000 – $525,000) Total December 31, 2007 Base inventory 2006 layer (remaining) Total (a) (b) $525,000 210,000 $735,000 (a) $525,000 115,000 $640,000 (b) (a) 1.00 1.13 (a) $525,000 129,950 $654,950 Per schedule for instruction (a). After liquidation of $95,000 base cost ($735,000 – $640,000). 8-55 PROBLEM 8-10 Base-Year Cost December 31, 2005 January 1, 2005, base December 31, 2005, layer $45,000 11,000 $56,000 Index % 100 115* Dollar-Value LIFO $45,000 12,650 $57,650 December 31, 2006 January 1, 2005, base December 31, 2005, layer December 31, 2006, layer $45,000 11,000 12,400 $68,400 100 115 128** $45,000 12,650 15,872 $73,522 December 31, 2007 January 1, 2005, base December 31, 2005, layer December 31, 2006, layer December 31, 2007, layer $45,000 11,000 12,400 1,600 $70,000 100 115 128 130*** $45,000 12,650 15,872 2,080 $75,602 *$64,500 ÷ $56,000 **$87,300 ÷ $68,400 ***$90,800 ÷ $70,000 8-56 PROBLEM 8-11 (a) Schedule A A Current $ 2003 2004 2005 2006 2007 2008 $ 80,000 115,500 108,000 131,300 154,000 174,000 B Price Index 1.00 1.05 1.20 1.30 1.40 1.45 C Base-Year $ $ 80,000 110,000 90,000 101,000 110,000 120,000 D Change from Prior Year — $+30,000 (20,000) +11,000 +9,000 +10,000 Schedule B Ending Inventory-Dollar-Value LIFO: 2003 2004 $ 80,000 $ 80,000 31,500 $111,500 $ 80,000 10,500 $ 90,500 $ 80,000 10,500 14,300 $104,800 8-57 $80,000 @ $1.00 = 30,000 @ 1.05 = $80,000 @ 1.00 = 10,000 @ 1.05 = 2007 $80,000 @ $1.00 = 10,000 @ 1.05 = 11,000 @ 1.30 = 9,000 @ 1.40 = 2008 $80,000 @ 1.00 = 10,000 @ 1.05 = 11,000 @ 1.30 = 9,000 @ 1.40 = 10,000 @ 1.45 = $ 80,000 10,500 14,300 12,600 $117,400 $ 80,000 10,500 14,300 12,600 14,500 $131,900 2005 2006 $80,000 @ 1.00 = 10,000 @ 1.05 = 11,000 @ 1.30 = PROBLEM 8-11 (Continued) (b) To: From: Subject: Warren Dunn Accounting Student Dollar-Value LIFO Pool Accounting Dollar-value LIFO is an inventory method which values groups or “pools” of inventory in layers of costs. It assumes that any goods sold during a given period were taken from the most recently acquired group of goods in stock and, consequently, any goods remaining in inventory are assumed to be the oldest goods, valued at the oldest prices. Because dollar-value LIFO combines various related costs in groups or “pools,” no attempt is made to keep track of each individual inventory item. Instead, each group of annual purchases forms a new cost layer of inventory. Further, the most recent layer will be the first one carried to cost of goods sold during this period. However, inflation distorts any cost of purchases made in subsequent years. To counteract the effect of inflation, this method measures the incremental change in each year’s ending inventory in terms of the first year’s (base year’s) costs. This is done by adjusting subsequent cost layers, through the use of a price index, to the base year’s inventory costs. Only after this adjustment can the new layer be valued at current-year prices. To do this valuation, you need to know both the ending inventory at yearend prices and the price index used to adjust the current year’s new layer. The idea is to convert the current ending inventory into base-year costs. The difference between the current year’s and the previous year’s ending inventory expressed in base-year costs usually represents any inventory which has been purchased but not sold during the year, that is, the newest LIFO layer. This difference is then readjusted to express this most recent layer in current-year costs. 8-58 PROBLEM 8-11 (Continued) 1. Refer to Schedule A. To express each year’s ending inventory (Column A) in terms of base-year costs, simply divide the ending inventory by the price index (Column B). For 2003, this adjustment would be $80,000/100% or $80,000; for 2004, it would be $115,500/105%, etc. The quotient (Column C) is thus expressed in base-year costs. Next, compute the difference between the previous and the current years’ ending inventory in base-year costs. Simply subtract the current year’s base-year inventory from the previous year’s. In 2004, the change is +$30,000 (Column D). Finally, express this increment in current-year terms. For the second year, this computation is straightforward: the base-year ending inventory value is added to the difference in #2 above multiplied by the price index. For 2004, the ending inventory for dollar-value LIFO would equal $80,000 of base-year inventory plus the increment ($30,000) times the price index (1.05) or $111,500. The product is the most recent layer expressed in current-year prices. See Schedule B. 2. 3. Be careful with this last step in subsequent years. Notice that, in 2005, the change from the previous year is –$20,000, which causes the 2004 layer to be eroded during the period. Thus, the 2005 ending inventory is valued at the original base-year cost $80,000 plus the remainder valued at the 2004 price index, $10,000 times 1.05. See 2005 computation on Schedule B. When valuing ending inventory, remember to include each yearly layer adjusted by that year’s price index. Refer to Schedule B for 2006. Notice that the +$11,000 change from the 2006 ending inventory indicates that the 2004 layer was not further eroded. Thus, ending inventory for 2006 would value the first $80,000 worth of inventory at the base-year price index (1.00), the next $10,000 (the remainder of the 2004 layer) at the 2004 price index (1.05), and the last $11,000 at the 2006 price index (1.30). These instructions should help you implement dollar-value LIFO in your inventory valuation. 8-59 TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 8-1 (Time 15–20 minutes) Purpose—a short case designed to test the skills of the student in determining whether an item should be reported in inventory. In addition, the student is required to speculate as to why the company may wish to postpone recording this transaction. CA 8-2 (Time 15–25 minutes) Purpose—to provide the student with four questions about the carrying value of inventory. These questions must be answered and defended with rationale. The topics are shipping terms, freight–in, weighted-average cost vs. FIFO, and consigned goods. CA 8-3 (Time 25–35 minutes) Purpose—to provide a number of difficult financial reporting transactions involving inventories. This case is vague and much judgment is required in its analysis. Right or wrong answers should be discouraged; rather emphasis should be placed on the underlying rationale to defend a given position. Includes a product versus period cost transaction, proper classification of a possible inventory item, and a product financing arrangement. CA 8-4 (Time 15–25 minutes) Purpose—the student discusses the acceptability of alternative methods of reporting cash discounts. Also, the student identifies the effects on financial statements of using LIFO instead of FIFO when prices are rising. CA 8-5 (Time 20–25 minutes) Purpose—to provide a broad overview to students as to why inventories must be included in the balance sheet and income statement. In addition, students are asked to determine why taxable income and accounting income may be different. Finally, the conditions under which FIFO and LIFO may give different answers must be developed. CA 8-6 (Time 15–20 minutes) Purpose—to provide the student with the opportunity to discuss the rationale for the use of the LIFO method of inventory valuation. The conditions that must exist before the tax benefits of LIFO will accrue also must be developed. CA 8-7 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to discuss the cost flow assumptions of average cost, FIFO, and LIFO. Student is also required to distinguish between weighted-average and movingaverage and discuss the effect of LIFO on the B/S and I/S in a period of rising prices. CA 8-8 (Time 25–30 minutes) Purpose—to provide the student with the opportunity to discuss the differences between traditional LIFO and dollar-value LIFO. In this discussion, the specific procedures employed in traditional LIFO and dollar-value LIFO must be examined. This case provides a good basis for discussing LIFO conceptual issues. CA 8-9 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to discuss the concept of a LIFO pool and its use in various LIFO methods. The student is also asked to define LIFO liquidation, to explain the use of price indexes in dollar-value LIFO, and to discuss the advantages of using dollar-value LIFO. 8-60 Time and Purposes of Concepts for Analysis (Continued) CA 8-10 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to analyze the effect of changing from the FIFO method to the LIFO method on items such as ending inventory, net income, earnings per share, and year-end cash balance. The student is also asked to make recommendations considering the results from computation and other relevant factors. CA 8-11 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to analyze the ethical implications of purchasing decisions under LIFO. 8-61 SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 8-1 (a) Purchased merchandise in transit at the end of an accounting period to which legal title has passed should be recorded as purchases within the accounting period. If goods are shipped f.o.b. shipping point, title passes to the buyer when the seller delivers the goods to the common carrier. Generally when the terms are f.o.b. shipping point, transportation costs must be paid by the buyer. This liability arises when the common carrier completes the delivery. Thus, the client has a liability for the merchandise and the freight. (b) Inventory .................................................................................................. Accounts Payable—Supplier........................................................... Inventory .................................................................................................. Accounts Payable—Transportation Co......................................... (c) 35,300 35,300 1,500 1,500 Possible reasons to postpone the recording of the transaction might include: 1. Desire to maintain a current ratio at a given level which would be affected by the additional inventory and accounts payable. 2. Desire to minimize the impact of the additional inventory on other ratios such as inventory turnover. 3. Possible tax ramifications. CA 8-2 (a) If the terms of the purchase are f.o.b. shipping point (manufacturer’s plant), Sherman Enterprises should include in its inventory goods purchased from its suppliers when the goods are shipped. For accounting purposes, title is presumed to pass at that time. (b) Freight-in expenditures should be considered an inventoriable cost because they are part of the price paid or the consideration given to acquire the asset. (c) Theoretically the net approach is the more appropriate because the net amount (1) provides a correct reporting of the cost of the asset and related liability and (2) presents the opportunity to measure the inefficiency of financial management if the discount is not taken. Many believe, however, that the difficulty involved in using the somewhat more complicated net method is not justified by the resulting benefits. (d) Products on consignment represent inventories owned by Sherman Enterprises, which are physically transferred to another enterprise. However, Sherman Enterprises retains title to the goods until their sale by the other company (Lovey Smith Inc.). The goods consigned are still included by Sherman Enterprises in the inventory section of its balance sheet. Often the inventory is reclassified from regular inventory to consigned inventory (Note to instructor: There is no reason why the student will know this last point given that only Chapter 8 has been covered.). The other company reports neither inventory nor a liability in its balance sheet. 8-62 CA 8-3 (a) Statement 3 of Chapter 4, ARB No. 43 states in part: “As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.” The discussion includes the following: “Selling expenses constitute no part of the inventory costs.” To the extent that warehousing is a necessary function of importing merchandise before it can be sold, certain elements of warehousing costs might be considered an appropriate cost of inventory in the warehouse. For example, if goods must be brought into the warehouse before they can be made ready for sale, the cost of bringing such goods into the warehouse would be considered a cost of inventory. Similarly, if goods must be handled in the warehouse for assembly or for removal of foreign packaging, etc., it would be appropriate to include such costs in inventory. However, costs involved in storing the goods for any additional period would appear to be period costs. Costs of delivering the goods from the warehouse would appear to be selling expenses related to the goods sold, and should not under any circumstances be allocated to goods that are still in the warehouse. In theory, warehousing costs are considered a product cost because these costs are incurred to maintain the product in a salable condition. However, in practice, warehousing costs are most frequently treated as a period cost. Under the Tax Reform Act of 1986, warehousing and off-site storage of inventory, including finished goods, are specifically included in the “production and resale activities” that are to be capitalized for tax purposes. (b) It is correct to conclude that obsolete items are excludable from inventory. Cost attributable to such items is “nonuseful” and “nonrecoverable” cost (except for possible scrap value) and should be written off. If the cost of obsolete items was simply excluded from ending inventory, the resultant cost of goods sold would be overstated by the amount of these costs. The cost of obsolete items, if immaterial, should be commingled with cost of goods sold. If material, these costs should be separately disclosed. The primary use of the airplanes should determine their treatment on the balance sheet. Since the airplanes are held primarily for sale, and chartering is only a temporary use, the airplanes should be classified as current assets. Depreciation would not be appropriate if the planes are considered inventory. Accounting Research Bulletin No. 43, Chapter 4, Inventory Pricing Statement No. 1, states in part that the term Inventory “excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified.” The transaction is a product financing arrangement and should be reported by the company as inventory with a related liability. The substance of the transaction is that inventory has been purchased and the fact that a trust is established to purchase the goods has no economic significance. Given that the company agrees to buy the coal over a certain period of time at specific prices, it appears clear that the company has the liability and not the trust. (c) (d) CA 8-4 (a) Cash discounts should not be accounted for as financial income when payments are made. Income should be recognized when the earnings process is complete (when the company sells the inventory). Furthermore, cash discounts should not be recorded when the payments are made because in order to properly match a cash discount with the related purchase, the cash discount should be recorded when the related purchase is recorded. 8-63 CA 8-4 (Continued) (b) Cash discounts should not be accounted for as a reduction of cost of goods sold for the period when payments are made. Cost of goods sold should be reduced when the earnings process is complete (when the company sells the inventory which has been reduced by the cash discounts). Furthermore, cash discounts should not be recorded when the payments are made because in order to properly match a cash discount with the related purchase, the cash discount should be recorded when the related purchase is recorded. (c) Cash discounts should be accounted for as a direct reduction of purchase cost because they reduce the cost of acquiring the inventories. Purchases should be recorded net of cash discounts to reflect the net cash to be paid. The primary basis of accounting for inventories is cost, which represents the price paid or consideration given to acquire an asset. CA 8-5 (a) 1. Inventories are unexpired costs and represent future benefits to the owner. A balance sheet includes a listing of unexpired costs and future benefits of the owner’s assets at a specific point in time. Because inventories are assets owned at the specific point in time for which a balance sheet is prepared, they must be included in order that the owner’s financial position will be presented fairly. 2. Beginning and ending inventories are included in the computation of net income only for the purpose of arriving at the cost of goods sold during the period of time covered by the statement. Goods included in the beginning inventory which are no longer on hand are expired costs to be matched against revenues earned during the period. Goods included in the ending inventory are unexpired costs to be carried forward to a future period, rather than expensed. (b) Financial accounting has as its goal the proper reporting of financial transactions and events in accordance with generally accepted accounting principles. Income tax accounting has as its goal the reporting of taxable transactions and events in conformity with income tax laws and regulations. While the primary purpose of an income tax is the production of tax revenues to finance the operations of government, income tax laws and regulations are often produced by various forces. The income tax may be used as a tool of fiscal policy to stimulate all of the segments of the economy or to decelerate the economy. Some income tax laws may be passed because of political pressures brought to bear by individuals or industries. When the purposes of financial accounting and income tax accounting differ, it is often desirable to report transactions or events differently and to report the deferred tax consequences of any existing temporary differences as assets or liabilities. (c) FIFO and LIFO are inventory costing methods employed to measure the flow of costs. FIFO matches the first cost incurred with the first revenue produced while LIFO matches the last cost incurred with the first revenue produced after the cost is incurred. (This, of course, assumes a perpetual inventory system is in use and may not be precisely true if a periodic inventory system is employed.) If prices are changing, different costs would be matched with revenue for the same quantity sold depending upon whether the LIFO or FIFO system is in use. (In a period of rising or falling prices FIFO tends to value inventories at approximate market value in the balance sheet and LIFO tends to match approximately the current replacement cost of an item with the revenue produced.) CA 8-6 (a) Inventory profits occur when the inventory costs matched against sales are less than the replacement cost of the inventory. The cost of goods sold therefore is understated and net income is considered overstated. By using LIFO (rather than some method such as FIFO), more recent costs are matched against revenues and inventory profits are thereby reduced. 8-64 CA 8-6 (Continued) (b) As long as the price level increases and inventory quantities do not decrease, a deferral of income taxes occurs under LIFO because the items most recently purchased at the higher price level are matched against revenues. It should be noted that where unit costs tend to decrease as production increases, the tax benefits that LIFO might provide are nullified. Also, where the inventory turnover is high, the difference between inventory methods is negligible. CA 8-7 (a) The average-cost method assumes that inventories are sold or issued evenly from the stock on hand; the FIFO method assumes that goods are sold or used in the order in which they are purchased (i.e., the first goods purchased are the first sold or used); and the LIFO method matches the cost of the last goods purchased against revenue. (b) The weighted-average cost method combines the cost of all the purchases in the period with the cost of beginning inventory and divides the total costs by the total number of units to determine the average cost per unit. The moving-average cost method, on the other hand, calculates a new average unit cost when a purchase is made. The moving-average cost method is used with perpetual inventory records. (c) When the purchase prices of inventoriable items are rising for a significant period of time, the use of the LIFO method (instead of FIFO) will result in a lower net income figure. The reason is that the LIFO method matches most recent purchases against revenue. Since the prices of goods are rising, the LIFO method will result in higher cost of goods sold, thus lower net income. On the balance sheet, the ending inventory tends to be understated (i.e., lower than the most recent replacement cost) because the oldest goods have lower costs during a period of rising prices. In addition, retained earnings under the LIFO method will be lower than that of the FIFO method when inflation exists. CA 8-8 (a) 1. The LIFO method (periodic) allocates costs on the assumption that the last goods purchased are used first. If the amount of the inventory is computed at the end of the month under a periodic system, then it would be assumed that the total quantity sold or issued during the month would have come from the most recent purchases, and ordinarily no attempt would be made to compare the dates of purchases and sales. 2. The dollar-value method of LIFO inventory valuation is a procedure using dollars instead of units to measure increments or reductions in inventory. The method presumes that goods in the inventory can be classified into pools or homogenous groups. After the grouping into pools the ending inventory is priced at the end-of-year prices and a price index number is applied to convert the total pool to the base-year price level. Such a price index might be obtained from government sources, if available, or computed from the company’s records. The pools or groupings of inventory are required where a single index number is inappropriate for all elements of the inventory. After the closing inventory and the opening inventory have been placed on the same base-year price level, any difference between the two inventories is attributable to an increase or decrease in inventory quantity at the base-year price. An increase in quantity so determined is converted to the current-year price level and added to the amount of the opening inventory as a separate inventory layer. A decrease in quantity is deducted from the appropriate layer of opening inventory at the price level in existence when the layer was added. 8-65 CA 8-8 (Continued) (b) The advantages of the dollar-value method over the traditional LIFO method are as follows: 1. The application of the LIFO method is simplified because, under the pooling procedure, it is not necessary to assign costs to opening and closing quantities of individual items. As a result, companies with inventories comprised of thousands of items may adopt the dollar-value method and minimize their bookkeeping costs. 2. Base inventories are more easily maintained. The dollar-value method permits greater flexibility because each pool is made up of dollars rather than quantities. Thus, the problem of a LIFO liquidation is less possible. The disadvantages of the dollar-value method as compared to the traditional LIFO method are as follows: 1. Due to technological innovations and improvements over time, material changes in the composition of inventory may occur. Items found in the ending inventory may not have existed during the base year. Thus, conversion of the ending inventory to base-year prices may be difficult to calculate or to justify conceptually. This may necessitate a periodic change in the choice of base year used. 2. Application of a year-end index, although widely used, implies use of the FIFO method. Other indexes used include beginning-of-year index and average indexes. 3. Determination of the degree of similarity between items for the purpose of grouping them into pools may be difficult and may be based upon arbitrary management decisions. (c) The basic advantages of LIFO are: 1. Matching—In LIFO, the more recent costs are matched against current revenues to provide a better measure of current earnings. 2. Tax benefits—As long as the price level increases and inventory quantities do not decrease, a deferral of income taxes occurs. 3. Improved cash flow—By receiving tax benefits from use of LIFO, the company may reduce its borrowings and related interest costs. 4. Future earnings hedge—With LIFO, a company’s future reported earnings will not be affected substantially by future price declines. LIFO eliminates or substantially minimizes write-downs to market as a result of price decreases because the inventory value ordinarily will be much lower than net realizable value, unlike FIFO. The major disadvantages of LIFO are: 1. Reduced earnings—Because current costs are matched against current revenues, net income is lower than it is under other inventory methods when price levels are increasing. 2. Inventory understated—The inventory valuation on the balance sheet is ordinarily outdated because the oldest costs remain in inventory. 3 . Physical flow—LIFO does not approximate physical flow of the items except in peculiar situations. 4. Real income not measured—LIFO falls short of measuring real income because it is often not an adequate substitute for replacement cost. 5. Involuntary liquidation—If the base or layers of old costs are partially liquidated, irrelevant costs can be matched against current revenues. 6. Poor buying habits—LIFO may cause poor buying habits because a company may simply purchase more goods and match the cost of these goods against revenue to insure that old costs are not charged to expense. 8-66 CA 8-9 (a) A LIFO pool is a group of similar items which are combined and accounted for together under the LIFO inventory method. (b) It is possible to use a LIFO pool concept without using dollar-value LIFO. For example, the specific goods pooled approach utilizes the concept of a LIFO pool with quantities as its measurement basis. (c) A LIFO liquidation occurs when a significant drop in inventory level leads to the erosion of an earlier or base inventory layer. In a period of inflation (as usually is the case) LIFO liquidation will distort net income (make it higher) and incur substantial tax payments. (d) Price indexes are used in the dollar-value LIFO method to: (1) convert the ending inventory at current year-end cost to base-year cost, and (2) determine the current-year cost for each inventory layer other than the base-year layer. (e) The dollar-value LIFO method measures the increases and decreases in a pool in terms of total dollar value, not by the physical quantity of the goods in the inventory pool. As a result, the dollarvalue LIFO approach has the following advantages over specific goods LIFO pool. First, the pooled approach reduces record keeping and clerical costs. Second, replacement is permitted if it is a similar material, or similar in use, or interchangeable. Thus, it is more difficult to erode LIFO layers when using dollar-value LIFO techniques. CA 8-10 (a) FIFO (Amounts in thousands, except earnings per share) 2007 Sales $11,000 Cost of goods sold Beginning inventory 7,000 Purchases 7,000 Cost of goods available for sale 14,000 (1) Ending inventory* 6,300 Cost of goods sold 7,700 Gross profit 3,300 Operating expense (15% of sales) (1,650) Depreciation expense (300) Income before taxes 1,350 Income tax expense (40%) 540 (2) Net income $ 810 8-67 2008 $10,000 6,300 8,800 15,100 8,000 7,100 2,900 (1,500) (300) 1,100 440 $ 660 2009 $15,600 8,000 10,800 18,800 8,100 10,700 4,900 (2,340) (300) 2,260 904 $ 1,356 CA 8-10 (Continued) (3) Earnings per share (4) Cash balance Beginning balance Sales proceeds Purchases Operating expenses Property, plant, and equipment Income taxes Ending balance $ 0.81 $ 0.66 $ 1.36 $ 400 11,000 (7,000) (1,650) (350) (540) $ 1,860 $ 1,860 10,000 (8,800) (1,500) (350) (440) $ 770 $ 770 15,600 (10,800) (2,340) (350) (904) $ 1,976 *2007 = $7 X (1,000 + 1,000 – 1,100) = $6,300. 2008 = $8 X ( 900 + 1,100 – 1,000) = $8,000. 2009 = $9 X (1,000 + 1,200 – 1,300) = $8,100. LIFO (Amounts in thousands, except earnings per share) 2007 Sales Cost of goods sold Beginning inventory Purchases Cost of goods available for sale (1) Ending inventory** Cost of goods sold Gross profit Operating expense Depreciation expense Income before taxes Income tax expense (2) Net income 8-68 2008 $10,000 6,300 8,800 15,100 7,100 8,000 2,000 (1,500) (300) 200 80 $ 120 2009 $15,600 7,100 10,800 17,900 6,300 11,600 4,000 (2,340) (300) 1,360 544 $ 816 $11,000 7,000 7,000 14,000 6,300 7,700 3,300 (1,650) (300) 1,350 540 $ 810 CA 8-10 (Continued) (3) Earnings per share (4) Cash balance Beginning balance Sales proceeds Purchases Operating expenses Property, plant, and equipment Income taxes Ending balance $ 0.81 $ 0.12 $ 0.82 $ 400 11,000 (7,000) (1,650) (350) (540) $ 1,860 $ 1,860 10,000 (8,800) (1,500) (350) (80) $ 1,130 $ 1,130 15,600 (10,800) (2,340) (350) (544) $ 2,696 **2007 = $7 X (1,000 + 1,000 – 1,100) = $6,300. 2008 = ($7 X 900) + ($8 X 100) = $7,100. 2009 = $7 X 900 = $6,300. (b) According to the computation in (a), Günter Grass Company can achieve the goal of income tax savings by switching to the LIFO method. As shown in the schedules, under the LIFO method, Grass will have lower net income and thus lower income taxes for 2008 and 2009 (tax savings of $360,000 in each year). As a result, Grass will have a better cash position at the end of 2008 and especially 2009 (year-end cash balance will be higher by $360,000 for 2008 and $720,000 for 2009). However, since Grass Company is in a period of rising purchase prices, the LIFO method will result in significantly lower net income and earnings per share for 2008 and 2009. The management may need to evaluate the potential impact that lower net income and earnings per share might have on the company before deciding on the change to the LIFO method. 8-69 CA 8-11 (a) Major stakeholders are investors, creditors, Gamble Company’s management (including the president and plant accountant), and other employees of Gamble Company. The inventory purchase in this instance reduces net income substantially and lowers Gamble Company’s tax liability. Current stockholders and company management benefit during the current year by this decision. However, the purchasing department may be concerned about inventory management and complications such as storage costs and possible inventory obsolescence. Assuming awareness of these benefits and possible complications, the plant accountant may follow the president’s recommendation without violating GAAP. The plant accountant also must consider whether this action is in the long-term best interests of the company and whether inventory amounts would provide a meaningful picture of Gamble Company’s financial condition. (b) No, the president would not recommend a year-end inventory purchase because under FIFO there would be no effect on net income. 8-70 FINANCIAL STATEMENT ANALYSIS CASE 1 (a) Sales Cost of goods sold* Gross profit Selling and administrative expense Income from operations Other expense Income before income tax *Cost of goods sold (per annual report) LIFO effect ($5,263,000 – $3,993,000) Cost of goods sold (per LIFO) $618,876,000 474,206,000 144,670,000 102,112,000 42,558,000 (24,712,000) $ 17,846,000 $475,476,000 (1,270,000) $474,206,000 (b) $17,846,000 income before taxes X 46.6% tax = $8,316,236 tax; $17,846,000 – $8,316,236 tax = $9,529,764 net income as compared to $8,848,000 net income under LIFO. This is $681,764 or about 8% different. The question as to materiality is to allow the students an opportunity to judge the significance of the difference between the two costing methods. Since it is less than 10% different, some students may feel that it is not material. An 8% change in net income, however, is probably material, but this would depend on the industry and perhaps on the company’s own past averages. No, the use of different costing methods does not necessarily mean that there is a difference in the physical flow of goods. As explained in the text, the actual physical flow need have no relationship to the cost flow assumption. The management of T J International has determined that LIFO is appropriate only for a subset of its products, and these reasons have to do with economic characteristics, rather than the physical flow of the goods. (c) 8-71 FINANCIAL STATEMENT ANALYSIS CASE 2 (a) The most likely physical flow of goods for a pharmaceutical manufacturer would be FIFO; that is, the first goods manufactured would be the first goods sold. This is because pharmaceutical goods have an expiration date. The manufacturer would be careful to ship the goods made earliest first and thereby reduce the risk that outdated goods will remain in the warehouse. Noven should consider first whether the inventory costing method will make a difference. If the prices in the economy, especially if the raw materials prices, are stable, then the inventory cost will be nearly the same under any of the measurement methods. If inventory levels are very small, then the method used will make little difference. Noven should also consider the cost of keeping records. A small company might not want to invest in complicated record keeping. The tax effects of any differences should be considered, as well as any international rules that might dictate Noven’s measurement of part of its inventory. This amount is likely not shown in a separate inventory account because it is immaterial; that is, it is not large enough to make a difference with investors. Another possible reason is that no goods have yet been offered for sale. This amount might be in the Inventory of supplies account, but it is more likely to be included with Prepaid and other current assets, since it clearly is not just an article of supplies. This will definitely be shown separately as soon as Noven begins to sell its products to outside customers. (b) (c) 8-72 FINANCIAL STATEMENT ANALYSIS CASE 3 Revenues Cost of sales Ending inventories at FIFO Ending inventories at LIFO Difference FIFO adjusted cost of sales (a) Jan. 31 2002 $36,605 26,179 $3,793 3,196 (597) $25,582 Jan. 30 2003 $35,626 25,248 $3,256 2,973 (283) $24,965 2003 8.19 7.08 Jan. 29 2004 $35,436 25,306 $3,611 3,035 (576) $24,730 2004 8.42 7.20 (i) Inventory turnover @LIFO (ii) Inventory turnover @FIFO Recall that the formula for computing inventory turnover is Cost of Sales/Average Inventory (b) (i) Inventory turnover using sales and LIFO 2003 11.55 2004 11.80 Recall that the formula for computing inventory turnover in part (b) is Sales/Average Inventory (ii) Inventory turnover using sales and FIFO (c) 10.11 10.32 It appears that Albertson’s calculates its Inventory Turnover using LIFO inventory with the standard formula of Cost of Sales/Average Inventory. Using sales instead of cost of goods sold accounts for the mark-up in the inventory. By using cost of goods sold, there is a better matching of the costs associated to inventory, and should result in more useful information. (d) 8-73 RESEARCH CASES CASE 1 Answer depends on firm selected. CASE 2 (a) Per the “Fortune 500” issue of April 18, 2005, the rankings are: (1) by revenue (Wal-Mart, Exxon-Mobil, General Motors), (2) by profit (ExxonMobil, Citigroup, General Electric), (3) by assets (Citigroup, JP Morgan Chase, Bank of America), (4) by market value (Exxon-Mobil, General Electric, Microsoft), and (5) by employees (Wal-Mart, McDonalds, United Parcel Service). Depends on location. (b) 8-74 FINANCIAL ACCOUNTING RESEARCH (FARs) Search Strings: “right of return,” “revenue recognition” (a) FAS 48, Par 3. This Statement specifies criteria for recognizing revenue on a sale in which a product may be returned, whether as a matter of contract or as a matter of existing practice, either by the ultimate customer or by a party who resells the product to others. The product may be returned for a refund of the purchase price, for a credit applied to amounts owed or to be owed for other purchases, or in exchange for other products. The purchase price or credit may include amounts related to incidental services, such as installation. FAS 48, Par 13. It is the practice in some industries for customers to be given the right to return a product to the seller under certain circumstances. In the case of sales to the ultimate customer, the most usual circumstance is customer dissatisfaction with the product. For sales to customers engaged in the business of reselling the product, the most usual circumstance is that the customer has not been able to resell the product to another party. (Arrangements in which customers buy products for resale with the right to return products often are referred to as guaranteed sales.) Yes, different industries should be allowed to make different types of policies. FAS 48, Par 14. Sometimes, the returns occur very soon after a sale is made, as in the newspaper and perishable food industries. In other cases, returns occur over a longer period, such as with book publishing and equipment manufacturing. The rate of returns varies considerably from a low rate usually found in the food industry to a high rate often found in the publishing industry. FAS 48, Par 8. The ability to make a reasonable estimate of the amount of future returns depends on many factors and circumstances that will vary from one case to the next. However, the following factors may impair the ability to make a reasonable estimate: a. The susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand. b. Relatively long periods in which a particular product may be returned c. Absence of historical experience with similar types of sales of similar products, or inability to apply such experience because of changing circumstances, for example, changes in the selling enterprise’s marketing policies or relationships with its customers d. Absence of a large volume of relatively homogeneous transactions The existence of one or more of the above factors, in light of the significance of other factors, may not be sufficient to prevent making a reasonable estimate; likewise, other factors may preclude a reasonable estimate. (b) (c) (d) 8-75 PROFESSIONAL SIMULATION A 1 2 3 4 5 6 7 8 9 10 11 B C D E F This cell contains the following function: =SUM(B5:E5) G H I J Beginning Inventory Ending Inventory Average Inventory Cost of Goods Sold Inventory Turnover Unadjusted Adjustment (a) Adjustment (b) Adjustment (c) $125.50 116.70 $2.00 $5.00 $46.00 121.10 1,776.40 (2.00) (5.00) (46.00) 14.67 Ending inventory Norwell should count under FIFO would be the goods it has Goods officially $770 (220@$3.50) -consigned in other change hands at the $46 ($770 – $724) stores. point of destination. higher than LIFO. Adjusted $125.50 169.70 147.60 1,723.40 11.68 This cell contains the following formula: =+(F4+F5)/2 This cell contains the following function: =SUM(B7:E7) This cell contains the following formula: =+F9/F8 Explanation 12 13 Explanation To: From: Re: Norwel Management Student Advantages of LIFO The major advantages of the LIFO inventory method include better matching of costs with revenues, deferral of income taxes, improved cash flow, and minimization of the impact of future price declines on future earnings. Better matching arises in the use of LIFO because the most recent costs are matched with current revenues. In times of rising prices, this matching will result in lower taxable income, which in turn will reduce current taxes. The deferral of taxes under LIFO contributes to a higher cash flow. As illustrated in the analysis above the switch to FIFO resulted in a higher ending inventory, which leads to a lower cost of goods sold and higher income; thus, Norwel’s reported income will be higher but so will its taxes. Note that under LIFO, future taxes may be higher when lower cost items of inventory are sold in future periods and matched with higher sales prices. 8-76 CHAPTER 9 Inventories: Additional Valuation Issues ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. Lower of cost or market. 2. Inventory accounting changes; relative sales value method; net realizable value. 3. Purchase commitments. 4. Gross profit method. Questions 1, 2, 3, 4, 5, 6 7, 8 Brief Exercises 1, 2, 3 4 Exercises 1, 2, 3, 4, 5, 6 7, 8 Problems 1, 2, 3, 9, 10 7, 11 Concepts for Analysis 1, 2, 3 4 9 10, 11, 12, 13 14, 15, 16 17, 18 19 5, 6 7 9, 10 11, 12, 13, 14, 15, 16, 17 18, 19, 20, 22, 23, 26 21 22, 23 24, 25, 26, 27 28 9 4, 5 5. Retail inventory method. 6. Presentation and analysis. *7. LIFO retail. *8. Dollar-value LIFO retail. *9. Special LIFO problems. 8 9 10 11 6, 7, 8, 10, 11 9 12, 13, 14 11, 13 13, 14 4, 5, 6 7 *This material is discussed in an Appendix to the chapter. 9-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives 1. 2. 3. 4. 5. Describe and apply the lower-of-cost-or market rule. Explain when companies value inventories at net realizable value. Explain when companies use the relative sales value method to value inventories. Discuss accounting issues related to purchase commitments. Determine ending inventory by applying the gross profit method. Determine ending inventory by applying the retail inventory method. Explain how to report and analyze inventory. Determine ending inventory by applying the LIFO retail methods. Brief Exercises 1, 2, 3 1, 2, 3 4 5, 6 7 Exercises 1, 2, 3, 4, 5, 6 1, 2, 3, 4, 5, 6 7, 8 9, 10 11, 12, 13, 14, 15, 16, 17 18, 19, 20 21 22, 23, 24, 25, 26, 27, 28 9 4, 5 Problems 1, 2, 3, 9, 10 1, 2, 3, 9, 10 6. 7. *8. 8 9 10, 11 6, 7, 8 9 11, 12, 13, 14 *This material is discussed in an Appendix to the chapter. 9-2 ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty Simple Simple Simple Simple Moderate Simple Simple Simple Simple Simple Simple Simple Simple Moderate Simple Simple Moderate Moderate Simple Simple Simple Moderate Moderate Simple Simple Moderate Moderate Simple Simple Moderate Moderate Moderate Complex Moderate Moderate Time (minutes) 15–20 10–15 15–20 10–15 20–25 10–15 15–20 12–17 05–10 15–20 8–13 10–15 15–20 15–20 10–15 15–20 20–25 20–25 12–17 20–25 10–15 25–35 15–20 10–15 5–10 20–25 20–25 10–15 10–15 25–30 30–35 20–30 40–45 20–30 20–30 Item E9-1 E9-2 E9-3 E9-4 E9-5 E9-6 E9-7 E9-8 E9-9 E9-10 E9-11 E9-12 E9-13 E9-14 E9-15 E9-16 E9-17 E9-18 E9-19 E9-20 E9-21 *E9-22 *E9-23 *E9-24 *E9-25 *E9-26 *E9-27 *E9-28 P9-1 P9-2 P9-3 P9-4 P9-5 P9-6 P9-7 Description Lower-of-cost-or-market. Lower-of-cost-or-market. Lower-of-cost-or-market. Lower-of-cost-or-market—journal entries. Lower-of-cost-or-market—valuation account. Lower-of-cost-or-market—error effect. Relative sales value method. Relative sales value method. Purchase commitments. Purchase commitments. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Retail inventory method. Retail inventory method. Retail inventory method. Analysis of inventories. Retail inventory method—conventional and LIFO. Retail inventory method—conventional and LIFO. Dollar-value LIFO retail. Dollar-value LIFO retail. Conventional retail and dollar-value LIFO retail. Dollar-value LIFO retail. Change to LIFO retail. Lower-of-cost-or-market. Lower-of-cost-or-market. Entries for lower-of-cost-or-market—direct and allowance. Gross profit method. Gross profit method. Retail inventory method. Retail inventory method. 9-3 ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item P9-8 P9-9 P9-10 *P9-11 *P9-12 *P9-13 *P9-14 CA9-1 CA9-2 CA9-3 CA9-4 CA9-5 CA9-6 *CA9-7 Description Retail inventory method. Statement and note disclosure, LCM, and purchase commitment. Lower of cost or market. Conventional and dollar-value LIFO retail. Retail, LIFO retail, and inventory shortage. Change to LIFO retail. Change to LIFO retail; dollar-value LIFO retail. Lower-of-cost-or-market. Lower-of-cost-or-market. Lower-of-cost-or-market. Retail inventory method. Cost determination, LCM, retail method. Purchase commitment. Retail inventory method and LIFO retail. Level of Difficulty Moderate Moderate Moderate Moderate Moderate Moderate Complex Moderate Moderate Moderate Moderate Moderate Moderate Simple Time (minutes) 20–30 30–40 30–40 30–35 30–40 30–40 40–50 15–25 20–30 15–20 25–30 15–25 20–25 10–15 9-4 ANSWERS TO QUESTIONS 1. Where there is evidence that the utility of goods to be disposed of in the ordinary course of business will be less than cost, the difference should be recognized as a loss in the current period, and the inventory should be stated at market value in the financial statements. The upper (ceiling) and lower (floor) limits for the value of the inventory are intended to prevent the inventory from being reported at an amount in excess of the net realizable value or at an amount less than the net realizable value less a normal profit margin. The maximum limitation, not to exceed the net realizable value (ceiling) covers obsolete, damaged, or shopworn material and prevents overstatement of inventories and understatement of the loss in the current period. The minimum limitation deters understatement of inventory and overstatement of the loss in the current period. The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required, however, when the utility of the goods included in the inventory is less than their cost. This loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower of cost or market rule arose from the accounting convention of providing for all losses and anticipating no profits.) In accordance with the foregoing reasoning, the rule of “cost or market, whichever is lower” may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly reflects operations. The rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product, alternative procedures are suitable. The arguments against the use of the lower of cost or market method of valuing inventories include the following: (1) The method requires the reporting of estimated losses (all or a portion of the excess of actual cost over replacement cost) as definite income charges even though the losses have not been sustained to date and may never be sustained. Under a consistent criterion of realization a drop in replacement cost below original cost is no more a sustained loss than a rise above cost is a realized gain. (2) A price shrinkage is brought into the income statement before the loss has been sustained through sale. Furthermore, if the charge for the inventory write-downs is not made to a special loss account, the cost figure for goods actually sold is inflated by the amount of the estimated shrinkage in price of the unsold goods. The title “Cost of Goods Sold” therefore becomes a misnomer. (3) The method is inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of the price increases. (4) The method is also inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost in one year and at market in the next year. (5) The lower of cost or market method values the inventory in the balance sheet conservatively. Its effect on the income statement, however, may be the opposite. Although the income statement for the year in which the unsustained loss is taken is stated conservatively, the net income on the income statement of the subsequent period may be distorted if the expected reductions in sales prices do not materialize. 9-5 2. 3. Questions Chapter 9 (Continued) (6) In the application of the lower of cost or market rule a prospective “normal profit” is used in determining inventory values in certain cases. Since “normal profit” is an estimated figure based upon past experiences (and might not be attained in the future), it is not objective in nature and presents an opportunity for manipulation of the results of operations. 4. The lower of cost or market rule may be applied directly to each item or to the total of the inventory (or in some cases, to the total of the components of each major category). The method should be the one that most clearly reflects income. The most common practice is to price the inventory on an item-by-item basis. Companies favor the individual item approach because tax requirements require that an individual item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation for balance sheet purposes. 1. 2. 3. 4. 5. $14.30. $16.10. $13.75. $9.70. $15.90. 5. 6. One approach is to record the inventory at cost and then reduce it to market, thereby reflecting a loss in the current period (often referred to as the indirect method). The loss would then be shown as a separate item in the income statement and the cost of goods sold for the year would not be distorted by its inclusion. An objection to this method of valuation is that an inconsistency is created between the income statement and balance sheet. In attempting to meet this inconsistency some have advocated the use of a special account to receive the credit for such an inventory write-down, such as Allowance to Reduce Inventory to Market which is a contra account against inventory on the balance sheet. It should be noted that the disposition of this account presents problems to accountants. Another approach is merely to substitute market for cost when pricing the new inventory (often referred to as the direct method). Such a procedure increases cost of goods sold by the amount of the loss and fails to reflect this loss separately. For this reason, many theoretical objections can be raised against this procedure. 7. An exception to the normal recognition rule occurs where (1) there is a controlled market with a quoted price applicable to specific commodities and (2) no significant costs of disposal are involved. Certain agricultural products and precious metals which are immediately marketable at quoted prices are often valued at net realizable value (market price). Relative sales value is an appropriate basis for pricing inventory when a group of varying units is purchased at a single lump sum price (basket purchase). The purchase price must be allocated in some manner or on some basis among the various units. When the units vary in size, character, and attractiveness, the basis for allocation must reflect both quantitative and qualitative aspects. A suitable basis then is the relative sales value of the units that comprise the inventory. The drop in the market price of the commitment should be charged to operations in the current year if it is material in amount. The following entry would be made [($6.40 – $5.90) X 150,000] = $75,000: Unrealized Holding Gain or Loss—Income (Purchase Commitments) ........... Estimated Liability on Purchase Commitments ...................................... 75,000 75,000 8. 9. The entry is made because a loss in utility has occurred during the period in which the market decline took place. The account credited in the above entry should be included among the current liabilities on the balance sheet with an appropriate note indicating the nature and extent of the commitment. This liability indicates the minimum obligation on the commitment contract at the present time—the amount that would have to be forfeited in case of breach of contract. 9-6 Questions Chapter 9 (Continued) 10. The major uses of the gross profit method are: (1) it provides an approximation of the ending inventory which the auditor might use for testing validity of physical inventory count; (2) it means that a physical count need not be taken every month or quarter; and (3) it helps in determining damages caused by casualty when inventory cannot be counted. 11. Gross profit as a percentage of sales indicates that the margin is based on selling price rather than cost; for this reason the gross profit as a percentage of selling price will always be lower than if based on cost. Conversions are as follows: 20% on cost = 33 1/3% on cost = 33 1/3% on selling price = 60% on selling price = 16 2/3% on selling price 25% on selling price 50% on cost 150% on cost 12. A markup of 25% on cost equals a 20% markup on selling price; therefore, gross profit equals $1,200,000 ($6 million X 20%) and net income equals $300,000 [$1,200,000 – (15% X $6 million)]. The following formula was used to compute the 20% markup on selling price: Gross profit on selling price = Percentage markup on cost .25 = = 20% 100% + Percentage markup on cost 1 + .25 $ 400,000 $1,140,000 60,000 1,750,000 700,000 1,050,000 $ 550,000 1,200,000 1,600,000 13. Inventory, January 1, 2008 Purchases to February 10, 2008 Freight-in to February 10, 2008 Merchandise available Sales to February 10, 2008 Less gross profit at 40% Sales at cost Inventory (approximately) at February 10, 2008 14. The validity of the retail inventory method is dependent upon (1) the composition of the inventory remaining approximately the same at the end of the period as it was during the period, and (2) there being approximately the same rate of markup at the end of the year as was used throughout the period. The retail method, though ordinarily applied on a departmental basis, may be appropriate for the business as a unit if the above conditions are met. 15. The conventional retail method is a statistical procedure based on averages whereby inventory figures at retail are reduced to an inventory valuation figure by multiplying the retail figures by a percentage which is the complement of the markup percent. To determine the markup percent, original markups and additional net markups are related to the original cost. The complement of the markup percent so determined is then applied to the inventory at retail after the latter has been reduced by net markdowns, thus in effect achieving a lower of cost or market valuation. An example of reduction to market follows: Assume purchase of 100 items at $1 each, marked to sell at $1.50 each, at which price 80 were sold. The remaining 20 are marked down to $1.15 each. The inventory at $15.33 is $4.67 below original cost and is valued at an amount which will produce the “normal” 33 1/3% gross profit if sold at the present retail price of $23.00. 9-7 Questions Chapter 9 (Continued) Computation of Inventory Cost Purchases Sales Markdowns (20 X $.35) Inventory at retail Inventory at lower of cost or market $23 X 66 2/3% = $15.33 16. (a) Ending inventory: Cost Beginning inventory Purchases Freight-in Totals Add net markups Deduct net markdowns Deduct sales Ending inventory, at retail $1,619,000 $2,535,500 $ 149,000 1,400,000 70,000 1,619,000 _________ $1,619,000 Retail $ 283,500 2,160,000 0 2,443,500 92,000 2,535,500 48,000 2,487,500 2,235,000 $ 252,500 $100 Retail $150 (120) (7) $ 23 Ratio 66 2/3% Ratio of cost to selling price = 64%. Ending inventory estimated at cost = 64% X $252,500 = $161,600. (b) The retail method, above, showed an ending inventory at retail of $252,500; therefore, merchandise not accounted for amounts to $12,500 ($252,500 – $240,000) at retail and $8,000 ($12,500 X .64) at cost. 17. Information relative to the composition of the inventory (i.e., raw material, work-in-process, and finished goods); the inventory financing where significant or unusual (transactions with related parties, product financing arrangements, firm purchase commitments, involuntary liquidations of LIFO inventories, pledging inventories as collateral); and the inventory costing methods employed (lower of cost or market, FIFO, LIFO, average cost) should be disclosed. Because Deere Company uses LIFO, it should also report the LIFO RESERVE. 18. Inventory turnover measures how quickly inventory is sold. Generally, the higher the inventory turnover, the better the enterprise is performing. The more times the inventory turns over, the smaller the net margin can be to earn an appropriate total profit and return on assets. For example, a company can price its goods lower if it has a high inventory turnover. A company with a low profit margin, such as 2%, can earn as much as a company with a high net profit margin, such as 40%, if its inventory turnover is often enough. To illustrate, a grocery store with a 2% profit margin can earn as much as a jewelry store with a 40% profit margin and an inventory turnover of 1 if its turnover is more than 20 times. *19. Two major modifications are necessary. First, the beginning inventory should be excluded from the numerator and denominator of the cost to retail percentage and second, markdowns should be included in the denominator of the cost to retail percentage. 9-8 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 9-1 (a) Ceiling Floor (b) (c) $106.00 $51.00 $198.00 ($217 – $19) $166.00 ($217 – $19 – $32) BRIEF EXERCISE 9-2 Designated Item Jokers Penguins Riddlers Scarecrows Cost $2,000 5,000 4,400 3,200 Market $1,900 4,950 4,550 3,070 LCM $1,900 4,950 4,400 3,070 BRIEF EXERCISE 9-3 (a) Direct method Cost of Goods Sold........................................................... Inventory .................................................................... (b) Indirect method Loss Due to Market Decline of Inventory .................. Allowance to Reduce Inventory to Market...... 17,000 17,000 17,000 17,000 9-9 BRIEF EXERCISE 9-4 Sales Price per CD $5 $10 $15 Total Sales Price 500 8,000 1,500 $10,000 $ Relative Sales Price Cost Allocated to CDs $ 300 4,800 900 $6,000 Group 1 2 3 Number of CDs 100 800 100 Total Cost Cost per CD $3** $6 $9 5/100* X $6,000 = 80/100 X $6,000 = 15/100 X $6,000 = *$500/$10,000 = 5/100 **$300/100 = $3 BRIEF EXERCISE 9-5 Unrealized Holding Loss—Income (Purchase Commitments) ..................................................................... Estimated Liability on Purchase Commitments............................................................ 70,000 70,000 BRIEF EXERCISE 9-6 Purchases (Inventory) .......................................................... Estimated Liability on Purchase Commitments .......... Cash................................................................................. 930,000 70,000 1,000,000 BRIEF EXERCISE 9-7 Beginning inventory Purchases Cost of goods available Sales Less gross profit (31% X 700,000) Estimated cost of goods sold Estimated ending inventory destroyed in fire 9-10 $150,000 500,000 650,000 $700,000 217,000 483,000 $167,000 BRIEF EXERCISE 9-8 Cost Beginning inventory Net purchases Net markups Totals Deduct: Net markdowns Sales Ending inventory at retail Cost-to-retail ratio: $132,000 ÷ $200,000 = 66% Ending inventory at lower of cost or market (66% X $36,000) = $23,760 7,000 157,000 $ 36,000 $132,000 $ 12,000 120,000 Retail $ 20,000 170,000 10,000 200,000 BRIEF EXERCISE 9-9 Inventory turnover: $198,747 $26,612 + $24,401 2 Average days to sell inventory: 365 ÷ 7.79 = 46.9 days = 7.79 times 9-11 *BRIEF EXERCISE 9-10 Cost Beginning inventory Net purchases Net markups Net markdowns Total (excluding beginning inventory) Total (including beginning inventory) Deduct: Sales Ending inventory at retail Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4% Ending inventory at cost $20,000 X 60% ($12,000/$20,000) = $12,000 16,000 X 69.4% = 11,104 $36,000 $23,104 $ 12,000 120,000 _______ 120,000 $132,000 Retail $ 20,000 170,000 10,000 (7,000) 173,000 193,000 157,000 $ 36,000 *BRIEF EXERCISE 9-11 Cost Beginning inventory Net purchases Net markups Net markdowns Total (excluding beginning inventory) Total (including beginning inventory) Deduct: Sales Ending inventory at retail $ 12,000 120,000 _______ 120,000 $132,000 Retail $ 20,000 170,000 10,000 (7,000) 173,000 193,000 157,000 $ 36,000 9-12 *BRIEF EXERCISE 9-11 (Continued) Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4% Ending inventory at retail deflated to base year prices $36,000 ÷ 1.20 = $30,000 Ending inventory at cost $20,000 X 100% X 60% = $12,000 10,000 X 120% X 69.4% = 8,328 $20,328 9-13 SOLUTIONS TO EXERCISES EXERCISE 9-1 (15–20 minutes) Per Unit Part No. 110 111 112 113 120 121 122 Totals (a) (b) Quantity 600 1,000 500 200 400 1,600 300 Cost $ 90 60 80 170 205 16 240 Market $100.00 52.00 76.00 180.00 208.00 0.20 235.00 Total Cost $ 54,000 60,000 40,000 34,000 82,000 25,600 72,000 $367,600 Total Market $ 60,000 52,000 38,000 36,000 83,200 320 70,500 $340,020 Lower of Cost or Market $ 54,000 52,000 38,000 34,000 82,000 320 70,500 $330,820 $330,820. $340,020. EXERCISE 9-2 (10–15 minutes) Net Realizable Value Less Normal Profit (Floor) $70** 60 45 45 60 40 Item D E F G H I Net Realizable Value (Ceiling) $90* 80 65 65 80 60 Replacement Cost $120 72 70 30 70 30 Designated Market $90 72 65 45 70 40 Cost $75 80 80 80 50 36 LCM $75 72 65 45 50 36 *Estimated selling price – Estimated selling expense = $120 – $30 = $90. **Net realizable value – Normal profit margin = $90 – $20 = $70. 9-14 EXERCISE 9-3 (15–20 minutes) Net Real. Value Less Normal Profit $2.90** 2.50 3.60 2.05 1.85 2.90 1.25 4.50 Item No. 1320 1333 1426 1437 1510 1522 1573 1626 Cost per Unit $3.20 2.70 4.50 3.60 2.25 3.00 1.80 4.70 Replacement Cost $3.00 2.30 3.70 3.10 2.00 2.70 1.60 5.20 Net Realizable Value $4.15* 3.00 4.60 2.95 2.45 3.40 1.75 5.50 Designated Market Value $3.00 2.50 3.70 2.95 2.00 2.90 1.60 5.20 Quantity 1,200 900 800 1,000 700 500 3,000 1,000 Final Inventory Value $ 3,600 2,250 2,960 2,950 1,400 1,450 4,800 4,700*** $24,110 *$4.50 – $.35 = $4.15. **$4.15 – $1.25 = $2.90. ***Cost is used because it is lower than designated market value. EXERCISE 9-4 (10–15 minutes) (a) 12/31/07 Cost of Goods Sold .................................... Inventory.............................................. Cost of Goods Sold .................................... Inventory.............................................. Loss Due to Market Decline of Inventory..................................................... Allowance to Reduce Inventory to Market .......................................... Allowance to Reduce Inventory to Market ..................................................... Recovery of Loss Due to Market Decline of Inventory....... 19,000 19,000 15,000 15,000 12/31/08 (b) 12/31/07 19,000 19,000 12/31/08 4,000* 4,000 9-15 EXERCISE 9-4 (Continued) *Cost of inventory at 12/31/07 Lower of cost or market at 12/31/07 Allowance amount needed to reduce inventory to market (a) Cost of inventory at 12/31/08 Lower of cost or market at 12/31/08 Allowance amount needed to reduce inventory to market (b) Recovery of previously recognized loss $346,000 (327,000) $ 19,000 $410,000 (395,000) $ 15,000 = (a) – (b) = $19,000 – $15,000 = $4,000. (c) Both methods of recording lower of cost or market adjustments have the same effect on net income. EXERCISE 9-5 (20–25 minutes) (a) Sales Cost of goods sold Inventory, beginning Purchases Cost of goods available Inventory, ending Cost of goods sold Gross profit Gain (loss) due to market fluctuations of inventory* February $29,000 15,000 20,000 35,000 15,100 19,900 9,100 (2,000) $ 7,100 March $35,000 15,100 24,000 39,100 17,000 22,100 12,900 1,100 $14,000 April $40,000 17,000 26,500 43,500 13,000 30,500 9,500 700 $10,200 9-16 EXERCISE 9-5 (Continued) * Inventory at cost Inventory at the lower of cost or market Allowance amount needed to reduce inventory to market Gain (loss) due to market fluctuations of inventory** **$500 – $2,500 = $(2,000) $2,500 – $1,400 = $1,100 $1,400 – $700 = $700 Jan. 31 $15,000 14,500 $ 500 Feb. 28 $15,100 12,600 $ 2,500 $ (2,000) Mar. 31 $17,000 15,600 $ 1,400 $ 1,100 $ $ Apr. 30 $13,000 12,300 700 700 (b) Jan. 31 Loss Due to Market Decline of Inventory ..... Allowance to Reduce Inventory to Market ................................................... Loss Due to Market Decline of Inventory ..... Allowance to Reduce Inventory to Market ................................................... Allowance to Reduce Inventory to Market....... Recovery of Loss Due to Market Decline of Inventory .............................. Allowance to Reduce Inventory to Market....... Recovery of Loss Due to Market Decline of Inventory .............................. 500 500 2,000 2,000 1,100 1,100 700 700 Feb. 28 Mar. 31 Apr. 30 9-17 EXERCISE 9-6 Net realizable value (ceiling) Net realizable value less normal profit (floor) Replacement cost Designated market Cost Lower of cost or market $45 – $14 = $31 $31 – $ 9 = $22 $35 $31 Ceiling $40 $31 $35 figure used – $31 correct value per unit = $4 per unit. $4 X 1,000 units = $4,000. If ending inventory is overstated, net income will be overstated. If beginning inventory is overstated, net income will be understated. Therefore, net income for 2007 was overstated by $4,000 and net income for 2008 was understated by $4,000. 9-18 No. of Lots Relative Sales Price $27,000/$127,800 X $89,460 $60,000/$127,800 X $40,800/$127,800 X 89,460 28,560 $89,460 $80,000 56,000 24,000 18,200 $ 5,800 89,460 42,000 $18,900 $3,000 4,000 2,400 $127,800 40,800 60,000 $ 27,000 Sales Price Per Lot Total Sales Price Total Cost $2,100 2,800 1,680 Cost Allocated to Lots Cost Per Lot (Cost Allocated/ No. of Lots) Group 1 9 Group 2 15 Group 3 17 Sales (see schedule) EXERCISE 9-7 (15–20 minutes) Cost of goods sold (see schedule) Gross profit Operating expenses Net income 9-19 Number of Lots Sold* Cost Per Lot Sales $12,000 32,000 36,000 $80,000 Gross Profit $ 3,600 9,600 10,800 $2,100 2,800 1,680 $56,000 25,200 22,400 $ 8,400 Cost of Lots Sold Group 1 4 Group 2 8 Group 3 15 Total 27 $24,000 * 9–5=4 15 – 7 = 8 17 – 2 = 15 Chairs 400 $56.70 50.40 31.50 300 700 $95,000 $59,850 50 $35,000/$95,000 X 59,850 35,000 22,050 80 $24,000/$95,000 X 59,850 24,000 15,120 $90 $36,000 $36,000/$95,000 X $59,850 $22,680 No. of Chairs Relative Sales Price Sales Price per Lot Total Cost Cost per Chair Total Sales Price Cost Allocated to Chairs Lounge chairs Armchairs EXERCISE 9-8 (12–17 minutes) Straight chairs Chairs 200 $56.70 50.40 31.50 3,780 $20,160 $32,000 6,000 5,040 8,000 $11,340 100 120 $18,000 $ 6,660 2,960 2,220 $11,840 Number of Chairs Sold Sales Gross Profit Cost per Chair Cost of Chairs Sold Lounge chairs 9-20 Armchairs Straight chairs Inventory of straight chairs (700 – 120) X $31.50 = $18,270 EXERCISE 9-9 (5–10 minutes) Unrealized Holding Gain or Loss—Income (Purchase Commitments)......................................... Estimated Liability on Purchase Commitments ..................................................... 35,000 35,000 EXERCISE 9-10 (15–20 minutes) (a) If the commitment is material in amount, there should be a footnote in the balance sheet stating the nature and extent of the commitment. The footnote may also disclose the market price of the materials. The excess of market price over contracted price is a gain contingency which per FASB Statement No. 5 cannot be recognized in the accounts until it is realized. The drop in the market price of the commitment should be charged to operations in the current year if it is material in amount. The following entry would be made: Unrealized Holding Gain or Loss—Income (Purchase Commitments) ............................................. Estimated Liability on Purchase Commitments ......................................................... (b) 10,800 10,800 The entry is made because a loss in utility has occurred during the period in which the market decline took place. The account credited in the above entry should be included among the current liabilities on the balance sheet, with an appropriate footnote indicating the nature and extent of the commitment. This liability indicates the minimum obligation on the commitment contract at the present time—the amount that would have to be forfeited in case of breach of contract. (c) Assuming the $10,800 market decline entry was made on December 31, 2008, as indicated in (b), the entry when the materials are received in January 2009 would be: Raw Materials ....................................................................... Estimated Liability on Purchase Commitments........ Accounts Payable..................................................... 97,200 10,800 108,000 9-21 EXERCISE 9-10 (Continued) This entry debits the raw materials at the actual cost, eliminates the $10,800 liability set up at December 31, 2008, and records the contractual liability for the purchase. This permits operations to be charged this year with the $97,200, the other $10,800 of the cost having been charged to operations in 2008. EXERCISE 9-11 (8–13 minutes) 1. 20% 100% + 20% 25% 100% + 25% = 16.67% OR 16 2/3%. 2. = 20%. 3. 33 1/3% = 25%. 100% + 33 1/3% 50% 100% + 50% 4. = 33.33% OR 33 1/3%. EXERCISE 9-12 (10–15 minutes) (a) Inventory, May 1 (at cost) Purchases (at cost) Purchase discounts Freight-in Goods available (at cost) Sales (at selling price) $1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) 930,000 Less: Gross profit (30% of $930,000) 279,000 Sales (at cost) Approximate inventory, May 31 (at cost) 9-22 $160,000 640,000 (12,000) 30,000 818,000 651,000 $167,000 EXERCISE 9-12 (Continued) (b) Gross profit as a percent of sales must be computed: 30% 100% + 30% = 23.08% of sales. $160,000 640,000 (12,000) 30,000 818,000 Inventory, May 1 (at cost) Purchases (at cost) Purchase discounts Freight-in Goods available (at cost) Sales (at selling price) $1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) 930,000 Less: Gross profit (23.08% of $930,000) 214,644 Sales (at cost) Approximate inventory, May 31 (at cost) 715,356 $102,644 EXERCISE 9-13 (15–20 minutes) (a) Merchandise on hand, January 1 Purchases Less: Purchase returns and allowances Freight-in Total merchandise available (at cost) Cost of goods sold* Ending inventory Less: Undamaged goods Estimated fire loss *Gross profit = 33 1/3% = 25% of sales. 100% + 33 1/3% $ 38,000 72,000 (2,400) 3,400 111,000 75,000 36,000 10,900 $ 25,100 Cost of goods sold = 75% of sales of $100,000 = $75,000. 9-23 EXERCISE 9-13 (Continued) (b) Cost of goods sold = 66 2/3% of sales of $100,000 = $66,667 Total merchandise available (at cost) [$111,000 (as computed above) – $66,667] Less: Undamaged goods Estimated fire loss $44,333 10,900 $33,433 EXERCISE 9-14 Beginning inventory Purchases Purchase returns Goods available (at cost) Sales Sales returns Net sales Less: Gross profit (40% X $626,000) Estimated ending inventory (unadjusted for damage) Less: Goods on hand—undamaged (at cost) $21,000 X (1 – 40%) Less: Goods on hand—damaged (at net realizable value) Fire loss on inventory (12,600) (5,300) $136,500 $650,000 (24,000) 626,000 (250,400) 375,600 154,400 $170,000 390,000 560,000 (30,000) 530,000 9-24 EXERCISE 9-15 (10–15 minutes) Beginning inventory (at cost) Purchases (at cost) Goods available (at cost) Sales (at selling price) Less sales returns Net sales Less: Gross profit* (2/7 of $112,000) Net sales (at cost) Estimated inventory (at cost) Less: Goods on hand ($30,500 – $6,000) Claim against insurance company $ 38,000 85,000 123,000 $116,000 4,000 112,000 32,000 80,000 43,000 24,500 $ 18,500 *Computation of gross profit: 40% = 2/7 of selling price 100% + 40% Note: Depending on details of the consignment agreement and Duncan’s insurance policy, the consigned goods might be covered by Duncan’s insurance policy. EXERCISE 9-16 (15–20 minutes) Lumber Inventory 1/1/08 (cost) Purchases to 8/18/08 (cost) Cost of goods available Deduct cost of goods sold* Inventory 8/18/08 $ 250,000 1,500,000 1,750,000 1,664,000 $ 86,000 Millwork $ 90,000 375,000 465,000 410,000 $ 55,000 Hardware $ 45,000 160,000 205,000 150,000 $ 55,000 *(See computations on next page) 9-25 EXERCISE 9-16 (Continued) Computation for cost of goods sold:* $2,080,000 = $1,664,000 1.25 $533,000 1.30 $210,000 1.40 Lumber: Millwork: = $410,000 Hardware: = $150,000 *Alternative computation for cost of goods sold: Markup on selling price: 25% = 20% or 1/5 100% + 25% 30% = 3/13 100% + 30% 40% = 2/7 100% + 40% Cost of goods sold: Lumber: $2,080,000 X 80% = $1,664,000 Millwork: $533,000 X 10/13 = $410,000 Hardware: $210,000 X 5/7 = $150,000 9-26 EXERCISE 9-17 (20–25 minutes) Ending inventory: (a) Gross profit is 45% of sales Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (45% of sales) Sales (at cost) Ending inventory (at cost) $2,500,000 1,125,000 1,375,000 $ 725,000 $2,100,000 (b) Gross profit is 60% of cost 60% 100% + 60% = 37.5% markup on selling price Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (37.5% of sales) Sales (at cost) Ending inventory (at cost) $2,500,000 937,500 $2,100,000 1,562,500 $ 537,500 (c) Gross profit is 35% of sales Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (35% of sales) Sales (at cost) Ending inventory (at cost) 9-27 $2,100,000 $2,500,000 875,000 1,625,000 $ 475,000 EXERCISE 9-17 (Continued) (d) Gross profit is 25% of cost 25% 100% + 25% = 20% markup on selling price Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (20% of sales) Sales (at cost) Ending inventory (at cost) $2,100,000 $2,500,000 500,000 2,000,000 $ 100,000 EXERCISE 9-18 (20–25 minutes) (a) Beginning inventory Purchases Net markups Totals Net markdowns Sales price of goods available Deduct: Sales Ending inventory at retail Cost $ 58,000 122,000 _______ $180,000 Retail $100,000 200,000 10,345 310,345 (26,135) 284,210 186,000 $ 98,210 (b) 1. 2. 3. 4. $180,000 ÷ $300,000 = 60% $180,000 ÷ $273,865 = 65.73% $180,000 ÷ $310,345 = 58% $180,000 ÷ $284,210 = 63.33% 9-28 EXERCISE 9-18 (Continued) (c) 1. 2. 3. Method 3. Method 3. Method 3. (d) (e) (f) 58% X $98,210 = $56,962 $180,000 – $56,962 = $123,038 $186,000 – $123,038 = $62,962 EXERCISE 9-19 (12–17 minutes) Cost $ 200,000 1,375,000 1,575,000 $95,000 (15,000) Retail $ 280,000 2,140,000 2,420,000 Beginning inventory Purchases Totals Add: Net markups Markups Markup cancellations Totals Deduct: Net markdowns Markdowns Markdowns cancellations Sales price of goods available Deduct: Sales Ending inventory at retail Cost-to-retail ratio = $1,575,000 $2,500,000 _________ $1,575,000 80,000 2,500,000 35,000 (5,000) 30,000 2,470,000 2,200,000 $ 270,000 = 63% Ending inventory at cost = 63% X $270,000 = $170,100 9-29 EXERCISE 9-20 (20–25 minutes) Cost $30,000 48,000 (2,000) 2,400 78,400 $10,000 (1,500) _______ $78,400 8,500 140,000 Retail $ 46,500 88,000 (3,000) _______ 131,500 Beginning inventory Purchases Purchase returns Freight on purchases Totals Add: Net markups Markups Markup cancellations Net markups Totals Deduct: Net markdowns Markdowns Markdowns cancellations Net markdowns Sales price of goods available Deduct: Net sales ($99,000 – $2,000) Ending inventory, at retail Cost-to-retail ratio = $78,400 $140,000 9,300 (2,800) 6,500 133,500 97,000 $ 36,500 = 56% Ending inventory at cost = 56% X $36,500 = $20,440 EXERCISE 9-21 (10–15 minutes) (a) Inventory turnover: 2004 $6,584 = 6.13 times $1,063 + $1,082 2 (b) Average days to sell inventory: 2004 365 ÷ 6.13 = 59.5 days 9-30 2003 $6,109 $1,082 + $1,055 2 = 5.72 times 2003 365 ÷ 5.72 = 63.8 days *EXERCISE 9-22 (25–35 minutes) (a) Conventional Retail Method Cost Inventory, January 1, 2006 Purchases (net) Add: Net markups Totals Deduct: Net markdowns Sales price of goods available Deduct: Sales (net) Ending inventory at retail $169,000 $260,000 $ 38,100 130,900 169,000 ________ $169,000 Retail $ 60,000 178,000 238,000 22,000 260,000 13,000 247,000 167,000 $ 80,000 Cost-to-retail ratio = = 65% Ending inventory at cost = 65% X $80,000 = $52,000 (b) LIFO Retail Method Cost Inventory, January 1, 2006 Net Purchases Net markups Net markdowns Total (excluding beginning inventory) Total (including beginning inventory) Deduct sales (net) Ending inventory at retail $130,900 $187,000 $ 38,100 130,900 Retail $ 60,000 178,000 22,000 (13,000) 187,000 247,000 167,000 $ 80,000 130,900 $169,000 Cost-to-retail ratio = = 70% 9-31 *EXERCISE 9-22 (Continued) Computation of ending inventory at LIFO cost, 2007: Ending Inventory at Retail Prices $80,000 Layers at Retail Prices 2006 $60,000 2007 20,000 X X Cost to Retail (Percentage) 63.5%* 70.0% Ending Inventory at LIFO Cost $38,100 14,000 $52,100 *$38,100 $60,000 (prior years cost to retail) *EXERCISE 9-23 (15–20 minutes) (a) Inventory, January 1, 2007 Net Purchases Freight-in Net markups Totals Sales Net markdowns Estimated theft Ending inventory at retail $80,300 $110,000 Cost $14,000 58,800 7,500 $80,300 Retail $ 20,000 81,000 9,000 110,000 (80,000) (1,600) (2,000) $ 26,400 Cost-to-retail ratio: = 73% Ending inventory at lower of average cost or market = $26,400 X 73% = $19,272 9-32 *EXERCISE 9-23 (Continued) (b) Purchases Freight-in Net markups Net markdowns Totals $66,300 $88,400 Cost $58,800 7,500 ______ $66,300 Retail $81,000 9,000 (1,600) $88,400 Cost-to-retail ratio: = 75% The increment at retail is $26,400 – $20,000 = $6,400. The increment is costed at 75% X $6,400 = $4,800. Ending inventory at LIFO retail: Cost Beginning inventory, 2007 Increment Ending inventory, 2007 $14,000 4,800 $18,800 Retail $20,000 6,400 $26,400 *EXERCISE 9-24 (10–15 minutes) (a) $216,000 = 72% $300,000 Cost-to-retail ratio—beginning inventory: *($294,300 ÷ 1.09) X 72% = $194,400 *Since the above computation reveals that the inventory quantity has declined below the beginning level, it is necessary to convert the ending inventory to beginning-of-the-year prices (by dividing by 1.09) and then multiply it by the beginning cost-to-retail ratio (72%). 9-33 *EXERCISE 9-24 (Continued) (b) Ending inventory at retail prices deflated $365,150 ÷ 1.09 Beginning inventory at beginning-of-year prices Inventory increase in terms of beginning-of-year dollars Beginning inventory (at cost) Additional layer, $35,000 X 1.09 X 76%* $335,000 300,000 $ 35,000 $216,000 28,994 $244,994 *($364,800 ÷ $480,000) *EXERCISE 9-25 (5–10 minutes) Ending inventory at retail (deflated) $100,100 ÷ 1.10 Beginning inventory at retail Increment at retail Ending inventory on LIFO basis First layer Second layer ($16,500 X 1.10 X 60%) $91,000 74,500 $16,500 Cost $36,000 10,890 $46,890 9-34 *EXERCISE 9-26 (20–25 minutes) (a) Beginning inventory Net purchases Net markups Totals Net markdowns Sales Ending inventory at retail Cost $ 30,100 108,500 ________ $138,600 Retail $ 50,000 150,000 10,000 210,000 (5,000) (126,900) $ 78,100 Cost-retail ratio = 66% ($138,600/$210,000) Ending inventory at cost ($78,100 X 66%) (b) Cost $ 30,100 108,500 $ 51,546 Retail $ 50,000 150,000 10,000 (5,000) 155,000 205,000 (126,900) 78,100 $ 71,000 Beginning inventory Net purchases Net markups Net markdowns Total (excluding beginning inventory) 108,500 Total (including beginning inventory) $138,600 Sales Ending inventory at retail (current) Ending inventory at retail (base year) ($78,100 ÷ 1.10) Cost-retail ratio for new layer: $108,500/$155,000 = 70% Layers: Base layer $50,000 X 1.00 X 60.2%* = New layer ($71,000 – $50,000) X 1.10 X 70% = *($30,100/$50,000) (c) Cost of goods available for sale Ending inventory at cost, from (b) Cost of goods sold $ 30,100 16,170 $ 46,270 $138,600 46,270 $ 92,330 9-35 *EXERCISE 9-27 (20–25 minutes) 2006 Restate to base-year retail ($118,720 ÷ 1.06) Layers: 1. $100,000 X 1.00 X 54%* = 2. $ 12,000 X 1.06 X 57% = Ending inventory *$54,000 ÷ $100,000 2007 Restate to base-year retail ($138,750 ÷ 1.11) Layers: 1. $100,000 X 1.00 X 54% = 2. $ 12,000 X 1.06 X 57% = 3. $ 13,000 X 1.11 X 60% = Ending inventory 2008 Restate to base-year retail ($125,350 ÷ 1.15) Layers: 1. $100,000 X 1.00 X 54% = 2. $ 9,000 X 1.06 X 57% = Ending inventory 2009 Restate to base-year retail ($162,500 ÷ 1.25) Layers: 1. $100,000 X 1.00 X 54% = 2. $ 9,000 X 1.06 X 57% = 3. $ 21,000 X 1.25 X 58% = Ending inventory $125,000 $ 54,000 7,250 8,658 $ 69,908 $109,000 $ 54,000 5,438 $ 59,438 $130,000 $ 54,000 5,438 15,225 $ 74,663 $112,000 $ 54,000 7,250 $ 61,250 *EXERCISE 9-28 (5–10 minutes) Inventory (beginning) ........................................................ Adjustment to Record Inventory at Cost* ........ ($212,600 – $205,000) 7,600 7,600 *Note: This account is an income statement account showing the effect of changing from a lower-of-cost-or-market approach to a straight cost basis. 9-36 TIME AND PURPOSE OF PROBLEMS Problem 9-1 (Time 10–15 minutes) Purpose—to provide the student with an understanding of the lower of cost or market approach to inventory valuation, similar to Problem 9-2. The major difference between these problems is that Problem 9-1 provides some ambiguity to the situation by changing the catalog prices near the end of the year. Problem 9-2 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the lower of cost or market approach to inventory valuation. The student is required to examine a number of individual items and apply the lower of cost or market rule and to also explain the use and value of the lower of cost or market rule. Problem 9-3 (Time 30–35 minutes) Purpose—to provide a problem that requires entries for reducing inventory to lower of cost or market under the perpetual inventory system using both the direct and the indirect method. Problem 9-4 (Time 20–30 minutes) Purpose—to provide another problem where a fire loss must be computed using the gross profit method. Certain goods remained undamaged and therefore an adjustment is necessary. In addition, the inventory was subject to an obsolescence factor which must be considered. Problem 9-5 (Time 40–45 minutes) Purpose—to provide the student with a complex problem involving a fire loss where the gross profit method must be employed. The problem is complicated because a number of adjustments must be made to the purchases account related to merchandise returned, unrecorded purchases, and shipments in transit. In addition, some cash to accrual computations are necessary. Problem 9-6 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. The problem is relatively straightforward although transfers-in from other departments as well as the proper treatment for normal spoilage complicate the problem. A good problem that summarizes the essentials of the retail inventory method. Problem 9-7 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. This problem is similar to Problem 9-6, except that a few different items must be evaluated in finding ending inventory at retail and cost. Unusual items in this problem are employee discounts granted and loss from breakage. A good problem that summarizes the essentials of the retail inventory method. Problem 9-8 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. This problem is similar to Problems 9-6 and 9-7, except that the student is asked to list the factors that may have caused the difference between the computed inventory and the physical count. Problem 9-9 (Time 30–40 minutes) Purpose—to provide the student with a problem requiring financial statement and note disclosure of inventories, the income disclosure of an inventory market decline, and the treatment of purchase commitments. Problem 9-10 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to write a memo explaining what is designated market value and how it is computed. As part of this memo, the student is required to compute inventory on the lower of cost or market basis using the individual item approach. 9-37 Time and Purpose of Problems (Continued) *Problem 9-11 (Time 30–35 minutes) Purpose—to provide the student with a retail inventory problem where both the conventional retail and dollar-value LIFO method must be computed. An excellent problem for highlighting the difference between these two approaches to inventory valuation. It should be noted that the cost to retail percentage is given for LIFO so less computation is necessary. *Problem 9-12 (Time 30–40 minutes) Purpose—to provide the student with a comprehensive problem covering the retail and LIFO retail inventory methods, the computation of an inventory shortage, and the treatment of four special items relative to the retail inventory method. *Problem 9-13 (Time 30–40 minutes) Purpose—to provide the student with a basic problem illustrating the change from conventional retail to LIFO retail. This problem emphasizes many of the same issues as Problem 9-11, except that a dollarvalue LIFO computation is not needed. A good problem for providing the essential issues related to a change to LIFO retail. *Problem 9-14 (Time 40–50 minutes) Purpose—to provide the student with a retail inventory problem where both the conventional retail and dollar-value LIFO method must be computed. The problem is similar to Problem 9-10, except that the problem involves a three-year period which adds complexity to the problem. This problem provides an excellent summary of the essential elements related to the change of the retail inventory method from conventional retail to LIFO retail and dollar-value LIFO retail. 9-38 SOLUTIONS TO PROBLEMS PROBLEM 9-1 Item A B C D Cost $470 450 830 960 Replacement Cost $ 460 440 610 1,000 Ceiling* $ 455 480 810 1,070 Floor** $355 372 630 830 Designated Market $ 455 440 630 1,000 Lower of Cost or Market $455 440 630 960 *Ceiling = 2009 catalog selling price less sales commissions and estimated other cost of disposal. (2009 catalogue prices are in effect as of 12/01/08.) **Floor = Ceiling less (20% X 2009 catalog selling price). 9-39 PROBLEM 9-2 (a) 1. The balance in the Allowance to Reduce Inventory to Market at May 31, 2007, should be $36,000, as calculated in Exhibit 1 below. Exhibit 1 Calculations of Proper Balance on the Allowance to Reduce Inventory to Market At May 31, 2007 NRV less Replacement Cost Aluminum siding Cedar shake siding Louvered glass doors Thermal windows Totals $ 70,000 86,000 112,000 140,000 $408,000 Cost $ 62,500 79,400 124,000 122,000 $387,900 NRV (Ceiling) $ 56,000 84,800 168,300 140,000 $449,100 normal profit (Floor) $ 50,900 77,400 149,800 124,600 $402,700 LCM $ 56,000 79,400 112,000 124,600 $372,000 Inventory cost LCM valuation Allowance at May 31, 2007 $408,000 372,000 $ 36,000 2. For the fiscal year ended May 31, 2007, the loss that would be recorded due to the change in the Allowance to Reduce Inventory to Market would be $6,500, as calculated below. Balance prior to adjustment Required balance Loss to be recorded $29,500 (36,000) $( 6,500) 9-40 PROBLEM 9-2 (Continued) (b) The use of the lower of cost or market (LCM) rule is based on both the matching principle and the concept of conservatism. The matching principle applies because the application of the LCM rule allows for the recognition of a decline in the utility (value) of inventory as a loss in the period in which the decline takes place. The departure from the cost principle for inventory valuation is permitted on the basis of conservatism. The general rule is that the historical cost principle is abandoned when the future utility of an asset is no longer as great as its original cost. 9-41 PROBLEM 9-3 (a) 12/31/07 (Direct Method) Cost of Goods Sold ........................................................... Inventory .................................................................... 12/31/08 Cost of Goods Sold ........................................................... Inventory .................................................................... 58,000 58,000 70,000 70,000 (b) 12/31/07 (Allowance Method) To write down inventory to market: Loss Due to Market Decline of Inventory................... Allowance to Reduce Inventory to Market ...... 12/31/08 To write down inventory to market: Loss Due to Market Decline of Inventory................... Allowance to Reduce Inventory to Market ...... [($900,000 – $830,000) – $58,000] 58,000 58,000 12,000 12,000 9-42 PROBLEM 9-4 Beginning inventory Purchases Purchase returns Total goods available Sales Sales returns Less: Gross profit (34% of $394,000) Ending inventory (unadjusted for damage) Less: Goods on hand—undamaged ($30,000 X [1 – 34%]) Inventory damaged Less: Salvage value of damaged inventory Fire loss on inventory $415,000 (21,000) 394,000 133,960 $ 80,000 280,000 360,000 (28,000) 332,000 (260,040) 71,960 19,800 52,160 7,150 $ 45,010 9-43 PROBLEM 9-5 John Kimmel Corporation COMPUTATION OF INVENTORY FIRE LOSS April 15, 2008 Inventory, 1/1/08 Purchases, 1/1/ – 3/31/08 April merchandise shipments paid Unrecorded purchases on account Total Less: Shipments in transit Merchandise returned Merchandise available for sale Less estimated cost of sales: Sales, 1/1/ – 3/31/08 Sales, 4/1/ – 4/15/08 Receivables acknowledged at 4/15/08 Estimated receivables not acknowledged Total Add collections, 4/1/ – 4/15/08 ($12,950 – $950) Total Less receivables, 3/31/08 Total sales 1/1/ – 4/15/08 Less gross profit (44%* X $151,000) Estimated merchandise inventory Less: Sale of salvaged inventory Inventory fire loss $ 75,000 52,000 3,400 10,600 141,000 $ 2,300 950 3,250 137,750 135,000 $36,000 8,000 44,000 12,000 56,000 40,000 16,000 151,000 66,440 84,560 53,190 3,500 $ 49,690 9-44 PROBLEM 9-5 (Continued) *Computation of Gross Profit Ratio Net sales, 2006 Net sales, 2007 Total net sales Beginning inventory Net purchases, 2006 Net purchases, 2007 Total Less: Ending inventory Gross profit Gross profit ratio ($404,800 ÷ $920,000) $ 75,200 235,000 280,000 590,200 75,000 515,200 $404,800 44% $390,000 530,000 920,000 9-45 PROBLEM 9-6 (a) Beginning Inventory Purchases Freight-in Purchase returns Transfers-in from suburb branch Totals Net markups Net markdowns Sales Sales returns Inventory losses due to breakage Ending inventory at retail $117,400 $180,000 Cost $ 17,000 86,500 7,000 (2,300) 9,200 $117,400 Retail $ 25,000 137,000 (3,000) 13,000 172,000 8,000 180,000 (4,000) $(85,000) 2,400 (82,600) (400) $ 93,000 Cost-to-retail ratio = = 65.2% (b) Ending inventory at lower of average cost or market (65.2% of $93,000) $ 60,636 9-46 PROBLEM 9-7 Cost Beginning Inventory Purchases Purchase returns Purchase discounts Freight-in Markups Markup cancellations Totals Markdowns Markdown cancellations Sales Sales returns Inventory losses due to breakage Employee discounts Ending inventory at retail $1,165,500 $1,850,000 $1,165,500 (45,000) 20,000 $(1,460,000) 97,500 $ 250,000 914,500 (60,000) (18,000) 79,000 120,000 (40,000) Retail $ 390,000 1,460,000 (80,000) 80,000 1,850,000 (25,000) (1,362,500) (2,500) (8,000) $ 452,000 Cost-to-retail ratio = = 63% Ending inventory at cost (63% of $452,000) $ 284,760 9-47 PROBLEM 9-8 (a) Inventory (beginning) Purchases Purchase returns Freight-in Totals Markups Markup cancellations Net markdowns Normal spoilage and breakage Sales Ending inventory at retail $325,000 $500,000 Cost $ 52,000 262,000 (5,600) 16,600 $325,000 9,000 (2,000) Retail $ 78,000 423,000 (8,000) 493,000 7,000 500,000 (3,600) (10,000) (380,000) $106,400 Cost-to-retail ratio = = 65% Ending inventory at lower of cost or market (65% of $106,400) (b) $ 69,160 The difference between the inventory estimate per retail method and the amount per physical count may be due to: 1. 2. 3. 4. 5. 6. Theft losses (shoplifting or pilferage). Spoilage or breakage above normal. Differences in cost/retail ratio for purchases during the month, beginning inventory, and ending inventory. Markups on goods available for sale inconsistent between cost of goods sold and ending inventory. A wide variety of merchandise with varying cost/retail ratios. I ncorrect reporting of markdowns, additional markups, or cancellations. 9-48 PROBLEM 9-9 (a) The inventory section of Brooks’ Balance Sheet as of November 30, 2007, including required footnotes, is presented below. Also presented below are the inventory section supporting calculations. Current assets Inventory Section (Note 1.) Finished goods (Note 2.) Work-in-process Raw materials Factory supplies Total inventories Note 1. $641,000 108,700 227,400 64,800 $1,041,900 Lower of cost (first-in, first-out) or market is applied on a major category basis for finished goods, and on a total inventory basis for work-in-process, raw materials, and factory supplies. Seventy-five percent of bar end shifters finished goods inventory in the amount of $136,500 ($182,000 X .75) is pledged as collateral for a bank loan, and one-half of the head tube shifters finished goods is held by catalog outlets on consignment. Note 2. 9-49 PROBLEM 9-9 (Continued) Supporting Calculations Finished Goods $264,000 182,000 195,000 Work-inProcess Raw Materials Factory Supplies Down tube shifters at market Bar end shifters at cost Head tube shifters at cost Work-in-process at market Derailleurs at market Remaining items at market Supplies at cost Totals 1 $108,700 $100,0001 127,400 $641,000 $108,700 $227,400 $64,8002 $64,800 $240,000 X 1/2 = $120,000; $120,000 ÷ 1.2 = $100,000. 2 $69,000 – $4,200 = $64,800. (b) The decline in the market value of inventory below cost may be reported using one or two alternate methods, the direct write-down of inventory or the establishment of an allowance account. The decline in the market value of inventory may be reflected in Brooks’ Income Statement as a separate loss item for the fiscal year ended November 30, 2007. The loss amount may also be written off directly, increasing the cost of goods sold on Brooks’ Income Statement. The loss must be reported in continuing operations rather than in extraordinary items. The loss must be included in the Income Statement since it is material to Brooks’ financial statements. Purchase contracts for which a firm price has been established should be disclosed on the financial statements of the buyer. If the contract price is greater than the current market price and a loss is expected when the purchase takes place, an unrealized holding loss amounting to the difference between the contracted price and the current market price should be recognized on the Income Statement in the period during which the price decline takes place. Also, an estimated liability on purchase commitments should be recognized on the Statement of Financial Position. The recognition of the loss is unnecessary if a firm sales commitment exists which precludes the loss. (c) 9-50 PROBLEM 9-10 (a) Schedule A NRV— Normal Profit (Floor) $7.20 7.30 5.50 4.00 5.10 Item A B C D E On Hand Quantity 1,100 800 1,000 1,000 1,400 Replacement Cost/Unit $8.40 8.00 5.40 4.20 6.30 NRV (Ceiling) $9.00 8.50 6.10 5.50 6.10 Designated Market $8.40 8.00 5.50 4.20 6.10 Cost $7.50 8.20 5.60 3.80 6.40 Lower of Cost or Market $7.50 8.00 5.50 3.80 6.10 Schedule B Item A B C D E Cost 1,100 X $7.50 = $8,250 800 X $8.20 = $6,560 1,000 X $5.60 = $5,600 1,000 X $3.80 = $3,800 1,400 X $6.40 = $8,960 Lower of Cost or Market 1,100 X $7.50 = $8,250 800 X $8.00 = $6,400 1,000 X $5.50 = $5,500 1,000 X $3.80 = $3,800 1,400 X $6.10 = $8,540 Difference None $160 $100 None $420 $680 680 680 (b) Cost of Goods Sold............................................................. Inventory........................................................................ or Loss Due to Market Decline of Inventory .................... Allowance to Reduce Inventory to Market ......... 680 680 9-51 PROBLEM 9-10 (Continued) (c) To: From: Date: Subject: Finn Berg, Clerk Manager of Accounting January 14, 2007 Instructions on determining lower of cost or market for inventory valuation This memo responds to your questions regarding our use of lower of cost or market for inventory valuation. Simply put, value inventory at whichever is the lower: the actual cost or the market value of the inventory at the time of valuation. The term cost is relatively simple. It refers to the amount our company paid for our inventory including costs associated with preparing the inventory for sale. The term market, on the other hand, is more complicated. As you have already noticed, this value could be the inventory’s replacement cost, its net realizable value (selling price minus any estimated costs to complete and sell), or its net realizable value less a normal profit margin. The profession requires that the middle value of the three above costs be chosen as the “designated market value.” This designated market value is then compared to the actual cost in determining the lower of cost or market. Refer to Item A on the attached schedule. The values for the replacement cost, net realizable value, and net realizable value less a normal profit margin are $8.40, $9.00 ($10.50 – $1.50), and $7.20 ($9.00 – $1.80) respectively. The middle value is the replacement cost, $8.40, which becomes the designated market value for Item A. Compare it with the actual cost, $7.50, choosing the lower to value Item A in inventory. In this case, $7.50 is the value chosen to value inventory. Thus, inventory for Item A amounts to $8,250. (See Schedule B, Item A.) 9-52 PROBLEM 9-10 (Continued) Proceed in the same way, always choosing the middle value among replacement cost, net realizable value, and net realizable value less a normal profit, and compare that middle value to the actual cost. The lower of these will always be the amount at which you value the particular item. After you have aggregated the total lower of cost or market for all items, you will be likely to have a loss on inventory which must be accounted for. In our example, the loss is $680. You can journalize this loss in one of two ways: Cost of Goods Sold ........................................................................... Inventory..................................................................................... or Loss Due to Market Decline of Inventory ................................... Allowance to Reduce Inventory to Market ...................... 680 680 680 680 This memo should answer your questions about which value to choose when valuing inventory at lower of cost or market. Schedule A NRV— Normal Profit (Floor) $7.20 7.30 5.50 4.00 5.10 Item A B C D E On Hand Quantity 1,100 800 1,000 1,000 1,400 Replacement Cost/Unit $8.40 8.00 5.40 4.20 6.30 NRV Ceiling $9.00 8.50 6.10 5.50 6.10 Designated Market $8.40 8.00 5.50 4.20 6.10 Cost $7.50 8.20 5.60 3.80 6.40 Lower of Cost or Market $7.50 8.00 5.50 3.80 6.10 Schedule B Item A B C D E Cost 1,100 X $7.50 = $8,250 800 X $8.20 = $6,560 1,000 X $5.60 = $5,600 1,000 X $3.80 = $3,800 1,400 X $6.40 = $8,960 Lower of Cost or Market 1,100 X $7.50 = $8,250 800 X $8.00 = $6,400 1,000 X $5.50 = $5,500 1,000 X $3.80 = $3,800 1,400 X $6.10 = $8,540 9-53 Difference None $160 $100 None $420 $680 *PROBLEM 9-11 (a) Inventory, January 1 Purchases Purchase returns Totals Add: Net markups Markups Markup cancellations Totals Deduct: Net markdowns Markdowns Markdown cancellations Sales price of goods available Sales Sales returns and allowances Ending inventory at retail Cost-to-retail ratio = $136,000 $200,000 Cost $ 30,000 108,800 (2,800) 136,000 $ $136,000 $ 10,500 (6,500) $159,000 (8,000) 9,200 (3,200) Retail $ 43,000 155,000 (4,000) 194,000 6,000 200,000 4,000 196,000 151,000 $ 45,000 = 68% Inventory at lower of cost or market (68% X $45,000) (b) Ending inventory at retail at January 1 price level ($54,000 ÷ 1.08) Less beginning inventory at retail Inventory increment at retail, January 1 price level Inventory increment at retail, June 30 price level ($7,000 X 1.08) Beginning inventory at cost Inventory increment at cost at June 30 price level ($7,560 X 70%) Ending inventory at dollar-value LIFO cost $ 30,600 $ 50,000 43,000 $ 7,000 $ 7,560 $ 30,000 5,292 $ 35,292 9-54 *PROBLEM 9-12 (a) The retail method is appropriate in businesses that sell many different items at relatively low unit costs and that have a large volume of transactions such as Sears or Wal-Mart. The advantages of the retail method in these circumstances include the following: (1) (2) Interim physical inventories can be estimated. The retail method acts as a control as deviations from the physical count will have to be explained. (b) Sprint Department Stores’ ending inventory value, at cost, is $75,300, calculated as follows: Cost $ 68,000 $248,200 Retail $100,000 $400,000 50,000 (110,000) 340,000 440,000 (330,000) $110,000 Beginning inventory Purchases Net markups Net markdowns Net purchases Goods available Sales Estimated ending inventory at retail $248,200 Cost-to-retail percentage: $248,200 ÷ $340,000 = 73%. Beginning inventory layer Incremental increase At retail ($110,000 – $100,000) At cost ($10,000 X 73%) Estimated ending inventory at LIFO cost $ 68,000 $100,000 10,000 7,300 $ 75,300 $110,000 9-55 *PROBLEM 9-12 (Continued) (c) The estimated shortage amount, at retail, for Sprint Department Stores is $3,000 calculated as follows: Estimated ending inventory at retail Actual ending inventory at retail Estimated inventory shortage (d) $110,000 107,000 $ 3,000 When using the retail inventory method, the four expenses and allowances noted are treated in the following manner: (1) Freight costs are added to the cost of purchases. (2) Purchase returns and allowances are considered as reductions to both the cost price and the retail price. (3) Sales returns and allowances are subtracted as an adjustment to sales. (4) Employee discounts are deducted from the retail column in a manner similar to sales. They are not considered in the cost-toretail percentage because they do not reflect an overall change in the selling price. 9-56 *PROBLEM 9-13 (a) Inventory (beginning) Purchases Markups Totals Markdowns Sales Ending inventory at retail Cost-to-retail ratio = $129,800 $220,000 Cost $ 13,600 116,200 $129,800 Retail $ 24,000 184,000 12,000 220,000 (5,500) (170,000) $ 44,500 = 59% $ 26,255 Ending inventory at cost (59% X $44,500) (b) Ending inventory for 2007 under the LIFO method: The cost-to-retail ratio for 2007 can be computed as follows: Net purchases at cost Net purchases plus markups less markdowns at retail = $116,200 $184,000 + $12,000 – $5,500 = 61% December 31, 2007, inventory at LIFO cost: Retail Beginning inventory Increment in 2007 Ending inventory *$44,500 – $24,000 = $20,500 $24,000 20,500* $44,500 Ratio 57% 61% LIFO Cost $13,680 12,505 $26,185 9-57 *PROBLEM 9-14 (a) Rudyard Kipling Department Store COMPUTATION OF COST OF DECEMBER 31, 2005, INVENTORY BASED ON THE CONVENTIONAL RETAIL METHOD At Cost At Retail $ 56,000 554,000 (10,000) Beginning inventory, January 1, 2005 Add (deduct) transactions affecting cost ratio: Gross purchases Purchase returns Purchase discounts Freight-in Net markups Totals Add (deduct) other retail transactions not considered in computation of cost ratio: Gross sales Sales returns Net markdowns Employee discounts Totals Inventory, December 31, 2005: At retail At cost ($63,000 X 55.5%*) $ 26,700 311,000 (5,200) (6,000) 17,600 $344,100 20,000 620,000 (551,000) 9,000 (12,000) (3,000) (557,000) $ 63,000 $ 34,965 *Ratio of cost to retail = $344,100 ÷ $620,000 = 55.5% 9-58 *PROBLEM 9-14 (Continued) (b) COMPUTATION OF COST OF DECEMBER 31, 2005 INVENTORY UNDER THE LIFO RETAIL METHOD Cost Totals used in computing cost ratio under conventional retail method (part a) Exclude beginning inventory Net purchases Deduct net markdowns Totals used on computing cost ratio under LIFO retail method Cost ratio under LIFO retail method ($317,400 ÷ $552,000) Inventory, December 31, 2005: At Retail (Conventional) At Cost under LIFO retail method ($63,000 X 57.5%) $344,100 26,700 317,400 Retail $620,000 56,000 564,000 12,000 $552,000 $317,400 57.5% $63,000 $ 36,225 9-59 *PROBLEM 9-14 (Continued) (c) COMPUTATION OF 2006 AND 2007 YEAR-END INVENTORIES UNDER THE DOLLAR-VALUE LIFO METHOD Computation of retail values on the basis of January 1, 2006, price levels Cost 2006: Inventory at end of year (given) Inventory at end of year stated in terms of January 1, 2006 prices ($73,500 ÷ 105%) January 1, 2006 inventory base (given) cost ratio of 55.5% ($34,965 ÷ $63,000) Increment in inventory: In terms of January 1, 2006 prices In terms of 2006 prices—$7,000 X 105% At LIFO cost—61% (2003 cost ratio) X $7,350 December 1, 2006 inventory at LIFO cost 2007: Inventory at end of year (given) Inventory at end of year stated in terms of January 1, 2007 prices ($65,880 ÷ 108%) December 31, 2007 inventory at LIFO cost—55.5%* (January 1, 2006 cost ratio) X $61,000 $65,880 4,484 $39,449 $73,500 Retail 70,000 $34,965 63,000 $ 7,000 $ 7,350 $61,000 $33,855 9-60 *PROBLEM 9-14 (Continued) (Note to instructor: Because the retail inventory stated in terms of January 1, 2006 prices at December 31, 2006, $61,000, has fallen below the January 1, 2007 inventory base at retail, $63,000, under the LIFO theory the 2007 layer has been depleted and only a portion of the original inventory base remains. Hence the LIFO cost at December 31, 2007 is determined by applying the January 1, 2006 cost ratio of 55.5 percent to the retail inventory value of $61,000). $34,965 Cost = 55.5%. $63,000 Retail *Based on the beginning inventory for 2006 of 9-61 TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 9-1 (Time 15–25 minutes) Purpose—to provide the student with an opportunity to discuss the purpose, the application, and the potential disadvantages of the lower of cost or market method. In addition, the student is asked to discuss the ceiling and floor constraints for determining “market” value. CA 9-2 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to examine ethical issues related to lower-of-costor-market on an individual-product basis. A relatively straightforward case. CA 9-3 (Time 15–20 minutes) Purpose—to provide the student with a case that requires an application and an explanation of the lower-of-cost-or-market rule and a differentiation of the LIFO and the average cost methods. CA 9-4 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to discuss the main features of the retail inventory system. In this case, the following must be explained: (a) accounting features of the method, (b) conditions that may distort the results under the method, (c) advantages of using the retail method versus using a cost method, and (d) the accounting theory underlying net markdowns and net markups. A relatively straightforward case. CA 9-5 (Time 15–25 minutes) Purpose—the student discusses which costs are inventoriable, the theoretical arguments for the lower of cost or market rule, and the amount that should be used to value inventories when replacement cost is below the net realizable value less a normal profit margin. The treatment of beginning inventories and net markdowns when using the conventional retail inventory method must be explained. CA 9-6 (Time 10–15 minutes) Purpose—to provide the student with a case that allows examination of ethical issues related to the recording of purchase commitments. *CA 9-7 (Time 10–15 minutes) Purpose—to provide the student with a number of items that might be encountered when a conventional retail or LIFO retail problem develops. The student must determine whether items, such as markdowns, markdown cancellations, sales discounts, etc. should be considered in computing the cost-to-retail percentage. 9-62 SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 9-1 (a) The purpose of using the lower of cost or market method is to reflect the decline of inventory value below its original cost. A departure from cost is justified on the basis that a loss of utility should be reported as a charge against the revenues in the period in which it occurs. (b) The term “market” in the phrase “the lower of cost or market” generally means the cost to replace the item by purchase or reproduction. Market is limited, however, to an amount that should not exceed the net realizable value (the “ceiling”) (that is, the estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal) and should not be less than net realizable value reduced by an allowance for an approximately normal profit margin (the “floor”). The “ceiling” covers obsolete, damaged, or shopworn material and prevents serious overstatement of inventory. The “floor,” on the other hand, deters serious understatement of inventory. (c) The lower of cost or market method may be applied either directly to each inventory item, to a category, or to the total inventory. The application of the rule to the inventory total, or to the total components of each category, ordinarily results in an amount that more closely approaches cost than it would if the rule were applied to each individual item. Under the first two methods, increases in market prices offset, to some extent, the decreases in market prices. The most common practice is, however, to price the inventory on an item-by-item basis. Companies favor the individual item approach because tax rules require that an individual item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation for balance sheet purposes. (d) Conceptually, the lower of cost or market method has some deficiencies. First, decreases in the value of the asset and the charge to expense are recognized in the period in which loss in utility occurs—not in the period of sale. On the other hand, increases in the value of the asset are recognized only at the point of sale. This situation is inconsistent and can lead to distortions in the presentation of income data. Second, there is difficulty in defining “market” value. Basically, three different types of valuation can be used: replacement cost, net realizable value, and net realizable value less a normal markup. A reduction in the replacement cost of an item does not necessarily indicate a corresponding reduction in the utility (price) of the item. To recognize a loss in one period may misstate the period’s income and also that of future periods because when the merchandise is sold subsequently, the full price for the item is received. Net realizable value reflects the future service potential of the asset and, for that reason, it is conceptually sound. But net realizable value cannot often be measured with any certainty. Therefore, we revert to replacement cost because net realizable value less a normal markup is even more uncertain than net realizable value. From the standpoint of accounting theory there is little to justify the lower of cost or market rule. Although conservative from the balance sheet point of view, it permits the income statement to show a larger net income in future periods than would be justified if the inventory were carried forward at cost. The rule is applied only in those cases where strong evidence indicates that market declines in inventory prices have occurred that will result in losses when such inventories are disposed of. 9-63 CA 9-2 (a) The accountant’s ethical responsibility is to provide fair and complete financial information. In this case, the direct method distorts the cost of goods sold and hides the decline in market value. If Brucki’s direct method is used, management may have difficulty in calculations that involve the cost of goods sold. For example, these calculations are useful in establishing profit margins and determining selling prices; but from the investors’ and stockholders’ viewpoint, it is not good policy to hide declines in market value. Maher should use the allowance method to disclose the decline in market value and avoid distorting cost of goods sold. However, she faces an ethical dilemma if Brucki will not accept the method Maher wants to use. She should consider various alternatives including the extremes of simply accepting her boss’s decision to quitting if Brucki will not change his mind. Maher should assess the consequences of each possible alternative and weigh them carefully before she decides what to do. (b) (c) CA 9-3 (a) 1. Horne’s inventory should be reported at net realizable value. According to the lower of cost or market rule, market is defined as replacement cost. However, market cannot exceed net realizable value. In this instance, net realizable value is below original cost. 2. The lower of cost or market rule is used to report the inventory in the balance sheet at its future utility value. It also recognizes a decline in the utility of inventory in the income statement in the period in which the decline occurs. (b) Generally, ending inventory would have been higher and cost of goods sold would have been lower had Horne used the LIFO inventory method in a period of declining prices. Inventory quantities increased and LIFO associates the oldest purchase prices with inventory. However, in this instance, there would have been no effect on ending inventory or cost of goods sold had Horne used the LIFO inventory method because Horne’s inventory would have been reported at net realizable value according to the lower of cost or market rule. Net realizable value of the inventory is less than either its average cost or LIFO cost. CA 9-4 (a) The retail inventory method can be employed to estimate retail, wholesale, and manufacturing finished goods inventories. The valuation of inventory under this method is arrived at by reducing the ending inventory at retail to an estimate of the lower of cost or market. The retail value of ending inventory can be computed by (1) taking a physical inventory, or by (2) subtracting net sales and net markdowns from the total retail value of merchandise available for sale (i.e., the sum of beginning inventory at retail, net purchases at retail, and net markups). The reduction of ending inventory at retail to an estimate of the lower of cost or market is accomplished by applying to it an estimated cost ratio arrived at by dividing the retail value of merchandise available for sale as computed in (2) above into the cost of merchandise available for sale (i.e., the sum of beginning inventory, net purchases, and other inventoriable costs). 9-64 CA 9-4 (Continued) (b) Since the retail method is based on an estimated cost ratio involving total merchandise available during the period, its validity depends on the underlying assumption that the merchandise in ending inventory is a representative mixture of all merchandise handled. If this condition does not exist, the cost ratio may not be appropriate for the merchandise in ending inventory and can result in significant error. Where there are a number of inventory subdivisions for which differing rates of markup are maintained, there is no assurance that the ending inventory mix will be representative of the total merchandise handled during the period. In such cases accurate results can be obtained by subclassifications by rate of markup. Seasonal variations in the rate of markup will nullify the ending inventory “representative mix” assumption. Since the estimated cost ratio is based on total merchandise handled during the period, the same rate of markup should prevail throughout the period. Because of seasonal variations it may be necessary to use data for the last six months, quarter, or month to compute a cost ratio that is appropriate for ending inventory. Material quantities of special sale merchandise handled during the period may also bias the result of this method because merchandise data included in arriving at the estimated cost ratio may not be proportionately represented in ending inventory. This condition may be avoided by accumulating special sale merchandise data in separate accounts. Distortion of the ending inventory approximation under this method is often caused by an inadequate system of inventory control. Adequate accounting controls are necessary for the accurate accumulation of the data needed to arrive at a valid cost ratio. Physical controls are equally important because, for interim purposes, this method is usually applied without taking a physical inventory. (c) The advantages of using the retail method as compared to cost methods include the following: 1. Approximate inventory values can be determined without maintaining perpetual inventory records. 2. The preparation of interim financial statements is facilitated. 3. Losses due to fire or other casualty are readily determined. 4. Clerical work in pricing the physical inventory is reduced. 5. The cost of merchandise can be kept confidential in intracompany transfers. (d) The treatments to be accorded net markups and net markdowns must be considered in light of their effects on the estimated cost ratio. If both net markups and net markdowns are used in arriving at the cost ratio, ending inventory will be converted to an estimated average cost figure. Excluding net markdowns will result in the inventory being stated at an estimate of the lower of cost or market. The lower cost ratio arrived at by excluding net markdowns permits the pricing of inventory at an amount that reflects its current utility. The assumption is that net markdowns represent a loss of utility that should be recognized in the period of markdown. Ending inventory is therefore valued on the basis of its revenue-producing potential and may be expected to produce a normal gross profit if sold at prevailing retail prices in the next period. 9-65 CA 9-5 (a) 1. E.A. Poe’s inventoriable cost should include all costs incurred to get the lighting fixtures ready for sale to the customer. It includes not only the purchase price of the fixtures but also the other associated costs incurred on the fixtures up to the time they are ready for sale to the customer, for example, freight-in. 2. No, administrative costs are assumed to expire with the passage of time and not to attach to the product. Furthermore, administrative costs do not relate directly to inventories, but are incurred for the benefit of all functions of the business. (b) 1. The lower of cost or market rule is used for valuing inventories because of the concept of balance sheet conservatism and because the decline in the utility of the inventories below their cost should be recognized as a loss in the current period. 2. The net realizable value less a normal profit margin should be used to value the inventories because market should not be less than net realizable value less a normal profit margin. To carry the inventories at net realizable value less a normal profit margin provides a means of measuring residual usefulness of an inventory expenditure. (c) Poe’s beginning inventories at cost and at retail would be included in the calculation of the cost ratio. Net markdowns would be excluded from the calculation of the cost ratio. This procedure reduces the cost ratio because there is a larger denominator for the cost ratio calculation. Thus, the concept of balance sheet conservatism is being followed and a lower of cost or market valuation is approximated. CA 9-6 (a) Accounting standards require that when a contracted price is in excess of market, as it is in this case (market is $5,000,000 and the contract price is $6,000,000), and it is expected that losses will occur when the purchase is effected, losses should be recognized in the period during which such declines in market prices take place. It would be unethical to ignore recognition of the loss now if a loss is expected to occur when the purchase is effected. If the loss is material, new and continuing shareholders are harmed by nonrecognition of the loss. Walker’s position as an accounting professional also is affected if he accepts a financial report he knows violates GAAP. If the preponderance of the evidence points to a loss when the purchase is effected, the controller should recognize the amount of the loss in the period in which the price decline occurs. In this case the loss is measured at $1,000,000 and recorded as follows: Unrealized Holding Gain or Loss—Income (Purchase Commitments)........................................................................ Estimated Liability on Purchases Commitments....................... 1,000,000 1,000,000 (b) (c) Walker should insist on statement preparation in accordance with GAAP. If Hands will not accept Walker’s position, Walker will have to consider alternative courses of action such as contacting higher-ups at Vineland and assess the consequences of each course of action. 9-66 *CA 9-7 (a) Conventional retail 3. Cost of items transferred in from other departments. 4. Retail value of items transferred in from other departments. 6. Purchase discounts. 8. Cost of beginning inventory. 9. Retail value of beginning inventory. 10. Cost of purchases. 11. Retail value of purchases. 12. Markups. 13. Markup cancellations. (b) LIFO retail 1. Markdowns. 2. Markdown cancellations. 3. Cost of items transferred in from other departments. 4. Retail value of items transferred in from other departments. 6. Purchase discounts. 10. Cost of purchases. 11. Retail value of purchases. 12. Markups. 13. Markup cancellations. (Note to instructor: If the goods broken or stolen are abnormal shrinkage, they are deducted from both the cost and retail columns.) 9-67 FINANCIAL REPORTING PROBLEM (a) Inventories are valued at cost, which is not in excess of current market prices. Product-related inventories are primarily maintained on the first-in, first-out method. Minor amounts of product inventories, including certain cosmetics and commodities are maintained on the last-in, first-out method. The cost of spare part inventories is maintained using the average cost method. Inventories are reported on the balance sheet simply as “inventories” with sub-totals reported for (1) Materials and supplies, (2) Work in process, and (3) Finished goods. In its note describing Cost of Products Sold, P&G indicates that cost of products sold primarily comprises direct materials and supplies consumed in the manufacture of product, as well as manufacturing labor and direct overhead expense necessary to acquire and convert the purchased materials and supplies into finished product. Cost of products sold also includes the cost to distribute products to customers, inbound freight costs, internal transfer costs, warehousing costs and other shipping and handling activity. Shipping and handling costs invoiced to customers are included in net sales. Inventory turnover = Cost of Goods Sold $25,076 = Average Inventory $4,400 + $3,640 2 = 6.24 or approximately 58 days to turn its inventory, which is an improvement relative to 2003 (6.03 or 61 days). (b) (c) (d) Its gross profit percentages for 2004 and 2003 are as follows: 2004 $51,407 25,076 $26,331 51.22% 2003 $43,377 22,141 $21,236 48.96% Net sales Cost of goods sold Gross profit Gross profit percentage P&G had a solid improvement in its Gross profit and Gross profit percentage. Sales in 2004 showed a 18.5% increased, probably due to an improving economy. It appears that P&G has been able to manage its costs to produce better gross margins on these increased sales. 9-68 FINANCIAL STATEMENT ANALYSIS CASE 1 (a) Although no absolute rules can be stated, preferability for LIFO can ordinarily be established if (1) selling prices and revenues have been increasing, whereas costs have lagged, to such a degree that an unrealistic earnings picture is presented, and (2) LIFO has been traditional, such as department stores and industries where a fairly constant “base stock” is present such as refining, chemicals, and glass. Conversely, LIFO would probably not be appropriate: (1) where prices tend to lag behind costs; (2) in situations where specific identification is traditional, such as in the sale of automobiles, farm equipment, art, and antique jewelry; and (3) where unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide. Note that where inventory turnover is high, the difference between inventory methods is usually negligible. In this case, it is impossible to determine what conditions exist, but it seems probable that the characteristics of certain parts of the inventory make LIFO desirable, whereas other parts of the inventory provide higher benefits if FIFO is used. (b) It may provide this information (although it is not required to do so) because it believes that this information tells the reader that both its income and inventory would be higher if FIFO had been used. The LIFO liquidation reduces operating costs because low price goods are matched against current revenue. As a result, operating costs are lower than normal because higher operating costs would have normally been deducted from revenues. It would probably have reported more income if it had been on a FIFO basis. For example, its inventory as of December 31, 2007 was stated at $1,635,040. Its inventory under FIFO would have been $564,960 higher (2007) if FIFO had been used. On the other hand, the LIFO liquidation would not have occurred in 2007 or previous years because FIFO would have been used. Thus, the 2007 reduction in operating costs of $24,000 due to the LIFO liquidation would not have occurred. 9-69 (c) (d) FINANCIAL STATEMENT ANALYSIS CASE 2 (a) There are probably no finished goods because gold is a highly liquid commodity, and so it can be sold as soon as processing is complete. Ore in stockpiles is a noncurrent asset probably because processing takes more than one year. Sales are recorded as follows: Accounts Receivable or Cash Sales Revenue AND Cost of Goods Sold Gold in Process Inventory XXX XXX Income Statement Cost of goods sold Net income Understated Overstated (b) XXX XXX (c) Balance Sheet Inventory Retained earnings Accounts payable Working capital Current ratio Overstated Overstated No effect Overstated Overstated 9-70 COMPARATIVE ANALYSIS CASE (a) Coca-Cola reported inventories of $1,420 million, which represents 4.5% of total assets. PepsiCo reported inventories of $1,541 million, which represents 5.5% of its total assets. Coca-Cola determines the cost of its inventories on the basis of average cost or first-in, first-out (FIFO) methods; its inventories are valued at the lower of cost or market. PepsiCo reported that the cost of 16% of its 2004 inventories was computed using the LIFO method. PepsiCo’s inventories are valued at the lower of cost (computed on the average, FIFO or LIFO method) or market. Coca-Cola classifies and describes its inventories as primarily raw materials and supplies. PepsiCo classifies and describes its inventories as (1) raw materials, (2) work-in-process and (3) finished goods. Inventory turnover ratios and days to sell inventory for 2004: Coca-Cola $7,638 = 5.7 times $1,420 + $1,252 2 365 ÷ 5.7 = 64 days PepsiCo $13,406 = 9.1 times $1,541 + $1,412 2 365 ÷ 9.1 = 40 days (b) (c) (d) A substantial difference between Coca-Cola and PepsiCo exists regarding the inventory turnover and related days to sell inventory. The primary reason is that PepsiCo’s cost of goods sold and related inventories involves food operations as well as beverage cost. This situation is not true for Coca-Cola. Food will have a much higher turnover ratio because food must be turned over quickly or else spoilage will become a major problem. 9-71 RESEARCH CASES CASE 1 Answers will depend on companies selected. CASE 2 (a) CompUSA estimated a retail value of $7.6 million, while one bidder predicted a selling price less than $1 million. The computers experienced an excessively high failure rate, leading to speculation that the units would sell for the value of the parts. The sealed-bid auction had two major rules: (1) all of the units were to be sold together for cash, and (2) the buyer had to haul the units away. Depends on students’ opinions. (b) (c) (d) 9-72 FINANCIAL ACCOUNTING RESEARCH (FARs) (a) ARB 43, Chapter 4. Search Strings: “inventory pricing”, “lower of cost or market”, “state above cost”, “inventory cost method.” (b) ARB 43, Ch 4, Par 3. The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of companies such as oil producers are usually treated as inventory. (c) ARB 43, Ch 4, State 6. As used in the phrase lower of cost or market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) except that: a. Market should not exceed the net realizable value (i.e., estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal); and b. Market should not be less than net realizable value reduced by an allowance for an approximately normal profit margin. (d) ARB 43, Ch4, State 9. Only in exceptional cases may inventories properly be stated above cost. For example, precious metals having a fixed monetary value with no substantial cost of marketing may be stated at such monetary value; any other exceptions must be justifiable by inability to determine appropriate approximate costs, immediate marketability at quoted market price, and the characteristic of unit interchangeability. Where goods are stated above cost this fact should be fully disclosed. ARB 43, Ch 4, Par 16. It is generally recognized that income accrues only at the time of sale, and that gains may not be anticipated by reflecting assets at their current sales prices. For certain articles, however, exceptions are permissible. Inventories of gold and silver, when there is an effective government-controlled market at a fixed monetary value, are ordinarily reflected at selling prices. A similar treatment is not uncommon for inventories representing agricultural, mineral, and other products, units of which are interchangeable and have an immediate marketability at quoted prices and for which appropriate costs may be difficult to obtain. Where such inventories are stated at sales prices, they should of course be reduced by expenditures to be incurred in disposal, and the use of such basis should be fully disclosed in the financial statements. 9-73 PROFESSIONAL SIMULATION Resources Journal Entry Cost of Goods Sold Inventory Note: This entry assumes use of direct method. 4,000 4,000 Explanation Expected selling prices are important in the application of the lower of cost or market rule because they are used in measuring losses of utility in inventory that otherwise would not be recognized until the period during which the inventory is sold. Declines in replacement cost generally are assumed to foreshadow declines in selling prices expected in the next period and hence in the revenue expected upon the sale of the inventory during the next period. However, the use of current replacement cost as “market” is limited to those situations in which it falls between (1) net realizable value (the “ceiling”) and (2) net realizable value less a “normal” profit (the “floor”), both of which depend upon the selling prices expected in the next period for their computation. 9-74 CHAPTER 10 Acquisition and Disposition of Property, Plant, and Equipment ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. Valuation and classification of land, buildings, and equipment. 2. Self-constructed assets, capitalization of overhead. 3. Capitalization of interest. 4. Exchanges of assets Questions 1, 2, 3, 4, 6, 7, 12, 13, 18 5, 8, 20, 21 7, 9, 10, 13, 18 12, 16, 17 2, 3, 4 8, 9, 10, 11, 12 6, 7 Brief Exercises 1 Exercises 1, 2, 3, 4, 5, 13 4, 6, 12 4, 5, 7, 8, 9, 10, 16 3, 11, 16, 17, 18, 19, 20 3, 6, 11, 12, 13, 14, 15, 16 21, 22, 23 3 24, 25 4 1 1, 5, 6, 7 4, 8, 9, 10, 11 1, 11 Problems 1, 2, 3, 5 Concepts for Analysis 1, 6, 7 2 3, 4 5 5. Lump-sum purchases, issuance of stock, deferred payment contracts. 6. Costs subsequent to acquisition. 7. Alternative valuations. 8. Disposition of assets. 12, 14, 15 16, 18, 19, 22 23 24 13 5 14, 15 1 10-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives 1. 2. 3. 4. 5. Describe property, plant, and equipment. Identify the costs to include in initial valuation of property, plant, and equipment. Describe the accounting problems associated with self-constructed assets. Describe the accounting problems associated with interest capitalization. Understand the accounting issues related to acquiring and valuing plant assets. Describe the accounting treatment for costs subsequent to acquisition. Describe the accounting treatment for the disposal of property, plant, and equipment. 2, 3, 4 5, 6, 7, 8, 9, 10, 11, 12 13 14, 15 1 1, 2, 3, 4, 5, 11, 12, 13 4, 5, 6, 11, 12 5, 6, 7, 8, 9, 10 11, 12, 13, 14, 15, 16, 17, 18, 19, 20 21, 22, 23, 24 25 2, 4, 11 1, 2, 3, 4, 5, 6, 11 3 5, 6, 7, 8, 9, 10, 11 3, 4 Brief Exercises Exercises Problems 6. 7. 10-2 ASSIGNMENT CHARACTERISTICS TABLE Item E10-1 E10-2 E10-3 E10-4 E10-5 E10-6 E10-7 E10-8 E10-9 E10-10 E10-11 E10-12 E10-13 E10-14 E10-15 E10-16 E10-17 E10-18 E10-19 E10-20 E10-21 E10-22 E10-23 E10-24 E10-25 P10-1 P10-2 P10-3 P10-4 P10-5 P10-6 P10-7 P10-8 P10-9 P10-10 P10-11 Description Acquisition costs of realty. Acquisition costs of realty. Acquisition costs of trucks. Purchase and self-constructed cost of assets. Treatment of various costs. Correction of improper cost entries. Capitalization of interest. Capitalization of interest. Capitalization of interest. Capitalization of interest. Entries for equipment acquisitions. Entries for asset acquisition, including self-construction. Entries for acquisition of assets. Purchase of equipment with zero-interest-bearing debt. Purchase of computer with zero-interest-bearing debt. Asset acquisitions. Nonmonetary exchange. Nonmonetary exchange. Nonmonetary exchange. Nonmonetary exchange. Analysis of subsequent expenditures. Analysis of subsequent expenditures. Analysis of subsequent expenditures. Entries for disposition of assets. Disposition of assets. Classification of acquisition and other asset costs. Classification of acquisition costs. Classification of land and building costs. Dispositions, including condemnation, demolition, and trade-in. Classification of costs and interest capitalization. Interest during construction. Capitalization of interest, disclosures. Nonmonetary exchanges. Nonmonetary exchanges. Nonmonetary exchanges. Purchases by deferred payment, lump-sum, and nonmonetary exchanges. Acquisition, improvements, and sale of realty. Accounting for self-constructed assets. 10-3 Level of Difficulty Moderate Simple Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Simple Simple Simple Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate Simple Simple Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Time (minutes) 15–20 10–15 10–15 20–25 30–40 15–20 20–25 20–25 20–25 20–25 10–15 15–20 20–25 15–20 15–20 25–35 10–15 20–25 15–20 15–20 20–25 15–20 20–25 20–25 15–20 35–40 40–55 35–45 35–40 20–30 25–35 20–30 35–45 30–40 30–40 35–45 CA10-1 CA10-2 Moderate Moderate 20–25 20–25 ASSIGNMENT CHARACTERISTICS TABLE (Continued) Level of Difficulty Simple Moderate Moderate Simple Moderate Time (minutes) 20–25 30–40 30–40 20–25 20–25 Item CA10-3 CA10-4 CA10-5 CA10-6 CA10-7 Description Capitalization of interest. Capitalization of interest. Nonmonetary exchanges. Costs of acquisition. Cost of land versus buildings—ethics. 10-4 ANSWERS TO QUESTIONS 1. The major characteristics of plant assets are (1) that they are acquired for use in operations and not for resale, (2) that they are long-term in nature and usually subject to depreciation, and (3) that they have physical substance. The company should report the asset at its historical cost of $420,000, not its current value. The main reasons for this position are (1) at the date of acquisition, cost reflects fair value; (2) historical cost involves actual, not hypothetical transactions, and as a result is extremely reliable; and (3) gains and losses should not be anticipated but should be recognized when the asset is sold. (a) The acquisition costs of land may include the purchase or contract price, the broker’s commission, title search and recording fees, assumed taxes or other liabilities, and surveying, demolition (less salvage), and landscaping costs. (b) Machinery and equipment costs may properly include freight and drayage (handling), taxes on purchase, insurance in transit, installation, and expenses of testing and breaking-in. (c) If a building is purchased, all repair charges, alterations, and improvements necessary to ready the building for its intended use should be included as a part of the acquisition cost. Building costs in addition to the amount paid to a contractor may include excavation, permits and licenses, architect’s fees, interest accrued on funds obtained for construction purposes (during construction period only) called avoidable interest, insurance premiums applicable to the construction period, temporary buildings and structures, and property taxes levied on the building during the construction period. 4. (a) (b) (c) (d) (e) (f) (g) (h) (i) 5. Land. Land. Land. Machinery. The only controversy centers on whether fixed overhead should be allocated as a cost to the machinery. Land Improvements, may be depreciated. Building. Building, provided the benefits in terms of information justify the additional cost involved in providing the information (FASB Statement No. 34). Land. Land. 2. 3. (a) The position that no fixed overhead should be capitalized assumes that the construction of plant (fixed) assets will be timed so as not to interfere with normal operations. If this were not the case, the savings anticipated by constructing instead of purchasing plant assets would be nullified by reduced profits on the product that could have been manufactured and sold. Thus, construction of plant assets during periods of low activity will have a minimal effect on the total amount of overhead costs. To capitalize a portion of fixed overhead as an element of the cost of constructed assets would, under these circumstances, reduce the amount assignable to operations and therefore overstate net income in the construction period and understate net income in subsequent periods because of increased depreciation charges. (b) Capitalizing overhead at the same rate as is charged to normal operations is defended by those who believe that all manufacturing overhead serves a dual purpose during plant asset construction periods. Any attempt to assign construction activities less overhead than the normal rate implies costing favors and results in the misstatement of the cost of both plant assets and finished goods. 10-5 Questions Chapter 10 (Continued) 6. (a) Disagree. Organization and promotion expenses should be expensed. (b) Agree. Architect’s fees for plans actually used in construction of the building should be charged to the building account as part of the cost. (c) Agree. FASB Statement No. 34 recommends that avoidable interest or actual interest cost, whichever is lower, be capitalized as part of the cost of acquiring an asset if a significant period of time is required to bring the asset to a condition or location necessary for its intended use. Interest costs are capitalized starting with the first expenditure related to the asset and capitalization would continue until the asset is substantially completed and ready for its intended use. Property taxes during construction should also be charged to the building account. (d) Disagree. Interest revenue is not considered to be related to the interest received as part of the acquisition cost of the building. 7. Since the land for the plant site will be used in the operations of the firm, it is classified as property, plant, and equipment. The other tract is being held for speculation. It is classified as an investment. A common accounting justification is that all costs associated with the construction of an asset, including interest, should be capitalized in order that the costs can be matched to the revenues which the new asset will help generate. Assets that do not qualify for interest capitalization are (1) assets that are in use or ready for their intended use, and (2) assets that are not being used in the earnings activities of the firm. 8. 9. 10. The avoidable interest is determined by multiplying (an) interest rate(s) by the weighted-average amount of accumulated expenditures on qualifying assets. For the portion of weighted-average accumulated expenditures which is less than or equal to any amounts borrowed specifically to finance construction of the assets, the capitalization rate is the specific interest rate incurred. For the portion of weighted-average accumulated expenditures which is greater than specific debt incurred, the interest rate is a weighted average of all other interest rates incurred. The amount of interest to be capitalized is the avoidable interest, or the actual interest incurred, whichever is lower. As indicated in the chapter, an alternative to the specific rate is to use an average borrowing rate. 11. The total interest cost incurred during the period should be disclosed, indicating the portion capitalized and the portion charged to expense. Interest revenue from temporarily invested excess funds should not be offset against interest cost when determining the amount of interest to be capitalized. The interest revenue would be reported in the same manner customarily used to report any other interest revenue. 12. (a) Assets acquired by issuance of capital stock—when property is acquired by issuance of securities such as common stock, the cost of the property is not measured by par or stated value of such stock. If the stock is actively traded on the market, then the market value of the stock is a fair indication of the cost of the property because the market value of the stock is a good measure of the current cash equivalent price. If the market value of the common stock is not determinable, then the market value of the property should be established and used as the basis for recording the asset and issuance of common stock. 10-6 Questions Chapter 10 (Continued) (b) Assets acquired by gift or donation—when assets are acquired in this manner a strict cost concept would dictate that the valuation of the asset be zero. However, in this situation, accountants record the asset at its fair market value. The credit would be made to Contribution Revenue or “donated capital.” Contributions received should be credited to revenue unless the contribution is from a governmental unit. Even in that case, we believe that the credit should be to contribution revenue. (c) Cash discount—when assets are purchased subject to a cash discount, the question of how the discount should be handled occurs. If the discount is taken, it should be considered a reduction in the asset cost. Different viewpoints exist, however, if the discount is not taken. One approach is that the discount must be considered a reduction in the cost of the asset. The rationale for this approach is that the terms of these discounts are so attractive that failure to take the discount must be considered a loss because management is inefficient. The other view is that failure to take the discount should not be considered a loss, because the terms may be unfavorable or the company might not be prudent to take the discount. Presently both methods are employed in practice. The former approach is conceptually correct. (d) Deferred payments—assets should be recorded at the present value of the consideration exchanged between contracting parties at the date of the transaction. In a deferred payment situation, there is an implicit (or explicit) interest cost involved, and the accountant should be careful not to include this amount in the cost of the asset. (e) Lump sum or basket purchase—sometimes a group of assets are acquired for a single lump sum. When a situation such as this exists, the accountant must allocate the total cost among the various assets on the basis of their relative fair market value. (f) Trade or exchange of assets—when one asset is exchanged for another asset, the accountant is faced with several issues in determining the value of the new asset. The basic principle involved is to record the new asset at the fair market value of the new asset or the fair market value of what is given up to acquire the new asset, whichever is more clearly evident. However, the accountant must also be concerned with whether the exchange has commercial substance and whether monetary consideration is involved in the transaction. The commercial substance issue rests on whether the expected cash flows on the assets involved are significantly different. In addition, monetary consideration may affect the amount of gain recognized on the exchange under consideration. 13. The cost of such assets includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembly and installation costs, and costs of conducting trial runs. Costs thus include all expenditures incurred in acquiring the equipment and preparing it for use. When plant assets are purchased subject to cash discounts for prompt payment, the question of how the discount should be handled arises. The appropriate view is that the discount, whether taken or not, is considered a reduction in the cost of the asset. The rationale for this approach is that the real cost of the asset is the cash or cash equivalent price of the asset. Similarly, assets purchased on long-term payment plans should be accounted for at the present value of the consideration exchanged between the contracting parties at the date of the transaction. 14. Fair market value of land Fair market value of building and land $500,000 X $2,200,000 = $440,000 $2,500,000 X Cost = Cost allocated to land $2,000,000 $2,500,000 (Bldg. = X $2,200,000 = $1,760,000) Cost allocated to the land is therefore $440,000. Cost allocated to building is $1,760,000 ($2,200,000 – $440,000). 10-7 Questions Chapter 10 (Continued) 15. $10,000 + $4,058 = $14,058 16. Ordinarily accounting for the exchange of nonmonetary assets should be based on the fair value of the asset given up or the fair value of the asset received, whichever is clearly more evident. Thus any gains and losses on the exchange should be recognized immediately. If the fair value of either asset is not reasonably determinable, the book value of the asset given up is usually used as the basis for recording the nonmonetary exchange. This approach is always employed when the exchange has commercial substance. The general rule is modified when exchanges lack commercial substance. In this case, the enterprise is not considered to have completed the earnings process and therefore a gain should not be recognized. However, a loss should be recognized immediately. In certain situations, gains on an exchange that lacks commercial substance may be recorded when monetary consideration is received. When monetary consideration is received, it is assumed that a portion of the earnings process is completed, and therefore, a partial gain is recognized. 17. In accordance with SFAS No. 153 which requires losses to be recognized immediately, the entry should be: Heavy Duty Truck (new) .................................................................................. Accumulated Depreciation on Heavy Duty Truck....................................... Loss on Disposal of Heavy Duty Truck......................................................... Heavy Duty Truck (old) ............................................................................. Cash.............................................................................................................. *[($30,000 – $6,000) X 49 months/120 months = $9,800] **(Book value $20,200 – $13,000 trade-in = $7,200 loss) 18. Ordinarily such expenditures include (1) the recurring costs of servicing necessary to keep property in good operating condition, (2) cost of renewing structural parts of major plant units, and (3) costs of major overhauling operations which may or may not extend the life beyond original expectation. The first class of expenditures represents the day-to-day service and in general in chargeable to operations as incurred. These expenditures should not be charged to the asset accounts. The second class of expenditures may or may not affect the recorded cost of property. If the asset is rigidly defined as a distinct unit, the renewal of parts does not usually disturb the asset accounts; however, these costs may be capitalized and apportioned over several fiscal periods on some equitable basis. If the property is conceived in terms of structural elements subject to separate replacement, such expenditures should be charged to the plant asset accounts. The third class of expenditures, major overhauls, is usually entered through the asset accounts because replacement of important structural elements is usually involved. Other than maintenance charges mentioned above are those expenditures which add some physical aspect not a part of the asset at the time of its original acquisition. These expenditures may be capitalized in the asset account. An expenditure which extends the life but not the usefulness of the asset is often charged to the accumulated depreciation account. A more appropriate treatment requires retiring from the asset and accumulated depreciation accounts the appropriate amounts (original cost from the asset account ) and to capitalize in the asset account the new cost. Often it is difficult to determine the original cost of the item being replaced. For this reason the replacement or renewal is charged to the accumulated depreciation account. 19. (a) Additions. Additions represent entirely new units or extensions and enlargements of old units. Expenditures for additions are capitalized by charging either old or new asset accounts depending on the nature of the addition. 10-8 39,000 9,800* 7,200** 30,000 26,000 Questions Chapter 10 (Continued) (b) Major Repairs. Expenditures to replace parts or otherwise to restore assets to their previously efficient operating condition are regarded as repairs. To be considered a major repair, several periods must benefit from the expenditure. The cost should be handled as an addition, improvement or replacement depending on the type of major repair made. (c) Improvements. An improvement does not add to existing plant. Expenditures for such betterments represent increases in the quality of existing plant by rearrangements in plant layout or the substitution of improved components for old components so that the facilities have increased productivity, greater capacity, or longer life. The cost of improvement is accounted for by charges to the appropriate property accounts and the elimination of the cost and accumulated depreciation associated with the replaced components, if any. Replacements. Replacements involve an “in kind” substitution of a new asset or part for an old asset or part. Accounting for major replacements requires entries to retire the old asset or part and to record the cost of the new asset or part. Minor replacements are treated as period costs. 20. The cost of installing the machinery should be capitalized, but the extra month’s wages paid to the dismissed employees should not, as this payment did not add any value to the machinery. The extra wages should be charged off immediately as an expense; the wages could be shown as a separate item in the income statement for disclosure purposes. 21. (a) Overhead of a business which builds its own equipment. Some accountants have maintained that the equipment account should be charged only with the additional overhead caused by such construction. However, a more realistic figure for cost of equipment results if the plant asset account is charged for overhead applied on the same basis and at the same rate as used for production (see Question 5). (b) Cash discounts on purchases of equipment. Some accountants treat all cash discounts as financial or other revenue, regardless of whether they arise from the payment of invoices for merchandise or plant assets. Others take the position that only the net amount paid for plant assets should be capitalized on the basis that the discount represents a reduction of price and is not income. The latter position seems more logical in light of the fact that plant assets are purchased for use and not for sale and that they are written off to expense over a long period of time. (c) Interest paid during construction of a building. FASB Statement No. 34 recommends that avoidable or actual interest cost, whichever is lower, be capitalized as part of the cost of acquiring an asset if a significant period of time is required to bring the asset to a condition and location necessary for its intended use. (d) Cost of a safety device installed on a machine. This is an addition to the machine and should be capitalized in the machinery account if material. (e) Freight on equipment returned before installation, for replacement by other equipment of greater capacity. If ordering the first equipment was an error, whether due to judgment or otherwise, the freight should be regarded as a loss. However, if information became available after the order was placed which indicated purchase of the new equipment was more advantageous, the cost of the return freight may be viewed as a necessary cost of the new equipment. 10-9 Questions Chapter 10 (Continued) (f) Cost of moving machinery to a new location. Normally, only the cost of one installation should be capitalized for any piece of equipment. Thus the original installation and any accumulated depreciation relating thereto should be removed from the accounts and the new installation costs (i.e., cost of moving) should be capitalized. In cases where this is not possible and the cost of moving is substantial, it is capitalized and depreciated appropriately over the period during which it makes a contribution to operations. (g) Cost of plywood partitions erected in the remodeling of the office. This is a part of the remodeling cost and may be capitalized if the remodeling itself is of such a nature that it is an addition to the building and not merely a replacement or repair. (h) Replastering of a section of the building. This seems more in the nature of a repair than anything else and as such should be treated as expense. (i) Cost of a new motor for one of the trucks. This probably extends the useful life of the truck. As such it may be viewed as an extraordinary repair and charged against the accumulated depreciation on the truck. The remaining service life of the truck should be estimated and depreciation adjusted to write off the new book value, less salvage, over the remaining useful life. A more appropriate treatment is to remove the cost of the old motor and related depreciation and add the cost of the new motor if possible. 22. The authors believe it is difficult to justify an Allowance for Repairs account under any circumstances, except possibly for interim statements. It is difficult to justify the “Allowance for Repairs” as a liability under any conditions because no past transaction has occurred which will result in future payments to satisfy an existing obligation. Furthermore, as a liability we might ask the question—whom do you owe? Placement in the stockholders’ equity section is also illogical because no addition to the stockholders’ investment has taken place. The only reasonable method of presentation appears to be as a contra account to the asset involved. Even this approach is highly questionable. 23. This approach is not correct since at the very minimum the investor should be aware that certain assets are used in the business which are not reflected in the main body of the financial statements. Either the company should keep these assets on the balance sheet or they should be recorded at salvage value and the resulting gain recognized. In either case, there should be a clear indication that these assets are fully depreciated, but are still being used in the business. 24. Gains or losses on plant asset retirements should be shown in the income statement along with other items that arise from customary business activities. 10-10 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 10-1 $27,000 + $1,400 + $12,200 = $40,600 BRIEF EXERCISE 10-2 Expenditures Date 3/1 6/1 12/31 Amount $1,500,000 1,200,000 3,000,000 $5,700,000 Capitalization Period 10/12 7/12 0 Weighted-Average Accumulated Expenditures $1,250,000 700,000 0 $1,950,000 BRIEF EXERCISE 10-3 Principal 13%, 5-year note 15%, 4-year note $2,000,000 3,500,000 $5,500,000 Interest $260,000 525,000 $785,000 $785,000 $5,500,000 = 14.27% Weighted-average interest rate = BRIEF EXERCISE 10-4 Weighted-Average Accumulated Expenditures $1,000,000 950,000 $1,950,000 10-11 X Interest Rate 12% 14.27% = Avoidable Interest $120,000 135,565 $255,565 BRIEF EXERCISE 10-5 Truck ($80,000 X .63552)............................................... Discount on Notes Payable ......................................... Notes Payable........................................................ 50,842 29,158 80,000 BRIEF EXERCISE 10-6 Recorded Amount $ 51,000 187,000 68,000 $306,000 Fair Value Land Building Equipment $ 60,000 220,000 80,000 $360,000 % of Total 60/360 220/360 80/360 X X X Cost $306,000 $306,000 $306,000 BRIEF EXERCISE 10-7 Land (2,000 X $41) .......................................................... Common Stock (2,000 X $10) ........................... Paid-in Capital in Excess of Par...................... 82,000 20,000 62,000 BRIEF EXERCISE 10-8 Computer ........................................................................... Accumulated Depreciation .......................................... Truck......................................................................... Cash.......................................................................... Gain on Disposal of Truck................................. 3,700 18,000 20,000 1,000 700 10-12 BRIEF EXERCISE 10-9 Computer ($3,700 – $700) ............................................. Accumulated Depreciation........................................... Truck ......................................................................... Cash .......................................................................... 3,000 18,000 20,000 1,000 BRIEF EXERCISE 10-10 Office Equipment............................................................. Accumulated Depreciation........................................... Loss on Disposal of Machine ...................................... Machine.................................................................... Cash .......................................................................... 5,000 3,000 3,000 9,000 2,000 BRIEF EXERCISE 10-11 Truck.................................................................................... Accumulated Depreciation........................................... Loss on Disposal of Truck ........................................... Truck ......................................................................... Cash .......................................................................... 35,000 27,000 1,000 30,000 33,000 BRIEF EXERCISE 10-12 Truck.................................................................................... Accumulated Depreciation........................................... Loss on Disposal of Truck ........................................... Truck ......................................................................... Cash .......................................................................... 35,000 17,000 1,000 20,000 33,000 10-13 BRIEF EXERCISE 10-13 Only cost (b) is expensed when incurred. BRIEF EXERCISE 10-14 (a) Depreciation Expense ($3,000 X 8/12).......................... Accumulated Depreciation.................................... Cash ........................................................................................ Accumulated Depreciation .............................................. Machinery ................................................................... Gain on Disposal of Machinery ........................... 2,000 2,000 10,500 11,000 20,000 1,500 (b) BRIEF EXERCISE 10-15 (a) Depreciation Expense ($3,000 X 8/12).......................... Accumulated Depreciation.................................... Cash ........................................................................................ Loss on Disposal of Machinery...................................... Accumulated Depreciation .............................................. Machinery ................................................................... 2,000 2,000 5,200 3,800 11,000 20,000 (b) 10-14 SOLUTIONS TO EXERCISES EXERCISE 10-1 (15–20 minutes) Land Improvements Item (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p) Land Building $275,000 Other Accounts ($275,000) Notes Payable $ 8,000 7,000 6,000 (1,000) 22,000 250,000 9,000 $ 4,000 11,000 (5,000) 13,000 19,000 14,000 3,000 EXERCISE 10-2 (10–15 minutes) The allocation of costs would be as follows: Land Razing costs Salvage Legal fees Survey Plans Title insurance Liability insurance Construction Interest Land $400,000 42,000 (6,300) 1,850 Building $ 1,500 2,200 68,000 $439,050 900 2,740,000 170,000 $2,981,100 10-15 EXERCISE 10-3 (10–15 minutes) 1. Truck #1........................................................................... 13,900.00 Cash....................................................................... Truck #2........................................................................... 14,727.26* Discount on Notes Payable ...................................... 1,272.74 Cash....................................................................... Notes Payable..................................................... *PV of $14,000 @ 10% for 1 year = $14,000 X .90909 = $12,727.26 $12,727.26 + $2,000.00 = $14,727.26 Truck #3........................................................................... 15,200.00 Cost of Goods Sold..................................................... 12,000.00 Inventory .............................................................. Sales ...................................................................... 13,900.00 2. 2,000.00 14,000.00 3. 12,000.00 15,200.00 [Note to instructor: The selling (retail) price of the computer system appears to be a better gauge of the fair value of the consideration given than is the list price of the truck as a gauge of the fair value of the consideration received (truck). Vehicles are very often sold at a price below the list price.] 4. Truck #4........................................................................... 13,000.00 Common Stock .................................................. Paid-in Capital in Excess of Par................... (1,000 shares X $13 = $13,000) 10,000.00 3,000.00 10-16 EXERCISE 10-4 (20–25 minutes) Purchase Cash paid for equipment, including sales tax of $5,000 Freight and insurance while in transit Cost of moving equipment into place at factory Wage cost for technicians to test equipment Special plumbing fixtures required for new equipment Total cost $105,000 2,000 3,100 4,000 8,000 $122,100 The insurance premium paid during the first year of operation of this equipment should be reported as insurance expense, and not be capitalized. Repair cost incurred in the first year of operations related to this equipment should be reported as repair and maintenance expense, and not be capitalized. Both these costs relate to periods subsequent to purchase. Construction Material and purchased parts ($200,000 X .98) Labor costs Overhead costs Cost of installing equipment Total cost $196,000 190,000 50,000 4,400 $440,400 Note that the cost of material and purchased parts is reduced by the amount of cash discount not taken because the equipment should be reported at its cash equivalent price. The imputed interest on funds used during construction related to stock financing should not be capitalized or expensed. This item is an opportunity cost that is not reported. Profit on self-construction should not be reported. Profit should only be reported when the asset is sold. 10-17 EXERCISE 10-5 (30–40 minutes) Land Abstract fees Architect’s fees Cash paid for land and old building Removal of old building ($20,000 – $5,500) Interest on loans during construction Excavation before construction Machinery purchased Freight on machinery Storage charges caused by noncompletion of building New building Assessment by city Hauling charges—machinery Installation—machinery Landscaping $ 520 $ 87,000 14,500 7,400 19,000 $53,900 1,340 $1,100 —Misc. expense (Discount Lost) —Misc. expense (Loss) 3,170 Buildings M&E Other 2,180 485,000 1,600 620 2,000 5,400 $109,020 $514,570 $57,240 $3,900 —Misc. expense (Loss) EXERCISE 10-6 (15–25 minutes) 1. Land ................................................................................. Buildings......................................................................... Equipment ...................................................................... Cash....................................................................... $700,000 X $150,000 $800,000 $350,000 $800,000 $300,000 $800,000 = $131,250 Land 131,250 306,250 262,500 700,000 $700,000 X = $306,250 Buildings $700,000 X = $262,500 10-18 Equipment EXERCISE 10-6 (Continued) 2. Store Equipment ........................................................... Cash ....................................................................... Note Payable ....................................................... Office Equipment.......................................................... Accounts Payable ($20,000 X .98) ................ Land ................................................................................. Contribution Revenue ...................................... Warehouse...................................................................... Cash ....................................................................... 25,000 2,000 23,000 19,600 19,600 27,000 27,000 600,000 600,000 3. 4. 5. EXERCISE 10-7 (20–25 minutes) (a) Avoidable Interest Weighted-Average Accumulated Expenditures $2,000,000 1,600,000 $3,600,000 X Interest Rate = Avoidable Interest 12% 10.42% $240,000 166,720 $406,720 Principal $1,400,000 1,000,000 $2,400,000 Interest $140,000 110,000 $250,000 Weighted-average interest rate computation 10% short-term loan 11% long-term loan Total Interest Total Principal = $250,000 = 10.42% $2,400,000 10-19 EXERCISE 10-7 (Continued) (b) Construction loan Short-term loan Long-term loan Actual Interest $2,000,000 X 12% = $1,400,000 X 10% = $1,000,000 X 11% = Total $240,000 140,000 110,000 $490,000 Because avoidable interest is lower than actual interest, use avoidable interest. Cost $5,200,000 Interest capitalized 406,720 Total cost $5,606,720 Depreciation Expense = $5,606,720 – $300,000 = $176,891 30 years EXERCISE 10-8 (20–25 minutes) (a) Computation of Weighted-Average Accumulated Expenditures Expenditures Date March 1 June 1 July 1 December 1 Amount $ 360,000 600,000 1,500,000 1,500,000 $3,960,000 X Capitalization Period 10/12 7/12 6/12 1/12 = Weighted-Average Accumulated Expenditures $ 300,000 350,000 750,000 125,000 $1,525,000 Computation of Avoidable Interest Weighted-Average Accumulated Expenditures X $1,525,000 Interest Rate .12 (Construction loan) = Avoidable Interest $183,000 Computation of Actual Interest Actual interest $3,000,000 X 12% $4,000,000 X 13% $1,600,000 X 10% $ 360,000 520,000 160,000 $1,040,000 Note: Use avoidable interest for capitalization purposes because it is lower than actual. 10-20 EXERCISE 10-8 (Continued) (b) Building............................................................................ Interest Expense* ......................................................... Cash ($360,000 + $520,000 + $160,000) ...... *Actual interest for year Less: Amount capitalized Interest expense debit $1,040,000 (183,000) $ 857,000 183,000 857,000 1,040,000 EXERCISE 10-9 (20–25 minutes) (a) Computation of Weighted-Average Accumulated Expenditures Expenditures Date July 31 November 1 Amount $200,000 100,000 X Capitalization Period 3/12 0 = Weighted-Average Accumulated Expenditures $50,000 0 $50,000 Interest revenue Avoidable interest $100,000 X 10% X 3/12 = $2,500 Weighted-Average Accumulated Expenditures X $50,000 Actual Interest $300,000 X 12% X 5/12 = $30,000 X 8% = Interest Rate 12% = Avoidable Interest $6,000 $15,000 2,400 $17,400 $ 6,000 10-21 Interest capitalized EXERCISE 10-9 (Continued) (b) (1) 7/31 Cash .......................................................... Note Payable ................................ Machine .................................................... Trading Securities................................. Cash................................................ (2) 11/1 Cash .......................................................... Interest Revenue ($100,000 X 10% X 3/12) ........ Trading Securities...................... Machine .................................................... Cash................................................ (3) 12/31 Machine .................................................... Interest Expense ($17,400 – $6,000) .............................. Cash ($30,000 X 8%) .................. Interest Payable ($300,000 X 12% X 5/12) ........ 300,000 300,000 200,000 100,000 300,000 102,500 2,500 100,000 100,000 100,000 6,000 11,400 2,400 15,000 EXERCISE 10-10 (20–25 minutes) Situation I. $80,000—The requirement is the amount Oksana Baiul should report as capitalized interest at 12/31/07. The amount of interest eligible for capitalization is Weighted-Average Accumulated Expenditures X Interest Rate = Avoidable Interest Since Oksana Baiul has outstanding debt incurred specifically for the construction project, in an amount greater than the weighted-average accumulated expenditures of $800,000, the interest rate of 10% is used for capitalization purposes. Therefore, the avoidable interest is $80,000, which is less than the actual interest. $800,000 X .10 = $80,000 10-22 EXERCISE 10-10 (Continued) Finally, per FASB Statement No. 62, the interest earned of $250,000 is irrelevant to the question addressed in this problem because such interest earned on the unexpended portion of the loan is not to be offset against the amount eligible for capitalization. Situation II. $ 39,000—The requirement is total interest costs to be capitalized. FASB Statement No. 34 identifies assets which qualify for interest capitalization: assets constructed for an enterprise’s own use and assets intended for sale or lease that are produced as discrete projects. Inventories that are routinely produced in large quantities on a repetitive basis do not qualify for interest capitalization. Therefore, only $30,000 and $9,000 are capitalized. Situation III. $385,000—The requirement is to determine the amount of interest to be capitalized on the financial statements at April 30, 2008. The requirements of the FASB Statement No. 34 are met: (1) expenditures for the asset have been made, (2) activities that are necessary to get the asset ready for its intended use are in progress, and (3) interest cost is being incurred. The amount to be capitalized is determined by applying an interest rate to the weighted-average amount of accumulated expenditures for the asset during the period. Because the $7,000,000 of expenditures incurred for the year ended April 30, 2008, were incurred evenly throughout the year, the weighted-average amount of expenditures for the year is $3,500,000, ($7,000,000 ÷ 2). Therefore, the amount of interest to be capitalized is $385,000 ($3,500,000 X 11%). In any period the total amount of interest cost to be capitalized shall not exceed the total amount of interest cost incurred by the enterprise. (Total interest is $1,100,000). Finally, per FASB Statement No. 62, the interest earned of $650,000 is irrelevant to the question addressed in this problem because such interest earned on the unexpended portion of the loan is not to be offset against the amount eligible for capitalization. 10-23 EXERCISE 10-11 (10–15 minutes) (a) Equipment ...................................................................... Accounts Payable ............................................. Accounts Payable........................................................ Equipment ($10,000 X .02).............................. Cash....................................................................... (b) Equipment (new) .......................................................... Loss on Disposal of Equipment.............................. Accumulated Depreciation ....................................... Accounts Payable ............................................. Equipment (old) ................................................. **Cost Accumulated depreciation Book value Fair market value Loss *Cost ($9,500 + $400) $8,000 6,000 2,000 400 $1,600 $9,900 9,500 9,500 9,908 892 10,800 892 10,800 892 10,800 10,000 10,000 10,000 200 9,800 9,900* 1,600** 6,000 9,500 8,000 Accounts Payable........................................................ Cash....................................................................... (c) Equipment ($10,800 X .91743).................................. Discount on Note Payable ........................................ ($10,800 – $9,908) Note Payable....................................................... Interest Expense .......................................................... Note Payable.................................................................. Discount on Note Payable.............................. Cash....................................................................... 10-24 EXERCISE 10-12 (15–20 minutes) (a) Land .................................................................................. Contribution Revenue ...................................... Land .................................................................................. Buildings ......................................................................... Common Stock ($50 X 13,000) ...................... Additional Paid-in Capital*.............................. 81,000 81,000 180,000 630,000 650,000 160,000 (b) *Since the market value of the stock is not determinable, the market value of the property is used as the basis for recording the asset and issuance of the stock. (c) Machinery........................................................................ Materials ............................................................... Direct Labor ......................................................... Factory Overhead .............................................. *Fixed overhead applied Additional overhead Factory supplies used (60% X $15,000) 40,100 12,500 15,000 12,600* $ 9,000 2,700 900 $12,600 EXERCISE 10-13 (20–25 minutes) 1. Land ................................................................................. Building............................................................................ Machinery and Equipment......................................... Common Stock (12,500 X $100) .................... Paid-in Capital in Excess of Par ................... ($2,100,000 – $1,250,000) 350,000 1,050,000 700,000 1,250,000 850,000 The cost of the property, plant and equipment is $2,100,000 ($12,500 X $168). This cost is allocated based on appraisal values as follows: Land Building Machinery & Equipment $400,000 X $2,100,000 = $350,000 $2,400,000 $1,200,000 X $2,100,000 = $1,050,000 $2,400,000 $800,000 X $2,100,000 = $700,000 $2,400,000 10-25 EXERCISE 10-13 (Continued) 2. Buildings ($105,000 plus $161,000) ....................... Machinery and Equipment ........................................ Land Improvements .................................................... Land ................................................................................. Cash....................................................................... Machinery and Equipment ........................................ Cash....................................................................... ($10,500 plus $254,800, which is 98% of $260,000.) 266,000 135,000 122,000 18,000 541,000 265,300 265,300 3. EXERCISE 10-14 (15–20 minutes) (a) Equipment ...................................................................... Discount on Notes Payable ...................................... Notes Payable..................................................... *PV of $160,000 annuity @ 12% for 5 years ($160,000 X 3.60478) = $576,765 Interest Expense .......................................................... Notes Payable ............................................................... Discount on Notes Payable ........................... Cash....................................................................... *(12% X $576,765) 576,765* 223,235 800,000 (b) 69,212* 160,000 69,212 160,000 Year 1/2/07 12/31/07 12/31/08 Note Payment $160,000 160,000 12% Interest $69,212 58,317 Reduction of Principal $ 90,788 101,683 Balance $576,765 485,977 384,294 10-26 EXERCISE 10-14 (Continued) (c) Interest Expense ........................................................... Notes Payable................................................................ Discount on Notes Payable ............................ Cash ....................................................................... Depreciation Expense................................................. Accumulated Depreciation ............................. *($576,765 ÷ 10) 58,317 160,000 58,317 160,000 57,677* 57,677 (d) EXERCISE 10-15 (15–20 minutes) (a) Equipment....................................................................... 86,861.85* Discount on Notes Payable....................................... 18,138.15 Cash ....................................................................... Notes Payable ..................................................... *PV of $15,000 annuity @ 10% for 5 years ($15,000 X 3.79079) $56,861.85 Down payment 30,000.00 Capitalized value of equipment $86,861.85 Notes Payable................................................................ Interest Expense (see schedule) ............................. Cash ....................................................................... Discount on Notes Payable ............................ 15,000.00 5,686.19 15,000.00 5,686.19 30,000.00 75,000.00 (b) Year 12/31/06 12/31/07 12/31/08 Note Payment $15,000.00 15,000.00 10% Interest $5,686.19 4,754.80 Reduction of Principal $ 9,313.81 10,245.20 Balance $56,861.85 47,548.04 37,302.84 10-27 EXERCISE 10-15 (Continued) (c) Notes Payable ............................................................... Interest Expense .......................................................... Cash....................................................................... Discount on Notes Payable ........................... 15,000.00 4,754.80 15,000.00 4,754.80 EXERCISE 10-16 (25–35 minutes) Hayes Industries Acquisition of Assets 1 and 2 Use Appraised Values to break-out the lump-sum purchase Value on Books 75,000 25,000 Description Machinery Office Equipment Appraisal 90,000 30,000 120,000 Percentage 90/120 30/120 Lump-Sum 100,000 100,000 Machinery .......................................................................... Office Equipment ............................................................ Cash.......................................................................... Acquisition of Asset 3 75,000 25,000 100,000 Use the cash price as a basis for recording the asset with a discount recorded on the note. Machinery .......................................................................... Discount on Notes Payable ($40,000 – $35,900)........ Cash.......................................................................... Notes Payable........................................................ 35,900 4,100 10,000 30,000 10-28 EXERCISE 10-16 (Continued) Acquisition Asset 4 Since the exchange lacks commercial substance, a gain will be recognized in the proportion of cash received ($10,000/$80,000) times the $20,000 gain (FMV of $80,000 minus BV of $60,000). The gain recognized will then be $2,500 with $17,500 of it being unrecognized and used to reduce the basis of the asset acquired. Machinery ($70,000 – $17,500) ................................. Accumulated Depreciation........................................ Cash .................................................................................. Machinery............................................................. Gain on Disposal of Machinery..................... 52,500 40,000 10,000 100,000 2,500 Acquisition of Asset 5 In this case the Office Equipment should be placed on Hayes’s books at the fair market value of the stock. The difference between the stock’s par value and its fair market value should be credited to Additional Paid-in Capital in Excess of Par. Office Equipment.......................................................... Common Stock ................................................... Additional Paid-in Capital ............................... 1,100 800 300 10-29 EXERCISE 10-16 (Continued) Schedule of Weighted-Average Accumulated Expenditures Current Year Capitalization Period 9/12 9/12 5/12 2/12 0/12 Weighted-Average Accumulated Expenditures $112,500 90,000 150,000 80,000 0 $432,500 Date February 1 February 1 June 1 September 1 November 1 Amount $ 150,000 120,000 360,000 480,000 100,000 $1,210,000 Note that the capitalization is only 9 months in this problem. Avoidable Interest Weighted-Average Accumulated Expenditures $432,500 X Interest Rate .12 = Avoidable Interest $51,900 The weighted expenditures are less than the amount of specific borrowing; the specific borrowing rate is used. Land Cost Building Cost 150,000 1,111,900 (1,060,000 + 51,900) Land.................................................................................. 150,000 Building ........................................................................... 1,111,900 Cash....................................................................... Interest Expense................................................ 1,210,000 51,900 10-30 EXERCISE 10-17 (10–15 minutes) Busytown Corporation Machine ($340 + $85)...................................................... Accumulated Depreciation........................................... Loss on Disposal of Machine ...................................... Machine.................................................................... Cash .......................................................................... *Computation of loss: Book value of old machine ($290 – $140) Fair value of old machine Loss on exchange Dick Tracy Business Machine Company Cash ..................................................................................... Inventory ............................................................................ Cost of Goods Sold ........................................................ Sales.......................................................................... Inventory.................................................................. 425 140 65* 290 340 $150 (85) $ 65 340 85 270 425 270 10-31 EXERCISE 10-18 (20–25 minutes) (a) Exchange has commercial substance: Depreciation Expense ................................................ Accumulated Depreciation—Melter ............ ($11,200 – $700 = $10,500; $10,500 ÷ 5 = $2,100; $2,100 X 4/12 = $700) Melter ............................................................................... Accumulated Depreciation—Melter ....................... Gain on Disposal of Plant Assets................ Melter..................................................................... Cash....................................................................... *Cost of old asset Accumulated depreciation ($6,300 + $700) Book value Fair market value of old asset Gain (on disposal of plant asset) **Cash paid Fair market value of old melter Cost of new melter $11,200 (7,000) 4,200 (5,200) $ 1,000 $10,000 5,200 $15,200 700 700 15,200** 7,000 1,000* 11,200 10,000 10-32 EXERCISE 10-18 (Continued) (b) Exchange lacks commercial substance: Depreciation Expense................................................. Accumulated Depreciation—Melter............. Melter................................................................................ Accumulated Depreciation—Melter........................ Gain on Disposal of Plant Assets................. Melter ..................................................................... Cash ....................................................................... **Cash paid Fair market value of old asset Cost of new asset $10,000 5,200 $15,200 700 700 15,200** 7,000 1,000 11,200 10,000 Note that the entries are the same for both (a) and (b). Gain is not deferred because cash boot is greater than 25%, which makes the transaction monetary in nature. 10-33 EXERCISE 10-19 (15–20 minutes) (a) Exchange lacks commercial substance. Carlos Arruza Company: Equipment .................................................................. Accumulated Depreciation ................................... Equipment ....................................................... Cash................................................................... Valuation of equipment Book value of equipment given Fair value of boot given New equipment OR Fair value received Less: Gain deferred New equipment *Fair value of old equipment Book value of old equipment Gain on disposal $15,500 3,500* $12,000 $12,500 (9,000) $ 3,500 12,000 19,000 28,000 3,000 $ 9,000 3,000 $12,000 Note: Cash paid is less than 25%, the transaction is nonmonetary, so the gain is deferred. Tony Lo Bianco Company: Cash ................................................................................... Equipment ........................................................................ Accumulated Depreciation—Equipment................ Loss on Disposal of Plant Assets ............................ Equipment ............................................................. *Computation of loss: Book value of old equipment Fair value of old equipment Loss on disposal of equipment 10-34 3,000 12,500 10,000 2,500* 28,000 $18,000 15,500 $ 2,500 EXERCISE 10-19 (Continued) (b) Exchange has commercial substance Carlos Arruza Company Equipment....................................................................... Accumulated Depreciation—Equipment .............. Equipment ............................................................ Cash ....................................................................... Gain on Disposal of Equipment .................... *Cost of new equipment: Cash paid Fair value of old equipment Cost of new equipment $ 3,000 12,500 $15,500 15,500* 19,000 28,000 3,000 3,500** **Computation of gain on disposal of equipment: Fair value of old equipment Book value of old equipment ($28,000 – $19,000) Gain on disposal of equipment $12,500 9,000 $ 3,500 Tony LoBianco Company Cash .................................................................................. Equipment....................................................................... Accumulated Depreciation—Equipment (Old) ....... Loss on Disposal of Equipment .............................. Equipment ............................................................ *Cost of new equipment: Fair value of equipment Less: Cash received Cost of new equipment $15,500 3,000 $12,500 3,000 12,500* 10,000 2,500** 28,000 **Computation of loss on disposal of equipment: Book value of old equipment ($28,000 – $10,000) Fair value of equipment (Old) Loss on disposal of equipment 10-35 $18,000 15,500 $ 2,500 EXERCISE 10-20 (15–20 minutes) (a) Exchange has commercial substance Automatic Equipment................................................. Accumulated Depreciation—Equipment.............. Gain on Disposal of Equipment ................... Equipment ........................................................... Cash....................................................................... Valuation of equipment Cash Installation cost Market value of used equipment Cost of new equipment Computation of gain Cost of old asset Accumulated depreciation Book value Fair market value of old asset Gain on disposal of equipment (b) Exchange lacks commercial substance Automatic Equipment................................................. Accumulated Depreciation—Equipment.............. Equipment ........................................................... Cash....................................................................... *Basis of new equipment Book value of old equipment Cash paid (including installation costs) Basis of new equipment $42,000 9,100 $51,100 51,100* 20,000 62,000 9,100 $62,000 20,000 42,000 47,800 $ 5,800 $ 8,000 1,100 47,800 $56,900 56,900 20,000 5,800 62,000 9,100 10-36 EXERCISE 10-21 (20–25 minutes) (a) Any addition to plant assets is capitalized because a new asset has been created. This addition increases the service potential of the plant. Expenditures that do not increase the service benefits of the asset are expensed. Painting costs are considered ordinary repairs because they maintain the existing condition of the asset or restore it to normal operating efficiency. The approach to follow is to remove the old book value of the roof and substitute the cost of the new roof. It is assumed that the expenditure increases the future service potential of the asset. Conceptually, the book value of the old electrical system should be removed. However, practically it is often difficult if not impossible to determine this amount. In this case, one of two approaches is followed. One approach is to capitalize the replacement on the theory that sufficient depreciation was taken on the old system to reduce the carrying amount to almost zero. A second approach is to debit accumulated depreciation on the theory that the replacement extends the useful life of the asset and thereby recaptures some or all of the past depreciation. In our present situation, the problem specifically states that the useful life is not extended and therefore debiting Accumulated Depreciation is inappropriate. Thus, this expenditure should be added to the cost of the plant facility. See discussion in (d) above. In this case, because the useful life of the asset has increased, a debit to Accumulated Depreciation would appear to be the most appropriate. (b) (c) (d) (e) 10-37 EXERCISE 10-22 (15–20 minutes) 1/30 Accumulated Depreciation—Buildings............... Loss on Disposal of Plant Assets......................... Buildings............................................................. Cash ..................................................................... *(5% X $132,000 = $6,600; $6,600 X 17 = $112,200) **($132,000 – $112,200) + $5,100 3/10 Cash ($2,900 – $300).................................................. Accumulated Depreciation—Machinery ............. Loss on Disposal of Plant Assets......................... Machinery ........................................................... *(70% X $16,000 = $11,200) **($16,000 – $11,200) + $300 – $2,900 3/20 Machinery...................................................................... Cash ..................................................................... Machinery...................................................................... Accumulated Depreciation—Machinery ............. Loss on Disposal of Plant Assets......................... Machinery ........................................................... Cash ..................................................................... *(60% X $3,500 = $2,100) **($3,500 – $2,100) Building Maintenance and Repairs Expense .... Cash ..................................................................... 8,000 8,000 5,500 2,100* 1,400** 3,500 5,500 2,600 11,200* 2,200** 16,000 112,200* 24,900** 132,000 5,100 5/18 6/23 6,900 6,900 10-38 EXERCISE 10-23 (20–25 minutes) (a) (b) (c) (d) (e) (f) (g) (h) C E, assuming immaterial C C C C C E EXERCISE 10-24 (20–25 minutes) (a) Depreciation Expense (8/12 X $60,000) ............... Accumulated Depreciation—Machine ....... Loss on Disposal of Machine.................................. ($1,300,000 – $400,000) – $430,000 Cash ................................................................................ Accumulated Depreciation—Machine.................. ($360,000 + $40,000) Machine ............................................................... (b) Depreciation Expense (3/12 X $60,000) ............... Accumulated Depreciation—Machine ....... 40,000 40,000 470,000 430,000 400,000 1,300,000 15,000 15,000 Cash ................................................................................ 1,040,000 Accumulated Depreciation—Machine.................. 375,000 ($360,000 + $15,000) Machine ............................................................... Gain on Disposal of Machine ....................... *$1,040,000 – ($1,300,000 – $375,000) 1,300,000 115,000* 10-39 EXERCISE 10-24 (Continued) (c) Depreciation Expense (7/12 X $60,000)............... Accumulated Depreciation—Machine....... Contribution Expense ............................................... Accumulated Depreciation—Machine ................. ($360,000 + $35,000) Machine............................................................... Gain on Disposal of Machine....................... *$1,100,000 – ($1,300,000 – $395,000) 35,000 35,000 1,100,000 395,000 1,300,000 195,000* EXERCISE 10-25 (15–20 minutes) April 1 Cash ........................................................................... Accumulated Depreciation—Building ............. Land.................................................................. Building........................................................... Gain on Disposal of Plant Assets........... *Computation of gain: Book value of land $ 60,000 Book value of buildings ($280,000 – $160,000) 120,000 Book value of land and building 180,000 Cash received 430,000 Gain on disposal $250,000 Aug. 1 Land ............................................................................ Building...................................................................... Cash ................................................................. 90,000 400,000 490,000 430,000 160,000 60,000 280,000 250,000* 10-40 TIME AND PURPOSE OF PROBLEMS Problem 10-1 (Time 35–40 minutes) Purpose—to provide a problem involving the proper classification of costs related to property, plant, and equipment. Property, plant, and equipment must be segregated into land, buildings, leasehold improvements, and machinery and equipment for purposes of the analysis. Such costs as demolition costs, real estate commissions, imputed interest, minor and major repair work, and royalty payments are presented. An excellent problem for reviewing the first part of this chapter. Problem 10-2 (Time 40–55 minutes) Purpose—to provide a problem involving the proper classification of costs related to property, plant, and equipment. Such costs as land, freight and unloading, installation, parking lots, sales and use taxes, and machinery costs must be identified and appropriately classified. An excellent problem for reviewing the first part of this chapter. Problem 10-3 (Time 35–45 minutes) Purpose—to provide a problem involving the proper classification of costs related to land and buildings. Typical transactions involve allocation of the cost of removal of a building, legal fees paid, general expenses, cost of organization, special tax assessments, etc. A good problem for providing a broad perspective as to the types of costs expensed and capitalized. Problem 10-4 (Time 35–40 minutes) Purpose—to provide a problem involving the method of handling the disposition of certain properties. The dispositions include a condemnation, demolition, trade-in, contribution and sale to a stockholder. The problem therefore involves a number of situations and provides a good overview of the accounting treatment accorded property dispositions. Problem 10-5 (Time 20–30 minutes) Purpose—to provide the student with a problem in which schedules must be prepared on the costs of acquiring land and the costs of constructing a building. Interest costs are included. Problem 10-6 (Time 25–35 minutes) Purpose—to provide the student with a problem to determining costs to include in the value of land and plant, including interest capitalization. Problem 10-7 (Time 20–30 minutes) Purpose—to provide the student with a problem to compute capitalized interest and to present disclosures related to capitalized interest. Problem 10-8 (Time 35–45 minutes) Purpose—to provide the student with a problem involving the exchange of machinery. Four different exchange transactions are possible, and journal entries are required for each possible transaction. The exchange transactions cover the receipt and disposition of cash as well as the purchase of a machine from a dealer of machinery. Problem 10-9 (Time 30–40 minutes) Purpose—to provide a problem on the accounting treatment for exchanges of assets that have and do not have commercial substance involving gain situations is highlighted. Problem 10-10 (Time 30–40 minutes) Purpose—to provide the student with another problem involving the exchange of productive assets. This problem is unusual because the size of the boot is greater than 25%. As a result, the entire transaction is monetary in nature and all gains and losses are recognized. Problem 10-11 (Time 35–45 minutes) Purpose—to provide a property, plant, and equipment problem consisting of three transactions that have to be recorded—(1) an asset purchased on a deferred payment contract, (2) a lump sum purchase, and (3) a nonmonetary exchange. 10-41 SOLUTIONS TO PROBLEMS PROBLEM 10-1 (a) Craig Ehlo Company ANALYSIS OF LAND ACCOUNT for 2007 $ 230,000 Balance at January 1, 2007 Land site number 621 Acquisition cost Commission to real estate agent Clearing costs Less: Amounts recovered Total land site number 621 Land site number 622 Land value Building value Demolition cost Total land site number 622 Balance at December 31, 2007 $850,000 51,000 $35,000 13,000 22,000 923,000 300,000 120,000 41,000 461,000 $1,614,000 Craig Ehlo Company ANALYSIS OF BUILDINGS ACCOUNT for 2007 Balance at January 1, 2007 Cost of new building constructed on land site number 622 Construction costs Excavation fees Architectural design fees Building permit fee Balance at December 31, 2007 10-42 $ 890,000 $330,000 38,000 11,000 2,500 381,500 $1,271,500 PROBLEM 10-1 (Continued) Craig Ehlo Company ANALYSIS OF LEASEHOLD IMPROVEMENTS ACCOUNT for 2007 Balance at January 1, 2007 Office space Balance at December 31, 2007 Craig Ehlo Company ANALYSIS OF MACHINERY AND EQUIPMENT ACCOUNT for 2007 Balance at January 1, 2007 Cost of the new machines acquired Invoice price Freight costs Unloading charges Balance at December 31, 2007 (b) $875,000 $ 87,000 3,300 2,400 $660,000 89,000 $749,000 92,700 $967,700 Items in the fact situation which were not used to determine the answer to (a) above are as follows: 1. Interest imputed on common stock financing is not permitted by FASB Statement No. 34 and thus does not appear in any financial statement. Land site number 623, which was acquired for $650,000, should be included in Ehlo’s balance sheet as land held for resale (investment section). Royalty payments of $17,500 should be included as a normal operating expense in Ehlo’s income statement. 2. 3. 10-43 PROBLEM 10-2 (a) Spud Webb Corporation ANALYSIS OF LAND ACCOUNT 2007 Balance at January 1, 2007 Plant facility acquired from Ken Norman Company— portion of fair value allocated to land (Schedule 1) Balance at December 31, 2007 Spud Webb Corporation ANALYSIS OF LAND IMPROVEMENTS ACCOUNT 2007 Balance at January 1, 2007 Parking lots, streets, and sidewalks Balance at December 31, 2007 Spud Webb Corporation ANALYSIS OF BUILDINGS ACCOUNT 2007 Balance at January 1, 2007 Plant facility acquired from Ken Norman Company— portion of fair value allocated to building (Schedule 1) Balance at December 31, 2007 $1,100,000 $140,000 95,000 $235,000 $300,000 185,000 $485,000 555,000 $1,655,000 10-44 PROBLEM 10-2 (Continued) Spud Webb Corporation ANALYSIS OF MACHINERY AND EQUIPMENT ACCOUNT 2007 Balance at January 1, 2007 Cost of new machinery and equipment acquired Invoice price Freight and unloading costs Sales taxes Installation costs $ 960,000 $400,000 13,000 20,000 26,000 459,000 $1,419,000 Deduct cost of machines disposed of Machine scrapped June 30, 2007 Machine sold July 1, 2007 Balance at December 31, 2007 $ 80,000* 44,000* 124,000 $1,295,000 *(The accumulated depreciation account can be ignored for this part of the problem.) 10-45 PROBLEM 10-2 (Continued) Schedule 1 Computation of Fair Value of Plant Facility Acquired from Ken Norman Company and Allocation to Land and Building 20,000 shares of Webb common stock at $37 quoted market price on date of exchange (20,000 X $37) Allocation to land and building accounts in proportion to appraised values at the exchange date: Percentage of total 25 75 100 $185,000 555,000 $740,000 $740,000 Amount Land Building Total Land Building Total (b) $230,000 690,000 $920,000 ($740,000 X 25%) ($740,000 X 75%) Items in the fact situation that were not used to determine the answer to (a) above, are as follows: 1. The tract of land, which was acquired for $150,000 as a potential future building site, should be included in Webb’s balance sheet as an investment in land. The $110,000 and $320,000 book values respective to the land and building carried on Ken Norman’s books at the exchange date are not used by Webb. The $12,080 loss (Schedule 2) incurred on the scrapping of a machine on June 30, 2007, should be included in the other expenses and losses section in Webb’s income statement. The $67,920 accumulated depreciation (Schedule 3) should be deducted from the accumulated depreciation—machinery and equipment account in Webb’s balance sheet. 10-46 2. 3. PROBLEM 10-2 (Continued) 4. The $3,000 loss on sale of a machine on July 1, 2007 (Schedule 4) should be included in the other expenses and losses section of Webb’s income statement. The $21,000 accumulated depreciation (Schedule 4) should be deducted from the accumulated depreciation—machinery and equipment account in Webb’s balance sheet. Schedule 2 Loss on Scrapping of Machine June 30, 2007 Cost, January 1, 1999 Accumulated depreciation (double-declining-balance method, 10-year life) January 1, 1999, to June 30, 2007 (Schedule 3) Asset book value June 30, 2007 Loss on scrapping of machine $80,000 67,920 $12,080 $12,080 10-47 PROBLEM 10-2 (Continued) Schedule 3 Accumulated Depreciation Using Double-Declining-Balance Method June 30, 2007 (Double-declining-balance rate is 20%) Book Value at Beginning of Year $80,000 64,000 51,200 40,960 32,768 26,214 20,971 16,777 13,422 Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 (6 months) Depreciation Expense $16,000 12,800 10,240 8,192 6,554 5,243 4,194 3,355 1,342 Accumulated Depreciation $16,000 28,800 39,040 47,232 53,786 59,029 63,223 66,578 67,920 Schedule 4 Loss on Sale of Machine July 1, 2007 Cost, January 1, 2004 Depreciation (straight-line method, salvage value of $2,000, 7-year life) January 1, 2004, to July 1, 2007 [31/2 years ($44,000 – $2,000) ÷ 7] Asset book value July 1, 2007 Asset book value Proceeds from sale Loss on sale $44,000 (21,000) $23,000 $23,000 (20,000) $ 3,000 10-48 PROBLEM 10-3 (a) 1. Land (Schedule A) .................................................. Building (Schedule B)............................................ Insurance Expense (6 months X $95)............... Prepaid Insurance (16 months X $95) .............. Organization Expense ........................................... Retained Earnings .................................................. Salary Expense ........................................................ Land and Building ........................................ Additional Paid-in Capital .......................... (800 shares X $7) Schedule A Amount Consists of: Acquisition Cost ($80,000 + [800 X $107] Removal of Old Building Legal Fees (Examination of title) Special Tax Assessment Total Schedule B Amount Consists of: Legal Fees (Construction contract) Construction Costs (First payment) Construction Costs (Second payment) Insurance (2 months) ([2,280 ÷ 24] = $95 X 2 = $190) Plant Superintendent’s Salary Construction Costs (Final payment) Total 2. Land and Building................................................... Depreciation Expense................................. Accumulated Depreciation—Building ...... 10-49 180,700 146,250 570 1,520 610 43,800 32,100 399,950 5,600 $165,600 9,800 1,300 4,000 $180,700 $ 1,860 60,000 40,000 190 4,200 40,000 $146,250 4,000 2,537 1,463 PROBLEM 10-3 (Continued) Schedule C Depreciation taken Depreciation that should be taken (1% X $146,250) Depreciation adjustment (b) Plant, Property, and Equipment: Land Building Less: Accumulated depreciation Total $ 4,000 (1,463) $ 2,537 $180,700 $146,250 1,463 144,787 $325,487 10-50 PROBLEM 10-4 The following accounting treatment appears appropriate for these items: Land—The loss on the condemnation of the land of $9,000 ($40,000 – $31,000) should be reported as an extraordinary item on the income statement. If condemnations are either usual or recurring, then an ordinary or unusual classification is more appropriate. The $35,000 land purchase has no income statement effect. Building—There is no recognized gain or loss on the demolition of the building. The entire purchase cost ($15,000), decreased by the demolition proceeds ($3,600), is allocated to land. Warehouse—The gain on the destruction of the warehouse should be reported as an extraordinary item, assuming that it is unusual and infrequent. The gain is computed as follows: Insurance proceeds Deduct: Cost Less: Accumulated depreciation Realized gain $74,000 $70,000 11,000 59,000 $15,000 Some contend that a portion of this gain should be deferred because the proceeds are reinvested in similar assets. We do not believe such an approach should be permitted. Deferral of the gain in this situation is not permitted under GAAP. Machine—The recognized gain on the transaction would be computed as follows: Fair market value of old machine Deduct: Book value of old machine Cost Less: Accumulated depreciation Total gain Total gain recognized = $2,400 X $7,200 $8,000 3,200 4,800 $2,400 $900 $900 + $6,300 = $300 The gain deferred is $2,100 ($2,400 – $300) 10-51 PROBLEM 10-4 (Continued) This gain would probably be reported in other revenues and gains. It might be reported as an unusual item if the company believes that such a situation occurs infrequently and if material. The cost of the new machine would be capitalized at $4,200. Fair market value of new machine Less: Gain deferred ($2,400 – $300) Cost of new machine $6,300 2,100 $4,200 Furniture—The contribution of the furniture would be reported as a contribution expense of $3,100 with a related gain on disposition of furniture of $950: $3,100 – ($10,000 – $7,850). The contribution expense and the related gain may be netted, if desired. Automobile—The loss on sale of the automobile of $1,580: [$2,960 – ($8,000 – $3,460)] should probably be reported in the other expenses or losses section. It might be reported as an unusual item if the company believes that such a situation occurs infrequently. 10-52 PROBLEM 10-5 (a) George Solti Corporation Cost of Land (Site #101) As of September 30, 2008 $600,000 36,000 6,000 18,000 54,000 $714,000 Cost of land and old building Real estate broker’s commission Legal fees Title insurance Removal of old building Cost of land (b) George Solti Corporation Cost of Building As of September 30, 2008 Fixed construction contract price Plans, specifications, and blueprints Architects’ fees Interest capitalized during 2007 (Schedule 1) Interest capitalized during 2008 (Schedule 2) Cost of building Schedule 1 Interest Capitalized During 2007 and 2008 Weighted-average accumulated construction expenditures 2007: 2008: $1,200,000 $1,900,000 $3,000,000 21,000 82,000 120,000 190,000 $3,413,000 X X X 10-53 Interest rate 10% 10% = = = Interest to be capitalized $120,000 $190,000 PROBLEM 10-6 Interest Capitalization Balance in the Land Account Purchase Price Surveying Costs Title Insurance Policy Demolition Costs Salvage Total Land Cost $142,000 2,000 4,000 3,000 (1,000) $150,000 Expenditures (2005) Date 1-Dec 1-Dec 1-Dec Amount $150,000 30,000 3,000 $183,000 Fraction 1/12 1/12 1/12 Weighted—Average Accumulated Expenditures $12,500 2,500 250 $15,250 Interest Capitalized for 2005 Weighted—Average Accumulated Expenditures $15,250 Interest Rate 0.08 Amount Capitalizable $1,220 Interest charged to Interest Expense [($600,000 X .08 X 1/12) – $1,220] $2,780 10-54 PROBLEM 10-6 (Continued) Expenditures (2006) Date 1-Jan 1-Jan 1-Mar 1-May 1-Jul Amount $183,000 1,220 240,000 360,000 60,000 $844,220 Fraction 6/12 6/12 4/12 2/12 0 Weighted Expenditure $ 91,500 610 80,000 60,000 0 $232,110 Interest Capitalized for 2006 Weighted Expenditure $232,110 Interest Rate 0.08 Amount Capitalizable $18,568.80 Interest charged to Interest Expense [($600,000 X .08) – $18,568.80] (a) (b) (c) Balance in Land Account—2005 and 2006 Balance in Building—2005 Balance in Building—2006 Balance in Interest Expense—2005 Balance in Interest Expense—2006 $29,431.20 150,000.00 34,220.00* 712,788.80** 2,780.00 29,431.20 *$30,000 + $3,000 + $1,220 **$34,220 + $240,000 + $360,000 + $60,000 + $18,568.80 10-55 PROBLEM 10-7 (a) Computation of Weighted-Average Accumulated Expenditures Expenditures Date July 30, 2007 January 30, 2008 May 30, 2008 Amount $1,200,000 1,500,000 1,300,000 $4,000,000 Capitalization Weighted-Average X Period = Accumulated Expenditures 10/12 4/12 0 $1,000,000 500,000 0 $1,500,000 (b) Weighted-Average Accumulated Expenditures $1,500,000 Weighted-Average Interest Rate X 13%* = Avoidable interest $195,000 Loans Outstanding During Construction Period Principal *14.5% five-year note 12% ten-year bond $2,000,000 3,000,000 $5,000,000 $650,000 $5,000,000 Actual Interest $290,000 360,000 $650,000 Total interest Total principal (c) (1) and (2) = = 13% (weighted-average rate) Total actual interest cost Total interest capitalized Total interest expensed $650,000 $195,000 $455,000 10-56 PROBLEM 10-8 1. Susquehanna Corporation Cash.................................................................................... Machinery.......................................................................... Accumulated Depreciation.......................................... Loss on Exchange of Machinery............................... Machinery ................................................................ *Computation of loss: Book value Fair value Loss $110,000 (92,000) $ 18,000 23,000 69,000 50,000 18,000* 160,000 Choctaw Company Machinery.......................................................................... Accumulated Depreciation.......................................... Loss on Exchange of Machinery............................... Cash .......................................................................... Machinery ................................................................ *Computation of loss: Book value Fair value Loss 2. $ 75,000 (69,000) $ 6,000 92,000 45,000 6,000* 23,000 120,000 Susquehanna Corporation Machinery.......................................................................... Accumulated Depreciation.......................................... Loss on Exchange of Machinery............................... Machinery ................................................................ Powhatan Company Machinery ($92,000 – $16,000) ................................... Accumulated Depreciation.......................................... Machinery ................................................................ *Computation of gain deferred: Fair value $92,000 Book value (76,000) Gain deferred $16,000 10-57 92,000 50,000 18,000 160,000 76,000* 71,000 147,000 PROBLEM 10-8 (Continued) 3. Susquehanna Corporation Machinery ........................................................................ Accumulated Depreciation ........................................ Loss on Exchange of machinery............................. Machinery............................................................... Cash......................................................................... Shawnee Company Machinery ........................................................................ Accumulated Depreciation ........................................ Cash .................................................................................. Machinery............................................................... Gain on Exchange of Machinery .................... *Fair value Book value Gain $100,000 (85,000) $ 15,000 100,000 50,000 18,000 160,000 8,000 92,000 75,000 8,000 160,000 15,000* Because the exchange has commercial substance, the entire gain should be recognized. 4. Susquehanna Corporation Machinery ........................................................................ Accumulated Depreciation ........................................ Loss on Exchange of machinery............................. Machinery............................................................... Cash......................................................................... Seminole Company Cash .................................................................................. Used Machine Inventory............................................. Sales ........................................................................ 185,000 50,000 18,000 160,000 93,000 93,000 92,000 185,000 Cost of Goods Sold...................................................... 130,000 Inventory ................................................................ 130,000 10-58 PROBLEM 10-9 (a) Exchange has commercial substance: Arna Inc.’s Books Asset B ............................................................................ Accumulated Depreciation—Asset A .................... Asset A ................................................................... Gain on Disposal of Plant Assets ($60,000 – [$96,000 – $45,000]).................... Cash ........................................................................ Bontemps Inc.’s Books Cash.................................................................................. Asset A ............................................................................ Accumulated Depreciation—Asset B .................... Asset B ................................................................... Gain on Disposal of Plant Assets ($75,000 – [$110,000 – $52,000]) ................. 15,000 60,000 52,000 110,000 17,000 75,000 45,000 96,000 9,000 15,000 (b) Exchange lacks commercial substance: Arna Inc.’s Books Asset B ($75,000 – $9,000) ........................................ Accumulated Depreciation—Asset A .................... Asset A ................................................................... Cash ........................................................................ *Computation of gain deferred: Fair value Book value Gain deferred 66,000* 45,000 96,000 15,000 $60,000 (51,000) $ 9,000 10-59 PROBLEM 10-9 (Continued) Bontemps Inc.’s Books Cash ................................................................................... 15,000 Asset A.............................................................................. 46,400** Accumulated Depreciation—Asset B ..................... 52,000 Asset B..................................................................... Gain on Disposal of Plant Assets ................... Computation of total gain: Fair value of Asset B Book value of Asset B Total gain *Gain recognized = 110,000 3,400* $75,000 (58,000) $17,000 $15,000 X $17,000 = $3,400 $15,000 + $60,000 $60,000 13,600 $46,400 **Fair value of asset acquired Less: Gain deferred ($17,000 – $3,400) Basis of Asset A OR Book value of Asset B Portion of book value sold $58,000 (11,600) $46,400 Note to instructor: This illustrates the exception to no gain or loss recognition for exchanges that lack commercial substance. Although it would be rare for an exchange to lack commercial substance when cash is received, a gain can be recognized based on the proportion of cash received to the overall fair value (para. 22, APB 29—which was not modified by FAS No. 153) 10-60 PROBLEM 10-10 (a) Has Commercial Substance (1) Garrison Construction Equipment ($72,000 + $118,000).......................... 190,000 Accumulated Depreciation—Equipment .......... 60,000 Loss on Disposal of Plant Assets....................... 8,000* Equipment ........................................................ Cash.................................................................... *Computation of loss: Book value of old crane ($140,000 – $60,000) $80,000 Fair value of old crane 72,000 Loss on disposal of plant assets $ 8,000 Keillor Manufacturing Cash .............................................................................. 118,000 Equipment Inventory............................................... 72,000 Sales................................................................... Cost of Goods Sold ................................................. 165,000 Equipment Inventory .................................... (b) 140,000 118,000 (2) 190,000 165,000 Lacks Commercial Substance (1) Garrison Construction should record the same entry as in part (a) above, since the exchange resulted in a loss. (2) Keillor should record the same entry as in part (a) above. No gain is deferred because we are assuming that Garrison is a customer. In addition, because the cash involved is greater than 25% of the value of the exchange, the entire transaction is considered a monetary transaction and a gain is recognized. Has Commercial Substance (1) Garrison Construction Equipment ($98,000 + $92,000) ............................ 190,000 Accumulated Depreciation—Equipment .......... 60,000 Equipment ........................................................ Cash.................................................................... Gain on Disposal of Plant Assets............. *Computation of gain: Book value of old crane ($140,000 – $60,000) $80,000 Fair value of old crane 98,000 Gain on disposal of plant assets $18,000 10-61 (c) 140,000 92,000 18,000* PROBLEM 10-10 (Continued) Keillor Manufacturing Cash ........................................................................... Equipment Inventory ............................................ Sales ................................................................ Cost of Goods Sold............................................... Equipment Inventory.................................. (d) (1) Garrison Construction Equipment ................................................................ Accumulated Depreciation—Equipment........ Cash ................................................................. Equipment...................................................... Gain on Disposal of Plant Assets .......... (2) 92,000 98,000 190,000 165,000 165,000 190,000 60,000 103,000 140,000 7,000* *[Fair Value–Old ($87,000) – Book Value–Old ($80,000)] Note: Cash involved is greater than 25% of the value of the exchange, so the gain is not deferred. Keillor Manufacturing Cash ........................................................................... Equipment Inventory ............................................ Sales ................................................................ Cost of Goods Sold............................................... Equipment Inventory.................................. Same reasons as cited in (b) (2) above. Note: Even though the exchange lacks commercial substance, cash paid exceeds 25% of total fair value so the transaction is treated as a monetary exchange and recorded at fair value (EITF 86-29). Note that with this much cash involved, it is unlikely that the exchange would lack commercial substance. (2) 103,000 87,000 190,000 165,000 165,000 10-62 PROBLEM 10-11 (a) The major characteristics of plant assets, such as land, buildings, and equipment, that differentiate them from other types of assets are presented below. 1. Plant assets are acquired for use in the regular operations of the enterprise and are not for resale. 2. Property, plant, and equipment possess physical substance or existence and are thus differentiated from intangible assets such as patents and goodwill. Unlike other assets that possess physical substance (i.e., raw material), property, plant, and equipment do not physically become part of the product held for resale. 3. These assets are durable and long-term in nature and are usually subject to depreciation. Transaction 1. To properly reflect cost, assets purchased on deferred payment contracts should be accounted for at the present value of the consideration exchanged between the contracting parties at the date of the consideration. When no interest rate is stated, interest must be imputed at a rate that approximates the rate that would be negotiated in an arm’s-length transaction. In addition, all costs necessary to ready the asset for its intended use are considered to be costs of the asset. Asset cost = Present value of the note + Freight + Installation $20,000 = × 3.17 + $425 + $500 4 = $15,850 + 925 = $16,775 (b) 10-63 PROBLEM 10-11 (Continued) Transaction 2. The lump-sum purchase of a group of assets should be accounted for by allocating the total cost among the various assets on the basis of their relative fair market values. The $8,000 of interest expense incurred for financing the purchase is a period cost and is not a factor in determining asset cost. Inventory $210,000 X ($ 50,000/$250,000) = $42,000 Land $210,000 X ($ 80,000/$250,000) = $67,200 Building $210,000 X ($120,000/$250,000) = $100,800 Transaction 3. The cost of a nonmonetary asset acquired in exchange that has commercial substance should be recorded at the fair value of the asset given up plus any cash paid. Furthermore, any gain on exchange is also recognized. Fair value of trucks Cash paid Cost of land (c) 1. $46,000 19,000 $65,000 2. 3. A building purchased for speculative purposes is not a plant asset as it is not being used in normal operations. The building is more appropriately classified as an investment. The two-year insurance policy covering plant equipment is not a plant asset as it is not long-term in nature, not subject to depreciation, and has no physical substance. This policy is more appropriately classified as a current asset (prepaid insurance). The rights for the exclusive use of a process used in the manufacture of ballet shoes are not plant assets as they have no physical substance. The rights should be classified as an intangible asset. 10-64 TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 10-1 (Time 20–25 minutes) Purpose—the student discusses which expenditures related to purchasing land, constructing a building, and adding to the building should be capitalized and how each should be depreciated. When the land and building are sold, the student discusses how the book value is determined and how a gain would be reported. CA 10-2 (Time 20–25 minutes) Purpose—to provide the student with a situation involving the proper allocation of costs to selfconstructed machinery. As part of this case, the student is required to discuss the propriety of including overhead costs in the construction costs. Finally, the proper accounting treatment accorded the development costs associated with the construction of a new machine must be evaluated. CA 10-3 (Time 20–25 minutes) Purpose—to provide the student with a problem involving the proper accounting treatment for interest costs. The student is required to assess the advantages and disadvantages of capitalizing interest. In addition, this problem should provide you with an opportunity to discuss the FASB pronouncement in this area. CA 10-4 (Time 30–40 minutes) Purpose—to provide the student a context to determine capitalization of interest and to explain in a memorandum the conceptual basis for interest capitalization. CA 10-5 (Time 30–40 minutes) Purpose—to provide the student with a context in which to examine differences in accounting for exchanges that have or lack commercial substance. CA 10-6 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the proper accounting treatment involving incidental costs associated with the purchase of a machine. The student must be able to defend why certain costs might be capitalized even though this valuation has no relationship to net realizable value. In addition, the costs may be charged off immediately for tax purposes and the student is required to analyze why these costs may still be capitalized for book purposes. CA 10-7 (Time 20–25 minutes) Purpose—to provide the student with a case involving allocation of costs between land and buildings, including ethical issues. 10-65 SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 10-1 (a) Expenditures should be capitalized when they benefit future periods. The cost to acquire the land should be capitalized and classified as land, a nondepreciable asset. Since tearing down the small factory is readying the land for its intended use, its cost is part of the cost of the land and should be capitalized and classified as land. As a result, this cost will not be depreciated as it would if it were classified with the capitalizable cost of the building. Since rock blasting and removal is required for the specific purpose of erecting the building, these costs are part of the cost of the building and should be capitalized and classified with the capitalizable cost of the building. This cost should be depreciated over the estimated useful life of the building. The road and the parking lot are land improvements, and these costs should be capitalized and classified separately as a land improvements. These costs should be depreciated over their estimated useful lives. The added four stories is an addition, and its cost should be capitalized and classified with the capitalizable cost of the building. This cost should be depreciated over the remaining life of the original office building because that life is shorter than the estimated useful life of the addition. (b) A gain should be recognized on the sale of the land and building because income is realized whenever the earning process has been completed and a sale has taken place. The net book value at the date of sale would be composed of the capitalized cost of the land, the land improvement, and the building, as determined above, less the accumulated depreciation on the land improvement and the building. The excess of the proceeds received from the sale over the net book value at the date of sale would be accounted for as a gain in continuing operations in the income statement. CA 10-2 (a) Materials and direct labor used in the construction of the equipment definitely should be charged to the equipment account. It should be emphasized that no gain on self-construction should be recorded because such an approach violates the historical cost principle. The controversy centers on the assignment of indirect costs, called overhead or burden, consisting of power, heat, light, insurance, property taxes on factory buildings, etc. The suggested approaches are discussed below. (b) 1. Many believe that only the variable overhead costs that increase as a result of the construction should be assigned to the cost of the asset. This approach assumes that the company will have the same fixed costs regardless of whether the company constructs the asset or not, so to charge a portion of the fixed overhead costs to the equipment will usually decrease current expenses and consequently overstate income of the current period. Therefore, only the incremental costs should be charged. 2. Proponents of alternative (2) argue that such assets should be given the same treatment as inventory items and that all costs should be allocated thereto just as if saleable goods were being produced. They state that no special favor should be granted in the allocation of any cost, as long as sufficient facts are available to enable the allocation to be made. They argue that allocation of overhead to fixed assets is similar to allocation to joint products and byproducts, and should be made at regular rates. Of course, no item should be capitalized at an amount greater than that prevailing in the market. 10-66 CA 10-2 (Continued) (c) It could be argued that because costs of development are usually higher on the first few units, the additional costs of $273,000 should be allocated to all four machines. If these costs are due to inefficiency and not development costs, the additional costs should be expensed. CA 10-3 Three approaches have been suggested to account for actual interest incurred in financing the construction or acquisition of property, plant, and equipment. One approach is to capitalize no interest during construction. Under this approach interest is considered a cost of financing and not a cost of construction. It is contended that if the company had used stock financing rather than debt financing, this expense would not have developed. The major arguments against this approach are that an implicit interest cost is associated with the use of cash regardless of the source. A second approach is to capitalize the actual interest costs. This approach relies on the historical cost concept that only actual transactions are recorded. It is argued that interest incurred is as much a cost of acquiring the asset as the cost of the materials, labor, and other resources used. As a result, a company that uses debt financing will have an asset of higher cost than an enterprise that uses stock financing. The results achieved by this approach are held to be unsatisfactory by some because the cost of an asset should be the same whether cash, debt financing, or stock financing is employed. A third approach is to charge construction with all costs of funds employed, whether identifiable or not. This approach is an economic cost approach that maintains that one part of the cost of construction is the cost of financing whether by debt, cash, or stock financing. An asset should be charged with all costs necessary to get it ready for its intended use. Interest, whether actual or imputed, is a cost of building, just as labor, materials, and overhead are costs. A major criticism of this approach is that imputation of a cost of equity capital is subjective and outside the framework of a historical cost system. FASB Statement No. 34 requires that the lower of actual or avoidable interest cost be capitalized as part of the cost of acquiring an asset if a significant period of time is required to bring the asset to a condition or location necessary for its intended use. Interest costs would be capitalized (provided interest costs are being incurred) starting with the first expenditure related to the asset and would continue until the asset is substantially completed and ready for its intended use. Capitalization should occur only if the benefits exceed the costs. 10-67 CA 10-4 To: From: Date: Subject: Dee Pettepiece, President Good Student, Manager of Accounting January 15, 2006 Capitalization of avoidable interest on the warehouse construction project I am writing in response to your questions about the capitalized interest costs for the warehouse construction project. This brief explanation of my calculations should facilitate your understanding of these costs. Generally, the accounting profession does not allow accrued interest to be capitalized along with an asset’s cost. However, the FASB made an exception for interest costs incurred during construction. In order to qualify for this treatment, the constructed asset must require a period of time to become ready for its intended use. Because interest capitalization is allowed in special circumstances only, the company must be especially careful to capitalize only that interest which is associated with the construction itself. Thus, the FASB issued a standard indicating how much interest may be associated with the con struction, i.e., the lower of actual or avoidable interest. On the surface, this standard seems simple. Actual interest incurred during the construction period equals all interest which accrued on any debt outstanding during that period. Avoidable interest equals the amount of interest which would not have been incurred if the construction project had not been undertaken. The amount of interest capitalized is the smaller of the two. To determine the amount capitalized, we must calculate both the actual and the avoidable interest during 2005. Actual interest is computed by applying the interest rates of 12%, 10%, and 11% to their related debt. Thus, total actual interest for this period is $600,000 (see Schedule #1). 10-68 CA 10-4 (Continued) Calculations for avoidable interest are more complex. First, interest can be capitalized only on the weighted-average amount of accumulated expenditures. Although total costs amounted to $6,200,000 for the project, an average of only $4,000,000 was outstanding during the period of construction. Second, of the total $5,400,000 debt outstanding during this period, only 2,000,000 of it can be associated with the actual construction project. Therefore, rather than arbitrarily choose the interest rate for one of the other loans, we must calculate the weighted-average interest rate. This rate is the ratio of accrued interest on the other loans to the total amount of their principal. For the $2,000,000 balance of weighted-average accumulated expenditures, this interest rate equals 10.59% (see Schedule #2). Third, we compute our avoidable interest as follows: calculate the interest on the loan directly associated with the construction. Apply the weightedaverage interest rate to the remainder of the weighted-average accumulated expenditure. Now, add these products. Avoidable interest for 2005 amounts to $451,800 (see Schedule #3). So as not to overstate the interest associated with the construction, we capitalize the smaller of the two—$451,800—along with the other construction costs. The remainder of the interest ($148,200) is expensed. I hope that this explanation has answered any questions you may have had about capitalized interest. If any further questions should arise, please contact me. 10-69 CA 10-4 (Continued) Schedule #1 Actual Interest Construction loan Short-term loan Long-term loan $2,000,000 X 12% = $1,400,000 X 10% = $2,000,000 X 11% = Total $240,000 140,000 220,000 $600,000 Schedule #2 Weighted-Average Interest Rate Weighted-average interest rate computation 10% short-term loan 11% long-term loan Principal Interest $1,400,000 $140,000 2,000,000 220,000 $3,400,000 $360,000 = 10.59% Total Interest = Total Principal Schedule #3 $360,000 $3,400,000 Avoidable Interest Weighted-Average Accumulated Expenditures $2,000,000 2,000,000 $4,000,000 Schedule #4 X Interest Rate 12% 10.59% = Avoidable Interest $240,000 211,800 $451,800 Interest Capitalized Because avoidable interest is lower than actual interest, use avoidable interest. Cost $6,200,000 Interest capitalized 451,800 Total cost $6,651,800 10-70 CA 10-5 (a) Client A Treatment if has Commercial Substance Client A would recognize a gain of $35,000 on the exchange. The basis of the asset acquired would be $125,000. The entry would be as follows: Machinery ($95,000 + $30,000)........................................................................ Accumulated Depreciation—Machinery .......................................................... Cash .............................................................................................................. Gain on Disposal of Plant Assets ............................................................ Machinery..................................................................................................... *Book value of old machinery ($100,000 – $40,000) Fair value of old machinery Gain on disposal of plant asset (b) Treatment if lacks Commercial Substance Client A would be prohibited from recognizing a $35,000 gain on the exchange. This is because the transaction lacks commercial substance. The new asset on his books would have a basis of $90,000 ($125,000 less the $35,000 unrecognized gain). The entry would be as follows: Machinery ($125,000 – $35,000)...................................................................... Accumulated Depreciation ................................................................................. Cash .............................................................................................................. Machinery..................................................................................................... (c) Memo to the Controller: TO: RE: The Controller Exchanges of Assets—Commercial Substance Issues. 90,000 40,000 30,000 100,000 $60,000 95,000 $35,000 125,000 40,000 30,000 35,000* 100,000 Financial statement effect of treating the exchange as having commercial substance versus not. 1. The income statement will reflect a before tax gain of $35,000. This gain will increase the reported income on this year’s financial statements. Future income statements will probably show a higher depreciation deduction because of an increased book value of the new asset. Thus future income statements will reflect lower income. The current balance sheet will show a $35,000 higher value for fixed assets, a higher liability for taxes payable and higher retained earnings if the exchange has commercial substance. This difference will disappear gradually as the asset is depreciated. 2. 10-71 CA 10-5 (Continued) (d) Client B Treatment if Exchange has Commercial Substance In this situation, the full $55,000 gain would be recognized on this year’s income statement. The new asset would go on the books at its fair market value. The entry is as follows: Machinery ............................................................................................................ Accumulated Depreciation—Machinery ........................................................ Cash...................................................................................................................... Machinery ................................................................................................... Gain on Exchange of Plant Assets ........................................................ *Book value of old machinery ($150,000 – $80,000) Fair value of old machinery Gain on disposal of plant assets (e) Treatment if Exchange Lacks Commercial Substance Machinery ($95,000 – $41,800)..................................................................... Accumulated Depreciation—Machinery....................................................... Cash.................................................................................................................... Machinery.................................................................................................. Gain on Exchange of Plant Assets ...................................................... 53,200 80,000 30,000 150,000 13,200* $ 70,000 125,000 $ 55,000 95,000 80,000 30,000 150,000 55,000* * A partial gain will be recognized in the ratio of cash received. In this case, a gain of $13,200 will be recognized ($30,000/$125,000 times the gain of $55,000). The unrecognized portion of $41,800 will be used to reduce the basis of the new asset. The entry to record the exchange is as above. (f) Memo to the Controller: TO: RE: The Controller Exchanges of Assets—Commercial Substance Issues Financial Statement effect of treating the exchange as having commercial substance versus not. TO: RE: 1. The Controller Asset Exchanges—Commercial Substance The income statement will reflect a before tax gain of $55,000 if the exchange has commercial substance. This gain will increase the reported income on this year’s financial statements. Future income statements will probably show a higher depreciation deduction because of an increased book value of the new asset. Thus future income statements will reflect lower income. The reported gain will only be $13,200 if the exchange lacks commercial substance. The current balance sheet will show a $41,800 higher value for fixed assets, a higher liability for taxes payable and higher retained earnings if the exchange has commercial substance. This difference will disappear gradually as the asset is depreciated. 10-72 2. CA 10-6 In general, the inclusion of the $7,500 as part of the cost of the machine is justified because the primary purpose in accounting for plant asset costs is to secure an equitable allocation of incurred costs over the period of time when the benefits are being received from the use of the assets. These costs—both the $40,000 and the $7,500—are much like prepaid expenses, to be matched against the revenue emerging through their use. The purpose of accounting for plant assets then is not primarily aimed at determining the fair valuation of the asset for balance sheet purposes, but proper matching of incurred costs with revenue resulting from use of the asset