Environmental and
Theoretical Structure
of Financial
Accounting
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1
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1-2
Learning Objectives
Describe the function and primary
focus of financial accounting.
1-3
Financial Accounting Environment
Providers of
Financial Information
Profit-oriented
companies
Not-for-profit
entities
Households
External
User Groups
Relevant
Financial
Information
Investors
Creditors
Employees
Labor unions
Customers
Suppliers
Government
agencies
Financial
intermediaries
1-4
Financial Accounting Environment
Relevant financial information is provided
primarily through financial statements and
related disclosure notes.




Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Shareholders’ Equity
The Economic Environment and
Financial Reporting
A sole proprietorship
is owned by a
single individual.
A partnership is
owned by two or
more individuals.
A corporation is owned
by stockholders,
frequently numbering
in the tens of thousands
in large corporations.
A highly-developed system of financial
reporting is necessary to communicate
financial information from a corporation
to its many shareholders.
1-5
Investment-Credit Decisions
A Cash Flow Perspective
Corporate shareholders receive cash from
their investments through . . .
 Periodic dividend distributions from the
corporation.
 The ultimate sale of the ownership shares of
stock.
1-6
Investment-Credit Decisions
A Cash Flow Perspective
Accounting information should help
investors evaluate the amount, timing,
and uncertainty of the enterprise’s
future cash flows.
1-7
1-8
Learning Objectives
Explain the difference between
cash and accrual accounting.
1-9
Cash Versus Accrual Accounting
Cash Basis Accounting
Revenue is recognized when cash is received.
Expenses are recognized when cash is paid.
1-10
Cash Versus Accrual Accounting
Cash Basis Accounting
Carter Company has sales on account totaling
$100,000 per year for three years. Carter collected
$50,000 in the first year and $125,000 in the second
and third years. The company prepaid $60,000 for
three years’ rent in the first year. Utilities are $10,000
per year, but in the first year only $5,000 was paid.
Payments to employees are $50,000 per year.
Let’s look at the cash flows.
1-11
Cash Versus Accrual Accounting
Cash Basis Accounting
Year 1
Cash receipts from
customers
$ 50,000
Summary of Cash Flows
Year 2
Year 3
$ 125,000
$ 125,000
Total
$ 300,000
Payment of 3
years' rent
(60,000)
-
-
(60,000)
Salaries to
employees
(50,000)
(50,000)
(50,000)
(150,000)
(5,000)
$ (65,000)
(15,000)
$ 60,000
(10,000)
$ 65,000
(30,000)
$ 60,000
Payments for
utilities
Net cash flow
1-12
Cash Versus Accrual Accounting
Cash Basis Accounting
Year 1
Cash receipts from
customers
$ 50,000
Payment of 3
years' rent
(60,000)
Summary of Cash Flows
Year 2
Year 3
$ 125,000
-
$ 125,000
-
Total
$ 300,000
(60,000)
Salaries to
Cash flows
in any one
year may(50,000)
not be a (150,000)
employees
(50,000)
(50,000)
Payments for
utilities
Net cash flow
predictor of future cash flows.
(5,000)
$ (65,000)
(15,000)
$ 60,000
(10,000)
$ 65,000
(30,000)
$ 60,000
1-13
Cash Versus Accrual Accounting
Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
Let’s reconsider the Carter
Company information.
1-14
Cash Versus Accrual Accounting
Accrual Accounting
Revenue is recognized when earned.
Expenses are recognized when incurred.
Let’s reconsider the Carter
Company information.
1-15
Learning Objectives
Define generally accepted accounting
principles (GAAP) and discuss the historical
development of accounting standards.
The Development of Financial Accounting
and Reporting Standards
Concepts,
principles, and
procedures were
developed to meet the
needs of external
users (GAAP).
1-16
1-17
Historical Perspective and Standards
Securities and Exchange Commission
 1934 – present
Evolution of Standard-Setting Process
 1938 – 1959:
Committee on Accounting Procedures (CAP)
 1959 – 1973:
Accounting Principles Board (APB)
Current Standard Setting - FASB
www.fasb.org
 Supported by the Financial Accounting
Foundation.
 Seven full-time, independent voting members
serving for 10 years.
 Answerable only to the Financial Accounting
Foundation.
 Members not required to be CPAs.
1-18
1-19
Learning Objectives
Explain why the establishment of
accounting standards is characterized
as a political process.
Establishment of Accounting Standards
A Political Process
Internal Revenue
Service
www.irs.gov
American Institute
of CPAs
www.aicpa.org
Securities and
Exchange
Commission
www.sec.gov
Financial Executives
International
www.fei.org
GAAP
Governmental
Accounting
Standards Board
www.gasb.org
American
Accounting
Association
www.aaa-edu.org
1-20
1-21
FASB’s Standard-Setting Process








Identification of problem.
The task force.
Research and analysis.
Discussion memorandum.
Public response.
Exposure draft.
Public response.
Statement issued.
International Accounting Standards
Board (IASB)
 Established in 1973 to narrow the
range of differences in accounting
standards.
 Increase in international trade has
motivated the IASB to attempt to
eliminate alternative accounting
treatments.
1-22
1-23
Role of the Auditor
Independent intermediary to help insure that
management has in fact appropriately
applied GAAP.
1-24
Financial Reporting Reform
As a result of numerous financial scandals,
Congress passed the Public Company
Accounting Reform and Investor Protection
Act of 2002, commonly referred to as the
Sarbanes-Oxley Act for the two congressmen
who sponsored the bill.
1-25
Learning Objectives
Explain the purpose of the
FASB’s conceptual framework.
1-26
The Conceptual Framework
 Maintain consistency among standards.
 Resolve new accounting problems.
 Provide user benefits.
1-27
Learning Objectives
Identify the objectives of financial reporting, the
qualitative characteristics of accounting
information, and the elements of financial
statements.
Describe the four basic
assumptions underlying GAAP
Describe the four basic accounting
principles that guide accounting practice.
1-28
Objectives
Qualitative
Characteristics
Understandability
Primary
Relevance
Reliability
Secondary
Comparability
Consistency
Elements
Assets
Liabilities
Equity
Investments by Owners
Distributions to owners
Revenues
Expenses
Gains
Losses
Comprehensive Income
Financial Statements
Constraints
Cost effectiveness
Materiality
Conservatism
Balance sheet
Income statement
Statement of cash flows
Statement of shareholders’ equity
Related disclosures
Recognition and
Measurement
Concepts
Assumptions
Economic entity
Going concern
Periodicity
Monetary unit
Principles
Historical cost
Realization
Matching
Full Disclosure
1-29
Qualitative Characteristics of
Accounting Information
Decision Usefulness
Relevance
Predictive
Value
Feedback
Value
Comparability
Reliability
Timeliness
Verifiability
Neutrality
Consistency
Representational
Faithfulness
Practical Constraints to Achieving
Desired Qualitative Characteristics
Conservatism
Cost
Effectiveness
Materiality
1-30
SFAC No. 6
Assets and Liabilities
Assets are probable future economic benefits
obtained or controlled by a particular entity as a
result of past transactions or events.
Liabilities are probable future sacrifices of
economic benefits arising from present
obligations of a particular entity to transfer or
provide services to other entities in the future as
a result of past transactions or events.
1-31
SFAC No. 6
Equity
Equity, or net assets, called shareholders’
equity or stockholders’ equity for a
corporation, is the residual interest in the
assets of an entity that remains after
deducting liabilities.
1-32
SFAC No. 6
Investments and Distributions
Investments by owners are increases in
equity resulting from transfers of resources
(usually cash) to a company in exchange
for ownership interest.
Distributions to owners are decreases in
equity resulting from transfers to the
owners.
1-33
SFAC No. 6
Revenues
Revenues are inflows or other
enhancements of assets or settlements of
liabilities from delivering or producing
goods, rendering services, or other
activities that constitute the entity’s
ongoing major, or central, operations.
1-34
SFAC No. 6
Expenses
Expenses are outflows or other using up of
assets or incurrences of liabilities during a
period from delivering or producing goods,
rendering services, or other activities that
constitute the entity’s ongoing major, or
central, operations.
1-35
SFAC No. 6
Gains and Losses
Gains are increases in equity peripheral, or
incidental, transactions of an entity.
Losses represent decreases in equity arising
from peripheral, or incidental, transactions
of an entity.
1-36
SFAC No. 6
Comprehensive Income
Comprehensive income is the change in equity
of a business enterprise during a period from
transactions and other events and
circumstances from nonowner sources. It
includes all changes in equity during a period
except those resulting from investments from
owners and distributions to owners.
1-37
1-38
Recognition and Measurement Concepts
Review of the
Accounting
Process
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1-40
The Basic Model
Economic events cause
changes in the financial
position of a company.
External events
involve an exchange
between the company
and another entity.
Internal events do not
involve an exchange
transaction but do
affect the company’s
financial position.
1-41
Learning Objectives
Analyze routine economic events—
transactions—and record their effects on a
company’s financial position using the
accounting equation format.
1-42
Accounting Equation for a Corporation
A = L + SE
+ Paid-in Capital
+ Retained Earnings
+ Revenues - Expenses - Dividends
+ Gains
- Losses
1-43
Account Relationships
Debits and credits affect the Balance Sheet
Model as follows:
A = L + PIC + RE
Assets
Dr. Cr.
+
-
Liabilities
Dr. Cr.
+
Paid-in
Capital
Dr. Cr.
+
Retained
Earnings
Dr. Cr.
+
Revenues
and Gains
Dr. Cr.
+
Expenses
and Losses
Dr. Cr.
+
-
1-44
Source
documents
Transaction
Analysis
Record in
Journal
Post to
Ledger
Financial
Statements
Adjusted
Trial Balance
Record & Post
Adjusting
Entries
Unadjusted
Trial Balance
Close Temporary
Accounts
Post-Closing
Trial Balance
The
Accounting
Processing
Cycle
1-45
Learning Objectives
Record transactions using the general journal
format.
1-46
Accounting Processing Cycle
On January 1, 2007, $40,000 was borrowed
from a bank and a note payable was signed.
Two accounts are affected:
Cash (an asset) increases by $40,000.
 Notes Payable (a liability) increases by $40,000.

GENERAL JOURNAL
Date
Page
Post.
Ref.
Prepare
the
journal
entry.
Cash
40,000
Description
Jan 1
Account
numbers are
Payable
references for Notes
posting
to
the General Ledger.
Debit
1
Credit
40,000
1-47
General Ledger
GENERAL LEDGER
Account:
Acct. No.
##
Balance
Date
Item
Post.
Ref.
Debit
Credit
The “T” account is a shorthand used by
accountants to analyze transactions. It
is not part of the bookkeeping system.
DR (CR)
1-48
Learning Objectives
Post the effects of journal entries to T-accounts
and prepare an unadjusted trial balance.
1-49
Posting Journal Entries
On July 1, 2006, the owners invest $60,000 in a new
business, Dress Right Clothing Corporation.
GENERAL JOURNAL
Date
Description
July 1 Cash
Page
Post.
Ref.
Debit
1
Credit
60,000
Common Stock
60,000
Post the debit portion of the entry to the Cash ledger account.
1-50
Posting Journal Entries
GENERAL JOURNAL
Date
Page
Post.
Ref.
Description
July 1 Cash
1
Debit
Credit
60,000
Common Stock
60,000
GENERAL LEDGER
Account: Cash
Date
1
Item
Acct. No.
Post.
Ref.
Debit
Credit
100
Balance
1-51
Posting Journal Entries
GENERAL JOURNAL
Date
Page
Post.
Ref.
Description
July 1 Cash
Debit
Credit
60,000
Common Stock
2
60,000
GENERAL LEDGER
Account: Cash
Date
July
1
1
3
Acct. No.
Item
Post.
Ref.
Debit
60,000
Credit
100
Balance
1-52
Posting Journal Entries
GENERAL JOURNAL
Date
Page
Post.
Ref.
Description
1
Debit
July 1 Cash
Credit
60,000
Common Stock
60,000
4
GENERAL LEDGER
Account: Cash
Date
July
1
Acct. No.
Item
Post.
Ref.
J1
100
5
Debit
60,000
Credit
Balance
60,000
1-53
Posting Journal Entries
GENERAL JOURNAL
Date
Page
Post.
Ref.
Description
July 1 Cash
100
1
Debit
Credit
60,000
Common Stock
60,000
6
GENERAL LEDGER
Account: Cash
Date
July
1
Acct. No.
Item
Post.
Ref.
J1
Debit
60,000
Credit
100
Balance
60,000
1-54
Posting Journal Entries
GENERAL JOURNAL
Date
Page
Post.
Ref.
Description
July 1 Cash
100
1
Debit
Credit
60,000
Common Stock
60,000
Post the credit portion of the entry to the Common Stock ledger
account.
GENERAL LEDGER
Account: Common Stock
Date
Item
1
Post.
Ref.
Acct. No.
Debit
Credit
300
Balance
1-55
Posting Journal Entries
GENERAL JOURNAL
Date
Page
Post.
Ref.
Description
July 1 Cash
100
Debit
60,000
GENERAL LEDGER
Account: Common Stock
Date
July
1
Item
Post.
Ref.
Credit
60,000
Common Stock
2
1
Debit
3
Acct. No.
300
Credit
60,000
Balance
1-56
Posting Journal Entries
GENERAL JOURNAL
Date
Page
Post.
Ref.
Description
July 1 Cash
100
1
Debit
Credit
60,000
Common Stock
60,000
4
GENERAL LEDGER
Account: Common Stock
Date
July
1
Item
Acct. No.
Post.
Ref.
J1
300
5
Debit
Credit
60,000
Balance
60,000
1-57
Posting Journal Entries
GENERAL JOURNAL
Date
Page
Post.
Ref.
Description
July 1 Cash
100
300
Common Stock
1
Debit
Credit
60,000
60,000
6
GENERAL LEDGER
Account: Common Stock
Date
July
1
Item
Acct. No.
Post.
Ref.
J1
Debit
Credit
60,000
300
Balance
60,000
1-58
After recording all entries for the period, Dress
Right’s Trial Balance would be as follows:
Dress Right Clothing Corporation
Unadjusted Trial Balance
July 31, 2006
Account Title
Cash
Accounts receivable
Supplies
Prepaid rent
Inventory
Furniture and fixtures
Accounts payable
Notes payable
Unearned rent revenue
Common stock
Retained earnings
Sales revenue
Cost of goods sold
Salaries expense
Total
Debits
$ 68,500
2,000
2,000
24,000
38,000
12,000
Credits
$
35,000
40,000
1,000
60,000
A Trial
Balance is a
listing of all
accounts
and their
balances at
a point in
time.
1,000
38,500
22,000
5,000
$ 174,500
$ 174,500
Debits = Credits
1-59
Adjusting Entries
At the end of the period,
some transactions or
events remain
unrecorded.
Because of this, several
accounts in the ledger
need adjustments
before their balances
appear in the financial
statements.
1-60
Learning Objectives
Identify and describe the different types of
adjusting journal entries.
Determine the required adjustments, record
adjusting journal entries in general journal
format, and prepare an adjusted trial balance.
1-61
Adjusting Entries
Prepayments
(Deferrals)
Transactions
where cash is
paid or received
before a related
expense or
revenue is
recognized.
Accruals
Transactions
where cash is
paid or received
after a related
expense or
Estimates
1-62
Alternative Approach to Record Prepayments
Prepaid Expenses
Record initial cash
payments as follows:
Expense
Cash
$$$
$$$
Adjusting Entry
Record the amount for the
prepaid expense as
follows:
Prepaid expense
Expense
$$
$$
Unearned Revenue
Record initial cash receipts
as follows:
Cash
Revenue
$$$
$$$
Adjusting Entry
Record the amount for the
unearned liability as
follows:
Revenue
$$
Unearned revenue $$
1-63
Accrued Liabilities
Last pay
date
7/20/06
7/1/06
Next pay
date
8/2/06
7/31/06
Month end
Record adjusting
journal entry.
On July 31, 2006, the
employees have earned
salaries of $5,500.
GENERAL JOURNAL
Date
Description
July 31 Salaries Expense
Salaries Payable
Page 30
Post.
Ref.
Debit
Credit
5,500
5,500
1-64
Accrued Receivables
Assume that Dress Right loaned another corporation
$30,000 at the beginning of August. Terms of the note
call for the payment of principal, $30,000, and interest at
8% in three months.
First, let’s determine the amount of interest to accrue at
August 31, 2006.
P×R×T
$30,000
.08
Interest = $200
1/
12
1-65
Accrued Receivables
Assume that Dress Right loaned another corporation
$30,000 at the beginning of August. Terms of the note
call for the payment of principal, $30,000, and interest at
8% in three months.
Now, let’s prepare the adjusting entry for August 31, 2006.
GENERAL JOURNAL
Date
Description
Aug. 31 Interest Receivable
Interest Revenue
Page 30
Post.
Ref.
Debit
Credit
200
200
1-66
Estimates
 Uncollectible
accounts and
depreciation of fixed
assets are estimated.
 An
estimated item is
a function of future
events and
developments.
$
1-67
Estimates
The estimate of bad debt expense at the end of the
period is an example of an adjusting entry that requires
an estimate.
Assume that Dress Right’s management determines that
of the $2,000 of accounts receivable recorded at July 31,
2006, only $1,500 will ultimately be collected. Prepare
the adjusting entry for July 31, 2006.
GENERAL JOURNAL
Date
Description
July 31 Bad Debt Expense
Allowance for Uncollectible
Accounts
Page 30
Post.
Ref.
Debit
Credit
500
500
DRESS RIGHT CLOTHING CORPORATION
Adjusted Trial Balance
July 31, 2006
Account Title
Debits
Credits
Cash
$
68,500
Accounts receivable
2,000
Allowance for uncollectible accounts
$
500
Supplies
1,200
Prepaid rent
22,000
Inventory
38,000
Furniture and fixtures
12,000
Accumulated depr.-furniture & fixtures
200
Accounts payable
35,000
Note payable
40,000
Unearned rent revenue
750
Salaries payable
5,500
Interest payable
333
Common stock
60,000
Retained earnings
1,000
Sales revenue
38,500
Rent revenue
250
Cost of goods sold
22,000
Salaries expense
10,500
Supplies expense
800
Rent expense
2,000
Depreciation expense
200
Interest expense
333
Bad debt expense
500
Totals
$ 181,033 $ 181,033
1-68
This is the Adjusted
Trial Balance for
Dress Right after all
adjusting entries have
been recorded and
posted.
Dress Right will use
these balances to
prepare the financial
statements.
1-69
Learning Objectives
Describe the four basic financial statements.
1-70
Dress Right Clothing Corporation
Income Statement
For Month Ended July 31, 2006
Sales revenue
$
Cost of goods sold
Gross profit
Other expenses:
Salaries
$
10,500
Supplies
800
Rent
2,000
Depreciation
200
Bad debt
500
Total operating expenses
Operating income
Other income (expense):
Rent revenue
250
Interest expense
(333)
Net income
$
38,500
22,000
16,500
14,000
2,500
(83)
2,417
The income statement summarizes the results of
operating activities of the company.
1-71
Dress Right Clothing Corporation
Balance Sheet
At July 31, 2006
Assets
Current assets:
Cash
Accounts receivable
Less: Allowance for uncollectible accounts
Supplies
Inventory
Prepaid rent
Total current assets
Property and equipment:
Furniture and fixtures
Less: Accumulated depreciation
Total assets
$
$
2,000
500
68,500
1,500
1,200
38,000
22,000
131,200
12,000
200
$
11,800
143,000
The balance sheet presents the financial position
of the company on a particular date.
1-72
Dress Right Clothing Corporation
Balance Sheet
At July 31, 2006
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable
$
Salaries payable
Unearned rent revenue
Interest payable
Note payable
Total current liabilities
Long-term liabilities:
Note payable
Shareholders' equity:
Common stock
$
60,000
Retained earnings
1,417
Total shareholders' equity
Total liabilities and shareholders' equity
$
35,000
5,500
750
333
10,000
51,583
30,000
61,417
143,000
The balance sheet presents the financial position
of the company on a particular date.
1-73
Dress Right Clothing Corporation
Statement of Cash Flows
For the Month of July 2006
Cash flows from operating activities:
Cash inflows:
From customers
$
From rent
Cash outflows:
For rent
For supplies
To suppliers for merchandise
To employees
Net cash used by operating activities
Cash flows from investing activities:
Purchase of furniture and fixtures
Cash flows from financing activities:
Issue of capital stock
$
Increase in notes payable
Payment of cash dividend
Net cash provided by financing activities
Net increase in cash
36,500
1,000
(24,000)
(2,000)
(25,000)
(5,000)
$
(18,500)
(12,000)
60,000
40,000
(1,000)
$
99,000
68,500
The statement of cash flows discloses the
changes in cash during a period.
1-74
Dress Right Clothing Corporation
Statement of Shareholders' Equity
For the Month of July 2006
Balance at July 1, 2006
Issue of capital stock
Net income for July 2006
Less: Dividends
Balance at July 31, 2006
Common Retained
Stock
Earnings
$
$
60,000
2,417
(1,000)
$
60,000 $
1,417
Total
Shareholders'
Equity
$
60,000
2,417
(1,000)
$
61,417
The statement of shareholders’ equity presents
the changes in permanent shareholder accounts.
1-75
Learning Objectives
Explain the closing process.
1-76
The Closing Process


Resets revenue, expense
and dividend account
balances to zero at the
end of the period.
Helps summarize a
period’s revenues and
expenses in the Income
Summary account.
Identify accounts for
closing.
Record and post closing
entries.
Prepare post-closing trial
balance.
1-77
Temporary and Permanent Accounts
Income
Summary
Liabilities
Permanent
Accounts
Shareholders’
Equity
Temporary
Accounts
Assets
Dividends
Expenses
Revenues
The closing process applies
only to temporary accounts.
1-78
Closing Entries
 Close Revenue
accounts to Income
Summary.
 Close Expense
accounts to Income
Summary.
 Close Income Summary
account to Retained
Earnings.
Let’s prepare the
closing entries for
Dress Right.
DRESS RIGHT CLOTHING CORPORATION
Adjusted Trial Balance
July 31, 2006
Account Title
Debits
Credits
Cash
$
68,500
Accounts receivable
2,000
Allowance for uncollectible accounts
$
500
Supplies
1,200
Prepaid rent
22,000
Inventory
38,000
Furniture and fixtures
12,000
Accumulated depr.-furniture & fixtures
200
Accounts payable
35,000
Note payable
40,000
Unearned rent revenue
750
Salaries payable
5,500
Interest payable
333
Common stock
60,000
Retained earnings
1,000
Sales revenue
38,500
Rent revenue
250
Cost of goods sold
22,000
Salaries expense
10,500
Supplies expense
800
Rent expense
2,000
Depreciation expense
200
Interest expense
333
Bad debt expense
500
Totals
$ 181,033 $ 181,033
1-79
Close Revenue
accounts to
Income Summary.
 Close Revenue Accounts to Income
Summary
GENERAL JOURNAL
Date
Description
July 31 Sales Revenue
Rent Revenue
1-80
Page 34
Post.
Ref.
Debit
Credit
38,500
250
Income Summary
Now, let’s look at the ledger accounts after
posting this closing entry.
38,750
 Close Revenue Accounts to Income
Summary
1-81
Sales Revenue
38,500
38,500
-
Income Summary
38,750
38,750
Rent Revenue
250
250
-
DRESS RIGHT CLOTHING CORPORATION
Adjusted Trial Balance
July 31, 2006
Account Title
Debits
Credits
Cash
$
68,500
Accounts receivable
2,000
Allowance for uncollectible accounts
$
500
Supplies
1,200
Prepaid rent
22,000
Inventory
38,000
Furniture and fixtures
12,000
Accumulated depr.-furniture & fixtures
200
Accounts payable
35,000
Note payable
40,000
Unearned rent revenue
750
Salaries payable
5,500
Interest payable
333
Common stock
60,000
Retained earnings
1,000
Sales revenue
38,500
Rent revenue
250
Cost of goods sold
22,000
Salaries expense
10,500
Supplies expense
800
Rent expense
2,000
Depreciation expense
200
Interest expense
333
Bad debt expense
500
Totals
$ 181,033 $ 181,033
1-82
Close Expense
accounts to
Income Summary.
 Close Expense Accounts to Income
Summary
GENERAL JOURNAL
Date
Description
July 31 Income Summary
1-83
Page 34
Post.
Ref.
Debit
Credit
36,333
Cost of goods sold
22,000
Salaries expense
10,500
Supplies expense
800
Rent expense
2,000
Depreciation expense
200
Interest expense
333
Bad debts expense
500
Now, let’s look at the ledger accounts after
posting this closing entry.
Bad Debts Exp.
500
500
-
 Close Expense Accounts to
Income Summary
Depreciation Exp.
200
200
-
Rent Expense
2,000
2,000
-
Salaries Expense
10,500
10,500
-
Supplies Expense
800
800
-
Interest Expense
333
333
-
Cost of Goods Sold
22,000
22,000
-
1-84
Income Summary
36,333 38,750
2,417
Net Income
DRESS RIGHT CLOTHING CORPORATION
Adjusted Trial Balance
July 31, 2006
Account Title
Debits
Credits
Cash
$
68,500
Accounts receivable
2,000
Allowance for uncollectible accounts
$
500
Supplies
1,200
Prepaid rent
22,000
Inventory
38,000
Furniture and fixtures
12,000
Accumulated depr.-furniture & fixtures
200
Accounts payable
35,000
Note payable
40,000
Unearned rent revenue
750
Salaries payable
5,500
Interest payable
333
Common stock
60,000
Retained earnings
1,000
Sales revenue
38,500
Rent revenue
250
Cost of goods sold
22,000
Salaries expense
10,500
Supplies expense
800
Rent expense
2,000
Depreciation expense
200
Interest expense
333
Bad debt expense
500
Totals
$ 181,033 $ 181,033
1-85
Close Income
Summary to
Retained
Earnings.
 Close Income Summary to Retained
Earnings
GENERAL JOURNAL
Date
Description
July 31 Income Summary
1-86
Page 34
Post.
Ref.
Debit
Credit
2,417
Retained Earnings
Now, let’s look at the ledger accounts after
posting this closing entry.
2,417
 Close Income Summary to Retained
Earnings
Retained Earnings
1,000
2,417
1,417
Income Summary
36,333 38,750
2,417
-
1-87
1-88
Post-Closing Trial Balance
DRESS RIGHT CLOTHING CORPORATION
Post-Closing Trial Balance
July 31, 2006
Account Title
Debits
Credits
Cash
$
68,500
Accounts receivable
2,000
Allowance for uncollectible accounts
$
500
Supplies
1,200
Prepaid rent
22,000
Inventory
38,000
Furniture and fixtures
12,000
Accumulated depr.-furniture & fixtures
200
Accounts payable
35,000
Note payable
40,000
Unearned rent revenue
750
Salaries payable
5,500
Interest payable
333
Common stock
60,000
Retained earnings
1,417
Totals
$ 143,700 $ 143,700
Lists permanent
accounts and their
balances.
Total debits equal
total credits.
1-89
Reversing
Entries
Appendix 2B
1-90
Reversing Entries
Reversing entries remove the effects of some of
the adjusting entries made at the end of the
previous reporting period for the sole purpose of
simplifying journal entries made during the new
period. Reversing entries are optional and are used
most often with accruals.
Let’s consider the following accrual adjusting
entry made by Dress Right.
GENERAL JOURNAL
Date
Description
July 31 Salaries Expense
Salaries Payable
Page 30
Post.
Ref.
Debit
Credit
5,500
5,500
1-91
Reversing Entries
If reversing entries are used, the following reversing entry is
made on August 1, 2006. This entry reduces the salaries
payable account to zero and reduces the salaries expense
account by $5,500.
GENERAL JOURNAL
Date
Aug
Description
1 Salaries Payable
Salaries Expense
Salaries Expense
Bal. 7/31
10,500
5,500 Reverse
Bal.
5,000
Page 30
Post.
Ref.
Debit
Credit
5,500
5,500
Salaries Payable
5,500 Bal. 7/31
Reverse 5,500
Bal.
1-92
End of Chapter 2
The Balance
Sheet and
Financial
Disclosures
3
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1-94
Learning Objectives
Describe the purpose of the balance sheet and
understand its usefulness and limitations.
1-95
The Balance Sheet
The purpose of the balance sheet is to report a
company’s financial position on a particular date.
Limitations:
 The balance sheet does not
portray the market value of
the entity as a going concern
nor its liquidation value.
 Resources such as
employee skills and
reputation are not recorded
in the balance sheet.
Usefulness:
 The balance sheet describes
many of the resources a
company has available for
generating future cash flows.
 It provides liquidity
information useful in
assessing a company’s
ability to pay its current
obligations.
 It provides long-term
solvency information relating
to the riskiness of a
company with regard to the
amount of liabilities in its
capital structure.
1-96
Balance Sheet
Claims against
resources (Liabilities)
Resources
(Assets)
Remaining claims
accruing to owners
(Owners’ Equity)
1-97
Learning Objectives
Distinguish between current and noncurrent
assets and liabilities.
Identify and describe the various balance
sheet asset classifications.
1-98
FedEx Corporation
Balance Sheet
31-May
Assets are
probable
future
economic
benefits
obtained or
controlled by
a particular
entity as a
result of past
transactions
or events.
(In millions)
Assets:
Current assets:
Cash and cash equivalents
Receivables, less allowances
Spare parts, supplies, and fuel
Deferred income taxes
Prepaid expenses and other
Total current assets
Property and equipment, at cost:
Aircraft and related equipment
Package handling & ground support
equipment and vehicles
Computer & electronic equipment
Other
Less accumulated depreciation
Net property and equipment
Other long-term assets:
Goodwill
Prepaid pension cost
Intangible and other assets
Total other long-term assets
Total Assets
2004
$
2003
$
1,046 $
3,027
249
489
159
4,970 $
538
2,627
228
416
132
3,941
$
7,001 $
6,624
$
5,296
3,537
4,477
20,311
11,274
9,037
5,013
3,180
4,200
19,017
10,317
8,700
2,802
1,127
1,198
5,127
19,134 $
1,063
1,269
412
2,744
15,385
1-99
Current Assets
Current
Assets
Cash
Cash Equivalents
Short-term Investments
Receivables
Inventories
Prepayments
Will be converted
to cash or
consumed within
one year or the
operating cycle,
whichever is
longer.
Cash equivalents
include certain
negotiable items such
as commercial paper,
money market funds,
and U.S. treasury bills.
1100
Current Assets
Current
Assets
Cash
Cash Equivalents
Short-term Investments
Receivables
Inventories
Prepayments
Will be converted
to cash or
consumed within
one year or the
operating cycle,
whichever is
longer.
Cash that is restricted
for a special purpose
and not available for
current operations
should not be
classified as a current
asset.
Operating Cycle of a Typical Manufacturing
Company
Use cash to acquire raw materials
Convert raw materials to finished
product
Deliver product to customer
Collect cash from customer
1101
1102
Noncurrent Assets
Noncurrent
Assets
Not expected to
be converted to
cash or
consumed within
one year or the
operating cycle,
whichever is
longer
Investments and
Funds
Property, Plant, &
Equipment
Intangibles
Other
1103
Noncurrent Assets
Investments and Funds
1. Not used in the operations of
the business
2. Includes both debt and equity
securities of other
corporations, land held for
Property,
Plant and
Equipment
speculation,
noncurrent
receivables,
and cash set
1. Are
tangible, long-lived,
and
asideinfor
purposes
used
thespecial
operations
of the
business
2. Includes land, buildings,
equipment, machinery, and
furniture as well as natural
resources such as mineral
©
Intangible Assets
1. Used in the operations of
the business but have no
physical substance
2. Includes patents,
copyrights, and
franchises
Other Assets
3. Reported net of
1. Includes
long-term
accumulated
prepaid
expenses and
amortization
any noncurrent assets
not falling in one of the
other classifications
1104
Learning Objectives
Identify and describe the two balance sheet
liability classifications.
FedEx Corporation
Balance Sheet
31-May
(In milions)
Liabilities:
Current liabilities:
Current portion of long-term debt
Accrued salaries & employee benefits
Accounts payable
Accrued expenses
Total current liabilities
Long-term debt, less current portion
Other long-term liabilities
Deferred income taxes
Pension, postretirement healthcare
and other benefit obligations
Self-insurance accruals
Deferred lease obligations
Deferred gains, principally related to
aircraft transactions
Other liabilities
Total other long-term liabilities
Total liabilities
1105
2004
$
2003
750 $ 308
1,062
724
1,615
1,168
1,305
1,135
4,732
3,335
2,837
1,709
1,181
882
768
591
503
657
536
466
426
60
3,529
11,098
455
57
3,053
8,097
Liabilities are
probable
future
sacrifices of
economic
benefits
arising from
present
obligations of
a particular
entity to
transfer
assets or
provide
services to
other entities
as a result of
past
transactions
or events.
1106
Current Liabilities
Current
Liabilities
Obligations expected to be
satisfied through current
assets or creation of other
current liabilities within one
year or the operating cycle,
whichever is longer
Accounts Payable
Notes Payable
Accrued Liabilities
Current Maturities
of Long-Term Debt
1107
Long-term Liabilities
Long-Term
Liabilities
Obligations that
will not be
satisfied within
one year or
operating cycle,
whichever is
longer
Notes Payable
Mortgages
Bonds Payable
Pension Obligations
Lease Obligations
1108
FedEx Corporation
Balance Sheet
31-May
(In millions, except shares)
Common Stockholders' Investment:
Common stock, $.10 par value, 800 million
shares authorized, 300 million shares
issued for 2004 and 299 million shares
issued for 2003
Additional paid-in capital
Retained earnings
Accumulated other comprehensive loss
Less deferred compensation and treasury
stock at cost
Total common stockholders' investment
2004
$
$
2003
30 $
30
1,079
7,001
(46)
8,064
1,088
6,250
(30)
7,338
28
8,036 $
50
7,288
Shareholders’ Equity is the residual interest in the
assets of an entity that remains after deducting
liabilities.
1109
Shareholders’ Equity
Capital
Stock
Deferred
Compensation
Retained
Earnings
Treasury
Stock
Accumulated Other Comprehensive Income
1110
Learning Objectives
Explain the purpose of financial statement
disclosures.
1111
Disclosure Notes
Summary of
Significant
Accounting Policies
Subsequent Events
Noteworthy Events
and Transactions
Conveys valuable
information about the
company’s choices from
among various alternative
accounting methods.
A significant development
that takes place after the
company’s fiscal year-end
but
before theor
financial
Transactions
events
statements
are issued.
that are potentially
important to evaluating a
company’s financial
statements, e.g., related
parties, errors and
irregularities, and illegal
acts.
1112
Learning Objectives
Explain the purpose of management’s
discussion and analysis.
1113
Management Discussion and Analysis
Provides a biased but
informed perspective of
a company’s
operations, liquidity,
and capital resources.
Management’s Responsibilities

Preparing the financial
statements and other
information in the
annual report.

Maintaining and
assessing the
company’s internal
control procedures.
1114
1115
Learning Objectives
Explain the purpose of an audit and describe
the content of the audit report.
Auditors’ Report
Expresses the auditors’ opinion
as to the fairness of
presentation of the financial
statements in conformity with
generally accepted accounting
principles
Must comply with specifications
of the AICPA and the PCAOB
1116
Auditors’ Opinions
Unqualified
Qualified
Adverse
Disclaimer
1117
Issued when the financial
statements present fairly
the financial position,
results of operations, and
cash flows in conformity
Issued when there is an
with GAAP
exception that is not of
sufficient seriousness to
invalidate the financial
statements as a whole
Issued when the
exceptions are so serious
that a qualified opinion is
not justified
Issued when insufficient
information has been
gathered to express an
opinion
1118
Learning Objectives
Describe the techniques used by financial
analysts to transform financial information into
forms more useful for analysis.
1119
Using Financial Statement Information
Comparative Financial
Statements
Horizontal Analysis
Vertical Analysis
Ratio Analysis
Allow financial statement
users to compare year-toyear financial position,
results of operations, and
Expresses each item in
cash flows
the financial statements
as a percentage of that
Involves
expressing
each
same
item
in the financial
item in theof
financial
statements
another
statements
as a
year
(base amount)
percentage of an
appropriate
corresponding total, or
base amount, within the
Allows analysts to control
same year.
for size differences over
time and among firms
1120
Learning Objectives
Identify and calculate the common liquidity and
financing ratios used to assess risk.
1121
Liquidity Ratios
Current assets
Current ratio =
Current liabilities
Measures a company’s ability to satisfy its
short-term liabilities
Quick assets
Acid-test ratio
=
Current liabilities
Provides a more stringent indication of a
company’s ability to pay its current
liabilities
1122
Financing Ratios
Total liabilities
Debt to equity
=
ratio
Shareholders’ equity
Indicates the extent of reliance on
creditors, rather than owners, in providing
resources
Times interest
earned ratio
=
Net income + Interest
expense + Taxes
Interest expense
Indicates the margin of safety provided to
creditors
The Income
Statement and
Statement of
Cash Flows
4
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1124
Learning Objectives
Explain the difference between net income and
comprehensive income and how we report
components of the difference.
1125
Comprehensive Income
An expanded
version of income
that includes four
types of gains and
losses that
traditionally have
not been included
in income
statements.
1126
Other Comprehensive Income
Statement of Financial Accounting Standards No. 130
Comprehensive income includes traditional net income
and changes in equity from nonowner transactions.
1. Changes in the market value of securities available for sale
(described in Chapter 12).
2. Gains, losses, and amendment costs for pensions and other
postretirement plans (described in Chapter 17).
3. When a derivative is designated as a cash flow hedge is adjusted to
fair value, the gain or loss is deferred as a component of
comprehensive income and included in earnings later, at the same
time as earnings are affected by the hedged transaction (described in
Chapter 14).
4. Gains or losses from changes in foreign currency exchange rates
(discussed elsewhere in your accounting curriculum).
1127
Accumulated Other Comprehensive Income
In addition to reporting comprehensive income that
occurs in the current period, we must also report these
amounts on a cumulative basis in the balance sheet as
an additional component of shareholders’ equity.
FedEx Corporation
Balance Sheet
31-May
(In millions, except shares)
Common Stockholders' Investment:
Common stock, $.10 par value, 800 million
shares authorized, 300 million shares
issued for 2004 and 299 million shares
issued for 2003
Additional paid-in capital
Retained earnings
Accumulated other comprehensive loss
Less deferred compensation and treasury
stock at cost
Total common stockholders' investment
2004
$
$
2003
30 $
30
1,079
7,001
(46)
8,064
1,088
6,250
(30)
7,338
28
8,036 $
50
7,288
1128
Learning Objectives
Discuss the importance of income from
continuing operations and describe its
components.
1129
Income from Continuing Operations
Revenues
Expenses
Inflows of
resources
resulting
from
providing
goods or
services to
customers.
Outflows of
resources
incurred in
generating
revenues.
Gains and
Losses
Income Tax
Expense
Increases or
decreases in
equity from
peripheral or
incidental
transactions
of an entity.
Because of
its
importance
and size,
income tax
expense is a
separate
item.
Operating Income Versus Nonoperating
Income
Operating
Income
Nonoperating
Income
Includes revenues
and expenses
directly related to
the principal
revenuegenerating
activities of the
company
Includes gains and
losses and
revenues and
expenses related
to peripheral or
incidental
activities of the
company
1130
1131
Income Statement (Single-Step)
{
Proper Heading
Revenues
& Gains
Expenses
& Losses
{
{
MAXWELL GEAR COMPANY
Income Statement
For the Year Ended December 31, 2006
Revenues and gains:
Sales
Interest and dividends
Gain on sale of opearting assets
Total revenues and gains
Expenses and losses:
Cost of goods sold
Selling
General and administrative
Research and development
Interest
Loss on sale of investment
Income taxes
Total expenses & losses
Net income
$
$
573,522
26,400
5,500
605,422
302,371
47,341
24,888
16,300
6,200
8,322
80,000
$
485,422
120,000
1132
Income Statement (Multiple-Step)
{
Proper Heading
Gross
Profit
Operating
Expenses
Nonoperating
Items
{
{
{
MAXWELL GEAR CORPORATION
Income Statement
For the Year Ended December 31, 2006
Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Selling
$
General and administrative
Research and development
Operating income
Other income (expense):
Interest and dividend revenue $
Gain on sale of operating assets
Interest expense
Loss on sale of investments
Income before income taxes
Income tax expense
Net income
$
47,341
24,888
16,300
573,522
302,371
271,151
88,529
182,622
26,400
5,500
(6,200)
(8,322)
$
17,378
200,000
80,000
120,000
1133
Learning Objectives
Describe earnings quality and how it is
impacted by management practices to
manipulate earnings.
1134
Earnings Quality
Earnings quality refers to
the ability of reported
earnings to predict a
company’s future.
The relevance of any
historical-based financial
statement hinges on its
predictive value.
1135
Manipulating Income and Income Smoothing
“Most managers prefer to report earnings that follow a
smooth, regular, upward path.”1
Two ways to manipulate income:
1. Income shifting
2. Income statement
classification
1
Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.
1136
Learning Objectives
Discuss the components of operating and
nonoperating income and their relationship to
earnings quality.
1137
Nonoperating Income and Earnings Quality
Gains and losses from the sale of operational
assets and investments often can significantly
inflate or deflate current earnings.
Example
As the stock market boom reached its
height late in the year 2000, many
companies recorded large gains from
sale of investments that had
appreciated significantly in value.
How should
those gains be
interpreted in
terms of their
relationship to
future
earnings? Are
they transitory
or permanent?
1138
Separately Reported Items
Reported separately, net of taxes:
Discontinued
operations
Income from continuing operations
before income taxes and
extraordinary items
Income tax expense
Income from continuing operations
before extraordinary items
Discontinued operations (net of $xx
in taxes)
Extraordinary items (net of $xx in
taxes)
Net Income
Extraordinary
items
$ xxx
xx
xxx
xx
xx
$ xxx
A third item,
the cumulative
effect of a
change in
accounting
principle, was
eliminated
from separate
reporting by a
1139
Intraperiod Income Tax Allocation
Income Tax Expense must be associated with
each component of income that causes it.
Show Income Tax
Expense related to
Income from
Continuing
Operations.
Report effects of
Discontinued Operations
and Extraordinary Items
NET OF RELATED
INCOME TAXES.
1140
Learning Objectives
Define what constitutes discontinued
operations and describe the appropriate
income statement presentation for these
transactions.
Discontinued Operations



A discontinued operation is the sale or
disposal of a component of an entity.
A component comprises operations and
cash flows that can be clearly
distinguished, operationally and for
financial reporting purposes, from the rest
of the entity.
A component could include:





Reportable segments
Operating segments
Reporting units
Subsidiaries
Asset groups
1141
1142
Discontinued Operations
Report results of operations separately if two
conditions are met:
The operations and
cash flows of the
component have been
(or will be) eliminated
from the ongoing
operations.
The entity will not have
any significant
continuing involvement
in the operations of the
component after the
disposal transaction.
1143
Discontinued Operations
Reporting for Components Sold
Operating income or
loss of the component
from the beginning of
the reporting period to
the disposal date.
Gain or loss on the
disposal of the
component.
Reporting for Components Held For Sale
Operating income or
loss of the component
from the beginning of
the reporting period to
the end of the reporting
period.
An “impairment loss” if
the carrying value of
the assets of the
component is more
than the fair value
minus cost to sell.
Discontinued Operations Example
1144
During the year, Apex Co. sold an
unprofitable component of the company. The
component had a net loss from operations
during the period of $150,000 and its assets
sold at a loss of $100,000. Apex reported
income from continuing operations of
$128,387. All items are taxed at 30%.
How will this appear in the income
statement?
Discontinued Operations Example
Computation of Loss from Discontinued Operations
(Net of Tax Effect):
Loss from discontinued operations
Less: Tax benefit ($150,000 × 30%)
Net loss
$
Loss on disposal of assets
Less: Tax benefit ($100,000 × 30%)
Net loss
$
$
$
(150,000)
45,000
(105,000)
(100,000)
30,000
(70,000)
1145
Discontinued Operations Example
Income Statement Presentation:
Income from continuing operations
Discontinued operations:
Loss from operations of discontinued
component (net of tax benefit of
$45,000)
Loss on disposal of discontinued
component (net of tax benefit of
$30,000)
Net loss
$ 128,387
(105,000)
(70,000)
$ (46,613)
1146
1147
Learning Objectives
Define extraordinary items and describe the
appropriate income statement presentation for
these transactions.
Extraordinary Items
 Material
events or
transactions
 Unusual in nature
 Infrequent in occurrence
 Reported net of related
taxes
1148
Extraordinary Items Example
During the year, Apex Co. experienced a
loss of $75,000 due to an earthquake at one
of its manufacturing plants in Nashville.
This was considered an extraordinary item.
The company reported income before
extraordinary item of $128,387. All gains
and losses are subject to a 30% tax rate.
How would this item appear in the
income statement?
1149
1150
Extraordinary Items Example
Computation of Loss from Extraordinary Item (Net of
Tax Effect):
Extraordinary Loss
Less: Tax Benefits
($75,000 × 30%)
Net Loss
$ (75,000)
22,500
$ (52,500)
Income Statement Presentation:
Income before extraordinary item
Extraordinary Loss:
Earthquake loss
(net of tax benefit of $22,500)
Net income
$ 128,387
(52,500)
$ 75,887
Unusual or Infrequent Items
Items that are material and are either
unusual or infrequent—but not both—
are included as a separate item in
continuing operations.
1151
1152
Accounting Changes
Type of Accounting
Change
Definition
Change in Accounting
Principle
Change from one GAAP method
to another GAAP method
Change in Accounting
Estimate
Revision of an estimate
because of new information or
new experience
Preparation of financial
statements for an accounting
entity other than the entity that
existed in the previous period
Change in Reporting
Entity
1153
Learning Objectives
Describe the measurement and reporting
requirements for a change in accounting
principle.
Change in Accounting Principle

Occurs when changing from one GAAP
method to another GAAP method

For example, a change from LIFO to FIFO

Voluntary changes in accounting
principles are accounted for
retrospectively by revising prior years’
financial statements.

Changes in depreciation, amortization, or
depletion methods are accounted for the
same way as a change in accounting
estimate.
1154
1155
Learning Objectives
Explain the accounting treatments of changes
in estimates and correction of errors.
Change in Accounting Estimate
Revision of a
previous accounting
estimate
Use new estimate in
current and future
periods
Includes treatment for
changes in depreciation,
amortization, and
depletion methods
1156
1157
Change in Accounting Estimate Example
On January 1, 2003, we purchased
equipment costing $30,000, with a useful
life of 10 years and no salvage value.
During 2006, we determine that the
remaining useful is 5 years (8-year total
life). We use straight-line depreciation.
Compute the revised depreciation
expense for 2006.
1158
Change in Accounting Estimate Example
Asset cost
Accumulated depreciation
12/31/05 - ($3,000 × 3 years)
Remaining to be depreciated
Remaining useful life
Revised annual depreciation
GENERAL JOURNAL
$
30,000
$
(9,000)
21,000
÷ 5 years
4,200
Page: 180
Credit
Description
PR
Debit
Record
depreciation
expense
of
$4,200
for
Depreciation Expense
4,200
2006 andDepreciation
subsequent years.
Accumulated
4,200
Date
Prior Period Adjustments
 Corrections
of errors from a
previous period
 Appear
in the Statement of
Retained Earnings as an
adjustment to beginning
retained earnings
 Must
show the adjustment
net of income taxes
1159
1160
Prior Period Adjustments Example
While reviewing the depreciation entries for
2002-2007, the controller found that in 2006
depreciation expense was incorrectly debited
for $150,000 when in fact it should have been
debited $125,000. (Ignore income taxes.)
GENERAL JOURNAL
Date
Description
12/31/06 Depreciation Expense
Accumulated Depreciation
PR
Debit
Page: 180
Credit
150,000
150,000
Prepare the necessary journal entry in 2007 to
correct this prior period error.
1161
Prior Period Adjustments Example
GENERAL JOURNAL
Date
Description
PR
Debit
Page: 180
Credit
2007 Entry
Accumulated Depreciation
Retained Earnings
25,000
25,000
1162
Learning Objectives
Define earnings per share (EPS) and explain
required disclosures of EPS for certain income
statement components.
1163
Earnings Per Share Disclosure
One of the most widely used ratios is earnings per
share (EPS), which shows the amount of income
earned by a company expressed on a per share basis.
Basic EPS
Net income less preferred
dividends
Weighted-average number
of common shares
outstanding for the period
Diluted EPS
Reflects the potential dilution
that could occur for companies
that have certain securities
outstanding that are convertible
into common shares or stock
options that could create
additional common shares if the
options were exercised.
1164
Earnings Per Share Disclosure
Report EPS data separately for:
1. Income from Continuing Operations
2. Separately Reported Items
a) Discontinued Operations
b) Extraordinary Items
3. Net Income
1165
Learning Objectives
Describe the purpose of the statement of cash
flows.
1166
The Statement of Cash Flows

Provides relevant information about a
company’s cash receipts and cash
disbursements.

Helps investors and creditors to assess




future net cash flows
liquidity
long-term solvency.
Required for each income statement period
presented.
1167
Learning Objectives
Identify and describe the various classifications
of cash flows presented in a statement of cash
flows.
1168
Operating Activities
Inflows from:

Sales to customers.
 Interest and dividends
received.
+
Outflows to:


Purchase of inventory.
Salaries, wages, and other
operating expenses.
 Interest on debt.
 Income taxes.
_
Cash
Flows
from
Operating
Activities
1169
Direct and Indirect Methods of Reporting
Two Formats for Reporting Operating Activities
Direct Method
Indirect Method
Reports the cash
effects of each
operating activity
Starts with
accrual net
income and
converts to cash
basis
1170
Investing Activities
Inflows from:



Sale of long-term assets used in
the business.
Sale of investment securities
(stocks and bonds).
Collection of nontrade
receivables.
+
Outflows to:

Purchase of long-term assets
used in the business.
 Purchase of investment
securities (stocks and bonds).
 Loans to other entities.
_
Cash
Flows
from
Investing
Activities
1171
Financing Activities
Inflows from:


Sale of shares to owners.
Borrowing from creditors
through notes, loans,
mortgages, and bonds.
+
Outflows to:

Owners in the form of dividends
or other distributions.
 Owners for the reacquisition of
shares previously sold.
 Creditors as repayment of the
principal amounts of debt.
_
Cash
Flows
from
Financing
Activities
1172
Noncash Investing and Financing Activities
Significant investing and financing
transactions not involving cash also
are reported.
Acquisition of equipment (an investing activity) by
issuing a long-term note payable (a financing
activity).
Cash and
Receivables
Insert Book Cover
Picture
7
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1174
Cash
Coins and
currency
Petty cash
Cashier’s checks
Certified checks
Money orders
Amounts on
deposit with
financial
institutions
1175
Cash Equivalents
Items very near cash but
not in negotiable form
Money market
funds
Treasury bills
Commercial
paper
Restricted Cash and
Compensating Balances
Restricted Cash
Management’s intent to use a certain amount
of cash for a specific purpose – future plant
expansion, future payment of debt.
Compensating Balance
Minimum balance that must be maintained
in a company’s account as support for
funds borrowed from the bank.
1176
1177
Learning Objectives
Distinguish between the gross and net
methods of accounting for cash discounts
Accounts Receivable
Amounts due from
customers for credit sales.
Credit sales require:
 Maintaining a separate
account receivable for each
customer.
 Accounting for bad debts
that result from credit
sales.
1178
1179
Cash Discounts
Increase sales.
Cash discounts . . .
Encourage early
payment.
Increase likelihood of
collections.
1180
Cash Discounts
2/10,n/30
Discount
Percent
Number of
Days
Discount is
Available
Otherwise,
Net (or All)
is Due
Credit
Period
1181
Cash Discounts
Sales are
recorded at the
invoice
amounts.
Gross
Method
Sales discounts
are recorded if
payment is
received within
the discount
period.
1182
Cash Discounts
Net
Method
Sales are recorded at the Sales discounts forfeited
invoice amount less the
are recorded if payment
discount.
is received after the
discount period.
1183
Learning Objectives
Describe the accounting treatment for
merchandise returns.
Sales Returns and Allowances
Sales Returns
Sales Allowances
Merchandise
returned by a
customer to a
supplier.
A reduction in
the cost of
defective
merchandise.
1184
Sales Returns and Allowances
On June 1, a customer of LarCo returns
$750 of merchandise. The merchandise
had been purchased on account and the
customer had not yet paid. LarCo uses
the periodic method to account for
inventory.
Record the journal entry for the return of
merchandise.
1185
1186
Sales Returns and Allowances
GENERAL JOURNAL
Date
Jun
Description
1 Sales Returns and Allowances
Post.
Ref.
Page 56
Debit
Credit
750
Accounts Receivable
Sales Returns and Allowances is a contra
account that reduces Sales Revenue in the
current accounting period.
750
1187
Learning Objectives
Describe the accounting treatment of
anticipated uncollectible accounts receivable.
Uncollectible Accounts Receivable
Bad debts result from credit customers who
are unable to pay the amount they owe,
regardless of continuing collection efforts.
PAST DUE
1188
Uncollectible Accounts Receivable
In conformity with the matching principle,
bad debt expense should be recorded in
the same accounting period in which the
sales related to the uncollectible account
were recorded.
1189
1190
Uncollectible Accounts Receivable
Most businesses record an estimate of the
bad debt expense by an adjusting entry
at the end of the accounting period.
GENERAL JOURNAL
Date
Description
Dec. 31 Bad Debt Expense
Allowance for Uncollectible
Accounts
Page 78
Post.
Ref.
Debit
Credit
####
####
1191
Uncollectible Accounts Receivable
Normally classified as
a selling expense and
closed at year-end.
Contra asset account to
Accounts Receivable.
GENERAL JOURNAL
Date
Description
Dec. 31 Bad Debt Expense
Allowance for Uncollectible
Accounts
Page 78
Post.
Ref.
Debit
Credit
####
####
Allowance for Uncollectible Accounts
1192
Accounts Receivable
Less: Allowance for Uncollectible Accounts
Net Realizable Value
Net realizable value is the amount of the
accounts receivable that the business
expects to collect.
1193
Learning Objectives
Describe the two approaches
to estimating bad debts.
1194
Estimating Bad Debts

Income Statement Approach

Balance Sheet Approach
Composite Rate
Aging of Receivables
PAST DUE
Income Statement Approach

Focuses on past credit sales to make
estimate of bad debt expense.

Emphasizes the matching principle by
estimating the bad debt expense associated
with the current period’s credit sales.
1195
Income Statement Approach
Bad debts expense is
computed as follows:
Current Period Credit Sales
× Bad Debt %
= Estimated Bad Debts Expense
1196
1197
Balance Sheet Approach
Focuses on the collectibility of accounts
receivable to make the estimate of uncollectible
accounts.
 Involves the direct computation of the desired
balance in the allowance for uncollectible
accounts.

1198
Balance Sheet Approach
Composite Rate
 Compute the desired balance in the Allowance for
Uncollectible Accounts.
Year-end Accounts Receivable
× Bad Debt %
 Bad Debts Expense is computed as:
1199
Now, let’s
look at the
accounts
receivable
aging
approach!
Balance Sheet Approach
Aging of Receivables
 Year-end Accounts Receivable is
broken down into age classifications.
 Each age grouping has a different
likelihood of being uncollectible.
 Compute desired uncollectible amount.
 Compare desired uncollectible amount
with the existing balance in the
allowance account.
1200
1201
Balance Sheet Approach
Aging of Receivables
At December 31, 2006, the receivables for
EastCo, Inc. were categorized as follows:
EastCo, Inc.
Schedule of Accounts Receivable by Age
Days Past Due
Current
1 - 30
31 - 60
Over 60
December 31, 2006
Accounts
Estimated
Estimated
Receivable Bad Debts Uncollectible
Balance
Percent
Amount
$

$
45,000
15,000
5,000
2,000
67,000

1% $
3%
5%
10%
$
450
450
250
200
1,350

1202
Balance Sheet Approach
Aging of Receivables
EastCo’s unadjusted balance
in the allowance account is
$500.

Allowance for
Uncollectible
Accounts
500
Per the previous computation,
the desired balance is $1,350.
1,350
GENERAL JOURNAL
Date
Description
Post
Ref.
Page 95
Debit
Prepare the entry to record bad debts
expense at Dec. 31, 2006.
Credit
1203
Balance Sheet Approach
Aging of Receivables
EastCo’s unadjusted balance
in the allowance account is
$500.

Allowance for
Uncollectible
Accounts
500
850
1,350
Per the previous computation,
the desired balance is $1,350.
GENERAL JOURNAL
Date
Dec.
Description
31 Bad Debts Expense
Allowance for
Uncollectible Accounts
Post
Ref.
Page 95
Debit
850
Credit
850
Methods to Estimate Bad Debts
Income
Statement
Approach
Balance Sheet
Approach
Emphasis on
Matching
Emphasis on
Realizable Value
Sales
Bad
Debts
Exp.
Income
Statement
Focus
Accts.
Rec.
All. for
Uncoll.
Accts.
Balance Sheet
Focus
1204
1205
Uncollectible Accounts
As accounts become uncollectible, the
following entry is made:
GENERAL JOURNAL
Date
Description
Allowance for Uncollectible Accounts
Accounts Receivable
Page 69
Post.
Ref.
Debit
Credit
####
####
So what happens if someone pays after a write-off
of the accounts receivable?
1206
Collection of Previously
Written-Off Accounts
When a customer makes a payment after an
account has been written off, two journal
entries are required.
GENERAL JOURNAL
Date
Description

Accounts Receivable

Cash
Page 69
Post.
Ref.
Debit
####
Allowance for Uncollectible Accounts
Accounts Receivable
Credit
####
####
####
1207
Learning Objectives
Describe the accounting treatment of shortterm notes receivable.
1208
Notes Receivable
PROMISSORY NOTE
$25,000
Face Value Term
One year after date
I
Date of
Note
Nov. 1, 2006
Date
promise to pay to the order of
Payee
Principal
Westward, Inc.
Twenty-five thousand and no/100------------------------ Dollars
Maker
plus interest at the annual12%
rate of
.
Interest Rate
Janet Lee , Winn,Co.
1209
Interest Computation
Face
amount
of the
note
×
Annual
interest
rate
Even for
maturities less
than 1 year,
the rate is
annualized.
×
Fraction of
the annual =
period
Interest
Interest-Bearing Notes
On November 1, 2006, Westward, Inc. loans
$25,000 to Winn, Co. The note bears
interest at 12% and is due on November 1,
2007.
Prepare the journal entry on November 1,
2006, December 31, 2006, (year-end) and
November 1, 2007 for Westward.
1210
1211
Interest-Bearing Notes
GENERAL JOURNAL
Date
Description
Page 56
Post.
Ref.
Debit
Credit
2006
Nov 1 Notes Receivable
25,000
Cash
Dec 31 Interest Receivable
Interest Revenue
$25,000 × 12% × (2 ÷ 12) = $500
25,000
500
500
1212
Interest-Bearing Notes
GENERAL JOURNAL
Date
Description
Page 56
Post.
Ref.
Debit
Credit
2007
Nov 1 Cash
28,000
Note Receivable
Interest Receivable
Interest Revenue
$25,000 × 12% = $3,000 - $500 = $2,500
25,000
500
2,500
Noninterest-Bearing Notes
 Actually do bear interest.
 Interest is deducted
(discounted) from the face
value of the note.
 Cash proceeds equal face
value of note less discount.
1213
Noninterest-Bearing Notes
On January 1, 2006, Westward, Inc. accepted
a $25,000 noninterest-bearing note from
Winn, Co as payment for a sale. The note is
discounted at 12% and is due on December
31, 2006.
Prepare the journal entries on January 1,
2006, and December 31, 2006 for Westward.
1214
1215
Noninterest-Bearing Notes
GENERAL JOURNAL
Date
Description
Page 56
Post.
Ref.
Debit
Credit
2006
Jan 1 Notes Receivable
25,000
Discount on Notes Receivable
3,000
Sales Revenue
22,000
$25,000 × 12% = $3,000
Dec 31 Cash
Discount on Notes Receivable
25,000
3,000
Interest Revenue
3,000
Notes Receivable
25,000
1216
Learning Objectives
Differentiate between the use of receivables
in financing arrangements accounted for
as a secured borrowing and those
accounted for as a sale.
Financing With Receivables
Secured borrowing
or
Sale of receivables
Method depends on the
surrender of control over
the receivables transferred.
1217
Secured Borrowing – Assigning
 The
1218
use of specific receivables for collateral,
and the promise that any failure to repay
debt will result in proceeds from specific
accounts receivable collections being used
to repay the debt.
 Reclassify Accounts Receivable as Accounts
Receivable Assigned.
Secured Borrowing – Pledging

Receivables in general are pledged as
collateral for loans.

Pledged receivables are disclosed in notes
to the financial statements.
1219
1220
Sale of Accounts Receivable
2. Accounts Receivable
SUPPLIER
(Transferor)
RETAILER
1. Merchandise
FACTOR
(Transferee)
A factor is a financial institution that buys receivables
for cash, handles the billing and collection of the
receivables and charges a fee for the service.
Sale of Accounts Receivable
Treat as a sale if all of these conditions are met:
Receivables are isolated from transferor.
Transferee has right to pledge or exchange
receivables.
Transferor does not have control over the
receivables.
 Transferor cannot repurchase
receivable before maturity.
 Transferor cannot require return
of specific receivables.
1221
Sale of Accounts Receivable
Without recourse
 An ordinary sale of receivables to the factor.
 Factor assumes all risk of uncollectibility.
 Control of receivable passes to the factor.
 Receivables are removed from the books,
cash is received and a financing expense or
loss is recognized.
1222
Sale of Accounts Receivable
With recourse
 Transferor (seller) retains risk of uncollectibility,
 Must meet the three conditions of determining
surrender of control to be recognized as a sale.
 If the transaction fails to meet the three conditions
necessary to be classified as
a sale, it will be treated as a
secured borrowing.
1223
Discounting a Note
1224
On December 31, Apex accepted a ninemonth 10 percent note for $200,000 from a
customer. Three months later on March 31,
Apex discounted the note at its local bank.
The bank’s discount rate 12 percent.
Prepare the journal entry to record the
discounting of the note receivable as a sale.
1225
Discounting a Note
Before the preparing the journal entry to
record the discounting, Apex must record
the accrued interest on the note from
December 31 until March 31.
GENERAL JOURNAL
Date
Description
Page 69
Post.
Ref.
Mar. 31 Interest Receivable
Interest Revenue
$200,000 × 10% × 3/12
Debit
Credit
5,000
5,000
1226
Discounting a Note
GENERAL JOURNAL
Date
Page 69
Post.
Ref.
Description
Mar. 31 Cash
Debit
Credit
202,100
Loss on Sale of Note Receivable
2,900
Notes Receivable
200,000
Interest Receivable
5,000
$205,000 - $202,100
Discounting a Note
If the three conditions for sale treatment are
not met, the transaction would be recorded
as a secured borrowing.
1227
Inventories:
Measurement
8
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1229
Inventory
Those assets that a company:
1. Intends to sell in the normal
course of business.
2. Has in production (work in
process) for future sale.
3. Uses currently in the production
of goods to be sold (raw materials).
1230
Types of Inventories
Types of Inventory
Merchandise
Inventory
Manufacturing
Inventory
Goods acquired for
resale
•Raw Materials
•Work-in-Process
•Finished Goods
1231
Inventory Cost Flows
Raw
Materials
(1) $XX$XX (4)
Work in
Process
$XX $XX (7)
Finished
Goods
$XX$XX (8)
Direct
Labor
(2) $XX$XX (5)
Manufacturing
Overhead
Cost of Good
Sold
$XX
(3) $XX$XX (6)
(1) Raw materials purchased
(2) Direct labor incurred
(3) Manufacturing overhead incurred
(4) Raw materials used
(5) Direct labor applied
(6) Manufacturing overhead applied
(7) Work in process transferred to
1232
Learning Objective
Explain the difference between a
perpetual inventory system and a
periodic inventory system.
1233
Inventory Methods
Two accounting systems are used to record
transactions involving inventory:
Perpetual
Inventory System
Periodic Inventory
System
The inventory
account is
continuously
updated as
purchases and
sales are made.
The inventory
account is
adjusted at the end
of a reporting
cycle.
1234
Periodic Cost of Goods Sold Equation
Beginning Inventory
+ Net Purchases
Cost of Goods
Available for Sale
- Ending Inventory
= Cost of Goods Sold
1235
Comparison of Inventory Systems
Transaction or
Event
Periodic
Inventory
Perpetual
Inventory
Routine purchases of
various inventory items
Costs debited to
purchases account
Costs debited to
inventory account
Sale of inventory
No accounting
entries made
Debit Cost of goods
sold and credit
inventory
End-of-period
accounting entries and
related activities
Physical count of
inventory to
determine cost of
good sold
No separate
determination of cost
of goods sold
necessary
1236
Learning Objective
Explain which physical quantities of goods
should be included in inventory.
1237
What is Included in Inventory?
General Rule
All goods owned by the company on the inventory
date, regardless of their location.
Goods in Transit
Depends on FOB
shipping terms.
Goods on
Consignment
1238
Learning Objective
Determine the expenditures that should
be included in the cost of inventory.
1239
Expenditures Included in Inventory
Invoice
Price
Purchase
Returns
+
Freight-in
on
Purchases
Purchase
Discounts
1240
Purchase Discounts
Gross Method
Date
10/5/06
10/14/06
11/4/06
10/5/06
10/14/06
11/4/06
Description
Debit
Purchases
Accounts payable
20,000
Accounts payable
Purchase discounts
Cash
14,000
Accounts payable
Cash
Net Method
Purchases
Accounts payable
6,000
Credit
20,000
280
13,720
6,000
19,600
19,600
Accounts payable
Cash
13,720
Accounts payable
Interest expense
Cash
5,880
120
13,720
6,000
Discount
terms are
$14,000
2/10,
n/30.
x 0.02
$ 280
Partial
payment not
made within
the discount
period
1241
Net Method Using Perpetual and Periodic
Matrix, Inc. purchased on account $6,000 of
merchandise for resale to customers. The merchandise
was purchased subject to a cash discount of 2/10, n/30.
The company incurred $160 in freight-in on the
merchandise. Upon inspection, the company found that
$200 of merchandise was damaged and the seller
agreed to accept the merchandise return and credit the
account of the company. The inventory was sold for
$8,300 on account. Let’s look at the journal entries
under both the perpetual and periodic accounting
system assuming Matrix uses the net method to record
merchandise purchases.
1242
Net Method Using Perpetual and Periodic
Perpetual Inventory Method
Description
Debit
Credit
Inventory
Accounts payable
Inventory
Cash
Accounts payable
Inventory
Accounts receivable
Sales revenue
5,880
5,880
160
160
200
200
8,300
8,300
Cost of goods sold
5,840
Inventory
Periodic Inventory Method
Purchases
5,880
Accounts payable
Freight-in
Cash
160
Accounts payable
Purchase returns
200
Accounts receivable
Sales revenue
8,300
5,840
5,880
160
200
8,300
Beginning inventory
Purchases
$ 5,880
Less: Returns
(200)
Plus: Freight-in
160
Net purchases
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
$
-
5,840
5,840
$ 5,840
1243
Learning Objective
Differentiate between the specific identification,
FIFO, LIFO, and average cost methods used
to determine the cost of ending inventory and
cost of goods sold.
1244
Inventory Cost Flow Methods

Specific cost identification

Average cost

First-in, first-out (FIFO)

Last-in, first-out (LIFO)
1245
Specific Cost Identification

Items are added to
inventory at cost when
they are purchased.

COGS for each sale is
based on the specific
cost of the item sold.


The specific cost of
each inventory item
must be known.
By selecting specific
items from inventory
at the time of sale,
income can be
manipulated.
1246
Average Cost Method
Periodic average cost uses a
weighted-average unit cost:
Weightedaverage
unit cost
Cost of
goods
=
available for
sale
÷
Quantity
available for
sale
Perpetual average cost uses a moving
average unit cost that is recomputed
each time a new purchase is made.
1247
First-In, First-Out
The FIFO
method
assumes that
items are sold
in the
chronological
order of their
acquisition.
 The
cost of the oldest
inventory items are
charged to COGS
when goods are sold.
 The cost of the
newest inventory
items remain in
ending inventory.
1248
First-In, First-Out
Even though the periodic
and the perpetual
approaches differ in the
timing of adjustments to
inventory . . .
. . . COGS and Ending
Inventory Cost are the
same under both
approaches.
1249
Last-In, First-Out
The LIFO
method
assumes that
the newest
items are sold
first, leaving the
older units in
inventory.
 The
cost of the
newest inventory
items are charged to
COGS when goods
are sold.
 The cost of the oldest
inventory items
remain in inventory.
1250
Last-In, First-Out
Unlike FIFO, using
the LIFO method
may result in COGS
and Ending
Inventory Cost that
differ under the
periodic and
perpetual
approaches.
1251
When Prices Are Rising . . .



FIFO
Matches low (older) costs
with current (higher)
sales.
Inventory is valued at
approximate replacement
cost.
Results in higher taxable
income.




LIFO
Matches high (newer)
costs with current (higher)
sales.
Inventory is valued based
on low (older) cost basis.
Results in lower taxable
income.
Is not officially endorsed
by the IASC.
1252
Comparison of Cost Flow Methods
Inventory Method Used by Major Companies
2003
FIFO
LIFO
Average
Other
Total
1973
# of
Companies
% of
Companies
# of
Companies
% of
Companies
384
251
167
31
833
46%
30%
20%
4%
100%
394
150
235
148
927
43%
16%
25%
16%
100%
1253
Learning Objective
Understand supplemental LIFO disclosures
and the effect of LIFO liquidations on net
income.
1254
LIFO Liquidation
When prices rise . . .
LIFO inventory costs on the balance
sheet are “out of date” because they reflect
old purchase transactions.
If inventory declines,
these “out of date” costs
may be charged to
current earnings.
This LIFO
liquidation
results in
“paper profits.”
1255
LIFO Reserves
Many companies use LIFO for external reporting and
income tax purposes but maintain internal records using
FIFO or average cost.
The conversion from FIFO or average cost
to LIFO takes place at the end of the
period. The conversion may look like this:
Total inventories at FIFO
Less: LIFO allowance
Inventories, at LIFO cost
2003
2002
$ 12,541
1,581
$ 10,960
$ 11,544
1,807
$ 9,737
1256
Earnings Quality
Many believe that manipulating income reduces
earnings quality because it can mask permanent
earnings. Inventory write-downs and changes in
inventory method are two additional inventoryrelated techniques a company could use to
manipulate earnings.
Inventories:
Additional
Issues
9
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1258
Learning Objective
Understand and apply the lower-of-costor-market rule used to value inventories.
1259
Lower of Cost or Market (LCM)
GAAP requires that inventories be
carried at cost or current market
value, whichever is lower.
LCM is a departure from historical cost
and is a conservative accounting
method.
1260
Determining Market Value
 Market value is NOT
necessarily the
amount for which
inventory can be
sold.
 Accounting
Research Bulletin
No. 43 defines
“market value” in
terms of current
replacement cost.
Net Realizable
Value (Ceiling)
Net Realizable Value
less Normal Profit
(Floor)
1261
Determining Market Value
Net Realizable Value (NRV) is
the estimated selling price
less cost of completion and
disposal.
Net Realizable
Value (Ceiling)
Replacement
Cost
The definition of market
value varies
internationally. In many
countries, for example
New Zealand market value
is defined as NRV.
Net Realizable Value
less Normal Profit
(Floor)
1262
Determining Market Value
If replacement cost
> Ceiling, then
Ceiling = Market
Value
Replacement
Cost
If replacement
cost < Floor, then
Floor = Market
Value
Net Realizable
Value (Ceiling)
Net Realizable Value
less Normal Profit
(Floor)
1263
Lower of Cost or Market
 An
item in inventory is currently carried at
historical cost of $20 per unit. At year-end
we gather the following per unit
information:
current replacement cost = $21.50
selling price = $30
cost to complete and dispose = $4
normal profit margin of = $5
 How
would we value this item in the
Balance Sheet?
1264
Lower of Cost or Market
Selling
Price
$ 30.00
Cost to
Complete
- $
4.00
=
Ceiling
=
$ 26.00
Replacement
Cost =$21.50
Normal
= Floor
Profit
$ 26.00 - $
5.00 = $ 21.00
Ceiling
-
Net Realizable
Value (Ceiling)
Which one do
we use?
Net Realizable
Value less Normal
Profit (Floor)
1265
Lower of Cost or Market
In this case, market value will be
$21.50 because the replacement
cost is between the ceiling and
the floor.
Net Realizable
Value (Ceiling)
Replacement
Cost =$21.50
Market value = $21.50
Cost = $20.00
Since
Should
Costthe
< Market,
inventory
thebe
LCM
rule
recorded
would dictate
at costthat
or market?
inventory
be recorded at Cost.
Net Realizable
Value less Normal
Profit (Floor)
1266
Lower of Cost or Market
An inventory item is currently carried at
historical cost of $95.00 per unit. At the
Balance Sheet date we gather the
following per unit information:
current replacement cost = $80.00
NRV = $100.00
NRV reduced by normal profit = $85.00
How would we value the item on our
Balance Sheet?
1267
Lower of Cost or Market
Net Realizable Value
(Ceiling) = $100
?
Which one do
we use as
market value?
?
Replacement
Cost =$80
?
Net Realizable Value
less Normal Profit
(Floor) = $85
1268
Lower of Cost or Market
Net Realizable Value
(Ceiling) = $100
Market Value = Floor
$100
>
$85
>
$80
Should the inventory be carried at
Market Value or Cost?
Replacement
Cost =$80
Market = $85 < Cost = $95
Net Realizable Value
less Normal Profit
(Floor) = $85
Our inventory item will be written down
to the Market Value $85.
1269
Applying Lower of Cost or Market
Lower of cost or market can be applied 3
different ways.
3.1.Apply
ApplyLCM
LCMto
tothe
each
entire
individual
inventory
itemasina
2. Apply LCM to each class of inventory.
inventory.
group.
1270
Adjusting Cost to Market - Options

Record the Loss as a Separate Item in
the Income Statement
Adjust inventory directly or by using an
allowance account.

Record the Loss as part of Cost of
Good Sold
Adjust inventory directly or by using an
allowance account.
1271
Learning Objective
Estimate ending inventory and cost of
goods sold using the gross profit method.
1272
Inventory Estimation Techniques
 Estimate
instead of taking
physical inventory
Less costly
Less time consuming
 Two
popular methods are . . .
Gross Profit Method
Retail Inventory Method
1273
Gross Profit Method
Auditors are testing
the overall
reasonableness of
client inventories.
Estimating inventory
& COGS for interim
reports.
Useful
when . . .
Determining the
cost of inventory
lost, destroyed, or
stolen.
Preparing budgets
and forecasts.
NOTE: The Gross Profit Method is not acceptable
for use in annual financial statements.
1274
Gross Profit Method
This method assumes that the historical
gross margin rate is reasonably
constant in the short run.
Net sales for the
period.
Cost of beginning
inventory.
We need to
know . . .
Historical gross
margin rate.
Net purchases for
the period.
1275
Steps to the Gross Profit Method
1. Estimate Historical Gross Margin %.
2. Sales x (1 - Estimated Gross Margin %) =
Estimated COGS
3. Beg. Inventory + Net Purchases = Cost of
Goods Available for Sale (COGAS)
4. COGAS - Estimated COGS = Estimated
Cost of Ending Inventory
1276
Gross Profit Method
Matrix, Inc. uses the gross profit method to
estimate end of month inventory. At the end
of May, the controller has the following data:
•Net sales for May = $1,213,000
•Net purchases for May = $728,300
•Inventory at May 1 = $237,400
•Gross margin = 43% of sales
Estimate Inventory at May 31.
1277
Gross Profit Method
Beginning Inventory
Plus: Net Purchases
= Goods Available for Sale
Less: Estimated COGS*
= Estimated Ending Inventory
$
$
* COGS = Sales x (1 - GM%) = $
= $
237,400
728,300
965,700
(691,410)
274,290
1,213,000 x ( 1 - 43% )
691,410
NOTE: The key to successfully applying this
method is a reliable Gross Margin Percentage.
1278
Learning Objective
Estimate ending inventory and cost of
goods sold using the retail inventory method,
1279
Retail Inventory Method
 This
method was developed for retail
operations like department stores.
 Uses both the retail value and cost of
items for sale to calculate a cost to
retail ratio.
Objective: Convert ending
inventory at retail to ending
inventory at cost.
1280
Retail Inventory Method
Beginning
inventory at retail
and cost.
Sales for the
period.
We need to
know . . .
Net purchases at
retail and cost.
Adjustments to the
original retail price.
1281
Steps to the Retail Inventory Method
1. Determine cost and retail value of goods
sold.
2. Calculate the cost-to-retail %.
3. Retail value of goods available for sale sales = ending inventory at retail.
4. Cost-to-retail % x Ending inventory at
retail = Estimated ending inventory at
cost.
1282
Retail Inventory Method
Matrix, Inc. uses the retail method to estimate
inventory at the end of each month. For the
month of May the controller gathers the following
information:
Beg. inventory at cost $27,000
(at retail $45,000)
Net purchases at cost $180,000
(at retail $300,000)
Net sales for May $310,000.
Estimate the inventory at May 31.
1283
Retail Inventory Method
Inventory, May 1
Net purchases for May
Goods available for sale
Cost ratio:
(207,000 ÷ 345,000) = 60%
Sales for May
Ending inventory at retail
Ending inventory at cost
Cost
$ 27,000
180,000
207,000
Retail
$
45,000
300,000
345,000
(310,000)
$
35,000
?
1284
Retail Inventory Method
Cost
$ 27,000
180,000
207,000
Retail
$
45,000
300,000
345,000
x
(310,000)
$
35,000
Inventory, May 1
Net purchases for May
Goods available for sale
Cost ratio:
(207,000 ÷ 345,000) = 60%
Sales for May
Ending inventory at retail
Ending inventory at cost
$
21,000
?
1285
Approximating Average Cost
Cost-toRetail %
=
Beginning Inventory + Net Purchases
Retail Value of (Beginning Inventory + Net
Purchases + Net Markups - Net Markdowns)
The primary difference
between this and our earlier,
simplified example, is the
inclusion of markups and
markdowns in the computation
of the Cost-to-Retail %.
1286
Retail Inventory Method - Average Cost
Matrix, Inc. uses the average cost retail method
to estimate inventory at the end of June. The
controller gathers the following information:
Beginning inventory at cost $21,000
(at retail $35,000)
Net purchases at cost $200,000
(at retail $304,000)
Net markups $8,000
Net markdowns $4,000
Net sales for June $300,000
Estimate inventory at June 30.
1287
Retail Inventory Method - Average Cost
Inventory, June 1
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods available for sale
Cost ratio:
(221,000 ÷ 343,000) = 64.43%
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
Cost
Retail
$ 21,000 $
35,000
200,000
304,000
8,000
(4,000)
221,000
343,000
(300,000)
$
43,000
?
1288
Retail Inventory Method - Average Cost
Cost
Retail
$ 21,000 $
35,000
200,000
304,000
8,000
(4,000)
221,000
343,000
Inventory, June 1
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods available for sale
Cost ratio:
343,000) == 64.43%
(221,000 ÷ 343,000)
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$
x
27,705
?
(300,000)
$
43,000
1289
Learning Objective
Explain how the retail inventory method
can be made to approximate the
lower-of-cost-or-market rule.
1290
Retail Inventory Method - Average LCM

Approximating Average LCM
Cost-toRetail %
=
Beginning Inventory + Net Purchases
Retail Value of (Beginning Inventory + Net
Purchases + Net Markups)
Net Markdowns are
excluded in the
computation of the
Cost-to-Retail %
1291
Retail Inventory Method - Average LCM
Matrix, Inc. uses the average cost retail method
to estimate inventory at the end of June. The
controller gathers the following information:
Beginning inventory at cost $21,000
(at retail $35,000)
Net purchases at cost $200,000
(at retail $304,000)
Net markups $8,000
Net markdowns $4,000
Net sales for June $300,000
Let’s estimate inventory at June 30.
1292
Retail Inventory Method - Average LCM
Inventory, June 1
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods Available for Sale
Cost ratio:
(221,000 ÷ 347,000) =
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$
Cost
Retail
21,000 $
35,000
200,000
304,000
8,000
347,000
(4,000)
221,000
343,000
63.69%
(300,000)
$
43,000
?
1293
Retail Inventory Method - Average LCM
Inventory, June 1
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods Available for Sale
Cost ratio:
(221,000 ÷ 347,000) =
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$
Cost
Retail
35,000
21,000 $
200,000
304,000
8,000
347,000
(4,000)
343,000
221,000
63.69%
x
$
27,387
?
(300,000)
$
43,000
1294
The LIFO Retail Method
 Assume
that retail prices of goods
remain stable during the period.
 Establish a LIFO base layer (beginning
inventory) and add (or subtract) the
layer from the current period.
 Calculate the cost-to-retail percentage
for beginning inventory and for
adjusted net purchases for the period.
1295
The LIFO Retail Method
LIFO Costto-Retail %
=
Net Purchases
Retail Value of (Net Purchases + Net
Markups - Net Markdowns)
Beginning inventory has its own
cost-to-retail percentage.
1296
The LIFO Retail Method
 Use the data from Matrix Inc. to estimate
the LIFO ending inventory.
1. Beginning inventory at cost $21,000, at retail
$35,000;
2. Net purchases at cost $200,000, at retail
$304,000;
3. Net markups $8,000;
4. Net markdowns $4,000;
5. Net sales for June $300,000.
Estimate ending inventory.
1297
The LIFO Retail Method
Current
Period
LIFO
Cost ratio:
Inventory,
June
1 (60%)
$
(200,000
÷ 308,000) =
64.94%
Plus:
Net Purchases
Retail
Net Markups
Beginning
$
35,000 x
Less: NetInventory
Markdowns
Current
Layer
8,000 x
GoodsPeriod's
Available
(Less Beg. Inv.)
Total Available (Incl. Beg.
$ Inv.)
43,000
Goods
* $21,000
÷ $35,000
LIFO Cost
ratio: = 60%
** rounded
Requires
(200,000
a composite
÷ 308,000)ratio
= 64.94%
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$
Cost
Retail
21,000 $
35,000
200,000
304,000
Cost
8,000
60%*
=
21,000
(4,000)
64.94% =
5,195 **
200,000
308,000
26,195
221,000
343,000
(300,000)
$
43,000
?26,195
1298
Learning Objective
Explain the appropriate accounting
treatment when an inventory error is
discovered.
1299
Inventory Errors

Overstatement of ending inventory
Understates cost of goods sold and
Overstates pretax income.

Understatement of ending inventory
Overstates cost of goods sold and
Understates pretax income.
1300
Inventory Errors
 Overstatement
of beginning inventory
Overstates cost of goods sold and
Understates pretax income.
 Understatement
of beginning
inventory
Understates cost of goods sold and
Overstates pretax income.
1301
Inventory Errors
 Overstatement
of purchases
Overstates cost of goods sold and
Understates pretax income.
 Understatement
of purchases
Understates cost of goods sold and
Overstates pretax income.
Operational
Assets:
Acquisition and
Disposition
Insert Book Cover
Picture
10
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Types of Operational Assets
Actively Used in Operations
Expected to Benefit Future Periods
Tangible
Property, Plant,
Equipment &
Natural
Resources
Intangible
No Physical
Substance
1303
1304
Learning Objectives
Identify the various costs included in the initial
cost of property, plant, and equipment, natural
resources, and intangible assets.
Costs to be Capitalized
General Rule
The initial cost of an operational asset
includes the purchase price and all
expenditures necessary to bring the asset
to its desired condition and location for use.
1305
Costs to be Capitalized
Equipment





Net purchase price
Taxes
Transportation costs
Installation costs
Modification to building
necessary to install
equipment
 Testing and trial runs
1306
1307
Costs to be Capitalized
Land







Purchase price
Real estate commissions
Attorney’s fees
Title search
Title transfer fees
Title insurance premiums
Removing old buildings
Land is not
depreciable.
Costs to be Capitalized
Land Improvements
Separately identifiable costs of
Driveways
Parking lots
Fencing
Landscaping
Private roads
1308
Costs to be Capitalized
Buildings
Purchase price
 Attorney’s fees
 Commissions
 Reconditioning

1309
Costs to be Capitalized
Natural Resources
Purchase price,
exploration and
development costs of:
 Timber
 Mineral deposits
 Oil and gas reserves
1310
Asset Retirement Obligations
1311
Often encountered with natural resource
extraction when the land must be
restored to a useable condition.
Recognize as a liability
and a corresponding
increase in the related asset.
Record at fair value, usually the
present value of future cash
outflows associated with the
reclamation or restoration.
1312
Intangible Assets
Lack physical
substance.
Exclusive
Rights.
Intangible
Assets
Future benefits
less certain than
tangible assets.
Usually acquired
for operational
use.
1313
Costs to be Capitalized
Intangible Assets
Record at current
cash equivalent
cost, including
purchase price,
legal fees, and
filing fees.
 Patents
 Copyrights
 Trademarks
 Franchises
 Goodwill
Patents
An exclusive right recognized by law and
granted by the US Patent Office for 20 years.
 Holder has the right to use, manufacture, or
sell the patented product or process without
interference or infringement by others.
 R & D costs that lead to an
internally developed patent
are expensed in the period
incurred.

1314
Patents
Torch, Inc. has developed a new device.
Research and development costs totaled
$30,000. Patent registration costs consisted
of $2,000 in attorney fees and $1,000 in
federal registration fees.
What is Torch’s patent cost?
Torch’s cost for the new patent is $3,000.
The $30,000 R & D cost is expensed as
incurred.
1315
1316
Goodwill
Goodwill
Occurs when one
company buys
another company.
Only purchased
goodwill is an
intangible asset.
The amount by which the
purchase price exceeds the fair
market value of net assets acquired.
Goodwill
Eddy Company paid $1,000,000 to
purchase all of James Company’s
assets and assumed James Company’s
liabilities of $200,000. James
Company’s assets were appraised at a
fair value of $900,000.
1317
Goodwill
What amount of goodwill should be recorded
on Eddy Company books?
a.
b.
c.
d.
$100,000
$200,000
$300,000
$400,000
1318
Goodwill
What amount of goodwill should be recorded
on Eddy Company books?
a.
b.
c.
d.
$100,000
$200,000
$300,000
$400,000
1319
1320
Learning Objectives
Determine the initial cost of individual
operational assets acquired as a group for a
lump-sum purchase price.
1321
Lump-Sum Purchases
Several assets are acquired for a single,
lump-sum price that may be lower than the
sum of the individual asset prices.
Allocation of the lump-sum
price is based on relative
values of the individual assets.
Asset 1
Asset 2
Asset 3
Lump-Sum Purchases
On May 13, we purchase land and building for
$200,000 cash. The appraised value of the
building is $162,500, and the land is appraised
at $87,500.
How much of the $200,000 purchase price will
be charged to the building account?
1322
1323
Lump-Sum Purchases
Asset
Land
Building
Total
Appraised
Value
(a)
$ 87,500
162,500
$ 250,000
% of
Value
(b)*
35%
65%
Purchase
Price
(c)
$ 200,000
200,000
Assigned
Cost
(b × c)
$ 70,000
130,000
$ 200,000
* $87,500÷$250,000 = 35%
The building will be apportioned $130,000
of the total purchase price of $200,000.
Prepare the journal entry to record the purchase.
1324
Lump-Sum Purchases
GENERAL JOURNAL
Date
Description
May 13 Land
Building
Page 14
PR
Debit
Credit
70,000
130,000
Cash
200,000
Noncash Acquisitions
Issuance of equity securities
 Deferred payments
 Donated Assets
 Exchanges

1325
Noncash Acquisitions
The asset acquired is recorded at
The fair value of the consideration given
or
The fair value of the asset acquired
Whichever is more objective and reliable.
1326
1327
Learning Objectives
Determine the initial cost of an operational
asset acquired in exchange for a deferred
payment contract.
1328
Deferred Payments
Note payable
Market interest
rate
Less than market rate
or noninterest bearing
Record asset at
face value of note
Record asset at present
value of future cash flows.
Let’s consider an example where we must compute
the present value of a noninterest-bearing note.
Deferred Payments
On January 2, 2006, Midwestern Corporation
purchased equipment by signing a
noninterest-bearing requiring $50,000 to be
paid on December 31, 2007. The prevailing
market rate of interest on notes of this nature
is 10%.
Prepare the required journal entries for
Midwestern on January 2, 2006; December
31, 2006 (year-end), and December 31, 2007
(year-end).
1329
1330
Deferred Payments
Since we do not know the cash equivalent
price in this example, we must use the
present value of the future cash payment.
Face amount of note
$ 50,000
× PV of $1, n=2, i=10%
0.82645
= PV of note (rounded) $ 41,323
GENERAL JOURNAL
Date
Description
Jan. 2 Equipment
2006 Discount on Note Payable
Note Payable
Discount = $50,000 - $41,323
Page 73
PR
Debit
Credit
41,323
8,677
50,000
1331
Deferred Payments
GENERAL JOURNAL
Date
Description
Page 74
PR
Dec. 31 Interest Expense
2006
Discount on Note Payable
Debit
Credit
4,132
4,132
Interest = 10% of $41,323
Dec. 31 Interest Expense
2007
Discount on Note Payable
Interest = 10% of ($41,323 + $4,132)
Dec. 31 Note Payable
2007
Cash
4,545
4,545
50,000
50,000
1332
Learning Objectives
Explain how to account for dispositions and
exchanges for other nonmonetary assets.
Dispositions
 Update depreciation to date
of disposal.
 Remove original cost of
asset and accumulated
depreciation from the
books.
 The difference between
book value of the asset and
the amount received is
recorded as a gain or loss.
1333
Dispositions
On June 30, 2006, MeLo, Inc. sold equipment for
$6,350 cash. The equipment was purchased on
January 1, 2001 at a cost of $15,000. The
equipment was depreciated using the straightline method over an estimated ten-year life with
zero salvage value. MeLo last recorded
depreciation on the equipment on December 31,
2005, its year-end.
Prepare the journal entries necessary to
record the disposition of this equipment.
1334
1335
Dispositions
Update depreciation to date of sale.
GENERAL JOURNAL
Date
Description
June 30 Depreciation Expense
Accumulated Depreciation
($15,000 ÷ 10 years) × ½ = $750
Page 9
PR
Debit
Credit
750
750
1336
Dispositions
Remove original cost of asset and
accumulated depreciation from the books.
Record the gain or loss.
GENERAL JOURNAL
Date
Description
June 30 Accumulated Depreciation
Cash
Loss on Sale
Equipment
($15,000 ÷ 10 years) × 5½ years = $8,250
Page 9
PR
Debit
Credit
8,250
6,350
400
15,000
Exchanges
 The
valuation of an asset exchange
depends on whether cash is paid or
received.
 General Valuation Principle (GVP):
Cost of asset acquired is . . .
Fair value of asset given up plus cash
paid or minus cash received
or
Fair value of asset acquired, if it is more
clearly evident.
1337
Exchanges
In the exchange of operational assets fair
value is used except in rare situations in which
the fair value cannot be determined or the
exchange lacks commercial substance.
When fair value cannot be determined or the
exchange lacks commercial substance, the
asset(s) acquired are valued at the book value
of the asset(s) given up, plus (or minus) any
cash exchanged. No gain is recognized.
1338
Fair Value Not Determinable
1339
Matrix, Inc. exchanges one unique operational
asset for another operational asset. Due to the
nature of the assets exchanged, Matrix could
not determine the fair value of the asset given
up or received. The asset given up had a cost
to Matrix of $600,000, and accumulated
depreciation of $400,000. Matrix exchanged
the asset and paid $100,000 cash.
Let’s record this unusual transaction.
Fair Value Not Determinable
Matrix, Inc.
Cost of asset given-up
$ 600,000
Accumulated depreciation
400,000
Book value
$ 200,000
In addition, Matrix paid $100,000 cash to
acquire the operational asset.
1340
1341
Fair Value Not Determinable
Matrix, Inc.
The journal entry below shows the proper
recording of the exchange.
GENERAL JOURNAL
Date
Description
Debit
Equipment ($200,000 + $100,000)
Accumulated depreciation
Equipment
Cash
300,000
400,000
Credit
600,000
100,000
1342
Exchange Lacks Commercial Substance
When exchanges are recorded at fair value, any
gain or loss is recognized for the difference
between the fair value and book value of the
asset(s) given-up. To preclude the possibility of
companies engaging in exchanges of
appreciated assets solely to be able to recognize
gains, fair value can only be used in legitimate
exchanges that have commercial substance.
1343
Exchange Lacks Commercial Substance
A nonmonetary exchange is considered to have
commercial substance if the company:
 expects a change in future cash flows as a
result of the exchange, and
 that expected change is significant relative to
the fair value of the assets exchanged.
1344
Exchanges
Matrix, Inc. exchanged new equipment and
$10,000 cash for equipment owned by Float, Inc.
Below is information about the asset exchanged
by Matrix. Record the transaction assuming the
exchange has commercial substance.
Cost
Matrix's
Equipment $ 500,000
Accumulated
Depreciation
$
Book
Value
Fair
Value
300,000 $ 200,000 $ 205,000
1345
Exchange Has Commercial Substance
Matrix, Inc.
Fair value of equipment $ 205,000
BV of equipment
($500,000 - $300,000)
200,000
Gain on exchange
$ 5,000
GENERAL JOURNAL
Date
Description
Debit
Equipment
Accumulated Depreciation
Equipment
Cash
Gain on exchange
215,000
300,000
$205,000 fair value + $10,000 cash
Credit
500,000
10,000
5,000
1346
Exchange Does Not Have
Commercial Substance
Equipment received should be valued at book value
of equipment transferred plus cash paid.
GENERAL JOURNAL
Date
Description
Debit
Equipment
Accumulated Depreciation
Equipment
Cash
210,000
300,000
$200,000 book value + $10,000 cash
Credit
500,000
10,000
1347
Learning Objectives
Identify the items included in the cost of a selfconstructed asset and determine the amount
of capitalized interest.
Self-Constructed Assets
When self-constructing an
asset, two accounting issues
must be addressed:
Overhead allocation to the selfconstructed asset.
 Incremental overhead only
 Full-cost approach
Proper treatment of interest
incurred during construction
1348
1349
Interest Capitalization
Under certain conditions, avoidable
interest incurred on qualifying assets is
capitalized.
Interest that could have
been avoided if the asset
were not constructed
and the money used to
retire debt.
An asset constructed:
 For a company’s own
use.
As a discrete project
for sale or lease.
Interest Capitalization
Capitalization begins when
 construction begins
 interest is incurred, and
 qualifying expenses are incurred.
Capitalization ends when . . .
 The asset is substantially complete and ready
for its intended use,
 or when interest costs no longer are being
incurred.
1350
1351
Interest Capitalization
Interest is capitalized based on Average
Accumulated Expenditures (AAE).
Qualifying
expenditures
weighted for the
number of months
outstanding during
the current
accounting period.
Qualifying expenditures
include labor, material and
overhead incurred on the
construction project
during accounting period.
1352
Interest Capitalization
If the qualifying
asset is financed
through a specific
new borrowing . . .
If there is no specific
new borrowing, and
the company has
other debt . . .
. . . use the specific
rate of the new
borrowing as the
capitalization rate.
. . . use the weighted
average cost of other
debt as the
capitalization rate.
Consider the following example.
Interest Capitalization
Welling, Inc. is constructing a building for its own
use. Construction activities started on May 1 and
have continued through Dec. 31. Welling made the
following qualifying expenditures: May 1, $125,000;
July 31, $160,000, Oct. 1, $200,000; and Dec. 1,
$300,000.
Welling borrowed $1,000,000 on May 1, from Bub’s
Bank for 10 years at 10 percent to finance the
construction. The loan is related to the construction
project and the company uses the specific interest
method to compute the amount of interest to
capitalize.
1353
1354
Interest Capitalization
Average Accumulated Expenditures
Date
5/1
7/31
10/1
12/1
Expenditure
$ 125,000
160,000
200,000
300,000
$ 785,000
Fraction of
Year
8/12
5/12
3/12
1/12
$
$
AAE
83,333
66,667
50,000
25,000
225,000
1355
Interest Capitalization
Since the $1,000,000 of specific borrowing is sufficient to
cover the $225,000 of average accumulated expenditures for
the year, use the specific borrowing rate of 10 percent to
determine the amount of interest to capitalize.
Interest = AAE × Specific Borrowing Rate
Interest = $225,000 × 10% = $22,500
GENERAL JOURNAL
Date
Description
Dec. 31 Construction-In-Progress
Interest Expense
Page 14
PR
Debit
Credit
22,500
22,500
Interest Capitalization
If Welling had not borrowed specifically for this construction
project, it would have used the weighted-average interest
method. The weighted average interest rate on other debt
would have been used to compute the amount of interest to
capitalize. For example, if the weighted-average interest
rate on other debt is 12 percent, the amount of interest
capitalized would be:
Interest = AAE × Weighted-average Rate
Interest = $225,000 × 12% = $27,000
1356
1357
Interest Capitalization
If specific new borrowing had been insufficient to
cover the average accumulated expenditures . . .
. . . Capitalize this
portion using the 12
percent weightedaverage cost of debt.
. . . Capitalize this
portion using the 10
percent specific
borrowing rate.
Other
debt
AAE
Specific
new
borrowing
Operational
Assets:
Utilization and
Impairment
Insert Book Cover
Picture
11
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1359
Learning Objectives
Explain the concept of cost allocation as it
pertains to operational assets.
Cost Allocation – An Overview
The matching principle requires that part of
the acquisition cost of operational assets be
expensed in periods when the future revenues
are earned.
Some of the cost is expensed each period.
Acquisition
Cost
(Balance Sheet)
Expense
(Income Statement)
1360
Cost Allocation – An Overview
Depreciation, depletion, and amortization
are cost allocation processes used to help
meet the matching principle requirements.
Some of the cost is expensed each period.
Acquisition
Cost
(Balance Sheet)
Expense
(Income Statement)
1361
Cost Allocation – An Overview
Type of
Operational
Asset
Debit
Property, Plant, &
Equipment
Depreciation
Natural Resource
Depletion
Intangible
Amortization
Account Credited
Accumulated
Depreciation
Natural Resource
Asset
Intangible Asset
Caution!
Depreciation, depletion, and amortization are
processes of cost allocation, not valuation!
1362
1363
Measuring Cost Allocation
Cost allocation requires three pieces of
information for each asset:
Service
Life
Allocation
Base
The estimated expected
use from an asset.
Allocation
Method
The systematic approach
used for allocation.
Total amount of cost to be allocated.
Cost - Residual Value (at end of useful life)
1364
Learning Objectives
Determine periodic depreciation using both
time-based and activity-based methods.
1365
Depreciation of Operational Assets
Time-based Methods
Straight-line (SL)
Accelerated Methods
Sum-of-the-years’ digits (SYD)
Declining Balance (DB)
Group and
composite
methods
Tax
depreciation
Activity-based methods
Units-of-production method (UOP).
Depreciation on the Balance Sheet
Net property, plant & equipment is the
undepreciated cost (book value) of plant assets.
1366
1367
Straight-Line
The most widely
used and most
easily understood
method.
Results in the same
amount of
depreciation in each
year of the asset’s
service life.
Straight-Line
On January 1, we purchase equipment for
$50,000 cash. The equipment has an
estimated service life of 5 years and
estimated residual value of $5,000.
What is the annual straight-line
depreciation?
1368
1369
Straight-Line
Annual
Straight-line
Depreciation
=
=
Acquisition
Residual
–
Cost
Value
Estimated Service Life in
Years
$
= $
–
50,000
5
9,000
$
5,000
1370
Straight-Line
Year
1
2
3
4
5
Depreciation
(debit)
Accumulated
Depreciation
(credit)
Accumulated
Depreciation
Balance
$
$
$
$
9,000
9,000
9,000
9,000
9,000
45,000
$
9,000
9,000
9,000
9,000
9,000
45,000
9,000
18,000
27,000
36,000
45,000
Undepreciated
Balance
(book value)
$
50,000
41,000
32,000
23,000
14,000
5,000
Residual Value
Note that at the end of the asset’s
useful life, BV = Residual Value
1371
Depreciation
Straight-Line
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
1
2
3
Life in Years
4
5
1372
Accelerated Methods
Accelerated methods result in more
depreciation in the early years of an
asset’s useful life and less depreciation
in later years of an asset’s useful life.
Note that total
depreciation over the
asset’s useful life is the
same as the Straightline Method.
1373
Sum-of-the-Years’ Digits (SYD)
SYD depreciation is computed as follows:
SYD
= ( Cost
Depreciation
* Sum-oftheYears'Digits
= (
Residual
–
) ×
Value
Useful
Life
× [
Remaining Years
of Useful Life
Sum-of-the-Years
Digits*
Useful
Life
2
+ 1 ] )
Sum-of-the-Years’-Digits (SYD)
On January 1, we purchase equipment for
$50,000 cash. The equipment has a
service life of 5 years and an estimated
residual value of $5,000.
Using SYD, compute depreciation
for the first two years.
1374
1375
Sum-of-the-Years’ Digits (SYD)
* Sum-oftheYears'Digits
=
(
Useful
Life
× [
Useful
Life
+ 1 ] )
2
=
=
=
(
5
30
15
× [
÷
2
5
+ 1]) ÷ 2
Use this in your computation of SYD
Depreciation for Years 1 & 2.
Sum-of-the-Years’ Digits (SYD)
SYD
= (
Depreciation
Cost
Remaining Years
of Useful Life
Residual
–
) ×
Value
Sum-of-the-Years
Digits
5
15
$ 15,000 Depreciation in Year 1
= ( $ 50,000 – $ 5,000 ) ×
=
4
= ( $ 50,000 – $ 5,000 ) ×
15
=
$ 12,000 Depreciation in Year 2
1376
Sum-of-the-Years’ Digits (SYD)
Fraction
5/15
4/15
3/15
2/15
1/15
Depreciation
(debit)
Accumulated
Depreciation
Balance
$
$
$
15,000
12,000
9,000
6,000
3,000
45,000
15,000
27,000
36,000
42,000
45,000
Undepreciated
Balance
(book value)
$
50,000
35,000
23,000
14,000
8,000
5,000
Residual Value
1377
1378
Sum-of-the-Years’ Digits (SYD)
Depreciation
16000
14000
12000
10000
8000
6000
4000
2000
0
1
2
3
Life in Years
4
5
Declining-Balance (DB) Methods
1379
DB depreciation


Based on the straightline rate multiplied by an
acceleration factor.
Computations initially
ignore residual value.
Stop depreciating
when:
BV=Residual Value
1380
Double-Declining-Balance (DDB)
DDB depreciation is computed as follows:
DDB =
Book
Value
× ( 2 ÷ Useful Life )
Note that the Book Value
will get lower each time
depreciation is computed!
1381
Double-Declining-Balance (DDB)
On January 1, we purchase equipment for
$50,000 cash. The equipment has a service
life of 5 years and an estimated residual
value of $5,000.
What is depreciation for
the first two years using
double-declining-balance?
1382
Double-Declining-Balance (DDB)
DDB =
Book
Value
× ( 2 ÷ Useful Life )
= $ 50,000 × ( 2 ÷ 5 )
= $ 20,000 1st Year Depreciation
= ($50,000 - $20,000) × (2 ÷ 5)
= $ 12,000 2nd Year Depreciation
1383
Double-Declining-Balance (DDB)
Year
1
2
3
4
5
Depreciation
(debit)
$
$
20,000
12,000
7,200
4,320
1,480
45,000
Accumulated
Depreciation
Balance
$
20,000
32,000
39,200
43,520
45,000
Undepreciated
Balance
(book value)
50,000
$
30,000
18,000
10,800
6,480
5,000
We usually have to force depreciation in the
latter years to an amount that brings BV = Residual Value.
1384
Depreciation
Double-Declining-Balance (DDB)
20000
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
1
2
3
Life in Years
4
5
Activity-Based Depreciation

Depreciation can also be
based on measures of
input or output like:
 Service hours, or
 Units-of-Production

Depreciation is not taken
for idle assets.
This approach
looks different.
1385
1386
Units-of-Production
Depreciation
rate per unit
of output
=
Acquisition
Cost
Residual
–
Value
Estimated Output in Units
Depreciation
Depreciation =
rate per unit
×
Units of
output
Units-of-Production
On January 1, we purchased equipment for
$50,000 cash. The equipment is expected
to produce 100,000 units during its life and
has an estimated residual value of $5,000.
If 22,000 units were produced this year,
what is the amount of depreciation?
1387
1388
Units-of-Production
Depreciation
rate per unit
Depreciation
$50,000 – $5,000
=
100,000
=
Depreciation
rate per unit
=
=
$0.45
$9,900
= $0.45
×
Units of
output
×
22,000
1389
Use of Various Depreciation Methods
Recent Survey of Large Public Companies (Sample of 684)
30 4
41
22
7
Straight Line
Declining Balance
Sum-of-the-years' digits
Other Accelerated
Units of Production
Other
580
Group and Composite Methods
 Assets
are grouped by common
characteristics.
 An average depreciation rate is used.
 Annual depreciation is the average rate ×
the total group acquisition cost.
 Accumulated depreciation records are not
maintained for individual assets.
1390
Group and Composite Methods
 If
assets in the group are sold, or
new assets added, the composite
rate remains the same.
 When an asset in the group is sold or
retired, debit accumulated
depreciation for the difference
between the asset’s cost and the
proceeds.
1391
1392
Learning Objectives
Calculate the periodic depletion of a natural
resource.
Depletion of Natural Resources
As natural resources
are “used up”, or
depleted, the cost of
the natural resources
must be allocated to
the units extracted.
The approach is
based on the unitsof-production
method.
1393
Depletion of Natural Resources
Depletion rate
=
per unit
Total
Depletion
Cost
=
Cost of Natural
Resource
Residual
–
Value
Estimated Recoverable Units
Unit Depletion
Rate
×
Units
Extracted
1394
Depletion of Natural Resources
ABC Mining acquired a tract of
land containing ore deposits.
Total costs of acquisition and
development were $1,100,000.
ABC estimated the land
contained 40,000 tons of ore, and
that the land will be sold for
$100,000 after the coal is mined.
1395
Depletion of Natural Resources
What is ABC’s unit depletion rate?
a.
b.
c.
d.
$40 per ton
$50 per ton
$25 per ton
$20 per ton
1396
Depletion of Natural Resources
What is ABC’s unit depletion rate?
Cost / Units
a.
b.
c.
d.
$40 per ton
$50 per ton
$25 per ton
$20 per ton
$1,000,000 / 40,000 Tons
= $25 Per Ton
1397
Depletion of Natural Resources
For the year ABC mined 13,000 tons and sold
9,000 tons. What is the total depletion and the
depletion expense?
a.
b.
c.
d.
$325,000 & $225,000
$325,000 & $325,000
$225,000 & $225,000
$275,000 & $225,000
1398
Depletion of Natural Resources
For the year ABC mined 13,000 tons and sold
9,000 tons. What is the total depletion and the
depletion expense?
Depletion = 13,000 x $25
a.
b.
c.
d.
$325,000 & $225,000
$325,000 & $325,000
$225,000 & $225,000
$275,000 & $225,000
= $325,000
Expense = 9,000 x $25
= $225,000
1399
1400
Learning Objectives
Calculate the periodic amortization of an
intangible asset.
Amortization of Intangible Assets
The amortization process uses the
straight-line method, but assumes
residual value = 0.
Economic
Life
Amortization period
is the shorter of:
or
Legal
Life
1401
1402
Amortization of Intangible Assets
The amortization entry is:
GENERAL JOURNAL
Date
Description
Amortization Expense
Intangible Asset
Page 42
PR
Debit
Credit
$$$
Note that the amortization process does
not use a contra-asset account.
$$$
Intangible Assets Not Subject
to Amortization
Goodwill
Not amortized.
Subject to assessment
for impairment
value and may be
written down.
1403
1404
Partial-Period Depreciation
I bought an asset on May
19 this year. Do I get a full
year’s depreciation?
May
19
Partial-Period Depreciation
Pro-rating the depreciation based on the
date of acquisition is time-consuming
and costly. A commonly used alternative
is the . . .
Half-Year Convention
Take ½ of a year of depreciation in the
year of acquisition, and the other ½ in
the year of disposal.
1405
1406
Learning Objectives
Explain the appropriate accounting treatment
required when a change is made in the service
life or residual value of an operational asset.
1407
Changes in Estimates
Depreciation Expense is based on . . .
ESTIMATED
service life
ESTIMATED
residual value
If the estimates change, the book value less
any residual value at the date of change is
depreciated over the remaining useful life.
Changes in Estimates
On January 1, equipment was
purchased that cost $30,000,
has a useful life of 10 years and
no salvage value. At the
beginning of the fourth year, it
was decided that there were
only 5 years remaining, instead
of 7 years.
Calculate depreciation expense
for the fourth year using the
straight-line method.
1408
1409
Changes in Estimates
Asset cost
Accumulated depreciation
($3,000 per year × 3 years)
Remaining book value
Divide by remaining life
Revised annual depreciation
$ 30,000
9,000
21,000
÷ 5
$ 4,200
What happens if we change
depreciation methods?
1410
Learning Objectives
Explain the appropriate accounting treatment
required when a change in depreciation
method is made.
Change in Depreciation Method
A change in depreciation, amortization, or
depletion method is considered a change in
accounting estimate that is achieved by a
change in accounting principle.
We account for these changes
prospectively, exactly as we would any
other change in estimate.
1411
Change in Depreciation Method
On January 1, 2004, Matrix, Inc., a calendar
year-end company purchased equipment for
$400,000. Matrix expected a residual value
$40,000, and a service life of 5 years. Matrix
uses the double-declining-balance method to
depreciate this type of asset. During 2006, the
company switched from double-declining
balance to straight-line depreciation. Let’s
determine the amount of depreciation to be
recorded at the end of 2006.
1412
1413
Change in Depreciation Method
Depreciation - 2004
Depreciation - 2005
Total Depreciation
$ 160,000 ($400,000 × 40%)
96,000 [($400,000 - $160,000) × 40%]
$ 256,000
Cost of asset
Accumulated depreciation
Undepreciated balance
Remaining service life
Annual depreciation
$
÷
$
400,000
(256,000)
144,000
3
48,000
General Journal
2006 Depreciation
Description
Debit
Depreciation expense
Accumulated depreciation
48,000
Credit
48,000
1414
Learning Objectives
Identify situations that involve a significant
impairment of the value of operational assets
and describe the required accounting
procedures.
Impairment of Value
Occasionally, asset value
must be written down due
to permanent loss of
benefits of the asset
through . . .
 Casualty.
 Obsolescence.
 Lack of demand for the
asset’s services.
1415
1416
Impairment of Value
Accounting treatment differs.
Operational assets
to be held and used
Tangible and
intangible
with finite
useful lives
Intangible
with
indefinite
useful lives
Operational assets
held to be sold
Goodwill
1417
Impairment of Value
Test for impairment of value
Test for
when it is suspected that
impairment of
book value may not be
value at least
Accounting treatment differs.annually.
recoverable
Operational assets
to be held and used
Tangible and
intangible
with finite
useful lives
Intangible
with
indefinite
useful lives
Operational assets
held to be sold
Goodwill
Test for impairment
of value when
considered for sale.
Impairment of Value –
Tangible and Finite-Life Intangibles
Measurement – Step 1
An asset is impaired if . . .
Recoverable cost < Book value
Expected future total
undiscounted net cash
inflows generated by use of
the asset.
1418
Impairment of Value –
1419
Tangible and Finite-Life Intangibles
Measurement – Step 2
Impairment
loss
Reported as
part of
income from
continuing
operations.
=
Book
value
–
Fair
value
Market value, price of
similar assets, or PV of
future net cash inflows.
Fair value < recoverable
value due to the time
value of money.
Impairment of Value –
1420
Tangible and Finite-Life Intangibles
Measurement – Step 2
$0
Fair
Value
$125
Case 1:
$50 book value
No loss recognized
Case 2:
$150 book value
No loss recognized
Recoverable
Cost
$250
Case 3:
$275 book value
Loss = $275 - $125
Impairment of Value –
1421
Indefinite Life Intangibles
Goodwill
Step 1 If BV of business
unit > FV, impairment
indicated.
Step 2 Loss = BV of
goodwill less implied value
of goodwill.
Other Indefinite
Life Intangibles
One-step Process
If BV of asset >
FV, recognize
impairment loss.
Goodwill
Example
1422
Impairment of Value – Goodwill
Parent Company purchased Sub Company for $500 million at
a time when the fair value of Sub’s net identifiable assets
were $400 million. Sub continued to operate as a separate
company. At the end of the next year, Parent did a goodwill
impairment test revealing the following:
Book value of Sub's assets,
including $100 million of goodwill
$ 440
Sub's fair value
$ 350
Fair value of Sub's identifiable assets
excluding goodwill
$ 325
Goodwill
impaired?
Impairment of Value – Goodwill
1423
Impairment of Value –
1424
Operational Assets to be Sold
Operational assets to be sold
includes assets that management
has committed to sell immediately in
their present condition and
for which sale is probable.
Impairment
loss
=
Book
value
Fair value less
–
cost to sell
1425
Learning Objectives
Discuss the accounting treatment of repairs
and maintenance, additions, improvements,
and rearrangements to operational assets.
Expenditures Subsequent to Acquisition
Maintenanc
e and
ordinary
repairs.
Rearrangement
s and other
adjustments.
Improvements
(betterments),
replacements,
and extraordinary
repairs.
Additions
.
1426
Expenditures Subsequent to Acquisition
Normally we debit an expense
account for amounts spent on:
1427
Expenditures Subsequent to Acquisition
Normally we debit the asset account
for amounts spent on:
1428
Expenditures Subsequent to Acquisition
Normally we debit the asset account
for amounts spent on:
1429
Expenditures Subsequent to Acquisition
Normally, we debit an asset account
for amounts spent on:
1430
ACG 3141:
INTERMEDIATE
ACCOUNTING
University of Central Florida
Lecturer: Mary Walsh
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1432
Class Schedule

Week 1, Class 1: Begin Chapter 13 Lecture and In-Class Problems


Current vs. Long-Term Liabilities
Accounting for Short-Term Notes Payable



Interest-bearing
Non interest-bearing
Week 1, Class 2: Continue Chapter 13 Lecture and In-Class
Problems

Accounting for Advance Collections





Refundable Deposits
Advances from Customers
Collections for Third Parties
Classification of a current liability as a long-term liability.
Contingencies






Loss Contingencies
Warranties
Premiums
Litigation Claims
Subsequent Events
Gain Contingencies
1433
Chapter 13 Learning Objectives
1.
2.
3.
4.
5.
6.
7.
Define liabilities and distinguish between current and
long-term liabilities.
Account for the issuance and payment of various forms
of notes and record the interest on notes.
Characterize accrued liabilities and liabilities from
advance collection and describe when and how they
should be recorded.
Determine when a current liability can be classified as a
noncurrent obligation.
Identify situations that constitute contingencies and the
circumstances under which they should be accrued.
Demonstrate the appropriate accounting treatment for
contingencies, including unasserted claims and
assessments.
Demonstrate the appropriate accounting treatment for
payroll related liabilities.
1434
Learning Objectives
Define liabilities and distinguish between
current and long-term liabilities.
1435
Liabilities
Probable
future
sacrifices of
economic
benefits . . .
. . . Arising
from present
obligations
to other
entities . . .
. . . Resulting
from past
transactions
or events.
1436
What is a Current Liability?
LIABILITIES
Current Liabilities
Obligations payable within one year
or one operating cycle, whichever is
longer.
Expected to be satisfied with
current assets or by the creation
of other current liabilities.
Long-term Liabilities
1437
Current Liabilities
Accounts
payable
Taxes
payable
Unearned
revenues
Cash dividends
payable
Current
Liabilities
Accrued
expenses
Short-term
notes payable
1438
Open Accounts and Notes

Accounts Payable
Obligations to suppliers for goods
purchased on open account.

Trade Notes Payable
Similar to accounts payable, but
recognized by a written promissory
note.

Short-term Notes Payable
Cash borrowed from the bank and
recognized by a promissory note.
1439
Credit Lines
Prearranged agreements
with a bank that allow a
company to borrow cash
without following normal
loan procedures and
paperwork.
Opening a line of credit is
NOT an accounting event
1440
Learning Objectives
Account for the issuance and payment of
various forms of notes and record the interest
on notes.
1441
Interest
Interest on notes is calculated as follows:
Face
Amount
Amount
borrowed
×
Annual
Rate
Interest rate is
always stated
as an annual
rate.
×
Time To
Maturity
Interest owed is
adjusted for the
portion of the year
that the face
amount is
outstanding.
1442
Interest-Bearing Notes
On September 1, Eagle Boats borrows $80,000 from
Cooke Bank. The note is due in 6 months and has a
stated interest rate of 9%.
Record the borrowing on September 1.
GENERAL JOURNAL
56
Page:
Date
Description
Sept. 1 Cash
Notes Payable
to record receipt of short-term
loan proceeds from Cooke
Bank
PR
Debit
Credit
80,000
80,000
1443
Interest-Bearing Notes
How much interest is due to Cooke
Bank at year-end, on December 31?
a.
b.
c.
d.
$2,400
$3,600
$7,200
$87,200
1444
Interest-Bearing Notes
How much interest is due to Cooke
Bank at year-end, on December 31?
a.
b.
c.
d.
$2,400
$3,600
$7,200
$87,200
Interest is calculated as:
Face
Annual
Time to
× Rate
× maturity =
Amount
$80,000
×
9%
×
4/12
$2,400 interest due to Cooke Bank.
=
1445
Interest-Bearing Notes
Assume Eagle Boats’ year-end is December 31.
Record the necessary adjustment at year-end.
GENERAL JOURNAL
28
Page:
Date
Description
PR
Debit
Credit
1446
Interest-Bearing Notes
Assume Eagle Boats’ year-end is December 31.
Record the necessary adjustment at year-end.
GENERAL JOURNAL
28
Page:
Date
Description
Dec. 31 Interest Expense
Interest Payable
to accrue interest on note due
to Cooke Bank
PR
Debit
Credit
2,400
2,400
1447
Interest-Bearing Notes
Assume Eagle Boats’ year-end is December 31.
Record the necessary journal entry when the note
matures on February 28.
GENERAL JOURNAL
12
Page:
Date
Description
PR
Debit
Credit
1448
Interest-Bearing Notes
Assume Eagle Boats’ year-end is December 31.
Record the necessary journal entry when the note
matures on February 28.
GENERAL JOURNAL
12
Page:
Date
Description
Feb. 28 Interest Payable
Interest Expense
Note Payable
Cash
to pay off note and interest
PR
Debit
Credit
2,400
1,200
80,000
83,600
1449

Let’s do Lecture Problem 1 – Notes Payable
(interest-bearing) Problem. See the Chapter 13
Lecture Problems Handout.
Short-Term Notes Payable
Noninterest-Bearing
 Notes
without a stated
interest rate carry an
implicit, or effective,
rate.
 The face of the note
includes the amount
borrowed and the
interest.
1450
Short-Term Notes Payable
Noninterest-Bearing
On May 1, Batter-Up, Inc. issued a one-year,
noninterest-bearing note with a face amount
of $10,600 in exchange for equipment
valued at $10,000.
How much interest will Batter-Up pay on the note?
Interest = Face Amount - Amount Borrowed
=
$10,600
$10,000
=
$600
1451
Short-Term Notes Payable
Noninterest-Bearing
On May 1, Batter-Up, Inc. issued a one-year,
noninterest-bearing note with a face amount
of $10,600 in exchange for equipment
valued at $10,000.
What is the effective interest rate on the note?
Amount
Interest
=
Borrowed
Rate
$ 600 ÷ $ 10,000 =
6.00%
Interest ÷
1452
1453

Let’s do Lecture Problem 2 – Notes Payable
(non interest-bearing) Problem. See the
Chapter 13 Lecture Problems handout.
1454
Learning Objectives
Characterize accrued liabilities and liabilities
from advance collection and describe when
and how they should be recorded.
1455
Accrued Liabilities

Accrued Liabilities represent expenses already
incurred but not yet paid.


Recorded at period end through AJEs. The entry will
always involve a debit to expense and a credit to an
accrued liability.
Examples of Accrued Liabilities



Interest Payable
Income Tax Payable
Salaries Payable


Regular Compensation and Bonuses
Accrued Vacation: Let’s do Lecture Problem 3 – Vacation
Pay Accrual. See the Chapter 13 Lecture Problems handout.
1456
Liabilities from Advance Collections

Liabilities are created when amounts are
received from customers that will be returned to
the customers.


Refundable Deposits: Let’s do Lecture Problem 4 –
Customer Deposits. See the Chapter 13 Lecture
Problems handout.
Advances from Customers: Let’s do Lecture
Problem 5 – Advance Collections. See the Chapter
13 Lecture Problems handout.
1457
Collections for Third Parties

Similar to liabilities for advance collections,
companies often make collections for third
parties from customers and employees and
remit the amounts to the appropriate
governmental (or other) parties. These amounts
are never revenue to the company, nor do they
represent expenses to the company – they are
liabilities until remitted or returned. Examples
include sales tax payable (collected from
customers) and employment taxes payable
(i.e., the employee portion of FICA collected
from employees). Let’s skip to the Appendix 13
slides (slide 43).
1458
Learning Objectives
Determine when a current liability can be
classified
as a noncurrent obligation.
Short-Term Obligations
Expected to Be Refinanced
A company may reclassify a short-term liability
as long-term only if two conditions are met:
 It has the intent to
refinance on a
long-term basis.
and
 It has demonstrated
the ability to
refinance.
The ability to refinance on a long-term basis
can be demonstrated by:
 An existing refinancing agreement, or
 By actual financing prior to issuance of the
financial statements.
1459
1460
Learning Objectives
Identify situations that constitute contingencies
and the circumstances under which they
should be accrued.
1461
Contingencies
A loss contingency is an
existing uncertain situation
involving potential loss
depending on whether
some future event occurs.
1462
Contingencies
Two factors affect whether a loss
contingency must be accrued and
reported as a liability (i.e., recorded):
1. the likelihood that the confirming event
will occur.
2. whether the loss amount can be
reasonably estimated.
Contingencies –
Likelihood of Occurrence
 Probable
A confirming event is likely to occur.
 Reasonably
Possible
The chance the confirming event will occur is
more than remote, but less than likely.
 Remote
The chance the confirming event will occur is
slight.
1463
1464
Contingencies
Dollar Amount of Potential Loss
Likelihood
Probable
Reasonably possible
Remote
Known
Reasonably
Estimable
Liability accrued
Liability accrued
and disclosure note and disclosure note
Disclosure note
Disclosure note
only
only
No disclosure
No disclosure
required
required
Not Reasonably
Estimable
Disclosure note
only
Disclosure note
only
No disclosure
required
A loss contingency is accrued (recorded) only if a loss is
probable and the amount is either known, or can
reasonably be estimated.
1465
Learning Objectives
Demonstrate the appropriate accounting
treatment for contingencies, including
unasserted claims and assessments.
1466
Product Warranties and Guarantees



If a product is sold under warranty, the matching principle requires
that warranty costs (i.e., warranty expense) should be recorded at
the time of the sale.
The amount of those costs can be reasonably estimated using
commonly available estimation techniques.
The estimate requires the following entry:
GENERAL JOURNAL
15
Page:
Date
Description
Debit
Warranty Expense
Estimated Warranty Liability
$$$
Credit
$$$
Let’s do Lecture Problem 6 – Warranties. See the Chapter 13 Lecture
Problems handout.
1467
Extended Warranties
 Extended
warranties are sold
separately from the product.
 The related revenue is not earned
until
 Claims are made against the
extended warranty, or
 The extended warranty period expires.
1468
Premiums
Premiums (i.e., rebate)
included with the product are
expensed in the period of sale
(matching principle).
 Premiums that are contingent
on action by the customer
require accounting similar to
warranties.
 Let’s do Lecture Problem 7 –
Premiums Problem. See the
Chapter 13 Lecture Problems
handout.

1469
Litigation Claims
 The
majority of medium
and large-size corporations
annually report loss
contingencies due to
litigation.
 The most common
disclosure is a note to the
financial statements.
Why? It’s hard to estimate
the amount.
1470
Subsequent Events
Events occurring between the year-end date
and report date can affect the appearance
of disclosures on the financial statements.
Cause of Loss Contingency
Fiscal Year Ends
Clarification
Financial Statements
1471
Unasserted Claims and Assessments
End
No
Is a claim or
assessment
probable?
Yes
Disclosure
of claim or
assessment
No
Can amount
be estimated?
Yes
Record
estimated claim
or assessment
1472
Gain Contingencies
Note that the prior rules have
supported the recording of LOSS
contingencies.
As a general rule, we
never record GAIN
contingencies.
Generally, gain is
ONLY recorded
when the gain is
actually
REALIZED...why??
CONSERVATISM
1473
Learning Objectives
Demonstrate the appropriate accounting
treatment for payroll related liabilities
(Appendix 13).
1474
Payroll-Related Liabilities
Employers incur
several expenses
and liabilities
from having
employees.
1475
Payroll-Related Liabilities
Gross Pay
FICA
Taxes
Medicare
Taxes
Federal
Income Tax
State and Local
Income Taxes
Net Pay
Voluntary
Deductions
1476
Employee FICA Taxes
Federal Insurance Contributions Act (FICA)
FICA Taxes
6.2% of the first $90,000
earned in the year.
Medicare Taxes
1.45% of all wages
earned in the year.
Employers must pay withheld taxes
to the Internal Revenue Service (IRS).
Additionally, Employers OWE an equivalent
amount of FICA taxes.
1477
Employee Income Taxes
Federal
Income Tax
State and
Local Income
Taxes
Amounts withheld depend on the employee’s earnings,
tax rates, and number of withholding allowances.
Employers must pay the taxes withheld from employees’
gross pay to the appropriate government agency.
1478
Employee Voluntary Deductions
Voluntary Deductions
Amounts withheld depend on the employee’s request.
Examples include union dues, savings accounts,
pension contributions, insurance premiums, charities
Employers owe voluntary amounts withheld from
employees’ gross pay to the designated agency.
1479
Employer Payroll Taxes
FICA Taxes
Medicare
Taxes
Federal and
State
Unemployment
Taxes
Employers pay amounts equal to that
withheld from the employee’s gross pay.
The amount owed by the employer is an
expense to the employer
Federal and State
Unemployment Taxes
Federal
Unemployment Tax
(FUTA)
State
Unemployment Tax
(SUTA)
1480
6.2% on the first
$7,000 of wages paid
to each employee (A
credit up to 5.4% is
given for SUTA paid.)
Basic rate of 5.4% on
the first $7,000 of
wages paid to each
employee (Merit
ratings may lower
SUTA rates.)
1481
Employment Taxes Example

X Corporation pays its employees $2,000,000 in wages
for the current pay period. Information relating to these
wages are as follows:






Federal income taxes to be withheld
Local income taxes to be withheld
FUTA Rate
SUTA Rate
Social Security tax Rate
Medicare tax rate
400,000
53,000
.80%
5.40%
6.20%
1.45%
Required: Prepare the appropriate journal entries to
record salaries and wages expense and payroll tax
expense for the current pay period
1482
Employment Taxes Solution
Entry 1: Record the Amounts Subject to Withholding
Dr. Salaries and wages expense (total amount earned)
2,000,000
Cr. Withholding taxes payable (federal income tax)
400,000
Cr. Withholding taxes payable (local income tax)
53,000
Cr. Social security taxes payable ($2,000,000 x 6.2%)
124,000
Cr. Medicare taxes payable ($2,000,000 x 1.45%)
29,000
Cr. Salaries and wages payable (net pay)
1,394,000
Entry 2: Record the Employer Expense
Dr. Payroll tax expense (total)
Cr. Social security taxes payable
(employer’s matching amount)
Cr. Medicare taxes payable
(employer’s matching amount)
Cr. FUTA payable ($2,000,000 x 0.8%)
Cr. SUTA payable ($2,000,000 x 5.4%)
277,000
124,000
29,000
16,000
108,000
1483
Fringe Benefits
In addition to salaries and wages,
withholding taxes, and payroll taxes,
most companies provide a variety
of fringe benefits.
Health
insurance
premiums
Life
insurance
premiums
Retirement
plan
contributions
Employers must pay the amounts promised to fund
employee fringe benefits to the designated agency.
Fringe benefits will yield additional wage expense to the
employer.
Chapter 21
The Statement
of
Cash Flows
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
The Purpose of the
Statement of Cash Flows
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1486
The Statement of Cash Flows
Summarizes cash flows for a period of time
“For the year ended...”
Explains how cash was generated and used
Reflects transactions already reported in the
balance sheet
income statement
Financial Accounting, 7e Stice/Stice,
486
1487
The Statement of Cash Flows
Particularly useful when net income does not
accurately reflect the economic performance of a
business:
Noncash expenses are high
Growth companies use more cash than expenses imply
Accrual basis accounting assumptions are stretched to
the limit
Financial Accounting, 7e Stice/Stice,
487
1488
The
Statement
of Cash
A one-page
summary
of theFlows
results of a company’s
operating, investing, and financing activities
A pro forma SCF
As a forecasting tool
Whether future cash activities are consistent and
workable
Financial Accounting, 7e Stice/Stice,
488
Information Reported on
Statement of Cash Flows
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1490
Cash Equivalents
The SCF explains the changes in cash and cash
equivalents during a period
short-term, highly liquid investments
i.e., treasury bills, commercial paper, and money market
funds
Financial Accounting, 7e Stice/Stice,
490
1491
Three Categories of Cash Flows
Cash receipts and disbursements are classified
into three main categories:
Operating activities
Investing activities
Financing activities
Financial Accounting, 7e Stice/Stice,
491
1492
Operating Activities
Includes all transactions relating to a company
delivering or producing its goods for sale and
providing its services
Financial Accounting, 7e Stice/Stice,
492
1493
Major Cash Flows:
Operating Activities
Cash receipts from:
Sale of goods or
services
Sale of trading
securities
Interest revenue
Dividend revenue
Cash payments for:
Inventory purchases
Wages and salaries
Taxes
Interest expense
Other expenses (e.g.,
utilities, rent)
Purchase of trading
securities
493
Financial Accounting, 7e Stice/Stice,
1494
Investing Activities
Includes cash inflows and outflows from changes
in noncurrent assets:
Productive assets
Investment securities
Loans to others
Financial Accounting, 7e Stice/Stice,
494
1495
Major Cash Flows:
Investing Activities
Cash receipts from:
Sale of plant assets
Sale of a business
segment
Sale of nontrading
securities
Collection of principal
on loans
Cash payments for:
Purchase plant assets
Purchase of nontrading
securities
Making loans to other
entities
Financial Accounting, 7e Stice/Stice,
495
1496
Financing Activities
Includes obtaining resources from
owners and providing them a return on their investment
creditors and repaying those borrowings
Financial Accounting, 7e Stice/Stice,
496
1497
Major Cash Flows:
Financing Activities
Cash receipts from:
Issuance of stock
Borrowing (e.g., bonds,
notes, mortgages)
Cash payments for:
Cash dividends
Repayment of loans
Repurchase of stock
(treasury stock)
Financial Accounting, 7e Stice/Stice,
497
Balance Sheet and Income
Statement
Balance Sheet
Current Assets
1498
Stmt of Cash Flows
Operating
Investing
Long-term Assets
Financing
Net Change in Cash
Current Liabilities
Accts Pay & Accrued Liabil
Short-term Loans Pay
Current Portion Long-term
Long-term Liabilities
Accrual Adjustments
Income Statement
Revenues
Expenses
Stockholders’ Equity
Net Income
Financial Accounting, 7e Stice/Stice,
498
1499
Cash Flow Pattern
Cash from...
Operations
Cash flow is typically
Inflow
Outflow
(positive)
(negative)

Investing
Financing

Financial Accounting, 7e Stice/Stice,
or


499
1500
Cash Flow Pattern
A company’s cash flow pattern is a general
reflection of where the company is in its life cycle
...
Financial Accounting, 7e Stice/Stice,
500
1501
Cash Flow Pattern
Start-Up, High Growth Company
Investing
Financing
Operating
Financial Accounting, 7e Stice/Stice,
501
1502
Cash Flow Pattern
Steady-State Company
Investing
Dividends
Financing
Operating
Financial Accounting, 7e Stice/Stice,
502
1503
Cash Flow Pattern
Cash Cow
Investing
Loan Repayment
Share Repurchases
Financing
Dividends
Operating
Financial Accounting, 7e Stice/Stice,
503
Noncash Investing and Financing
Activities
Activities that affect a company’s financial position
but do not result in cash flows
Example: Land acquired by issuing stock
These activities should be disclosed separately in
a schedule or in the notes to the financial
statements
Financial Accounting, 7e Stice/Stice,
504
1504
Analysis of Other Primary
Financial Statement for SCF
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Alternative Approach
Statement of Cash Flows
1506
Determine cash inflows and outflows through
analysis of changes in
Individual income statement accounts
Individual balance sheet accounts
Financial Accounting, 7e Stice/Stice,
506
A Six-step Process
For Preparing The SCF
1.
2.
Compute cash balance change for the year
Convert income statement from accrual to cash basis
a.
b.
c.
3.
4.
5.
6.
Eliminate non-cash expenses
Eliminate gains and losses from investing and financing activities
Adjust revenues and expenses for changes in current assets and
current liabilities
Analyze long-term assets to determine investing activities
Analyze long-term debt and stockholders’ equity to determine
financing activities
Reconcile total of steps 2, 3, & 4 with step 1; prepare statement
Disclosure other significant non-cash financing and investing
activities
1507
Reporting Cash Flows From
Operations
1508
Two methods
Indirect Method
Used by most companies because it is easy to construct
from the balance sheet and income statement
Direct Method
Preferred by the FASB and many users because it is easy to
understand
Financial Accounting, 7e Stice/Stice,
508