Chapter 01 - Financial Statements and Business Decisions
Chapter 01
Financial Statements and Business
Decisions
ANSWERS TO QUESTIONS
1. Accounting is a system that collects and processes (analyzes, measures, and
records) financial information about an organization and reports that information to
decision makers.
2. Financial accounting involves preparation of the four basic financial statements and
related disclosures for external decision makers. Managerial accounting involves
the preparation of detailed plans, budgets, forecasts, and performance reports for
internal decision makers.
3. Financial reports are used by both internal and external groups and individuals. The
internal groups are comprised of the various managers of the entity. The external
groups include the owners, investors, creditors, governmental agencies, other
interested parties, and the public at large.
4. Investors purchase all or part of a business and hope to gain by receiving part of
what the company earns and/or selling the company in the future at a higher price
than they paid. Creditors lend money to a company for a specific length of time and
hope to gain by charging interest on the loan.
5. In a society each organization can be defined as a separate accounting entity. An
accounting entity is the organization for which financial data are to be collected.
Typical accounting entities are a business, a church, a governmental unit, a
university and other nonprofit organizations such as a hospital and a welfare
organization. A business typically is defined and treated as a separate entity
because the owners, creditors, investors, and other interested parties need to
evaluate its performance and its potential separately from other entities and from its
owners.
6.
Name of Statement
(a) Income Statement
(b) Balance Sheet
(c) Audit Report
Alternative Title
(a) Statement of Earnings; Statement of
Income; Statement of Operations
(b) Statement of Financial Position
(c) Report of Independent Accountants
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Chapter 01 - Financial Statements and Business Decisions
7. The heading of each of the four required financial statements should include the
following:
(a) Name of the entity
(b) Name of the statement
(c) Date of the statement, or the period of time
(d) Unit of measure
8. (a)
(b)
(c)
(d)
The purpose of the income statement is to present information about the
revenues, expenses, and the net income of the entity for a specified period of
time.
The purpose of the balance sheet is to report the financial position of an entity
at a given date, that is, to report information about the assets, obligations and
stockholders’ equity of the entity as of a specific date.
The purpose of the statement of cash flows is to present information about the
flow of cash into the entity (sources), the flow of cash out of the entity (uses),
and the net increase or decrease in cash during the period.
The statement of retained earnings reports the way that net income and
distribution of dividends affected the retained earnings of the company during
the accounting period.
9. The income statement and the statement of cash flows are dated “For the Year
Ended December 31, 2010,” because they report the inflows and outflows of
resources during a period of time. In contrast, the balance sheet is dated “At
December 31, 2010,” because it represents the resources, obligations and
stockholders’ equity at a specific date.
10. Assets are important to creditors and investors because assets provide a basis for
judging whether sufficient resources are available to operate the company. Assets
are also important because they could be sold for cash in the event the company
goes out of business. Liabilities are important to creditors and investors because
the company must be able to generate sufficient cash from operations or further
borrowing to meet the payments required by debt agreements. If a business does
not pay its creditors, the law may give the creditors the right to force the sale of
assets sufficient to meet their claims.
11. Net income is the excess of total revenues over total expenses. Net loss is the
excess of total expenses over total revenues.
12. The equation for the income statement is Revenues - Expenses = Net Income (or
Net Loss if the amount is negative). Thus, the three major items reported on the
income statement are (1) revenues, (2) expenses, and (3) net income.
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Chapter 01 - Financial Statements and Business Decisions
13. The equation for the balance sheet (also known as the basic accounting equation)
is: Assets = Liabilities + Stockholders’ Equity. Assets are the probable (expected)
future economic benefits owned by the entity as a result of past transactions. They
are the resources owned by the business at a given point in time such as cash,
receivables, inventory, machinery, buildings, land, and patents. Liabilities are
probable (expected) debts or obligations of the entity as a result of past
transactions which will be paid with assets or services in the future. They are the
obligations of the entity such as accounts payable, notes payable, and bonds
payable. Stockholders’ equity is financing provided by owners of the business and
operations. It is the claim of the owners to the assets of the business after the
creditor claims have been satisfied. It may be thought of as the residual interest
because it represents assets minus liabilities.
14. The equation for the statement of cash flows is: Cash flows from operating activities
+ Cash flows from investing activities + Cash flows from financing activities =
Change in cash for the period. The net cash flows for the period represent the
increase or decrease in cash that occurred during the period. Cash flows from
operating activities are cash flows directly related to earning income (normal
business activity including interest paid and income taxes paid). Cash flows from
investing activities include cash flows that are related to the acquisition or sale of
productive assets used by the company. Cash flows from financing activities are
directly related to the financing of the enterprise itself.
15. The equation for the statement of retained earnings is: Beginning Retained
Earnings + Net Income - Dividends = Ending Retained Earnings. It begins with
beginning-of-the-year Retained Earnings which is the prior year’s ending retained
earnings reported on the balance sheet. The current year's Net Income reported on
the income statement is added and the current year's Dividends are subtracted
from this amount. The ending Retained Earnings amount is reported on the end-ofperiod balance sheet.
16. Marketing managers and credit managers use customers' financial statements to
decide whether to extend them credit for their purchases. Purchasing managers
use potential suppliers' financial statements to judge whether the suppliers have the
resources necessary to meet current and future demand. Human resource
managers use financial statements as a basis for contract negotiations, to
determine what pay rates the company can afford. The net income figure even
serves as a basis to pay bonuses not only to management, but to other employees
through profit sharing plans.
17. The Securities and Exchange Commission (SEC) is the U.S. government agency
which determines the financial statements that public companies must provide to
stockholders and the measurement rules used in producing those statements. The
Financial Accounting Standards Board (FASB) is the private sector body given the
primary responsibility to work out the detailed rules which become generally
accepted accounting principles.
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Chapter 01 - Financial Statements and Business Decisions
18. Management is responsible for preparing the financial statements and other
information contained in the annual report and for the maintenance of a system of
internal accounting policies, procedures and controls. These measures are
intended to provide reasonable assurance, at appropriate cost, that transactions are
processed in accordance with company authorization as well as properly recorded
and reported in the financial statements, and that assets are adequately
safeguarded. Independent auditors examine the financial reports (prepared by
management) and the underlying records to assure that the reports represent what
they claim and conform with generally accepted accounting principles (GAAP).
19. A sole proprietorship is an unincorporated business owned by one individual. A
partnership is an unincorporated association of two or more individuals to carry on a
business. A corporation is a business that is organized under the laws of a
particular state whereby a charter is granted and the entity is authorized to issue
shares of stock as evidence of ownership by the owners (i.e., stockholders).
20. A CPA firm normally renders three services: auditing, management advisory
services, and tax services. Auditing involves examination of the records and
financial reports to determine whether they “fairly present” the financial position and
results of operations of the entity. Management advisory services involve
management advice to the individual business enterprises and other entities. It is
like a consulting firm. Tax services involve providing tax planning advice to clients
(both individuals and businesses) and preparation of their tax returns.
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Chapter 01 - Financial Statements and Business Decisions
ANSWERS TO MULTIPLE CHOICE
1. b)
6. d)
2. d)
7. a)
3. d)
8. a)
1-5
4. c)
9. c)
5. a)
10. b)
Chapter 01 - Financial Statements and Business Decisions
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
5
3
5
Exercises
No.
Time
1
12
2
12
3
12
4
20
5
25
6
20
7
15
8
25
9
25
10
25
11
30
12
15
13
12
14
30
Problems
No.
Time
1
45
2
45
3
45
4
45
Alternate
Problems
No.
Time
1
45
2
45
3
45
Cases and
Projects
No.
Time
1
20
2
30
3
30
4
60
5
30
6
20
7
*
* Due to the nature of these cases and projects, it is very difficult to estimate the amount
of time students will need to complete the assignment. As with any open-ended project,
it is possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time discussing research strategies. When we want the students
to focus on a real accounting issue, we offer suggestions about possible companies or
industries.
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Chapter 01 - Financial Statements and Business Decisions
MINI-EXERCISES
M1–1.
B
D
A
C*
B
D
A
D
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Element
Expenses
Cash flow from investing activities
Assets
Dividends
Revenues
Cash flow from operating activities
Liabilities
Cash flow from financing activities
A.
B.
C.
D.
Financial Statement
Balance sheet
Income statement
Statement of retained earnings
Statement of cash flows
*Dividends paid in cash are also subtracted in the Financing section of the Statement of
Cash Flows
M1–2.
SE
A
R
A
E
A
E
L
A
(1) Retained earnings
(2) Accounts receivable
(3) Sales revenue
(4) Property, plant, and equipment
(5) Cost of goods sold expense
(6) Inventories
(7) Interest expense
(8) Accounts payable
(9) Land
M1–3.
(1)
(2)
(3)
(4)
(5)
Abbreviation
CPA
GAAP
AICPA
SEC
FASB
Full Designation
Certified Public Accountant
Generally Accepted Accounting Principles
American Institute of Certified Public Accountants
Securities and Exchange Commission
Financial Accounting Standards Board
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Chapter 01 - Financial Statements and Business Decisions
EXERCISES
E1–1.
K
G
I
E
A
D
J
F
C
L
H
B
N
M
Term or Abbreviation
(1) SEC
(2) Audit
(3) Sole proprietorship
(4) Corporation
(5) Accounting
(6) Accounting entity
(7) Audit report
(8) Cost principle
(9) Partnership
(10) FASB
(11) CPA
(12) Unit of measure
(13) GAAP
(14) Publicly traded
Definition
A. A system that collects and processes financial
information about an organization and reports that
information to decision makers.
B. Measurement of information about an entity in the
monetary unit–dollars or other national currency.
C. An unincorporated business owned by two or more
persons.
D. The organization for which financial data are to be
collected (separate and distinct from its owners).
E. An incorporated entity that issues shares of stock as
evidence of ownership.
F. Initial recording of financial statement elements at
acquisition cost.
G. An examination of the financial reports to ensure that
they represent what they claim and conform with
generally accepted accounting principles.
H. Certified Public Accountant.
I. An unincorporated business owned by one person.
J. A report that describes the auditor’s opinion of the
fairness of the financial statement presentations and
the evidence gathered to support that opinion.
K. Securities and Exchange Commission.
L. Financial Accounting Standards Board.
M. A company with stock that can be bought and sold by
investors on established stock exchanges.
N. Generally accepted accounting principles.
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Chapter 01 - Financial Statements and Business Decisions
E1–2.
A
A
R
L
L
SE
E
E
E
L
A
A
L
A
E
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
(13)
(14)
(15)
Accounts receivable
Cash and cash equivalents
Net sales
Notes payable
Taxes payable
Retained earnings
Cost of products sold
Marketing, administrative, and other operating expenses
Income taxes
Accounts payable
Land
Property, plant, and equipment
Long-term debt
Inventories
Interest expense
E1–3.
L
E
L
L
SE
A
A
E
E
(1) Notes payable to banks
(2) General and administrative
(3) Accounts payable
(4) Dividends payable
(5) Retained earnings
(6) Cash and cash equivalents
(7) Accounts receivable
(8) Provision for income taxes*
(9) Cost of goods sold
A
R
A
E
A
A
L
E
A
(10) Machinery and equipment
(11) Net sales
(12) Inventories
(13) Marketing, selling, and advertising
(14) Buildings
(15) Land
(16) Income taxes payable
(17) Distribution and warehousing costs
(18) Investments (in other companies)
*Note that “Provision for income taxes” is a common synonym for “Income tax expense.”
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Chapter 01 - Financial Statements and Business Decisions
E1–4.
Honda Motor Corporation
Balance Sheet
as of March 31, 2009
(in billions of Yen)
Assets
Cash and cash equivalents
Trade accounts, notes, and other receivables
Inventories
Investments
Net property, plant and equipment
Other assets
Total assets
Liabilities
Accounts payable and other current liabilities
Long-term debt
Other liabilities
Total liabilities
Stockholders’ Equity
Contributed capital
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
1-10
¥
690
854
1,244
639
2,148
6,244
¥11,819
¥ 4,237
1,933
1,519
7,689
259
3,871
4,130
¥11,819
Chapter 01 - Financial Statements and Business Decisions
E1–5.
Req. 1
NEW WORLD BOOK STORE
Balance Sheet
At December 31, 2011
ASSETS
Cash
Accounts receivable
Store and office equipment
LIABILITIES
$68,350
39,000
72,000
Accounts payable
Note payable
Interest payable
Total liabilities
$12,000
3,000
120
15,120
STOCKHOLDERS’ EQUITY
Total assets
$179,350
Contributed capital
Retained earnings
Total stockholders’ equity
Total liabilities and
stockholders' equity
140,000
24,230
164,230
$179,350
Req. 2
Net income for the year was $24,230. This is the first year of operations and no
dividends were declared or paid to stockholders; therefore, the ending retained earnings
of $24,230 represents income for one year.
E1–6.
COLLEGE CONNECTION
Income Statement
For the Month of January 2011
Revenues:
Sales: Cash
On credit
Total sales revenue
Expenses:
Cost of goods sold
Salaries, rent, supplies, and other
expenses (paid in cash)
Utilities
Total expenses
Net Income
$110,000
3,000
$113,000
50,000
37,000
900
87,900
$25,100
1-11
Chapter 01 - Financial Statements and Business Decisions
E1–7.
WALGREEN CO.
Income Statement
For the Quarter ended May 31, 2009
(in millions)
Revenues:
Net sales
Total revenues
Expenses:
Cost of sales
Selling, occupancy and
administration expense
Interest Expense
Total expenses
Pretax income
Income tax expense
Net earnings
$16,210
$16,210
11,751
3,613
25
15,389
821
299
$ 522
*Note that “Provision for income taxes” is a common synonym for “Income tax
expense.”
E1–8.
NEIGHBORHOOD REALTY, INCORPORATED
Income Statement
For the Year Ended December 31, 2012
Revenues:
Commissions earned ($150,900+$16,800)
Rental service fees
Total revenues
Expenses:
Salaries expense
Commission expense
Payroll tax expense
Rent expense ($2,475+$225)*
Utilities expense
Promotion and advertising expense
Miscellaneous expenses
Total expenses (excluding income taxes)
Pretax income
Income tax expense
Net Income
$167,700
20,000
$187,700
62,740
35,330
2,500
2,700
1,600
7,750
500
113,120
74,580
24,400
$50,180
*$2,475 has been paid for 11 months ($225 per month) plus $225 owed for December.
1-12
Chapter 01 - Financial Statements and Business Decisions
E1–9.
Net Income (or Loss) = Revenues - Expenses
Assets = Liabilities + Stockholders’ Equity
A
Net Income = $91,700 - $76,940 = $14,760;
Stockholders’ Equity = $140,200 - $69,000 = $71,200.
B
Total Revenues = $74,240 + $14,740 = $88,980;
Total Liabilities = $107,880 - $79,010 = $28,870.
C
Net Loss = $69,260 - $76,430 = ($7,170);
Stockholders’ Equity = $97,850 - $69,850 = $28,000.
D
Total Expenses = $58,680 - $21,770 = $36,910;
Total Assets = $17,890 + $78,680 = $96,570.
E
Net Income = $84,840 - $78,720 = $6,120;
Total Assets = $25,520 + $79,580 = $105,100.
E1–10.
Net Income (or Loss) = Revenues - Expenses
Assets = Liabilities + Stockholders’ Equity
A
Net Income = $231,820 - $196,700 = $35,120;
Stockholders’ Equity = $294,300 - $75,000 = $219,300.
B
Total Revenues = $175,780 + $29,920 = $205,700;
Total Liabilities = $590,000 - $348,400 = $241,600.
C
Net Loss = $72,990 - $91,890 = ($18,900);
Stockholders’ Equity = $258,200 - $190,760 = $67,440.
D
Total Expenses = $36,590 - $9,840 = $26,750;
Total Assets = $189,675 + $97,525 = $287,200.
E
Net Income = $224,130 - $210,630= $13,500;
Total Assets = $173,850 + $361,240 = $535,090.
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Chapter 01 - Financial Statements and Business Decisions
E1–11.
PAINTER CORPORATION
Income Statement
For the Month of January 2011
Total revenues
Less: Total expenses (excluding income tax)
Pretax income
Less: Income tax expense
Net income
$299,000
189,000
110,000
34,500
$ 75,500
PAINTER CORPORATION
Balance Sheet
At January 31, 2011
Assets
Cash
Receivables from customers
Merchandise inventory
Total assets
$ 65,150
34,500
96,600
$196,250
Liabilities
Payables to suppliers
Income taxes payable
Total liabilities
Stockholders' Equity
Contributed capital (2,600 shares)
Retained earnings (from income statement above)
Total stockholders’ equity
Total liabilities and stockholders' equity
1-14
$26,450
34,500
60,950
59,800
75,500
135,300
$196,250
Chapter 01 - Financial Statements and Business Decisions
E1–12.
CLINT’S STONEWORK CORPORATION
Statement of Retained Earnings
For the Year Ended December 31, 2012
Beginning retained earnings*
Net income
Dividends
Ending retained earnings
$16,800
42,000
18,700
$40,100
* Beginning retained earnings + Net income – Dividends = Ending retained earnings
For 2011: $0 + 31,000 – 14,200 = $16,800;
Ending retained earnings for 2011 becomes beginning retained earnings for 2012
E1–13.
(I)
O
(F)
(O)
(O)
(O)
I
(F)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Purchases of property, plant, and equipment
Cash received from customers
Cash paid for dividends to stockholders
Cash paid to suppliers
Income taxes paid
Cash paid to employees
Cash proceeds received from sale of investment in another company
Repayment of borrowings
1-15
Chapter 01 - Financial Statements and Business Decisions
E1–14.
LAH MANUFACTURING CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 2011
Cash flow from operating activities
Cash collections from sales
$270,000
Cash paid for operating expenses
(175,000)
Net cash flow from operating activities
$95,000
Cash flow from investing activities
Sale of land
25,000
Purchase of new machines
(48,000)
Net cash flow from investing activities
(23,000)
Cash flow from financing activities
Sale of capital stock
30,000
Payment on long-term notes
(80,000)
Payment of cash dividends
(18,000)
Net cash flow from financing activities
(68,000)
Net increase in cash
4,000
Cash at beginning of year
63,000
Cash at end of year
$ 67,000
1-16
Chapter 01 - Financial Statements and Business Decisions
PROBLEMS
(Note to the instructor: Most students find the Problems in this chapter to be quite
challenging.)
P1–1.
Req. 1
GASLIGHT COMPANY
Income Statement
For the Year Ended December 31, 2011
Total sales revenue (given)
Total expenses (given)
Pretax income
Income tax expense ($45,800 x 30%)
Net income
$126,000
80,200
45,800
13,740
$ 32,060
Req. 2
GASLIGHT COMPANY
Statement of Retained Earnings
For the Year Ended December 31, 2011
Beginning retained earnings
+Net income (from req. 1)
–Dividends (given)
Ending retained earnings
$
0
32,060
10,000
$ 22,060
Req. 3
GASLIGHT COMPANY
Balance Sheet
At December 31, 2011
Assets
Cash (given)
Receivables from customers (given)
Inventory of merchandise (given)
Equipment (given)
Total assets
Liabilities
Accounts payable (given)
Salary payable (given)
Total liabilities
Stockholders' Equity
Contributed capital (given)
Retained earnings (from req. 2)
Total stockholders' equity
Total liabilities and stockholders' equity
$24,500
10,800
81,000
40,700
$157,000
$46,140
1,800
$ 47,940
$87,000
22,060
109,060
$157,000
1-17
Chapter 01 - Financial Statements and Business Decisions
P1–2.
Req. 1
BRIDGET'S LAWN SERVICE
Income Statement
For the Three Months Ended August 31, 2011
Revenues
Lawn service–cash
–credit
Total revenues
Expenses
Gas, oil, and lubrication ($940+$180)
Pickup repairs
Repair of mowers
Miscellaneous supplies used
Helpers (wages)
Payroll taxes
Preparation of payroll tax forms
Insurance
Telephone
Interest expense on note paid
Equipment use cost (depreciation)
Total expenses
Net income
$12,300
700
$13,000
1,120
250
110
80
5,400
190
25
125
110
65
600
8,075
$ 4,925
Req. 2
Because the above report reflects only revenues, expenses, and net income, it is
reasonable to suppose that Bridget would need the following:
(1)
(2)
(3)
A balance sheet–that is, a statement that reports for the business, at the end of
August 2011, each asset (name and amount, such as Cash, $XX), each liability
(such as Wages Payable, $XX), and stockholders’ equity.
A statement of retained earnings that shows how income and dividends (if any)
affect retained earnings on the balance sheet.
A statement of cash flows–that is, a statement of the inflows and outflows of cash
during the period in three categories: operating, investing, and financing.
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Chapter 01 - Financial Statements and Business Decisions
P1–3.
Req. 1
Transaction Income
(a)
+$66,000
Req. 2–Explanation
Cash
+$55,000
(b)
–0–
+45,000
(c)
–0–
–9,500
All services performed increase income;
cash received during the period was,
$66,000 – 11,000 = $55,000.
Cash borrowed is not income.
Purchase of the truck does not represent
an expense until it is used (it is an asset);
cash outflow was $9,500.
(d)
–21,000
–10,500
(e)
–2,900
–3,800
Not all of the supplies were used; expense is
the amount used, $3,800 – 900 = $2,900.
Cash paid during the quarter was $3,800.
(f)
–39,000
–32,500
All expenses incurred reduce income; cash
expended was, $39,000 – 6,500 = $32,500.
All of the wages incurred reduce income,
$21,000; cash paid during the quarter was,
$21,000 x 1/2 = $10,500. The $10,500
owed will be paid on the next payroll date.
Based only
on the above:
Income (loss) $3,100
Cash inflow
(outflow)
$ 43,700
1-19
Chapter 01 - Financial Statements and Business Decisions
P1–4.
Req. 1
The personal residences of the organizers are not resources of the business entity.
Therefore, they should be excluded.
Req. 2
It is not indicated whether the $57,000 listed for service trucks and equipment is their
cost when acquired or the current market value on December 31, 2011.
Req. 3
The list of company resources (i.e., assets) suggests the following areas of concern:
Company resources:
(1)
Cash, inventories, and bills due from customers (i.e., accounts receivable)–these
items tend to fluctuate; they may be significantly more or less at date of the loan
and during the term of the loan.
(2)
Service trucks and equipment–as noted above, it is not indicated whether the
$57,000 is cost when acquired or current market value on December 31, 2011.
(3)
Personal residences–as noted above, these items are not resources of the
business entity and should be excluded.
Company obligations:
(4)
Unpaid wages of $19,000, which are now due, pose a serious problem because
only $12,000 cash currently is available.
(5)
Unpaid taxes and accounts payable to suppliers–it is not clear when these
payments of $8,000 and $10,000, respectively, are due (cash needed to pay
them is a problem).
(6)
The $45,000 owed on the service trucks probably is long term; however, shortterm installments may be required–these details are very important to the bank.
(7)
Loan from organizer–the expected payment date and interest rate are important
issues for which details are not provided. This is a major cash demand.
In general, the bank should request more details about the specific resources and
debts. The personal residences are not a part of the resources of the business entity.
The bank should request that the owners provide audited information about the entity's
assets and debts.
1-20
Chapter 01 - Financial Statements and Business Decisions
P1–4. (continued)
Req. 4
The amount of stockholders’ equity (i.e., assets minus liabilities) for Northwest
Company, assuming the amounts provided by the owners are acceptable, would be:
Assets ($311,000–$190,000)
Liabilities
Stockholders’ equity
$121,000
92,000
$29,000
1-21
Chapter 01 - Financial Statements and Business Decisions
ALTERNATE PROBLEMS
AP1–1.
Req. 1
INFLUENCE CORPORATION
Income Statement
For the Year Ended June 30, 2011
Total sales revenue (given)
Total expenses (given)
Pretax income
Income tax expense ($31,500 x 30%)
Net income
$100,000
68,500
31,500
9,450
$22,050
Req. 2
INFLUENCE CORPORATION
Statement of Retained Earnings
For the Year Ended June 30, 2011
Beginning retained earnings
+Net income (from req. 1)
–Dividends (given)
Ending retained earnings
$
0
22,050
0
$ 22,050
Req. 3
INFLUENCE CORPORATION
Balance Sheet
At June 30, 2011
Assets
Cash (given)
Receivables from customers (given)
Inventory of merchandise (given)
Equipment (given)
Total assets
Liabilities
Accounts payable (given)
Salary payable (given)
Total liabilities
Stockholders' Equity
Contributed capital (given)
Retained earnings (from req. 2)
Total stockholders' equity
Total liabilities and stockholders' equity
$13,150
10,900
27,000
66,000
$117,050
$31,500
1,500
$ 33,000
$62,000
22,050
84,050
$117,050
1-22
Chapter 01 - Financial Statements and Business Decisions
AP1–2.
Req. 1
LIST ELECTRIC REPAIR COMPANY, INC.
Income Statement
For the Three Months Ended December 31, 2011
Revenues:
Electric repair services–cash
–credit
Total revenues
Expenses:
Electrician's assistant (wages)
Payroll taxes
Supplies used on jobs
Oil, gas, and maintenance on truck
Insurance
Rent ($500+$250)
Utilities and telephone
Miscellaneous expenses
Depreciation of truck and tools (use)
Total expenses
Pretax Income
Income taxes
Net Income
$32,000
3,500
$35,500
7,500
175
9,500
1,200
700
750
825
600
1,200
22,450
13,050
3,930
$ 9,120
Req. 2
Because the above report reflects only revenues, expenses, and net income, it is
reasonable to suppose that Sam would have need for the following:
(1)
(2)
(3)
A statement that reports for the business, at the end of 2011, each asset (name
and amount such as Cash, $XX), and each liability (such as Income taxes
payable, $XX), and stockholders' equity; that is, a balance sheet.
A statement of the sources and uses of cash during the period; that is, a
statement of cash flows.
A statement of retained earnings that shows how net income and dividends affect
retained earnings on the balance sheet.
1-23
Chapter 01 - Financial Statements and Business Decisions
AP1–3.
Req. 1
Transaction Income
Cash
(a)
+$85,000
+$70,000
(b)
–0–
+25,000
(c)
–0–
–8,000
(d)
–36,000
–30,000
(e)
–3,000
–4,000
(f)
–31,000
–15,500
Req. 2–Explanation
All services performed increase income;
cash received during the period was,
$85,000 – 15,000 = $70,000.
Cash borrowed is not income.
Purchase of the truck does not represent
an expense until it is used (it is an asset);
cash outflow was $8,000.
All of the wages incurred reduce income,
$36,000; cash paid during the quarter was,
$36,000 x 5/6 = $30,000. The $6,000
owed will be paid on the next payroll date.
Not all of the supplies were used; expense is
the amount used, $4,000 – 1,000 = $3,000.
Cash paid during the quarter was $4,000.
All expenses incurred reduce income; cash
expended was, $31,000 – 15,500 = $15,500.
Based only
on the above:
Income (loss) $15,000
Cash inflow
(outflow)
$ 37,500
1-24
Chapter 01 - Financial Statements and Business Decisions
CASES AND PROJECTS
ANNUAL REPORT CASES
CP1–1.
1. It sells its own brand of high quality, on-trend clothing, accessories, and personal
care products targeting 15 to 25 year-old customers.
2. The company’s most recent fiscal year ended on January 31, 2009.
3. a. Balance Sheets–2 years
b. Income Statements–3 years
c. Cash Flow Statements–3 years
4. Yes, it is audited by independent CPAs, as indicated by the ”Report of Independent
Registered Public Accounting Firm” on page 68 of the annual report.
5. Its total assets increased from $1,867,680,000 to $1,963,676,000. The instructor
should note that the reported numbers are in thousands.
6. As of January 31, 2009, the company had $294,928,000 in inventory.
7. Assets
= Liabilities*
$1,963,676,000 = $554,645,000
+ Stockholders’ Equity
+ $1,409,031,000
*Liabilities are determined by either adding current ($401,763,000) and long term
liabilities ($152,882,000) or by solving the accounting equation: Assets
($1,963,676,000) = Liabilities + Stockholders’ Equity ($1,409,031,000)
1-25
Chapter 01 - Financial Statements and Business Decisions
CP1–2.
1. Net income was $199,364 thousand or $199,364,000 for the year ended January 31,
2009. This is disclosed on the income statement. The instructor should note that
the reported numbers are in thousands. Some students will erroneously report
income as $199,364. Students should also be warned that different companies
often use different terminology—some companies may use the term “net earnings”
to describe net income.
2. Net sales were $1,834,618,000. This is also disclosed on the income statement.
3. Inventory is $169,698,000. This is disclosed on the balance sheet.
4. Cash and cash equivalents increased by $210,764,000 during the year. This amount
can be computed from the balance sheet or it can be found on the statement of cash
flows.
5. The auditor is Deloitte & Touche LLP. This is found on the auditor’s report (in this
case, called the “report of independent registered public accounting firm”).
CP1–3.
1. American Eagle Outfitters had total assets of $1,963,676,000 at the end of the most
recent year, whereas Urban Outfitters had total assets of $1,329,009,000. Clearly
American Eagle Outfitters is the larger of the two companies in terms of total assets at
the end of the most recent year.
2. Urban Outfitters had net sales of $1,834,618,000 in the most recent year, while
American Eagle Outfitters had greater net sales in the amount of $2,988,866,000.
Again, American Eagle Outfitters is the larger of the two companies in terms of net
sales.
3. In the most recent year, Urban Outfitters had growth in total assets of
($1,329,009,000 - $1,142,791,000)/($1,142,791,000) = 16.3%, while American Eagle
Outfitters had lower growth in total assets of ($1,963,676,000 $1,867,680,000)/($1,867,680,000) = 5.1%.
Similarly, Urban Outfitters had growth in net sales of ($1,834,618,000 $1,507,724,000)/($1,507,724,000) = 21.7%, while American Eagle Outfitters had
negative growth in net sales of ($2,988,866,000 - $3,055,419,000)/($3,055,419,000) =
-2.2%.
By both measures, Urban Outfitters is growing faster.
1-26
Chapter 01 - Financial Statements and Business Decisions
FINANCIAL REPORTING AND ANALYSIS CASES
CP1–4.
Req. 1–Deficiencies:
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Heading: titles of the reports are missing and dates are not in proper form.
Income statement should show revenues and expenses separately.
“Profit earned in 2009” should be “Net income.”
Balance sheet should separately report assets, liabilities, and stockholders'
equity.
Retained earnings, $30,000, should be reported under stockholders' equity.
Due from customers, $13,000, should be reported under assets.
Supplies on hand, $15,000, should be reported under assets.
Accumulated depreciation, $10,000, should be subtracted from service vehicles.
1-27
Chapter 01 - Financial Statements and Business Decisions
CP1–4. (continued)
Req. 2–Financial Statements:
PERFORMANCE CORPORATION
Income Statement
For the Year Ended December 31, 2009
Revenues:
Sales
$175,000
Services
52,000
Total revenues
Expenses:
Cost of goods sold
$ 90,000
Selling expenses
25,000
Depreciation expense
10,000
Salaries and wages
62,000
Total expenses (excluding income tax)
Pretax income
Income tax expense (25% x $40,000)
Net income
$227,000
187,000
40,000
10,000
$30,000
PERFORMANCE CORPORATION
Balance Sheet
At December 31, 2009
Assets
Cash
Accounts receivable (from customers)
Merchandise inventory (for resale)
Supplies inventory (for use in rendering services)
Service vehicles
$50,000
Less accumulated depreciation
(10,000)
Total assets
Liabilities
Accounts payable (to suppliers)
Note payable (to bank)
Total liabilities
Stockholders' equity
Contributed capital, 6,500 shares
$65,000
Retained earnings
30,000
Total stockholders' equity
Total liabilities and stockholders' equity
1-28
$ 32,000
13,000
42,000
15,000
40,000
$142,000
$22,000
25,000
47,000
95,000
$142,000
Chapter 01 - Financial Statements and Business Decisions
CRITICAL THINKING CASES
CP1–5.
Req. 1 You should forcefully assert the need for an independent audit of the financial
statements each year because this is the best way to assure credibility–
conformance with GAAP, completeness and absence of bias.
You should firmly reject “Uncle Ray” as the auditor because there is no evidence
about his competence as an accountant or auditor. Also, he is related to the
partner who prepares the financial statements; there is a conflict of interest.
Req. 2 You should strongly recommend the selection of an independent CPA in public
practice because the financial statements should be audited by a competent and
independent professional who must follow prescribed accounting and auditing
standards on a strictly independent basis. An audit by “Uncle Ray” would not
meet any of these requisites, particularly the important one in this case–
independence (and absence of bias).
1-29
Chapter 01 - Financial Statements and Business Decisions
CP1–6.
The textbook does not explicitly cover the elements of independence. The case is
designed to permit the students to develop their own values. We have found that it is
useful to emphasize the difference between independence in fact and in appearance
during these discussions.
1.
Most students feel that there is no problem with independence if the stock held is
immaterial in amount. When asked about a possible headline that might read
“Auditor who was shareholder is accused of fraud,” most students see a problem
with the appearance. In fact, the AICPA does not apply a materiality threshold
where there is a direct financial interest. Any holding of stock is a problem.
2.
This is an example of an indirect holding of stock. A materiality threshold is
applied in these situations. There could be a question of independence if the
auditor held a material interest in the mutual fund (relative to her net worth) and
the mutual fund held a material interest in the company that she audited.
3.
The AICPA Code of Professional Conduct applies only to audit professionals who
are members (though most state laws incorporate similar rules). Bob's employers
may want to assign him to a different company but there is no conflict with the
Code.
4.
Clearly there is an ethics violation in this case because she would audit
statements that covered a period of time where she was responsible for the
accounting operations of the company. This is a problem both in appearance and
in fact.
5.
The original Code indicated that a loan from a bank that was made under normal
lending procedures, terms, and requirements was not an impairment of
independence. This issue is currently under a review that will probably result in a
modification of the rule. It is an excellent example of how ethics rules can change
over time. The savings and loan debacle with the resulting lawsuits has caused
the profession to reconsider the appearance of loans to auditors.
FINANCIAL REPORTING AND ANALYSIS PROJECTS
CP1–7.
The solutions to this case will depend on the company and/or accounting period
selected for analysis.
1-30
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
Chapter 02
Investing and Financing Decisions and
the Balance Sheet
ANSWERS TO QUESTIONS
1.
The primary objective of financial reporting for external users is to provide useful
economic information about a business to help external parties, primarily
investors and creditors, make sound financial decisions. These users are
expected to have a reasonable understanding of accounting concepts and
procedures. Usually, they are interested in information to assist them in
projecting future cash inflows and outflows of a business.
2.
(a)
An asset is a probable future economic benefit owned by the entity as a
result of past transactions.
(b)
A current asset is an asset that will be used or turned into cash within one
year; inventory is always considered a current asset regardless of how
long it takes to produce and sell the inventory.
(c)
A liability is a probable debt or obligation of the entity as a result of a past
transaction, which will be paid with assets or services.
(d)
A current liability is a liability that will be paid in cash (or other current
assets) or satisfied by providing service within the coming year.
(e)
Contributed capital is the financing provided to the business by owners;
usually owners provide cash and sometimes other assets such as
equipment and buildings.
(f)
Retained earnings are the cumulative earnings of a company that are not
distributed to the owners and are reinvested in the business.
2-1
Chapter 02 Investing and Financing Decisions and the Balance Sheet
3.
(a)
The separate-entity assumption requires that business transactions are
separate from the transactions of the owners. For example, the purchase
of a truck by the owner for personal use is not recorded as an asset of the
business.
(b)
The unit-of-measure assumption requires information to be reported in the
national monetary unit. That means that each business will account for
and report its financial results primarily in terms of the national monetary
unit, such as Yen in Japan and Australian dollars in Australia.
(c)
Under the continuity or going-concern assumption, businesses are
assumed to operate into the foreseeable future. That is, they are not
expected to liquidate.
(d)
The historical cost principle requires assets to be recorded at the cashequivalent cost on the date of the transaction. Cash-equivalent cost is the
cash paid plus the dollar value of all noncash considerations.
4.
Accounting assumptions are necessary because they reflect the scope of
accounting and the expectations that set certain limits on the way accounting
information is reported.
5.
An account is a standardized format used by organizations to accumulate the
dollar effects of transactions on each financial statement item. Accounts are
necessary to keep track of all increases and decreases in the fundamental
accounting model.
6.
The fundamental accounting model is provided by the equation:
Assets = Liabilities + Stockholders' Equity
7.
A business transaction is (a) an exchange of resources (assets) and obligations
(debts) between a business and one or more outside parties, and (b) certain
events that directly affect the entity such as the use over time of rent that was
paid prior to occupying space and the wearing out of equipment used to operate
the business. An example of the first situation is (a) the sale of goods or
services. An example of the second situation is (b) the use of insurance paid
prior to coverage.
8.
Debit is the left side of a T-account and credit is the right side of a T-account. A
debit is an increase in assets and a decrease in liabilities and stockholders'
equity. A credit is the opposite -- a decrease in assets and an increase in
liabilities and stockholders' equity.
2-2
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
9.
Transaction analysis is the process of studying a transaction to determine its
economic effect on the entity in terms of the accounting equation:
Assets = Liabilities + Stockholders' Equity
The two principles underlying the process are:
* every transaction affects at least two accounts.
* the accounting equation must remain in balance after each
transaction.
The two steps in transaction analysis are:
(1) identify and classify accounts and the direction and amount of the
effects.
(2) determine that the accounting equation (A = L + SE) remains in
balance.
10.
The equalities in accounting are:
(a) Assets = Liabilities + Stockholders' Equity
(b) Debits = Credits
11.
The journal entry is a method for expressing the effects of a transaction on
accounts in a debits-equal-credits format. The title of the account(s) to be
debited is (are) listed first and the title of the account(s) to be credited is (are)
listed underneath the debited accounts. The debited amounts are placed in a
left-hand column and the credited amounts are placed in a right-hand column.
12.
The T-account is a tool for summarizing transaction effects for each account,
determining balances, and drawing inferences about a company's activities. It is
a simplified representation of a ledger account with a debit column on the left
and a credit column on the right.
13.
The current ratio is computed as current assets divided by current liabilities. It
measures the ability of the company to pay its short-term obligations with current
assets. A high ratio normally suggests good liquidity, but a ratio that is too high
may indicate inefficient use of resources. The rule of thumb was a ratio between
1.0 and 2.0 (twice as many current assets as current liabilities), but sophisticated
cash management systems allow many companies to minimize funds invested in
current assets and have a current ratio below 1.0.
14.
Investing activities on the statement of cash flows include the buying and selling
of productive assets and investments. Financing activities include borrowing and
repaying debt, issuing and repurchasing stock, and paying dividends.
2-3
Chapter 02 Investing and Financing Decisions and the Balance Sheet
MULTIPLE CHOICE
1.
2.
3.
4.
5.
b
d
b
a
d
6.
7.
8.
9.
10.
c
d
d
b
a
2-4
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
3
2
3
3
4
4
4
5
5
6
3
7
3
8
6
9
6
10
6
11
4
12
4
Exercises
No.
Time
1
8
2
15
3
8
4
10
5
10
6
10
7
10
8
15
9
20
10
20
11
15
12
20
13
20
14
20
15
20
16
15
17
10
18
10
19
15
20
10
Problems
No.
Time
1
20
2
25
3
40
4
15
5
40
6
20
Alternate
Problems
No.
Time
1
20
2
25
3
40
4
15
Cases and
Projects
No.
Time
1
15
2
15
3
15
4
20
5
15
6
20
7
30
8
20
9
*
* Due to the nature of these cases and projects, it is very difficult to estimate the
amount of time students will need to complete the assignment. As with any openended project, it is possible for students to devote a large amount of time to these
assignments. While students often benefit from the extra effort, we find that some
become frustrated by the perceived difficulty of the task. You can reduce student
frustration and anxiety by making your expectations clear. For example, when our goal
is to sharpen research skills, we devote class time discussing research strategies.
When we want the students to focus on a real accounting issue, we offer suggestions
about possible companies or industries.
2-5
Chapter 02 Investing and Financing Decisions and the Balance Sheet
MINI-EXERCISES
M2–1.
C
(1) Separate-entity assumption
H
(2) Historical cost principle
G
(3) Credits
A
(4) Assets
I
(5) Account
M2–2.
D
(1) Journal entry
C
(2) A = L + SE, and Debits = Credits
A
(3) Assets = Liabilities + Stockholders’ Equity
I
(4) Liabilities
B
(5) Income statement, balance sheet, statement of retained earnings, and
statement of cash flows
M2–3.
(1) Y
(2) N
(3) Y
(4) N
(5) Y
(6) N
2-6
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
M2–4.
CL
(1) Accounts Payable
CA
(2) Accounts Receivable
NCA
(3) Buildings
CA
(4) Cash
SE
(5) Contributed Capital
NCA
(6) Land
CA
(7) Merchandise Inventory
CL
(8) Income Taxes Payable
NCA
(9) Long-Term Investments
NCL
(10) Notes Payable (due in three years)
CA
(11) Notes Receivable (due in six months)
CA
(12) Prepaid Rent
SE
(13) Retained Earnings
CA
(14) Supplies
CL
(15) Utilities Payable
CL
(16) Wages Payable
M2–5.
Assets
=
a.
Cash
+20,000
b.
Cash
Notes
receivable
–7,000
+7,000
c.
Cash
+1,000
d.
Cash
Equipment
e.
Cash
–6,000
+15,000
+ Stockholders’ Equity
Liabilities
Notes payable +20,000
Notes payable
–2,000
2-7
Contributed
capital
+1,000
Retained
earnings
–2,000
+9,000
Chapter 02 Investing and Financing Decisions and the Balance Sheet
M2–6.
Debit
Increases
Decreases
Decreases
Credit
Decreases
Increases
Increases
Increase
Decrease
Assets
Debit
Credit
Liabilities
Credit
Debit
Stockholders’ equity
Credit
Debit
Assets
Liabilities
Stockholders’ equity
M2–7.
M2–8.
a.
Cash (+A) ............................................................................
Notes Payable (+L) ........................................................
b.
c.
d.
e.
20,000
20,000
Notes Receivable (+A).........................................................
Cash (A) .......................................................................
7,000
Cash (+A) ............................................................................
Contributed Capital (+SE) ..............................................
1,000
Equipment (+A) ...................................................................
Cash (A) .......................................................................
Notes Payable (+L) ........................................................
15,000
Retained Earnings (SE) .....................................................
Cash (A) .......................................................................
2,000
7,000
1,000
6,000
9,000
2,000
M2–9.
Cash
Beg.
800
(a) 20,000 7,000
(c)
1,000 6,000
2,000
6,800
(b)
(d)
(e)
Notes Receivable
Beg.
900
(b)
7,000
7,900
Equipment
Beg. 15,000
(d) 15,000
30,000
2-8
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
Notes Payable
2,700 Beg.
20,000 (a)
9,000 (d)
Contributed Capital
5,000 Beg.
1,000 (c)
31,700
Retained Earnings
9,000 Beg.
(e)
2,000
6,000
7,000
M2–10.
Pitt Inc.
Balance Sheet
At January 31, 2012
Assets
Current assets:
Cash
Notes receivable
Total current assets
Equipment
Total Assets
$ 6,800
7,900
14,700
30,000
$44,700
Liabilities
Current liabilities:
Notes payable
Total current liabilities
Stockholders’ Equity
Contributed capital
Retained earnings
Total stockholders’ equity
Total Liabilities &
Stockholders’ Equity
$ 31,700
31,700
6,000
7,000
13,000
$44,700
M2–11.
Current Ratio =
2007
2008
Current Assets
240,000
260,000
÷
÷
÷
Current Liabilities
160,000
220,000
=
=
1.50
1.18
This ratio indicates that Sal’s Pizza has sufficient current assets to settle current
liabilities, but that the ratio has also decreased between 2007 and 2008 by .32 (21%).
Sal’s Pizza’s ratio is higher than Papa John’s 2008 ratio (of .75), indicating that Sal’s
Pizza appears to have stronger liquidity than Papa John’s. However, given its size,
Papa John’s is likely to have a strong cash management system that can keep current
asset levels low.
2-9
Chapter 02 Investing and Financing Decisions and the Balance Sheet
M2–12.
(a) F
(b) I
(c) F
(d) I
(e) F
EXERCISES
2-10
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
E2–1.
E
(1) Transaction
F
(2) Continuity assumption
B
(3) Balance sheet
P
(4) Liabilities
K
(5) Assets = Liabilities + Stockholders’ Equity
M
(6) Note payable
S
(7) Conservatism
H
(8) Historical cost principle
I
(9) Account
Q
(10) Dual effects
O
(11) Retained earnings
A
(12) Current assets
C
(13) Separate-entity assumption
W
(14) Reliability
D
(15) Debits
J
(16) Accounts receivable
N
(17) Unit-of-measure assumption
U
(18) Materiality
T
(19) Relevance
R
(20) Stockholders’ Equity
2-11
Chapter 02 Investing and Financing Decisions and the Balance Sheet
E2–2.
Req. 1
Received
Given
(a)
Cash (A)
Contributed capital (SE)
(b)
Equipment (A)
(c)
No exchange transaction
—
(d)
Equipment (A)
Note payable (L)
(e)
Building (A)
(f)
Intangibles (A)
(g)
Retained earnings (SE) [Received a reduction Cash (A)
in the amount available for payment to
stockholders]
(h)
Land (A)
(i)
Intangibles (A)
(j)
No exchange transaction
—
(k)
Investments (A)
Cash (A)
(l)
Cash (A)
Short-term note payable (L)
(m)
Note payable (L)
promise to pay]
[or Delivery truck]
Cash (A)
[or Computer equipment]
[or Construction in progress]
[or Copyright]
Cash (A)
Cash (A)
Cash (A)
[or Patents]
Cash (A) and Note payable (L)
[Received a reduction in its Cash (A)
Req. 2
The truck in (b) would be recorded as an asset of $18,000. The land in (h) would be
recorded as an asset of $50,000. These are applications of the historical cost principle.
Req. 3
The agreement in (c) involves no exchange or receipt of cash, goods, or services and
thus is not a transaction. Since transaction (j) occurs between the owner and others,
there is no effect on the business because of the separate-entity assumption.
2-12
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
E2–3.
Balance Sheet
Categorization
Debit or Credit
Balance
(1) Accounts Receivable
CA
Debit
(2) Retained Earnings
SE
Credit
(3) Taxes Payable
CL
Credit
(4) Prepaid Expenses
CA
Debit
(5) Contributed Capital
SE
Credit
(6) Long-Term Investments
NCA
Debit
(7) Plant, Property, and Equipment
NCA
Debit
(8) Accounts Payable
CL
Credit
(9) Short-Term Investments
CA
Debit
NCL
Credit
Account
(10) Long-Term Debt
E2–4.
Event
a.
b.
Assets
Cash
=
+34,000
Equipment
+8,000
Cash
–1,000
c.
Cash
+9,000
d.
Note
receivable
+500
Cash
–500
Land
+15,000
Cash
–4,000
e.
+ Stockholders’ Equity
Liabilities
Contributed
capital
Notes payable
+7,000
Notes payable
+9,000
Mortgage note
payable
+11,000
2-13
+34,000
Chapter 02 Investing and Financing Decisions and the Balance Sheet
E2–5.
Req. 1
Event
Assets
a.
Buildings
Equipment
Cash
b.
Cash
=
+212.0
+30.4
– 43.2
Liabilities
+ Stockholders’ Equity
Notes payable
(long-term) +199.2
+186.6
c.
Contributed
capital
Dividends
payable
d.
Short-term
Investments
Cash
e.
No effects
f.
Cash
Short-term
Investments
+121.4
Retained
earnings
+186.6
–121.4
+2,908.7
– 2,908.7
+2,390.0
– 2,390.0
Req. 2
The separate-entity assumption states that transactions of the business are separate
from transactions of the owners. Since transaction (e) occurs between the owners and
others in the stock market, there is no effect on the business.
2-14
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
E2–6.
a.
b.
c.
d.
e.
Cash (+A) ............................................................................
Contributed capital (+SE) ...............................................
34,000
Equipment (+A) ...................................................................
Cash (A) .......................................................................
Notes payable (+L) ........................................................
8,000
Cash (+A) ............................................................................
Notes payable (+L) .........................................................
9,000
Notes receivable (+A) .........................................................
Cash (A) ......................................................................
500
Land (+A).............................................................................
Cash (A) .......................................................................
Mortgage notes payable (+L) ........................................
15,000
Buildings (+A) ......................................................................
Equipment (+A) ..................................................................
Cash (A) .......................................................................
Note payable (+L) .........................................................
212.0
30.4
Cash (+A) ............................................................................
Contributed capital (+SE) ...............................................
186.6
Retained earnings (SE) .....................................................
Dividends payable (+L) ..................................................
121.4
Short-term investments (+A)................................................
Cash (A) .......................................................................
2,908.7
34,000
1,000
7,000
9,000
500
4,000
11,000
E2–7.
Req. 1
a.
b.
c.
d.
e.
No journal entry required.
f.
Cash (+A) ............................................................................
Short-term investments (A) ..........................................
2-15
43.2
199.2
186.6
121.4
2,908.7
2,390.0
2,390.0
Chapter 02 Investing and Financing Decisions and the Balance Sheet
Req. 2
The separate-entity assumption states that transactions of the business are separate
from transactions of the owners. Since transaction (e) occurs between the owners and
others in the stock market, there is no effect on the business.
E2–8.
Req. 1
Cash
Beg.
0
(a) 63,000 5,000 (b)
(d)
4,000 2,500 (e)
59,500
Land
Beg.
0
(d) 13,000
13,000
Note Receivable
Beg.
0
(e)
2,500
2,500
Equipment
Beg.
0
(b) 20,000
20,000
Note Payable
0 Beg.
15,000 (b)
Contributed Capital
0 Beg.
63,000 (a)
17,000 (d)
15,000
80,000
Req. 2
Assets $
95,000
= Liabilities $ 15,000
+ Stockholders’ Equity $
80,000
Req. 3
The agreement in (c) involves no exchange or receipt of cash, goods, or services and
thus is not a transaction. Since transaction (f) occurs between the owner and others,
there is no effect on the business due to the separate-entity assumption.
2-16
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
E2–9.
Req. 1
Transaction
1
Brief Explanation
Issued capital stock to shareholders for $15,000 cash. (FastTrack
Sports Inc. is a corporation.)
2
Borrowed $75,000 cash and signed a short-term note for this amount.
3
Purchased land for $16,000; paid $5,000 cash and gave an $11,000
short-term note payable for the balance.
4
Loaned $4,000 cash; borrower signed a short-term note for this amount
(Note Receivable).
5
Purchased store fixtures for $9,500 cash.
6
Purchased land for $4,000, paid for by signing a short-term note.
Req. 2
FastTrack Sports Inc.
Balance Sheet
At January 7, 2011
Assets
Current Assets
Cash
Note receivable
Total Current Assets
Store fixtures
Land
Total Assets
$71,500
4,000
75,500
9,500
20,000
$105,000
2-17
Liabilities
Current Liabilities
Note payable
Total Current Liabilities
Stockholders’ Equity
Contributed capital
Total Stockholders’ Equity
Total Liabilities &
Stockholders’ Equity
$90,000
90,000
15,000
15,000
$105,000
Chapter 02 Investing and Financing Decisions and the Balance Sheet
E2–10.
Req. 1
Transaction
1
Brief Explanation
Issued capital stock to shareholders for $50,000 cash.
2
Purchased a delivery truck for $30,000; paid $6,000 cash and gave a
$24,000 long-term note payable for the balance.
3
Loaned $4,000 cash; borrower signed a short-term note for this
amount.
4
Purchased short-term investments for $7,000 cash.
5
Sold short-term investments at cost for $2,000 cash.
6
Issued capital stock to shareholders for $4,000 of computer equipment.
Req. 2
Volz Cleaning, Inc.
Balance Sheet
At March 31, 2011
Assets
Current Assets
Cash
Investments
Note receivable
Total Current Assets
Computer equipment
Delivery truck
Total Assets
$35,000
5,000
4,000
44,000
4,000
30,000
$78,000
2-18
Liabilities
Notes payable
Total Liabilities
Stockholders’ Equity
Contributed capital
Total Stockholders’ Equity
Total Liabilities &
Stockholders’ Equity
$24,000
24,000
54,000
54,000
$78,000
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
E2–11.
a.
Cash (+A) ............................................................................
Contributed capital (+SE) ...............................................
65,000
65,000
b.
No transaction has occurred because there has been no
exchange or receipt of cash, goods, or services.
c.
Cash (+A) ............................................................................
Notes payable (long-term) (+L) ......................................
10,000
Equipment (+A) ...................................................................
Cash (A) .......................................................................
Notes payable (short-term) (+L) .....................................
13,000
Notes receivable (short-term) (+A) ......................................
Cash (A) .......................................................................
1,000
Store fixtures (+A) ...............................................................
Cash (A) .......................................................................
20,000
d.
e.
f.
10,000
1,500
11,500
1,000
20,000
E2–12.
a.
Retained earnings (SE) .....................................................
Dividends payable (+L) ..................................................
197
197
b.
No transaction has occurred because there has been no exchange or receipt of
cash, goods, or services.
c.
Dividends payable (L) ........................................................
Cash (A) .......................................................................
694
Cash (+A) ............................................................................
Notes payable (+L) .........................................................
2,655
Cash (+A) ............................................................................
Equipment (A) ..............................................................
285
Equipment (+A) ...................................................................
Cash (A) .......................................................................
Notes payable (+L) ........................................................
1,255
Investments (+A) .................................................................
Cash (A) .......................................................................
2,220
d.
e.
f.
g.
2-19
694
2,655
285
970
285
2,220
Chapter 02 Investing and Financing Decisions and the Balance Sheet
E2–13.
Req. 1
Assets $
8,500
= Liabilities $
+ Stockholders’ Equity $
2,500
6,000
Req. 2
Cash
4,000
3,000
1,000
1,250
300 (d)
8,950
Beg.
(a)
(b)
(c)
End.
Short-Term Investments
Beg. 2,000
1,000 (b)
Property & Equipment
Beg. 2,500
1,250 (c)
End.
End.
1,000
Short-Term
Notes Payable
2,200 Beg.
Long-Term
Notes Payable
300 Beg.
3,000 (a)
2,200 End.
3,300 End.
Contributed Capital
4,000 Beg.
Retained Earnings
2,000 Beg.
(d)
300
4,000 End.
1,700 End.
Req. 3
Assets $
11,200
= Liabilities $
1,250
+ Stockholders’ Equity $
5,500
5,700
Req. 4
Current
Ratio
=
Current Assets
Current Liabilities
=
$8,950+$1,000
$2,200
=
$9,950 = 4.52
$2,200
This ratio indicates that, for every $1 of current liabilities, Zeber maintains $4.52 of
current assets. Zeber’s ratio is higher than the industry average of 1.50, indicating that
Zeber maintains a lower level of short-term debt and has higher liquidity. However,
maintaining such a high current ratio also suggests that the company may not be using
its resources efficiently. Increasing short-term obligations would lower Zeber’s current
ratio, but this strategy alone would not help its efficiency. Zeber should consider
investing more of its cash in order to generate future returns.
2-20
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
E2–14.
Zeber Company
Balance Sheet
At December 31, 2012
Assets
Current Assets
Cash
Short-term investments
Total Current Assets
Property and equipment
$ 8,950
1,000
9,950
1,250
$11,200
Total Assets
Liabilities
Current Liabilities
Short-term notes payable
Total Current Liabilities
Long-term notes payable
Total Liabilities
Stockholders’ Equity
Contributed capital
Retained earnings
Total Stockholders’ Equity
Total Liabilities &
Stockholders’ Equity
$ 2,000
2,200
3,300
5,500
4,000
1,700
5,700
$11,200
E2–15.
Req. 1
Cash
Beg.
0
(a) 40,000 4,000 (c)
1,000 (d)
35,000
Equipment
Beg.
0
(c) 20,000
(d)
1,000
21,000
Short-Term
Notes Receivable
Beg.
0
(e)
4,000
4,000
Land
Beg.
0
(b) 16,000 4,000 (e)
12,000
Short-Term
Notes Payable
0 Beg.
16,000 (b)
16,000
Contributed Capital
0 Beg.
40,000 (a)
40,000
2-21
Long-Term
Notes Payable
0 Beg.
16,000 (c)
16,000
Chapter 02 Investing and Financing Decisions and the Balance Sheet
E2–15. (continued)
Req. 2
Strauderman Delivery Company, Inc.
Balance Sheet
At December 31, 2011
Assets
Current Assets
Cash
Short-term note receivable
Total Current Assets
Land
Equipment
$35,000
4,000
39,000
12,000
21,000
$72,000
Total Assets
Liabilities
Current Liabilities
Short-term notes payable
Total Current Liabilities
Long-term notes payable
Total Liabilities
Stockholders’ Equity
Contributed capital
Total Stockholders’ Equity
Total Liabilities &
Stockholders’ Equity
$16,000
16,000
16,000
32,000
40,000
40,000
$72,000
Req. 3
2011:
Current
Ratio
=
Current Assets
Current Liabilities
=
$39,000
$16,000
= 2.44
2012:
Current
Ratio
=
Current Assets
Current Liabilities
=
$52,000
$23,000
= 2.26
2013:
Current
Ratio
=
Current Assets
Current Liabilities
=
$47,000
$40,000
= 1.18
The current ratio has decreased over the years, suggesting that the company’s liquidity
is decreasing. Although the company still maintains sufficient current assets to settle
the short-term obligations, this steep decline in the ratio may be of concern – it may be
indicative of more efficient use of resources or it may suggest the company is having
cash flow problems.
2-22
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
Req. 4
The management of Strauderman Delivery Company has already been financing the
company’s development through additional short-term debt, from $16,000 in 2011 to
$40,000 in 2013. This suggests the company is taking on increasing risk. Additional
lending, particularly short-term, to the company may be too much risk for the bank to
absorb. Based solely on the current ratio, the bank’s vice president should consider not
providing the loan to the company as it currently stands. Of course, additional analysis
would provide better information for making a sound decision.
E2–16.
Transaction
Brief Explanation
(a)
Issued capital stock to shareholders in exchange for $16,000 cash and
$4,000 tools and equipment.
(b)
Loaned $1,500 cash; borrower signed a note receivable for this
amount.
(c)
Purchased a building for $50,000; paid $10,000 cash and gave a
$40,000 note payable for the balance.
(d)
Sold $800 of tools and equipment for their original cost.
E2–17.
Req. 1
Increases with…
Decreases with…
Equipment
Purchases of equipment
Sales of equipment
Notes receivable
Additional loans to others
Collection of loans
Notes payable
Additional borrowings
Payments of debt
Req. 2
Equipment
1/1
500
250
12/31
100
Notes Receivable
1/1
650
150
245
12/31
Notes Payable
100 1/1
225
170
2-23
110
170
160 12/31
Chapter 02 Investing and Financing Decisions and the Balance Sheet
Beginning
balance
$500
+
“+”

“”
=
+
250

?
?
=
=
Ending
balance
$100
650
Notes receivable
150
+
?

225
?
=
=
170
245
Notes payable
100
+
170

?
?
=
=
160
110
Equipment
E2–18.
Activity
(a)
(b)
(c)
(d)
(e)
Reduction of long-term debt
Sale of short-term investments
Issuance of common stock
Capital expenditures (for property, plant, and equipment)
Dividends paid on common stock.
Type of
Activity
F
I
F
I
F
E2–19.
Starwood Hotels & Resorts Worldwide, Inc.
Partial Statement of Cash Flows
For the Year Ended December 31, 2012
(in millions)
Investing Activities
Purchase of investments
Sale of assets and investments
Purchase and renovation of properties
Receipt of payment from note receivable
Cash flow from investing activities
$ (37)
359
(476)
172
18
Financing Activities
Additional borrowing from banks
Issuance of stock
Payment of debt
Cash flow from financing activities
986
120
(574)
$ 532
2-24
Effect on
Cash

+
+


Chapter 02 - Investing and Financing Decisions and the Balance Sheet
E2–20.
1. Current assets
2. Debt principal repaid
3. Significant accounting policies
4. Cash received on sale of
noncurrent assets
5. Dividends paid
6. Short-term obligations
7. Date of the statement of
financial position.
In the asset section of a classified balance sheet.
In the financing activities section of the statement of
cash flows.
Usually the first note after the financial statements.
In the investing activities section of the statement of
cash flows.
In the financing activities section of the statement of
cash flows.
In the current liabilities section of a classified
balance sheet.
In the heading of the balance sheet.
PROBLEMS
P2–1.
Balance
Sheet
Classification
Debit or
Credit
Balance
(1)
Notes and Loans Payable (short-term)
CL
Credit
(2)
Materials and Supplies
CA
Debit
(3)
Contributed Capital
SE
Credit
(4)
Patents (an intangible asset)
NCA
Debit
(5)
Income Taxes Payable
CL
Credit
(6)
Long-Term Debt
NCL
Credit
(7)
Marketable Securities (short-term)
CA
Debit
(8)
Property, Plant, and Equipment
NCA
Debit
(9)
Retained Earnings
SE
Credit
(10)
Notes and Accounts Receivable (short-term)
CA
Debit
(11)
Investments (long-term)
NCA
Debit
(12)
Cash and Cash Equivalents
CA
Debit
(13)
Accounts Payable
CL
Credit
(14)
Crude Oil Products and Merchandise
CA
Debit
2-25
Chapter 02 Investing and Financing Decisions and the Balance Sheet
P2–2.
Req. 1
East Hill Home Healthcare Services was organized as a corporation. Only a
corporation issues shares of capital stock to its owners in exchange for their
investment, as in transaction (a).
Req. 2 (On next page)
Req. 3
The transaction between the two stockholders (Event e) was not included in the
tabulation. Since the transaction in (e) occurs between the owners, there is no effect
on the business due to the separate-entity assumption.
Req. 4
(a)
Total assets = $111,500 + $18,000 + $5,000 + $510,500 + $160,000 + $65,000
= $870,000
(b)
Total liabilities = $100,000 + $180,000
= $280,000
(c)
Total stockholders’ equity = Total assets – Total liabilities
= $870,000 – $280,000 = $590,000
(d)
Cash balance = $50,000 + $90,000 – $9,000 + $3,500 – $18,000 – $5,000
= $111,500
(e)
Total current assets = Cash $111,500 + Short-Term Investments $18,000 + Notes
Receivable $5,000 = $134,500
Req. 5
Current
Ratio
=
Current Assets
Current Liabilities
= $111,500+$18,000+$5,000 = $134,500 = 1.35
$100,000
100,000
This suggests that for every $1 in current liabilities, East Hill maintains $1.35 in current
assets. The ratio suggests that East Hill is likely maintaining adequate liquidity and
using resources efficiently.
2-26
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
P2–2. (continued)
Req. 2
Assets
Beg.
Short-Term
Notes
Cash
Investments Receivable
50,000
=
ST Notes LT Notes
Land Buildings Equipment
Payable Payable
500,000 100,000
50,000 = 100,000
100,000
(a)
+90,000
(b)
–9,000
+14,000
(c)
+3,500
–3,500
(d)
–18,000
(e)
No effect
(f)
–5,000
+111,500
Liabilities
=
+60,000
Stockholders' Equity
Contributed Retained
Capital
Earnings
100,000
400,000
+90,000
+15,000 =
+80,000
=
+18,000
=
+5,000
+18,000
+
=
+5,000 +510,500 +160,000
+65,000 = +100,000
$870,000
+180,000
$280,000
2-27
+190,000
+400,000
$590,000
Chapter 02 Investing and Financing Decisions and the Balance Sheet
P2–3.
Req. 1 and 2
Beg.
(e)
(f)
(i)
Cash
19,000
12,000
9,000 (a)
12,000
7,000 (b)
1,000
6,000 (c)
3,000 (g)
9,000 (h)
Investments (short-term)
Beg.
2,000
(a)
9,000
Accounts Receivable
Beg.
3,000
End.
11,000
End.
Beg.
Inventory
24,000
24,000
End.
10,000
End.
Beg.
(c)
Equipment
48,000
18,000
1,000 (i)
Beg.
(h)
End.
65,000
3,000
Notes Receivable (long-term)
Beg.
1,000
(b)
7,000
End.
8,000
Beg.
(g)
Intangibles
3,000
3,000
End. 115,000
End.
6,000
Accounts Payable
15,000 Beg.
Accrued Liabilities Payable
2,000 Beg.
15,000 End.
2,000 End.
Notes Payable (short-term)
7,000 Beg.
12,000 (c)
12,000 (f)
31,000 End.
Long-Term Notes Payable
46,000 Beg.
16,000 (h)
Contributed Capital
90,000 Beg.
12,000 (e)
Retained Earnings
30,000 Beg.
62,000 End.
102,000 End.
30,000 End.
Factory Building
90,000
25,000
2-28
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
P2–3. (continued)
Req. 3
No effect was recorded for (d). The agreement in (d) involves no exchange or receipt of
cash, goods, or services and thus is not a transaction.
Req. 4
Cougar Plastics Company
Balance Sheet
At December 31, 2012
Assets
Current Assets
Cash
Investments
Accounts receivable
Inventory
Total Current Assets
$ 10,000
11,000
3,000
24,000
48,000
Notes receivable
Equipment
Factory building
Intangibles
8,000
65,000
115,000
6,000
$242,000
Total Assets
Liabilities
Current Liabilities
Accounts payable
Accrued liabilities payable
Notes payable
Total Current Liabilities
Long-term notes payable
Total Liabilities
Stockholders’ Equity
Contributed capital
Retained earnings
Total Stockholders’ Equity
Total Liabilities &
Stockholders’ Equity
Req. 5
Current
Ratio
=
Current Assets
Current Liabilities
=
$48,000 = 1.00
$48,000
This ratio indicates that Cougar Plastics has relatively low liquidity; for every $1 of
current liabilities, Cougar Plastics maintains only $1 of current assets.
2-29
$ 15,000
2,000
31,000
48,000
62,000
110,000
102,000
30,000
132,000
$242,000
Chapter 02 Investing and Financing Decisions and the Balance Sheet
P2–4.
Transaction
Type of Activity
Effect on Cash
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
I
I
I
NE
F
F
I
I
I
–
–
–
NE
+
+
–
–
+
P2–5.
Req. 1
a.
b.
c.
d.
e.
f.
g.
Cash (+A) ............................................................................
Long-term liabilities (+L) .................................................
30
Receivables and other assets (+A)......................................
Cash (A) .......................................................................
250
Long-term investments (+A) ................................................
Short-term investments (+A) ...............................................
Cash (A) .......................................................................
2,600
10,400
Property, plant, and equipment (+A)....................................
Cash (A) .......................................................................
Long-term liabilities (+L) .................................................
2,285
Cash (+A) ............................................................................
Contributed capital (+SE) ...............................................
200
Cash (+A) ............................................................................
Short-term investments (A) ..........................................
10,000
Retained earnings (SE) .....................................................
Cash (A) .......................................................................
52
2-30
30
250
13,000
875
1,410
200
10,000
52
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
P2–5. (continued)
Req. 2
Beg.
(a)
(e)
(f)
Cash
8,352
30
250
200 13,000
10,000
875
52
(b)
(c)
(d)
(g)
Beg.
(c)
Beg.
4,405
Short-Term
Investments
740
10,400 10,000 (f)
1,140
Inventories
867
Receivables and
Other Assets
Beg.
6,443
(b)
250
6,693
Other Current Assets
Beg.
3,749
867
Property, Plant, and
Equipment
Beg.
2,277
(d)
2,285
4,562
Accounts
Payable
8,309 Beg.
Beg.
(c)
Long-Term
Investments
454
2,600
3,054
11,389
Other
Noncurrent Assets
Beg.
3,618
3,618
Other Short-term
Obligations
6,550 Beg.
8,309
Contributed
Capital
11,189
200 (e)
3,749
Long-Term Liabilities
7,370 Beg.
30 (a)
1,410 (d)
8,810
6,550
Other Stockholders’
Equity Items
Beg. 27,904
(g)
27,904
2-31
Retained
Earnings
20,986 Beg.
52
20,934
Chapter 02 Investing and Financing Decisions and the Balance Sheet
P2–5. (continued)
Req. 3
Dell, Inc.
Balance Sheet
At January 29, 2010
(in millions)
ASSETS
Current Assets
Cash
Short-term investments
Receivables and other assets
Inventories
Other current assets
$
Noncurrent Assets
Property, plant and equipment
Long-term investments
Other noncurrent assets
Total assets
4,405
1,140
6,693
867
3,749
16,854
4,562
3,054
3,618
$28,088
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts payable
Other short-term obligations
Long-term Liabilities
Stockholders’ Equity
Contributed capital
Retained earnings
Other stockholders’ equity items
Total liabilities and stockholders’ equity
$ 8,309
6,550
14,859
8,810
11,389
20,934
(27,904)
$28,088
Req. 4
Current
Ratio
=
Current Assets
Current Liabilities
=
$16,854
$14,859
= 1.13
For every $1 of short-term liabilities, Dell has $1.13 of current assets. This low current
ratio suggests that Dell is using its resources efficiently and has sufficient liquidity.
2-32
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
P2–6.
Dell, Inc.
Partial Statement of Cash Flows
For the Year Ended January 29, 2010
(in millions of dollars)
INVESTING ACTIVITIES
Purchase of property, plant, and equipment
Purchase of investments
Loan of funds to affiliates
Sale of investments
Cash flow used in investing activities
$
FINANCING ACTIVITIES
Borrowings
Issuance of stock
Payment of dividends
Cash flow provided by financing activities
Net change in cash
Beginning balance of cash
Cash balance on January 29, 2010
2-33
(875)
(13,000)
(250)
10,000
(4,125)
30
200
(52)
178
$
(3,947)
8,352
4,405
Chapter 02 Investing and Financing Decisions and the Balance Sheet
ALTERNATE PROBLEMS
AP2–1.
Balance
Sheet
Classification
Debit or
Credit
Balance
(1)
Prepaid Expenses
CA
Debit
(2)
Inventories
CA
Debit
(3)
Accounts Receivable
CA
Debit
(4)
Long-Tterm Debt
NCL
Credit
(5)
Cash and Cash Equivalents
CA
Debit
(6)
Goodwill (an intangible asset)
NCA
Debit
(7)
Accounts Payable
CL
Credit
(8)
Income Taxes Payable
CL
Credit
(9)
Property, Plant, and Equipment
NCA
Debit
(10)
Retained Earnings
SE
Credit
(11)
Contributed Capital
SE
Credit
(12)
Short-Tterm Borrowings
CL
Credit
(13)
Accrued Liabilities
CL
Credit
2-34
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
AP2–2.
Req. 1
Adamson Incorporated was organized as a corporation. Only a corporation issues
shares of capital stock to its owners in exchange for their investment, as Adamson did
in transaction (c).
Req. 2 (On next page)
Req. 3
Since the transaction in (i) occurs between the owners and others outside the company,
there is no effect on the business due to the separate-entity assumption.
Req. 4
(a)
Total assets = $35,000 + $2,000 + $85,000 + $107,000 + $510,000 = $739,000
(b)
Total liabilities = $169,000 + $170,000 = $339,000
(c)
Total stockholders’ equity = Total assets – Total liabilities
= $739,000 – $339,000 = $400,000
(d)
Cash balance = $120,000 + $110,000 – $3,000 + $100,000 – $5,000 – $2,000
– $200,000 – $85,000 = $35,000
(e)
Total current assets = $35,000 + $2,000 = $37,000
Req. 5
Current
Ratio
=
Current Assets
Current Liabilities
=
$35,000 + $2,000
$169,000
=
$37,000 = 0.22
$169,000
This suggests that Adamson may not have sufficient liquidity to cover its current
obligations. Adamson should consider increasing its current assets or seeking to
convert some of its short-term debt to long-term debt.
2-35
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
AP2–2. (continued)
Req. 2
Assets
Beg.
=
Liabilities
+ Stockholders' Equity
Short-Term Long-Term
Notes
Long-Term
Notes
Notes
Contributed Retained
Cash Receivable Investments Equipment Building
Payable
Payable
Capital
Earnings
120,000
70,000 310,000 =
140,000
60,000
220,000
80,000
(a) +110,000
(b)
=
–3,000
+30,000
=
(c) +100,000
(d)
–5,000
(e)
–2,000
+10,000
=
+2,000
+100,000
+5,000
=
+200,000 =
–85,000
+85,000
=
–3,000
(h)
=
(i) No effect
+35,000
+27,000
=
(f) –200,000
(g)
+110,000
–3,000
=
+2,000
+85,000
+107,000 +510,000 =
$739,000
+169,000
$339,000
2-37
+170,000
+320,000
$400,000
+80,000
Chapter 02 Investing and Financing Decisions and the Balance Sheet
AP2–3.
Req. 1 and 2
Cash and Cash
Equivalents
Beg. 74,376
(a)
1,020
3,400
(d)
4,020
2,980
(g)
310
1,830
300
(b)
(e)
(f)
(h)
Beg.
(e)
Short-Term
Investments
0
2,980
2,980
36,865
Beg.
Other
Assets
4,540
12,672
Inventories
Beg. 186,265
186,265
71,216
Prepaid Expenses and
Other Current Assets
Beg. 36,865
Beg.
Accounts
Receivable
12,672
Property, Plant,
and Equipment
Beg. 350,432
(f)
11,230
4,020 (d)
357,642
Accounts
Payable
26,444 Beg.
Intangibles
Beg. 96,823
(b)
3,400
100,223
Accrued Expenses
Payable
109,017 Beg.
310 (g)
4,230
Long-Term
Debt*
203,029 Beg.
9,400 (f)
212,429
26,444
Other Long-Term
Liabilities
47,710 Beg.
47,710
* Current portion is $41.
109,017
Contributed
Capital
21,048 Beg.
1,020 (a)
22,068
Retained Earnings
354,725 Beg.
(h)
300
354,425
Req. 3
No effect was recorded for (c). Ordering goods involves no exchange or receipt of
cash, goods, or services and thus is not a transaction.
2-38
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
AP2–3. (continued)
Req. 4
Ethan Allen Interiors, Inc.
Balance Sheet
At September 30, 2008
(in thousands of dollars)
Assets
Current assets
Cash and cash equivalents
Short-term investments
Accounts receivable
Inventories
Prepaid expenses and other current assets
Total current assets
Property, plant, and equipment
Intangibles
Other assets
Total Assets
Liabilities
Current liabilities
Accounts payable
Accrued expenses payable
Current portion of long-term debt
Total current liabilities
Long-term debt
Other long-term liabilities
Total Liabilities
Stockholders’ Equity
Contributed capital
Retained earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
$ 71,216
2,980
12,672
186,265
36,865
309,998
357,642
100,223
4,230
$772,093
$ 26,444
109,017
41
135,502
212,388
47,710
395,600
22,068
354,425
376,493
$772,093
Req. 5
Current
Ratio
=
Total Current Assets = $309,998 = 2.29
Total Current Liabilities
$135,502
Ethan Allen maintains a relatively high current ratio, indicating that they are highly liquid.
Initially, this seems to suggest that they are not investing their resources efficiently.
However, a closer look reveals that a significant portion of their current assets are
invested in inventory, which often necessitates a higher current ratio.
2-39
Chapter 02 Investing and Financing Decisions and the Balance Sheet
AP2–4.
Transaction
Type of Activity
Effect on Cash
(a)
(b)
F
I
+
(c)
(d)
(e)
NE
I
I
(f)
I
(g)
(h)
I
F

NE
+


+

2-40
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
CASES AND PROJECTS
ANNUAL REPORT CASES
CP2–1.
1. The company is a corporation since it maintains share capital and its owners are
referred to as “shareholders.” (Refer to the stockholders’ equity section of the
balance sheet).
2. The amount listed on the balance sheet for inventories does not represent the
expected selling price. It represents the historical cost of acquiring the inventory, as
required by the cost principle.
3. The company’s current obligations include: accounts payable, notes payable,
accrued compensation and payroll taxes, accrued rent, accrued income and other
taxes, unredeemed stored value cards and gift certificates, current portion of
deferred lease credits, and other liabilities and accrued expenses.
4 Current
Ratio
=
Current Assets
Current Liabilities
=
$925,359 = 2.30
$401,763
The current ratio measures the ability of the company to settle short-term obligations
with current assets. American Eagle Outfitters’ current ratio of 2.30 suggests strong
liquidity with $2.30 in current assets for every $1 in current liabilities. In the most
recent year presented, the company had a significant amount of cash primarily from
selling short-term investments. Given the poor economic environment beginning in
2008 with a downturn in the financial markets, maintaining a cash position may be
an investing strategy.
5. The company spent $265,335,000 on purchasing property and equipment in the
year ended 1/31/09; $250,407,000 in the year ended 2/2/08; and $225,939,000 in
the year ended 2/3/07. This information is listed as Capital Expenditures on the
Statement of Cash Flows in the investing activities section.
2-41
Chapter 02 Investing and Financing Decisions and the Balance Sheet
CP2–2.
1.
Assets
$1,329,009,000
=
=
Liabilities
$275,234,000
+
+
Shareholders’ Equity
$1,053,775,000
2. No – shareholders’ equity is a residual balance, meaning that the shareholders will
receive what remains in cash and assets after the creditors have been satisfied. It is
likely that shareholders would receive less than $1,053,775,000. In addition, nearly
all assets on the balance sheet are not stated at market value, only historical cost.
3. The company’s only noncurrent liability is Deferred Rent and Other Liabilities.
4. Current
Ratio
=
Current Assets
Current Liabilities
= $624,402,000 =4.42
$141,150,000
5. The company had a net cash outflow from investing activities of $56,907,000,
primarily because of capital expenditures (the purchase of property and equipment
for $112,553,000).
The company also purchased marketable securities
(investments) for $809,039,000, nearly equivalent to the amount of marketable
securities that were sold or matured during the year ($864,685,000).
2-42
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
CP2–3.
1.
Current Ratio =
Industry
Average
2.55
American Eagle
Outfitters
2.30
Urban
Outfitters
4.42
American Eagle Outfitters’ current ratio of 2.30 is slightly lower than the industry
average, but Urban Outfitters’ current ratio of 4.42 is significantly higher than the
industry average of 2.55. For the year ended January 31, 2009, Urban Outfitters
tripled its amount of cash from the prior year while maintaining similar balances in
the remaining current assets. This suggests that Urban Outfitters chose to respond
to the poor economic environment beginning in 2008 by maintaining a strong cash
position.
Many retailers, such as American Eagle Outfitters, choose to rent space rather than
purchase buildings for stores. Acquiring buildings often requires borrowing longterm (mortgages). Thus, the choice of renting or purchasing buildings does not
have an effect on the numerator or denominator of the current ratio.
2. As indicated in the financing activities section of each company’s statement of cash
flows, during the most recent year, American Eagle Outfitters spent $3,432,000
repurchasing common stock from employees with no repurchases from investors.
This was a dramatic shift from prior years. Urban Outfitters did not repurchase
shares of common stock in the current or prior years.
3. As indicated the statement of cash flows, American Eagle Outfitters paid
$82,394,000 in dividends. Urban Outfitters did not pay any dividends during the
year. Refer to the financing activities section of the statement of cash flows.
4. American Eagle reports “Property and equipment, at cost, net of accumulated
depreciation and amortization” and Urban Outfitters reports “Property and
equipment, net.” Details of the amount of land, building, and equipment are
reported by each in the notes to the financial statements. Other companies
sometimes choose to report these assets separately on the balance sheet, for
example in accounts such as: “Land,” “Buildings and building improvements,”
Furniture, fixtures and equipment,” and “Rental property and equipment.”
2-43
Chapter 02 Investing and Financing Decisions and the Balance Sheet
FINANCIAL REPORTING AND ANALYSIS CASES
CP2–4.
1. (a) Papa John’s total assets reported at March 29, 2009 are $387,861,000.
(b) Long-term debt including the current portion due decreased over three months
from $130,654,000 ($123,579,000 long-term + $7,075,000 current portion) at
December 28, 2008, to $111,525,000 ($103,075,000 long-term + $8,450,000
current portion) on March 29, 2009.
(c) Current
Ratio
=
Current Assets = $80,351,000 = .79
Current Liabilities
$102,065,000
Papa John’s current ratio increased from the level of .75 as discussed in the
chapter. This indicates that, between December 28, 2008, and March 29, 2009,
Papa John’s increased its liquidity slightly. Current assets increased by
approximately $5 million while current liabilities increased by only $2 million.
Cash and cash equivalents increased the most (over $7 million). Given the
difficult economic environment that continued through 2009, Papa John’s
appeared to increase its cash balance as an added cushion.
2. (a) For the three months ended March 29, 2009, Papa John’s spent $5,064,000 on
the purchase of property and equipment, its largest use of cash for investing
activities.
(b) The total cash flows used in financing activities was $17,447,000, mostly from
the repayment of debt and the repurchase of its common stock.
CP2–5.
The major deficiency in this balance sheet is the inclusion of the owner’s personal
residence as a business asset. Under the separate-entity assumption, each business
must be accounted for as an individual organization, separate and apart from its
owners. The improper inclusion of this asset as part of Frances Sabatier’s business:
 overstates total assets by $300,000; total assets should be $105,000 rather than
$405,000, and
 Overstates stockholders’ equity that should be only $5,000, rather than
$305,000.
Since current assets and current liabilities were not affected, the current ratio remains
the same. However, other ratios involving long-term assets and/or stockholders’ equity
will be affected.
2-44
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
CP2–6.
1. The company is a corporation since its owners are referred to as “stockholders.”
2. Assets
$26,500
3. Current
Ratio
= Liabilities
= $22,229
=
+ Stockholders’ Equity (in millions)
+
$4,271
Current Assets
Current Liabilities
=
$20,151
$14,859
= 1.36 (dollars in millions)
For every $1 of current liabilities, Dell maintains $1.36 of current assets, suggesting
that Dell has the ability to pay its short-term obligations with current assets in the
upcoming year. The interpretation of this ratio would be more useful given
information on the company’s current ratio over time and on the typical current ratio
for the computer industry.
4. Accounts Payable (L) ........................................................
8,309 million
Cash (A) ...................................................................... 8,309 million
5. Over its years in business, it appears that Dell has been profitable, based on a
positive amount in Retained Earnings of $20,677,000,000. The Retained Earnings
account represents the cumulative earnings of the firm less any dividends paid to
the shareholders since the business began.
In addition, Dell appears profitable in the most recent year because Retained
Earnings increased. It is possible to determine the amount of net income by using
the following equation, assuming no dividends were declared:
(in millions)
Beg.
For the Year
End.
Retained Earnings + Net Income – Dividends declared = Retained Earnings
$18,199
+
?
–
$ 0
=
$20,677
Thus, net income for the most recent year was $2,478,000,000.
2-45
Chapter 02 Investing and Financing Decisions and the Balance Sheet
CRITICAL THINKING CASES
CP2–7.
Req. 1
Dewey, Cheetum, and Howe, Inc.
Balance Sheet
December 31, 2012
Assets
Current Assets:
Cash
Accounts receivable
Inventory
Total current assets
Furniture and fixtures
Delivery truck (net)
Buildings (net)
Total assets
$
1,000
8,000
8,000
17,000
52,000
12,000
60,000
$141,000
Liabilities
Current Liabilities:
Accounts payable
Payroll taxes payable
Total current liabilities
Notes payable (due in three years)
Mortgage payable
Total liabilities
$ 16,000
13,000
29,000
15,000
50,000
94,000
Stockholders' Equity
Contributed capital
Accumulated deficit
Total stockholders' equity
Total liabilities and stockholders' equity
80,000
(33,000)
47,000
$141,000
2-46
Chapter 02 - Investing and Financing Decisions and the Balance Sheet
CP2–7. (continued)
Req. 2
Dear ___________,
I corrected the balance sheet for Dewey, Cheetum, and Howe, Inc. Primarily, I
reduced the amount reported for buildings to $60,000 which is the historical cost less
any depreciation. Estimated market value is not a generally accepted accounting
principle for recording property, plant, and equipment. The $38,000 difference ($98,000
– $60,000) reduces total assets and reduces retained earnings. In fact, retained
earnings becomes negative suggesting that there may have been several years of
operating losses.
Before making a final decision on investing in this company, you should examine
the past three years of audited income statements and the past two years of audited
balance sheets to identify positive and negative trends for this company. You can also
compare this company's current ratio to that of the industry to assess trends in liquidity,
and compare how this company’s long-term debt as a proportion of stockholders’ equity
has changed over time. You should also learn as much about the industry as you can
by reviewing recent articles on economic and technological trends which may have an
impact on this company.
2-47
Chapter 02 Investing and Financing Decisions and the Balance Sheet
CP2–8.
1. The most obvious parties harmed by the fraud at Ahold’s U.S. Foodservice, Inc.,
were the stockholders and creditors. Stockholders were purchasing shares of stock
that were inflated due to the fraud. Creditors were lending funds to the company
based on inflated income statement and balance sheet information. When the fraud
was discovered, the stock price dropped causing the stockholders to lose money on
their investments. In addition, the creditors have a lower probability of receiving full
payment on their loans. The vendors who assisted in verifying false promotional
allowances were also investigated.
Those who were helped by the fraud included the former executives who were
able to receive substantial bonuses based on the inflated results of operations. The
SEC also charged two individuals with insider trading for trading on a tip illegally.
2. U.S. Foodservice set certain financial goals and tied the former executives’ bonuses
to meeting the goals. Adopting targets is a good tool for monitoring progress toward
goals and identifying problem areas, such as rising costs or sagging sales. Better
decision making can result by heading off potential problems before they grow too
large. However, setting unrealistic financial targets, especially in poor economic
times, can result in those responsible for meeting the targets circumventing
appropriate procedures and policies for their own benefit.
3. In many cases of fraudulent activity, auditors are named in lawsuits along with the
company. If the auditors are found to be negligent in performing their audit, then
they are liable. However, in many frauds, the management at multiple levels of the
organization are so involved in covering the fraud that it becomes nearly impossible
for the auditors to detect the fraudulent activity. In this case, it appears that top
executives concocted a scheme to induce vendors to confirm false promotional
allowance income by signing audit letters agreeing to the false amounts. In audits,
confirming balances or amounts with external parties usually provides evidence for
the auditors on potential problem areas. The auditors appropriately relied on this
external evidence in performing their audit, not knowing it to be tainted or fraudulent.
FINANCIAL REPORTING AND ANALYSIS TEAM PROJECT
CP2–9.
The solution to this team project will depend on the companies and/or accounting
period selected for analysis.
2-48
Chapter 03 - Operating Decisions and the Income Statement
Chapter 03
Operating Decisions and the Income
Statement
ANSWERS TO QUESTIONS
1.
A typical business operating cycle for a manufacturer would be as follows:
inventory is purchased, cash is paid to suppliers, the product is manufactured
and sold on credit, and the cash is collected from the customer.
2.
The time period assumption means that the financial condition and performance
of a business can be reported periodically, usually every month, quarter, or year,
even though the life of the business is much longer.
3.
Net Income = Revenues + Gains - Expenses - Losses.
Each element is defined as follows:
Revenues -- increases in assets or settlements of liabilities from ongoing
operations.
Gains -increases in assets or settlements of liabilities from peripheral
transactions.
Expenses -- decreases in assets or increases in liabilities from ongoing
operations.
Losses -decreases in assets or increases in liabilities from peripheral
transactions.
4.
Both revenues and gains are inflows of net assets. However, revenues occur in
the normal course of operations, whereas gains occur from transactions
peripheral to the central activities of the company. An example is selling land at
a price above cost (at a gain) for companies not in the business of selling land.
Both expenses and losses are outflows of net assets. However, expenses occur
in the normal course of operations, whereas losses occur from transactions
peripheral to the central activities of the company. An example is a loss suffered
from fire damage.
5.
Accrual accounting requires recording revenues when earned and recording
expenses when incurred, regardless of the timing of cash receipts or payments.
Cash basis accounting is recording revenues when cash is received and
expenses when cash is paid.
3-1
Chapter 03 - Operating Decisions and the Income Statement
6.
The four criteria that must be met for revenue to be recognized under the accrual
basis of accounting are (1) delivery has occurred or services have been
rendered, (2) there is persuasive evidence of an arrangement for customer
payment, (3) the price is fixed or determinable, and (4) collection is reasonably
assured.
7.
The matching principle requires that expenses be recorded when incurred in
earning revenue. For example, the cost of inventory sold during a period is
recorded in the same period as the sale, not when the goods are produced and
held for sale.
8.
Net income equals revenues minus expenses. Thus revenues increase net
income and expenses decrease net income. Because net income increases
stockholders’ equity, revenues increase stockholders’ equity and expenses
decrease it.
9.
Revenues increase stockholders’ equity and expenses decrease stockholders’
equity. To increase stockholders’ equity, an account must be credited; to
decrease stockholders’ equity, an account must be debited. Thus revenues are
recorded as credits and expenses as debits.
10.
Item
Increase
Decrease
Credit
Debit
Credit
Debit
Debit
Credit
Debit
Credit
Debit
Credit
Decrease
Increase
Decrease
Increase
Increase
Decrease
Increase
Decrease
Operating,
Investing, or
Financing
Direction
of the Effect
on Cash
Operating
None
Operating
Investing
Operating
Financing
–
None
+
–
–
+
Revenues
Losses
Gains
Expenses
11.
Item
Revenues
Losses
Gains
Expenses
12.
Transaction
Cash paid to suppliers
Sale of goods on account
Cash received from customers
Purchase of investments
Cash paid for interest
Issuance of stock for cash
3-2
Chapter 03 - Operating Decisions and the Income Statement
Total asset turnover is calculated as Sales (or Operating revenues)  Average
total assets. The total asset turnover ratio measures the sales generated per
dollar of assets. A high ratio suggests that the company is managing its assets
(resources used to generate revenues) efficiently.
13.
ANSWERS TO MULTIPLE CHOICE
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
c
a
b
b
b
c
d
b
a
b
3-3
Chapter 03 - Operating Decisions and the Income Statement
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
6
3
6
4
5
5
5
6
5
7
5
8
6
9
6
10
6
11
6
Exercises
No.
Time
1
10
2
15
3
20
4
20
5
20
6
20
7
18
8
20
9
20
10
20
11
20
12
15
13
20
14
20
15
20
16
20
17
20
18
10
19
10
Problems
No.
Time
1
20
2
20
3
25
4
40
5
20
6
40
7
30
Alternate
Problems
No.
Time
1
30
2
30
3
35
4
40
5
20
6
40
Cases and
Projects
No.
Time
1
20
2
30
3
30
4
20
5
30
6
30
7
60
8
30
9
*
* Due to the nature of this project, it is very difficult to estimate the amount of time
students will need to complete the assignment. As with any open-ended project, it is
possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time discussing research strategies. When we want the students
to focus on a real accounting issue, we offer suggestions about possible companies or
industries.
3-4
Chapter 03 - Operating Decisions and the Income Statement
MINI-EXERCISES
M3–1.
TERM
G
C
F
E
B
(1) Losses
(2) Matching principle
(3) Revenues
(4) Time period assumption
(5) Operating cycle
M3–2.
Cash Basis
Income Statement
Revenues:
Cash sales
Customer deposits
Expenses:
Inventory purchases
Wages paid
Net Income
$10,000
3,000
1,000
750
$11,250
3-5
Accrual Basis
Income Statement
Revenues:
Sales to customers
$15,000
Expenses:
Cost of sales
Wages expense
Utilities expense
Net Income
9,000
750
200
$5,050
Chapter 03 - Operating Decisions and the Income Statement
M3–3.
Revenue Account Affected
a. Games Revenue
b. Sales Revenue
Amount of Revenue Earned in July
$13,000
$7,000
c. None
No revenue earned in July; cash collections in
July related to earnings in June.
d. None
No revenue earned in July; earnings process is
not yet complete – Unearned Revenue is
recorded upon receipt of cash.
M3–4.
Expense Account Affected
e. Cost of Goods Sold
f. None
g. Wages Expense
h. Insurance Expense
i. Repairs Expense
j. Utilities Expense
Amount of Expense Incurred in July
$3,890
No expense is incurred in July; payment related
to June electricity usage.
$4,700
$600 incurred and expensed in July and
$1,200 not incurred until future months
(recorded as Prepaid Expense (A)).
$1,400
$2,600 incurred in July
3-6
Chapter 03 - Operating Decisions and the Income Statement
M3–5.
a.
b.
c.
d.
Cash (+A) ............................................................................
Games Revenue (+R, +SE) ...........................................
13,000
Cash (+A) ............................................................................
Accounts Receivable (+A) ...................................................
Sales Revenue (+R, +SE) ..............................................
3,000
4,000
Cash (+A) ............................................................................
Accounts Receivable (A) ..............................................
2,500
Cash (+A) ............................................................................
Unearned Revenue (+L).................................................
2,600
Cost of Goods Sold (+E, SE) .............................................
Inventory (A).................................................................
3,890
Accounts Payable (–L) ........................................................
Cash (A) .......................................................................
1,900
Wages Expense (+E, SE) ..................................................
Cash (A) .......................................................................
4,700
Insurance Expense (+E, SE) .............................................
Prepaid Expenses (+A)........................................................
Cash (A) .......................................................................
600
1,200
Repairs Expense (+E, SE).................................................
Cash (A) .......................................................................
1,400
Utilities Expense (+E, SE) .................................................
Accounts Payable (+L) ...................................................
2,600
13,000
7,000
2,500
2,600
M3–6.
e.
f.
g.
h.
i.
j.
3-7
3,890
1,900
4,700
1,800
1,400
2,600
Chapter 03 - Operating Decisions and the Income Statement
M3–7.
Assets
Balance Sheet
Income Statement
Stockholders’
Net
Liabilities
Equity
Revenues Expenses
Income
a.
+13,000
NE
+13,000
+13,000
NE
+13,000
b.
+7,000
NE
+7,000
+7,000
NE
+7,000
c.
+2,500
–2,500
NE
NE
NE
NE
NE
d.
+2,600
+2,600
NE
NE
NE
NE
Transaction (c) results in an increase in an asset (cash) and a decrease in an asset
(accounts receivable). Therefore, there is no net effect on assets.
M3–8.
Assets
Balance Sheet
Income Statement
Stockholders’
Net
Liabilities
Equity
Revenues Expenses
Income
e.
–3,890
NE
–3,890
NE
+3,890
–3,890
f.
–1,900
–1,900
NE
NE
NE
NE
g.
–4,700
NE
–4,700
NE
+4,700
–4,700
h.
–1,800/
+1,200
NE
–600
NE
+600
–600
i.
–1,400
NE
–1,400
NE
+1,400
–1,400
j.
NE
+2,600
–2,600
NE
+2,600
–2,600
Transaction (h) results in an increase in an asset (prepaid expenses) and a decrease in
an asset (cash). Therefore, the net effect on assets is  600.
3-8
Chapter 03 - Operating Decisions and the Income Statement
M3–9.
Craig’s Bowling, Inc.
Income Statement
For the Month of July 2011
Revenues:
Games revenue
Sales revenue
Total revenues
$13,000
7,000
20,000
Expenses:
Cost of goods sold
Utilities expense
Wages expense
Insurance expense
Repairs expense
Total expenses
3,890
2,600
4,700
600
1,400
13,190
Net income
$ 6,810
M3–10.
Craig’s Bowling, Inc.
Partial Statement of Cash Flows
For the Month of July 2011
Cash Flows from Operating Activities:
Cash received from customers
(=$13,000+$3,000+$2,500+$2,600)
$21,100
Cash paid to suppliers
(=$1,900+$1,800+$1,400)
(5,100)
Cash paid to employees
(4,700)
Cash from operating activities
$11,300
M3–11.
2012
Total Asset =
Sales
Turnover
Average Total Assets
$163,000
$56,500*
2011
= 2.89
$151,000
$47,000**
= 3.21
* ($53,000 + $60,000) ÷ 2
** ($41,000 + $53,000) ÷ 2
The decrease in the asset turnover ratio suggests that the company is managing its
assets less efficiently, generating fewer sales per dollar of assets in 2012 than in 2011.
3-9
Chapter 03 - Operating Decisions and the Income Statement
EXERCISES
E3–1.
TERM
K
E
G
I
M
C
D
F
J
L
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Expenses
Gains
Revenue principle
Cash basis accounting
Unearned revenue
Operating cycle
Accrual basis accounting
Prepaid expenses
(9) Revenues  Expenses = Net Income
(10) Ending Retained Earnings =
Beginning Retained Earnings + Net Income  Dividends Declared
E3–2.
Req. 1
Cash Basis
Income Statement
Revenues:
Cash sales
Customer deposits
Expenses:
Inventory purchases
Wages paid
Utilities paid
Net Income
$520,000
35,000
90,000
164,200
17,200
$283,600
Accrual Basis
Income Statement
Revenues:
Sales to customers $630,000
Expenses:
Cost of sales
Wages expense
Utilities expense
387,000
169,000
18,940
Net Income
$55,060
Req. 2
Accrual basis financial statements provide more useful information to external users.
Financial statements created under cash basis accounting normally postpone (e.g.,
$110,000 credit sales) or accelerate (e.g., $35,000 customer deposits) recognition of
revenues and expenses long before or after goods and services are produced and
delivered (until cash is received or paid). They also do not necessarily reflect all assets
or liabilities of a company on a particular date.
3-10
Chapter 03 - Operating Decisions and the Income Statement
E3–3.
Activity
Amount of Revenue Earned in
September
Revenue Account Affected
a.
None
No revenue earned in September;
earnings process is not yet complete.
b.
Interest revenue
$12 (= $1,200 x 12% x 1month/12 months)
c.
Sales revenue
$18,050
d.
None
No transaction has occurred; exchange of
promises only.
e.
Sales revenue
$15,000 (= 1,000 shirts x $15 per shirt);
revenue earned when goods are delivered.
f.
None
Payment related to revenue recorded
previously in (e) above.
g.
None
No revenue earned in September;
earnings process is not yet complete.
h.
None
No revenue is earned; the issuance of
stock is a financing activity.
i.
None
No revenue earned in September;
earnings process is not yet complete.
j.
Ticket sales revenue
$3,660,000 (= $18,300,000 ÷ 5 games)
k.
None
No revenue earned in September;
earnings process is not yet complete.
l.
Sales revenue
$18,400
m.
Sales revenue
$100
3-11
Chapter 03 - Operating Decisions and the Income Statement
E3–4.
Activity
Amount of Expense Incurred in
January
Expense Account Affected
a.
Utilities expense
$2,754
b.
Advertising expense
$282(= $846 x 1 month/3 months) incurred
in January. The remainder is a prepaid
expense (A) that is not incurred until
February and March.
c.
Salary expense
$189,750 incurred in January.
The remaining half was incurred in
December.
d.
None
Expense will be recorded when the related
revenue has been earned.
e.
None
Expense will be recorded in the future when
the related revenue has been earned.
f.
Cost of goods sold
$40,050 (= 450 books x $89 per book)
g.
None
December expense paid in January.
h.
Commission expense
$14,470
i.
None
Expense will be recorded as depreciation
over the equipment’s useful life.
j.
Supplies expense
$5,190 (= $4,000 + $2,600 - $1,410)
k.
Wages expense
$104 (= 8 hours x $13 per hour)
l.
Insurance expense
$300 (= $3,600 ÷ 12 months)
m.
Repairs expense
$300
n.
Utilities Expense
$202
o.
Consulting Expense
$1,285
p.
None
December expense paid in January.
q.
Cost of goods sold
$5,000 (= 500 shirts x $10 per shirt)
3-12
Chapter 03 - Operating Decisions and the Income Statement
E3–5.
Assets
Balance Sheet
Income Statement
Stockholders’
Net
Liabilities
Equity
Revenues Expenses
Income
a.
+
NE
+
NE
NE
NE
b.
+
+
NE
NE
NE
NE
c.
-
NE
-
NE
NE
NE
d.
+
NE
+
+
NE
+
e.
NE
+
–
NE
+
–
f.
+
NE
+
+
NE
+
g.
–
–
NE
NE
NE
NE
h.
–
NE
–
NE
+
–
i.
+
NE
+
+
NE
+
j.
+
+
NE
NE
NE
NE
k.
+/–
NE
NE
NE
NE
NE
l.
–
NE
–
NE
+*
–
m.
–
+
–
NE
+
–
n.
–
NE
–
NE
+
–
Transaction (k) results in an increase in an asset (cash) and a decrease in an asset
(accounts receivable). Therefore, there is no net effect on assets.
* A loss affects net income negatively, as do expenses.
3-13
Chapter 03 - Operating Decisions and the Income Statement
E3–6.
Assets
Balance Sheet
Income Statement
Stockholders’
Net
Liabilities
Equity
Revenues Expenses
Income
a.
+7,047
NE
+7,047
NE
NE
NE
b.
+765,472
+765,472
NE
NE
NE
NE
c.
+59,500
+59,500
NE
NE
NE
NE
NE
NE
+1,220,568
–734,547
+1,220,568
NE
NE
+734,547
+1,220,568
–734,547
NE
–20,758
NE
NE
NE
NE
NE
NE
NE
NE
d. +1,220,568
–734,547
–20,758
e.
f. +/–24,126
g.
–258,887
+86,296
–345,183
NE
+345,183
–345,183
h.
+1,757
NE
+1,757
+1,757
NE
+1,757
i.
NE
+2,850
–2,850
NE
+2,850
–2,850
Transaction (f) results in an increase in an asset (property, plant, and equipment) and a
decrease in an asset (cash). Therefore, there is no net effect on assets.
E3–7.
(in thousands)
a.
b.
c.
Plant and equipment (+A) ...................................................
515
Cash (A) .......................................................................
Debits equal credits. Assets increase and decrease by the same amount.
515
Cash (+A) ...........................................................................
758
Short-term notes payable (+L) .......................................
Debits equal credits. Assets and liabilities increase by the same amount.
758
Cash (+A) ...........................................................................
10,272
Accounts receivable (+A) ....................................................
27,250
Service revenue (+R, +SE) .............................................
37,522
Debits equal credits. Revenue increases retained earnings (part of
stockholders' equity). Stockholders' equity and assets increase by the same
amount.
3-14
Chapter 03 - Operating Decisions and the Income Statement
E3–7. (continued)
d.
4,300
Accounts payable (L) ........................................................
4,300
Cash (A) .......................................................................
Debits equal credits. Assets and liabilities decrease by the same amount.
e.
Inventory (+A) .....................................................................
30,449
Accounts payable (+L) ....................................................
30,449
Debits equal credits. Assets and liabilities increase by the same amount.
f.
3,500
Wages expense (+E, SE) .................................................
3,500
Cash (A) .......................................................................
Debits equal credits. Expenses decrease retained earnings (part of
stockholders' equity). Stockholders' equity and assets decrease by the same
amount.
g.
Cash (+A) ...........................................................................
37,410
37,410
Accounts receivable (A) ...............................................
Debits equal credits. Assets increase and decrease by the same amount.
h.
750
Fuel expense (+E, SE) .....................................................
750
Cash (A) .......................................................................
Debits equal credits. Expenses decrease retained earnings (part of
stockholders' equity). Stockholders' equity and assets decrease by the same
amount.
i.
497
Retained earnings (SE) ....................................................
497
Cash (A) .......................................................................
Debits equal credits. Assets and stockholders’ equity decrease by the same
amount.
j.
68
Utilities expense (+E, SE) .................................................
55
Cash (A) .......................................................................
13
Accounts payable (+L) ....................................................
Debits equal credits. Expenses decrease retained earnings (part of
stockholders' equity). Together, stockholders' equity and liabilities decrease by
the same amount as assets.
3-15
Chapter 03 - Operating Decisions and the Income Statement
E3–8.
Req. 1
a.
Cash (+A) ................................................................... 2,500,000
Short-term note payable (+L) ...........................
2,500,000
Debits equal credits. Assets and liabilities increase by the same amount.
b.
Equipment (+A) .......................................................... 95,000
Cash (A).........................................................
95,000
Debits equal credits. Assets increase and decrease by the same amount.
c.
Merchandise inventory (+A)........................................
40,000
Accounts payable (+L) .....................................
40,000
Debits equal credits. Assets and liabilities increase by the same amount.
d.
Repair and maintenance expense (+E, SE) ............. 62,000
Cash (A).........................................................
62,000
Debits equal credits. Expenses decrease retained earnings (part of stockholders'
equity). Stockholders' equity and assets decrease by the same amount.
e.
Cash (+A) ................................................................... 372,000
Unearned pass revenue (+L) ...........................
372,000
Debits equal credits. Since the season passes are sold before Vail Resorts
provides service, revenue is deferred until it is earned. Assets and liabilities
increase by the same amount.
f. Two transactions occur:
(1) Accounts receivable (+A) ......................................
750
Ski shop sales revenue (+R, +SE) ...................
750
Debits equal credits. Revenue increases retained earnings (a part of
stockholders' equity). Stockholders' equity and assets increase by the same
amount.
(2) Cost of goods sold (+E, SE) ................................
450
Merchandise inventory (A) .............................
450
Debits equal credits. Expenses decrease retained earnings (a part of
stockholders' equity). Stockholders' equity and assets decrease by the same
amount.
3-16
Chapter 03 - Operating Decisions and the Income Statement
E3–8. (continued)
g.
Cash (+A) ................................................................... 270,000
Lift revenue (+R, +SE) .....................................
270,000
Debits equal credits. Revenue increases retained earnings (a part of
stockholders' equity). Stockholders' equity and assets increase by the same
amount.
h.
Cash (+A) ................................................................... 3,200
Unearned rent revenue (+L) ............................
3,200
Debits equal credits. Since the rent is received before the townhouse is used,
revenue is deferred until it is earned. Assets and liabilities increase by the same
amount.
i.
Accounts payable (L) ................................................ 20,000
Cash (A).........................................................
20,000
Debits equal credits. Assets and liabilities decrease by the same amount.
j.
Cash (+A) ...................................................................
400
Accounts receivable (A) .................................
400
Debits equal credits. Assets increase and decrease by the same amount.
k.
Wages expense (+E, SE) ......................................... 258,000
Cash (A).........................................................
258,000
Debits equal credits. Expenses decrease retained earnings (a part of
stockholders' equity). Stockholders' equity and assets decrease by the same
amount.
Req. 2
Accounts Receivable
(j)
Beg. bal. 1,200 400
(f)
750
End. bal. 1,550
3-17
Chapter 03 - Operating Decisions and the Income Statement
E3–9.
2/1 Rent expense (+E, SE) .....................................................
Cash (A) .................................................................
275
2/2 Fuel expense (+E, SE) .....................................................
Accounts payable (+L) ..............................................
490
2/4 Cash (+A) ...........................................................................
Unearned revenue (+L) ............................................
820
2/7 Cash (+A) ...........................................................................
Transport revenue (+R, +SE) ...................................
910
2/10 Advertising expense (+E, SE) ...........................................
Cash (A) .................................................................
175
2/14 Wages payable (L) ...........................................................
Cash (A) .................................................................
2,300
2/18 Cash (+A) ...........................................................................
Accounts receivable (+A) ....................................................
Transport revenue (+R, +SE) ...................................
1,600
2,200
2/25 Parts supplies (+A) .............................................................
Accounts payable (+L) ..............................................
2,550
2/27 Retained earnings (SE) ....................................................
Dividends payable (+L) .............................................
200
3-18
275
490
820
910
175
2,300
3,800
2,550
200
Chapter 03 - Operating Decisions and the Income Statement
E3–10.
Req. 1 and 2
Cash
Beg. 6,200
(a) 18,400 2,140
(b)
600 15,000
(c)
820 2,600
(d) 7,200
960
12,520
(g)
(i)
(j)
(k)
Equipment
Beg. 9,600
(h) 920
10,520
Accounts
Payable
9,600 Beg.
(g) 2,140
520 (e)
7,980
Contributed Capital
8,600 Beg.
920 (h)
9,520
Rent Revenue
0 Beg.
820
(c)
820
Accounts Receivable
Beg.30,000
7,200 (d)
22,800
Land
Beg. 7,200
7,200
Unearned Fee
Revenue
3,840 Beg.
600 (b)
4,440
Retained Earnings
10,800 Beg.
(j) 2,600
8,200
Wages Expense
Beg.
0
(i) 15,000
15,000
Item (f) is not a transaction; there has been no exchange.
3-19
Supplies
Beg. 1,440
(k)
960
2,400
Building
Beg. 26,400
26,400
Note
Payable
48,000 Beg.
48,000
Rebuilding Fees
Revenue
0 Beg.
18,400 (a)
18,400
Utilities Expense
Beg.
0
(e) 520
520
Chapter 03 - Operating Decisions and the Income Statement
E3–10. (continued)
Req. 3
Net income using the accrual basis of accounting:
Revenues
$19,220 ($18,400 + $820)
– Expenses
15,520 ($15,000 + $520)
Net Income
$ 3,700
(accrual basis)
Assets
$12,520
22,800
2,400
10,520
7,200
26,400
$81,840
=
Liabilities
$ 7,980
4,440
48,000
$60,420
+
Stockholders’ Equity
$ 9,520
8,200
3,700 net income
$21,420
Req. 4
Net income using the cash basis of accounting:
Cash receipts
$27,020 (transactions a through d)
– Cash disbursements
18,100 (transactions g, i, and k)
Net Income
$ 8,920
(cash basis)
Cash basis net income ($8,920) is higher than accrual basis net income ($3,700)
because of the differences in the timing of recording revenues versus receipts and
expenses versus disbursements between the two methods. The $7,800 higher amount
in cash receipts over revenues includes cash received prior to being earned (from (b),
$600) and cash received after being earned (in (d), $7,200). The $2,580 higher amount
in cash disbursements over expenses includes cash paid after being incurred in the
prior period (in (g), $2,140), plus cash paid for supplies to be used and expensed in the
future (in (k), $960), less an expense incurred in January to be paid in February (in (e),
$520).
3-20
Chapter 03 - Operating Decisions and the Income Statement
E3–11.
Req. 1
STACEY’S PIANO REBUILDING COMPANY
Income Statement (unadjusted)
For the Month Ended January 31, 2011
Operating Revenues:
Rebuilding fees revenue
Total operating revenues
$ 18,400
18,400
Operating Expenses:
Wages expense
Utilities expense
Total operating expenses
Operating Income
15,000
520
15,520
2,880
Other Item:
Rent revenue
820
Net Income
$ 3,700
Req. 2
STACEY’S PIANO REBUILDING COMPANY
Statement of Stockholders’ Equity (unadjusted)
For the Month Ended January 31, 2011
Balance, December 31, 2010
Additional contributions
Net income
Dividends
Balance, January 31, 2011
Contributed
Capital
$ 8,600
920
$ 9,520
3-21
Retained
Earnings
$ 10,800
3,700
(2,600)
$11,900
Total
Stockholders’
Equity
$19,400
920
3,700
(2,600)
$21,420
Chapter 03 - Operating Decisions and the Income Statement
E3–11. (continued)
Req. 3
STACEY’S PIANO REBUILDING COMPANY
Balance Sheet (unadjusted)
At January 31, 2011
Assets
Current assets:
Cash
Accounts receivable
Supplies
Total current assets
Equipment
Land
Building
Total Assets
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable
Unearned fee revenue
Total current liabilities
Note payable
Total Liabilities
Stockholders’ Equity:
Contributed Capital
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
3-22
$ 12,520
22,800
2,400
37,720
10,520
7,200
26,400
$ 81,840
$
7,980
4,440
12,420
48,000
60,420
9,520
11,900
21,420
$ 81,840
Chapter 03 - Operating Decisions and the Income Statement
E3–12.
STACEY’S PIANO REBUILDING COMPANY
Statement of Cash Flows
For the Month Ended January 31, 2011
Operating Activities
Cash received from customers
(=$18,400+$600+$820+$7,200)
Cash paid to employees
Cash paid to suppliers (=$2,140+$960)
Total cash from operating activities
Investing Activities
None
Total cash provided by investing activities
Financing Activities
Dividends paid
Total cash used in financing activities
Increase in cash
Beginning cash balance
Ending cash balance
$27,020
(15,000)
(3,100)
8,920
0
0
(2,600)
(2,600)
6,320
6,200
$12,520
Transaction (h) is omitted from the statement of cash flows because the transaction did
not involve a cash payment. However, as discussed in future chapters, this type of
transaction is a noncash investing and financing activity that requires supplemental
disclosure.
3-23
Chapter 03 - Operating Decisions and the Income Statement
E3–13.
Req. 1 and 2
Cash
Beg.
0 72,000
(a)160,000 10,830
(c) 50,000
363
(e) 2,600
6,280
(f) 11,900
600
70,000
64,427
(b)
(d)
(h)
(i)
(j)
(k)
Equipment
Beg.
0
(a) 18,300
(k) 50,000
68,300
(j)
3,600
Beg.
Supplies Expense
Beg.
0
(d) 10,830
10,830
Supplies
Beg.
0
(a) 1,200
1,200
Building
Beg.
0
(b)360,000
(k) 20,000
380,000
Note Payable
0 Beg.
50,000 (c)
50,000
Retained
Earnings
0
600
600
Accounts Receivable
Beg.
0
(a) 2,000
(e) 1,600
Accounts Payable
0 Beg.
420
(g)
420
Mortgage Payable
0 Beg.
288,000(b)
288,000
Contributed Capital
0 Beg.
181,500 (a)
181,500
Food Sales Revenue
0 Beg.
11,900 (f)
11,900
Catering Sales
Revenue
0 Beg.
4,200 (e)
4,200
Utilities Expense
Beg.
0
(g)
420
420
Fuel Expense
Beg.
0
(h)
363
363
3-24
Wages Expense
Beg.
0
(i) 6,280
6,280
Chapter 03 - Operating Decisions and the Income Statement
E3–14.
Req. 1
TRAVELING GOURMET, INC.
Income Statement (unadjusted)
For the Month Ended March 31, 2011
Revenues:
Food sales revenue
Catering sales revenue
Total revenues
Expenses:
Supplies expense
Utilities expense
Wages expense
Fuel expense
Total costs and expenses
Net Loss
$ 11,900
4,200
16,100
$
10,830
420
6,280
363
17,893
(1,793)
Req. 2
TRAVELING GOURMET, INC.
Statement of Stockholders’ Equity (unadjusted)
For the Month Ended March 31, 2011
Beginning, March 1, 2011
Additional contributions
Net loss
Dividends
Ending, March 31, 2011
Contributed
Capital
$
0
181,500
$ 181,500
Retained
Earnings
$
0
(1,793)
(600)
$ (2,393)
Total
Stockholders’
Equity
$
0
181,500
(1,793)
(600)
$179,107
Note: In many states, dividends could not have been declared legally due to the
insufficient amount in retained earnings.
3-25
Chapter 03 - Operating Decisions and the Income Statement
E3–14. (continued)
Req. 3
TRAVELING GOURMET, INC.
Balance Sheet (unadjusted)
At March 31, 2011
Assets
Current assets:
Cash
Accounts receivable
Supplies
Total current assets
Equipment
Building
Total Assets
Liabilities
Current liabilities:
Accounts payable
Note payable
Total current liabilities
Mortgage payable
Total Liabilities
Stockholders’ Equity
Contributed capital
Retained earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
$ 64,427
3,600
1,200
69,227
68,300
380,000
$517,527
$
420
50,000
50,420
288,000
338,420
181,500
(2,393)
179,107
$517,527
Req. 4
The company generated a small loss during its first month of operations, before making
any adjusting entries. The adjusting entries for depreciation and interest expense will
increase the loss. So far the company does not appear to be successful, but it is only in
its first month of operating a retail store. If sales can be increased without inflating fixed
costs (particularly salaries expense), the company may soon turn a profit. It is not
unusual for small businesses to lose money as they start up operations.
3-26
Chapter 03 - Operating Decisions and the Income Statement
E3–15.
TRAVELING GOURMET, INC.
Statement of Cash Flows
For the Month Ended March 31, 2011
Operating Activities
Cash received from customers
(=$2,600+$11,900)
Cash paid to employees
Cash paid to suppliers (=$10,830+$363)
Total cash used in operating activities
$ 14,500
(6,280)
(11,193)
(2,973)
Investing Activities
Purchased building (=$72,000+$20,000)
Purchased equipment
Total cash used in investing activities
(92,000)
(50,000)
(142,000)
Financing Activities
Borrowed on a note payable
Issued stock
Paid dividends
Total cash from financing activities
Increase in cash
Beginning cash balance
50,000
160,000
(600)
209,400
64,427
0
Ending cash balance
$ 64,427
Note that portions of transactions (a) and (b) are omitted from the statement of cash
flows. However, as discussed in future chapters, these types of transactions are
noncash investing and financing activities that require supplemental disclosure.
3-27
Chapter 03 - Operating Decisions and the Income Statement
E3–16.
Req. 1
Transaction
Brief Explanation
a
Issued capital stock to shareholders for $63,300 cash.
b
Purchased store fixtures for $13,700 cash.
c
Purchased $24,800 of inventory, paying $6,200 cash and the balance
on account.
d
Sold $12,400 of goods or services to customers, receiving $8,680 cash
and the balance on account. The cost of the goods sold was $6,510.
e
Used $1,480 of utilities during the month, not yet paid.
f
Paid $1,240 in wages to employees.
g
Paid $2,480 in cash for rent, $620 related to the current month and
$1,860 related to future months.
h
Received $3,720 cash from customers, $1,240 related to current sales
and $2,480 related to goods or services to be provided in the future.
Req. 2
Kate’s Kite Company
Income Statement
For the Month Ended April 30, 2011
Sales Revenue
Expenses:
Cost of sales
Wages expense
Rent expense
Utilities expense
Total expenses
Net Income
3-28
$ 13,640
$
6,510
1,240
620
1,480
9,850
3,790
Chapter 03 - Operating Decisions and the Income Statement
E3–16. (continued)
Kate’s Kite Company
Balance Sheet
At April 30, 2010
Assets
Current Assets:
Cash
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Store fixtures
$52,080
3,720
18,290
1,860
75,950
13,700
Total Assets
$89,650
Liabilities and Shareholders’ Equity
Current Liabilities:
Accounts payable
$20,080
Unearned revenue
2,480
Total current liabilities
22,560
Shareholders’ Equity:
Contributed capital
63,300
Retained earnings
3,790
Total shareholders’ equity
67,090
Total Liabilities &
Shareholders’ Equity
$89,650
E3–17.
Req. 1
Assets
$ 3,200
8,000
6,400
$17,600
=
Liabilities
$ 2,400
5,600
1,600
$9,600
3-29
+
Stockholders’ Equity
$ 4,800
3,200
$ 8,000
Chapter 03 - Operating Decisions and the Income Statement
E3–17. (continued)
Req. 2
Cash
Beg. 3,200 57,200 (d)
(a) 48,000
480 (g)
(b) 5,600
(c)
400
(e) 1,600
1,120
Accounts
Receivable
Beg. 8,000 5,600
(a) 10,000
(b)
12,400
6,400
Accounts
Payable
(d) 1,600 2,400 Beg.
800 (f)
1,600
Unearned
Revenue
5,600 Beg.
1,600 (e)
7,200
Contributed Capital
4,800 Beg.
4,800
Retained Earnings
(g)
480 3,200 Beg.
2,720
Consulting Fee
Revenue
0 Beg.
58,000 (a)
58,000
Investment
Income
0 Beg.
400 (c)
400
Wages Expense
Beg.
0
(d) 36,000
36,000
Long-Term
Investments
Beg. 6,400
Travel Expense
Beg.
0
(d) 12,000
12,000
Rent Expense
Beg.
0
(d) 7,600
7,600
3-30
Long-Term
Notes Payable
1,600 Beg.
1,600
Utilities Expense
Beg.
0
(f)
800
800
Chapter 03 - Operating Decisions and the Income Statement
E3–17. (continued)
Req. 3
Revenues
– Expenses
Net Income
Assets
$ 1,120
12,400
6,400
$19,920
$58,400 ($58,000 + $400)
56,400 ($36,000 + $12,000 + $800 + $7,600)
$ 2,000
=
Liabilities
$ 1,600
7,200
1,600
$10,400
+
Stockholders’ Equity
$ 4,800
2,720
2,000 net income
$ 9,520
Req. 4
Total Asset Turnover =
Sales (Operating) Revenues
Average Total Assets
= $58,000* = 3.09
$18,760**
* The $400 of investment income is not an operating revenue and is not included in the
computation.
** ($17,600 beginning total assets + $19,920 ending total assets) ÷ 2
The increasing trend in the total asset turnover ratio from 1.80 in 2010 and 2.00 in 2011
to 3.09 in 2012 suggests that the company is managing its assets more efficiently over
time.
3-31
Chapter 03 - Operating Decisions and the Income Statement
E3–18.
Req. 1
Accounts receivable increases with customer sales on account and decreases with
cash payments received from customers.
Prepaid expenses increase with cash payments of expenses related to future periods
and decrease as these expenses are incurred over time.
Unearned subscriptions increases with cash payments received from customers for
goods or services to be provided in the future and decreases when those goods and
services are provided.
Req. 2
Accounts
Receivable
1/1
438
2,949
12/31
Prepaid
Expenses
1/1
90
313
2,983
404
Unearned
Subscriptions
12/31
81 1/1
148 151
277
126
84 12/31
Computations:
Beginning
+
“+”

“”
=
Ending
Accounts
receivable
438
+
2,949

?
?
=
=
404
2,983
Prepaid
expenses
90
+
313

?
?
=
=
126
277
Unearned
subscriptions
81
+
151

?
?
=
=
84
148
3-32
Chapter 03 - Operating Decisions and the Income Statement
E3–19.
ITEM
LOCATION
1. Description of a company’s
primary business(es).
Letter to shareholders;
Management’s Discussion and Analysis;
Summary of significant accounting policies
note
2. Income taxes paid.
Notes; Statement of cash flows
3. Accounts receivable.
Balance sheet
4. Cash flow from operating
activities.
Statement of cash flows
5. Description of a company’s
revenue recognition policy.
Summary of significant accounting policies
note
6. The inventory sold during the
year.
Income statement (Cost of Goods Sold)
7. The data needed to compute the
total asset turnover ratio.
Balance sheet and income statement
3-33
Chapter 03 - Operating Decisions and the Income Statement
PROBLEMS
P3-1.
Transactions
Debit
Credit
5
1, 8
Paid cash for salaries and wages earned by employees this
period.
14
1
Paid cash on accounts payable for expenses
incurred last period.
7
1
d.
Purchased supplies to be used later; paid cash.
3
1
e.
Performed services this period on credit.
2
13
f.
Collected cash on accounts receivable for services
performed last period.
1
2
g.
Issued stock to new investors.
1
11
h.
Paid operating expenses incurred this period.
14
1
i.
Incurred operating expenses this period to be paid
next period.
14
7
j.
Purchased a patent (an intangible asset); paid cash.
6
1
k.
Collected cash for services performed this period.
1
13
l.
Used some of the supplies on hand for operations.
14
3
m.
Paid three-fourths of the income tax expense for the year;
the balance will be paid next year.
15
1, 10
8, 16
1
4
1
a.
b.
c.
n.
o.
Example: Purchased equipment for use in the business;
paid one-third cash and signed a note payable for the balance.
Made a payment on the equipment note in (a); the payment
was part principal and part interest expense.
On the last day of the current period, paid cash for an
insurance policy covering the next two years.
3-34
Chapter 03 - Operating Decisions and the Income Statement
P3–2.
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
Cash (+A) ............................................................................
Contributed capital (+SE) ...............................................
40,000
Cash (+A) ............................................................................
Note payable (long-term) (+L) ........................................
60,000
Rent expense (+E, SE)......................................................
Prepaid rent (+A) .................................................................
Cash (A) .......................................................................
1,500
1,500
Prepaid insurance (+A) ........................................................
Cash (A) ......................................................................
2,400
Equipment (+A) ...................................................................
Accounts payable (+L) ..................................................
Cash (A) ......................................................................
15,000
Inventory (+A) ......................................................................
Cash (A) ......................................................................
2,800
Advertising expense (+E, SE)............................................
Cash (A) ......................................................................
350
Cash (+A) ............................................................................
Accounts receivable (+A) ....................................................
Sales revenue (+R, +SE) ..............................................
850
850
Cost of goods sold (+E, SE) ..............................................
Inventory (A) ...............................................................
900
Accounts payable (L) .........................................................
Cash (A) ......................................................................
12,000
Cash (+A) ............................................................................
Accounts receivable (A) ..............................................
210
3-35
40,000
60,000
3,000
2,400
12,000
3,000
2,800
350
1,700
900
12,000
210
Chapter 03 - Operating Decisions and the Income Statement
P3–3.
Req. 1
Req. 2
Assets
Balance Sheet
Income Statement
Stockholders’
Net
Liabilities
Equity
Revenues Expenses Income
Stmt of
Cash
Flows
a.
+/–
+
NE
NE
NE
NE
O
b.
+/–
NE
NE
NE
NE
NE
I
c.
–
+
–
NE
+
–
O
d.
+
NE
+
+
NE
+
O
e.
–
NE
–
NE
+
–
NE*
f.
–
NE
–
NE
NE
NE
F
g.
+
NE
+
+
NE
+
O
h.
–
NE
–
NE
+
–
O
* Cash is not affected in this transaction.
3-36
Chapter 03 - Operating Decisions and the Income Statement
P3–4.
Req. 1 and 2
Cash
Beg.
0 5,640
(a) 27,600 1,430
(e) 11,000 11,000
(h) 2,675
500
(k)
155
550
(m) 2,400 1,500
130
23,080
(b)
(d)
(f)
(g)
(i)
(j)
(l)
Inventory
Beg.
0 1,200 (h)
(c) 5,500 1,210 (m)
3,090
Accounts Receivable
Beg.
0 155 (k)
(h)
325
170
1,430
Prepaid Expenses
Beg.
0
(b) 5,640
5,640
Furniture and Fixtures
Beg.
0
(f) 8,250
8,250
Accounts Payable
(i)
550
0 Beg.
5,500 (c)
4,950
Contributed Capital
0 Beg.
27,600 (a)
Sales Revenue
0 Beg.
3,000 (h)
2,400 (m)
5,400
27,600
Advertising Expense
Beg.
0
(g) 500
500
Supplies
Beg.
0
(d) 1,430
Wage Expense
Beg.
0
(j) 1,500
1,500
3-37
Equipment
Beg.
0
(f) 2,750
2,750
Notes Payable
0 Beg.
11,000 (e)
11,000
Cost of Goods Sold
Beg.
0
(h) 1,200
(m) 1,210
2,410
Repair Expense
Beg.
0
(l) 130
130
Chapter 03 - Operating Decisions and the Income Statement
P3–4. (continued)
Req. 3
BRI’S SWEETS
Income Statement (unadjusted)
For the Month Ended February 28, 2011
Revenues:
Sales revenue
$ 5,400
Expenses:
Cost of goods sold
Advertising expense
Wage expense
Repair expense
Total costs and expenses
Net Income
2,410
500
1,500
130
4,540
$ 860
BRI’S SWEETS
Statement of Stockholders’ Equity (unadjusted)
For the Month Ended February 28, 2011
Beginning, February 1, 2011
Additional contributions
Net income
Dividends
Ending, February 28, 2011
Contributed
Capital
$
0
27,600
$27,600
3-38
Retained
Earnings
$
0
$
860
(0)
860
Total
Stockholders’
Equity
$
0
27,600
860
(0)
$28,460
Chapter 03 - Operating Decisions and the Income Statement
P3–4. (continued)
BRI’S SWEETS
Balance Sheet (unadjusted)
At February 28, 2011
Assets
Current assets:
Cash
Accounts receivable
Inventory
Supplies
Prepaid expenses
Total current assets
Furniture and fixtures
Equipment
Total Assets
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable
Total current liabilities
Notes payable
Total Liabilities
Stockholders’ Equity:
Contributed capital
Retained earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
$ 23,080
170
3,090
1,430
5,640
33,410
8,250
2,750
$ 44,410
$ 4,950
4,950
11,000
15,950
27,600
860
28,460
$ 44,410
Req. 4
Date: (today’s date)
To:
Brianna Webb
From: (your name)
After analyzing the effects of transactions for Bri’s Sweets for February, the
company has realized a profit of $860. This is 16% of sales revenue. However, this is
based on unadjusted amounts. There are several additional expenses that will
decrease the net income amount, perhaps resulting in a net loss. These include rent,
supplies, depreciation, interest, and wages. Therefore, the company does not appear to
be profitable, which is common for small businesses at the beginning of operations. A
focus on maintaining expenses while increasing revenues should result in profit in future
periods. It would also be useful to prepare a budget of cash flows each month for the
upcoming year to decide how potential cash shortages will be handled.
3-39
Chapter 03 - Operating Decisions and the Income Statement
P3–4. (continued)
Req. 5
Total Asset =
Turnover
Sales
Average
Total Assets
2012
2013
$82,500 =1.88
$44,000*
$93,500 = 1.36
$68,750**
* ($38,500 + $49,500) ÷ 2
** ($49,500 + $88,000) ÷ 2
The ratio for 2013 is lower than it otherwise would have been given Brianna’s decision
to open a second store. The loans and inventory purchases required have increased
the average total assets used and therefore decreased the turnover ratio. With future
sales expected to grow, the ratio should increase in coming years. Based on this
rationale, the manager should be promoted.
P3–5.
BRI’S SWEETS
Statement of Cash Flows
For the Month Ended February 28, 2011
Operating Activities
Cash received from customers
(=$2,675+$155+$2,400)
Cash paid to employees
Cash paid to suppliers
(=$5,640+$1,430+$500+$550+$130)
Total cash used in operating activities
Investing Activities
Purchased equipment
Total cash used in investing activities
$ 5,230
(1,500)
(8,250)
(4,520)
(11,000)
(11,000)
Financing Activities
Issued stock
Borrowed from bank
Total cash from financing activities
27,600
11,000
38,600
Increase in cash
Beginning cash balance
23,080
0
Ending cash balance
$23,080
3-40
Chapter 03 - Operating Decisions and the Income Statement
P3–6.
Req. 1 and 2
Cash
4,598
Beg. 360
(a) 17,600
1,348
(e) 4,824
18
(g)
16 10,031
5,348
784
673
(c)
(d)
(f)
(h)
(i)
(j)
Prepaid Expenses
Beg.
82
(c) 1,531
1,613
Other Noncurrent
Assets
Beg. 1,850
Receivables
Beg. 1,162 4,824 (e)
(a) 4,567
905
294
Other Current Assets
Beg. 1,196
1,196
(j)
Accounts
Payable
784 835 Beg.
1,850
51
Other Current
Liabilities
297 Beg.
297
Contributed Capital
492 Beg.
16 (g)
508
Delivery Service
Revenue
0 Beg.
22,167 (a)
22,167
Wage Expense
Beg.
0
(h) 10,031
10,031
Spare Parts, Supplies,
and Fuel
Beg. 294
Long-Term
Notes Payable
(f)
18
667 Beg.
1,345 (b)
1,994
Property and
Equipment (net)
Beg. 8,362
(b) 1,345
9,707
Accrued Expenses
Payable
1,675 Beg.
1,675
Other Noncurrent
Liabilities
3,513
Beg.
3,513
Retained Earnings
5,827 Beg.
5,827
Rental
Expense
Beg.
0
(c) 3,067
3,067
Fuel Expense
Beg.
0
(i) 5,348
5,348
3-41
Repair
Expense
Beg.
0
(d) 1,348
1,348
Item k does not
constitute a transaction.
Chapter 03 - Operating Decisions and the Income Statement
P3–6. (continued)
Req. 3
FedEx
Income Statement (unadjusted)
For the Year Ended May 31, 2012
(in millions)
Revenues:
Delivery service revenue
Expenses:
Rental expense
Wage expense
Fuel expense
Repair expense
Total expenses
Net Income
$ 22,167
3,067
10,031
5,348
1,348
19,794
$ 2,373
FedEx
Statement of Stockholders’ Equity (unadjusted)
For the Year Ended May 31, 2012
(in millions)
Beginning, May 31, 2011
Additional contributions
Net income
Dividends
Ending, May 31, 2012
Contributed
Capital
$ 492
16
$
508
3-42
Retained
Earnings
$5,827
2,373
(0)
$8,200
Total
Stockholders’
Equity
$6,319
16
2,373
(0)
$8,708
Chapter 03 - Operating Decisions and the Income Statement
P3–6. Req. 3 (continued)
FedEx
Balance Sheet (unadjusted)
At May 31, 2012
(in millions)
Assets
Current assets:
Cash
Receivables
Prepaid expenses
Spare parts, supplies, and fuel
Other current assets
Total current assets
Property and equipment (net)
Other noncurrent assets
Total assets
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable
Accrued expenses payable
Other current liabilities
Total current liabilities
Long-term notes payable
Other noncurrent liabilities
Total liabilities
Stockholders' Equity:
Contributed capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
3-43
$
673
905
1,613
294
1,196
4,681
9,707
1,850
$ 16,238
$
51
1,675
297
2,023
1,994
3,513
7,530
508
8,200
8,708
$ 16,238
Chapter 03 - Operating Decisions and the Income Statement
P3–6. Req. 3 (continued)
FedEx
Statement of Cash Flows
For the Year Ended May 31, 2012
(in millions)
Cash Flows from Operating Activities
Cash received from customers
(=$17,600+$4,824)
Cash paid to employees
Cash paid to suppliers
(=$4,598+$1,348+$5,348+$784)
Total cash provided by operating activities
Cash Flows from Investing Activities
None
$ 22,424
(10,031)
(12,078)
315
0
0
Cash Flows from Financing Activities
Repayment of long-term debt
Proceeds from share issuance
Total cash used in financing activities
(18)
16
(2)
Increase in cash
Beginning cash balance
313
360
Ending cash balance
$ 673
Note that transaction (b) is omitted from the statement of cash flows. However, as
discussed in future chapters, this type of transaction is a noncash investing and
financing activity that requires supplemental disclosure.
3-44
Chapter 03 - Operating Decisions and the Income Statement
P3–6. (continued)
Req. 4
Total Asset Turnover
=
Sales (or Operating
Revenues)
Average Total Assets
* (Beginning $13,306
+
=
$22,167 = 1.50
$14,772*
Ending $16,238) ÷ 2
($360 + $1,162 + $294 + $82 + $1,196 + $8,362 + $1,850)
(computed in Req. 3)
The asset turnover ratio suggests that the company obtained $1.50 in sales for the year
for every $1 in assets. To analyze this result, we would need to calculate the ratio for
the company over time to observe the trend in how efficiently assets are being utilized.
We would also need the industry ratio for the current period to determine how the
company is doing in comparison to others in the industry.
P3–7.
Req. 1
(in thousands)
a. Cash (+A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Admissions revenue (+R, +SE). . . . . . . . . . . . . . . .
b.
c.
d.
e.
f.
566,266
566,266
Operating expenses (+E, SE). . . . . . . . . . . . . . . . . . .
Cash (A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts payable (+L). . . . . . . . . . . . . . . . . . . . . . . .
450,967
Notes payable (L). . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash (A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
58,962
Cash (+A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Food, merchandise, and games revenue (+R, + SE)
335,917
Cost of goods sold (+E, SE). . . . . . . . . . . . . . . . . .
Food and merchandise inventory (A). . . . . . . . . . . .
90,626
Property and equipment (+A). . . . . . . . . . . . . . . . . . . . .
Cash (A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
83,841
Cash (+A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable (+A). . . . . . . . . . . . . . . . . . . . . . . .
Accommodations revenue (+R, +SE). . . . . . . . . . . . .
72,910
1,139
3-45
412,200
38,767
58,962
335,917
90,626
83,841
74,049
Chapter 03 - Operating Decisions and the Income Statement
P3–7. (continued)
g.
h.
i.
j.
Interest expense (+E, SE). . . . . . . . . . . . . . . . . . .
Cash (A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
125,838
Food and merchandise inventory (+A). . . . . . . . . . .
Cash (A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts payable (+L). . . . . . . . . . . . . . . . . . . . .
146,100
Selling, general and admin. expenses (+E, SE)
Cash (A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts payable (+L). . . . . . . . . . . . . . . . . . . . .
131,882
Accounts payable (L). . . . . . . . . . . . . . . . . . . . . . .
Cash (A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9,600
125,838
118,000
28,100
125,500
6,382
9,600
Req. 2
Transaction
Operating, Investing, or
Financing Effect
Direction and Amount
of the Effect (in thousands)
(a)
O
+566,266
(b)
O
–412,200
(c)
F
–58,962
(d)
O
+335,917
(e)
I
–83,841
(f)
O
+72,910
(g)
O
–125,838
(h)
O
–118,000
(i)
O
–125,500
(j)
O
–9,600
3-46
Chapter 03 - Operating Decisions and the Income Statement
ALTERNATE PROBLEMS
AP3-1.
c.
Transactions
Example: Issued stock to new investors.
Incurred and recorded operating expenses on credit to
be paid next period.
Purchased on credit but did not use supplies this period.
d.
Performed services for customers this period on credit.
e.
Prepaid a fire insurance policy this period to cover the
next 12 months.
Purchased a building this period by making a 20 percent
cash down payment and signing a mortgage loan for the
balance.
Collected cash this year for services rendered and
recorded in the prior year.
Collected cash for services rendered this period.
Paid cash this period for wages earned and recorded
last period.
Paid cash for operating expenses charged on accounts
payable in the prior period.
Paid cash for operating expenses incurred in the current
period.
Made a payment on the mortgage loan, which was part
principal repayment and part interest.
This period a shareholder sold some shares of her stock
to another person for an amount above the original
issuance price.
Used supplies on hand to clean the offices.
Recorded income taxes for this period to be paid at the
beginning of the next period.
Declared and paid a cash dividend this period.
a.
b.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
p.
3-47
Debit
1
Credit
11
14
7
3
7
2
13
4
1
5
1, 8
1
1
2
13
9
1
7
1
14
1
8, 14
1
None
14
None
3
15
12
10
1
Chapter 03 - Operating Decisions and the Income Statement
AP3–2.
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
Accounts receivable (+A) ....................................................
Service revenue (+R, +SE) ........................................
23,500
Accounts payable (L) .........................................................
Cash (A) ..................................................................
3,005
Office supplies (+A) .............................................................
Accounts payable (+L) ...............................................
2,600
Equipment (+A) ...................................................................
Cash (A) ..................................................................
3,800
Advertising expense (+E, SE) ............................................
Cash (A) ..................................................................
1,400
Wages expense (+E, SE) ..................................................
Wages payable (L) ............................................................
Cash (A) ..................................................................
8,100
3,800
Cash (+A) ............................................................................
Contributed capital (+SE) ..........................................
135,000
Cash (+A) ............................................................................
Accounts receivable (A) ...........................................
12,500
Accounts receivable (+A) ....................................................
Service revenue (+R, +SE) ........................................
14,500
Land (+A) ............................................................................
Cash (A) ..................................................................
Note payable (+L) ......................................................
10,000
Utilities expense (+E, SE) ..................................................
Accounts payable (+L) ...............................................
1,950
3-48
23,500
3,005
2,600
3,800
1,400
11,900
135,000
12,500
14,500
3,000
7,000
1,950
Chapter 03 - Operating Decisions and the Income Statement
AP3–3.
Req. 1
Req. 2
Assets
Balance Sheet
Income Statement
Stmt of
Cash Flows
Stockholders’
Net
Liabilities
Equity
Revenues Expenses Income
a.
–
+
–
NE
+
–
O
b.
–
NE
–
NE
+
–
O
c.
+
NE
+
+
NE
+
NE
–
NE
–
NE
+
–
NE
NE
+
+
NE
+
I
(Net +)
d.
+/–
(Net +)
e.
+/–
NE
NE
NE
NE
NE
O
f.
–
NE
–
NE
+
–
NE
g.
–
–
NE
NE
NE
NE
F
h.
+
NE
+
+
NE
+
O
i.
+/–
+
NE
NE
NE
NE
I
(Net +)
j.
–
–
NE
NE
NE
NE
O
k.
+
NE
+
NE
NE
NE
F
l.
–
NE
–
NE
+
–
O
3-49
Chapter 03 - Operating Decisions and the Income Statement
AP3–4.
Req. 1 and 2
Cash
Beg.
0 31,000 (b)
(a) 60,000 1,240 (g)
(d) 13,200 2,700 (h)
(e) 2,400 6,000 (j)
(i) 10,000 3,600 (k)
500 (m)
40,560
Accounts Receivable
Beg.
0 10,000 (i)
(c) 35,260
25,260
15,810
Prepaid Insurance
Beg.
0
(k) 3,600
Land
Beg.
0
(a) 90,000
Barns
Beg.
0
(a)100,000
(b) 62,000
162,000
3,600
90,000
Accounts Payable
(h) 2,700
0 Beg.
3,810 (f)
1,800 (l)
2,910
Unearned Revenue
0 Beg.
2,400 (e)
Contributed Capital
0 Beg.
262,000(a)
262,000
Retained Earnings
(m) 500
0 Beg.
Animal Care
Service Revenue
0 Beg.
35,260 (c)
35,260
Utilities Expense
Beg.
0
(g) 1,240
(l) 1,800
3,040
2,400
500
Rental
Revenue
0 Beg.
13,200 (d)
13,200
Wages Expense
Beg.
0
(j) 6,000
6,000
3-50
Supplies
Beg.
0
(a) 12,000
(f) 3,810
Long-term
Note Payable
0 Beg.
31,000 (b)
31,000
Chapter 03 - Operating Decisions and the Income Statement
AP3–4. (continued)
Req. 3
ALPINE STABLES, INC.
Income Statement (unadjusted)
For the Month Ended April 30, 2011
Revenues:
Animal care service revenue
Rental revenue
Total revenues
$ 35,260
13,200
48,460
Expenses:
Wages expense
Utilities expense
Total costs and expenses
Net Income
6,000
3,040
9,040
$ 39,420
ALPINE STABLES, INC.
Statement of Stockholders’ Equity (unadjusted)
For the Month Ended April 30, 2011
Contributed
Capital
Beginning, April 1, 2011
$
0
Additional contributions
262,000
Net income
Dividends
Ending, April 30, 2011
$262,000
3-51
Retained
Earnings
$
0
39,420
(500)
$ 38,920
Total
Stockholders’
Equity
$
0
262,000
39,420
(500)
$300,920
Chapter 03 - Operating Decisions and the Income Statement
AP3–4. (continued)
ALPINE STABLES, INC.
Balance Sheet (unadjusted)
At April 30, 2011
Assets
Current assets:
Cash
Accounts receivable
Supplies
Prepaid insurance
Total current assets
$ 40,560
25,260
15,810
3,600
85,230
Barns
Land
Total Assets
162,000
90,000
$337,230
Liabilities
Current liabilities:
Accounts payable
Unearned revenue
Total current liabilities
Note payable
Total Liabilities
Stockholders’ Equity
Contributed Capital
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
$
2,910
2,400
5,310
31,000
36,310
262,000
38,920
300,920
$337,230
Req. 4
Date: (today’s date)
To:
Shareholders of Alpine Stables, Inc.
From: (your name)
After analyzing the effects of transactions for Alpine Stables, Inc., for April, the
company has realized a profit of $39,420. This is 81% of total revenues. However, this
is based on unadjusted amounts. There are several additional expenses that will
decrease the net income amount. These include depreciation of the barns, supplies,
insurance, interest, and wages. Therefore, the company appears to have earned a
small profit in its first month. It would be useful to prepare a budget of income and of
cash flows each month for the upcoming year to decide whether the positive income
and cash flows are likely to continue in the future.
3-52
Chapter 03 - Operating Decisions and the Income Statement
AP3–4. (continued)
Req. 5
2012:
Total =
Asset
Turnover
2013:
Sales (Operating)
Revenue
=
$400,000
= $400,000 = 1.29
Average
($300,000+$320,000)÷2
$310,000
Total Assets
Sales (Operating)
Revenue
Total =
=
$450,000
($320,000+$480,000)÷2
Asset
Average
Turnover
Total Assets
= $450,000 = 1.13
$400,000
Under your management, the asset turnover ratio appears to be decreasing over time.
The ratio for 2013 is lower than it otherwise would have been given the shareholders’
decision to build a riding arena. The loans and building have increased the average
total assets used and therefore decreased the turnover ratio. In addition, with the new
facilities, revenues should increase in the future. Based on this rationale, you should be
promoted.
AP3–5.
ALPINE STABLES, INC.
Statement of Cash Flows
For the Month Ended April 30, 2011
Operating Activities
Cash received from customers ($13,200 +$2,400 +$10,000)
Cash paid to employees
Cash paid to suppliers ($1,240+$2,700+$3,600)
Total cash provided by operating activities
$25,600
(6,000)
(7,540)
12,060
Investing Activities
Purchase of barns
Total cash used in investing activities
(31,000)
(31,000)
Financing Activities
Proceeds from share issuance
Dividends paid
Total cash provided by financing activities
60,000
(500)
59,500
Increase in cash
Beginning cash balance
40,560
0
Ending cash balance
$40,560
3-53
Chapter 03 - Operating Decisions and the Income Statement
AP3–6.
Req. 1 and 2 (in millions)
Cash
3 (c)
Beg. 31,437
(b) 3,100
1,238 (e)
7,545 (f)
82 (h)
11 (i)
6 (j)
25,652
Inventories
Beg. 9,331 5,984 (d)
(g)
23
3,370
Investments
Beg. 28,556
28,556
Accounts Payable
36,640 Beg.
1,610 (a)
23 (g)
38,273
Notes Payable (LT)
7,025 Beg.
Marketable Securities
Beg. 570
570
Retained Earnings
107,651 Beg.
107,651
Utilities Expense
Beg.
0
(c)
3
3
61,382
Prepaid Expenses
Beg. 2,315
(h)
82
2,397
Property &
Equipment (net)
Beg.121,346
(a)
1,610
122,956
Income Tax Payable
(f)
7,545 10,060 Beg.
2,515
Other Long-Term Debt
(i)
10 58,962 Beg.
7,025
58,952
Sales Revenue
0 Beg.
39,780 (d)
39,780
Interest Expense
Beg.
0
(i)
1
1
3-54
Accounts Receivable
3,100 (b)
Beg. 24,702
(d) 39,780
Other Current Assets
Beg. 3,911
3,911
Other Assets and
Intangibles (net)
Beg. 5,884
(j)
6
5,890
Notes Payable (ST)
2,400 Beg.
2,400
Contributed Capital
5,314 Beg.
5,314
Cost of Sales
Beg.
0
(d) 5,984
5,984
Wages Expense
Beg.
0
(e) 1,238
1,238
Chapter 03 - Operating Decisions and the Income Statement
AP3–6. (continued)
Req. 3
Exxon Mobil Corporation
Income Statement (unadjusted)
For the Month Ended January 31, 2011
(in millions)
Revenues:
Sales revenue
$39,780
Costs and expenses:
Cost of sales
Wage expense
Utilities expense
Total costs and expenses
Operating income
5,984
1,238
3
7,225
32,555
Other revenues (expenses):
Interest expense
Net Income (pretax)
1
$32,554
Exxon Mobil Corporation
Statement of Stockholders’ Equity (unadjusted)
For the Month Ended January 31, 2011
(in millions)
Beginning, December 31, 2010
Stock issuance
Net income
Dividends
Ending, January 31, 2011
Contributed
Capital
$ 5,314
0
$ 5,314
3-55
Retained
Earnings
$107,651
32,554
(0)
$140,205
Total
Stockholders’
Equity
$112,965
0
32,554
(0)
$145,519
Chapter 03 - Operating Decisions and the Income Statement
AP3–6. (continued)
Exxon Mobil Corporation
Balance Sheet (unadjusted)
At January 31, 2011
(in millions)
Assets
Current assets:
Cash
Marketable securities
Accounts receivable
Inventories
Prepaid expenses
Other current assets
Total current assets
Investments
Property & equipment (net)
Other assets and intangibles (net)
$ 25,652
570
61,382
3,370
2,397
3,911
97,282
28,556
122,956
5,890
Total assets
$254,684
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable
Income tax payable
Notes payable
Total current liabilities
Notes payable
Other long-term debt
Total liabilities
Shareholders' Equity:
Contributed capital
Retained earnings
Total stockholders’ equity
Total liabilities and shareholders' equity
3-56
$38,273
2,515
2,400
43,188
7,025
58,952
109,165
5,314
140,205
145,519
$254,684
Chapter 03 - Operating Decisions and the Income Statement
AP3–6. (continued)
Exxon Mobil Corporation
Statement of Cash Flows
For the Month Ended January 31, 2011
(in millions)
Cash Flows from Operating Activities
Cash received from customers
Cash paid to employees
Cash paid to suppliers (= $3 + $82)
Cash paid to government for taxes
Interest paid
Total cash used in operating activities
$ 3,100
(1,238)
(85)
(7,545)
(1)
(5,769)
Cash Flows from Investing Activities
Purchase of intangible assets
Total cash used in investing activities
(6)
(6)
Cash Flows from Financing Activities
Repayment of debt
Total cash used in financing activities
(10)
(10)
Decrease in cash
Beginning cash balance
(5,785)
31,437
Ending cash balance
$ 25,652
Req. 4
Total Asset
Turnover
=
Sales
=
Average Total Assets
$39,780
$241,368
= 0.165
* ($228,052 + $254,684) ÷ 2
The asset turnover ratio suggests that the company obtained $0.165 in sales for the
month for every $1 in assets. Assuming that sales are spread equally throughout the
year, the annual asset turnover would be 1.98 (0.165 x 12 months). Compared to other
examples in the text, this suggests that Exxon Mobil is a higher capital intensive
industry (requiring extremely high levels of assets). Exxon Mobil’s actual asset turnover
for a recent year was 2.03.
3-57
Chapter 03 - Operating Decisions and the Income Statement
CASES AND PROJECTS
FINANCIAL REPORTING AND ANALYSIS CASES
CP3–1.
1. The largest expense on the income statement for the year ended January 31, 2009,
is the “cost of sales” for $1,814,765 (in thousands). As goods were sold throughout
the year, cost of goods sold would be recorded and inventory would be reduced.
2. This question is intended to focus students on accounts receivable and the typical
activities that increase and decrease the account.
Assuming all net sales are on credit, American Eagle Outfitters collected
$2,797,510,000 from customers. T-account numbers are in thousands.
Accounts and Notes
Receivable
Beginning
Sales
Ending
31,920
2,988,866
2,979,315 Collections
41,471
Most retailers settle sales in cash at the register and would not have accounts
receivable related to sales unless they had layaway or private credit. For American
Eagle, the accounts receivable on the balance sheet primarily relates to amounts
owed from landlords for their construction allowances for building new American
Eagle stores in malls.
3. Over the life of the business, total earnings will equal total net cash flow. However,
for any given year, the assumption that net earnings is equal to cash inflows is not
valid. Accrual accounting requires recording revenues when earned and expenses
when incurred, not necessarily when cash is received or paid. There may be
revenues recorded as earnings that are not yet received in cash. In the same way,
there may be cash outflows as prepayments of expenses that are not recorded as
expenses until incurred, such as inventories, insurance, and rent. Or, there may be
expenses that have been incurred for which payment will occur in the future.
4. An income statement reports the financial performance of a company over a period
of time in terms of revenues, gains, expenses, and losses. A balance sheet or
statement of financial position lists the economic resources owned by an entity and
the claims to those resources from creditors and investors at a point in time. They
are linked through retained earnings.
3-58
Chapter 03 - Operating Decisions and the Income Statement
CP3–1. (continued)
5.
Total Asset =
Turnover
(In thousands)
$2,988,866
($1,867,680 +
$1,963,676)÷2
Sales
=
Average
Total Assets
= $2,988,866
$1,915,678
=
1.56
The total asset turnover ratio measures the sales generated per dollar of assets.
American Eagle Outfitters generated $1.56 of sales per $1 of assets.
CP3-2.
1. Urban Outfitters’ revenue recognition policy for retail store sales is to record
revenues when customers purchase merchandise. Internet, catalog, and wholesale
sales are recognized when the goods are shipped. Revenue is recognized for
stored value cards and gift certificates when they are redeemed for merchandise.
(See pages F-10 and F-11 of the notes to the financial statements).
2. Assuming that $50 million of cost of sales is due to distribution and occupancy costs,
Urban Outfitters purchased $1,068,913 thousand worth of inventory.
Inventory (in thousands)
Beginning
171,925
Purchases
1,068,913
Ending
1,071,140 Cost of Sales*
169,698
* Total cost of sales reported $1,121,140 - an estimated $50,000 for noninventory
purchase costs = $1,071,140.
3.
Year ended 1/31/09
Year ended 1/31/08
Percentage
Genl., Admin. &
Selling Expenses
Net Sales
$414,043
$1,834,618
22.6%
Percentage
$351,827
$1,507,724
23.3%
General, Administration, & Selling Expenses increased by 17.7% over the amount for
the year ended 1/31/08.
3-59
Chapter 03 - Operating Decisions and the Income Statement
4.
Total Asset =
Turnover
Sales
=
$1,834,618
= $1,834,618 = 1.48
Average
($1,329,009+$1,142,791)÷2
$1,235,900
Total Assets
The total asset turnover ratio measures the sales generated per dollar of assets. Urban
Outfitters generated $1.48 of sales per $1 of assets.
CP3–3.
1. American Eagle Outfitters calls its income statement the “Consolidated Statements
of Operations.” Urban Outfitters calls its income statement the “Consolidated
Statements of Income.” “Consolidated” implies that the statements of two or more
companies (usually the company and its majority-owned subsidiaries) have been
combined into a single statement for presentation.
2. Urban Outfitters had the higher net income of $199,364 for the year ended January
31, 2009, compared to American Eagle Outfitters’ net income of $179,061 for the
same year (all dollars in thousands). American Eagle reported a $22,889
impairment charge in the most recent year that reduced net income. Urban
Outfitters did not report any impairment charge. If the charge were not included,
American Eagle would have reported $201,950 in net income, higher than Urban
Outfitters.
3.
(in thousands)
Total Asset =
Sales
Turnover
Average Total Assets
American Eagle
Outfitters
Urban
Outfitters
$2,988,866 =1.56
$1,915,678*
$1,834,618 = 1.48
$1,235,900**
* ($1,867,680 + $1,963,676)÷2
** ($1,329,009+$1,142,791)÷2
American Eagle Outfitters has the higher asset turnover ratio, 1.56 compared to Urban
Outfitters’ of 1.47, suggesting that Urban Outfitters is utilizing its assets less effectively
to generate sales than is American Eagle Outfitters. However, the difference is not
very large.
4.
Asset Turnover =
Industry
Average
1.90
American Eagle
Outfitters
1.56
3-60
Urban
Outfitters
1.48
Chapter 03 - Operating Decisions and the Income Statement
Both American Eagle Outfitters and Urban Outfitters are utilizing their assets to
generate sales less effectively than the average company in their industry. Companies
that are expanding will have higher asset values that may not as of yet have generated
sales.
5.
Operating
cash flows
2009
2008
$302,193
$464,270
2009
Operating
cash flows
2008
$251,570 $254,353
American Eagle Outfitters
Percentage
Change
2008
2007
(34.91%)
$464,270 $749,268
Urban Outfitters
Percentage
Change
2008
(1.09%)
3-61
2007
$254,353 $187,117
Percentage
Change
(38.04%)
Percentage
Change
35.93%
Chapter 03 - Operating Decisions and the Income Statement
CP3–4.
Req. 1
American Eagle Outfitters (dollars in thousands)
Fiscal year ended:
2006:
Total =
Sales
=
$2,321,962
= $2,321,962 = 1.58
($1,328,926+$1,605,649)÷2
Asset
Average
$1,467,287.5
Turnover
Total Assets
2007:
Total =
Sales
=
$2,794,409
= $2,794,409 = 1.56
($1,605,649+$1,979,558)÷2
Asset
Average
$1,792,603.5
Turnover
Total Assets
2008:
Total =
Sales
=
$3,055,419
= $3,055,419 = 1.59
Asset
Average
($1,979,558+$1,867,680) ÷2
$1,923,619
Turnover
Total Assets
2009:
Total =
Sales
=
$2,988,866
= $2,988,866 = 1.56
Asset
Average
($1,867,680+$1,963,676)÷2
$1,915,678
Turnover
Total Assets
Req. 2
Current Ratio =
Current Assets
Current Liabilities
Reported in American Eagle Outfitters’ 10-K report (Item 6):
2006
3.06
2007
2.56
2008
2.71
2009
2.30
Req. 3
American Eagle Outfitters’total asset turnover ratio has remained relatively stable from
2006 to 2009.
On the other hand, the current ratio has steadily declined from 3.06 in 2006 to 2.30 in
2009, although American Eagle Outfitters continues to have sufficient liquidity.
Companies with strong cash management systems tend to have lower current ratios. In
addition, American Eagle Outfitters receives most of its sales in cash and should have
sufficient cash flows to pay current liabilities when they come due.
3-62
Chapter 03 - Operating Decisions and the Income Statement
CP3–5.
Req. 1
Accrual accounting is defined in the article as follows:
“By accruing, or allotting, revenues to specific periods, they (accountants) aim to
allocate income to the quarter or year in which it was effectively earned, though
not necessarily received. Likewise, expenses are allocated to the period when
sales were made, not necessarily when the money was spent.” (from Business
Week, October 4, 2004, p. 78)
Req. 2
The author of the article suggests that “fuzzy numbers” result from the judgments
companies make to come up with revenues and expenses on an accrual basis.
Companies are given wide discretion in determining estimates to use to compute net
income under current accounting rules, and users of the financial statements need to
read statements carefully to understand the impact of management judgments and
accounting rules. Even then, the author suggests that financial statements are often
unclear, incomplete, or too complex.
Req. 3
Congress and the SEC have adopted reforms to attempt to address the rising concerns
about financial reporting. The article suggests that many of the reforms will not help to
make financial statements clearer and more consistent. Instead, many of the reforms
are aimed at policing managers and auditors and not at clarifying estimates managers
make.
3-63
Chapter 03 - Operating Decisions and the Income Statement
CP3–6.
Req. 1
a. Given as an example in the textbook.
b. Cash decreased $5,000, Office Fixtures increased $22,000, and long-term Notes
Payable increased $17,000. Therefore, transaction (b) was the purchase of office
fixtures for $22,000, paid partly in cash of $5,000 and the rest by signing a long-term
notes payable for $17,000.
c. Cash increased $15,000, Accounts Receivable increased $12,000, and Paint
Revenue increased $27,000. Therefore, transaction (c) was delivery of painting
services for $27,000; $15,000 was received in cash and the rest was on account.
d. Cash decreased $14,000, Land increased $18,000, and Note Payable increased
$4,000. Therefore, transaction (d) was a purchase of land for $18,000; $14,000 was
paid in cash and an interest-bearing note was signed for the remainder.
e. Cash decreased $10,000, Accounts Payable increased $3,000, Supplies Expense
increased $5,000, and Wages Expense increased $8,000. Therefore, transaction (e)
was purchase and use of $5,000 of supplies and $8,000 of employee labor. $10,000
was paid in cash and $3,000 is owed.
f. Cash increased $3,000, Accounts Receivable increased $14,000, and Paint Revenue
increased $17,000. Therefore, transaction (f) was a sale of painting services made
on account for $14,000 while $3,000 was received in cash.
g. Cash decreased $4,000, and Retained Earnings decreased $4,000. Therefore,
transaction (g) was declaration and payment of a dividend of $4,000.
h. Cash decreased $11,000, Accounts Payable increased $7,000, Supplies Expense
increased $3,000, and Wages Expense increased $15,000. Therefore, transaction
(h) was purchase and use of supplies of $3,000 and employee labor of $15,000.
$11,000 was paid in cash, and $7,000 is owed.
i. Cash decreased by $5,000, and Accounts Payable decreased by $5,000. Therefore,
transaction (i) is a payment made on account.
j. Cash increased $16,000, Accounts Receivable decreased $16,000. Therefore,
transaction (j) was the receipt of payments from customers.
3-64
Chapter 03 - Operating Decisions and the Income Statement
CP3–6. (continued)
Req. 2
PETE’S PAINTING SERVICE
Income Statement
For the Month Ended January 31, 2011
Revenues:
Paint revenue
$44,000
Expenses:
Supplies expense
Wages expense
Total costs and expenses
Net Income
8,000
23,000
31,000
$13,000
PETE’S PAINTING SERVICE
Statement of Stockholders’ Equity
For the Month Ended January 31, 2011
Beginning, January 20, 2011
Additional contributions
Net income
Dividends
Ending, January 31, 2011
Contributed
Capital
$
0
75,000
$75,000
3-65
Retained
Earnings
$
0
13,000
(4,000)
$ 9,000
Total
Stockholders’
Equity
$
0
75,000
13,000
(4,000)
$84,000
Chapter 03 - Operating Decisions and the Income Statement
CP3–6. (continued)
PETE’S PAINTING SERVICE
Balance Sheet
At January 31, 2011
Assets
Current assets:
Cash
Accounts receivable
Total current assets
Office fixtures
Land
Total assets
$ 60,000
10,000
70,000
22,000
18,000
$110,000
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable
Total current liabilities
Notes payable
Total liabilities
$ 5,000
5,000
21,000
26,000
Shareholders' Equity:
Contributed capital
Retained earnings
Total shareholders’ equity
Total liabilities and shareholders' equity
75,000
9,000
84,000
$110,000
Req. 3
Transaction
Operating, Investing, or
Financing Effect
(a)
F
+75,000
(b)
I
–5,000
(c)
O
+15,000
(d)
I
–14,000
(e)
O
–10,000
(f)
O
+3,000
(g)
F
–4,000
(h)
O
–11,000
(i)
O
–5,000
(j)
O
+16,000
3-66
Direction and Amount
of the Effect
Chapter 03 - Operating Decisions and the Income Statement
CRITICAL THINKING CASES
CP3–7.
Req. 1
Estela used the cash basis of accounting. We can infer this from his references to
income collected rather than earned, expenses paid rather than incurred, and supplies
purchased rather than used. Accrual accounting should be used because it correctly
assigns revenues and expenses to the accounting period in which they are earned or
incurred.
Req. 2
(a)
(b)
Building (+A) ........................................................................
Tools and equipment (+A) ...................................................
Land (+A) ............................................................................
Cash (+A) ............................................................................
Contributed capital (+SE) .........................................
21,000
17,000
20,000
1,000
Cash (+A) .............................................................................
Accounts receivable (+A) .....................................................
Unearned revenue (+L) .............................................
Service fees revenue (+R, +SE) ................................
55,000
52,000
59,000
20,000
87,000
(c)
No entry
(d)
Operating expenses (+E, SE) ............................................
Accounts payable (+L) ...............................................
Cash (A) ..................................................................
61,000
Supplies expense (+E, SE)* ..............................................
Supplies (+A) .......................................................................
Cash (A) ..................................................................
2,500
700
(e)
Other
(1) Loss from theft (+E, SE) ....................................................
Cash (A) ..................................................................
(2)
Tools and equipment (+A) ...................................................
Cash (A) ..................................................................
39,000
22,000
3,200
500
500
1,000
* Supplies purchased, $3,200  Supplies on hand at end of 2012, $700 = $2,500
supplies used
3-67
1,000
Chapter 03 - Operating Decisions and the Income Statement
CP3–7. (continued)
ASSETS:
Cash
Beg.
0 22,000
3,200
(a) 1,000
(b) 55,000
500
1,000
Accounts Receivable
(d) Beg.
0
(e) (b) 52,000
(1)
(2)
29,300
Building
Beg.
0
(a) 21,000
21,000
LIABILITIES:
Accounts Payable
0 Beg.
39,000 (d)
39,000
SHAREHOLDER’S EQUITY:
Contributed Capital
0 Beg.
59,000 (a)
59,000
52,000
Beg.
(e)
Supplies
0
700
700
Land
Beg.
0
(a) 20,000
Tools and Equipment
Beg.
0
(a) 17,000
(2) 1,000
20,000
18,000
Unearned Revenue
0 Beg.
20,000 (b)
20,000
Retained Earnings
0 Beg.
0
REVENUES AND EXPENSES:
Service Fees Revenue
Operating Expenses
0 Beg. Beg.
0
87,000 (b)
(d) 61,000
87,000
61,000
Loss from Theft
Beg.
0
(1)
500
500
3-68
Supplies Expense
Beg.
0
(e)
2,500
2,500
Chapter 03 - Operating Decisions and the Income Statement
CP3–7. (continued)
Req. 3
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
ESTELA COMPANY
Income Statement
For the Year Ended December 31, 2012
Revenues:
Service fees revenue
[see note]
Costs and expenses:
Operating expenses
Supplies expense
Loss from theft
Total costs and expenses
Net Income
$ 87,000
61,000
2,500
500
64,000
$ 23,000
Use the standard title.
Date to indicate time period covered.
Use appropriate title.
Use accrual figure -- revenue earned, rather than cash collected.
Exclude the dividends because the stock is owned by Julio and not the company
-- apply the separate entity assumption.
Use appropriate title.
Use accrual figure -- expenses incurred, not cash paid.
Expense is supplies used, $2,500; the $700 is still an asset until used.
Stolen property should be recorded as a loss for the amount not covered by
insurance.
Use appropriate caption.
Use standard terminology.
3-69
Chapter 03 - Operating Decisions and the Income Statement
CP3–7. (continued)
ESTELA COMPANY
Balance Sheet
At December 31, 2012
Assets
Current assets:
Cash
Accounts receivable
Supplies
Total current assets
Building
Land
Tools and equipment
Total assets
$ 29,300
52,000
700
82,000
21,000
20,000
18,000
$141,000
Liabilities
Current liabilities:
Accounts payable
Unearned revenue
Total current liabilities
$ 39,000
20,000
59,000
Shareholders' Equity
Contributed capital
Retained earnings
Total shareholders’ equity
Total liabilities and shareholders' equity
59,000
23,000
82,000
$141,000
3-70
Chapter 03 - Operating Decisions and the Income Statement
CP3–7. (continued)
ESTELA COMPANY
Statement of Cash Flows
For the Year Ended December 31, 2012
Cash from Operating Activities
Cash received from customers
Cash paid to suppliers ($22,000 + $3,200)
Cash stolen
Total cash provided by operating activities
Cash from Investing Activities
Purchase of tools and equipment
Total cash used in investing activities
Cash from Financing Activities
Proceeds from share issuance
Total cash provided by financing activities
Increase in cash
Beginning cash balance
$55,000
(25,200)
(500)
29,300
(1,000)
(1,000)
1,000
1,000
29,300
0
Ending cash balance
$29,300
Req. 4
The above statements do not yet take into account most year-end adjustments,
including depreciation and income taxes. The adjusting entry for income taxes is
especially important because of the implication for future cash flows.
The statements also record the building, land, and tools and equipment originally
contributed in exchange for shares in the new company at their market value at that
time. Their current market value at year-end is more relevant to a loan decision.
Current market values for the building and land are provided ($32,000 and $30,000,
respectively), but the current value of the tools and equipment is also needed.
The stock in ABC Industrial is owned by Julio and not the company. However, it may be
used as collateral if Julio is willing to sign an agreement pledging personal assets as
collateral for the loan. This is a common requirement for small start-up businesses.
Other of Julio’s personal assets could also be considered for collateral.
Lastly, pro forma financial statements (or budgets) outlining the expected revenues,
expenses, and cash flows from the expanded business would be helpful to gauge its
viability.
3-71
Chapter 03 - Operating Decisions and the Income Statement
CP3–7. (continued)
Req. 5
(today’s date)
Dear Mr. Estela:
We regret to inform you that your request for a $100,000 loan has been denied.
Your current business appears profitable and appears to generate sufficient cash to
maintain operations, even once additional expenses, such as income taxes, are
considered. However, pro forma financial statements (or budgets) outlining the
expected revenues, expenses, and cash flows from the expanded business would be
needed to gauge its future viability.
We also require that there be sufficient collateral pledged against the loan before we
can consider it. A loan of this size would increase your company’s size by over 70% of
its current asset base. The current market value of the building and land held by the
company are insufficient as collateral. The current value of the tools and equipment
may provide additional collateral, if you provide us with this information. Your personal
investments may also be considered viable collateral if you are willing to sign an
agreement pledging these assets as collateral for the loan. This is a common
requirement for small start-up businesses.
If you would like us to reconsider your application, please provide us with the pro forma
financial statements and with the current market values of any assets you would pledge
as collateral.
Regards,
(your name)
Loan Application Department,
Your Bank
3-72
Chapter 03 - Operating Decisions and the Income Statement
CP3–8.
Req. 1
This type of ethical dilemma occurs quite frequently. The situation is difficult personally
because of the possible repercussions to you by your boss, Mr. Lynch, if you do not
meet his request. At the same time, the ethical and professional response is to follow
the revenue recognition rule and account for the cash collection as deferred revenue (as
was done). To record the collection as revenue overstates income in the current period.
Req. 2
In the short run, Mr. Lynch would benefit by receiving a larger bonus. You also
benefit in the short run because you would not experience any negative repercussions
from your boss. However, there is the risk that sometime in the future, perhaps through
an audit, the error will be found. At that point, both you and Mr. Lynch could be
implicated in a fraud. In addition, this may be the first instance where you are being
asked to account for a transaction in violation of accepted principles or company
policies. There is a very strong possibility Mr. Lynch may ask you for additional favors
in the future if you demonstrate your willingness at this point.
Req. 3
In the larger picture, shareholders are harmed by the misleading income figures
by relying on them to purchase stock at inflated prices. In addition, creditors may lend
funds to the insurance company based on the misleading information. The negative
impact of the discovery of misleading financial information will cause stock prices to fall,
causing shareholders to lose on their investment. Creditors will be concerned about
future debt repayment. You will also experience diminished self-respect because of the
violation of your integrity.
Req. 4
Managers are agents for shareholders. To act in ways to the benefit of the
manager at the detriment of the shareholders is inappropriate. Therefore, the ethically
correct response is to fail to comply with Mr. Lynch's request. Explaining your position
to Mr. Lynch will not be easy. You may want to express that you understand the reason
for his request, but cannot ethically or professionally comply.
FINANCIAL REPORTING AND ANALYSIS TEAM PROJECT
CP3–9.
The solution to this project will depend on the companies and/or accounting periods
selected for analysis.
3-73
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
Chapter 04
Adjustments, Financial Statements, and
the Quality of Earnings
ANSWERS TO QUESTIONS
1. A trial balance is a list of the individual accounts, usually in financial statement
order, with their debit or credit balances. It is used to provide a check on the
equality of the debits and credits.
2. Adjusting entries are made at the end of the accounting period to record all
revenues and expenses that have not been recorded but belong in the current
period. They update the balance sheet and income statement accounts at the end
of the accounting period.
3. The four different types are adjustments for:
(1) Deferred revenues -- previously recorded liabilities that need to be adjusted at
the end of the period to reflect revenues that have been earned (e.g., Unearned
Ticket Revenue must be adjusted for the portion of ticket revenues earned in
the current period).
(2) Accrued revenues -- revenues that have been earned by the end of the
accounting period but which will be collected in a future accounting period (e.g.,
recording Interest Receivable for interest revenues not yet collected).
(3) Deferred expenses -- previously recorded assets that need to be adjusted at
the end of the period to reflect incurred expenses (e.g., Prepaid Insurance must
be adjusted for the portion of insurance expense incurred in the current period).
(4) Accrued expenses -- expenses that have been incurred by the end of the
accounting period but which will be paid in a future accounting period (e.g.,
recording Utilities Payable for utilities expense incurred during the period that
has not yet been paid).
4. A contra-asset is an account related to an asset that is an offset or reduction to the
asset's balance. Accumulated Depreciation is a contra-account to the equipment
and buildings accounts.
4-1
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
5. The net income on the income statement is included in determining ending retained
earnings on the statement of stockholders’ equity and the balance sheet. The
change in the cash account on the balance sheet is analyzed and categorized on
the statement of cash flows into cash from operating activities, investing activities,
and financing activities.
6. (a) Income statement: Revenues (and gains) - Expenses (and losses) = Net Income
(b) Balance sheet: Assets = Liabilities + Stockholders' Equity
(c) Statement of cash flows: Changes in cash for the period = Cash from
Operations + Cash from Investing Activities + Cash from Financing Activities
(d) Statement of stockholders' equity: Ending Stockholders' Equity = (Beginning
Contributed Capital + Stock Issuances - Stock Repurchases) + (Beginning
Retained Earnings + Net Income - Dividends Declared)
7. Adjusting entries have no effect on cash. For deferred revenues and deferred
expenses, cash was received or paid at some point in the past. For accruals, cash
will be received or paid in a future accounting period. At the time of the adjusting
entry, there is no cash being received or paid.
8. Earnings per share = Net income ÷ average number of shares of stock outstanding
during the period.
Earnings per share measures the average amount of net income for the year
attributable to one share of common stock.
9. Net profit margin = Net income ÷ net sales
The net profit margin measures how much of every sales dollar generated during
the period is profit.
10. An unadjusted trial balance is prepared after all current transactions have been
journalized and posted to the ledger. It does not include the effects of the adjusting
entries. The basic purpose of an unadjusted trial balance is to check the equalities
of the accounting model (particularly, Debits = Credits) and to provide the data in a
form convenient for further processing in the accounting information processing
cycle.
In contrast, an adjusted trial balance is prepared after the effects of all of the
adjusting entries have been applied to the corresponding (prior) unadjusted trial
balance amounts. The basic purpose of an adjusted trial balance is to insure that
accuracy has been attained in applying the effect of the adjusting entries. The
adjusted trial balance provides a second check in the model equalities (primarily
Debits = Credits). It also provides data in a form convenient for further processing.
4-2
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
11. The closing entry is made at the end of the accounting period to (1) transfer the
balances in the temporary income statement accounts to retained earnings and (2)
reduce the revenue, gain, expense, and loss accounts to a zero balance so that
they can be used for the accumulation process during the next period. A closing
entry must be entered into the system through the journal and posted to the ledger
accounts to state properly the temporary and permanent account balances (i.e.,
zero balances in the temporary accounts).
12. (a) Permanent accounts -- balance sheet accounts; that is, the asset, liability, and
stockholders’ equity accounts (these are not closed at the end of each period).
(b) Temporary accounts -- income statement accounts; that is, revenues, gains,
expenses, and losses (these are closed at the end of each period).
(c) Real accounts -- another name for permanent accounts.
(d) Nominal accounts -- another name for temporary accounts.
13. The income statement accounts are closed at the end of the accounting period
because, in effect, they are temporary subaccounts to retained earnings (i.e., a part
of stockholders' equity). They are used only for accumulation during the accounting
period. When the period ends, these accumulated accounts must be transferred
(closed) to retained earnings. The closing process serves:
(1) to correctly state retained earnings, and
(2) to clear out the balances of the temporary accounts for the year just ended so
that these subaccounts can be used again during the next period for
accumulation and classification purposes.
Balance sheet accounts are not closed at the end of the period because they reflect
permanent accumulated balances of assets, liabilities, and stockholders' equity.
Permanent accounts show the entity's financial position at the end of the period and
are the beginning amounts for the next period.
14. A post-closing trial balance is a listing taken from the ledger after the adjusting and
closing entries have been journalized and posted. It is not a necessary part of the
accounting information processing cycle but it is useful because it demonstrates the
equality of the debits and credits in the ledger after the closing entry has been
journalized and posted and that all temporary accounts have zero balances.
4-3
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
ANSWERS TO MULTIPLE CHOICE
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
c
b
b
a
b
c
c
d
c
a
4-4
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
5
3
3
4
5
5
5
6
5
7
5
8
5
9
5
10
5
11
5
12
3
Exercises
No. Time
1
10
2
10
3
10
4
15
5
10
6
20
7
20
8
20
9
15
10
20
11
10
12
20
13
15
14
15
15
20
16
20
17
20
18
20
19
10
20
15
Problems
No.
Time
1
15
2
20
3
20
4
20
5
20
6
25
7
30
Alternate
Comprehensive
Problems
Problems
No.
Time
No.
Time
1
15
1
60
2
20
2
60
3
20
4
20
5
20
6
25
7
30
Cases and
Projects
No.
Time
1
25
2
25
3
25
4
20
5
25
6
40
7
45
8
35
9
50
10
25
11
*
* Due to the nature of this project, it is very difficult to estimate the amount of time
students will need to complete the assignment. As with any open-ended project, it is
possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time to discussing research strategies. When we want the
students to focus on a real accounting issue, we offer suggestions about possible
companies or industries.
4-5
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
MINI-EXERCISES
M4–1.
Hagadorn Company
Adjusted Trial Balance
At June 30, 2011
Debit
Cash
Accounts receivable
Inventories
Prepaid expenses
Buildings and equipment
Accumulated depreciation
Land
Accounts payable
Accrued expenses payable
Income taxes payable
Unearned fees
Long-term debt
Contributed capital
Retained earnings
Sales revenue
Interest income
Cost of sales
Salaries expense
Rent expense
Depreciation expense
Interest expense
Income taxes expense
Totals
$
Credit
175
420
710
30
1,400
$
250
300
250
160
50
90
1,460
400
150
2,400
60
780
640
460
150
70
135
$ 5,270
M4–2.
(1) D
(2) C
(3) A
(4) D
(5) A
(6) B
(7) B
(8) C
4-6
$ 5,270
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
M4–3.
(1) D
(2) C
(3) A
(4) B
M4–4.
(a) 1. Rent revenue is now earned.
2. Cash was received in the past – a deferred revenue was recorded.
3. Amount: $1,000  4 months = $250 earned
Adjusting entry –
Unearned rent revenue (L).........................
Rent revenue (+R, +SE) .......................
250
250
(b) 1. Depreciation Expense on the equipment is now incurred.
2. Cash was paid in the past when the equipment was purchased -- a
deferred expense was recorded. The net book value of the equipment is
overstated. Accumulated Depreciation (the contra-account) needs to be
increased for the amount used during the period.
3. Amount: $3,000 given
Adjusting entry –
Depreciation expense (+E, SE) .................. 3,000
Accumulated depreciation (+XA, A) ....
3,000
(c) 1. Insurance expense was incurred in the period.
2. Cash was paid for the insurance in the past – a deferred expense was
recorded.
3. Amount: $4,200 x 6/24 = $1,050
Adjusting entry –
Insurance expense (+E, SE) ......................
Prepaid insurance (A) ..........................
4-7
1,050
1,050
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
M4–5.
Balance Sheet
Stockholders’
Liabilities
Equity
–250
+250
Income Statement
Revenues Expenses
+250
NE
Net
Income
+250
Transaction
a.
Assets
NE
b.
–3,000
NE
–3,000
NE
+3,000
–3,000
c.
–1,050
NE
–1,050
NE
+1,050
–1,050
M4–6.
(a) 1. Utilities Expense is incurred.
2. Cash will be paid in the future for utilities used in the current period – an
accrued expense needs to be recorded.
3. Amount: $380 given
Adjusting entry –
Utilities expense (+E, SE) ...........................
Utilities payable (+L) ..............................
380
380
(b) 1. Interest revenue is now earned on the note receivable.
2. Cash for the interest will be received in the future – an accrued revenue
needs to be recorded.
3. Amount: $5,000 principal x .14 annual rate x 4/12 of a year = $233
Adjusting entry –
Interest receivable (+A) ................................
Interest revenue (+R, +SE)....................
233
233
(c) 1. Wages expense was incurred in the period.
2. Cash will be paid in the future to the employees who worked in the current
period – an accrued expense needs to be recorded.
3. Amount: 10 employees x 4 days x $150 per day = $6,000
Adjusting entry –
Wages expense (+E, SE) ...........................
Wages payable (+L) ..............................
4-8
6,000
6,000
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
M4–7.
Balance Sheet
Stockholders’
Liabilities
Equity
+380
–380
Income Statement
Revenues Expenses
NE
+380
Net
Income
–380
Transaction
a.
Assets
NE
b.
+233
NE
+233
+233
NE
+233
c.
NE
+6,000
–6,000
NE
+6,000
–6,000
M4–8.
ROMNEY’S MARKETING COMPANY
Income Statement
For the Year Ended December 31, 2012
Operating Revenues:
Sales revenue
Total operating revenues
Operating Expenses:
Wages expense
Depreciation expense
Utilities expense
Insurance expense
Rent expense
Total operating expenses
Operating Income
Other Items:
Interest revenue
Rent revenue
Pretax Income
Income tax expense
Net Income
$ 37,650
37,650
19,000
1,800
320
700
9,000
30,820
6,830
$
100
750
7,680
2,700
4,980
$9.05
Earnings per share*
* calculated as $4,980  [(300 + 800)  2] = $4,980  550 = $9.05
Average number of shares
4-9
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
M4–9.
ROMNEY’S MARKETING COMPANY
Statement of Stockholders’ Equity
For the Year Ended December 31, 2012
Balance, January 1, 2012
Share issuance
Net income
Dividends declared
Balance, December 31, 2012
Contributed
Capital
$
700
3,000
$ 3,700
Work backwards
4-10
Total
Stockholders’
Equity
$ 2,700
3,000
4,980
4,980
(0)
(0)
$ 6,980
$ 10,680
* From the trial balance.
Retained
Earnings
$ 2,000*
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
M4–10.
Req. 1
ROMNEY’S MARKETING COMPANY
Balance Sheet
At December 31, 2012
Assets
Current Assets:
Cash
Accounts receivable
Interest receivable
Prepaid insurance
Total current assets
Notes receivable
Equipment (net of accumulated depreciation, $3,000)
Total Assets
Liabilities
Current Liabilities:
Accounts payable
Accrued expenses payable
Income taxes payable
Unearned rent revenue
Total current liabilities
Stockholders’ Equity
Contributed capital
Retained earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
$
1,500
2,200
100
1,600
5,400
2,800
12,000
$ 20,200
$ 2,400
3,920
2,700
500
9,520
3,700
6,980
10,680
$ 20,200
Req. 2
The adjustments in M4–4 and M4–6 have no effect on the operating, investing, and
financing activities on the statement of cash flows because no cash is paid or received
at the time of the adjusting entries.
4-11
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
M4–11.
Revenues:
Sales revenue
Interest revenue (not operating)
Rent revenue (not operating)
Total revenues
Costs and expenses:
Wages expense
Depreciation expense
Utilities expense
Insurance expense
Rent expense
Income tax expense
Total costs and expenses
Net Income
$ 37,650
100
750
38,500
19,000
1,800
320
700
9,000
2,700
33,520
$ 4,980
Net profit margin = Net income  Operating revenues = $4,980  $37,650 = 13.23%
The operating revenue source for this company is from sales. Interest revenue and
rent revenue are not included in the denominator because they are other (nonoperating) revenue sources.
M4–12.
Sales revenue (R) ................................................
Interest revenue (R) .............................................
Rent revenue (R) ..................................................
Retained earnings (+SE) ..............................
Wages expense (E) ...................................
Depreciation expense (E) ..........................
Utilities expense (E) ...................................
Insurance expense (E) ..............................
Rent expense (E) ......................................
Income tax expense (E) ............................
4-12
37,650
100
750
4,980
19,000
1,800
320
700
9,000
2,700
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
EXERCISES
E4–1.
Paige Consultants, Inc.
Unadjusted Trial Balance
At September 30, 2012
Debit
Cash
Accounts receivable
Supplies
Prepaid expenses
Investments
Buildings and equipment
Accumulated depreciation
Land
Accounts payable
Accrued expenses payable
Unearned consulting fees
Income taxes payable
Notes payable
Contributed capital
Retained earnings *
Consulting fees revenue
Investment income
Gain on sale of land
Wages and benefits expense
Utilities expense
Travel expense
Rent expense
Professional development expense
Other operating expenses
General and administrative expenses
Interest expense
Totals
Credit
$ 153,000
225,400
12,200
10,200
145,000
323,040
$
18,100
60,000
96,830
25,650
32,500
3,030
160,000
223,370
144,510
2,564,200
10,800
6,000
1,610,000
25,230
23,990
152,080
18,600
188,000
321,050
17,200
$3,284,990 $3,284,990
* Since debits are supposed to equal credits in a trial balance, the balance in Retained
Earnings is determined as the amount in the credit column necessary to make debits
equal credits (a “plugged” figure).
4-13
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–2.
Req. 1
Types
Deferred Revenues:
Deferred Revenue may need to be
adjusted for any revenue earned
during the period
Deferred Revenue (L) and Product
Revenue and/or Service
Revenue (R)
Accrued Revenues:
Interest may be earned on Short-term
Investments
Interest Receivable (A) and Interest
Revenue (R)
Any unrecorded sales or services
provided will need to be recorded
Deferred Expenses:
Other Current Assets may include
supplies, prepaid rent, prepaid
insurance, or prepaid advertising
Any additional use of Property, Plant,
and Equipment during the period
will need to be recorded
Accrued Expenses:
Interest incurred on Short-term Note
Payable and Long-term Debt will
need to be recorded
Accounts to be Adjusted
Accounts Receivable (A) and
Product Revenue and/or
Service Revenue (R)
Other Current Assets (A) and
Selling, General, and
Administrative Expense (E)
Accumulated Depreciation (XA) and
Cost of Products and/or Cost
of Services (E)
Accrued Liabilities (L) and Interest
Expense (E)
There are likely many other accrued
expenses to be recorded, including
wages, warranties, and utilities
Accrued Liabilities (L) and Selling,
General, and Administrative
Expenses (among other
expenses) (E)
Income taxes must be computed for
the period and accrued
Income Tax Payable (L) and
Income Tax Expense (E)
Req. 2
Temporary accounts that accumulate during the period are closed at the end of the
year to the permanent account Retained Earnings. These include: Product revenue,
service revenue, interest revenue, cost of products, cost of services, interest expense,
research and development expense, selling, general, and administrative expense, other
expenses, and income tax expense.
4-14
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–3.
Req. 1
The annual reporting period for this company is January 1 through December 31, 2011.
Req. 2 (Adjusting entries)
Both transactions are accruals because revenue has been earned and expenses
incurred but no cash has yet been received or paid.
(a) 1. Wages expense is incurred.
2. Cash will be paid in the next period to employees who worked in the
current period – an accrued expense needs to be recorded.
3. Amount: $7,000 given
Adjusting entry –
Wages expense (+E, SE) ..........................
Wages payable (+L)..............................
7,000
7,000
(b) 1. Interest revenue is now earned.
2. Cash will be received in the future – an accrued revenue needs to be
recorded.
3. Amount: $2,000 given
Adjusting entry –
Interest receivable (+A) ................................ 2,000
Interest revenue (+R, +SE)....................
2,000
Req. 3
Adjusting entries are necessary at the end of the accounting period to ensure that all
revenues earned and expenses incurred and the related assets and liabilities are
measured properly. The entries above are accruals; entry (a) is an accrued expense
(incurred but not yet recorded) and entry (b) is an accrued revenue (earned but not yet
recorded). In applying the accrual basis of accounting, revenues should be recognized
when earned and measurable and expenses should be recognized when incurred in
generating revenues.
4-15
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–4.
Req. 1
Prepaid Insurance is a deferred expense that needs to be adjusted each period for the
amount used during the period.
The amount of expense is computed as follows: $3,600 x 3/24 = $450 used
Adjusting entry:
Insurance expense (+E, SE).....................................
Prepaid insurance (A) ....................................
450
450
Req. 2
Shipping Supplies is a deferred expense that needs to be adjusted at the end of the
period for the amount of supplies used during the period.
The amount is computed as follows: Beginning balance
Supplies purchased
Supplies on hand at end
Supplies used
Adjusting entry:
Shipping supplies expense (+E, SE) ........................
Shipping supplies (A) .....................................
$11,000
60,000
(20,000)
$51,000
51,000
51,000
Req. 3
Prepaid Insurance
10/1 3,600
AJE 450
End.
3,150
Insurance Expense
AJE
End.
Shipping Supplies
Beg. 11,000
Purch. 60,000 AJE 51,000
End. 20,000
450
450
Shipping Supplies Expense
AJE 51,000
End. 51,000
2011 Income statement:
Insurance expense
$ 450
Shipping supplies expense $51,000
Req. 4
2011 Balance sheet:
Prepaid insurance $ 3,150
Shipping supplies $20,000
4-16
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–5.
Transaction Assets
E4–3 (a)
NE
E4–3 (b)
+2,000
E4–4 (a)
–450
E4–4 (b)
–51,000
Balance Sheet
Stockholders’
Liabilities
Equity
+7,000
–7,000
NE
+2,000
NE
–450
NE
–51,000
Income Statement
Net
Revenues Expenses Income
NE
+7,000
–7,000
+2,000
NE
+2,000
NE
+450
–450
NE
+51,000
–51,000
E4–6.
Req. 1
a.
b.
c.
d.
e.
f.
g.
Accrued expense
Deferred expense
Accrued revenue
Deferred expense
Deferred expense
Deferred revenue
Accrued revenue
Req. 2
a.
2,700
Wages expense (+E, SE) ..........................................
Wages payable (+L) .......................................... 2,700
b.
675
Office supplies expense (+E, SE)..............................
Office supplies (A) ...........................................
675
Computations
Given
$450 + $500
- $275 = $675 used
c.
Rent receivable (+A)....................................................
1,120
Rent revenue (+R, +SE) .................................... 1,120
$560 x 2 months
= $1,120 earned
d.
12,100
Depreciation expense (+E, SE) .................................
12,100
Accumulated depreciation (+XA, A)
Given
e.
600
Insurance expense (+E, SE) .....................................
Prepaid insurance (A) ......................................
$2,400 x 6/24 =
$600 used
600
f.
3,200
Unearned rent revenue (L) ........................................
Rent revenue (+R, +SE) .................................... 3,200
$9,600 x 2/6 =
$3,200 earned
g.
Repair accounts receivable (+A) .................................
800
Repair shop revenue (+R, +SE) ........................
Given
4-17
800
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–7.
Req. 1
a.
b.
c.
d.
e.
f.
g.
Accrued revenue
Deferred expense
Accrued expense
Deferred revenue
Deferred expense
Deferred expense
Accrued expense
Req. 2
a.
Accounts receivable (+A) ............................................
2,700
Service revenue (+R, +SE)................................ 2,700
Computations
Given
900
Advertising expense (+E, SE)....................................
Prepaid advertising (A) ....................................
$1,200 x 9/12 =
$900 used
b.
900
c.
5,000
Interest expense (+E, SE) .........................................
Interest payable (+L) ......................................... 5,000
$250,000 x .12
x 2/12 (since last
payment) = $5,000
incurred
d.
750
Unearned storage revenue (L) ..................................
Storage revenue (+R, +SE) ...............................
$4,500 x 1/6 =
$750 earned
750
e.
22,000
Depreciation expense (+E, SE) .................................
22,000
Accumulated depreciation (+XA, A)
Given
f.
50,100
Supplies expense (+E, SE) .......................................
Supplies (A) .....................................................50,100
$16,500 +
$46,000 – $12,400
= $50,100 used
g.
3,800
Wages expense (+E, SE) ..........................................
Wages payable (+L) .......................................... 3,800
Given
4-18
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–8.
Balance Sheet
Stockholders’
Liabilities
Equity
Income Statement
Revenues Expenses
Net
Income
Transaction
Assets
(a)
NE
+2,700
–2,700
NE
+2,700
–2,700
(b)
–675
NE
–675
NE
+675
–675
(c)
+1,120
NE
+1,120
+1,120
NE
+1,120
(d)
–12,100
NE
–12,100
NE
+12,100
–12,100
(e)
–600
NE
–600
NE
+600
–600
(f)
NE
–3,200
+3,200
+3,200
NE
+3,200
(g)
+800
NE
+800
+800
NE
+800
E4–9.
Balance Sheet
Stockholders’
Liabilities
Equity
Income Statement
Transaction
Assets
(a)
+2,700
NE
+2,700
+2,700
NE
+2,700
(b)
–900
NE
–900
NE
+900
–900
(c)
NE
+5,000
–5,000
NE
+5,000
–5,000
(d)
NE
–750
+750
+750
NE
+750
(e)
–22,000
NE
–22,000
NE
+22,000
–22,000
(f)
–50,100
NE
–50,100
NE
+50,100
–50,100
(g)
NE
+3,800
–3,800
NE
+3,800
–3,800
4-19
Revenues Expenses
Net
Income
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–10.
a.
Independent Situations
Accrued wages, unrecorded and unpaid at
year-end, $400 (example).
Debit
Code Amount
N
400
Credit
Code Amount
G
400
b.
Service revenue earned but not yet
collected at year-end, $600.
C
600
L
600
c.
Dividends declared and paid during the
year, $900.
K
900
A
900
d.
Office Supplies on hand during the year,
$400; supplies on hand at year-end, $160.
Q
240
B
240
e.
Service revenue collected in advance,
$800.
A
800
I
800
f.
Depreciation expense for the year, $1,000.
O
1,000
E
1,000
g.
At year-end, interest on note payable not
yet recorded or paid, $220.
P
220
H
220
h.
Balance at year-end in Service Revenue
account, $56,000. Give the closing entry
at year-end.
L
56,000
K
56,000
i.
Balance at year-end in Interest Expense
account, $460. Give the closing entry at
year-end.
K
460
P
460
E4–11.
Selected Balance Sheet Amounts at December 31, 2012
Assets:
Equipment (recorded at cost per cost principle)
Accumulated depreciation (for one year, as given)
Net book value of equipment (difference)
$12,000
(1,200)
10,800
Office supplies (on hand, as given)
400
Prepaid insurance (remaining coverage, $600 x 18/24 months)
450
Selected Income Statement Amounts for the Year Ended December 31, 2012
Expenses:
Depreciation expense (for one year, as given)
$ 1,200
Office supplies expense (used, $1,600 - $400 on hand)
1,200
Insurance expense (for 6 months, $600 x 6/24 months)
150
4-20
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–12.
Date
Note 1:
April 1, 2011
December 31, 2011a
March 31, 2012b
Note 2:
August 1, 2011
December 31, 2011c
January 31, 2012d
Balance Sheet
Income Statement
Stockholders’
Net
Assets Liabilities
Equity
Revenues Expenses Income
+30,000/
–30,000
+ 2,250
+33,000/
–32,250
NE
NE
NE
NE
NE
NE
+ 2,250
+ 2,250
NE
+ 2,250
NE
+ 750
+750
NE
+ 750
NE
NE
NE
NE
+ 30,000 + 30,000
NE
+ 1,500
- 1,500
NE
+ 1,500
- 1,500
- 31,800
- 31,500
- 300
NE
+ 300
- 300
(a) $30,000 principal x .10 annual interest rate x 9/12 of a year = $2,250
(b) Additional interest revenue in 2012: $30,000 x .10 x 3/12 = $750. Cash
received was $33,000 ($30,000 principal + $3,000 interest for 12 months);
receivables decreased by the $30,000 note receivable and $2,250 interest
receivable accrued in 2011.
(c) $30,000 principal x .12 annual interest rate x 5/12 of a year = $1,500
(d) Additional interest expense in 2012: $30,000 x .12 x 1/12 = $300. Cash paid
was $31,800 ($30,000 principal + $1,800 interest for 6 months); payables
decreased by the $30,000 note payable and $1,500 interest payable accrued in
2011.
4-21
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–13.
Req. 1
(a)
Cash paid on accrued income taxes payable.
(b)
Accrual of additional income tax expense.
(c)
Cash paid on dividends payable.
(d)
Amount of dividends declared for the period.
(e)
Cash paid on accrued interest payable.
(f)
Accrual of additional interest expense.
Req. 2 Computations:
(a)
Beg. Bal. +
accrued income taxes
$135
+
656
-
cash paid
?
?
=
=
=
(c)
Beg. Bal.
$110
dividends declared
456
-
cash paid
?
?
=
=
=
End. bal.
$118
$448 paid
accrued interest expense
?
?
-
cash paid
1,127
=
=
=
End. bal.
$150
$1,137 accrued
+
+
(f)
Beg. Bal. +
$140
+
4-22
End. bal.
$79
$712 paid
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–14.
Req. 1 Adjusting entries that were or should have been made at December 31:
(a) No entry was made. Entry that should have been made:
Rent receivable (+A) ...................................................
Rent revenue (+R, +SE) ..................................
1,400
1,400
(b) No entry was made. Entry that should have been made:
Depreciation expense (+E, SE) ................................ 15,000
Accumulated depreciation (+XA, A) …………
(c) No entry was made. Entry that should have been made:
Unearned fee revenue (L) ........................................
Fee revenue (+R, +SE) ....................................
15,000
1,500
1,500
(d) Entry that was already made:
Interest expense (+E, SE) .......................................
Interest payable (+L) .......................................
($17,000 x .09 x 12/12 months)
1,530
1,530
Entry that should have been made:
Interest expense (+E, SE) ........................................
Interest payable (+L) ........................................
($17,000 x .09 x 2/12 months)
255
255
(e) No entry was made. Entry that should have been made:
Insurance expense (+E, SE).....................................
Prepaid insurance (A) ....................................
650
650
Req. 2
Balance Sheet
Stockholders’
Liabilities
Equity
Income Statement
Assets
(a)
U 1,400
NE
U 1,400
U 1,400
NE
U 1,400
(b)
O 15,000
NE
O 15,000
NE
U 15,000
O 15,000
(c)
NE
O 1,500
U 1,500
U 1,500
NE
U 1,500
(d)
NE
O 1,275
U 1,275
NE
O 1,275
U 1,275
(e)
O 650
NE
O 650
NE
U 650
O 650
4-23
Revenues Expenses
Net
Income
Transaction
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–15.
Items
Balances reported
Additional adjustments:
a. Wages
b. Depreciation
c. Rent revenue
Adjusted balances
d. Income taxes
Correct balances
Net
Income
$60,000
(39,000)
(17,000)
3,200
7,200
(2,160)
$ 5,040
Total
Assets
$170,000
Total
Liabilities
$80,000
Stockholders’
Equity
$90,000
39,000
(39,000)
(17,000)
3,200
37,200
(2,160)
$35,040
(17,000)
153,000
$153,000
(3,200)
115,800
2,160
$117,960
Computations:
a.
Given, $39,000 accrued and unpaid.
b.
Given, $17,000 depreciation expense.
c.
$9,600 x 1/3 = $3,200 rent revenue earned. The remaining $6,400 in unearned
revenue is a liability for two months of occupancy "owed'' to the renter.
d.
$7,200 income before taxes x 30% = $2,160.
4-24
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–16.
Req. 1
a.
b.
c.
Rent receivable (+A) ...................................
Revenues (rent) (+R, +SE) ..................
2,500
Expenses (depreciation) (+E, SE) ............
Accumulated depreciation (+XA, A)...
4,500
Income tax expense (+E, SE) ...................
Income taxes payable (+L) ..................
5,100
2,500
4,500
5,100
Req. 2
Effects of
Adjusting
Entries
As
Prepared
Income statement:
Revenues
Expenses
Income tax expense
Net income
Balance Sheet:
Assets
Cash
Accounts receivable
Rent receivable
Equipment
Accumulated depreciation
Liabilities
Accounts payable
Income taxes payable
Stockholders' Equity
Contributed capital
Retained earnings
$97,000
(73,000)
a
b
c
$24,000
$2,500
(4,500)
(5,100)
(7,100)
$20,000
22,000
50,000
(10,000)
$82,000
4-25
$99,500
(77,500)
(5,100)
$16,900
a
2,500
b
(4,500)
(2,000)
$20,000
22,000
2,500
50,000
(14,500)
$80,000
c
5,100
$10,000
5,100
(7,100)
(2,000)
40,000
24,900
$80,000
$10,000
40,000
32,000
$82,000
Corrected
Amounts
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–17.
Req. 1
a.
b.
c.
d.
e.
Salaries and wages expense (+E, SE) ................
Salaries and wages payable (+L) ...................
730
Utilities expense (+E, SE)....................................
Utilities payable (+L) .......................................
440
Depreciation expense (+E, SE) ...........................
Accumulated depreciation (+XA, A) .............
24,000
Interest expense (+E, SE) ...................................
Interest payable (+L) ......................................
($15,000 x .08 x 3/12)
300
Maintenance expense (+E, SE)...........................
Maintenance supplies (A) .............................
1,100
f.
No adjustment is needed because the revenue
will not be earned until January (next year).
g.
Income tax expense (+E, SE)..............................
Income tax payable (+L) .................................
4-26
730
440
24,000
300
1,100
5,800
5,800
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–17. (continued)
Req. 2
TYSON, INC.
Income Statement
For the Year Ended December 31, 2011
Operating Revenue:
Rental revenue
Operating Expenses:
Salaries and wages ($26,500 + $730)
Maintenance expense ($12,000 + $1,100)
Rent expense
Utilities expense ($4,300 + $440)
Gas and oil expense
Depreciation expense
Miscellaneous expenses
Total expenses
Operating Income
Other Item:
Interest expense ($15,000 x .08 x 3/12)
Pretax income
Income tax expense
Net income
$109,000
$27,230
13,100
8,800
4,740
3,000
24,000
1,000
81,870
27,130
300
26,830
5,800
$ 21,030
Earnings per share: $21,030 ÷ 7,000 shares
$3.00
Req. 3
Net profit margin = Net Income  Net Sales (or Operating Revenue)
= $21,030  $109,000 = 19.3%
The net profit margin indicates that, for every $1 of rental revenues, Tyson earns
$0.193 (19.3%) in net income. This ratio is higher than the industry average net profit
margin of 18%, implying that Tyson is more profitable and better able to manage its
business (in terms of sales price or costs) than the average company in the industry.
4-27
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–18.
Req. 1
(a)
(b)
(c)
(d)
Insurance expense (+E, SE) ....................................
Prepaid insurance (A) ....................................
4
Wages expense (+E, SE) .........................................
Wages payable (+L) ........................................
5
Depreciation expense (+E, SE) ................................
Accumulated depreciation (+XA, A) ...............
8
Income tax expense (+E, SE) ...................................
Income tax payable (+L) ..................................
9
4
5
8
9
Req. 2
RED RIVER COMPANY
Trial Balance
December 31, 2011
(in thousands of dollars)
Account Titles
Cash
Accounts receivable
Prepaid insurance
Machinery
Accumulated depreciation
Accounts payable
Wages payable
Income taxes payable
Contributed capital
Retained earnings
Revenues (not detailed)
Expenses (not detailed)
Totals
Unadjusted
Debit
Credit
35
9
6
80
Adjustments
Debit
Credit
a 4
c 8
9
b 5
d 9
73
4
84
32
166
a
c
b
d
166
4-28
4
8
5
9
26
26
Adjusted
Debit
Credit
35
9
2
80
8
9
5
9
73
4
84
58
188
188
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–19.
RED RIVER COMPANY
Income Statement
For the Year Ended December 31, 2011
(in thousands of dollars)
Revenues (not detailed)
Expenses ($32 + $4 + $8 + $5)
Pretax income
Income tax expense
Net income
$84
49
35
9
$26
EPS ($26,000 ÷ 4,000 shares)
$6.50
RED RIVER COMPANY
Statement of Stockholders' Equity
For the Year Ended December 31, 2011
(in thousands of dollars)
Beginning balances, 1/1/2011
Stock issuance
Net income
Dividends declared
Ending balances, 12/31/2011
Contributed
Capital
$ 0
73
$ 73
Retained
Earnings
$ 0
26
(4) *
$ 22
Total
Stockholders'
Equity
$ 0
73
26
(4)
$ 95
* The amount of dividends declared can be inferred because the unadjusted trial
balance amount for retained earnings is a negative $4. Since this is the first year of
operations, we can assume the entire amount is due to a dividend declaration.
RED RIVER COMPANY
Balance Sheet
At December 31, 2011
(in thousands of dollars)
Assets
Current Assets:
Cash
Accounts receivable
Prepaid insurance ($6 - $4)
Total current assets
Machinery
Accumulated depreciation
Total assets
$ 35
9
2
46
80
(8)
$118
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable
$ 9
Wages payable
5
Income taxes payable
9
Total current liabilities
23
Stockholders' Equity:
Contributed capital
73
Retained earnings
22
Total liabilities and
stockholders' equity
$118
4-29
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
E4–20.
Req. 1
The purposes of “closing the books” at the end of the accounting period are to:
 Transfer the balance in the temporary accounts to a permanent account
(Retained Earnings).
 Create a zero balance in each of the temporary accounts for accumulation of
activities in the next accounting period.
Req. 2
Revenues (R) ...........................................................
Expenses ($32 + $4 + $8 + $5 + $9) (E)........
Retained earnings (+SE) .................................
4-30
84
58
26
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
PROBLEMS
P4–1.
Req. 1
Dell Inc.
Adjusted Trial Balance
At January 31, 2012
(in millions of dollars)
Debit
Cash
Marketable securities
Accounts receivable
Inventories
Property, plant, and equipment
Accumulated depreciation
Other assets
Accounts payable
Accrued expenses payable
Long-term debt
Other liabilities
Contributed capital
Retained earnings (deficit)
Sales revenue
Other income
Cost of sales
Selling, general, and administrative expenses
Research and development expense
Income tax expense
Totals
Credit
$ 8,352
740
6,443
867
4,510
$ 2,233
7,821
8,309
3,788
1,898
8,234
11,189
9,396
61,101
134
50,144
7,102
665
846
$ 96,886
$ 96,886
Req. 2
Since debits are supposed to equal credits in a trial balance, the balance in Retained
Earnings is determined as the amount in the debit column necessary to make debits
equal credits (a “plugged” figure).
4-31
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
P4–2.
Req. 1
a.
Deferred revenue
e.
Deferred expense
b.
Accrued expense
f.
Accrued revenue
c.
Deferred expense
g.
Accrued expense
d.
Deferred revenue
h.
Accrued expense
Req. 2
a.
b.
c.
d.
e.
f.
g.
h.
Unearned rent revenue (L) .........................................
Rent revenue (+R, +SE).....................................
($8,400 ÷ 6 months = $1,400 per month x 4 months)
5,600
Interest expense (+E, SE) ..........................................
Interest payable (+L) ............................................
($18,000 x .12 x 3/12)
540
Depreciation expense (+E, SE) ..................................
Accumulated depreciation (+XA, A) ..................
2,500
Unearned service revenue (L) ....................................
Service revenue (+R, +SE) .................................
($3,000 x 2/12)
500
5,600
540
2,500
500
1,500
Insurance expense (+E, SE) ......................................
Prepaid insurance (A) .....................................
($9,000 ÷ 12 months = $750 per month x 2 months of coverage)
Accounts receivable (+A) .............................................
Service revenue (+R, +SE) ................................
4,000
Wage expense (+E, SE) ............................................
Wages payable (+L) ...........................................
14,000
Property tax expense (+E, SE)...................................
Property tax payable (+L) .....................................
500
4-32
1,500
4,000
14,000
500
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
P4–3.
Req. 1
a.
Deferred expense
e.
Accrued revenue
b.
Deferred expense
f.
Deferred expense
c.
Accrued expense
g.
Accrued expense
d.
Accrued expense
h.
Accrued expense
Req. 2
a.
b.
c.
d.
e.
f.
g.
h.
Depreciation expense (+E, SE) ..................................
Accumulated depreciation (+XA, A) ..................
4,000
4,000
1,150
Supplies expense (+E, SE) ........................................
Supplies (A) .....................................................
(Beg. Inventory of $400 + Purchases $1,000 – Ending Inventory $250)
Repairs expense (+E, SE)..........................................
Accounts payable (+L) .......................................
1,200
Property tax expense (+E, SE)...................................
Property tax payable (+L) .....................................
1,500
Accounts receivable (+A) .............................................
Service revenue (+R, +SE) ................................
6,000
Insurance expense (+E, SE) ......................................
Prepaid insurance (A) .....................................
($1,200 ÷ 36 months x 6 months of coverage)
200
Interest expense (+E, SE) ..........................................
Interest payable (+L) ............................................
($11,000 x .14 x 3/12)
385
1,150
1,200
1,500
6,000
200
385
8,270
Income tax expense (+E, SE) ....................................
Income tax payable (+L) ......................................
8,270
To accrue income tax expense incurred but not paid:
Income before adjustments (given)
$30,000
Effect of adjustments (a) through (g)
(2,435) (–$4,000–$1,150–$1,200
Income before income taxes
27,565 –$1,500+$6,000–$200–$385)
Income tax rate
x 30%
Income tax expense
$ 8,270 (rounded)
4-33
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
P4–4.
Req. 1
a.
Deferred revenue
e.
Deferred expense
b.
Accrued expense
f.
Accrued revenue
c.
Deferred expense
g.
Accrued expense
d.
Deferred revenue
h.
Accrued expense
Req. 2
Transaction
Assets
Balance Sheet
Stockholders’
Liabilities
Equity
Income Statement
Revenues Expenses
Net
Income
a.
NE
–5,600
+5,600
+5,600
NE
+5,600
b.
NE
+540
–540
NE
+540
–540
c.
–2,500
NE
–2,500
NE
+2,500
–2,500
d.
NE
–500
+500
+500
NE
+500
e.
–1,500
NE
–1,500
NE
+1,500
–1,500
f.
+4,000
NE
+4,000
+4,000
NE
+4,000
g.
NE
+14,000
–14,000
NE
+14,000
–14,000
NE
+500
–500
NE
+500
–500
h.
Computations:
a.
$8,400 ÷ 6 months = $1,400 per month x 4 months = $5,600 earned
b.
$18,000 principal x .12 x 3/12 = $540 interest incurred
c.
Amount is given.
d.
$3,000 unearned x 2/12 = $500 earned
e.
$9,000 ÷ 12 months = $750 per month x 2 months of coverage = $1,500 incurred
f.
Amount is given.
g.
Amount is given.
h.
Amount is given.
4-34
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
P4–5.
Req. 1
a.
Deferred expense
e.
Accrued revenue
b.
Deferred expense
f.
Deferred expense
c.
Accrued expense
g.
Accrued expense
d.
Accrued expense
h.
Accrued expense
Req. 2
Balance Sheet
Stockholders’
Liabilities
Equity
Income Statement
Revenues Expenses
Net
Income
Transaction
Assets
a.
 4,000
NE
 4,000
NE
+ 4,000
 4,000
b.
 1,150
NE
 1,150
NE
+ 1,150
– 1,150
c.
NE
+ 1,200
 1,200
NE
+ 1,200
 1,200
d.
NE
+ 1,500
 1,500
NE
+ 1,500
 1,500
e.
+ 6,000
NE
+ 6,000
+ 6,000
NE
+ 6,000
f.
 200
NE
 200
NE
+ 200
 200
g.
NE
+ 385
 385
NE
+ 385
 385
h.
NE
+8,270
 8,270
NE
+ 8,270
 8,270
Computations:
a.
Amount is given.
b.
Beg. inventory, $400 + Purchases, $1,000 - Ending inventory, $250 = $1,150 used
c.
Amount is given.
d.
Amount is given.
e.
Amount is given.
f.
$1,200 x 6/36 = $200 used
g.
$11,000 x 14% x 3/12 = $385 interest expense for the period
h.
Adjusted income = $30,000 - $4,000 - $1,150 - $1,200 - $1,500 + $6,000 - $200 $385 = $27,565 x 30% tax rate = $8,270 income tax expense.
4-35
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
P4–6.
Req. 1
(1)
(2)
(3)
(4)
December 31, 2012, Adjusting Entries
Accounts receivable (+A) .........................................
560
Service revenue (+R, +SE) ...........................
To record service revenue earned, but not collected.
Insurance expense (+E, SE) .................................
Prepaid insurance (A) .................................
To record insurance expired as an expense.
Depreciation expense (+E, SE)..............................
Accumulated depreciation, equipment (+XA, A)
To record depreciation expense.
Income tax expense (+E, SE) ...............................
Income taxes payable (+L) ...........................
To record income taxes for 2012.
560
(b)
(i)
280
(l)
(c)
11,900
(k)
(e)
6,580
(m)
(f)
280
11,900
6,580
Req. 2
Amounts before
Adjusting Entries
Revenues:
Service revenue
Expenses:
Salary expense
Depreciation expense
Insurance expense
Income tax expense
Total expense
Net income (loss)
Amounts after
Adjusting Entries
$64,400
$64,960
56,380
56,380
11,900
280
6,580
75,140
$(10,180)
56,380
$ 8,020
Net loss is $10,180 because this amount includes all revenues and all expenses (after
the adjusting entries). This amount is correct because it incorporates the effects of the
revenue and matching principles applied to all transactions whose effects extend
beyond the period in which the transactions occurred. Net income of $8,020 was not
correct because expenses of $18,760 and revenues of $560 were excluded that should
have been recorded in 2012.
Req. 3
Earnings (loss) per share = $(10,180) net loss  3,000 shares = $(3.39) per share
4-36
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
P4–6. (continued)
Req. 4
Net profit margin = Net Income  Net Sales = $(10,180) net loss  $64,960 = (15.7)%
The net profit margin indicates that, for every $1 of service revenues, Ramirez actually
lost $0.157 of net income. This ratio implies that Ramirez destroys shareholder value in
generating its sales and suggests that better management of its business (in terms of
sales price or costs) is required.
Req. 5
Service revenue (R) ...............................................
Retained earnings (SE) .........................................
Salary expense (E).........................................
Depreciation expense (E)...............................
Insurance expense (E) ...................................
Income tax expense (E) .................................
4-37
64,960
10,180
56,380
11,900
280
6,580
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
P4–7.
Req. 1
December 31, 2011, Adjusting Entries:
(a)
(b)
(c)
(d)
(e)
Supplies expense (+E, SE) ......................................
Supplies (A) ..................................................
400
Insurance expense (+E, SE) ....................................
Prepaid insurance (A) ...................................
400
Depreciation expense (+E, SE) ...............................
Accumulated depreciation (+XA, A) ..............
4,200
Wages expense (+E, SE) .........................................
Wages payable (+L) .......................................
720
Income tax expense (+E, SE) ..................................
Income taxes payable (+L) .............................
5,880
400
400
4,200
720
5,880
Req. 2
ELLIS, INC.
Income Statement
For the Year Ended December 31, 2011
Operating Revenue:
Service revenue
$61,600
Operating Expenses:
Supplies expense ($640 - $240)
Insurance expense
Depreciation expense
Wages expense
Remaining expenses (not detailed)
Total expenses
Operating Income
Income tax expense
Net Income
400
400
4,200
720
33,360
39,080
22,520
5,880
$16,640
Earnings per share ($16,640 ÷ 5,000 shares)
4-38
$3.33
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
P4–7. (continued)
Req. 2 (continued)
ELLIS, INC.
Balance Sheet
At December 31, 2011
Assets
Current Assets:
Cash
Accounts receivable
Supplies
Prepaid insurance
Total current assets
Service trucks
Accumulated depreciation
Other assets (not detailed)
Total assets
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable
$ 2,400
Wages payable
720
Income taxes payable
5,880
Total current liabilities
9,000
Note payable, long term
16,000
Total liabilities
25,000
$46,000
10,400
240
400
57,040
16,000
(13,800)
Stockholders' Equity
Contributed capital
Retained earnings*
Total stockholders' equity
Total liabilities and
stockholders' equity
8,960
$68,200
20,560
22,640
43,200
$68,200
*Unadjusted balance, $6,000 + Net income, $16,640 = Ending balance, $22,640.
Req. 3
December 31, 2011, Closing Entry:
Service revenue (R) ..................................................
Retained earnings (+SE) ................................
Supplies expense (E) ....................................
Insurance expense (E) ..................................
Depreciation expense (E) .............................
Wages expense (E) ......................................
Remaining expenses (not detailed) (E)..........
Income tax expense (E) ................................
4-39
61,600
16,640
400
400
4,200
720
33,360
5,880
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
ALTERNATE PROBLEMS
AP4–1.
Req. 1
Starbucks Corporation
Adjusted Trial Balance
At September 30, 2012
(in millions)
Debit
Cash
Short-term investments
Accounts receivable
Inventories
Prepaid expenses
Other current assets
Long-term investments
Property, plant, and equipment
Accumulated depreciation
Other long-lived assets
Accounts payable
Accrued liabilities
Short-term bank debt
Long-term liabilities
Contributed capital
Retained earnings
Net revenues
Interest income
Cost of sales
Store operating expenses
Other operating expenses
Depreciation expense
General and administrative expenses
Interest expense
Income tax expense
Totals
$
Credit
270
43
330
693
169
234
374
5,717
$
2,761
594
325
1,152
713
992
40
2,124
10,497
9
$
4,645
3,745
330
549
723
53
144
18,613
$
18,613
Req. 2
Since debits are supposed to equal credits in a trial balance, the balance in Retained
Earnings is determined as the amount in the credit column necessary to make debits
equal credits (a “plugged” figure).
4-40
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
AP4–2.
Req. 1
a.
Deferred expense
e.
Deferred revenue
b.
Deferred revenue
f.
Accrued expense
c.
Accrued expense
g.
Accrued expense
d.
Deferred expense
h.
Accrued revenue
Req. 2
a.
b.
c.
d.
e.
f.
g.
h.
Insurance expense (+E, SE) ......................................
Prepaid insurance (A) .....................................
($3,200 ÷ 6 months x 3 months of coverage)
1,600
Unearned maintenance revenue (L) ..........................
Maintenance revenue (+R, +SE) .......................
($450 ÷ 2 months x 1 month)
225
Wage expense (+E, SE) ............................................
Wages payable (+L) ..........................................
900
Depreciation expense (+E, SE) .................................
Accumulated depreciation (+XA, A) ..................
3,000
Unearned service revenue (L) ...................................
Service revenue (+R, +SE) .................................
($4,200 ÷ 12 months x 2 months)
700
Interest expense (+E, SE)..........................................
Interest payable (+L) ............................................
($18,000 x .09 x 5/12)
675
Property tax expense (+E, SE) ..................................
Property tax payable (+L) ....................................
500
Accounts receivable (+A) .............................................
Service revenue (+R, +SE) ................................
2,000
4-41
1,600
225
900
3,000
700
675
500
2,000
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
AP4–3.
Req. 1
a.
Deferred expense
e.
Deferred expense
b.
Accrued revenue
f.
Deferred expense
c.
Deferred expense
g.
Accrued revenue
d.
Accrued expense
h.
Accrued expense
Req. 2
a.
1,250
Supplies expense (+E, SE) ........................................
1,250
Supplies (A) .....................................................
(Beg. Inventory of $450 + Purchases $1,200 – Ending Inventory $400)
b.
Accounts receivable (+A) .............................................
Catering revenue (+R, +SE) ...............................
7,500
Insurance expense (+E, SE) ......................................
Prepaid insurance (A) .....................................
($1,200 x 2/12 months of coverage)
200
Repairs expense (+E, SE)..........................................
Accounts payable (+L) .......................................
600
Rent expense (+E, SE) ..............................................
Prepaid rent (A) ..................................................
($2,100 x 1/3 months of rent used)
700
Depreciation expense (+E, SE) ..................................
Accumulated depreciation (+XA, A) ..................
2,600
Interest receivable (+A) ................................................
Interest income (+R, +SE)....................................
($4,000 x .12 x 2/12)
80
Income tax expense (+E, SE) ....................................
Income tax payable (+L) ......................................
7,389
c.
d.
e.
f.
g.
h.
4-42
7,500
200
600
700
2,600
80
7,389
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
To accrue income tax expense incurred but not paid:
Income before adjustments (given)
$22,400
Effect of adjustments (a) through (g) + 2,230 (-$1,250+$7,500
Income before income taxes
24,630 -$200-$600-$700
Income tax rate
x 30% -$2,600+$80)
Income tax expense
$ 7,389
AP4–4.
Req. 1
a.
Deferred expense
e.
Deferred revenue
b.
Deferred revenue
f.
Accrued expense
c.
Accrued expense
g.
Accrued expense
d.
Deferred expense
h.
Accrued revenue
Req. 2
Balance Sheet
Stockholders’
Liabilities
Equity
Income Statement
Transaction
Assets
a.
–1,600
NE
–1,600
NE
+1,600
–1,600
b.
NE
–225
+225
+225
NE
+225
c.
NE
+900
–900
NE
+900
–900
d.
–3,000
NE
–3,000
NE
e.
NE
–700
+700
+700
f.
NE
+675
–675
NE
+675
–675
g.
NE
+500
–500
NE
+500
–500
h.
+2,000
NE
+2,000
+2,000
4-43
Revenues Expenses
Net
Income
+3,000
NE
NE
–3,000
+700
+2,000
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
Computations:
a.
$3,200 prepaid insurance x 3/6 months of coverage = $1,600 used
b.
$450 unearned revenue x 1/2 months = $225 earned
c.
Amount is given.
d.
Amount is given.
e.
$4,200 unearned revenue x 2/12 months = $700 earned
f.
$18,000 principal x .09 x 5/12 months = $675 interest expense
g.
Amount is given.
h.
Amount is given.
AP4–5.
Req. 1
a.
Deferred expense
e.
Deferred expense
b.
Accrued revenue
f.
Deferred expense
c.
Deferred expense
g.
Accrued revenue
d.
Accrued expense
h.
Accrued expense
Req. 2
Balance Sheet
Stockholders’
Liabilities
Equity
Income Statement
Revenues Expenses
Net
Income
Transaction
Assets
a.
–1,250
NE
–1,250
NE
+1,250
–1,250
b.
+7,500
NE
+7,500
+7,500
NE
+7,500
c.
–200
NE
–200
NE
+200
–200
d.
NE
+600
–600
NE
+600
–600
e.
–700
NE
–700
NE
+700
–700
f.
–2,600
NE
–2,600
NE
+2,600
–2,600
g.
+80
NE
+80
+80
NE
+80
h.
NE
+7,389
–7,389
NE
+7,389
–7,389
4-44
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
Computations:
a.
Beg. Inventory of $450 + Purchases $1,200 – Ending Inventory $400 = $1,250
used for the period.
b.
Amount is given.
c.
$1,200 prepaid expense x 2/12 = $200 insurance used
d.
Amount is given.
e.
$2,100 x 1/3 = $700 rent used
f.
Amount is given.
g.
$4,000 principal x .12 x 2/12 months = $80 interest earned
h.
Adjusted income = $22,400 - $1,250 + $7,500 - $200 - $600 - $700 - $2,600 + $80
= $24,630 x 30% tax rate = $7,389 income tax expense
4-45
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
AP4–6.
Req. 1
(1)
(2)
(3)
(4)
(5)
December 31, 2011, Adjusting Entries
Accounts receivable (+A) ........................................
1,500
Service revenue (+R, +SE) ...........................
To record service revenues earned, but not
collected.
Rent expense (+E, SE) .........................................
Prepaid rent (A)............................................
To record rent expired as an expense.
400
Depreciation expense (+E, SE) .............................
Accumulated depreciation (+XA, A)
To record depreciation expense.
17,500
Unearned revenue (L) ...........................................
Service revenue (+R, +SE) ...........................
To record service revenue earned.
8,000
Income tax expense (+E, SE) ...............................
Income taxes payable (+L) ...........................
To record income taxes for 2011.
6,500
1,500
(b)
(j)
400
(m)
(c)
17,500
(l)
(e)
8,000
(g)
(j)
6,500
(n)
(f)
Req. 2
Amounts before
Adjusting Entries
Revenues:
Service revenue
Expenses:
Salary expense
Depreciation expense
Rent expense
Income tax expense
Total expense
Net income
Amounts after
Adjusting Entries
$83,000
$92,500
56,000
56,000
17,500
400
6,500
80,400
$ 12,100
56,000
$ 27,000
Net income is $12,100 because this amount includes all revenues and all expenses
(after the adjusting entries). This amount is correct because it incorporates the effects
of the revenue and matching principles applied to all transactions whose effects extend
beyond the period in which the transactions occurred. Net income of $27,000 was not
correct because expenses of $24,400 and revenues of $9,500 were excluded that
should have been recorded in 2011.
4-46
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
AP4–6. (continued)
Req. 3
Earnings per share = $12,100 net income  5,000 shares = $2.42 per share
Req. 4
Net profit margin = Net income  Net Sales (or Operating Revenue)
= $12,100  $92,500 = 13.1%
The net profit margin indicates that, for every $1 of service revenues, Taos made
$0.131 (13.1%) of net income. This ratio suggests that Taos is generally profitable.
Req. 5
Service revenue (R) ...............................................
Retained earnings (+SE) ..................................
Salary expense (E).........................................
Depreciation expense (E)...............................
Rent expense (E) ...........................................
Income tax expense (E) .................................
4-47
92,500
12,100
56,000
17,500
400
6,500
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
AP4–7.
Req. 1
December 31, 2011, Adjusting Entries:
(a)
(b)
(c)
(d)
(e)
Depreciation expense (+E, SE) ...............................
Accumulated depreciation (+XA, A) ..............
3,000
Insurance expense (+E, SE) ....................................
Prepaid insurance (A) ...................................
450
Wages expense (+E, SE) .........................................
Wages payable (+L) .......................................
2,100
Supplies expense (+E, SE) ......................................
Supplies (A) ..................................................
500
Income tax expense (+E, SE) ..................................
Income tax payable (+L) .................................
3,150
3,000
450
2,100
500
3,150
Req. 2
SOUTH BEND REPAIR SERVICE CO.
Income Statement
For the Year Ended December 31, 2011
Operating Revenue:
Service revenue
$48,000
Operating Expenses:
Depreciation expense
Insurance expense
Wages expense
Supplies expense ($1,300 balance - $800 on hand)
Remaining expenses (not detailed)
Total expenses
Operating Income
Income tax expense
Net Income
Earnings per share ($5,900 ÷ 3,000 shares)
4-48
3,000
450
2,100
500
32,900
38,950
9,050
3,150
$5,900
$1.97
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
AP4–7. (continued)
SOUTH BEND REPAIR SERVICE CO.
Balance Sheet
At December 31, 2011
Assets
Current Assets:
Cash
Accounts receivable
Supplies
Prepaid insurance
Total current assets
Equipment
Accumulated depreciation
Other assets (not detailed)
$19,600
7,000
800
450
27,850
27,000
(15,000)
5,100
Total assets
$44,950
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable
$ 2,500
Wages payable
2,100
Income tax payable
3,150
Total current liabilities
7,750
Note payable, long term
5,000
Total liabilities
12,750
Stockholders' Equity
Contributed capital
16,000
Retained earnings*
16,200
Total stockholders' equity
32,200
Total liabilities and
stockholders' equity
$44,950
*Unadjusted balance, $10,300 + Net income, $5,900 = Ending balance, $16,200.
Req. 3
December 31, 2011, Closing Entry:
Service revenue (R) ..................................................
Retained earnings (+SE) ................................
Depreciation expense (E) .............................
Insurance expense (E) ..................................
Wages expense (E) ......................................
Supplies expense (E) ....................................
Remaining expenses (not detailed) (E)..........
Income tax expense (E) ................................
4-49
48,000
5,900
3,000
450
2,100
500
32,900
3,150
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMPREHENSIVE PROBLEMS
COMP4–1.
Req. 1, 2, 3, and 5 T-accounts (in thousands)
Cash
Bal.
4 b
a
12 e
c
156 g
d
4 h
f
34 k
Bal. 53
Bal.
b
Bal.
12
91
13
19
22
Accounts Receivable
Bal.
7
c
52 f
34
Bal.
Land
0
12
12
25
Bal.
i
Bal.
Other Assets
Bal.
5
g
13
21
18
Accumulated
Depreciation
Bal.
8
m
8
Bal. 16
Equipment
Bal. 78
Bal.
Supplies
16
23 l
78
Accounts Payable
Bal.
0
h
19 e
20
i
23
Bal. 24
Income Tax Payable
Bal. 0
p
10
Wages Payable
Bal.
0
o
16
Bal. 16
Interest Payable
Bal.
0
n
1
Bal.
1
LT Notes Payable
Bal.
0
a
12
Bal. 12
Contributed
Capital
Bal. 85
d
4
Retained
Earnings
Bal.
22
CE
Bal.
Bal.
18
Bal.
Depreciation
Expense
Bal.
0
m
8 CE
Bal.
0
89
8
k
17
41
36
Income Tax
Expense
Bal.
0
p
10 CE
10
Bal.
0
4-50
Bal.
CE
10
Service
Revenue
Bal.
0
c
208
208
Bal.
0
Interest
Expense
Bal.
0
n
1 CE
Bal.
0
1
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
Supplies
Expense
Bal.
0
l
21 CE
Bal.
0
21
Wages
Expense
Bal.
0
o
16 CE
Bal.
0
16
Remaining
Expenses
Bal.
0
e
111 CE 111
Bal.
0
COMP4–1. (continued)
Req. 2
a. Cash (+A) ..........................................................
Notes payable (+L) ..................................
b.
c.
d.
e.
f.
g.
h.
i.
12,000
12,000
Land (+A)...........................................................
Cash (A) ................................................
12,000
Cash (+A) ..........................................................
Accounts receivable (+A)...................................
Service revenue (+R, +SE) ......................
156,000
52,000
Cash (+A) ..........................................................
Contributed capital (+SE) ........................
4,000
Remaining expenses (+E, SE) ........................
Accounts payable (+L) .............................
Cash (A) ................................................
111,000
Cash (+A) ..........................................................
Accounts receivable (A).........................
34,000
Other assets (+A) ..............................................
Cash (A) ................................................
13,000
Accounts payable (L) .......................................
Cash (A) ................................................
19,000
Supplies (+A) .....................................................
Accounts payable (+L) .............................
23,000
j.
No entry required; no revenue earned in 2012.
k.
Retained earnings (SE) ...................................
Cash (A) ................................................
4-51
12,000
208,000
4,000
20,000
91,000
34,000
13,000
19,000
23,000
22,000
22,000
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMP4–1. (continued)
Req. 3
l.
m.
n.
o.
p.
Supplies expense (+E, SE)..............................
Supplies (A) ............................................
($39,000 in account – $18,000 at year end)
21,000
Depreciation expense (+E, SE) .......................
Accumulated depreciation (+XA, A)........
8,000
Interest expense (+E, SE) ...............................
Interest payable (+L) ................................
($12,000 x .10 x 10/12)
1,000
Wages expense (+E, SE) ................................
Wages payable (+L) .................................
16,000
Income tax expense (+E, SE) ..........................
Income taxes payable (+L) .......................
10,000
21,000
8,000
1,000
16,000
10,000
Req. 4
H & H TOOL, INC.
Income Statement
For the Year Ended December 31, 2012
Operating Revenues:
Service revenue
Operating Expenses:
Depreciation expense
Supplies expense
Wages expenses
Remaining expenses
Total operating expenses
Operating Income
Other Item:
Interest expense
Pretax income
Income tax expense
Net Income
Earnings per share
[$41,000 ÷ 89,000 shares all year]
4-52
$208,000
8,000
21,000
16,000
111,000
156,000
52,000
1,000
51,000
10,000
$41,000
$0.46
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMP4–1. (continued)
H & H TOOL, INC.
Statement of Stockholders' Equity
For the Year Ended December 31, 2012
Balance, January 1, 2012
Additional stock issuance
Net income
Dividends declared
Balance, December 31, 2012
Contributed
Capital
$85,000
4,000
$89,000
Retained
Earnings
$ 17,000
41,000
(22,000)
$36,000
Total
Stockholders'
Equity
$102,000
4,000
41,000
(22,000)
$125,000
H & H TOOL, INC.
Balance Sheet
At December 31, 2012
Assets
Current Assets:
Cash
Accounts receivable
Supplies
Total current assets
Land
Equipment
Less: Accumulated deprec.
Other assets
$ 53,000
25,000
18,000
96,000
12,000
78,000
(16,000)
18,000
Total assets
$188,000
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable
$ 24,000
Interest payable
1,000
Wages payable
16,000
Income taxes payable
10,000
Total current liabilities
51,000
Notes payable
12,000
Total liabilities
63,000
Stockholders' Equity:
Contributed capital
89,000
Retained earnings
36,000
Total stockholders'
equity
125,000
Total liabilities and
stockholders' equity
$188,000
4-53
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMP4–1. (continued)
H & H TOOL, INC.
Statement of Cash Flows
For the Year Ended December 31, 2012
Cash from Operating Activities:
Cash collected from customers (c + f)
Cash paid to suppliers and employees (e +h)
Cash provided by operations
$190,000
(110,000)
80,000
Cash from Investing Activities:
Purchase of land (b)
Purchase of other assets (g)
Cash used for investing activities
(12,000)
(13,000)
(25,000)
Cash from Financing Activities:
Borrowing from bank (a)
Issuance of stock (d)
Payment of dividends (k)
Cash used for financing activities
Change in cash
Beginning cash balance, January 1, 2012
Ending cash balance, December 31, 2012
12,000
4,000
(22,000)
(6,000)
49,000
4,000
$ 53,000
Req. 5
December 31, 2012, Closing Entry
Service revenue (R) .........................................
Retained earnings (+SE) .........................
Depreciation expense (E) ......................
Interest expense (E) ..............................
Supplies expense (E) ............................
Wages expense (E) ...............................
Remaining expenses (E) .......................
Income tax expense (E) .........................
4-54
208,000
41,000
8,000
1,000
21,000
16,000
111,000
10,000
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMP4–1. (continued)
Req. 6
(a)
Current ratio = Current assets  Current liabilities
= $96,000  $51,000
= 1.88
This suggests that H & H Tool, Inc., has sufficient current assets to pay current
liabilities.
(b)
Total asset turnover = Sales  Average total assets
= $208,000  [($102,000 + $188,000)  2]
= $208,000  $145,000
= 1.43
This suggests that H & H Tool, Inc., generated $1.43 for every dollar of assets.
(c)
Net profit margin
= Net income  Sales
= $41,000  $208,000
= 0.197 or 19.7%
This suggests that H & H Tool, Inc., earns $0.197 for every dollar in sales that it
generates.
For all of the ratios, a comparison across time and a comparison against an
industry average or competitors will need to be analyzed to determine how liquid
(current ratio) the company is and how efficient (total asset turnover) and how
effective (net profit margin) H & H Tool’s management is.
COMP4-2.
Req. 1, 2, 3, and 5
Bal.
a
c
d
g
j
Bal.
Cash
5
20 b
5 e
56 f
8 h
3 k
27
18
28
3
11
10
T-accounts (in thousands)
Accounts
Receivable
Bal.
4
d
14 g
8
Bal.
10
Supplies
Bal.
2
i
10 l
Bal.
4-55
4
8
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
Small Tools
Bal.
6
f
3 l
1
Bal.
8
Equipment
Bal.
0
b
18
Bal. 18
Other Assets
Bal.
9
Accounts Payable
Bal.
7
h
11 e
7
i
10
Bal. 13
Bal.
9
Wages Payable
Bal.
0
o
3
Bal.
3
Unearned
Revenue
Bal.
j
Bal.
Notes Payable
Bal.
0
a
20
Bal.
0
3
3
Service Revenue
Bal.
0
d
70
CE
70
Bal.
0
Income Tax Expense
Bal.
0
p
4
CE
4
Bal.
0
Wages Expense
Bal.
0
o
3
CE
3
Bal.
0
4-56
20
Income Taxes
Payable
Bal.
0
p
4
Bal.
4
Interest Payable
Bal.
0
n
1
Bal.
1
Contributed
Capital
Bal. 15
c
5
Bal. 20
Depreciation Expense
Bal.
0
m
2
CE
2
Bal.
0
Accumulated
Depreciation
Bal.
0
m
2
Bal.
2
k
Retained
Earnings
10 Bal.
CE
Bal.
4
16
10
Interest Expense
Bal.
0
n
1
CE
1
Bal.
0
Remaining Expenses
Bal.
0
e
35
l
9 CE
44
Bal.
0
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMP4-2. (continued)
Req. 2
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
Cash (+A) ..........................................................
Notes payable (+L) ..................................
20,000
Equipment (+A) .................................................
Cash (A) ................................................
18,000
Cash (+A) ..........................................................
Contributed capital (+SE) ........................
5,000
Cash (+A) ..........................................................
Accounts receivable (+A)...................................
Service revenue (+R, +SE) ......................
56,000
14,000
Remaining expenses (+E, SE) ........................
Accounts payable (+L) .............................
Cash (A) ................................................
35,000
Small tools (+A) .................................................
Cash (A) ................................................
3,000
Cash (+A) ..........................................................
Accounts receivable (A).........................
8,000
Accounts payable (L) .......................................
Cash (A) ...............................................
11,000
Supplies (+A) .....................................................
Accounts payable (+L) .............................
10,000
Cash (+A) ..........................................................
Unearned revenue (+L) ..........................
3,000
Retained earnings (SE) ...................................
Cash (A) ................................................
10,000
4-57
20,000
18,000
5,000
70,000
7,000
28,000
3,000
8,000
11,000
10,000
3,000
10,000
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMP4-2. (continued)
Req. 3
l.
m.
n.
o.
p.
Remaining expenses (+E, SE) ........................
Supplies (A) ............................................
Small tools (A) ........................................
[Supplies used ($12 – 4) and small tools used
($9 – 8)]
9,000
Depreciation expense (+E, SE) .......................
Accumulated depreciation (+XA, A)........
2,000
Interest expense (+E, SE) ...............................
Interest payable (+L) ................................
($20,000 principal x .10 x 6/12)
1,000
Wages expense (+E, SE) ................................
Wages payable (+L) .................................
3,000
Income tax expense (+E, SE) ..........................
Income taxes payable (+L) .......................
4,000
8,000
1,000
2,000
1,000
3,000
4,000
Req. 4
FURNITURE REFINISHERS, INC.
Income Statement
For the Year Ended December 31, 2013
Operating Revenues:
Service revenue
Operating Expenses:
Depreciation expense
Wages expense
Remaining expenses
Total operating expenses
Operating Income
Other Item:
Interest expense
Pretax income
Income tax expense
Net Income
Earnings per share
($16,000 ÷ 20,000]
$70 000
2,000
3,000
44,000
49,000
21,000
1,000
20,000
4,000
$16,000
$0.80
4-58
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMP4-2. (continued)
FURNITURE REFINISHERS, INC.
Statement of Stockholders' Equity
For the Year Ended December 31, 2013
Balance, January 1, 2013
Additional stock issuance
Net income
Dividends declared
Balance, December 31, 2013
Contributed
Capital
$15,000
5,000
$20,000
Retained
Earnings
$ 4,000
16,000
(10,000)
$ 10,000
Total
Stockholders'
Equity
$19,000
5,000
16,000
(10,000)
$30,000
FURNITURE REFINISHERS, INC.
Balance Sheet
At December 31, 2013
Assets
Current Assets:
Cash
Accounts receivable
Supplies
Small tools
Total current assets
Equipment
Less: Accum. deprec.
Other assets
$27,000
10,000
4,000
8,000
49,000
18,000
(2,000)
9,000
Total assets
$74,000
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable
$13,000
Notes payable
20,000
Wages payable
3,000
Interest payable
1,000
Income taxes payable
4,000
Unearned revenue
3,000
Total current liabilities
44,000
Stockholders' Equity:
Contributed capital
20,000
Retained earnings
10,000
Total stockholders' equity
30,000
Total liabilities and
stockholders' equity
$74,000
4-59
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMP4-2. (continued)
FURNITURE REFINISHERS, INC.
Statement of Cash Flows
For the Period Ended December 31, 2013
Cash from Operating Activities:
Cash collected from customers (d + g + j)
Cash paid to suppliers and employees (e + h)
Cash provided by operations
$ 67,000
(39,000)
28,000
Cash from Investing Activities:
Purchase of equipment (b)
Purchase of small tools (f)
Cash used in investing activities
(18,000)
(3,000)
(21,000)
Cash from Financing Activities:
Borrowing from bank (a)
Issuance of stock (c)
Payment of dividends (k)
Cash provided by financing activities
Change in cash
Beginning cash balance, January 1, 2013
Ending cash balance, December 31, 2013
20,000
5,000
(10,000)
15,000
22,000
5,000
$ 27,000
Req. 5
December 31, 2013, Closing Entry
Service revenue (R) .........................................
Retained earnings (+SE) .........................
Depreciation expense (E) ......................
Interest expense (E) ..............................
Wages expense (E) ...............................
Remaining expenses (E) .......................
Income tax expense (E) .........................
4-60
70,000
16,000
2,000
1,000
3,000
44,000
4,000
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
COMP4-2. (continued)
Req. 6
(a)
Current ratio = Current assets  Current liabilities
= $49,000  $44,000
= 1.11
This result suggests that Furniture Refinishers, Inc., has sufficient current assets
to pay current liabilities in the coming period.
(b)
Total asset turnover = Sales  Average total assets
= $70,000  [($26,000 + $74,000)  2]
= $70,000  $50,000
= 1.40
This suggests that Furniture Refinishers, Inc., generates $1.40 for every dollar of
assets.
(c)
Net profit margin
= Net income  Sales
= $16,000  $70,000
= 0.23 or 23%
This suggests that Furniture Refinishers, Inc., earns $0.23 for every dollar in
sales that it generates.
For all of the ratios, a comparison across time and a comparison against an
industry average or competitors will need to be analyzed to determine how liquid
(current ratio) the company is and how efficient (total asset turnover) and how
effective (net profit margin) Furniture Refinishers, Inc.’s management is.
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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CASES AND PROJECTS
FINANCIAL REPORTING AND ANALYSIS CASES
CP4–1.
1. American Eagle paid $132,234 thousand in income taxes in its 2008 fiscal year, as
disclosed in note 2 under “Supplemental Disclosures of Cash Flow Information.”
2. The quarter ended January 31, 2009, was its best quarter in terms of sales at
$905,713,000 (this quarter covered the holiday shopping season, the biggest part of
the year for retailers). The worst quarter ended May 3, 2008 (the quarter following
the holiday season). This is a common pattern for retailers. Note 13 discloses
quarterly information.
3. Other income (net) is an aggregate of many accounts, but a summary entry for them
all would be:
Other income (net) ...................
17,790,000
Retained Earnings ..........
17,790,000
4. As disclosed in Note 5, Accounts and Note Receivable consists of (in thousands):
Construction allowances
11,139
Merchandise sell-offs
17,057
Interest income
1,355
Marketing cost reimbursements
2,363
Credit card receivable
5,175
Merchandise vendor receivables
2,899
Other
1,483
Total
$41,471
5. Fiscal year
(dollars are in thousands)
2008:
Net Profit Margin
= Net Income = $179,061 = 0.060
Sales
$2,988,866
2007:
Net Profit Margin
= Net Income = $400,019 = 0.131
Sales
$3,055,419
2006:
Net Profit Margin
= Net Income = $387,359 = 0.139
Sales
$2,794,409
Over the past three years, the company’s net profit margin has declined each year.
Likely due to the deteriorating global economy over this time period, the company was
less effective over time at controlling costs, generating greater sales, or both.
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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–2
1. At the end of the most recent year, Prepaid Expenses and Other Current Assets
was $46,412 thousand. This information is disclosed on the balance sheet.
2. The company reported $134,084 thousand in deferred rent. This information is
disclosed on the balance sheet.
3. Prepaid rent (an asset) represents rent that a company has paid in advance to its
landlords. If a company also rents property to tenants, deferred rent (a liability)
represents rent that it has collected in advance for which the company has an
obligation to allow a tenant to use the property. Urban Outfitters reported deferred
rent of $134,084,000 on January 31, 2009. However, the related note under
Summary of Significant Accounting Policies indicates that Urban Outfitters has
significant leases and records certain related liabilities in that account. This issue is
covered in a more advanced course.
4. Accrued Liabilities would consist of costs that have been incurred by the end of the
accounting period but which have not yet been paid.
5. Interest Income is related to the company’s short-term and long-term marketable
securities (investments).
6. The company’s income statement accounts (revenues, expenses, gains, and
losses) would not have balances on a post-closing trial balance. These accounts
are temporary accounts that have been closed to Retained Earnings.
7. Prepaid Expenses is an asset account. As such, it is a permanent account that
carries its ending balance into the next accounting period. It is not closed at the end
of the period.
8. The company reported basic earnings per share of $1.20 for the year ended
January 31, 2009, $0.97 for the year ended January 31, 2008, and $0.71 for the
year ended January 31, 2007.
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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
9.
Year Ended
(dollars in thousands)
1/31/09:
Net Profit Margin
= Net Income = $199,364 = 0.109
Sales
$1,834,618
1/31/08:
Net Profit Margin
= Net Income = $160,231 = 0.106
Sales
$1,507,724
1/31/07:
Net Profit Margin
= Net Income = $116,206 = 0.095
Sales
$1,224,717
Over the past three years, the company’s net profit margin has increased. For the
year ended January 31, 2009, management appears to be more effective at
controlling costs, generating greater sales, or both.
CP4–3.
1. American Eagle Outfitters reported an advertising expense of $79.7 million for the
most recent year (Note 2 under Advertising Costs). Urban Outfitters reported $45.6
million of advertising costs for the year. (See Note 2 under Advertising).
2.
Year
Ended
2009
2008
2007
American Eagle Outfitters
Advertising
Expense /
Net Sales
79,700 / 2,988,866
2.7%
74,900 / 3,055,419
2.5%
64,300 / 2,794,409
2.3%
Urban Outfitters
Advertising
Expense /
Net Sales
45,561 / 1,834,618
2.5%
40,828 / 1,507,724
2.7%
35,882 / 1,224,717
2.9%
Urban Outfitters incurred the higher percentage in 2007 and 2008, but American
Eagle incurred the higher percentage in 2009. While both firms increased
advertising expense each year, American Eagle’s has increased as a percentage of
sales while Urban Outfitters’ has decreased as a percentage of sales.
3.
Advertising/Sales =
Industry
Average
2.39%
American Eagle
Outfitters
2.7%
Urban
Outfitters
2.5%
Both American Eagle and Urban Outfitters are spending more on advertising as a
percentage of sales than the average company in the industry. This might imply that
they are less effective, as they are generating less sales per dollar spent on
advertising. Another interpretation is that they are better supporting their brand, and
sales will eventually increase as their brands gain value.
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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
4. Both accounting policies are similar indicating that advertising costs are expensed
when the marketing campaigns become publicly available. American Eagle
allocates advertising costs for television campaigns over the life of the campaign.
Urban Outfitters capitalizes expenses associated with direct-to-consumer advertising
(catalogs) and amortizes these expenses over the expected period of future
benefits. (The policies are disclosed in note 2 in both annual reports).
CP4–3. (continued)
American Eagle
Outfitters
Urban Outfitters
2009: Net Profit = Net Income
Margin
Sales
$179,061 = 0.060
$2,988,866
6.0%
$199,364 = 0.109
$1,834,618
10.9%
2008: Net Profit = Net Income
Margin
Sales
$400,019 = 0.131
$3,055,419
13.1%
$160,231 = 0.106
$1,507,724
10.6%
2007: Net Profit = Net Income
Margin
Sales
$387,359 = 0.139
$2,794,409
13.9%
$116,206 = 0.095
$1,224,717
9.5%
5. Year
Ended
American Eagle Outfitters shows decreasing profit margins each year, whereas
Urban Outfitters shows a steady increase in its profit margin over time. In 2007 and
2008, American Eagle was able to attain a greater profit margin than that for Urban
Outfitters, suggesting a better overall performance. However, despite the decline in
the world economy, Urban Outfitters was able to maintain, and even increase, its net
profit margin, whereas American Eagle failed to do so.
6.
Net Profit Margin =
Industry
Average
3.77%
American Eagle
Outfitters
6.0%
Urban Outfitters
10.9%
Both companies, American Eagle Outfitters and Urban Outfitters have higher Net
Profit Margins than the average company in their industry. This is likely due to the
strategy that these two companies have pursued, which is to differentiate their
clothing in terms of style and quality and appeal to a particular niche market,
therefore being able to charge a higher price.
4-65
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–4.
2011
Balance
$508,000
Financial
Statement
Income statement
71,000
Income statement
 68,000
9,150
Income statement
No effect
16,000
Balance sheet
No effect
5. Receivables from employees
1,500
Balance sheet
 1,500
6. Maintenance supplies
1,850
Balance sheet
 8,000
12,000
Balance sheet
+12,000
3,000
Balance sheet
 4,000
Account
1. Rent revenue
2. Salary expense
3. Maintenance supplies expense
4. Rent receivable
7. Unearned rent revenue
8. Salaries payable
(1)
Rent Revenue
492,000 (a)
16,000 (b)
508,000
(4)
Rent Receivable
(b) 16,000
(2)
Salary Expense
(e) 68,000
(f)
3,000
71,000
(3) Maintenance
Supplies Expense
Used 9,150
9,150
(5) Receivables
from Employees
(g)
1,500
16,000
(6) Maintenance
Supplies
(h) 3,000
(i) 8,000 9,150 used
(j) 1,850
1,500
(7) Unearned
Rent Revenue
12,000 (c)
12,000
(8)
Salaries Payable
(d)
4,000 4,000 Bal.
3,000 (f)
3,000
(a) from renters
(c) from renters
Cash
492,000 4,000
12,000 68,000
1,500
8,000
4-66
Effect on
Cash Flows
+ $492,000
Inferred
(d) to employees
(e) to employees
(g) to employees
(i) to suppliers
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–5.
Req. 1
Account
Cash
Maintenance supplies
Service equipment
Accumulated depreciation,
service equipment
Remaining assets
Note payable, 8%
Interest payable
Income taxes payable
Wages payable
Unearned revenue
Contributed capital
Retained earnings
Service revenue
Expenses
Unadjusted
Trial Balance
Debit
Credit
20,000
500
90,000
Adjusted
Trial Balance
Debit
Credit
20,000
200
90,000
18,000
42,500
27,000
42,500
10,000
12,000
50,000
9,000
214,000
160,000
313,000
313,000
Post-Closing
Trial Balance
Debit
Credit
20,000
200
90,000
27,000
42,500
10,000
800
13,020
500
10,000
800
13,020
500
6,000
50,000
45,380
0
6,000
56,000
9,000
220,000
183,620
336,320
336,320
0
152,700
152,700
Ending Retained Earnings = Beg., $9,000 + Net income, ($220,000 - $183,620)
Req. 2
(a)
To record the amount of supplies used during 2011, $300, and to reduce the
supplies account to the amount remaining on hand at the end of 2011.
(b)
To accrue interest expense for 2011 (the interest is payable in 2012, computed
as $10,000 x .08 = $800) and to record interest payable.
(c)
To reduce unearned revenue for the amount of revenue earned during 2011
$6,000.
(d)
To record depreciation expense for 2011, $9,000.
(e)
To record 2011 wages of $500 that will be paid in 2012.
(f)
To record 2011 income tax and the related liability, $13,020.
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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–5. (continued)
Req. 3
Closing Entry on December 31, 2011:
Service revenue (from the adjusted trial balance) (R) .........
220,000
Retained earnings (+SE) ............................................
36,380
Expenses (from the adjusted trial balance) (E) ........
183,620
Req. 4
Pretax income
x
($220,000 - 170,600) x
$49,400
x
Average income tax rate = Income tax expense
?
=
$13,020
?
=
$13,020
?
=
26.4%
Req. 5
Number of shares issued x
10,000
x
Average issue price = Total issue amount
?
=
$50,000
?
=
$5.00 per share
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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–6.
Transaction (a):
1.
This transaction will affect Carey’s financial statements for 14 years (from 2011 to
2024) in conformity with the matching principle. [$14,000 ÷ $1,000 per year = 14
years]
2. Income statement:
Depreciation expense, as given
$1,000 each year
3. Balance sheet at December 31, 2013:
Assets:
Office equipment
Less: Accumulated depreciation*
Net book (carrying) value
*$1,000 x 3 years = $3,000.
$14,000
3,000
$11,000
4. An adjusting entry each year over the life of the asset would be recorded to reflect
the allocation of the cost of the asset when used to generate revenues:
1,000
Depreciation expense (+E, SE) . . . . . . . .
1,000
Accumulated depreciation (+XA, A) .
Transaction (b):
1. This transaction will affect Carey’s financial statements for 2 years--2013 and 2014-because four month’s rent revenue was earned in 2013, and two months' rent
revenue will be earned in 2014.
2. The 2013 income statement should report rent revenue earned of $20,000
($30,000 x 4/6). Occupancy was provided for only 4 months in 2013. This is in
conformity with the revenue principle.
3. This transaction created a $10,000 liability ($30,000 - $20,000 = $10,000) as of
December 31, 2013, because at that date Carey "owes'' the renter two more
months' occupancy for which it has already collected the cash.
4. Yes, an adjusting entry must be made to (a) increase the Rent Revenue account by
$10,000 for two months’ rent earned in 2014 and (b) to decrease the liability to $0
representing no future occupancy owed (in conformity with the revenue principle).
December 31, 2014--Adjusting entry:
Unearned Rent Revenue (L) ......................... 10,000
Rent Revenue (+R, +SE) .......................
10,000
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Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–6. (continued)
Transaction (c):
1. This transaction will directly affect Carey’s financial statements for two years, with
the expense incurred in 2013 and the cash payment in 2014.
2. The $7,500 should be reported as wage expense in the 2013 income statement
and as a liability on the 2013 balance sheet. On January 5, 2014, the liability will
be paid. Therefore, the 2014 balance sheet will reflect a reduced cash balance and
reduced liability balance. The transaction will not directly affect the 2014 income
statement (unless the adjusting entry was not made).
3. Yes, an adjusting entry must be made to (a) record the $7,500 as an expense in
2013 (matching principle) and (b) to record the liability which will be paid in 2014.
December 31, 2013--Adjusting entry:
Wage expense (+E, SE) ...............................
7,500
Wages payable (+L) .............................
7,500
Note: On January 5, 2014, the liability, Wages Payable, of $7,500 will be paid. Wage
expense for 2014 will not include this $7,500. The 2014 related entry will debit
(decrease) Wages Payable, and credit (decrease) Cash, $7,500.
Transaction (d):
1. Yes, service revenue of $45,000 (i.e., $60,000 x 3/4) should be recorded as earned
by Carey in conformity with the revenue principle. Service revenue is recognized as
the service is performed.
2. Recognition of revenue earned but not collected by the end of 2013 requires an
adjusting entry. This adjusting entry is necessary to (a) record the revenue earned
(to be reported on the 2013 income statement) and (b) record the related account
receivable (an asset to be reported on the 2013 balance sheet). The adjusting
entry on December 31, 2013 is:
Accounts receivable (+A)............................................ 45,000
Service revenue (+R, +SE) ..............................
45,000
($60,000 total price x 3/4 completed)
3. February 15, 2014--Completion of the last phase of the service contract and cash
collected in full:
Cash (+A) .................................................................. 60,000
Accounts receivable (A) .................................
45,000
Service revenue (+R, +SE) ..............................
15,000
4-70
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–7.
Req. 1
Adjusting entries:
(a) Expenses (insurance) (+E, SE) .......................................
Prepaid insurance (A) ...........................................
To adjust for expired insurance.
(b)
(c)
(d)
(e)
(f)
1
1
Rent receivable (+A) .........................................................
Revenues (rent) (+R, +SE) ......................................
To adjust for rent revenue earned but not yet collected.
2
Expenses (depreciation) (+E, SE) ...................................
Accumulated depreciation (+XA, A) .......................
To adjust for annual depreciation.
11
Expenses (wages) (+E, SE) ............................................
Wages payable (+L) ................................................
To adjust for wages earned but not recorded or paid.
3
Income tax expense (+E, SE) .........................................
Income taxes payable (+L) .....................................
To adjust for income tax expense.
5
Unearned rent revenue (L)...............................................
Revenues (rent) (+R, +SE) ......................................
To adjust for rent revenue collected but unearned.
3
2
11
3
5
3
Req. 2
Closing entry (from the adjusted trial balance):
Revenues (R) ...................................................................
Retained earnings (+SE) ..............................................
Expenses (E)...............................................................
Income tax expense (E) ..............................................
To close the temporary accounts to Retained Earnings for
2011.
4-71
103
15
83
5
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–7. (continued)
Req. 3
(a) Shares outstanding: 1,000 shares (given) – no change all year.
(b) Interest expense: $20 thousand x .10 = $2 thousand.
(c) Ending balance in retained earnings:
Unadjusted balance, $(3,000) + Net income, $15,000 = $12,000.
(d) Average income tax rate: $5,000 income tax expense ÷ ($103,000 revenues $83,000 total expenses) = 25%.
(e) Rent Receivable -- report on the balance sheet as an asset (probably current).
Unearned Rent Revenue -- report on the balance sheet as a liability probably
(current) for future occupancy "owed''.
(f) Net income of $15,000 was computed on the basis of accrual accounting
concepts. Revenue is recognized when earned and expenses recorded when
incurred regardless of the timing of the respective cash flows. Cash inflows, in
addition to certain revenues, were from numerous sources such as the issuance of
capital stock, borrowing, and revenue collected in advance. Similarly, cash
outflows were, in addition to certain expenses, due to numerous transactions such
as the purchase of operational and other assets, prepaid insurance, and dividends
to stockholders.
(g) EPS: $15,000 ÷ 1,000 shares (per (a) above) =$15.00 per share.
(h) Selling price per share: $30,000 contributed capital ÷ 1,000 shares = $30 per
share.
(i) The prepaid insurance account reflected a $2,000 balance before the adjustment
(decrease) of $1,000. Therefore, it appears that the policy premium was paid on
January 1, 2011, and it was prepaid for two years (2011 and 2012). Other
possibilities might be (a) a 12-month policy purchased on July 1, 2011, or (b) a 2month policy purchased on December 1, 2011. In any case, one-half of the
premium has expired.
(j) Net profit margin: $15,000 net income ÷ $103,000 revenues = 0.146 (14.6%).
4-72
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–8.
Req. 1
CRYSTAL’S DAY SPA AND SALON, INC.
Income Statement
For the Year Ended December 31, 2012
Items
Revenues:
Spa fees
Expenses:
Office rent
Utilities
Telephone
Salaries
Supplies
Miscellaneous
Depreciation
Total expenses
Net income
*
**
Cash
Basis Per
Crystal’s
Statement
Explanation of Changes
Corrected
Basis
$1,215,000 See * below.
$1,102,000
130,000
43,600
12,200
562,000
31,900
12,400
0
792,100
$ 422,900
120,000
43,600
11,800
563,500
29,825
12,400
20,500
801,625
$ 300,375
Exclude rent for Jan. 2013 ($130,000 ÷ 13) (g)
No change
See ** below.
Add December 2012 salary ($18,000 ÷ 12) (e)
See *** below.
No change
Given for 2012 (c)
Cash collected for spa fees
Fees earned in prior years (a)
Fees earned in 2012 but not yet collected (b)
Fees earned in 2012
$1,215,000
-142,000
+ 29,000
$1,102,000
$12,200 telephone paid + $1,400 December 2012 telephone bill - $1,800
December 2011 bill paid in 2012 = $11,800
***
Beg.
Purchases
End.
Supplies (d)
3,125
31,900 29,825
5,200
Used
4-73
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–8. (continued)
Req. 2
Memo to Crystal Mullinex should include the following:
(1) Net income was overstated by $122,525 because of inappropriate recognition of
revenue (overstated by $113,000) and expenses (understated by $9,525).
Revenue should be recognized when earned, not when the cash is collected.
Similarly, expenses should be matched against revenue in the period when the
services or materials were used (including depreciation expense).
(2) Some other items the parties should consider in the pricing decision:
(a) A correct balance sheet at December 31, 2012.
(b) Collectability of any receivables (if they are to be sold with the business).
(c) Any liabilities of the spa to be assumed by the purchaser.
(d) Current employees -- how will they be affected?
(e) Adequacy of the rented space -- is there a long-term noncancellable lease?
(f) Characteristics of Crystal’s spa practices.
(g) Expected future cash flows of the business. What is the present value of
those expectations?
4-74
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CRITICAL THINKING CASES
CP4–9.
Req. 1
2012
12/31
(a)
(b)
(c)
(d)
(e)
(f)
Adjusting Entries
Debit
Supplies expense (+E, SE)…………………
Supplies (A)……………………………….
($4,000 - $1,800 = $2,200)
2,200
Insurance expense (+E, SE)…………………….
Prepaid insurance (A)……………………
($6,000 ÷ 2 years)
3,000
Depreciation expense (+E, SE)…………………
Accumulated depreciation (+XA, A)…….
8,000
Salaries expense (+E, SE)…………………………
Salaries payable (+L)………………………
3,200
Transportation revenue (R, SE) ………
Unearned transportation revenue (+L)……
Transportation revenue is too high and needs to be
reduced and an Unearned Revenue account
created for the appropriate amount.
7,000
Income tax expense (+E, SE)…………………...
Income tax payable (+L)……………………
To record 2011 income tax computation:
Transportation revenue: $85,000  $7,000 = $78,000
Expenses:
$47,000 + $2,200 + $3,000
+ $8,000 + $3,200 = 63,400
Pretax income
$14,600
Income tax expense: $14,600 x 35% = $ 5,110
5,110
4-75
Credit
2,200
3,000
8,000
3,200
7,000
5,110
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–9. (continued)
Req. 2
STOSCHECK MOVING CORPORATION
Corrections to 2012 Financial Statements
Amounts
Reported
2012 Income Statement:
Revenue:
Transportation revenue
Expenses:
Salaries expense
Supplies expense
Other expenses
Insurance expense
Depreciation expense
Income tax expense
Total expenses
Net income
December 31, 2012, Balance Sheet
Assets:
Current Assets:
Cash
Receivables
Supplies
Prepaid insurance
Total current assets
Equipment
Less: Accumulated deprec.
Remaining assets
Total assets
Liabilities:
Current Liabilities:
Accounts payable
Salaries payable
Unearned transportation revenue
Income tax payable
Total current liabilities
Changes
Debit Credit
Corrected
Amounts
$ 85,000
e
7,000
$ 78,000
17,000
12,000
18,000
0
0
0
47,000
$ 38,000
d
a
3,200
2,200
b
c
f
3,000
8,000
5,110
20,200
14,200
18,000
3,000
8,000
5,110
68,510
$ 9,490
$
2,000
3,000
4,000
6,000
15,000
40,000
0
27,000
$82,000
$ 9,000
0
0
0
9,000
4-76
a
b
2,200
3,000
c
8,000
d
e
f
3,200
7,000
5,110
$ 2,000
3,000
1,800
3,000
9,800
40,000
(8,000)
27,000
$68,800
$ 9,000
3,200
7,000
5,110
24,310
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
Stockholders' Equity
Contributed capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders'
equity
CP4–9. (continued)
35,000
38,000
73,000
$82,000
35,000
9,490
44,490
$68,800
Req. 3
Omission of the adjusting entries caused:
(a) Net income to be overstated by $28,510.
(b) Total assets to be overstated by $13,200.
(c) Total liabilities to be understated by $15,310.
Req. 4
(a) Earnings per share:
Unadjusted -- $38,000 net income  10,000 shares = $3.80 per share
Adjusted -- $ 9,490 net income  10,000 shares = $0.95 per share
(b) Net profit margin:
Unadjusted -- $38,000 net income  $85,000 sales = 44.7%
Adjusted -- $ 9,490 net income  $78,000 sales = 12.2%
Each of the ratios was affected by inclusion of the adjustments with revenues
decreasing and expenses increasing resulting in a lower net income. For earnings per
share, the numerator net income decreased while the denominator did not, resulting in
a significantly lower figure. For the net profit margin, the denominator sales was lower
but did not decrease more than the reduction in the numerator net income causing a
significantly lower percentage.
4-77
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–9. (continued)
Req. 5
To the Stockholders of Stoscheck Moving Corporation:
We regret to inform you that your request for a $30,000 loan has been denied.
Our review showed that various adjustments were required to the original set of
financial statements provided to us. The original (unadjusted) financial statements
overstated net income for 2012 by $28,510 (i.e., $38,000 - $9,490). This overstatement
was caused by incorrectly including $7,000 of revenue collected in advance that had
not been earned in 2012. Further, all of the expenses were understated and income
tax expense had been incorrectly excluded.
Total assets were overstated by $13,200 (i.e., $82,000 - $68,800). Supplies was
overstated by $2,200, prepaid insurance was overstated by $3,000, and the net book
value of the equipment was overstated by $8,000 because annual depreciation was not
properly recognized. Further, total liabilities were understated by $15,310.
A review of key financial ratios indicates that the adjustments caused earnings per
share and net profit margin to decline. Net profit margin declined from 44.7% to 12.2%.
The adjusted ratios, however, would be compared to those of other start-up companies
in the same industry.
We require that there be sufficient collateral pledged against the loan before we can
consider it. The current market value of the equipment may be able to provide
additional collateral against which the loan could be secured. Your personal
investments may also be considered viable collateral if you are willing to sign an
agreement pledging these assets as collateral for the loan. This is a common
requirement for small start-up businesses.
If you would like us to reconsider your application, please provide us the current market
values of any assets you would pledge as collateral.
Regards,
(your name)
Loan Application Department, Your Bank
CP4–10.
Req. 1 Cash from Operations:
$24,000
Req. 2 Subscriptions Revenue for fiscal year ended March 31, 2013
($24,000 x 7/36): $4,667
Req. 3 March 31, 2013, Unearned Subscriptions Revenue
($24,000 x 29/36) = $19,333 or $24,000 - $4,667 = $19,333.
4-78
Chapter 04 - Adjustments, Financial Statements, and the Quality of Earnings
CP4–10. (continued)
Req. 4
Adjusting entry (cash receipt credited to Unearned Subscriptions Revenue):
Unearned Subscriptions Revenue (L)
9/1
24,000
AJE
4,667
End. 19,333
Subscriptions Revenue (R)
Unearned subscriptions revenue (L) ........................
Subscriptions revenue (+R, +SE) ....................
AJE
4,667
End.
4,667
4,667
4,667
Req. 5
a. $6,000 revenue target based on cash sales:
This target is not clearly defined. Does management mean any cash
subscriptions received during the period? Your region generated $24,000 in
cash subscriptions. By this assumption, your region far exceeded the company’s
target. You may be entitled to a generous bonus due to your strong
performance.
On the other hand, management may mean any sales revenue earned that has
also been received in cash during the period. Under this assumption, sales
revenue earned and received in cash is $4,667 (the accrual accounting basis
amount). If this is the company’s intention of its target, then your region did not
meet the goal, only generating 77.8% of the target. You may need to provide an
analysis to management regarding this below par performance.
This example demonstrates the need for clear communication of expectations by
management.
b. $6,000 revenue target based on accrual accounting:
This situation is the same as the second assumption under a. Your region
earned $1,333 less than expected by the company.
FINANCIAL REPORTING AND ANLYSIS PROJECT
CP4–11.
The solutions to this project will depend on the company and/or accounting period
selected for analysis.
4-79
Chapter 05 - Communicating and Interpreting Accounting Information
Chapter 05
Communicating and Interpreting
Accounting Information
ANSWERS TO QUESTIONS
1. The primary responsibility for the accuracy of the financial records and conformance
with Generally Accepted Accounting Principles (GAAP) of the information in the
financial statements rests with management, normally the CEO and CFO.
Independent auditors or CPAs are responsible for conducting an examination of the
statements in accordance with Generally Accepted Auditing Standards (for private
companies) and PCAOB Auditing Standards (for public companies), and based on
that examination, attesting to the fairness of the financial presentations in
accordance with GAAP. Both management and the auditors assume a financial
responsibility to users of the statements.
2. Financial analysts, who normally work for brokerage and investment banking
houses, mutual funds, and investment advisory services, gather extensive financial
and nonfinancial information about a company, on which they base forecasts and
stock purchase and sale recommendations. Private investors include individuals
who purchase shares in companies, often on the basis of recommendations from
financial analysts. Institutional investors are managers of pension, mutual,
endowment, and other funds that invest on behalf of others.
3. Information services provide a wide variety of financial and nonfinancial information
to analysts and investors, often on-line or on CD-ROM. These services are
normally the first source where important financial information such as quarterly
earnings announcements are available.
4. To be useful, information must be relevant; that is, it must be timely and have
predictive and/or feedback value. However, if the information is not reliable
(accurate, unbiased, and verifiable) it will not be relied upon, and thus will not be
useful.
5. a. Income statement--Accrual basis required by GAAP.
b. Balance sheet--Accrual basis required by GAAP.
c. Statement of cash flows--Cash basis required by GAAP.
5-1
Chapter 05 - Communicating and Interpreting Accounting Information
6.
Private companies normally issue quarterly and annual reports, both of which are
normally simple photocopied reports. The quarterly reports normally present
unaudited summary income statement and balance sheet information. The annual
reports include the four basic financial statements, related notes, and the auditor’s
opinion if the statements are audited.
7.
Public companies issue quarterly press releases, quarterly reports, and annual
reports to shareholders and Forms 10-Q (quarterly reports), 10-K (annual reports),
and 8-K (special events) reports to the SEC. Press releases include a summary of
the quarterly report information and are the first announcement of quarterly financial
information. The quarterly reports normally present unaudited summary income
statement and balance sheet information along with an abbreviated management
discussion and analysis. Annual reports are often elaborate reports including
extensive discussions and color photos. The financial section includes: (1)
summarized financial data for a 5- or 10-year period; (2) management’s discussion
and analysis of financial condition and results of operations and disclosures about
market risk; (3) the four basic financial statements; (4) notes (footnotes); (5)
report of independent registered public accounting firm (auditor’s opinion) and the
management certification; (6) recent stock price information; (7) summaries of the
unaudited quarterly financial data; and (8) listings of directors and officers of the
company and relevant addresses. The Form 10-Q and 10-K provide more detailed
information than the quarterly and annual reports including additional disclosures
not included in those reports. The 8-K is issued irregularly when special events,
such as a change in auditors, occur.
8. The four major subtotals or totals on the income statement are: (a) gross profit, (b)
income from operations, (c) income before income taxes, and (d) net income.
9. Extraordinary items are reported on the income statement separately. They are
items that are both unusual and infrequent. They are set out separately to aid the
user in evaluating the profit performance of the business. Inclusion of extraordinary
items in the regularly occurring revenue and expense categories would lead the
user to believe that they are normal and will recur often in the future, which would
be misleading.
10. The six major classifications on the balance sheet are: (a) current assets, (b)
noncurrent assets, (c) current liabilities, (d) long-term liabilities, (e) contributed
capital and (f) retained earnings.
5-2
Chapter 05 - Communicating and Interpreting Accounting Information
11. Property, plant, and equipment are reported on the balance sheet. Property, plant,
and equipment are those assets held by the business not for resale but for use in
operating the business, such as a delivery truck. (a) Property, plant, and equipment
are reported at their acquisition cost which represents the amount of resources
expended in acquiring them. (b) Over their period of use, they are "depreciated"
because of being worn out (used up) or becoming obsolete in carrying out the
function for which they were acquired. A portion of the cost of this effect is known
as depreciation expense. A certain amount of depreciation is reported each period
as an expense on the income statement and the total amount of depreciation on the
asset from the date it was acquired up to the date of the financial statement is
known as accumulated depreciation. (c) Cost minus accumulated depreciation
equals net book value, as reported on the balance sheet. Net book value
(sometimes also called book value or carrying value) does not represent the current
market value of the asset but rather the original cost of it less the amount of that
cost that has been measured as depreciation expense for all of the periods since
the asset was acquired.
12. The major classifications of stockholders’ equity are: (1) contributed capital, which
represents the stockholders' investments and (2) retained earnings, which represent
the earnings of the company to date less any dividends paid to the owners.
Contributed capital is often split between the account common stock (which consists
of a nominal legal amount called par value) and additional paid-in capital.
13. The three major classifications on the Statement of Cash Flows are (a) cash from
operating activities, (b) cash from investing activities, and (c) cash from financing
activities.
14. The three major categories of footnotes are: (1) descriptions of accounting rules
applied to the company’s statements, often called significant accounting policies
(e.g., the depreciation method applied to property, plant, and equipment), (2)
additional details about financial statement numbers (e.g., sales by geographic
region), and (3) relevant financial information not listed on the statements (e.g., the
existence of a bank line of credit).
15. Return on assets (ROA) is a ratio measure defined as net income divided by
average assets. It measures how much the firm earned for each dollar of assets
available to management, regardless of the source of financing. A return on assets
analysis provides an overall framework for evaluating company performance by
breaking down ROA into its two determinants: net profit margin and total asset
turnover. Together, these indicate why ROA differs from prior levels or that of
competitors, and provide insights into strategies to improve ROA in future periods.
ANSWERS TO MULTIPLE CHOICE
1. b)
6. d)
2. b)
7. b)
3. d)
8. c)
5-3
4. a)
9. d)
5. b)
10. b)
Chapter 05 - Communicating and Interpreting Accounting Information
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
5
3
5
4
10
5
10
6
10
7
10
Exercises
No.
Time
1
10
2
10
3
15
4
10
5
20
6
30
7
10
8
15
9
12
10
25
11
25
12
20
13
20
14
15
15
15
16
20
17
25
18
20
Problems
No.
Time
1
30
2
20
3
40
4
20
5
20
6
40
7
35
8
20
Alternate
Problems
No.
Time
1
40
2
20
3
40
4
35
Cases and
Projects
No.
Time
1
30
2
30
3
40
4
30
5
30
6
30
7
40
8
*
* Due to the nature of these cases and projects, it is very difficult to estimate the amount
of time students will need to complete the assignment. As with any open-ended project,
it is possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time discussing research strategies. When we want the students
to focus on a real accounting issue, we offer suggestions about possible companies or
industries.
5-4
Chapter 05 - Communicating and Interpreting Accounting Information
MINI-EXERCISES
M5-1.
Players
____D____ (1)
____C____ (2)
____B____ (3)
____A____ (4)
Definitions
Independent auditor
CEO and CFO
Users
Financial analyst
A. Adviser who analyzes financial and other economic
information to form forecasts and stock recommendations.
B. Institutional and private investors and creditors (among
others).
C. Chief executive officer and chief financial officer who have
primary responsibility for the information presented in financial
statements.
D. Independent CPA who examines financial statements and
attests to their fairness.
M5-2.
No.
Title
____3_____
____1_____
____2_____
Form 10-K
Earnings press release
Annual report
Note: Many companies now issue the annual report and the 10-K at the same time.
M5-3.
Elements of
Financial Statements
A
C
A
B
A
C
A
B
B
D
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
Financial Statements
Expenses
Cash from operating activities
Losses
Assets
Revenues
Cash from financing activities
Gains
Owners' equity
Liabilities
Assets personally owned by stockholder
5-5
A. Income statement
B. Balance sheet
C. Cash flow statement
D. None of the above
Chapter 05 - Communicating and Interpreting Accounting Information
M5-4.
Transaction
Current
Assets
+
NE
a.
b.
Gross Profit
+
NE
Current
Liabilities
NE
+
The effects of the transactions can be seen by making the related journal entries and
using CA, CL, R, and E to denote current asset, current liability, revenue, and expense,
respectively.
a.
Accounts receivable (+CA) ........................................
Sales revenue (+R) ...........................................
Cost of goods sold (+E) ...............................................
Inventory (–CA) ...............................................
120
120
80
80
Note that Gross Profit increases (by $40) since it is defined as Sales (increased
by $120) less Cost of Goods Sold (increased by only $80).
b.
Advertising expense (+E) ..........................................
Accounts payable (+CL) .................................
10
10
Note that Advertising Expense is not included in Cost of Goods Sold and, hence,
has no effect on Gross Profit.
M5-5.
Assets
Liabilities
a.) Accounts Receivable +800
Inventory
b.) Cash
Stockholders’ Equity
Sales Revenue
-350
+800
Cost of Goods Sold -350
+80,000
*Common stock
+5,000
**Additional paid-in
capital
+75,000
*$1 par value  5,000 shares
**$80,000 cash - $5,000 common stock
5-6
Chapter 05 - Communicating and Interpreting Accounting Information
M5-6.
a.
b.
Accounts receivable (+A) ........................................................
Sales revenue (+R, +SE) .............................................
Cost of goods sold (+E, –SE) .................................................
Inventory (–A) ..............................................................
800
800
350
Cash (+A) ................................................................................ 80,000
Common stock ($1 par value  5,000 shares) (+SE) ....
Additional paid-in capital (+SE) .....................................
($80,000 cash - $5,000 common stock)
350
5,000
75,000
M5-7.
Return on assets (ROA) =
Net income =
$80
= $80 = 0.084 (8.4%)
Avg total assets ($1,000+$900)/2 $950
Return on assets (ROA) measures how much the firm earned for each dollar of
investment.
5-7
Chapter 05 - Communicating and Interpreting Accounting Information
EXERCISES
E5-1.
Players
F (1) Financial
analyst
A (2) Creditor
H (3) Independent
auditor
G (4) Private
investor
D (5) SEC
E (6) Information
service
C (7) Institutional
investor
B (8) CEO and
CFO
Definitions
A. Financial institution or supplier that lends money to the
company.
B. Chief Executive Officer and Chief Financial Officer who
have primary responsibility for the information
presented in financial statements.
C. Manager of pension, mutual, and endowment funds
that invest on the behalf of others.
D. Securities and Exchange Commission which regulates
financial disclosure requirements.
E. A company that gathers, combines, and transmits
(paper and electronic) financial and related information
from various sources.
F. Adviser who analyzes financial and other economic
information to form forecasts and stock
recommendations.
G. Individual who purchases shares in companies.
H. Independent CPA who examines financial statements
and attests to their fairness.
E5-2.
Information Release
C (1) Form 10-Q
B (2) Quarterly report
D (3) Press release
F (4) Annual report
E (5) Form 10-K
A (6) Form 8-K
A.
B.
C.
D.
E.
F.
Definitions
Report of special events (e.g., auditor changes,
mergers) filed by public companies with the
SEC.
Brief unaudited report for quarter normally
containing summary income statement and
balance sheet (unaudited).
Quarterly report filed by public companies with
the SEC that contains additional unaudited
financial information.
Written public news announcement that is
normally distributed to major news services.
Annual report filed by public companies with the
SEC that contains additional detailed financial
information.
Report containing the four basic financial
statements for the year, related notes, and
often statements by management and auditors.
5-8
Chapter 05 - Communicating and Interpreting Accounting Information
E5-3.
Information Item
B,F
B,F
B,F
E
Report
(1)
(2)
(3)
(4)
Summarized financial data for 5- or 10-year period.
Notes to financial statements.
The four basic financial statements for the year.
Summarized income statement information for the
quarter.
F
(5) Detailed discussion of the company’s competition.
D (6) Initial announcement of hiring of new vice president
for sales.
D (7) Initial announcement of quarterly earnings.
B,F (8) A description of those responsible for the financial
statements.
A (9) Complete quarterly income statement, balance sheet
and cash flow statement.
C (10) Announcement of a change in auditors.
E5-4.
No.
7
6
2
4
8
1
9
3
5
Title
Long-term liabilities
Current liabilities
Long-term investments
Intangible assets
Contributed capital
Current assets
Retained earnings
Property, plant, and equipment
Other noncurrent assets
5-9
A.
B.
C.
D.
E.
F.
G.
Form 10-Q
Annual report
Form 8-K
Press release
Quarterly report
Form 10-K
None of the above
Chapter 05 - Communicating and Interpreting Accounting Information
E5-5.
Campbell Soup Company
Consolidated Balance Sheet
August 2, Current Year
(in millions)
Assets
Current Assets
Cash and cash equivalents
Accounts receivable
Inventories
Other current assets
Total current assets
Noncurrent Assets
Property, plant, and equipment, net
Intangible assets
Other assets
Total assets
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable
Accrued expenses
Other current debt
Total current liabilities
Long-term liabilities
Other noncurrent liabilities
Total liabilities
Stockholders' Equity
Common stock, $0.0375 par value
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
5-10
$
51
528
824
148
1,551
1,977
2,423
105
$6,056
$ 569
579
480
1,628
3,700
5,328
352
376
728
$6,056
Chapter 05 - Communicating and Interpreting Accounting Information
E5-6.
Req. 1.
Lance, Inc.
Consolidated Balance Sheet
December 31, Current Year
(in millions)
Assets
CURRENT ASSETS
Cash and cash equivalents
Accounts receivable, net
Inventories
Prepaid expenses and other
Other current assets
Total current assets
Property, plant and equipment, net
Goodwill
Other intangible assets, net
Other assets
TOTAL ASSETS
Liabilities and Stockholders’ Equity
CURRENT LIABILITIES
Accounts payable
Accrued compensation
Other payables and accrued liabilities
Short-term debt
Total current liabilities
NONCURRENT LIABILITIES
Long-term debt
Other long-term liabilities
Total noncurrent liabilities
STOCKHOLDERS' EQUITY
Common stock, 28,947,222 shares outstanding
Additional paid-in capital
Retained earnings
Total stockholders' equity
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
5-11
$ 807
74,406
43,112
12,933
9,778
141,036
216,085
80,110
23,966
4,949
$466,146
$ 25,939
26,312
32,318
7,000
91,569
91,000
48,070
139,070
26,268
49,138
160,101
235,507
$466,146
Chapter 05 - Communicating and Interpreting Accounting Information
E5-6. (continued)
Req. 2.
In each case, the term “net” means that the account is reported after the balance in the
related contra account has been subtracted. Accounts receivable, net means that the
allowance for doubtful accounts contra account has been subtracted. Other intangible
assets, net means that the accumulated amortization contra account has been
subtracted. Property, plant and equipment, net means that the accumulated
depreciation contra account has been subtracted.
E5-7.
Cash (+A) ................................................................... 43,000
Common stock ($.01  10,200 shares) (+SE) ...
Additional paid-in capital ($43,000 – $102) (+SE)
102
42,898
E5-8.
Req. 1.
Beginning RE + Net income - Dividends = Ending RE
Dividends = Beginning RE + Net income - Ending RE
Dividends = $6,480 M + $1,249 M - $7,489 M = $240 M
Kroger declared dividends of $240,000,000 during the year.
Req. 2.
Cash (+A) ....................................................... 243,000,000
Common stock ($955 M – $947 M) (+SE)
Additional paid-in capital ($3,266 M – $3,031 M) (+SE)
5-12
8,000,000
235,000,000
Chapter 05 - Communicating and Interpreting Accounting Information
E5-9.
Terms
A
B
K
E
F
C
J
H
D
G
Definitions
(1) Net income
(2) Income tax expense
on operations
(3) Income before
extraordinary items
(4) Cost of goods sold
(5) Operating expenses
(6) Gross margin on
sales
(7) EPS
(8) Interest expense
(9) Service revenue
(10) Pretax income from
operations
A. Revenues + Gains - Expenses - Losses
including effects of discontinued operations and
extraordinary items (if any).
B. Income tax on revenues minus operating
expenses.
C. Sales revenue minus cost of goods sold.
D. Sales of services for cash or on credit.
E. Amount of resources used to purchase or
produce the goods that were sold during the
reporting period.
F. Total expenses directly related to operations.
G. Income before all income tax and before
discontinued operations and extraordinary
items (if any).
H. Cost of money (borrowing) over time.
I. Item that is both unusual and infrequent.
J. Net income divided by average shares
outstanding.
K. Income before unusual and infrequent items
and the related income tax.
L. None of the above.
E5-10.
Case A
$900
525*
375
Sales revenue
Cost of goods sold
Gross margin
Operating expenses:
Selling expense
50*
Administrative expense 125
Total expenses
175*
Pretax income
200
Income tax expense
80*
Net income
$120
*Amounts not given in the exercise.
Case B
$750
300
450*
100
150*
250*
200
30
$170*
5-13
Case C
$420
190*
230*
80
70
150*
80*
20
$60
Case D
$1,200*
500
700*
Case E
$750*
320
430
390
120
510*
190
50
$140*
240
90
330*
100*
20
$80
Chapter 05 - Communicating and Interpreting Accounting Information
E5-11.
Case A
$770
300*
470*
Sales revenue
Cost of goods sold
Gross margin
Operating expenses:
Selling expense
90
Administrative expense 200
Total expenses
290*
Pretax income
180*
Income tax expense
65
Net income
$115
*Amounts not given in the exercise.
Case B
$1,200*
320
880
275
120
395*
485*
210
$275
Case C
$400*
125
275*
Case D
$600
250
350*
45
80
125*
150
60
$90*
70
150*
220*
130
45
$85*
Case E
$1,050
420*
630
85*
175
260*
370
130*
$240
E5-12.
TOWNSHIP CORPORATION
Income Statement
For the Year Ended December 31, 2012
Sales revenue ................................
Cost of goods sold.......................... (a)
Gross profit.....................................
Operating expenses:
Selling expense ............................
Administrative expense ................ (c)
Total operating expenses ............... (b)
Pretax income ................................
Income tax expense ................... (d)
Net income ..................................... (e)
Computations in Order
Given
$79,000 - $28,000
Given
$79,000
51,000
28,000
Given
$7,000
$15,000 – $7,000
8,000
$28,000 – $13,000
Given
$13,000 x 35%*
$13,000 – $4,550
15,000
13,000
4,550
$ 8,450
Earnings per share ($8,450  3,500 shares*) $2.41
*Given
5-14
Chapter 05 - Communicating and Interpreting Accounting Information
E5-13.
COFELT APPLIANCES, INCORPORATED
Income Statement
For the Year Ended December 31, 2011
Sales revenue ................................
Cost of goods sold.......................... (a)
Gross profit.....................................
Operating expenses:
Administrative expense ...............
Selling expense ...........................
Total operating expenses ......... (b)
Income before income taxes .......... (c)
Income tax expense ................... (d)
Net income ..................................... (e)
Computations in Order
Given
$130,000 - $60,000 (given)
Given
$130,000
70,000
60,000
Given
$17,000
Given
19,000
$17,000 + $19,000
$60,000 - $36,000
30%* x $24,000
$24,000 - $7,200
36,000
24,000
7,200
$16,800
Earnings per share ($16,800  2,500 shares*) = $6.72
*Given
5-15
Chapter 05 - Communicating and Interpreting Accounting Information
E5-14.
Transaction
a.
b.
c.
Current
Assets
+$472.7
+$425.0
–$43.5
Gross Profit
+$472.7
NE
NE
Current
Liabilities
NE
+$425.0
NE
The effects of the transactions can be seen by making the related journal entries and
using CA, CL, R, and E to denote current asset, current liability, revenue, and expense,
respectively.
a.
Accounts receivable (+CA) ........................................
792.2
Sales revenue (+R) ...........................................
792.2
Cost of goods sold (+E) ...............................................
319.5
Inventory (–CA) ...............................................
319.5
Note that Gross Profit increases (by $472.7) since it is defined as Sales
(increased by $792.2) less Cost of Goods Sold (increased by only $319.5).
b.
Cash (+CA) ................................................................
Notes payable (+CL) .......................................
c.
425.0
425.0
Research and development expense (+E) ................
43.5
Cash (–CA) .....................................................
43.5
Note that Research and Development Expense is not included in Cost of Goods
Sold and, hence, has no effect on Gross Profit.
E5-15.
Transaction
a.
b.
Current
Assets
NE
– 3.1
Gross Profit
NE
NE
Current
Liabilities
NE
– 3.1
Cash Flow from
Operating Activities
+ 35.2
NE
The effects of the transactions can be seen by making the related journal entries and
using CA and CL to denote current asset and current liability, respectively.
a.
b.
Cash (+CA)..................................................................
Accounts receivable (–CA) ...............................
35.2
Notes payable (–CL)....................................................
Cash (–CA) .......................................................
3.1
Note that repayment of debt is a financing activity.
5-16
35.2
3.1
Chapter 05 - Communicating and Interpreting Accounting Information
E5-16.
AVALOS CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 2011
From Operating Activities
Net income .................................................................
Increase in accounts receivable .................................
Decrease in inventory ................................................
Decrease in accounts payable ...................................
Cash flows from operating activities .......................
$25,000
(9,000)
1,000
(3,000)
From Investing Activities
Purchased a new delivery truck ..................................
Purchased land ...........................................................
Cash flows from investing activities ........................
(7,000)
(36,000)
From Financing Activities
Borrowed cash on three-year note ..............................
Issued stock for cash ..................................................
Cash flows from financing activities ........................
Net cash inflows for the year ..............................
Beginning cash balance ....................................................
Ending cash balance .........................................................
5-17
$ 14,000
(43,000)
30,000
24,000
54,000
25,000
25,000
$ 50,000
Chapter 05 - Communicating and Interpreting Accounting Information
E5-17.
Req. 1.
Net Income (given)
Average Total Assets
(given)
Current
Year
$220,022 = 0.072
$3,051,594
Prior
Year
$323,478 = 0.112
$2,883,833
The decrease in ROA from 0.112 in the prior year to 0.072 in the current year means
that the firm earned $0.04 less for each $1 of investment.
Req. 2.
ROA Analysis
Net Income
Net Sales
x Net Sales
Average Total Assets
Current
Year
$220,022 = 0.077
$2,859,997
Prior
Year
$323,478 = 0.110
$2,938,771
$2,859,997 = 0.937
$3,051,594
$2,938,771 = 1.019
$2,883,833
Return on Assets
0.072
0.112
The decrease in ROA is caused by decreases in both net profit margin and asset
turnover (from 0.110 to 0.077, and from 1.019 to 0.937, respectively). The company’s
profit margin and efficiency appear to have declined with the world economy.
5-18
Chapter 05 - Communicating and Interpreting Accounting Information
E5-18.
Req. 1.
Net Income (given)
Average Total Assets
(given)
Current
Prior
Year
Year
$36,796 = 0.093 $32,735 = 0.084
$394,143
$390,728
The increase in ROA from 0.084 in the prior year to 0.093 in the current year means
that the firm earned $0.009 more for each $1 of investment.
Req. 2.
Security analysts would be more likely to increase their estimates of share value on the
basis of this change. The company increased its earnings by $0.009 for each $1 of
investment and, hence, increased the corresponding value of that investment.
5-19
Chapter 05 - Communicating and Interpreting Accounting Information
PROBLEMS
P5-1.
(1) E; (2) L; (3) D; (4) I; (5) M; (6) W; (7) B; (8) Q; (9) A; (10) H; (11) U; (12) J; (13) C;
(14) G; (15) V; (16) R; (17) K; (18) N; (19) T; (20) S; (21) O; (22) P; (23) F.
P5-2.
P
E
M
O
J
I
D
A
Q
G
(1) Capital in excess of par
(2) Assets
(3) Retained earnings
(4) Book value
(5) Other assets
(6) Shares outstanding
(7) Shareholders’ equity
(8) Liquidity
(9) Normal operating cycle
(10) Current assets
B
C
N
F
L
K
H
(11) Current liabilities
(12) Long-term liabilities
(13) Fixed assets
(14) Liabilities
(15) Contra-asset account
(16) Accumulated depreciation
(17) Intangible assets
5-20
Chapter 05 - Communicating and Interpreting Accounting Information
P5-3.
Req. 1
EXQUISITE JEWELERS
Balance Sheet
December 31, 2012
Assets
Current Assets
Cash ...........................................................................
Accounts receivable ....................................................
Prepaid insurance .......................................................
Merchandise inventory ................................................
Total current assets ............................................
Long-Term Investments
Stock of Z Corporation ................................................
Fixed Assets
Store equipment .........................................................
Less accumulated depreciation ..............................
Total fixed assets ...............................................
Other Assets
Used store equipment held for disposal ......................
Total assets ........................................................
$ 58,000
71,000
1,500
154,000
$284,500
36,000
67,000
19,000
48,000
9,000
$377,500
Liabilities
Current Liabilities
Accounts payable .......................................................
Income taxes payable .................................................
Total current liabilities.........................................
Long-Term Liabilities
Note payable ..............................................................
Total liabilities .....................................................
Stockholders' Equity
Contributed Capital
Common stock, par $1 per share, 100,000 shares .....
Additional paid-in capital .............................................
Total contributed capital .....................................
Retained Earnings .............................................................
Total stockholders' equity ...................................
Total liabilities and stockholders' equity .............
5-21
$ 52,500
9,000
$ 61,500
42,000
103,500
100,000
10,000
110,000
164,000
274,000
$377,500
Chapter 05 - Communicating and Interpreting Accounting Information
P5-3. (continued)
Req. 2
Store equipment
$67,000 - $19,000 =
$48,000
Acquisition cost less sum of all
depreciation expense to date.
Net book value (sometimes called book value or carrying value) is the amount of cost
less any contra accounts (offsets).
P5-4.
Req. 1
BARNARD CORPORATION
Balance Sheet (Partial)
December 31, 2012
Stockholders' Equity
Contributed capital:
Common stock par $15 per share, 7,000 shares outstanding
(7,000 x $15) ...............................................................
$105,000
Paid-in capital
[$13,000 + (1,000 shares x $10 = $10,000)] .................
23,000
Total contributed capital ..............................................
128,000
Retained earnings:
Ending balance
[$44,000 + $43,000 - (6,000 shares x $3 = $18,000)] ..
Total stockholders' equity ...........................................
69,000
$197,000
Req. 2
Cash (1,000 shares x $25) (+A) ..................................
Common stock, par $15 (1,000 shares) (+SE)..
Paid-in capital, common stock
[1,000 shares x ($25 - $15)] (+SE)................
5-22
25,000
15,000
10,000
Chapter 05 - Communicating and Interpreting Accounting Information
P5-5.
AEROPOSTALE, Inc.
Consolidated Statement of Income
For Year Ended March 31, Current Year
(In Thousands Except Per Share Amounts)
Net revenue
Cost of goods sold
Gross profit
Other selling, general and administrative expenses
Total operating expenses
Operating income
Interest income
Income before income taxes
Provision for income taxes
Net income
Earnings per share:
Basic earnings per share
Weighted average shares outstanding
5-23
$1,885,531
1,231,349
654,182
405,883
405,883
248,299
510
248,809
99,387
$149,422
$2.24
66,832
Chapter 05 - Communicating and Interpreting Accounting Information
P5-6.
(a)
JORDAN SALES COMPANY
Income Statement
For the Year Ended March 31, 2013
Sales revenue ...................................................................
Cost of goods sold ......................................................
Gross profit........................................................................
Operating expenses:
Operating expenses ....................................................
Depreciation expense .................................................
Total operating expenses .......................................
Income from operations.....................................................
Interest expense .........................................................
Income before income taxes ............................................
Income tax expense ($38,000 x 25%) ........................
Net income ........................................................................
Earnings per share ($28,500  33,000 shares) .................
5-24
$99,000
33,000
66,000
$19,000
8,000
27,000
39,000
1,000
38,000
9,500
$28,500
$ .86
Chapter 05 - Communicating and Interpreting Accounting Information
P5-6. (continued)
(b)
JORDAN SALES COMPANY
Balance Sheet
March 31, 2013
Assets
Current Assets:
Cash ...........................................................................
Accounts receivable ....................................................
Office supplies inventory .............................................
Total current assets ................................................
Noncurrent Assets:
Automobiles ................................................. $34,000
Less accumulated depreciation ................ 14,000
Office equipment ..........................................
3,000
Less accumulated depreciation ................
1,000
Total noncurrent assets ..........................................
Total assets ............................................................
Liabilities
Current Liabilities:
Accounts payable .......................................................
Income taxes payable .................................................
Salaries and commissions payable .............................
Total current liabilities .............................................
Long-Term Liabilities:
Note payable...............................................................
Total liabilities .........................................................
$58,000
49,000
1,000
$108,000
20,000
2,000
22,000
$130,000
$22,000
9,500
2,000
$33,500
33,000
66,500
Stockholders' Equity
Contributed capital:
Capital stock (33,000 shares, par $1) .........................
Paid-in capital .............................................................
Total contributed capital .........................................
Retained earnings (beginning balance, $7,500 + net income,
$28,500 - dividends declared and paid, $10,500) ...........
Total stockholders' equity ...........................................
Total liabilities and stockholders' equity ..................
5-25
33,000
5,000
38,000
25,500
63,500
$130,000
Chapter 05 - Communicating and Interpreting Accounting Information
P5-7.
Req. 1.
Transaction
a.
b.
c.
d.
Gross Profit
+
NE
NE
NE
Operating Income
(Loss)
+
–
NE
NE
Return on Assets
+
–
–
+
The effects of the transactions can be seen by making the related journal entries and
using A, L, SE, R, and E to denote asset, liability, shareholders’ equity, revenue, and
expense, respectively.
a.*
Accounts receivable (+A) .........................................................
500
Sales revenue (+R) .......................................................
500
Cost of goods sold (+E) ...........................................................
475
Inventory (–A) ...............................................................
475
*Note that net income goes up by $25 as does ending assets. As a consequence,
average assets ((beginning + ending)/2) increases by only one-half of that amount or
$12.5.
b.
c.
d.
Research and development expense (+E) ..............................
Cash (–CA) ...................................................................
100
Cash (+CA) ..............................................................................
Common stock and additional paid-in capital (+SE) .......
200
Retained earnings (–SE) .........................................................
Cash (–CA) ...................................................................
90
5-26
100
200
90
Chapter 05 - Communicating and Interpreting Accounting Information
P5-8.
NEWELL RUBBERMAID
Consolidated Statement of Operations
For the Year Ended December 31, 2008
(dollars in thousands)
Net Sales ..........................................................................
Cost of Products Sold ..............................................
Gross Profit .......................................................................
Operating Expenses:
Selling, General, and Administrative Expenses ........
Other Expense .........................................................
Total Operating Expenses ...................................
Operating Income (loss) ...................................................
Interest and Other Non-Operating Expense .............
Income before Income Taxes ...........................................
Income Tax Expense ..............................................
Net (Loss) Income from Continuing Operations ................
Loss on Sale of Discontinued Operations, Net of
Income Taxes ........................................................
Net (Loss) Income ...........................................................
5-27
$ 6,470.6
4,347.4
2,123.2
$1,502.7
419.7
1,922.4
200.8
199.0
1.8
53.6
(51.8)
(0.5)
$ (52.3)
Chapter 05 - Communicating and Interpreting Accounting Information
ALTERNATE PROBLEMS
AP5-1.
Req. 1
TANGOCO
Balance Sheet
December 31, 2012
Assets
Current Assets
Cash ...........................................................................
Accounts receivable ....................................................
Prepaid rent ................................................................
Inventory .....................................................................
Total current assets ............................................
Long-Term Investments
Stock of PIL Corporation .............................................
Fixed Assets
Store equipment .........................................................
Less accumulated depreciation ..............................
Total fixed assets ...............................................
Other Assets
Used store equipment held for disposal ......................
Total assets ........................................................
Liabilities
Current Liabilities
Accounts payable .......................................................
Income taxes payable .................................................
Total current liabilities.........................................
Long-Term Liabilities
Note payable ..............................................................
Total liabilities .....................................................
Stockholders' Equity
Contributed Capital
Common stock, par $1 per share, 100,000 shares .....
Additional paid-in capital .............................................
Total contributed capital .....................................
Retained Earnings .............................................................
Total stockholders' equity ...................................
Total liabilities and stockholders' equity .............
5-28
$ 48,800
71,820
1,120
154,000
$275,740
36,400
67,200
13,440
53,760
9,800
$375,700
$ 58,800
9,800
$ 68,600
32,000
100,600
100,000
10,000
110,000
165,100
275,100
$375,700
Chapter 05 - Communicating and Interpreting Accounting Information
AP5-1. (continued)
Req. 2
Store equipment
$67,200 - $13,440 = $53,760
Acquisition cost less sum of all
depreciation expense to date.
Net book value (sometimes called book value or carrying value) is the amount of cost
less any contra accounts (offsets).
AP5-2.
Req. 1
MESA INDUSTRIES
Balance Sheet
December 31, 2012
Stockholders' Equity
Common stock (par $15, 8,500 shares outstanding)
(8,500 x $15) ...............................................................
Additional paid-in capital
[$9,000 + (1,500 shares x $11 = $16,500)] ...................
Retained earnings
[$48,000 + $46,000 - (7,000 shares x $1 = $7,000)] ....
Total stockholders' equity ...........................................
$127,500
25,500
87,000
$240,000
Req. 2
Cash (1,500 shares x $26) (+A) ..................................
Common stock (1,500 shares x $15) (+SE) ......
Additional paid-in capital
[1,500 shares x ($26 - $15)] (+SE)................
5-29
39,000
22,500
16,500
Chapter 05 - Communicating and Interpreting Accounting Information
AP5-3.
(a)
DYNAMITE SALES
Income Statement
For the Year Ended August 31, 2012
Sales revenue ...................................................................
Cost of goods sold ......................................................
Gross profit........................................................................
Expenses:
Operating expenses ....................................................
Depreciation expense .................................................
Total operating expenses .......................................
Income from operations ....................................................
Interest expense .........................................................
Income before income taxes ............................................
Income tax expense ($30,600 x 30%) ........................
Net income ........................................................................
Earnings per share ($21,420  29,000 shares) .................
5-30
$81,000
27,000
54,000
$16,200
4,950
21,150
32,850
2,250
30,600
9,180
$21,420
$ .74
Chapter 05 - Communicating and Interpreting Accounting Information
AP5-3. (continued)
(b)
DYNAMITE SALES
Balance Sheet
August 31, 2012
Assets
Current Assets:
Cash ...........................................................................
Accounts receivable ....................................................
Office supplies ............................................................
Total current assets ................................................
Noncurrent Assets:
Company vehicles ....................................... $27,000
Less accumulated depreciation .................. 9,000
Equipment........................................................ 2,700
Less accumulated depreciation .......................
900
Total noncurrent assets ..........................................
Total assets ............................................................
Liabilities
Current Liabilities:
Accounts payable .......................................................
Income taxes payable .................................................
Salaries payable .........................................................
Total current liabilities .............................................
Long-Term Liabilities:
Long-term debt ...........................................................
Total liabilities .........................................................
$47,700
38,320
270
$86,290
18,000
1,800
19,800
$106,090
$16,225
9,180
1,350
$26,755
25,000
51,755
Stockholders' Equity
Contributed capital:
Capital stock (29,000 shares, par $1) .........................
Paid-in capital .............................................................
Total contributed capital .........................................
Retained earnings (beginning balance, $6,615 + net income,
$21,420 - dividends declared and paid, $7,200) .............
Total stockholders' equity ...........................................
Total liabilities and stockholders' equity ..................
5-31
29,000
4,500
33,500
20,835
54,335
$106,090
Chapter 05 - Communicating and Interpreting Accounting Information
AP5-4.
Req. 1.
Transaction
a.
b.
c.
d.
Operating Income
(Loss)
NE
NE
–
NE
Net Income
Return on Assets
+
NE
–
NE
+
–
–
–
The effects of the transactions can be seen by making the related journal entries and
using A, L, SE, R, and E to denote asset, liability, shareholders’ equity, revenue, and
expense, respectively.
a.
b.
c.
d.
Cash (+A) ..................................................................................
Interest income (+R) .....................................................
7
Inventory (+A) ..........................................................................
Accounts payable (+L) ..................................................
80
Advertising expense (+E) ........................................................
Cash (–A) ......................................................................
16
Cash (+A) ................................................................................
Common stock and additional paid-in capital (+SE) .......
40
7
80
16
40
Req. 2.
Assuming that next period Avon’s total assets increase by 5%, but Avon earns 20%
more income as during the current period, Avon’s ROA will increase over that earned in
the current period. Both the denominator and the numerator increase. In this case, net
income is increasing at a faster rate than average total assets, causing ROA to be
higher in the next period. (Students are encouraged to calculate ROA to verify this
assertion.)
Net Income
Average Total Assets
Current
Next
Year
Year
$875
= 0.15
$1,050
= 0.17
($5,716+$6,074)/2
($6,074+$6,378)
5-32
Chapter 05 - Communicating and Interpreting Accounting Information
CASES AND PROJECTS
ANNUAL REPORT CASES
CP5-1.
1. The Balance Sheet lists “Property and equipment”, “Goodwill”,
“Long-term investments”, Non-current deferred income taxes and “Other assets, net”
as non-current assets.
2. The company owned $6,364,000 in land at the end of the year. This is disclosed in
note 6, “Property and Equipment”.
3. Unredeemed stored value cards and gift certificates were $ 42,299,000, or 10.5% of
current liabilities for the year. This is disclosed on the Balance Sheet.
4. Website sales are recorded “upon the estimated customer receipt date of the
merchandise” (see note 2 under Revenue Recognition).
5. Although the company had negative cash from financing and continued to make
considerable capital expenditures, the company also realized significant proceeds
from the sale of available-for-sale securities. This resulted in a net inflow of
$69,878,000 from financing and investing activities. The effect of exchange rates on
cash was ($14,790,000), making up the difference between the $302,193,000 cash
provided by operations and the overall change in cash of 357,281,000.
6. The highest stock price was $23.45, in the 1st quarter of fiscal 2008. This
information is in Item 5 of the 10-K disclosed with the annual report.
7. ROA decreased from fiscal 2007 to 2008. This seems to be reflected in the share
price decreasing from a high of $23.94 in the 4th quarter of 2007 to a low of $7.11 in
the 4th quarter of 2008.
Fiscal 2008
Fiscal 2007
Net Income _
$179,061
_
Average
$(1,867,680+1,963,676)/2 = 0.093
Total Assets
5-33
$400,019
_
$(1,979,558+1,867,680)/2 = 0.21
Chapter 05 - Communicating and Interpreting Accounting Information
CP5-2.
1. The company presents the subtotals “gross profit,” “income from operations,” and
“income before income taxes”.
2. The cash flow statement indicates that operating activities provided $251,570,000 in
cash, while financing activities provided only $ 22,325,000 in cash. Thus, the
investing activities were financed primarily by operating activities.
3. The company’s largest asset (net) is “Property and Equipment, net” of $505,407,000
reported on the balance sheet.
4. The company “capitalizes applicable costs incurred during the application and
infrastructure development stage and expenses costs incurred during the planning
and operating stage”. This is disclosed in note 2.
5. Buildings are depreciated over useful lives of 39 years. This is disclosed in note 2.
6. Buildings are $96,205,000, which is 11% of the total balance of gross property and
equipment. This is disclosed in note 5.
5-34
Chapter 05 - Communicating and Interpreting Accounting Information
CP5-3.
Req. 1.
American Eagle Outfitters
Urban Outfitters
Net Income _
$179,061
_
Average
$(1,867,680 +1,963,676)/2 = 0.093
Total Assets
$199,364
= 0.161
$(1,142,791 +1,329,009)/2
Urban Outfitters had a higher return on assets during the current year.
Req. 2.
ROA Analysis
Net Income
Net Sales
Net Sales
Average Total Assets
American Eagle
Outfitters
179,061
2,988,866 = 0.06
2,988,866
1,915,678 = 1.56
Return on Assets
0.09
Urban Outfitters
199,364_
1,834,618
1,834,618
1,235,900
= 0.11
= 1.48
0.16
Urban Outfitters has a higher ROA than American Eagle because it has a higher profit
margin which more than compensates for its lower total asset turnover ratio. Ownership
of property, plant, and equipment decreases the total asset turnover ratio relative to
rentals. The owned assets would be included in “average total assets” while rented
assets would not be included—thus, for the same level of sales, asset turnover would
be lower.
5-35
Chapter 05 - Communicating and Interpreting Accounting Information
CP5-3. (continued)
Req. 3.
Industry Return on Assets (ROA) profit driver analysis:
ROA = Net Profit Margin  Total Asset Turnover
Industry
Average
American Eagle
Outfitters
Urban Outfitters
Net Profit Margin
.038
.060
.109
Total Asset Turnover
1.90
1.56
1.48
Return on Assets
0.07
0.09
0.16
ROA Analysis
Both firms have a higher ROA than the industry average. This is being driven solely by
their higher net profit margins. This is expected, given that the companies compete by
differentiating their product rather than competing only on price. Both firms have asset
turnover lower than the industry average.
5-36
Chapter 05 - Communicating and Interpreting Accounting Information
FINANCIAL REPORTING AND ANALYSIS CASES
CP5-4.
1. Gross margin on sales, $105,000.
Computation:
Sales revenue.........................................................
Less: Cost of goods sold ........................................
Gross margin on sales ............................................
$275,000
170,000
$105,000
2. EPS, $1.00.
Computation:
Net income, $10,000  ($100,000  $10 = 10,000 shares)
= $1.00 per share.
3. Pretax income, $13,333.
Computation (and proof):
Pretax income [$10,000  (100% - 25% = 75%)] ........
Proof:
Income tax ($13,333 x 25%) ...................................
Net income ($13,333 x 75%) (given) ......................
$13,333
3,333
$10,000
4. Average sales price per share of stock, $11.60.
Computation:
($100,000 + $16,000 = $116,000)  ($100,000  $10 = 10,000 shares)
= $11.60 per share.
5. Beginning balance, $70,000.
Computation: (work backwards)
Beginning balance (?) ($80,000 - $10,000) ............
Add: 2012 net income (given) .................................
Deduct: 2012 dividends (given) ..............................
Ending balance (given) ...........................................
5-37
$70,000
10,000
(None)
$80,000
Chapter 05 - Communicating and Interpreting Accounting Information
CRITICAL THINKING CASES
CP5-5.
Strategy
Change
a.
Current
Period
ROA
+
–
b.
Future
Periods’
ROA
Explanation
–
The decrease in R&D investments would lead to lower expense in
the current year, increasing current period’s income and ROA.
However, when fewer products are brought to market in future
periods, income and ROA will decrease.
+
The advertising expense would decrease income and ROA in the
current year. Assuming that the movie earns a greater income in
future periods because of the advertising, net income will
increase, increasing ROA in future periods.
CP5-6.
Error
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Net Income
2010
2011
O
NE
$950
O
U
500
$500
U
O
600
600
U
O
200
200
O
U
900
900
U
NE
300
NE
NE
Assets
2010
2011
O
O
$950
$950
NE
NE
Liabilities
2010
2011
NE
NE
U
600
U
200
NE
NE
U
$500
NE
NE
NE
NE
NE
NE
U
300
U
8,000
U
300
NE
U
900
NE
U
8,000
NE
5-38
NE
NE
NE
Chapter 05 - Communicating and Interpreting Accounting Information
CP5-6. (continued)
Explanation of analysis if not corrected:
(1) Given in problem (example).
(2) Wage expense should be increased (debited) by $500 in 2010 because the wages
were incurred in that year. This increase in expense was not recorded; therefore,
income for 2010 was overstated by $500. The wages were not paid when earned in
2010. Therefore, there is a 2010 liability of $500; thus, liabilities were understated
at the end of 2010. In 2011 when the wages are recorded, wage expense will be
overstated and income will be understated.
(3) Revenues were understated by $600 in 2010, which caused 2010 income to be
understated by $600. Also accounts receivable was understated because the
amount of $600 will be collected in 2011; thus, assets were understated by $600 at
the end of 2010. Also, if not corrected, the $600 of revenue would be recorded in
2011, which would cause 2011 revenues, and hence income, to be overstated.
(4) The $200 expense should be recorded as 2011 expense. It was recorded in 2010;
therefore, 2010 expense was overstated which would cause 2010 income to be
understated. If not corrected, 2011 expense would be understated, which would
cause 2011 income to be overstated by $200. Assets at the end of 2010 would be
understated by $200 because prepaid expense (an asset) should be debited at the
end of 2010 for this expenditure, because it was paid in advance.
(5) The $900 revenue should be recorded as revenue in 2011 because it was earned in
2011. Therefore, if not corrected, 2010 revenue and income would be overstated by
$900. Also, 2011 revenue and income would be understated by $900 because that
is the year that the $900 revenue was earned but was not recorded. At the end of
2010 liabilities would be understated by $900 because revenue collected in
advance (a liability to render future performance to earn the revenue) should be
credited for $900 at the end of 2010.
(6) This transaction should have been recorded as a credit to revenue of $300 instead
of a credit to accounts receivable. Therefore, revenue, and hence income, was
understated by $300. The credit to accounts receivable caused assets to be
understated by $300 for each year. Accounts receivable will continue to be
understated until a correction is made.
(7) This transaction should have been recorded in 2010 as a debit to Land (an asset)
and a credit to a liability, $8,000. Therefore, at the end of 2010 both assets and
liabilities were understated by $8,000. The entry in 2011 corrected the accounts.
5-39
Chapter 05 - Communicating and Interpreting Accounting Information
CP5-7.
1. At the time this solution was prepared, three former top managers had pleaded
guilty to fraud charges and the chief marketing officer pleaded not guilty and was
found guilty at trial. He received an 84 month prison sentence. Dutch authorities
fined two Dutch executives at Ahold but imposed no prison terms. Ahold settled
shareholder suits against it for $1.1 billion dollars and, in May of 2007, sold its U.S.
Foodservice unit to two private-equity firms.
2. In October 2004, the SEC chose not to impose a monetary fine on the company
because of its extensive cooperation with the investigation. The company promptly
attended to SEC requests for information, granted access to current employees,
waived attorney-client privilege in its internal investigations, revised its internal
control procedures to prevent further frauds, and fired employees found responsible
for the frauds. This move sends a strong signal to other companies that there is a
benefit to cooperating with SEC investigations.
3. Bonuses tied to performance measures such as accounting earnings tend to align
the managers' interests with those of the shareholders. However, when companies
face a significant downturn, and bonuses will not be awarded, some dishonest
managers attempt to meet performance goals by falsifying accounting numbers.
FINANCIAL REPORTING AND ANALYSIS PROJECT
CP5-8.
The solutions to this case will depend on the company and/or accounting period
selected for analysis.
5-40
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
Chapter 06
Reporting and Interpreting Sales
Revenue, Receivables, and Cash
ANSWERS TO QUESTIONS
1.
The difference between sales revenue and net sales is the amount of goods
returned by customers because the goods were either unsatisfactory or not
desired and also includes sales allowances given to customers (also refer to the
answers given below to questions 3, 4 and 5).
2.
Gross profit or gross margin on sales is the difference between net sales and
cost of goods sold. It represents the average gross markup realized on the goods
sold during the period. The gross profit ratio is computed by dividing the amount
of gross profit by the amount of net sales. For example, assuming sales of
$100,000, and cost of goods sold of $60,000, the gross profit on sales would be
$40,000. The gross profit ratio would be $40,000/$100,000 =.40. This ratio may
be interpreted to mean that out of each $100 of sales, $40 was realized above
the amount expended to purchase the goods that were sold.
3.
A credit card discount is the fee charged by the credit card company for services.
When a company deposits its credit card receipts in the bank, it only receives
credit for the sales amount less the discount. The credit card discount account
either decreases net sales (it is a contra revenue) or increases selling expense.
4.
A sales discount is a discount given to customers for payment of accounts within
a specified short period of time. Sales discounts arise only when goods are sold
on credit and the seller extends credit terms that provide for a cash discount. For
example, the credit terms may be 1/10, n/30. These terms mean that if the
customer pays within 10 days, 1% can be deducted from the invoice price of the
goods. Alternatively, if payment is not made within the 10-day period, no discount
is permitted and the total invoice amount is due within 30 days from the
purchase, after which the debt is past due. To illustrate, assume a $1,000 sale
with these terms. If the customer paid within 10 days, $990 would have been
paid. Thus, a sales discount of $10 was granted for early payment.
6-1
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
5.
A sales allowance is an amount allowed to a customer for unsatisfactory
merchandise or for an overcharge in the sales price. A sales allowance reduces
the amount the customer must pay, or if already paid, a cash refund is required.
Sales allowances may occur whether the sale was for cash or credit. In contrast,
a sales discount is a cash discount given to a customer who has bought on
credit, with payment made within the specified period of time. (Refer to
explanation of sales discount in Question 4, above.)
6.
An account receivable is an amount owed to the business on open account by a
trade customer for merchandise or services purchased. In contrast, a note
receivable is a short-term obligation owed to the company based on a formal
written document.
7.
In conformity with the matching principle, the allowance method records bad debt
expense in the same period in which the credit was granted and the sale was
made.
8.
Using the allowance method, bad debt expense is recognized in the period in
which the sale related to the uncollectible account was recorded.
9.
The write-off of bad debts using the allowance method decreases the asset
accounts receivable and the contra-asset allowance for doubtful accounts by the
same amount. As a consequence, (a) net income is unaffected and (b) accounts
receivable, net, is unaffected.
10.
An increase in the receivables turnover ratio generally indicates faster collection
of receivables. A higher receivables turnover ratio reflects an increase in the
number of times average trade receivables were recorded and collected during
the period.
11.
Cash includes money and any instrument, such as a check, money order, or
bank draft, which banks normally will accept for deposit and immediate credit to
the depositor’s account. Cash equivalents are short-term investments with
original maturities of three months or less that are readily convertible to cash,
and whose value is unlikely to change (e.g., bank certificates of deposit and
treasury bills).
12.
The primary characteristics of an internal control system for cash are: (a)
separation of the functions of cash receiving from cash payments, (b) separation
of accounting for cash receiving and cash paying, (c) separation of the physical
handling of cash from the accounting function, (d) deposit all cash receipts daily
and make all cash payments by check, (e) require separate approval of all
checks and electronic funds transfers, and (f) require monthly reconciliation of
bank accounts.
6-2
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
13.
Cash-handling and cash-recording activities should be separated to remove the
opportunity for theft of cash and a cover-up by altering the records. This
separation is accomplished best by assigning the responsibility for cash handling
to individuals other than those who have the responsibility for record-keeping. In
fact, it usually is desirable that these two functions be performed in different
departments of the business.
14.
The purposes of a bank reconciliation are (a) to determine the “true” cash
balance and (b) to provide data to adjust the Cash account to that balance. A
bank reconciliation involves reconciling the balance in the Cash account at the
end of the period with the balance shown on the bank statement (which is not the
“true” cash balance) at the end of that same period. Seldom will these two
balances be identical because of such items as deposits in transit; that is,
deposits that have been made by the company but not yet entered on the bank
statement. Another cause of the difference is outstanding checks, that is, checks
that have been written and recorded in the accounts of the company that have
not cleared the bank (and thus have not been deducted from the bank's balance).
Usually the reconciliation of the two balances, per books against per bank,
requires recording of one or more items that are reflected on the bank statement
but have not been recorded in the accounting records of the company. An
example is the usual bank service charge.
15.
The total amount of cash that should be reported on the balance sheet is the
sum of (a) the true cash balances in all checking accounts (verified by a bank
reconciliation of each checking account), (b) cash held in all “cash on hand” (or
“petty cash”) funds, and (c) any cash physically on hand (any cash not
transferred to a bank for deposit—usually cash held for change purposes).
16.
(Based on Supplement A) Under the gross method of recording sales discounts,
the amount of sales discount taken is recorded at the time the collection of the
account is recorded.
ANSWERS TO MULTIPLE CHOICE
1. b)
6. c)
2. b)
7. d)
3. b)
8. b)
6-3
4. d)
9. d)
5. c)
10. c)
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
5
3
10
4
10
5
10
6
10
7
10
8
5
9
10
Exercises
No.
Time
1
15
2
15
3
15
4
20
5
20
6
30
7
30
8
15
9
15
10
15
11
15
12
15
13
20
14
20
15
20
16
20
17
30
18
30
19
15
20
15
21
20
22
20
23
20
24
30
25
30
Problems
No.
Time
1
25
2
35
3
20
4
35
5
50
6
40
7
45
8
45
9
45
Alternate
Problems
No.
Time
1
35
2
35
3
50
4
40
5
45
Cases and
Projects
No.
Time
1
25
2
30
3
35
4
20
5
35
6
45
7
*
* Due to the nature of these cases and projects, it is very difficult to estimate the amount
of time students will need to complete the assignment. As with any open-ended project,
it is possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time to discussing research strategies. When we want the
students to focus on a real accounting issue, we offer suggestions about possible
companies or industries.
6-4
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
MINI-EXERCISES
M6–1.
Transaction
(a) Sale of inventory to a business
x
customer on open account
(b) Computer sold by mail order
x
company on a credit card
(c) Airline tickets sold by an airline on a
credit card
Point A
Point B
Shipment
Collection of account
Shipment
Delivery
Point of sale
x Completion of flight
M6–2.
If the buyer pays within the discount period, the income statement will report $8,415 as
net sales ($8,500 x 0.99).
M6–3.
Credit card sales (R)
Less: Credit card discount (XR)
Net credit card sales
$9,400
282
$9,118
Sales on account (R)
Less: Sales returns (XR)
Less: Sales discounts (1/2 x $10,000 x 2%) (XR)
Net sales on account
Net sales (reported on income statement)
$10,500
500
10,000
100
9,900
$19,018
M6–4.
Gross Profit Percentage = Gross Profit = $45,000 – $28,000 = $17,000 = 0.378
Net Sales
$45,000
$45,000
The gross profit percentage is 37.8%. This ratio measures the excess of sales prices
over the costs to purchase or produce the goods or services sold as a percentage. It
indicates a company’s ability to charge premium prices and produce goods and services
at lower cost.
6-5
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
M6–5.
(a)
(b)
Allowance for doubtful accounts (–XA, +A) .............. 19,000
Accounts receivable (–A) ..................................
To write off specific bad debts.
19,000
Bad debt expense (+E, –SE)..................................... 13,000
Allowance for doubtful accounts (+XA, –A) .......
To record estimated bad debt expense.
13,000
M6–6.
Assets
Bad debt expense –17,000
(a) Allowance for doubtful
accounts
–17,000
(b) Allowance for doubtful
accounts
Accounts receivable
Stockholders’ Equity
Liabilities
+8,000
–8,000
M6–7.
+
+
–
(a) Granted credit with shorter payment deadlines.
(b) Increased effectiveness of collection methods.
(c) Granted credit to less creditworthy customers.
M6–8.
Reconciling Item
(a) Outstanding checks
(b) Bank service charge
(c) Deposit in transit
Company’s
Bank
Books
Statement
–
–
+
M6–9. (Based on Supplement A)
An $8,000 credit sale with terms, 2/10, n/30, should be recorded as follows:
Accounts receivable (+A)............................................. 8,000
Sales revenue (+R, +SE) .................................
8,000
This entry records the sale at the gross amount. If the customer does pay within the
discount period, only $7,840 must be paid, in which case the entry for payment would
be as follows:
Cash (+A) ................................................................... 7,840
Sales discounts (+XR, –R, –SE) .................................
160
Accounts receivable (–A) .................................
8,000
6-6
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
EXERCISES
E6–1.
Sales revenue ($850 + $700 + $450) ........................................
Less: Sales discount ($850 collected from S. Green x 2%) ......
Net sales ...................................................................................
$2,000
17
$1,983
Sales revenue ($3,000 + $9,000 +$4,000) ................................
Less: Sales discounts ($9,000 collected from S x 3%) .............
Less: Credit card discounts ($3,000 from R x 2%) ...................
Net sales ...................................................................................
$16,000
270
60
$15,670
Sales revenue ($5,500 + $400 + $9,000) ..................................
Less: Sales returns and allowances (1/10 x $9,000 from D) .......
Less: Sales discounts (9/10 x $9,000 from D x 3%) ....................
Less: Credit card discounts ($400 from C x 2%) .......................
 Net sales .........................................................................
$14,900
900
243
8
$13,749
E6–2.
E6–3.
E6–4.
Transaction
July 12
July 15
July 20
July 21
Net Sales
+ 297
+ 5,000
– 150
– 1,000
Cost of
Goods Sold
+ 175
+ 2,500
NE
– 600
Gross Profit
+ 122
+ 2,500
– 150
– 400
E6–5.
Req. 1
(Amount saved ÷ Amount paid) = Interest rate for 40 days.
(3% ÷ 97%) = 3.09% for 40 days.
Interest rate for 40 days x (365 days ÷ 40 days) = Annual interest rate
3.09% x (365 ÷ 40 days) = 28.22%
Req. 2
Yes, because the 15% rate charged by the bank is less than the 28.22%
rate implicit in the discount. The company will earn 13.22% by doing so (28.22%
– 15%).
6-7
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–6.
Req. 1
WOLVERINE WORLD WIDE INC.
Income Statement
For the Year Ended
(dollars in thousands)
Sales of merchandise
Cost of products sold
Gross profit
Selling and administrative expense
Income from operations
Other income (expense)
Interest expense
Other income
Pretax income
Income taxes
Net Income
$1,220,568
734,547
486,021
345,183
140,838
(2,850)
839
138,827
44,763
$ 94,064
Earnings per share ($94,064 ÷ 48,888 shares)
$1.92
Req. 2
Gross profit margin: $1,220,568 – $734,547 = $486,021.
Gross profit percentage ratio: $486,021 ÷ $1,220,568 = .398 (or 39.8%).
Gross margin or gross profit in dollars is the difference between the sales prices and the
costs of purchasing or manufacturing all goods that were sold during the period
(sometimes called the markup); that is, net revenue minus only one of the expenses-cost of goods sold. The gross profit ratio is the amount of each net sales dollar that was
gross profit during the period. For this company, the rate was 39.8%, which means that
$.398 of each net sales dollar was gross profit (alternatively, 39.8% of each sales dollar
was gross profit for the period).
Wolverine World Wide's gross profit percentage was below Deckers’s current (2008)
percentage of 44.3%. Deckers’s shoes have a reputation as a rugged product as well
as a premium "high fashion" product. This has allowed it to maintain higher prices and
higher gross margins. In marketing this is called the value of brand equity.
6-8
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–7.
Req. 1
SLATE, INCORPORATED
Income Statement
For the Year Ended December 31, 2012
Amount
Gross sales ($233,000 + $40,000) ....................
Less sales returns and allowances ...................
Net sales revenue .............................................
Cost of goods sold.............................................
Gross profit .......................................................
Operating expenses:
Administrative expense ...................................
Selling expense ...............................................
Bad debt expense ($40,000 x 3%) ..................
Income from operations.....................................
Income tax expense ($50,600 x 30%) .............
Net income ........................................................
$273,000
8,000
265,000
146,000
119,000
$20,000
47,200
1,200
Earnings per share ($35,420 ÷ 4,500 shares)
68,400
50,600
15,180
$ 35,420
$7.87
Req. 2
Gross profit margin: $265,000 – $146,000 = $119,000.
Gross profit percentage ratio: $119,000 ÷ $265,000 = .45 (or 45%).
Gross margin or gross profit in dollars is the difference between the sales prices and the
costs of purchasing or manufacturing all goods that were sold during the period
(sometimes called the markup); that is, net revenue minus only one of the expenses-cost of goods sold. The gross profit ratio is the amount of each net sales dollar that was
gross profit during the period. For this company, the rate was 45%, which means that
$.45 of each net sales dollar was gross profit (alternatively, 45% of each sales dollar
was gross profit for the period).
6-9
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–8.
(a)
(b)
E6–9.
(a)
(b)
Bad debt expense (+E, –SE) ($800,000 x 0.01) ........ 8,000
Allowance for doubtful accounts (+XA, –A) .......
To record estimated bad debt expense.
8,000
Allowance for doubtful accounts (–XA, +A) .............. 2,500
Accounts receivable (–A) ..................................
To write off a specific bad debt.
2,500
Bad debt expense (+E, –SE) ($790,000 x 0.02) ........ 15,800
Allowance for doubtful accounts (+XA, –A) .......
To record estimated bad debt expense.
15,800
Allowance for doubtful accounts (–XA, +A) ..............
Accounts receivable (–A) ..................................
To write off a specific bad debt.
360
360
E6–10.
Assets
Liabilities
Bad debt expense –15,800
(a) Allowance for doubtful
accounts
–15,800
(b) Allowance for doubtful
accounts
Accounts receivable
E6–11.
Req. 1
(a)
(b)
Stockholders’ Equity
+360
–360
Bad debt expense (+E, –SE) ($680,000 x 0.035) ...... 23,800
Allowance for doubtful accounts (+XA, –A) .......
To record estimated bad debt expense.
23,800
Allowance for doubtful accounts (–XA, +A) .............. 2,800
Accounts receivable (–A) ..................................
To write off a specific bad debt.
2,800
Req. 2
Transaction
a.
b.
Net Sales
NE
NE
Gross Profit
NE
NE
6-10
Income from
Operations
– 23,800
NE
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–12.
Estimated
Estimated
percentage
amount
Aged accounts receivable
uncollectible
uncollectible
Not yet due
$16,000 x
2%
=
$ 320
Up to 120 days past due
5,500 x
14%
=
770
Over 120 days past due
2,500 x
35%
=
875
Estimated balance in Allowance for Doubtful Accounts
1,965
Current balance in Allowance for Doubtful Accounts
900
Bad Debt Expense for the year
$1,065
E6–13.
Req. 1
December 31, 2011-Adjusting entry:
Bad debt expense (+E, –SE) ....................................... 4,180
Allowance for doubtful accounts (+XA, –A).......
4,180
To adjust for estimated bad debt expense for 2011 computed as follows:
Estimated
Estimated
percentage
amount
Aged accounts receivable
uncollectible
uncollectible
Not yet due
$50,000 x
3%
=
$ 1,500
Up to 180 days past due
14,000 x
12%
=
1,680
Over 180 days past due
4,000 x
30%
=
1,200
Estimated balance in Allowance for Doubtful Accounts
4,380
Current balance in Allowance for Doubtful Accounts
200
Bad Debt Expense for the year
$4,180
Req. 2
Balance sheet:
Accounts receivable ($50,000 + $14,000 + $4,000)
Less allowance for doubtful accounts .....................
Accounts receivable, net of allowance for
doubtful accounts .........................................
6-11
$68,000
4,380
$63,620
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–14.
Req. 1
December 31, 2012-Adjusting entry:
Bad debt expense (+E, –SE) ....................................... 20,225
Allowance for doubtful accounts (+XA, –A).......
20,225
To adjust for estimated bad debt expense for 2012 computed as follows:
Estimated
Estimated
percentage
amount
Aged accounts receivable
uncollectible
uncollectible
Not yet due
$275,000 x
3.5%
=
$9,625
Up to 120 days past due
50,000 x
10%
=
5,000
Over 120 days past due
20,000 x
30%
=
6,000
Estimated balance in Allowance for Doubtful Accounts
20,625
Current balance in Allowance for Doubtful Accounts
400
Bad Debt Expense for the year
$20,225
Req. 2
Balance sheet:
Accounts receivable ($275,000 + $50,000 + $20,000)
Less allowance for doubtful accounts .....................
Accounts receivable, net of allowance for
doubtful accounts .........................................
$345,000
20,625
$324,375
E6–15.
1.
2.
Bad debt expense (+E, –SE) ................................................. 271
Allowance for doubtful accounts (+XA, –A)..................
To record estimated bad debt expense.
271
Allowance for doubtful accounts (–XA, +A) ............................ 153
Accounts receivable (–A) .............................................
To write off specific bad debts.
153
It would have no effect because the asset “Accounts receivable” and contraasset “Allowance for doubtful accounts” would both decline by Euro 10 million.
Neither “Receivables, net” nor “Net income” would be affected.
6-12
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–16.
Req. 1
Allowance for Doubtful Accounts
Write-offs
52
117
88
Beg. balance
Bad debt exp.
153
End. balance
Beg. Balance + Bad debt exp. – Write-offs = End. Balance
Beg. Balance + Bad debt exp. – End. Balance = Write-offs
117 + 88 – 153 = 52
Bad debt expense increases (is credited to) the allowance. Since we are given
the beginning and ending balances in the allowance, we can solve for write-offs,
which decrease (are debited to) the allowance.
Req. 2
Accounts Receivable (Gross)
Beg. balance*
Net sales
11,455
60,420
End. balance **
13,742
52
58,081
Write-offs
Cash collections
* 11,338 + 117
** 13,589 + 153
Beg. balance + Net sales – Write-offs – Cash collections = End. Balance
Beg. balance + Net sales – Write-offs – End. Balance = Cash collections
11,455 + 60,420 – 52 – 13,742 = 58,081
Accounts receivable gross is increased by recording credit sales and decreased
by recording cash collections and write-offs of bad debts. Thus, we can solve for
cash collections as the missing value.
6-13
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–17.
Req. 1
The allowance for doubtful accounts is increased (credited) when bad debt expense is
recorded and decreased (debited) when uncollectible accounts are written off. This case
gives the beginning and ending balances of the allowance account and the amount of
uncollectible accounts that were written off. Therefore, the amount of bad debt expense
(in thousands) can be computed as follows:
Allowance for Doubtful Accounts
Write-offs
811,000
570,000
1,251,000
Beg. balance
Bad debt exp.
1,010,000
End. balance
Beg. Balance + Bad debt exp. – Write-offs = End. Balance
End. Balance – Beg. Balance + Write-offs = Bad debt exp.
1,010,000 – 570,000 + 811,000 = 1,251,000
Req. 2
Working capital is unaffected by the write-off of an uncollectible account when the
allowance method is used. The asset account (accounts receivable) and the contraasset account (allowance for doubtful accounts) are both reduced by the same amount;
therefore, the book value of net accounts receivable is unchanged.
Working capital is decreased when bad debt expense is recorded because the contraasset account (allowance for doubtful accounts) is increased. From requirement (1), we
know that net accounts receivable was reduced by $1,251,000 when bad debt expense
was recorded in year 2, reducing working capital by $1,251,000.
Note that income before taxes was reduced by the amount of bad debt expense that
was recorded, therefore tax expense and tax payable will decrease. The decrease in
tax payable caused working capital to increase; therefore, the net decrease was
$1,251,000 – ($1,251,000 x 30%) = $875,700.
Req. 3
The entry to record the write-off of an uncollectible account did not affect any income
statement accounts; therefore, net income is unaffected by the $811,000 write-off in
year 2.
The recording of bad debt expense reduced income before taxes in year 2 by
$1,251,000 and reduced tax expense by $375,300 (i.e., $1,251,000 x 30%). Therefore,
year 2 net income was reduced by $875,700 (as computed in Req. 2).
6-14
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–18.
Req. 1
Dec. 31, 2012
Allowance for doubtful accounts (–XA, +A) ...............
Accounts receivable (J. Doe) (–A) ..................
To write off an account receivable determined to
be uncollectible.
Dec. 31, 2012
Bad debt expense (+E, –SE) ....................................
Allowance for doubtful accounts (+XA, –A).....
Adjusting entry--estimated loss on uncollectible
accounts; based on credit sales ($75,000 x 1.5%
= $1,125).
1,700
1,700
1,125
1,125
Req. 2
Income statement:
Operating expenses:
Bad debt expense ........................................................
Balance sheet:
Current assets
Accounts receivable ($16,000 + $75,000
- $60,000 - $1,700) .....................................
Less: Allowance for doubtful accounts
($900 - $1,700 + $1,125) ............................
$1,125
$29,300
325
$28,975
Req. 3
The 1.5% rate on credit sales may be too low because it resulted in bad debt expense only
two-thirds the amount of receivables written off ($1,700) during the year. However, if the
uncollectible account receivable written off during 2012 is not indicative of average
uncollectibles written off over a period of time, the 1.5% rate may be appropriate. There is
not sufficient historical data to make a definitive decision.
6-15
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–19.
Req. 1
Dec. 31, 2011
Allowance for doubtful accounts (–XA, +A) ...............
Accounts receivable (Toby’s Gift Shop) (–A) ..
To write off an account receivable determined to
be uncollectible.
Dec. 31, 2011
Bad debt expense (+E, –SE) ....................................
Allowance for doubtful accounts (+XA, –A).....
Adjusting entry--estimated loss on uncollectible
accounts; based on credit sales ($25,000 x 2.5%
= $625).
700
700
625
625
Req. 2
Income statement:
Operating expenses:
Bad debt expense ........................................................
Balance sheet:
Current assets
Accounts receivable ($4,000 + $25,000
- $19,000 - $700) ........................................
Less: Allowance for doubtful accounts
($300 - $700 + $625) ..................................
$625
$9,300
225
$9,075
Req. 3
The 2.5% rate on credit sales appears reasonable because it approximates the amount of
receivables written off ($700) during the year. However, if the uncollectible account
receivable written off during 2011 is not indicative of average uncollectibles written off over
a period of time, the 2.5% rate may not be appropriate. There is not sufficient historical
data to make a definitive decision.
6-16
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–20.
Req. 1
Receivables turnover =
Net Sales
= $35,497,000 = 9.16 times
Average Net Trade
$3,875,000*
Accounts Receivable
Average days sales
in receivables
365
= 365 = 39.8 days
Receivables Turnover
9.16
=
* ($4,359,000 + $3,391,000) ÷ 2
Req. 2
The receivables turnover ratio reflects how many times average trade receivables were
recorded and collected during the period. The average days sales in receivables
indicates the average time it takes a customer to pay its account.
E6–21.
Req. 1
Receivables turnover =
Net Sales
= $61,101,000 = 11.43 times
Average Net Trade
$5,346,000*
Accounts Receivable
Average days sales
in receivables
365
= 365 = 31.9 days
Receivables Turnover
11.43
=
* ($5,961,000 + $4,731,000) ÷ 2
Req. 2
The receivables turnover ratio reflects how many times average trade receivables were
recorded and collected during the period. The average days sales in receivables
indicates the average time it takes a customer to pay its account.
6-17
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–22.
Req. 1
The change in the accounts receivable balance ($48,066 – 63,403 = –$15,337) would
increase cash flow from operations by $15,337 thousand. This happens because the
Company is collecting cash faster than it is recording credit sales revenue.
Req. 2
(a) Declining sales revenue leads to lower accounts receivable because fewer new
credit sales are available to replace the receivables that are being collected.
(b) Cash collections from the prior period's higher credit sales are greater than the new
credit sales revenue. Note that in the next period, cash collections will also decline.
E6–23.
Req. 1
JACKSON COMPANY
Bank Reconciliation, June 30, 2011
Company's Books
Ending balance per Cash
account………………………
Additions:
None
Deductions:
Bank service charge……
Correct cash balance………
Bank Statement
Ending balance per bank
statement………………
Additions:
Deposit in transit…………
$6,000
$6,060
1,900*
7,960
Deductions:
Outstanding checks…
Correct cash balance……
40
$5,960
2,000
$5,960
*$18,100 – $16,200 = $1,900.
Req. 2
Bank service charge expense (+E, –SE) ...................................
Cash (–A)........................................................................
To record deduction from bank account for service charges.
40
40
Req. 3
The correct cash balance per the bank reconciliation ($6,000 – $40), $5,960
Req. 4
Balance sheet (June 30, 2011):
Current assets:
Cash ...................................................................................
6-18
$5,960
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–24.
Req. 1
BENNETT COMPANY
Bank Reconciliation, September 30, 2011
Company's Books
Ending balance per Cash
account...........................
Bank Statement
Ending balance per bank
statement ........................
$5,700
Additions:
None
Additions:
Deposit in transit* .........
Deductions:
Bank service charges ...
NSF check –
Betty Brown .............
Deductions:
$5,770
1,200*
6,970
$ 60
170
Correct cash balance .......
230
Outstanding checks
($28,900 – $27,400) ....
1,500
$5,470
Correct cash balance .......
$5,470
*$28,100 - $26,900 = $1,200.
Req. 2
(1)
(2)
Bank service charge expense (+E, –SE) ................................
Cash (–A).....................................................................
To record bank service charges deducted from bank balance.
60
Accounts receivable (Betty Brown) (+A) .................................
Cash (–A).....................................................................
To record customer check returned due to insufficient funds.
170
60
170
Req. 3
Same as the correct balance on the reconciliation, $5,470.
Req. 4
Balance Sheet (September 30, 2011):
Current Assets:
Cash .......................................................................................... $5,470
6-19
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
E6–25 (Based on Supplement A)
November 20, 2010
Cash (+A) ....................................................................
Credit card discount (+XR, –R, –SE) ...........................
Sales revenue (+R, +SE) ..................................
To record credit card sale.
November 25, 2010:
Accounts receivable (Customer C) (+A) ......................
Sales revenue (+R, +SE) ..................................
To record a credit sale.
November 28, 2010:
Accounts receivable (Customer D) (+A) ......................
Sales revenue (+R, +SE) ..................................
To record a credit sale.
441
9
450
2,800
2,800
7,200
7,200
November 30, 2010:
Sales returns and allowances (+XR, –R, –SE) ............
600
Accounts receivable (Customer D) (–A)............
To record return of defective goods, $7,200 x 1/12 = $600.
December 6, 2010:
Cash (+A) ....................................................................
Sales discounts (+XR, –R, –SE) ..................................
Accounts receivable (Customer D) (–A)............
To record collection within the discount period,
98% × ($7,200 – $600) = $6,468
December 30, 2010:
Cash (+A) ....................................................................
Accounts receivable (Customer C) (–A)............
To record collection after the discount period.
6,468
132
6,600
2,800
Sales revenue ($450 + $2,800 + $7,200) ..................................
Less: Sales returns and allowances ($7,200 x 1/12) .................
Less: Sales discounts (2% × ($7,200 – $600)) ..........................
Less: Credit card discounts ($450 x 2%) ...................................
Net sales ...................................................................................
6-20
600
2,800
$10,450
600
132
9
$9,709
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
PROBLEMS
P6–1.
Case A
Because Wendy's collects cash when the coupon books are sold, cash collection is not
an issue in this case. In order to determine if the revenue has been earned, the student
must be careful in analyzing what Wendy's actually sold. Students who focus on the
sale of the coupon book often conclude that the earning process is complete with the
delivery of the book to the customer. In reality, Wendy's has a significant additional
service to perform; it has to serve a meal. The correct point for revenue recognition in
this case is when the customer uses the coupon or when the coupon expires and
Wendy's has no further obligation.
Case B
In this case there is an extremely low down payment and some reason to believe that
Uptown Builders may default on the contract because of prior actions. If students
believe that Russell Land Development could sue and collect on the contract, they will
probably argue for revenue recognition. Given the risk of cash collection, most students
will argue that revenue should be recognized as cash is collected. The text does not
discuss FASB #66 (ASC 360-20-40), but the instructor may want to mention during the
discussion that there is authoritative guidance concerning minimum down payments
before revenue can be recorded on a land sale.
Case C
While warranty work on refrigerators can involve significant amounts of effort and
money, companies are permitted to record revenue at the point of sale. The text does
not discuss this specific issue but the matching concept is mentioned in the context of
revenue recognition. This is an excellent opportunity to mention the need to accrue
estimated warranty expense at the time that sales revenue is recorded. Some students
are surprised to see that costs that will be incurred in the future can be recorded as an
expense in the current accounting period.
6-21
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
P6–2.
Req. 1
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
(m)
Total
Sales
Revenue
+234,000
+11,500
+25,000
NE
+26,000
NE
NE
NE
+17,500
NE
NE
NE
NE
+$314,000
Sales Discounts
(taken)
NE
NE
NE
NE
NE
+220
+2,000*
+500
NE
–70
NE
NE
NE
+$2,650
Sales Returns
and Allowances
NE
NE
NE
+500
NE
NE
NE
NE
NE
+3,500
NE
NE
NE
+$4,000
Bad Debt
Expense
NE
NE
NE
NE
NE
NE
NE
NE
NE
NE
NE
NE
+1,140**
+$1,140
*$98,000 ÷ (1 ─ .02) = $100,000 gross sales; $100,000 x .02 = $2,000
**Credit sales ($11,500 + $25,000 + $26,000 + $17,500) . $80,000
Less: Sales returns ($500 + $3,500) .............................
4,000
Net sales revenue...........................................................
76,000
Estimated bad debt rate ................................................. x
1.5%
Bad debt expense ...........................................................
$1,140
Req. 2
Income statement:
Sales revenue ........................................................... $314,000
Less: Sales returns and allowances ..............
4,000
Sales discounts....................................
2,650
Net sales revenue .....................................................
Operating expenses
Bad debt expense ...................................................
6-22
$307,350
1,140
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
P6–3.
Income Statement Items
Gross sales revenue
Sales returns and allowances
Net sales revenue
Cost of goods sold
Gross profit
Operating expenses
Pretax income
Income tax expense (20%)
Income before extraordinary items
Extraordinary gain (loss)
Less: Income tax (20%)
Net income
EPS (10,000 shares)
Case A
a.
c.
b.
d.
e.
f.
g.
h.
i.
Note = Computations in order
a.
b.
c.
d.
e.
f.
g.
h.
i.
CASE A
$259,000 – $20,000 = $239,000
$239,000 x .30 = $71,700
$239,000 – $71,700 = $167,300
$71,700 – $22,000 = $49,700
$22,000 x .20 = $4,400
$22,000 – $4,400 = $17,600
$2,000 x .20 = $400
$17,600 - $2,000 + $400 = $16,000
$16,000 ÷ 10,000 = $1.60
a.
b.
c.
d.
e.
f.
g.
h.
i.
CASE B
$2.54 x 10,000 shares = $25,400
$10,000 x .20 = $2,000
$25,400 - $10,000 + $2,000 = $17,400
$17,400 ÷ .80 = $21,750
$21,750 - $17,400 = $4,350
$21,750 + $15,600 = $37,350
$37,350 ÷ (1 - .70) = $124,500
$124,500 - $37,350 = $87,150
$165,000 - $124,500 = $40,500
6-23
$259,000
20,000
239,000
167,300
(30%) 71,700
49,700
22,000
4,400
17,600
(2,000)
400
$16,000
$1.60
Case B
i.
g.
h.
f.
d.
e.
c.
b.
a.
$165,000
40,500
124,500
(70%) 87,150
37,350
15,600
21,750
4,350
17,400
10,000
(2,000)
$25,400
$2.54
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
P6–4.
1.
2.
Bad debt expense (+E, –SE) .....................................................
Allowance for doubtful accounts (+XA, –A).....................
End-of-period bad debt expense estimate.
7
Allowance for doubtful accounts (–XA, +A) ...............................
Accounts receivable (–A) ................................................
Write-off of bad debts.
2
Year 2 ........................................ $145
Year 1 ........................................ $89
+ $0
+ $57
Allowance for DA Year 2
Write-offs
78
145
0
67
Beg. bal.
Bad debt exp.
7
2
– $78 = $67
– $1 = $145
Allowance for DA Year 1
Write-offs 1
End. bal.
89
57
145
Beg. bal
Bad debt exp.
Ending Bal.
The solution involves solving for the missing value in the T-account.
6-24
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
P6–5.
Req. 1
Customer
B. Brown…………..
D. Donalds………..
N. Napier………….
S. Strothers………
T. Thomas………...
Totals……………
Aging Analysis of Accounts Receivable
(b) Up to One (c) More Than
Total
(a) Not Yet
Year Past
One Year
Receivables
Due
Due
Past Due
$ 5,200
$5,200
8,000
$ 8,000
7,000
$ 7,000
22,500
2,000
20,500
4,000
4,000
$46,700
$13,000
$28,500
$5,200
Req. 2
a.
b.
c.
Aging Schedule--Estimated Amounts Uncollectible
Amount of
Estimated
Estimated
Age
Receivables Uncollectible
Amount
Percentage Uncollectible
Not yet due……………………
$13,000
2%
$ 260
Up to one year past due…….
28,500
7%
1,995
Over one year past due……..
5,200
30%
1,560
Estimated ending balance in
3,815
Allowance for Doubtful Accounts
Balance before adjustment
920
Bad Debt Expense for the year
$2,895
Req. 3
Bad debt expense (+E, –SE) ..........................................
Allowance for doubtful accounts (+XA, –A) ...........
2,895
2,895
Req. 4
Income statement:
Operating expenses
Bad debt expense ..........................................................
Balance sheet:
Current Assets:
Accounts receivable .......................................................
Less: Allowance for doubtful accounts ..........................
Accounts receivable (net) ..............................................
6-25
$2,895
$46,700
3,815
$42,885
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
P6–6.
Req. 1
TUNGSTEN COMPANY, INC.
Income Statement
For the Year Ended December 31, 2011
Net sales revenue ($147,100  $5,600  $6,400) ................
Cost of goods sold................................................................
Gross profit on sales ............................................................
Operating expenses:
Selling expense ............................................................ $14,100
Administrative expense ................................................ 15,400
Bad debt expense ........................................................
1,600
Income from operations........................................................
Income tax expense .....................................................
Net income ........................................................................
$135,100
78,400
56,700
31,100
25,600
7,680
$ 17,920
Earnings per share on capital stock outstanding
($17,920 ÷ 10,000 shares) ................................................................
$1.79
Req. 2
Gross Profit Percentage =
Gross Profit
Net Sales
=
$56,700 = 0.420 (42.0%)
$135,100
The gross profit percentage measures the excess of sales prices over the costs to
purchase or produce the goods or services sold as a percentage.
Receivables =
Turnover
Net Sales
Average Net Trade
Accounts Receivable
=
$135,100 = 8.89
$15,200*
* ($16,000 + $14,400) ÷ 2
The receivables turnover ratio measures the effectiveness of credit-granting and
collection activities.
6-26
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
P6–7.
Req. 1
WOOD COMPANY
Bank Reconciliation, April 30, 2011
Company's Books
Bank Statement
Ending balance per Cash
account .........................
$23,900
Additions:
Interest collected ...............
Deductions:
NSF—A.B. Wright ..............
Bank charges ....................
Correct cash balance .........
1,180
25,080
160
50
210
$24,870
Ending balance per bank
statement .....................
Additions:
Deposits in transit* .............
$23,570
5,400
28,970
Deductions:
Outstanding checks ............
4,100
Correct cash balance .........
$24,870
*$41,500 - $36,100 = $5,400.
Req. 2
(1)
Cash (+A) .......................................................................... 1,180
Interest revenue (+R, +SE) .....................................
Interest collected.
(2)
(3)
Accounts receivable (A. B. Wright) (+A) ............................
Cash (–A)................................................................
Customer's check returned, insufficient funds.
160
Bank service charge expense (+E, –SE) ...........................
Cash (–A)................................................................
Bank service charges deducted from bank statement.
50
1,180
160
50
These entries are necessary because of the changes to the regular Cash account that
have not yet been recorded by the company. The bank already has recorded them in its
accounts. The Cash account (and the other accounts in the entries) must be brought up
to date for financial statement purposes.
Req. 3
Balance in regular Cash account ......................................................
$24,870
Req. 4
Balance Sheet (April 30, 2011):
Current Assets:
Cash ............................................................................
$24,870
6-27
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
P6–8.
Req. 1
Comparison of deposits listed in the Cash account with deposits listed on the bank
statement reveals a $5,200 deposit in transit on August 31.
Req. 2
Comparison of the checks cleared on the bank statement with (a) outstanding checks
from July, and (b) checks written in August reveals two outstanding checks at the end of
August ($280 + $510 = $790).
Req. 3
ALLISON COMPANY
Bank Reconciliation, August 31, 2011
Company's Books
Ending balance per Cash
account .........................
Additions:
Interest collected ...............
Deductions:
Bank service charges ...........................
Correct cash balance ...........................
$20,370
2,350
22,720
120
$22,600
Bank Statement
Ending balance per bank
statement .....................
Additions:
Deposits in transit ..............
Deductions:
Outstanding checks ............
Correct cash balance .........
Req. 4
(1)
Cash (+A) .......................................................................... 2,350
Interest revenue (+R, +SE) .....................................
Interest collected.
(2)
Bank service charge expense (+E, –SE) ..........................
Cash (–A)................................................................
Service charges deducted from bank balance.
$18,190
5,200
23,390
790
$22,600
2,350
120
120
These entries are necessary because of the changes in the regular Cash account that
have not yet been recorded by the company. The bank already has recorded them in its
accounts. The Cash account (and the other accounts in the entries) must be brought up
to date for financial statement purposes.
Req. 5
Current Assets:
Cash ............................................................................................
6-28
$22,600
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
P6–9. (Based on Supplement A)
Req. 1
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
Cash (+A) ..................................................................
Sales revenue (+R, +SE) ................................
Cash sales for 2011.
234,000
Accounts receivable (R. Smith) (+A)..........................
Sales revenue (+R, +SE) ................................
Credit sale, $11,500.
11,500
Accounts receivable (K. Miller) (+A) ..........................
Sales revenue (+R, +SE) ................................
Credit sale, $25,000.
25,000
Sales returns and allowances (+XR, –R, –SE) ..........
Accounts receivable (R. Smith) (–A) ...............
Sale return, 1 unit @ $500.
500
Accounts receivable (B. Sears) (+A) .........................
Sales revenue (+R, +SE) ................................
Credit sale, $26,000.
26,000
Cash (+A) ..................................................................
Sales discounts (+XR, –R, –SE) ................................
Accounts receivable (R. Smith) (–A) ...............
Paid account in full within discount period,
($11,500 - $500) x (1 - .02) = $10,780.
10,780
220
Cash (+A) ..................................................................
Sales discounts (+XR, –R, –SE) ................................
Accounts receivable (prior year) (–A) .............
Collected receivables of prior year, all within
discount periods $98,000 ÷ .98 = $100,000.
98,000
2,000
Cash (+A) ..................................................................
Sales discounts (+XR, –R, –SE) ................................
Accounts receivable (K. Miller) (–A) ................
Collected receivable within the discount period
$25,000 x .98 = $24,500.
24,500
500
Accounts receivable (R. Roy) (+A) ............................
Sales revenue (+R, +SE) ................................
Credit sale.
17,500
6-29
234,000
11,500
25,000
500
26,000
11,000
100,000
25,000
17,500
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
P6–9. (continued)
(j)
(k)
(l)
Sales returns and allowances (+XR, –R, –SE) ..........
Cash (–A)........................................................
Sales discounts (–XR, +R, +SE) .....................
Sales return, 7 units @ $500 less sales discounts taken
= $3,500 x .98.
3,500
Cash (+A) ..................................................................
Accounts receivable (–A) ................................
Collected receivable of prior year, after the discount
period.
6,000
Allowance for doubtful accounts (–XA, +A) ...............
Accounts receivable (2010 account) (–A) .......
Wrote off uncollectible account from 2010.
3,000
3,430
70
6,000
Bad debt expense (+E, –SE) .....................................
1,140
Allowance for doubtful accounts (+XA, –A).....
To adjust for estimated bad debt expense
Credit sales ($11,500 + $25,000 + $26,000 + $17,500) .. $80,000
Less: Sales returns ($500 + $3,500) .............................
4,000
Net sales revenue...........................................................
76,000
Estimated bad debt rate ................................................. x
1.5%
Bad debt expense...................................................
$1,140
.
3,000
(m)
1,140
Req. 2
Income statement:
Sales revenue ($234,000 + $11,500 + $25,000
+ $26,000 + $17,500) ..................................... $314,000
Less: Sales returns and
allowances ($3,500 + $500) ...............
4,000
Sales discounts ($220 + $2,000
+ $500 – $70) ....................................
2,650
Net sales revenue .............................................................
Operating expenses
Bad debt expense ...........................................................
6-30
$307,350
1,140
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
ALTERNATE PROBLEMS
AP6–1.
Req. 1
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
(m)
Total
Sales
Revenue
+227,000
+12,000
+23,500
NE
+26,000
NE
NE
NE
NE
+18,500
NE
NE
NE
+$307,000
Sales Discounts
(taken)
NE
NE
NE
+240
NE
-10
+1,800*
NE
+400
NE
NE
NE
NE
+$2,430
Sales Returns
and Allowances
NE
NE
NE
NE
NE
+500
NE
+3,500
NE
NE
NE
NE
NE
+$4,000
Bad Debt
Expense
NE
NE
NE
NE
NE
NE
NE
NE
NE
NE
NE
NE
+3,040**
+$3,040
* [($88,200/.98) x .02] = $1,800
**Credit sales ($12,000 + $23,500 + $26,000 + $18,500) .
Less: Sales returns ($500 + $3,500) .............................
Net sales revenue...........................................................
Estimated bad debt rate .................................................
Bad debt expense ...........................................................
$80,000
4,000
$76,000
x
4%
$3,040
Req. 2
Income statement:
Sales revenue ........................................................... $307,000
Less: Sales returns and allowances ..............
4,000
Sales discounts ....................................
2,430
Net sales revenue .....................................................
Operating expenses
Bad debt expense ...................................................
6-31
$300,570
$3,040
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
AP6–2.
1.
Bad debt expense (+E, –SE) ..................................................... 6,014
Allowance for doubtful accounts (+XA, –A).....................
6,014
End of period bad debt expense estimate.
Allowance for doubtful accounts (–XA, +A) ............................... 5,941
Accounts receivable (–A) ................................................
5,941
Write-off of bad debts.
2.
Allowances for
Doubtful
Accounts
Year 3
Balance at
Beginning
of Year
$1,108
Additions
Charged to
Costs and
Expenses
$6,014
Deductions
from
Reserve
$5,941
Balance at
End
of Year
$1,181
Year 2
2,406
4,453
5,751
1,108
Year 1
2,457
4,752
4,803
2,406
Year 3
Allowance for Doubtful Accounts
1,108
Beg. bal.
Write-offs
Year 2
6,014
Bad debt exp.
1,181
End. bal.
Allowance for Doubtful Accounts
2,406
Beg. bal.
Write-offs
Year 1
5,941
5,751
4,453
Bad debt exp.
1,108
End. bal.
Allowance for Doubtful Accounts
2,457
Beg. bal
Write-offs
4,803
4,752
Bad debt exp.
2,406
Ending bal.
The solution involves solving for the missing value in the T-account.
6-32
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
AP6–3.
Req. 1
Aging Analysis of Accounts Receivable
(a)
(b)
(c)
Not Yet
Up to
6 to
Total
Due
6 Mo.
12 Mo.
Customer
Receivable
Past Due
Past Due
R. Devens ………..
$ 2,000
$2,000
C. Howard ………..
6,000
D. McClain .……….
4,000
$ 4,000
T. Skibinski ………
14,500
$ 4,500
10,000
H. Wu ………..…...
13,000
13,000
Totals……………
$39,500
$17,500
$14,000
$2,000
(d)
More Than
12 Mo.
Past Due
$6,000
$6,000
Req. 2
a.
b.
c.
d.
Estimated Amounts Uncollectible
Amount of
Estimated
Age
Receivable
Loss Rate
Not yet due……………………
$17,500
1%
Up to 6 months past due...….
14,000
5%
6 to 12 months past due.….
2,000
20%
Over 12 months past due…...
6,000
50%
Estimated ending balance in
Allowance for Doubtful Accounts
Balance before adjustment
Bad Debt Expense for the year
Req. 3
Bad debt expense (+E, –SE) .........................................
Allowance for doubtful accounts (+XA, –A) ..........
6-33
1,550
$2,725
2,725
2,725
Req. 4
Income statement:
Operating expenses
Bad debt expense ..........................................................
Balance sheet:
Current Assets:
Accounts receivable .......................................................
Less: Allowance for doubtful accounts ..........................
Accounts receivable, net .......................................
Estimated
Uncollectible
$ 175
700
400
3,000
4,275
$2,725
$39,500
4,275
$35,225
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
AP6–4.
Req. 1
PERRY CORPORATION
Income Statement
For the Year Ended December 31, 2012
Net sales revenue ($184,000 - $9,000- $8,000) .................
Cost of goods sold..............................................................
Gross profit.........................................................................
Operating expenses:
Selling expense .......................................................... $17,000
Administrative and general expense .......................... 18,000
Bad debt expense ......................................................
2,000
Total operating expenses ...................................
Income from operations......................................................
Income tax expense ...................................................
Net income .........................................................................
$167,000
98,000
69,000
37,000
32,000
10,900
$ 21,100
Earnings per share on common stock outstanding
($21,100 ÷ 10,000 shares) ................................................................
$2.11
Req. 2
Gross Profit Percentage =
Gross Profit
Net Sales
=
$69,000 = 0.413 (41.3%)
$167,000
The gross profit percentage measures the excess of sales prices over the costs to
purchase or produce the goods or services sold as a percentage.
Receivables =
Turnover
Net Sales
Average Net Trade
Accounts Receivable
=
$167,000 = 9.82
$17,000*
* ($16,000 + $18,000) ÷ 2
The receivables turnover ratio measures the effectiveness of credit-granting and
collection activities.
6-34
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
AP6–5.
Req. 1
Comparison of (a) the unrecorded deposit carried over from November and (b) the
deposits listed on the bank statement reveals that the $13,000 deposit for December 31
is in transit.
Req. 2
Comparison of the checks cleared on the bank statement with (a) outstanding checks
from November and (b) checks written in December reveals that the outstanding checks
at the end of December are $5,000 + $3,500 + 500 = $9,000.
Req. 3
RIVAS COMPANY
Bank Reconciliation, December 31, 2011
Company's Books
Ending balance per Cash
account .........................
$61,060
Additions:
Interest collected ...............
Deductions:
NSF check—J. Left ............
Bank service charges .........
Correct cash balance .........
Bank Statement
5,250
66,310
Ending balance per bank
statement .....................
Additions:
Deposits in transit ..............
$61,860
13,000
74,860
Deductions:
$300
150
450
$65,860
6-35
Outstanding checks ............
Correct cash balance .........
9,000
$65,860
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
AP6–5. (continued)
Req. 4
(1)
(2)
(3)
Accounts receivable (J. Left) (+A) ..................................
Cash (–A).............................................................
To record NSF check.
300
Cash (+A) .......................................................................
Interest revenue (+R, +SE) ..................................
Interest collected.
5,250
Bank service charge expense (+E, –SE) ........................
Cash (–A).............................................................
Service charges deducted from bank balance.
150
300
5,250
150
These entries are necessary because of the changes in the regular Cash account that
have not yet been recorded by the company. The bank already has recorded them in its
accounts. The Cash account (and the other accounts in the entries) must be brought up
to date for financial statement purposes.
Req. 5
Balance Sheet (2011):
Current Assets:
Cash ................................................................................
6-36
$65,860
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
CASES AND PROJECTS
ANNUAL REPORT CASES
CP6–1.
1. The company includes liquid financial instruments with original maturities of three
months or less to be cash and cash equivalents. This information is from note 2 of
the financial statements. The amount disclosed is likely to be close to the fair
market value of the securities, given the short maturity date of the securities.
2. In addition to Cost of Goods Sold, American Eagle Outfitters subtracts buying,
occupancy and warehousing costs from Net Sales in its computation of Gross Profit.
This follows standard practice among retailers. No such additional expenses are
subtracted in Deckers’s (a footwear manufacturer) computation of Gross Profit. This
makes the interpretation of gross profit percentages across different industries
difficult.
3.
Receivables turnover =
Net Sales
= $2,988,866 = 81.4 times
Average Net Trade
$36,696*
Accounts Receivable
* ($31,920 + 41,471) ÷ 2
This question is designed to focus student attention on the mechanics of the
computation of the receivables turnover ratio and the effect of industry differences.
The receivables turnover is so high because of the nature of the company’s
business. Retail sales are likely to be made with cash or credit card. As a
consequence, most retailers would not have accounts receivable related to sales
unless they had private store credit card accounts. The accounts receivable on
American Eagle’s balance sheet relate primarily to amounts owed from landlords for
construction allowances for building new stores in malls.
4. No, the company does not report an allowance for doubtful accounts on the balance
sheet or in the notes. As a retailer, its trade receivables from customers are
immaterial—the company’s receivables consist of non-trade receivables and notes
receivable.
6-37
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
CP6–2.
1. The company held $316,035 thousand of cash and cash equivalents at the end of
the current year. This is disclosed on the balance sheet and the statement of cash
flows.
2. Accounts receivable increased by $10,025 thousand, decreasing Net Cash Provided
by Operating Activities for the current year. This is included in the operating section
of the statement of cash flows in the line item relating to changes in receivables. You
may wish to note to students that this amount does not agree with the amount on the
statement of cash flows which indicates a $10,726 increase. This difference is the
result of the translation of foreign currency receivables.
3.
2009
Gross Profit =
Percentage
Gross Profit
Net Sales
$713,478 = 0.389
1,834,618
2008
$576,772 = 0.383
1,507,724
The gross profit percentage increased slightly from 2008 to 2009. The increase
implies that the company has increased its ability to charge premium prices or to
purchase goods for resale at lower cost.
4. It discloses its revenue recognition policies in note 2 which summarizes significant
accounting policies. The company recognizes revenue from selling gift cards when
customers redeem a gift card for merchandise rather than when the gift card is sold.
When gift cards are sold, a current liability (deferred revenue) is recorded.
6-38
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
CP6–3.
1.
Current year
Gross Profit =
Percentage
American Eagle
Outfitters
Gross Profit
Net Sales
Prior year
Gross Profit =
Percentage
$1,174,101 = 0.393
2,988,866
American Eagle
Outfitters
Gross Profit
Net Sales
$1,423,138 = 0.466
3,055,419
Urban Outfitters
$713,478 = 0.389
1,834,618
Urban Outfitters
$576,772 = 0.383
1,507,724
The improved gross profit percentage for Urban Outfitters suggests higher sales
prices and/or lower costs of merchandise. Because other costs (occupancy, etc.) are
included along with cost of goods sold, the improved ratios may also result from
improved comparable store sales and better cost controls. The declining gross profit
percentage for American Eagle suggests the opposite scenarios.
2. Companies with unique items for sale or valuable brand images often produce higher
gross profit margins. Because American Eagle Outfitters and Urban Outfitters have
unique items for sale as well as valuable brand images in certain markets, their
margins are predicted to be in the mid to upper range of their industry.
3.
Gross Profit Percentage =
Industry
Average
39.0%
American Eagle
Outfitters
39.3%
Urban Outfitters
38.9%
Urban Outfitters’ gross profit percentage is just below and American Eagle Outfitters’
is above the industry average. The higher gross profit percentage for American
Eagle Outfitters was anticipated in Requirement 2, but Urban Outfitters is not above
the industry average (although it is close).
6-39
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
FINANCIAL REPORTING AND ANALYSIS CASES
CP6–4.
1.
Yes. Given that only one three-year project is worked on at a time, the completed
contract method would result in no revenue being recognized for two out of every
three years, and all of the revenue from each project being recognized during the
third. If the same amount of work was completed each year, the percentage of
completion method would result in an approximately equal amount of revenue
each period.
2.
If the company regularly started and completed a larger constant number of
equal sized projects each reporting period, the size of any difference between
revenues reported under the two methods would decline.
3.
Under generally accepted accounting principles, the appropriate method would
be determined by whether the costs to complete can be accurately assessed. If
they can be accurately estimated, the percentage of completion method is
appropriate. If not, the completed contract method should be used. However,
managers generally prefer to report the smoother earnings pattern conveyed by
the percentage of completion method because smoother earnings are generally
thought to convey lower risk to investors.
CRITICAL THINKING CASES
CP6–5.
1.
Recording sales for goods or services that had not been delivered as of year-end
violates the revenue principle. Recording revenue for sales that were subject to
cancellation, without estimating returns properly, is also a violation.
2.
It should establish a sales returns and allowances account (a contra revenue) for
potential cancellations. An estimate of future cancellations should be made and
the amount should reduce net sales in the period the revenue is recognized.
3.
Profiting from sales of stock they owned at an inflated stock price and perhaps
receiving bonuses determined on the basis of growth in net income probably
motivated management. Management was very focused on reporting increased
growth because the growth fueled the run-up in the stock price.
6-40
Chapter 06 - Reporting and Interpreting Sales Revenue, Receivables, and Cash
CP6–5. (continued)
4.
The other investors who paid inflated amounts for the stock, customers who were
poorly served during the period, and employees of the company who were drawn
into the fraud and suffered damage to their reputations were all hurt by
management’s conduct.
5.
Sales transactions booked near the end of the quarter and sales with special
terms, e.g. right of return or cancellation, should receive special attention from
auditors. Channel stuffing often lowers the receivables turnover ratio. To cover
up this change, management improperly reclassified some accounts receivable
as notes receivable.
CP6–6.
Req. 1
(a)
$50 x 12 months
(b)
$12 x (52 weeks x 5 days per week)
(c,d) Accounts receivable collections ($300 + $800)
Total approximate amount stolen
=
=
=
$ 600
3,120
1,100
$4,820
Req. 2
Basic recommendations:
(1)
Install a tight system of internal control, including the following:
a.
Separate cash handling from recordkeeping.
b.
Deposit all cash daily.
c.
Make all payments by check. Consider a separate cash on hand system
for small expense payments.
d.
Reconcile bank statement monthly.
e.
Institute a system of spot checks.
f.
Establish cash and paperwork flows.
(2)
a. Arrange for an annual independent audit on a continuing basis.
b. Carefully plan and assign definite responsibilities for all employees. Focus on
attaining internal control. Isolate the once trusted employee from all cash
handling and accounting activities and consider dismissing and bringing
charges against the employee.
FINANCIAL REPORTING AND ANALYSIS PROJECTS
CP6–7.
The solutions to this case will depend on the company and/or accounting period
selected for analysis.
6-41
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
Chapter 07
Reporting and Interpreting Cost of
Goods Sold and Inventory
ANSWERS TO QUESTIONS
1.
Inventory often is one of the largest amounts listed under assets on the balance
sheet which means that it represents a significant amount of the resources
available to the business. The inventory may be excessive in amount, which is a
needless waste of resources; alternatively it may be too low, which may result in
lost sales. Therefore, for internal users inventory control is very important. On
the income statement, inventory exerts a direct impact on the amount of income.
Therefore, statement users are interested particularly in the amount of this effect
and the way in which inventory is measured. Because of its impact on both the
balance sheet and the income statement, it is of particular interest to all
statement users.
2.
Fundamentally, inventory should include those items, and only those items,
legally owned by the business. That is, inventory should include all goods that
the company owns, regardless of their particular location at the time.
3.
The cost principle governs the measurement of the ending inventory amount.
The ending inventory is determined in units and the cost of each unit is applied to
that number. Under the cost principle, the unit cost is the sum of all costs
incurred in obtaining one unit of the inventory item in its present state.
4.
Goods available for sale is the sum of the beginning inventory and the amount of
goods purchased during the period. Cost of goods sold is the amount of goods
available for sale less the ending inventory.
5.
Beginning inventory is the stock of goods on hand (in inventory) at the start of the
accounting period. Ending inventory is the stock of goods on hand (in inventory)
at the end of the accounting period. The ending inventory of one period
automatically becomes the beginning inventory of the next period.
7-1
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
6.
7.
(a)
Average cost–This inventory costing method in a periodic inventory
system is based on a weighted-average cost for the entire period. At the
end of the accounting period the average cost is computed by dividing the
goods available for sale in units into the cost of goods available for sale
in dollars. The computed unit cost then is used to determine the cost of
goods sold for the period by multiplying the units sold by this average unit
cost. Similarly, the ending inventory for the period is determined by
multiplying this average unit cost by the number of units on hand.
(b)
FIFO–This inventory costing method views the first units purchased as the
first units sold. Under this method cost of goods sold is costed at the
oldest unit costs, and the ending inventory is costed at the newest unit
costs.
(c)
LIFO–This inventory costing method assumes that the last units
purchased are the first units sold. Under this method cost of goods sold is
costed at the newest unit costs and the ending inventory is costed at the
oldest unit costs.
(d)
Specific identification–This inventory costing method requires that each
item in the beginning inventory and each item purchased during the period
be identified specifically so that its unit cost can be determined by
identifying the specific item sold. This method usually requires that each
item be marked, often with a code that indicates its cost. When it is sold,
that unit cost is the cost of goods sold amount. It often is characterized as
a pick-and-choose method. When the ending inventory is taken, the
specific items on hand, valued at the cost indicated on each of them, is the
ending inventory amount.
The specific identification method of inventory costing is subject to manipulation.
Manipulation is possible because one can, at the time of each sale, select (pick
and choose) from the shelf the item that has the highest or the lowest (or some
other) unit cost with no particular rationale for the choice. The rationale may be
that it is desired to influence, by arbitrary choice, both the amount of income and
the amount of ending inventory to be reported on the financial statements. To
illustrate, assume item A is stocked and three are on the shelf. One cost $100;
the second one cost $115; and the third cost $125. Now assume that one unit is
sold for $200. If it is assumed arbitrarily that the first unit is sold, the gross profit
will be $100; if the second unit is selected, the gross profit will be $85; or
alternatively, if the third unit is selected, the gross profit will be $75. Thus, the
amount of gross profit (and income) will vary significantly depending upon which
one of the three is selected arbitrarily from the shelf for this particular sale. This
assumes that all three items are identical in every respect except for their unit
costs. Of course, the selection of a different unit cost, in this case, also will
influence the ending inventory for the two remaining items.
7-2
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
8.
LIFO and FIFO have opposite effects on the inventory amount reported under
assets on the balance sheet. The ending inventory is based upon either the
oldest unit cost or the newest unit cost, depending upon which method is used.
Under FIFO, the ending inventory is costed at the newest unit costs, and under
LIFO, the ending inventory is costed at the oldest unit costs. Therefore, when
prices are rising, the ending inventory reported on the balance sheet will be
higher under FIFO than under LIFO. Conversely, when prices are falling the
ending inventory on the balance sheet will be higher under LIFO than under
FIFO.
9.
LIFO versus FIFO will affect the income statement in two ways: (1) the amount of
cost of goods sold and (2) income. When the prices are rising, FIFO will give a
lower cost of goods sold amount and hence a higher income amount than will
LIFO. In contrast, when prices are falling, FIFO will give a higher cost of goods
sold amount and, as a result, a lower income amount.
10.
When prices are rising, LIFO causes a lower taxable income than does FIFO.
Therefore, when prices are rising, income tax is less under LIFO than FIFO. A
lower tax bill saves cash (reduces cash outflow for income tax). The total
amount of cash saved is the difference between LIFO and FIFO inventory
amounts multiplied by the income tax rate.
11.
LCM is applied when market (defined as current replacement cost) is lower than
the cost of units on hand. The ending inventory is valued at market (lower),
which (a) reduces net income and (b) reduces the inventory amount reported on
the balance sheet. The effect of applying LCM is to include the holding loss on
the income statement (as a part of CGS) in the period in which the replacement
cost drops below cost rather than in the period of actual sale.
12.
When a perpetual inventory system is used, the unit cost must be known for each
item sold at the date of each sale because at that time two things happen: (a) the
units sold and their costs are removed from the perpetual inventory record and
the new inventory balance is determined; (b) the cost of goods sold is
determined from the perpetual inventory record and an entry in the accounts is
made as a debit to Cost of Goods Sold and a credit to Inventory. In contrast,
when a periodic inventory system is used the unit cost need not be known at the
date of each sale. In fact, the periodic system is designed so that cost of goods
sold for each sale is not known at the time of sale. At the end of the period,
under the periodic inventory system, cost of goods sold is determined by adding
the beginning inventory to the total goods purchased for the period and
subtracting from that total the ending inventory amount. The ending inventory
amount is determined by means of a physical inventory count of the goods
remaining on hand and with the units valued on a unit cost basis in accordance
with the cost principle (by applying an appropriate inventory costing method).
7-3
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
ANSWERS TO MULTIPLE CHOICE
1. a)
6. c)
2. d)
7. a)
3. a)
8. c)
4. b)
9. c)
5. c)
10. a)
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
5
3
5
4
10
5
5
6
5
7
5
8
5
9
10
Exercises
No.
Time
1
15
2
20
3
20
4
10
5
15
6
15
7
30
8
30
9
30
10
30
11
15
12
20
13
15
14
20
15
15
16
20
17
20
18
20
19
25
20
20
21
25
22
25
Problems
No.
Time
1
30
2
30
3
40
4
40
5
45
6
50
7
40
8
40
9
35
10
20
Alternate
Problems
No.
Time
1
30
2
40
3
35
4
40
Cases and
Projects
No.
Time
1
20
2
20
3
20
4
20
5
40
6
20
7
30
8
*
* Due to the nature of these cases and projects, it is very difficult to estimate the
amount of time students will need to complete the assignment. As with any open-ended
project, it is possible for students to devote a large amount of time to these
assignments. While students often benefit from the extra effort, we find that some
become frustrated by the perceived difficulty of the task. You can reduce student
frustration and anxiety by making your expectations clear. For example, when our goal
is to sharpen research skills, we devote class time to discussing research strategies.
When we want the students to focus on a real accounting issue, we offer suggestions
about possible companies or industries.
7-4
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
MINI-EXERCISES
M7–1.
Type of Inventory
Type of Business
Merchandising
Manufacturing
Work in process
Finished goods
Merchandise
Raw materials
X
X
X
X
M7–2.
To record the purchase of 90 new shirts in accordance with the cost principle (perpetual
inventory system):
Inventory (+A) ..............................................................
Cash (A)..........................................................
2,600
2,600
Cost: $2,250 + $185 + $165 = $2,600.
The $135 interest expense is not a proper cost of the merchandise; it is recorded as
prepaid interest expense and later as interest expense.
M7–3.
(1) Part of
inventory
a.
Wages of factory workers
X
b.
Costs of raw materials purchased
X
c.
Sales salaries
d.
Heat, light, and power for the factory building
e.
Heat, light, and power for the headquarters
office building
(2) Expense
as incurred
X
7-5
X
X
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
M7–4.
Computation:
Simply rearrange the basic inventory model (BI + P – EI = CGS):
Cost of goods sold .................................................
+ Ending inventory ....................................................
– Beginning inventory ...............................................
Purchases ..............................................................
$11,571 million
3,259 million
(3,641) million
$11,189 million
M7–5.
(a)
(b)
Declining costs
Highest net income
Highest inventory
Rising costs
Highest net income
Highest inventory
LIFO
LIFO
FIFO
FIFO
M7–6.
LIFO is often selected when costs are rising because it reduces the company’s tax
liability which increases cash and benefits shareholders. However, it also reduces
reported net income.
M7–7.
Quantity
Item A
Item B
Total
70
30
Cost per
Item
$ 85
60
Replacement Lower of Cost
Reported on
Cost per Item
or Market
Balance Sheet
$100
$85
70 x $85 = $5,950
55
55
30 x $55 = $1,650
$7,600
M7–8.
+
(a)
Parts inventory delivered daily by suppliers instead of weekly.
NE
(b)
Extend payments for inventory purchases from 15 days to 30 days.
+
(c)
Shorten production process from 10 days to 8 days.
7-6
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
M7–9.
Understatement of the 2011 ending inventory by $100,000 caused 2011 pretax income
to be understated and 2012 pretax income to be overstated by the same amount.
Overstatement of the 2011 ending inventory would have the opposite effect; that is,
2011 pretax income would be overstated by $100,000 and 2012 pretax income
understated by $100,000. Total pretax income for the two years combined would be
correct.
7-7
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
EXERCISES
E7–1
Item
Amount
Explanation
Ending inventory (physical count on
December 31, 2011)
$34,500
Per physical inventory.
a.
Goods purchased and in transit
+
Goods purchased and in transit,
F.O.B. shipping point, are owned
by the purchaser.
b.
Samples out on trial to
customer
+ 1,800
c.
Goods in transit to customer
d.
Goods sold and in transit
700
Samples held by a customer on
trial are still owned by the vendor;
no sale or transfer of ownership
has occurred.
Goods shipped to customers,
F.O.B. shipping point, are owned
by the customer because
ownership passed when they were
delivered to the transportation
company. The inventory correctly
excluded these items.
+ 1,500
Correct inventory, December 31, 2011
Goods sold and in transit, F.O.B.
destination, are owned by the seller
until they reach destination.
$38,500
E7–2.
(Italics for missing amounts only.)
Case A
Net sales revenue ..........
Beginning inventory ........
Purchases ..................
Goods available for sale .
Ending inventory ............
Cost of goods sold..........
Gross profit ..................
Expenses
..................
Pretax income ................
Case B
$7,500
$11,200
5,000
16,200
10,200
$5,500
$ 6,500
8,550
15,050
11,050
6,000
1,500
400
$ 1,100
7-8
Case C
$6,000
$ 4,000
9,500
13,500
9,000
4,000
1,500
1,900
$ (400)
4,500
1,500
700
$ 800
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–3.
(Italics for missing amounts only.)
Beg.
Sales
InvenPurCase Revenue tory chases
A
B
C
D
E
$ 650
1,100
600
800
1,000
$100
200
150
150
200
$700
900
350
550
900
Total
Available
$800
1,100
500
700
1,100
Ending
Inventory
$500
300
300
300
600
Cost of
Goods
Sold
Gross
Profit
Expenses
$300
800
200
400
500
$350
300
400
400
500
$200
150
100
200
550
Pretax
Income
or
(Loss)
$150
150
300
200
(50)
E7–4.
Computations:
Simply rearrange the cost of goods sold equation
BI + P – EI = CGS
P = CGS – BI + EI
Cost of goods sold ................................... $1,178,584,000
– Beginning inventory ..................................
(333,153,000)
+ Ending inventory ......................................
372,422,000
Purchases ................................................ $1,217,853,000
E7-5
Units
Cost of goods sold:
Beginning inventory ($5) ............. 2,000
Purchases (March 21) ($7) ......... 5,000
(August 1) ($8) .......... 3,000
Goods available for sale .. 10,000
Ending inventory* ....................... 4,000
Cost of goods sold ........... 6,000
FIFO
LIFO
10,000
35,000
24,000
69,000
31,000
38,000
10,000
35,000
24,000
69,000
24,000
45,000
Average
Cost
10,000
35,000
24,000
69,000
27,600
41,400
*Ending inventory computations:
FIFO:
(3,000 units @ $8) + (1,000 units @ $7) = $31,000.
LIFO:
(2,000 units @ $5) + (2,000 units @ $7) = $24,000.
Average: [(2,000 units @ $5) + (5,000 units @ $7) + (3,000 units @ $8)] =
$69,000 ÷ 10,000 units = $6.90 per unit.
4,000 units @ $6.90 = $27,600.
7-9
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–6
Units
Cost of goods sold:
Beginning inventory ($5) ............. 2,000
Purchases (March 21) ($4) ......... 6,000
(August 1) ($2) .......... 4,000
Goods available for sale .. 12,000
Ending inventory* ....................... 3,000
Cost of goods sold ........... 9,000
FIFO
LIFO
Average
Cost
$10,000
24,000
8,000
42,000
6,000
$36,000
$10,000
24,000
8,000
42,000
14,000
$28,000
$10,000
24,000
8,000
42,000
10,500
$31,500
*Ending inventory computations:
FIFO:
(3,000 units @ $2) = $6,000.
LIFO:
(2,000 units @ $5) + (1,000 units @ $4) = $14,000.
Average: [(2,000 units @ $5) + (6,000 units @ $4) + (4,000 units @ $2)] =
$42,000 ÷ 12,000 units = $3.50 per unit.
3,000 units @ $3.50 = $10,500.
E7–7.
Req. 1
ELEMENT COMPANY
Income Statement
For the Year Ended December 31, 2012
Case A
FIFO
Sales revenue1 ..............................
Cost of goods sold:
Beginning inventory ................
Purchases ..............................
Goods available for sale2
Ending inventory3 ..................
Cost of goods sold ...........
Gross profit ..................................
Expenses
..................................
Pretax income ................................
$550,000
$ 36,000
210,000
246,000
130,000
Sales: (11,000 units @ $50) = $550,000
7-10
$550,000
$ 36,000
210,000
246,000
96,000
116,000
434,000
195,000
$239,000
Computations:
(1)
Case B
LIFO
150,000
400,000
195,000
$205,000
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–7. (continued)
(2)
Goods available for sale (for both cases):
Beginning inventory
Purchase, April 11, 2012
Purchase, June 1, 2012
Goods available for sale
Units
Unit Cost
Total Cost
3,000
9,000
8,000
20,000
$12
10
15
$ 36,000
90,000
120,000
$246,000
Ending inventory (20,000 available – 11,000 units sold = 9,000 units):
(3)
Case A
FIFO:
(8,000 units @ $15 = $120,000) +
(1,000 units @ $10 = $10,000) = $130,000.
Case B
LIFO:
(3,000 units @ $12 = $36,000)+
(6,000 units @ $10 = $60,000) = $96,000.
Req. 2
Comparison of Amounts
Pretax Income
Difference
Ending Inventory
Difference
Case A
FIFO
Case B
LIFO
$239,000
$205,000
$34,000
130,000
96,000
34,000
The above tabulation demonstrates that the pretax income difference between the two
cases is exactly the same as the inventory difference. Differences in inventory have a
dollar-for-dollar effect on pretax income.
Req. 3
LIFO may be preferred for income tax purposes because it reports less taxable income
(when prices are rising) and hence (a) reduces income tax and (b) as a result reduces
cash outflows for the period.
7-11
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–8.
Req. 1
BECK INC.
Income Statement
For the Year Ended December 31, 2012
Case A
FIFO
Sales revenue1 ..............................
Cost of goods sold:
Beginning inventory ................
Purchases ..............................
Goods available for sale2
Ending inventory3 ..................
Cost of goods sold ...........
Gross profit ..................................
Expenses
..................................
Pretax income ................................
Case B
LIFO
$704,000
$704,000
$ 35,000
281,000
316,000
128,000
$ 35,000
281,000
316,000
80,000
188,000
516,000
500,000
$16,000
236,000
468,000
500,000
$(32,000)
Computations:
(1)
(2)
Sales: (8,000 units @ $28) + (16,000 units @ $30) = $704,000
Goods available for sale (for both cases):
Beginning inventory
Purchase, March 5, 2012
Purchase, September 19, 2012
Goods available for sale
(3)
Units
Unit Cost
Total Cost
7,000
19,000
10,000
36,000
$5
9
11
$ 35,000
171,000
110,000
$316,000
Ending inventory (36,000 available – 24,000 units sold = 12,000 units):
Case A
FIFO:
(10,000 units @ $11 = $110,000) +
(2,000 units @ $9 = $18,000) = $128,000.
Case B
LIFO:
(7,000 units @ $5 = $35,000)+
(5,000 units @ $9 = $45,000) = $80,000.
7-12
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–8. (continued)
Req. 2
Comparison of Amounts
Case A
FIFO
Case B
LIFO
Pretax Income
Difference
$16,000
$(32,000)
Ending Inventory
128,000
Difference
$48,000
80,000
48,000
The above tabulation demonstrates that the pretax income difference between the two
cases is exactly the same as the inventory difference. Differences in inventory have a
dollar-for-dollar effect on pretax income.
Req. 3
LIFO may be preferred for income tax purposes because it reports less taxable income
(when prices are rising) and hence (a) reduces income tax and (b) as a result reduces
cash outflows for the period.
7-13
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–9.
Req. 1
LIFO
Average
Cost
$ 76,000
320,000
396,000
68,400
$327,600
$ 76,000
320,000
396,000
71,280
$324,720
FIFO
LIFO
Average
Cost
$615,000
324,000
291,000
194,500
96,500
28,950
$ 67,550
$615,000
327,600
287,400
194,500
92,900
27,870
$ 65,030
$615,000
324,720
290,280
194,500
95,780
28,734
$ 67,046
Units
FIFO
Cost of goods sold:
Beginning inventory .................... 2,000 $ 76,000
Purchases................................... 8,000
320,000
Goods available for sale .. 10,000
396,000
Ending inventory* ....................... 1,800
72,000
Cost of goods sold ........... 8,200 $324,000
Income statement
Sales revenue .......................................
Cost of goods sold.................................
Gross profit .........................................
Expenses
.........................................
Pretax income .......................................
Income tax expense (30%) .........
Net income .........................................
*Ending inventory computations:
FIFO:
1,800 units @ $40 = $72,000.
LIFO:
1,800 units @ $38 = $68,400.
Average: [(2,000 units @ $38) + (8,000 units @ $40)] ÷ 10,000 units =
$396,000 ÷ 10,000 units = $39.60 per unit.
$39.60 x 1,800 units = $71,280.
Req. 2
FIFO produces a more favorable (higher) net income because when prices are rising it
gives a lower cost of goods sold amount. FIFO allocates the old (lower) unit costs to
cost of goods sold.
LIFO produces a more favorable cash flow than FIFO because, when prices are rising,
it produces a higher cost of goods sold amount and lower taxable income and,
therefore, lower income tax expense for the period. Cash outflow is less under LIFO by
the amount of income tax reduction. LIFO causes these comparative effects because it
allocates the new (higher) unit costs to cost of goods sold.
Req. 3
When prices are falling, the opposite effect occurs–LIFO produces higher net income
and less favorable cash flow than does FIFO.
7-14
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–10.
Req. 1
FIFO
Cost of goods sold:
Beginning inventory (400 units @ $28)...
Purchases (475 units @ $36) .................
Goods available for sale .........................
Ending inventory (545 units)*..................
Cost of goods sold (330 units) ................
$11,200
17,100
28,300
19,060
$ 9,240
LIFO
$11,200
17,100
28,300
16,420
$11,880
Average
Cost
$11,200
17,100
28,300
17,625
$ 10,675
*Computation of ending inventory:
FIFO: (475 units x $36) + (70 units x $28) = $19,060
LIFO: (400 units x $28) + (145 units x $36) = $16,420
Weighted Average:
Units
400
475
875
Cost
$11,200
17,100
$28,300 = weighted-average unit cost of $32.34.
545 units x $32.34 = $17,625
Req. 2
FIFO
Sales revenue ($50 x 330) ...............................
Cost of goods sold.............................................
Gross profit .....................................................
Expenses
.....................................................
Pretax income ...................................................
7-15
$16,500
9,240
7,260
1,700
$ 5,560
LIFO
$16,500
11,880
4,620
1,700
$ 2,920
Average
Cost
$16,500
10,675
5,825
1,700
$ 4,125
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–10. (continued)
Req. 3
Ranking in order of favorable cash flow: The higher rankings are given to the methods
that produce the lower income tax expense because the lower the income tax expense
the higher the cash savings.
(1)
LIFO–produces the lowest pretax income, hence the lowest amount of cash to be
paid for income tax.
(2)
Weighted average–produces next lower pretax income.
(3)
FIFO–produces the highest pretax income and as a result the highest income
tax. This result causes the lowest cash savings on income tax.
The above comparative effects occurred because prices were rising. If prices were
falling the three methods would have produced the opposite ranking.
7-16
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–11.
Item Quantity
A
B
C
D
E
50
80
10
70
350
Total
Total Cost
x
x
x
x
x
$15
30
48
25
10
=
=
=
=
=
Total Market
$ 750
2,400
480
1,750
3,500
$8,880
x
x
x
x
x
$12
40
52
30
5
=
=
=
=
=
$600
3,200
520
2,100
1,750
$8,170
Inventory valuation that should be used (LCM)
LCM
Valuation
$600
2,400
480
1,750
1,750
$6,980
$6,980
E7–12.
Req. 1
Item Quantity
Total Cost
Total Market
LCM
Valuation
A
B
20
55
x
x
$10
40
=
=
$ 200
2,200
x
x
$15 =
44 =
$300
2,420
$200
2,200
C
D
35
10
Total
x
x
57
27
=
=
1,995
270
$4,665
x
x
55 =
32 =
1,925
320
$4,965
1,925
270
$4,595
Inventory valuation that should be used (LCM)
$4,595
Req. 2
The write-down to lower of cost or market will increase cost of goods sold expense by
the amount of the write-down, $70:
Total Cost  LCM Valuation = Write-down
$4,665 
$4,595
= $70 Write-down
7-17
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–13.
Req. 1
Inventory turnover
=
Cost of Goods Sold
Average Inventory
=
$50,144
($1,180+$867)/2
= 48.99
Average days to sell inventory = 365 / inventory turnover = 365 / 48.99 = 7.5 days
Req. 2
The inventory turnover ratio reflects how many times average inventory was produced
and sold during the period. Thus, Dell produced and sold its average inventory nearly
49 times during the year.
The average days to sell inventory indicates the average time it takes the company to
produce and deliver inventory to customers. Thus, Dell takes an average of about 7.5
days to produce and deliver its computer inventory to its customers.
7-18
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–14.
CASE A – FIFO:
Goods available for sale for FIFO:
Units (19 + 25 + 50) .....................................................
Amount ($304 + 350 + 950) .........................................
94
$1,604
Ending inventory: 94 units – 68 units = 26.
Ending inventory (26 units x $19) ................................
Cost of goods sold ($1,604 – $494).............................
Inventory turnover =
Cost of Goods Sold =
Average Inventory
$1,110
($304+$494)/2
$ 494
$1,110
= 2.78
CASE B – LIFO:
Goods available for sale for LIFO:
Units (19 + 25 + 50) .....................................................
Amount ($228 + 350 + 950) .........................................
94
$1,528
Ending inventory: 94 units – 68 units = 26.
Ending inventory (19 units x $12) + (7 units x $14) .....
Cost of goods sold ($1,528 – $326).............................
Inventory turnover =
Cost of Goods Sold =
Average Inventory
$1,202
($228+$326)/2
$ 326
$1,202
= 4.34
The FIFO inventory turnover ratio is normally thought to be a more accurate indicator
when prices are changing because LIFO can include very old inventory prices in ending
inventory balances.
7-19
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–15.
Inventory
A/P
Current Year Previous Year
22,813,850 – 20,838,171
9,462,883 –
9,015,376
=
=
Change
1,975,679
447,507
Increases in inventory cause cash flow from operations to decrease by $1,975,679.
This amount is subtracted in the computation of cash flow from operations. First Team
Sports was able to offset some of this by increasing its A/P by $447,507, which
increases cash flow from operations. This amount is added in the computation of cash
flow from operations. Effectively, the Company is letting its suppliers finance a portion
of its growing inventories.
E7–16.
Req. 1 The reported ending inventory for Ford was $8,618 million. If FIFO were used
exclusively, the ending inventory would have been $891 million higher than
reported, or $9,509 million.
Req. 2 The restated cost of goods sold amount must reflect the restatement of both
beginning and ending inventory:
Beginning inventory ...............................................
Less: Ending inventory ..........................................
Impact on COGS ...................................................
$1,100 million
891 million
$ 209 million
If FIFO had been used exclusively, cost of goods sold would have been $127,103 +
$209 = $127,312 million. In this case, FIFO cost of goods sold is greater than LIFO cost
of goods sold. This is likely the result of falling prices and/or a reduction in inventory
quantities.
Req. 3 When costs are rising, LIFO normally produces lower net income before taxes
and lower current tax payments.
7-20
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–17.
Req. 1 Net Income for 2011 will be Overstated. An understatement of purchases
produces an understatement of cost of goods sold which produces an
overstatement of the current period’s income.
BI + P - EI

Understate
=
CGS

Understate
Req. 2 Net Income for 2012 will be Understated. An overstatement of purchases
produces an overstatement of cost of goods sold which produces an
understatement of the current period’s income.
BI + P - EI

Overstate
=
CGS

Overstate
Req. 3 Retained Earnings for December 31, 2011, will be Overstated because of the
overstatement of Net Income for 2011.
Req. 4 Retained Earnings for December 31, 2012, will be Correct because the
overstatement of Net Income for 2011 and understatement of Net Income for
2012 will offset one another.
7-21
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–18.
Req. 1
When the ending inventory is overstated, cost of goods sold is understated which in turn
results in an overstatement of net income. Gibson’s income from operations should be
reduced by $8,806,000 and tax expense should be reduced by $3,460,758 (i.e.,
$8,806,000 x 0.393). Therefore, net income should be:
As reported:........................................................
Increase in cost of good sold ..............................
Reduction in tax expense ...................................
Corrected income ...............................................
$25,852,000
(8,806,000)
3,460,758
$20,506,758
Req. 2
The incorrect accounts can be summarized as follows:
Account
(a) Year of
Error
Beginning inventory
Cost of goods sold
Ending inventory
Income tax expense
Net income
Retained earnings
Taxes payable*
correct
understated
overstated
overstated
overstated
overstated
overstated
(b) Subsequent
Year
overstated
overstated
correct
understated
understated
correct
understated
*The income tax payable for each year is incorrect by the same amount; therefore the
total income tax paid was correct.
7-22
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–19.
Req. 1
The $600 understatement of ending inventory produced pretax income amounts that
were incorrect by the amount of $600 for each quarter. However, the effect on pretax
income for each quarter was opposite (i.e., the first quarter pretax income was
understated by $600, and in the second quarter it was overstated by $600). This selfcorrecting produces a correct combined income for the two quarters.
Req. 2
The error caused the pretax income for each quarter to be incorrect [see (1) above];
therefore, it produced incorrect EPS amounts for each quarter.
Req. 3
First Quarter
Sales revenue ........................................
Cost of goods sold:
Beginning inventory ..................... $4,000
Purchases.................................... 3,000
Goods available for sale ... 7,000
Ending inventory .......................... 4,400
Cost of goods sold ............
Gross profit ..........................................
Expenses
..........................................
Pretax income ........................................
Second Quarter
$11,000
$18,000
$ 4,400
13,000
17,400
9,000
2,600
8,400
5,000
$3,400
8,400
9,600
6,000
$3,600
Req. 4
1st Quarter
Incorrect
Beginning inventory
Correct
2nd Quarter
Error
Incorrect
Correct
Error
$4,000
$4,000
No error
$3,800
$4,400
$600 under
Ending inventory
3,800
4,400
$600 under
9,000
9,000
No error
Cost of goods sold
3,200
2,600
600 over
7,800
8,400
600 under
Gross profit
7,800
8,400
600 under
10,200
9,600
600 over
Pretax income
2,800
3,400
600 under
4,200
3,600
600 over
7-23
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–20. (Supplement A)
Req. 1
This actual footnote from ConocoPhillips illustrates the impact of “dipping into a LIFO
layer.'' Under LIFO, the cost of recently purchased items is assigned to cost of goods
sold. When prices are rising, cost of goods sold, under LIFO, will include unit costs that
are much higher than the unit costs assigned to ending inventory. This process will
continue year after year so that the unit costs assigned to the ending inventory often will
be significantly less than unit costs assigned to cost of goods sold. When a business
permits inventory quantity to decline, old (and often very low) costs are allocated to cost
of goods sold and are matched with revenues that usually are based on the current
(higher) costs. As a result, a decline in LIFO inventory quantity often will produce a
dramatic increase in net income for the company.
Req. 2
When FIFO is used, a decline in inventory quantity will not result in the dramatic
increase in net income that was discussed in requirement (1) because FIFO inventory
costs are represented by the most recent purchases.
E7–21. (Supplement B)
Req. 1
Req. 2
Req. 3
Req. 4
Req. 5
Req. 6
Accounts receivable (+A) ...................................................900
Sales (+R, +SE) ............................................................
900
Cost of goods sold (+E, SE) .............................................600
Inventory (A) ................................................................
600
Cash (+A) ($900 x 0.98) .....................................................882
Sales discounts (+XR, R, SE) ($900 x 0.02) .................. 18
Accounts receivable (A) ..............................................
900
Cash (+A) ...........................................................................900
Accounts receivable (A) ..............................................
900
Inventory (+A) .....................................................................
8,400
Accounts payable (+L)...................................................
8,400
8,400
Accounts payable (L) ........................................................
Inventory (A) ($8,400 x 0.03) ......................................
Cash (A) ($8,400 x 0.97).............................................
252
8,148
8,400
Accounts payable (L) ........................................................
Cash (A) .....................................................................
8,400
7-24
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
E7–22. (Supplement C)
CASE A: Perpetual inventory system:
January 14
Accounts receivable (+A) ....................................................950
Sales (+R, +SE) (20 units at $47.50).............................
950
Cost of goods sold (+E, SE) .............................................400
Inventory (A) (20 units at $20) .....................................
400
Inventory (+A) (15 units at $20) ..........................................300
Accounts payable (+L)...................................................
300
September 2 Accounts receivable (+A) ....................................................
2,250
Sales (+R, +SE) (45 units at $50)..................................
2,250
Cost of goods sold (+E, SE) .............................................900
Inventory (A) (45 units at $20) .....................................
900
April 9
End of year
No year-end adjusting entry needed.
CASE B: Periodic inventory system:
January 14
Accounts receivable (+A) ....................................................950
Sales (+R, +SE) (20 units at $47.50).............................
950
Purchases (+A) (15 units at $20) ........................................300
Accounts payable (+L)...................................................
300
September 2 Accounts receivable (+A) ....................................................
2,250
Sales (+R, +SE) (45 units at $50)..................................
2,250
2,300
Cost of goods sold (+E, SE) (goods avail. for sale) ..........
Purchases (A) .............................................................
Inventory (A) (Beginning: 100 units at $20) ................
300
2,000
Inventory (+A) (Ending: 50 units at $20) ............................
1,000
Cost of goods sold (E, +SE) ........................................
1,000
April 9
End of year
Calculation of cost of goods sold:
Beginning inventory (100 units at $20)
Add purchases
Goods available for sale
Ending inventory (physical count—50 units at $20)
Cost of goods sold
7-25
$2,000
300
2,300
1,000
$1,300
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
PROBLEMS
P7–1.
Item
Amount
Explanation
Ending inventory (physical count on
December 31, 2011)
$65,000 Per physical inventory.
a.
Goods out on trial to customer
+
b.
Goods in transit from supplier
Goods shipped by a supplier,
F.O.B. destination, are owned by
the supplier until delivery at
destination.
c.
Goods in transit to customer
Goods shipped to customers,
F.O.B. shipping point, are owned
by the customer because
ownership passed when they were
delivered to the transportation
company. The inventory correctly
excluded these items.
d.
Goods held for customer pickup – 1,590 The goods sold, but held for
customer pickup, are owned by the
customer. Ownership has passed.
e.
Goods purchased and in transit
+ 3,550 Goods purchased and in transit,
F.O.B. shipping point, are owned
by the purchaser.
f.
Goods sold and in transit
+
g.
Goods held on consignment
– 5,700 Goods held on consignment are
owned by the consignor (the
manufacturer), not by the
consignee.
$62,860
Correct inventory, December 31, 2011
750 Goods held by a customer on trial
are still owned by the vendor; no
sale or transfer of ownership has
occurred.
850
7-26
Goods sold and in transit, F.O.B.
destination, are owned by the seller
until they reach destination.
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
P7–2.
a) Goods available for sale for all methods:
Units
January 1, 2012–Beginning inventory
January 30, 2012–Purchase
May 1, 2012–Purchase
Goods available for sale
400
600
460
1,460
Unit
Cost
$3.00
3.20
3.50
Total
Cost
$ 1,200
1,920
1,610
$4,730
Ending inventory: 1,460 units – (160 + 700) = 600 units
b) and c)
1.
2.
Average cost:
Average unit cost
Ending inventory
Cost of goods sold
First-in, first-out:
Ending inventory
Cost of goods sold
3.
Last-in, first-out:
Ending inventory
Cost of goods sold
4.
Specific identification:
Ending inventory
Cost of goods sold
$4,730 ÷ 1,460 = $3.24
(600 units x $3.24)
($4,730 – $1,944)
$1,944
$2,786
(460 units x $3.50) +
(140 units x $3.20)
$2,058
($4,730 – $2,058)
$2,672
(400 units x $3.00) +
(200 units x $3.20)
$1,840
($4,730 – $1,840)
$2,890
(
0 units x $3.00) +
( 504 units x $3.20) +
( 96 units x $3.50)
$1,949
($4,730 – $1,949)
$2,781
7-27
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
P7–3.
Req. 1
DONNER COMPANY
Partial Income Statement
For the Month Ended January 31, 2011
(a)
Average
Cost
Sales revenue*
Cost of goods sold**
Gross profit
$9,920
3,630
$ 6,290
(b)
(c)
FIFO
LIFO
$9,920
3,220
$ 6,700
$9,920
4,040
$ 5,880
(d)
Specific
Identification
$9,920
3,350
$ 6,570
Computations:
*620 units @ $16 = $9,920.
**Cost of goods sold:
Units
Beginning inventory
Purchases (net)***
Goods available for sale
Ending inventory****
Cost of goods sold
***Purchases:
January 12
January 26
Totals
600
160
760
500
760
1,260
640
620
Average
Cost
$2,500
4,880
7,380
3,750
$3,630
units @ $6
units @ $8
****Ending inventory:
a.
Average cost:
Beginning inventory
Purchases (per above)
FIFO
LIFO
$2,500
4,880
7,380
4,160
$3,220
$2,500
4,880
7,380
3,340
$4,040
= $3,600
= 1,280
$4,880
Units
500
760
1,260
Amount
$2,500
4,880
$7,380
Average cost:
$7,380 ÷ 1,260 units = $5.86
Ending inventory:
640 units x $5.86 = $3,750
7-28
Specific
Identification
$2,500
4,880
7,380
4,030
$3,350
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
P7–3. (continued)
Req. 1 (continued)
b.
FIFO:
160
480
640
units @ $8 =
units @ $6 =
$1,280
2,880
$4,160
c.
LIFO:
500
140
640
units @ $5 =
units @ $6 =
$2,500
840
$3,340
d.
Specific identification:
130
units @ $5 =
350
units @ $6 =
160
units @ $8 =
640
$ 650
2,100
1,280
$4,030
Req. 2
FIFO reports a higher pretax income than LIFO because (1) prices are rising and (2)
FIFO allocates the old (lower) unit costs to cost of goods sold. For the same reason,
FIFO will report a higher EPS amount because it produces a higher pretax income than
LIFO.
Req. 3
Because LIFO reports a lower pretax income than FIFO for the reasons given in
Requirement (2), the former will derive less income tax by ($6,700 – $5,880) x 30% =
$246.
Req. 4
LIFO will provide a more favorable cash flow than FIFO of $246 because less cash will
be paid for income tax in the current year than would be paid under FIFO (for the
reasons given in Requirements 2 and 3).
7-29
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
P7–4.
Req. 1
Sales revenue
Cost of goods sold* (42 @ $10,000) + (5 @ $11,500)
Gross profit
Expenses
Pretax income
$1,151,500
477,500
674,000
300,000
$ 374,000
*Ending inventory (15 @ $11,500)
$ 172,500
Req. 2
Sales revenue
Cost of goods sold** (20 @ $9,500) + (27 @ $10,000)
Gross profit
Expenses
Pretax income
$1,151,500
460,000
691,500
300,000
$ 391,500
**Ending inventory (20 @ $11,500) + (15 @ $10,000)
$ 380,000
Req. 3
Pretax income increased by $17,500 because of the decision to purchase the additional
units at the end of the year. This decision provided lower cost units to allocate to cost of
goods sold, which increased pretax income.
There is evidence of deliberate income manipulation. Although no information is
provided as to expected future sales, nor the time to order and receive units, the timing
of the purchase of the additional units is suspect because the cost of the equipment will
be decreased again during the first quarter of next year.
(Instructional Note–This problem illustrates the way that income can be manipulated
under LIFO by buying, or not buying, at year-end. This opportunity to manipulate
income is not available under weighted average or FIFO.)
7-30
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
P7–5.
Req. 1
Sales revenue (500 units)
Cost of goods sold:
Beginning inventory
(300 units)
Purchases (400 units)
Goods available for sale
Ending inventory (200 units)*
Cost of goods sold
(500 units)
Gross profit
Expenses
Pretax income
Income tax expense (30%)
Net income
Prices Rising
A
B
FIFO
LIFO
$15,000
$15,000
3,300
4,800
8,100
2,400 (a)
5,700
9,300
4,000
5,300
1,590
$3,710
3,300
4,800
8,100
2,200 (b)
5,900
9,100
4,000
5,100
1,530
$3,570
*Inventory computations:
(a) FIFO:
200 units @ $12.00 =
(b) LIFO:
200 units @ $11.00 =
(c) FIFO:
200 units @ $11.00 =
(d) LIFO:
200 units @ $12.00 =
Prices Falling
C
D
FIFO
LIFO
$15,000
$15,000
3,600
4,400
8,000
2,200 (c)
5,800
9,200
4,000
5,200
1,560
$3,640
3,600
4,400
8,000
2,400 (d)
5,600
9,400
4,000
5,400
1,620
$3,780
$2,400
2,200
2,200
2,400
Req. 2
The above tabulation demonstrates that when prices are rising, FIFO gives a higher net
income than LIFO. When prices are falling, the opposite effect results. The difference
in pretax income (as between FIFO and LIFO) is the same as the difference in cost of
goods sold but in the opposite direction. The difference in net income (i.e., after tax) is
equal to the difference in cost of goods sold multiplied by one minus the income tax
rate.
Req. 3
When prices are rising, LIFO derives a more favorable cash position (than FIFO) equal
to the difference in income tax. In contrast, when prices are falling, FIFO derives a
more favorable cash position equal to the difference in income tax.
7-31
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
P7–5. (continued)
Req. 4
Either method can be defended reasonably. If one focuses on current income and EPS,
FIFO derives a more favorable result (higher than LIFO when prices are rising).
Alternatively, if one focuses on income tax expense and cash position, when prices are
rising, LIFO derives more favorable results (lower taxes, better cash position).
However, these comparative results will reverse if prices fall.
FIFO provides a better balance sheet valuation (higher current asset value) but on the
income statement does not match current expense (cost of goods sold) with current
revenues. Alternatively, LIFO better matches expenses with revenues but produces a
less relevant inventory valuation on the balance sheet.
P7–6.
Req. 1
HARVEY COMPANY
Income Statement (LCM basis)
For the Year Ended December 31, 2011
Sales revenue
Cost of goods sold:
Beginning inventory
Purchases
Goods available for sale
Ending inventory
Cost of goods sold
Gross profit
Operating expenses
Pretax income
Income tax expense ($38,850 x 30%)
Net income
*Computation of ending inventory on LCM basis:
7-32
$280,000
$ 33,000
184,000
217,000
37,850*
179,150
100,850
62,000
38,850
11,655
$ 27,195
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
Item Quantity
A
B
C
D
3,050
1,500
7,100
3,200
Total
Replacement
Cost (Market)
Original Cost
x $3
x 5
x1.5
x 6
= $ 9,150
=
7,500
= 10,650
= 19,200
$46,500
x $4
x3.5
x3.5
x 4
=
=
=
=
$12,200
5,250
24,850
12,800
$55,100
LCM inventory valuation
LCM Valuation
$ 9,150
5,250
10,650
12,800
$37,850
Req. 2
Item Changed
Ending inventory
Cost of goods sold
Gross profit
Pretax income
Income tax expense
Net income
P7–6. (continued)
FIFO
Cost Basis
LCM
Basis
Amount of
Change
(Decrease)
$ 46,500
170,500
109,500
47,500
14,250
33,250
$ 37,850
179,150
100,850
38,850
11,655
27,195
($8,650)
8,650
( 8,650)
( 8,650)
( 2,595)
( 6,055)
Req. 2 (continued)
Analysis
Ending inventory, cost of goods sold, gross profit, and pretax income each
changed by the change in the valuation of the ending inventory.
Income tax expense decreased because the increase in expense reduced pretax
income.
Net income was reduced by $8,650 (increased expense of $8,650) less the
income tax savings of $2,595 = $6,055.
Req. 3
The inventory costing methods (average cost, FIFO, LIFO, and specific identification)
apply the cost and matching principles. Cost of goods sold, under these principles, is
the actual cost incurred for the merchandise sold during the period; this cost is matched
with sales revenue of the period.
7-33
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
LCM is an exception to the cost principle. Conceptually, LCM is based on the view that
when replacement is less than the cost incurred for the merchandise, any such goods
on hand should be valued at the lower replacement (market) price. The effect is to
include the holding loss (i.e., the drop from cost to market) in the cost of goods sold
amount for the period in which the replacement cost dropped. LCM recognizes holding
losses in this manner; however, it does not recognize holding gains.
Req. 4
LCM reduced pretax income and income tax expense. There was a cash savings of
$2,595 for 2011 (assuming the LCM results are included on the income tax return). In
subsequent periods pretax income will be greater by the $8,650 and hence, income tax
and cash outflow will be more. The only real gain to the company would be the time
value of money between 2011 and the subsequent periods when increased income
taxes must be paid (of course, a change in tax rates would affect this analysis).
P7–7.
Req. 1
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
Projected
change
No change from
beginning of year
$7,008,984 = 14.2
$495,005*
$7,008,984 = 11.8
$595,700**
* ($595,700 + $394,310) ÷ 2
** ($595,700 + $595,700) ÷ 2
Req. 2
Projected decrease in inventory = $595,700 – $394,310 = $201,390
A $201,390 increase in cash flow from operating activities, because a decrease in
inventory would increase cash, all other items held constant.
Req. 3
An increase in the inventory turnover ratio indicates an increase in the number of times
average inventory was produced and sold during the period. A higher ratio indicates that
inventory moves more quickly through the production process to the ultimate customer.
As a consequence, the company can maintain less inventory on hand, all other things
being equal. This can benefit the company because less money is tied up in inventory
and as a result, cash flow from operations will be higher. The excess cash can be
invested, earning interest income, or used to reduce borrowings, reducing interest
expense.
7-34
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
P7–8.
Req. 1
A change that increases beginning inventory will decrease net income while a change
that increases ending inventory will increase net income.
Impact on GM net
income (in millions)
Change in ending inventory
Change in beginning inventory
Increase in pretax income
Increase in taxes (30%)
Increase in net income
$2,077.1
(1,784.5)
292.6
(87.8)
$ 204.8
Use of FIFO would result in an increase of $204.8 million in GM reported net income.
The change would result in an increase in income taxes because the LIFO conformity
rule precludes use of LIFO for tax purposes if a method other than LIFO were used for
financial reporting.
Reported net income
Increase
FIFO net income
$320.5
204.8
$525.3
Req. 2
If FIFO had been used, the ending inventory would have been $2,077.1 million higher.
Instead LIFO was used and the $2,077.1 million was allocated to cost of goods sold in
earlier accounting periods (including the current year). Thus, the cumulative difference
between LIFO pretax income and FIFO pretax income was $2,077.1 million, or a
difference of $1,454 million after taxes ($2,077.1 x .7). Therefore, retained earnings on
a FIFO basis would have been $16,794 million (i.e., $15,340 + $1,454).
Req. 3
The reduction in taxes (compared to FIFO) was $87.8 million (calculated in Req. 1).
7-35
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
P7–9.
Req. 1
2011
Sales revenue
Cost of goods sold
Gross profit
Expenses
Pretax income
Income tax expense (30%)
Net income
$2,025,000
1,505,000
520,000
490,000
30,000
9,000
$ 21,000
2012
2013
$2,450,000 $2,700,000
1,645,000* 1,764,000*
805,000
936,000
513,000
538,000
292,000
398,000
87,600
119,400
$ 204,400 $ 278,600
2014
$2,975,000
2,113,000
862,000
542,000
320,000
96,000
$ 224,000
*There was an overstatement of the ending inventory in 2012 by $18,000; this caused
cost of goods sold for 2012 to be understated and 2012 net income to be overstated.
Similarly, because this error was carried over automatically to 2013 as the beginning
inventory, cost of goods sold for 2013 was overstated and 2013 net income
understated. The amounts for 2011 and 2014 were not affected. This is called a selfcorrecting or counterbalancing error. Cumulative net income for the four-year period
was not affected.
Req. 2
2011
2012
Gross profit ratio (gross profit ÷ sales):
Before correction:
$520,000 ÷ $2,025,000 =
.26
$823,000 ÷ $2,450,000 =
$918,000 ÷ $2,700,000 =
$862,000 ÷ $2,975,000 =
After correction:
No change
$805,000 ÷ $2,450,000 =
$936,000 ÷ $2,700,000 =
No change
2013
2014
.34
.34
.29
.26
.33
.35
.29
Req. 3
The effect of the error on income tax expense was:
Income tax expense reported
Correct income tax expense
Income tax expense overstatement (understatement)
7-36
2012
$93,000
87,600
$ 5,400
2013
$114,000
119,400
$(5,400)
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
P7–10. (Supplement A)
Req. 1 Pretax operating profit (loss) for the current year had FIFO accounting been
employed instead of LIFO.
Difference in beginning inventory* (LIFO to FIFO)
Less: Difference in ending inventory* (LIFO to FIFO)
Difference in cost of goods sold (LIFO to FIFO)
$2,076
2,226
$ (150)
Difference in Pretax Net Income = $150 increase
(*The differences are the beginning and ending LIFO Reserve.)
Req. 2 Since prices are rising, LIFO liquidations increase net income before taxes.
The change in pretax operating profit during the current year is given in the
footnote as $23 million. As a consequence, net income before taxes would be
$23 million lower had there been no inventory quantity reduction.
7-37
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
ALTERNATE PROBLEMS
AP71.
a)
Goods available for sale for all methods:
Units
January 1, 2011–Beginning inventory
February 20, 2011–Purchase
June 30, 2011–Purchase
Goods available for sale
390
700
460
1,550
Unit
Cost
$32
34
37
Total
Cost
$12,480
23,800
17,020
$53,300
Ending inventory: 1,550 units – (70 + 750) = 730 units
b) and c)
1.
2.
Average cost:
Average unit cost
Ending inventory
Cost of goods sold
First-in, first-out:
Ending inventory
Cost of goods sold
3.
Last-in, first-out:
Ending inventory
Cost of goods sold
4.
Specific identification:
Ending inventory
Cost of goods sold
$53,300 ÷ 1,550=$34.39.
(730 units x $34.39)
($53,300 – $25,105)
$25,105
$28,195
(460 units x $37) +
(270 units x $34)
$26,200
($53,300 – $26,200)
$27,100
(390 units x $32) +
(340 units x $34)
$24,040
($53,300 – $24,040)
$29,260
(658 units x $34) +
(72 units x $37)
$25,036
($53,300 – $25,036)
$28,264
7-38
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
AP7–2.
Req. 1
NEWRIDGE COMPANY
Partial Income Statement
For the Month Ended January 31, 2012
Sales revenue*
Cost of goods sold**
Gross profit
(a)
Average
Cost
(b)
(c)
FIFO
LIFO
(d)
Specific
Identification
$3,840
2,256
$1,584
$3,840
2,040
$1,800
$3,840
2,560
$1,280
$3,840
2,060
$1,780
Computations:
*Sales revenue = 240 units @ $16 = $3,840.
**Cost of Goods Sold Amounts:
a) Average Cost
Number of Units
120
380
200
x
x
x
x
Total
Cost
$ 960
3,420
2,200
=
$8 =
9 =
11 =
Available
for Sale
700
=
Cost of Goods Sold
Unit Cost
$6,580
$6,580
700 units
=
$9.40 per unit
= $9.40 x 240 units
= $2,256
Cost of Goods Sold
b) FIFO First Units in (Beginning Inventory)
Next Units in (January 12)
Total Cost of Goods Sold (FIFO)
c) LIFO Last Units in (January 26)
Next Units in (January 12)
Total Cost of Goods Sold (LIFO)
7-39
Unit
Units Cost
120
$8
120
9
240
200
40
240
$11
9
Total
Cost
$ 960
1,080
$2,040
$2,200
360
$2,560
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
AP7–2. (continued)
Cost of Goods Sold
d) Specific
First sale
Identification Second sale
Total Cost of Goods Sold
Unit
Cost
$ 8
9
Units
100
140
240
Total Cost
$ 800
1,260
$2,060
Cost of Ending Inventory Amounts:
a) Average Cost
Ending Inventory
b)
c)
=
=
$9.40 x 460 units
$4,324
Ending Inventory
FIFO Last Units in (January 26)
Next Units in (January 12)
Total Ending Inventory FIFO
Units
200
260
460
LIFO First Units in (Beginning Inventory)
Next Units in (January 12)
Total Ending Inventory LIFO
Unit
Cost
Total Cost
$11
$2,200
9
2,340
$4,540
$8
9
120
340
460
Ending Inventory
d) Specific
Beginning
Identification January 12
January 26
Total Ending Inventory (Spec.)
Units
20
240
200
460
Unit
Cost
$ 8
9
11
$ 960
3,060
$4,020
Total Cost
$ 160
2,160
2,200
$4,520
Req. 2
FIFO reports a higher pretax income than LIFO because (1) prices are rising and (2)
FIFO allocates the old (lower) unit costs to cost of goods sold. For the same reason,
FIFO will report a higher EPS amount because it produces a higher pretax income than
LIFO.
7-40
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
AP7–2. (continued)
Req. 3
Because LIFO reports a lower pretax income than FIFO for the reasons given in
Requirement (2), LIFO will result in lower income tax by ($1,800 – $1,280) x 30% =
$156.
Req. 4
LIFO will provide a more favorable cash flow than FIFO of $156 because less cash will
be paid for income tax than would be paid under FIFO (for the reasons given in
Requirements 2 and 3).
7-41
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
AP7–3.
Req. 1
Sales revenue (510 units)
Cost of goods sold:
Beginning inventory
(340 units)
Purchases (410 units)
Goods available for sale
Ending inventory (240 units)*
Cost of goods sold
(510 units)
Gross profit
Expenses
Pretax income
Income tax expense (30%)
Net income
Prices Rising
A
B
FIFO
LIFO
$13,260
$13,260
3,060
4,100
7,160
2,400 (a)
4,760
8,500
5,000
3,500
1,050
$2,450
3,060
4,100
7,160
2,160 (b)
5,000
8,260
5,000
3,260
978
$2,282
*Inventory computations:
(a) FIFO:
240 units @ $10.00 =
(b) LIFO:
240 units @ $9.00 =
(c) FIFO:
240 units @ $9.00 =
(d) LIFO:
240 units @ $10.00 =
Prices Falling
C
D
FIFO
LIFO
$13,260
$13,260
3,400
3,690
7,090
2,160 (c)
4,930
8,330
5,000
3,330
999
$2,331
3,400
3,690
7,090
2,400 (d)
4,690
8,570
5,000
3,570
1,071
$2,499
$2,400
2,160
2,160
2,400
Req. 2
The above tabulation demonstrates that when prices are rising, FIFO gives a higher net
income than LIFO. When prices are falling, the opposite effect results. The difference
in pretax income (as between FIFO and LIFO) is the same as the difference in cost of
goods sold but in the opposite direction. The difference in net income (i.e., after tax) is
equal to the difference in cost of goods sold multiplied by one minus the income tax
rate.
Req. 3
When prices are rising, LIFO derives a more favorable cash position (than FIFO) equal
to the difference in income tax. In contrast, when prices are falling, FIFO derives a
more favorable cash position equal to the difference in income tax.
7-42
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
AP7–3. (continued)
Req. 4
Either method can be defended reasonably. If one focuses on current income and EPS,
FIFO derives a more favorable result (higher than LIFO when prices are rising).
Alternatively, if one focuses on income tax expense and cash position, when prices are
rising, LIFO derives more favorable results (lower taxes, better cash position).
However, these comparative results will reverse if prices fall.
FIFO provides a better balance sheet valuation (higher current asset value) but on the
income statement does not match current expense (cost of goods sold) with current
revenues. Alternatively, LIFO better matches expenses with revenues but produces a
less relevant inventory valuation on the balance sheet.
AP7–4.
Req. 1
COLCA COMPANY
Income Statements Corrected
2011
Sales revenue
Cost of goods sold
Gross profit
Expenses
Pretax income
2012
$60,000
39,000
21,000
16,000
$ 5,000
$63,000
41,000*
22,000
17,000
$ 5,000
2013
$65,000
46,000*
19,000
17,000
$ 2,000
2014
$68,000
46,000
22,000
19,000
$ 3,000
* Increase in the ending inventory in 2012 by $2,000 causes a decrease in cost of
goods sold by the same amount. Therefore, cost of goods sold for 2012 is $43,000 –
$2,000 = $41,000. Because the 2012 ending inventory is carried over as the 2013
beginning inventory, cost of goods sold for 2013 was understated by $2,000. Thus,
the correct cost of goods sold amount for 2013 is $44,000 + $2,000 = $46,000.
7-43
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
AP7–4. (continued)
Req. 2
2011
2012
Gross profit ratio (gross profit ÷ sales):
Before correction:
$21,000 ÷ $60,000 =
.35
$20,000 ÷ $63,000 =
$21,000 ÷ $65,000 =
$22,000 ÷ $68,000 =
After correction:
No change
$22,000 ÷ $63,000 =
$19,000 ÷ $65,000 =
No change
2013
2014
.32
.32
.32
.35
.35
.29
.32
Req. 3
The error would have the following effect on income tax expense:
2012
Before correction:
2012: $3,000 x 30% =
2013: $4,000 x 30% =
After correction:
2012: $5,000 x 30% =
2013: $2,000 x 30% =
Difference
2013
$900
$1,200
1,500
600
$ 600
$ (600)
The income tax expense would have been understated by $600 in 2012 and overstated
by $600 in 2013.
7-44
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
CASES AND PROJECTS
ANNUAL REPORT CASES
CP7–1
Req. 1
The company held $294,928 thousand of merchandise inventory at the end of the
current year. This is disclosed on the balance sheet.
Req. 2
The company purchased $1,823,208 thousand during the current year. The beginning
and ending inventory balances are disclosed on the balance sheet and cost of goods
sold is disclosed on the income statement. Purchases during the year can be computed
by rearranging the basic inventory equation (BI + P – EI = CGS) or using a T-account:
Cost of goods sold .............................................
$1,814,765 thousand
+
Ending inventory ...............................................
294,928 thousand
–
Beginning inventory ..........................................
(286,485) thousand
Purchases ........................................................
$1,823,208 thousand
Inventory
Beg. Balance
Purchases
286,485
1,814,765
1,823,208
End. Balance
Cost of goods
sold
294,928
Req. 3
The company uses the average cost method to determine the cost of its inventory. This
is disclosed in Note 2 under “Merchandise Inventory.” It indicates that inventory is
valued at the lower of average cost or market.
Req. 4
American Eagle Outfitters
Inventory =
Turnover
Cost of Goods Sold
Average Inventory
$1,814,765 = 6.24
290,706.5*
*(286,485 + $294,928) / 2
It indicates how many times the average inventory was purchased and sold during the
year.
7-45
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
CP7–2.
Req. 1
Given the general trend of little or no inflation every year, it would be unlikely that the
replacement cost of Urban Outfitters’ inventory would be lower than its current book
value. And, unless a severe market downturn (or extreme change in fashion) took
place, it would be unlikely that the net realizable value of the company’s current season
inventory would drop below its original cost. Since the end of the year coincides with
the end of the selling season for winter clothes, only these remaining goods are likely to
have a net realizable value below original cost. Therefore, it is likely that only these
items would require a writedown at the end of the year, because the company’s book
value for other inventory items will be lower than both replacement cost and net
realizable value.
Req. 2
The company uses the first-in, first-out method to determine the cost of its inventory.
This is disclosed in Note 2 under “Inventories.”
Req. 3
If the company had overstated its ending inventory by $10 million, its income before
income taxes would be overstated by $10 million. Recall that ending inventory reduces
cost of goods sold, which is an expense. Therefore, cost of goods sold would be $10
million lower and income before income taxes would be $10 million higher (i.e.,
$309,490,000 reported instead of the correct amount of $299,490,).
Req. 4
Urban Outfitters
Inventory =
Turnover
Cost of Goods Sold
Average Inventory
$1,121,140 = 6.56
170,811.5*
* (171,925 + $169,698) / 2
It indicates how many times the average inventory was purchased and sold during the
year.
7-46
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
CP7–3
Req. 1
American Eagle
Outfitters
Inventory =
Turnover
Cost of Goods Sold
Average Inventory
Urban Outfitters
$1,814,765 = 6.24
290,706.5*
$1,121,140 = 6.56
170,811.5**
* ($286,485 + $294,928) / 2
** ($171,925 + $169,698) / 2
Urban Outfitters has a higher inventory turnover ratio than American Eagle
Outfitters. This higher ratio implies that Urban Outfitters was more successful than
American Eagle in moving inventory quickly through the purchasing and sales
processes to the ultimate customer.
Req. 2
Industry
Average
5.92
American Eagle
Outfitters
6.24
Urban Outfitters
6.56
Both American Eagle Outfitters and Urban Outfitters have a higher inventory
turnover than the industry average. That means that they are doing a better job at
managing inventory levels, and moving inventory quickly through the purchasing and
sales processes to the ultimate customer.
7-47
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
FINANCIAL REPORTING AND ANALYSIS CASES
CP7–4.
Req. 1 Production costs included in inventory become cost of goods sold expense on
the income statement in the period the goods are sold.
Req. 2 Since some of the current year’s production is still not sold, some of these
production-related costs that were added to work-in-process inventory during
the production process are still in work-in-process inventory or in finished
goods. This increases total inventory. Since the items have not been sold, the
amounts have not been included in cost of goods sold expense. Thus total
expenses are lower which in turn increases net income.
CP7–5.
Req. 1
Caterpillar
Inventories - LIFO
Plus: LIFO Reserve
Inventories - FIFO
2008
$8,781
3,183
$11,964
2007
$7,204
2,617
$9,821
Cost of goods sold: LIFO
+ Beginning LIFO Reserve
- Ending LIFO Reserve
Cost of goods sold: FIFO
$38,415
2,617
3,183
$37,849
$32,626
2,403
2,617
$32,412
7-48
2006
$6,351
2,403
$8,754
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
2008 LIFO
Inventory turnover =
$38,415
=
($7,204 + $8,781) ÷ 2
4.8
$37,849
=
($9,821 + $11,964) ÷ 2
3.5
$32,626
=
($6,351 + $7,204) ÷ 2
4.8
$32,412
=
($8,754 + $9,821) ÷ 2
3.5
2008 FIFO
Inventory turnover =
2007 LIFO
Inventory turnover =
2007 FIFO
Inventory turnover =
CP7–5. (continued)
DEERE (as provided)
2008 LIFO
7.3
2008 FIFO
4.9
Req. 2
In all three cases, the ratio is higher under LIFO than FIFO. The LIFO beginning and
ending inventory numbers (the denominator) are artificially small because they reflect
old lower costs. LIFO cost of goods sold (the numerator) reflects the new higher costs.
Thus, the numerator in the LIFO calculation does not relate in a meaningful way to the
denominator.
7-49
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
Req. 3
The FIFO inventory turnover ratio is normally thought to be a more accurate indicator
when prices are changing because LIFO can include very old inventory prices in ending
inventory balances. According to the FIFO ratios, Caterpillar has used inventory no
more efficiently during the current period than the prior period. However, it is less
efficient than John Deere. Such comparisons should also consider any changes in
inventory mix between periods or companies, which may also affect the ratio.
7-50
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
CRITICAL THINKING CASES
CP7–6.
1. The press release states that management believes LIFO is more appropriate
because it better matches current costs with current revenues, and also mentions
that there are tax benefits to adopting LIFO for tax purposes.
2. The decrease in pre-tax income was $28,165,000. Thus, ending inventory was
decreased by $28,165,000 and cost of goods sold was increased by $28,165,000.
Since the company is in the 35% tax bracket, this resulted in a decrease in tax
expense of .35 x $28,165,000 = $9,858,000 (rounded to the nearest thousand) and
a decrease in net income of $ 18,307,000.
3. This $9,858,000 tax postponement is significant and is likely to be the main reason
that management adopted LIFO. A decrease in net income is normally a negative
sign to analysts, since it normally implies a decline in future cash flows. In this case,
however, the change had a positive cash flow effect. Most analysts would look
favorably on a change, the only effect of which is to provide the company with an
additional $9,858,000 in cash.
7-51
Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory
CP7–7.
To:
The Files
From: The New Staff Member
Re: Effect of restatement
1.
The Company understated purchases by $47.3 million. This causes cost of
goods sold to be understated and pre-tax income to be overstated by $47.3
million. Net income is overstated by that amount times 1 – tax rate:
$47.3 x (1 – .404) = $28.2 million overstatement
2.
The restatement of the purchases caused the board to rescind management’s
bonuses. Accordingly, pre-tax income will increase by $2.2 million, and net
income will increase by that amount times 1 – tax rate.
$2.2 x (1 – .404) = $1.3 million increase
3.
If it is assumed that bonuses are a fixed portion of net income, the bonus rate
can be roughly estimated using the amounts computed in parts 1 and 2.
Change in bonus
=
Bonus rate per dollar of net income
=
$.078 per dollar of net income (or 7.8%)
Change in net income
$2.2 million
$28.2 million
4.
The Board likely tied management compensation to net income to align the
interests of management with that of shareholders. Typically, increases in net
income will fuel a rise in the stock price. This type of compensation scheme
does create the possibility that unethical management may alter the financial
results to receive higher bonuses.
FINANCIAL REPORTING AND ANALYSIS PROJECTS
CP7–8.
The solution to this case will depend on the company and/or accounting period selected
for analysis.
7-52
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
Chapter 08
Reporting and Interpreting Property,
Plant, and Equipment; Natural
Resources; and Intangibles
ANSWERS TO QUESTIONS
1.
Long-lived assets are noncurrent assets, which a business retains beyond one
year, not for sale, but for use in the course of normal operations. Long-lived assets
include land in use, plant and equipment, natural resources, and certain intangibles
such as a patent used in operating the business. Long-lived assets are acquired
because of the future use that is expected of them. Thus, they may be thought of
as a bundle of future services to be used over a period of time to earn revenue. As
those services are used, as in the case of a machine, the cost of the asset is
allocated as a periodic expense (i.e., matched with revenue).
2.
The fixed asset turnover ratio =
Net sales
[(Beginning net fixed asset balance + Ending net fixed asset balance)  2]
This ratio measures how efficiently a company utilizes its investment in property,
plant, and equipment over time. The ratio can also be compared to the ratio for the
company’s competitors.
3.
Long-lived assets are classified as follows:
(1) Tangible long-lived assets—assets that are tangible (i.e., have physical
substance) and long-lived (i.e., beyond one year); they are acquired for use in
the operation of a business and are not intended for resale. They are
comprised of three different kinds of assets:
(a) Land—not subject to depreciation.
(b) Plant and equipment—subject to depreciation.
(c) Natural resources—mines, gravel pits, and timber tracts. Natural
resources are subject to depletion.
(2) Intangible long-lived assets—assets held by the business because of the
special valuable rights that they confer; they have no physical substance.
Examples are patents, copyrights, franchises, licenses, trademarks,
technology, and goodwill. Intangible assets with definite lives are subject to
amortization.
8-1
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
4.
When a long-lived asset is acquired, it is recorded in the accounts in conformity
with the cost principle. That is, the acquisition cost of a long-lived asset is the cash
equivalent price paid for it plus all incidental costs expended to obtain it, to place it
in the location in which it is to be used, and to prepare it for use.
5.
In measuring and reporting long-lived assets, the matching principle is applied. As
a long-lived asset is used, revenues are earned over a period of time. Over that
same period of time, the long-lived asset tends to be used up or worn out. As a
consequence, under the matching principle, the acquisition cost of the asset must
be allocated to the periods in which it is used to earn revenue. In this way the cost
of the asset is matched, as expense, with the revenues as they are earned from
period to period through the use of the asset.
6.
a. Capital expenditures—expenditures of resources (i.e., assets given up or debt
incurred) for a service or asset that will help earn revenue for periods beyond
the current accounting period. Capital expenditures should be debited to
appropriate asset accounts and then allocated to those future periods in which
revenues will be earned and against which the expenditures will be matched.
Revenue expenditures—expenditures that help earn revenue only for the
current period. Revenue expenditures are debited to appropriate expense
accounts in the period in which incurred.
b. Ordinary repairs—expenditures for the normal maintenance and upkeep of
machinery and other tangible long-lived assets that are necessary to keep the
assets in their usual operating conditions. Generally, ordinary repairs are
recurring in nature, involve relatively small amounts at each occurrence and do
not extend the useful estimated life of the asset. Ordinary repairs are debited to
expense in the period in which incurred.
Improvements—unusual, nonrecurring, major renovations that are necessary
because of unusual conditions. Generally, they are large in amount, not
recurring, and tend to either make the asset more efficient or to extend its
useful life. Extraordinary repairs are debited to the appropriate asset accounts
(or alternatively to the accumulated depreciation accounts) and in that way
affect the amount of depreciation expense for the remaining estimated life of
the asset.
7.
Depreciation—allocation of the cost of a tangible long-lived asset over its useful life.
Depreciation refers to allocation of the costs of such items as plant and equipment,
buildings, and furniture.
Depletion—allocation of the cost of a natural resource over its useful life. It is
identical in concept to depreciation except that it relates to a different kind of asset,
depletable natural resources.
Amortization—allocation of the cost of an intangible asset over its estimated useful
life. Conceptually, it is the same as depreciation and depletion except it relates to
an intangible asset.
8-2
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
8.
To compute depreciation, the three values that must be known or estimated are:
Cost—the actual total expenditures incurred in acquiring the asset in conformity
with the cost principle.
Estimated useful life—the estimated length of time that the asset will be used by
the present owner for the purposes for which it was acquired.
Residual value—the estimated amount of cash that is expected to be recovered at
the end of the estimated useful life of the asset. The residual value is the estimated
cash recovery amount minus the estimated cost of removing and disposing of the
asset at the end of its estimated useful life.
Notice that, on the acquisition date, the first of these values is an actual known
amount, while the latter two are estimates.
9.
The estimated useful life and estimated residual value of a long-lived asset when
used for depreciation purposes relate to the current owner-user and not to all
potential users of the asset because the asset’s cost must be allocated to the
revenue that it generates during the period in which it is to be used by the current
owner. The fact that the current owner may dispose of the asset and others may
use it to earn revenues for a number of periods after that is of no consequence to
the measurement of the asset and income for the current owner (other than for the
effect of estimated residual value).
10. a. The straight-line method of depreciation causes an equal amount of
depreciation expense to be apportioned to, or matched with, the revenues of
each period. It is especially appropriate for tangible long-lived assets that are
used at an approximately uniform level from period to period.
b. The units-of-production method of depreciation causes a depreciation expense
pattern that varies in amount with the rate at which the asset is used
productively each year. For example, if in the current year the asset is used
twice as much as in the prior year, twice as much depreciation expense would
be matched with the revenue of the current year as compared with the previous
year. Usually use is measured in terms of productive output. The units-ofproduction method of depreciation is particularly appropriate for those assets
that tend to earn revenue with use rather than with the passage of time. Thus, it
normally would apply to assets that are not used at a uniform rate from period
to period.
c.
The double-declining-balance method of depreciation is a form of accelerated
depreciation, causing a higher amount of depreciation expense to be matched
with revenue in early periods of the estimated useful life of the asset. The
double-declining-balance method is particularly appropriate when the long-lived
assets perform more efficiently and therefore produce more revenue in the
early years of their useful life than in the later years.
8-3
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
11. The cost of an addition to an existing long-lived asset should be depreciated over
the shorter of the estimated life of the addition or the remaining life of the existing
asset to which it relates. This rule is necessary because an addition to an existing
long-lived asset has no use after the useful life of the existing asset has expired.
12. Asset impairment—when events or changes in circumstances cause the book value
of long-lived assets to be higher than their related estimated future cash flows. It is
accounted for by writing down the asset to the asset’s fair value and recording a
loss.
13. When equipment is sold, the Equipment account is credited for the asset’s historical
cost. Its related Accumulated Depreciation account is debited for the amount
representing prior usage. The Cash account is debited for the sales price. If the
cash received exceeds the cost less accumulated depreciation (net book value), a
Gain on Sale of Equipment is recorded for the difference. If the cash received is
lower than the net book value, a Loss on Sale of Equipment is recorded for the
difference.
Net book value is the asset’s historical cost less accumulated
depreciation on the asset.
14. An intangible asset is acquired and held by the business for use in operations and
not for sale. Intangible assets are acquired because of the special rights they confer
on ownership. They have no physical substance but represent valuable rights that
will be used up in the future. Examples are patents, copyrights, trademarks,
technology, franchises, goodwill, and licenses.
When an intangible asset is purchased, managers determine if it has a definite or
indefinite life. If it has a definite life, the intangible asset’s cost is amortized on a
straight-line basis over its expected useful life. However, an intangible asset with
an indefinite life is not amortized, but is tested annually for probable impairment.
15. Goodwill represents an intangible asset that exists because of the good reputation,
customer appeal, and general acceptance of a business. Goodwill has value
because other parties often are willing to pay a substantial amount for it when they
buy a business. Goodwill should be recorded in the accounts and reported in the
financial statements only when it has been purchased at a measurable cost. The
cost of goodwill is measured in conformity with the cost principle. Because it is
considered to have an indefinite life, goodwill is not amortized, but it is reviewed
annually for impairment of value.
16. Depreciation expense is a noncash expense. That is, each period when
depreciation is recorded, no cash payment is made. (The cash outflow associated
with depreciation occurs when the related asset is first acquired.) Since no cash
payment is made for depreciation, the effect of the depreciation expense on net
income needs to be reversed in the reconciliation to cash flows. Depreciation
expense was originally subtracted to arrive at net income; thus, to reverse its effect,
depreciation expense needs to be added back to net income on the statement of
cash flows (indirect method).
8-4
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
ANSWERS TO MULTIPLE CHOICE
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
a
c
b
b
a
d
a
d
d
c
8-5
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
5
3
3
4
4
5
5
6
4
7
4
8
5
9
5
10
5
Exercises
No. Time
1
10
2
15
3
15
4
20
5
15
6
15
7
20
8
20
9
10
10
10
11
20
12
20
13
15
14
15
15
10
16
15
17
20
18
20
19
15
20
15
21
15
22
20
23
15
Problems
No.
Time
1
20
2
30
3
25
4
20
5
25
6
20
7
20
8
30
9
15
10
25
11
20
Alternate
Comprehensive
Problems
Problem
No.
Time
No.
Time
1
20
1
60
2
30
3
25
4
20
5
20
6
30
7
25
Cases and
Projects
No.
Time
1
20
2
20
3
20
4
15
5
10
6
15
7
15
8
15
9
15
10
20
11
*
* Due to the nature of this project, it is very difficult to estimate the amount of time
students will need to complete the assignment. As with any open-ended project, it is
possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time to discussing research strategies. When we want the
students to focus on a real accounting issue, we offer suggestions about possible
companies or industries.
8-6
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
MINI-EXERCISES
M8–1.
Asset
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
Tractors
Land in use
Timber tract
Warehouse
New engine for old machine
Operating license
Production plant
Trademark
Silver mine
Land held for sale
Nature
E
L
NR
B
E
I
B
I
NR
O (investment)
Cost
Allocation Concept
DR
NO
DP
DR
DR
A
DR
A
DP
NO
M8–2.
Kramer’s fixed asset turnover ratio is
=
Net sales
[(Beginning net fixed asset balance + Ending net fixed asset balance)  2]
=
$3,300,000
[($1,900,000 + $2,300,000)  2]
= 1.57
Kramer’s ratio is over 1½ times as high as Southwest’s 2008 ratio of 1.01, indicating
that Kramer may be much more efficient in its use of fixed assets.
M8–3.
(1) C
(2) R
(3) N
(4) C
(5) N
(6) R
(7) R
(8) C
(9) C
8-7
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
M8–4.
Machinery (original cost)
Accumulated depreciation at end of third year
Depreciation expense =
($31,000 cost – $1,000 residual value) x 1/5 = $6,000
$31,000
Accumulated depreciation = $6,000 annual depreciation expense x 3 yrs = 18,000
Net book value at the end of the third year
$13,000
M8–5.
Machinery (original cost)
$45,000
Accumulated depreciation at end of first year:
Depreciation expense = ($45,000 – $0 acc. depr.) x 2 / 4 = $22,500 22,500
Net book value at end of first year
$22,500
Machinery (original cost)
$45,000
Accumulated depreciation at end of second year:
Depreciation expense = ($45,000 - $22,500 acc. depr.) x 2 / 4 = $11,250
Accumulated depreciation = Year 1, $22,500 + Year 2, $11,250 =
33,750
Net book value at end of second year
$11,250
Machinery (original cost)
Accumulated depreciation at end of third year:
Depreciation expense = ($45,000 - $33,750 acc. depr.) x 2 / 4 = $5,625
Accumulated depreciation = (Year 2, $33,750 + Year 3, $5,625) =
Net book value at end of third year
$45,000
39,375
$5,625
M8–6.
Machinery (original cost)
Accumulated depreciation at end of third year
Depreciation expense per machine hour
= ($21,000 cost – $1,000 residual value) = $0.50 per machine hour
40,000 machine hours
Accumulated depreciation
= $0.50 depreciation expense per machine hr
x (3,200+7,050+7,500) hrs =
Net book value at end of third year
8-8
$21,000
8,875
$12,125
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
M8–7.
a. Machine
Impairment
Y
Loss
$6,000
Cost - Fair Value
$15,500 -$ 9,500
b. Copyright
N
—
Estimated cash flows
exceed book value
c. Factory building
Y
$31,000
$58,000 - $27,000
d. Building
N
—
Estimated cash flows
equal book value
M8–8.
Store fixtures (original cost)
Accumulated depreciation at end of tenth year
Depreciation expense =
($6,000 cost – $800 residual value) x 1/13 = $400
Accumulated depreciation = $400 annual depreciation expense x 10 yrs =
Net book value at end of tenth year (i.e., NBV immediately prior to sale)
Journal entry to record the disposal is as follows.
Cash (+A) ....................................................................
Accumulated depreciation, store fixtures (XA, +A) ....
Loss on sale of store fixtures (+Loss, SE) ................
Store fixtures (A) ............................................
$6,000
4,000
$2,000
1,800
4,000
200
6,000
M8–9.
Elizabeth Pie Company’s management may choose to accept the offer of $5,000,000 as
this amount is more than the $4,800,000 market value of separately identifiable assets
and liabilities ($4,500,000 market value of recorded assets and liabilities and $300,000
for the patent). If so, Giant Bakery would record $200,000 of goodwill on the date of
purchase (i.e., the excess of the $5,000,000 purchase price over the $4,800,000 fair
value of identifiable assets and liabilities). The $110,000 difference in goodwill
(Elizabeth’s $310,000 estimated value of goodwill less actual goodwill of $200,000)
provides potential for Elizabeth’s management to negotiate a higher purchase price.
8-9
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
M8–10.
Wexler Company
Excerpts from Statement of Cash Flows
For the Year Ended December 31, 2012
Cash flows from operating activities:
Net income
Add back: Depreciation expense
Cash provided by (used in) operating activities
$ 13,000
5,500
18,500
Cash flows from investing activities:
Purchase of equipment
Sale of land
Cash provided by (used in) investing activities
(156,000)
18,000
(138,000)
8-10
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
EXERCISES
E8–1.
Hasbro, Inc.
Excerpts from Balance Sheet
(in millions)
ASSETS
Current Assets
Cash and cash equivalents
Accounts receivable (net of allowance for doubtful accounts, $32)
Inventories
Prepaid expenses and other current assets
Total current assets
Property, Plant, and Equipment
Machinery and equipment
Buildings and improvements
Land and improvements
Property, plant, and equipment (at cost)
Less: Accumulated depreciation
Total property, plant, and equipment (net)
Other Assets
Goodwill
Other intangibles (net of accumulated amortization, $800)
Other noncurrent assets
Total other assets
Total Assets
8-11
$ 630
612
300
171
1,713
413
196
7
616
403
213
474
568
200
1,242
$3,168
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–2.
Req. 1
Fixed asset turnover ratio: (in millions)
Sales  [(beginning net fixed assets + ending net fixed assets)  2]
2007
2008
2009
$24,006  $1,556.5
$32,479  $2,393.0
$36,537  $2,704.5
15.42
13.57
13.51
Computation of denominator:
2007
($1,281 + $1,832)  2
2008
($1,832 + $2,954)  2
2009
($2,954 + $2,455)  2
= $1,556.5
= $2,393.0
= $2,704.5
Req. 2
Apple’s fixed asset turnover ratio fell each year from 2007 to 2009. This suggests that
Apple’s management became less efficient at utilizing its long-lived assets over time.
The decrease in 2008 was due primarily to a large increase in fixed assets that year.
Although the turnover has declined, it is possible that the build-up of fixed assets may
lead to increased sales in the future, thus increasing the fixed asset turnover ratio to
prior levels. An analyst can use this longitudinal analysis to observe possible trends
over time. In addition, the analyst may compare Apple’s ratios to those of competitors
in the industry.
8-12
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–3
Req. 1
Building (+A) .........................................................................
97,000
Land (+A) .............................................................................
113,000
Cash (A) ....................................................................
Building
$71,000
23,000
3,000
$97,000
Cash paid
+ renovations to prepare for use
+ share of transfer costs
210,000
Land
$107,000
6,000
$113,000
Req. 2
Straight-line depreciation computation:
($97,000 cost - $15,000 residual value) x 1/10 = $8,200 depreciation expense per year
Note: Land is not depreciated.
Req. 3
Computation of the book value of the property at the end of year 2:
Building
Less: Accumulated depreciation ($8,200 x 2 years)
Land
Net book value
8-13
$ 97,000
(16,400)
$ 80,600
113,000
$193,600
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–4.
Req. 1
Date
Assets
Liabilities
January No effect
1
January Cash
2
Equipment
January Cash
3
Equipment
January Cash
5
Equipment
July 1
Cash
No effect
Stockholders’ Equity
No effect
–6,000 Short term
+15,000
+21,000 note payable
–1,000
+1,000
–2,500
+2,500
–15,750 Short term
–15,000 Interest
note payable
expense*
–750
* $15,000 principal x .10 interest rate x 6/12 of a year = $750 interest
Req. 2
Acquisition cost of the machine:
Cash paid
Note payable with supplier
Freight costs
Installation costs
Acquisition cost
$ 6,000
15,000
1,000
2,500
$24,500
Req. 3
Depreciation for 2012: ($24,500 cost - $4,000 residual value) x 1/10
$ 2,050
Req. 4
On July 1, 2012, $750 ($15,000 x 10% x 6/12) is paid and is recorded as interest
expense. The amount is not capitalized (added to the cost of the asset) because
interest is capitalized only on constructed assets. This machine was purchased.
Req. 5
Equipment (cost) ......................................................................................
Less: Accumulated depreciation ($2,050 x 2 years) ..............................
Net book value at end of 2013 .................................................................
8-14
$24,500
4,100
$20,400
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–5.
Req. 1
Adjusting entry for 2010:
Depreciation expense (+E, SE) .......................................
Accumulated depreciation, equipment (+XA, A) ........
($100,000 – $10,000) x 1/15 = $6,000
6,000
6,000
Req. 2 ( beginning of 2011)
Estimated life
Less: Used life $54,000 accumulated depreciation  $6,000 annual expense =
Remaining life
15 years
9 years
6 years
Req. 3 (during 2011):
Repair and maintenance expense (+E, SE) ....................
Cash (A).....................................................................
(Ordinary repairs incurred.)
1,000
Equipment (+A) .................................................................
Cash (A).....................................................................
Extraordinary repairs incurred and capitalized.
12,000
1,000
12,000
E8–6.
Date
Assets
Liabilities
Stockholders’ Equity
1. 2010* Accumulated
depreciation
–6,000
Depreciation
expense
–6,000
2a. 2011 Cash
–1,000
Repair and
maintenance
expense
–1,000
2b. 2011 Cash
–12,000
Equipment
+12,000
* Adjusting entry for 2010:
($100,000 cost – $10,000 residual value) x 1/15 = $6,000.
8-15
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–7.
Req. 1
a. Straight-line:
Year
Computation
At acquisition
1
($10,000 - $1,000) x 1/4
2
($10,000 - $1,000) x 1/4
3
($10,000 - $1,000) x 1/4
4
($10,000 - $1,000) x 1/4
Depreciation
Expense
Accumulated
Depreciation
$2,250
2,250
2,250
2,250
$2,250
4,500
6,750
9,000
Net
Book Value
$10,000
7,750
5,500
3,250
1,000
b. Units-of-production: ($10,000 – $1,000)  9,000 = $1.00 per hour of output
Depreciation
Accumulated
Net
Year
Computation
Expense
Depreciation
Book Value
At acquisition
$10,000
1
$1.00 x 3,600 hours
$3,600
$3,600
6,400
2
$1.00 x 2,700 hours
2,700
6,300
3,700
3
$1.00 x 1,800 hours
1,800
8,100
1,900
4
$1.00 x 900 hours
900
9,000
1,000
c. Double-declining-balance:
Year
Computation
At acquisition
1
($10,000 - $0) x 2/4
2
($10,000 - $5,000) x 2/4
3
($10,000 - $7,500) x 2/4
4
($10,000 - $8,750) x 2/4
Depreciation
Expense
Accumulated
Depreciation
$5,000
2,500
1,250
625
250
$5,000
7,500
8,750
9,375
9,000
Net
Book Value
$10,000
5,000
2,500
1,250
625
1,000
Too large. Net book value cannot be below residual value.
Req. 2
If the machine is used evenly throughout its life and its efficiency (economic value in
use) is expected to decline steadily each period over its life, then straight-line
depreciation would be preferable. If the machine is used at a consistent rate but the
efficiency is expected to decline faster in the earlier years of its useful life, then an
accelerated method would be appropriate [such as, double-declining-balance]. If the
machine is used at different rates over its useful life and its efficiency declines with
output, then the units-of-production method would be preferable because it would result
in a better matching of depreciation expense with revenue earned.
8-16
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–8.
Req. 1
a. Straight-line:
Year
Computation
At acquisition
1
($580,000 - $60,000) x 1/5
2
($580,000 - $60,000) x 1/5
3
($580,000 - $60,000) x 1/5
4
($580,000 - $60,000) x 1/5
5
($580,000 - $60,000) x 1/5
Depreciation
Expense
Accumulated
Depreciation
$104,000
104,000
104,000
104,000
104,000
$104,000
208,000
312,000
416,000
520,000
Net
Book Value
$580,000
476,000
372,000
268,000
164,000
60,000
b. Units-of-production: ($580,000 – $60,000)  260,000 = $2.00 per unit of output
Depreciation Accumulated
Net
Year
Computation
Expense
Depreciation
Book Value
At acquisition
$580,000
1
$2.00 x 73,000 units
$146,000
$146,000
434,000
2
$2.00 x 62,000 units
124,000
270,000
310,000
3
$2.00 x 30,000 units
60,000
330,000
250,000
4
$2.00 x 53,000 units
106,000
436,000
144,000
5
$2.00 x 42,000 units
84,000
520,000
60,000
c. Double-declining-balance:
Year
Computation
At acquisition
1
($580,000 - 0) x 2/5
2
($580,000 - $232,000) x 2/5
3
($580,000 - $371,200) x 2/5
4
($580,000 - $454,720) x 2/5
5
($580,000 - $504,832) x 2/5
Depreciation
Expense
Accumulated
Depreciation
$232,000
139,200
83,520
50,112
30,067
15,168
$232,000
371,200
454,720
504,832
534,899
520,000
Net
Book Value
$580,000
348,000
208,800
125,280
75,168
45,101
60,000
Too large. Net book value cannot be below residual value.
8-17
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–8. (continued)
Req. 2
If the machine is used evenly throughout its life and its efficiency (economic value in
use) is expected to decline steadily each period over its life, then straight-line
depreciation would be preferable. If the machine is used at a consistent rate but the
efficiency is expected to decline faster in the earlier years of its useful life, then an
accelerated method would be appropriate [such as, double-declining-balance]. If the
machine is used at different rates over its useful life and its efficiency declines with
output, then the units-of-production method would be preferable because it would result
in a better matching of depreciation expense with revenue earned.
E8–9.
Management of General Motors Corporation probably anticipated that the pre-2001
property and equipment would be more productive or efficient in the earlier part of their
lives than in the later. Thus, the accelerated method would provide the best matching of
expenses with revenues in the same period. In 2001, however, General Motors’
management may have recognized a change in the revenue-generating capacity of the
property and equipment such that a better matching would occur using the straight-line
method in which equal amounts of depreciation expense would be computed each
period.
E8–10.
Straight-line depreciation (SL) is a simple method to use and understand. Managers
often prefer SL because it results in lower depreciation expense and higher net income
in the earlier years of an asset’s life when compared with the accelerated methods.
Because SL depreciation results in higher income in earlier years, it is not desirable to
use it for tax reporting purposes with the objective of lowering tax liabilities. By using SL
depreciation instead of an accelerated method in the earlier years for tax purposes, a
company would have to pay higher taxes. In any case, the tax code specifies that
MACRS, an accelerated method, may be used for most tangible depreciable property
placed in service after December 31, 1986. It is important to note, however, that, over
the entire useful life of an asset, total depreciation expense is the same regardless of
the method.
8-18
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–11.
Req. 1
Method of Depreciation
Straight-line ..........................
Units-of-production ...............
Double-declining-balance .....
Depreciation Expense
Year 1
Year 2
$22,500
$22,500
32,250
33,750
48,000
24,000
Book Value at End of
Year 1
Year 2
$73,500
$51,000
63,750
30,000
48,000
24,000
Computations:
Amount to be depreciated: $96,000 – $6,000 = $90,000:
Straight-line:
$90,000  4 years = $22,500 per year
Units-of-production: $90,000  120,000 units = $.75 per unit
Year 1: 43,000 x $.75
= $32,250
Year 2: 45,000 x $.75
= $33,750
Double-declining-balance (Rate: 2 x the straight line rate of 25% (2/4) = 50%):
Year 1:
$96,000 x 50% = $48,000
Year 2:
($96,000 – $48,000) x 50% = $24,000
Req. 2
The double-declining-balance method would result in the lowest EPS for Year 1
because it produced the highest depreciation expense and therefore the lowest income
(from Requirement 1). In Year 2, the units-of-production method would result in the
lowest EPS because it produced the highest depreciation expense and therefore the
lowest income in that year.
Req. 3
Depreciation is a noncash expense; that is, no cash is paid when depreciation is
recognized. Ignoring income tax implications, all methods have the same impact on
cash flows in year 1. Assuming a method is applied for tax determination, the straightline method will result in the lowest expense, highest net income, highest tax liability,
and therefore the highest amount of cash outflows in year 1.
Companies will select
methods for tax purposes that reduce tax obligations.
Req. 4
The machine acquisition would decrease cash provided by investing activities by the
purchase cost of $96,000. As a noncash expense, the annual depreciation should have
no overall effect on cash provided by operating activities—however, because it is
originally subtracted to arrive at net income, an adjustment needs to be made to reverse
this effect for cash flows. Hence, $22,500 (the annual straight-line depreciation) must
be added back to net income in the operating section of the statement of cash flows.
8-19
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–12.
Req. 1
Property, Plant, and Equipment
Beg. Bal
Capital expenditures
33,611
2,636
End. Bal.
35,098
1,040
109
Property sold
Write-offs
Accumulated Depreciation
Property sold
929
15,948
1,814
Beg. Bal.
Depreciation expense
16,833
End. Bal.
Disposal of property and equipment:
Cash (+A) .........................................................................
Accumulated depreciation (XA, +A) ................................
Property and equipment (A) .......................................
Gain on sale of property and equipment (+Gain, +SE)
147
929
Req. 2
Amount of property and equipment written off as impaired during the year:
Beginning balance
$33,611
+ Capital expenditures during year
2,636
- Cost of property sold during year
(1,040)
- Impairment loss during year
(?)
Ending balance
$35,098
Impairment loss = $109
8-20
1,040
36
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–13.
Req. 1a
Cash (+A) ..............................................................................
Accumulated depreciation (XA, +A) ....................................
Delivery truck (A) .............................................................
Sale of an asset at book value; the result is no loss or gain.
Req. 1b
Cash (+A) ............................................................................
Accumulated depreciation (XA, +A) ..................................
Gain on sale of long-lived asset (+Gain, +SE) .................
Delivery truck (A) ...........................................................
Sale of an asset above book value; the result is a gain.
Req. 1c
Cash (+A) ..............................................................................
Accumulated depreciation (XA, +A) ....................................
Loss on sale of long-lived asset (+Loss, SE) ......................
Delivery truck (A) .............................................................
Sale of an asset below book value; the result is a loss.
15,000
23,000
38,000
15,600
23,000
600
38,000
14,600
23,000
400
38,000
Req. 2 Summarization of the effects of the disposal:
1.
The loss or gain on disposal of a long-lived asset is the difference between the
disposal price and the book value at date of disposal.
2.
When the disposal price is the same as the book value there is no loss or gain;
when the price is above book value there is a gain; and when the price is below
book value, there is a loss on disposal.
3.
The book value does not purport to be market value, so a loss or gain on disposal
of a long-lived asset normally would occur.
8-21
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–14.
Req. 1a
Cash (+A) ..............................................................................
500,000
Accumulated depreciation (XA, +A) .................................... 5,500,000
Furniture (A) ....................................................................
Sale of an asset at book value; the result is no loss or gain.
Req. 1b
Cash (+A) ............................................................................
Accumulated depreciation (XA, +A) ..................................
Gain on sale of long-lived asset (+Gain, +SE) .................
Furniture (A) ..................................................................
Sale of an asset above book value; the result is a gain.
6,000,000
1,600,000
5,500,000
Req. 1c
Cash (+A) ..............................................................................
400,000
5,500,000
Accumulated depreciation (XA, +A) ....................................
100,000
Loss on sale of long-lived asset (+Loss, SE) ......................
Furniture (A) ....................................................................
Sale of an asset below book value; the result is a loss.
1,100,000
6,000,000
6,000,000
Req. 2 Summarization of the effects of the disposal:
1.
The loss or gain on disposal of a long-lived asset is the difference between the
disposal price and the book value at date of disposal.
2.
When the disposal price is the same as the book value there is no loss or gain;
when the price is above book value there is a gain; and when the price is below
book value, there is a loss on disposal.
3.
The book value does not purport to be market value, so a loss or gain on disposal
of a long-lived asset normally would occur.
8-22
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–15.
Req. 1
Depreciation expense per year:
$6,000 accumulated depreciation  3 years of usage = $2,000 per year
Estimated useful life:
($18,000 – $8,000) x 1/? useful life = $2,000 per year
$10,000 / $2,000 = 5 year useful life
Req. 2
December 31, 2012:
2,000
Depreciation expense (+E, SE) ....................................
2,000
Accumulated depreciation (+XA, A) ..........................
To bring accumulated depreciation up to the date of the accidental loss
($18,000 – $8,000) x 1/5 = $2,000.
Accumulated depreciation ($6,000 + $2,000) (XA, +A )
Loss on disposal of truck (+Loss, SE) ..........................
Truck (A) ...................................................................
To record disposal of wrecked truck.
8,000
10,000
18,000
E8–16.
Req. 1
Computation of acquisition cost of the deposit in 2012:
February 2012:
Purchase of mineral deposit
March 2012:
Preparation costs
Total acquisition cost in 2012
$ 700,000
74,000
$ 774,000
Req. 2
Computation of depletion for 2012:
$774,000 cost  900,000 cubic yards = $.86 per cubic yard depletion rate
60,000 cubic yards in 2012 x $.86 = $51,600
Req. 3
Computation of net book value of the deposit after the developmental work:
Total acquisition cost in 2012
$ 774,000
Less: 2012 depletion
(51,600)
January 2013 developmental costs
6,000
Net book value
$ 728,400
8-23
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–17.
Req. 1
Acquisition cost:
Technology
Patent
Trademark
$70,000
6,000
13,000
Req. 2
Amortization on December 31, 2012 (straight-line method with no residual value):
Technology: $70,000 x 1/4 = $17,500 amortization expense
Patent:
$6,000 x 1/15 remaining = $400 amortization expense
Trademark: The trademark is not amortized due to its indefinite life.
Req. 3
Income statement for 2012:
Operating expenses:
Amortization expense ($17,500 + $400)
$17,900
Balance sheet at December 31, 2012:
(under noncurrent assets)
Intangibles:
Technology ($70,000 - $35,000*) ....................................
$35,000
Patent ($6,000 - $800) ....................................................
5,200
Trademark ......................................................................
13,000 **
$53,200
* $17,500 amortization expense x 2 years
** Although trademarks are valuable assets, they are rarely seen on balance sheets.
8-24
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–18.
Req. 1
Acquisition cost:
Copyright
Goodwill
Patent
$12,300
65,000
39,200
Req. 2
Amortization on December 31, 2011 (straight-line method with no residual value):
Copyright: $12,300 x 1/10 = $1,230 amortization expense
Goodwill: The goodwill is not amortized due to its indefinite life.
Patent: $39,200 x 1/16 remaining at time of purchase = $2,450 amortization exp.
Req. 3
Income statement for 2011:
Operating expenses:
Amortization expense ($1,230 + $2,450)
Balance sheet at December 31, 2011:
(under noncurrent assets)
Intangibles:
Copyright ($12,300 - $1,230) ..........................................
$11,070
Goodwill .........................................................................
65,000
Patent ($39,200 - $4,900*) ..............................................
34,300
* $2,450 amortization expense x 2 years
8-25
$3,680
$110,370
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–19.
Req. 1 (January 1, 2012):
Leasehold improvements (+A) .............................................. 375,000
Cash (A) ..........................................................................
375,000
Req. 2 (Adjusting entry on December 31, 2012):
Amortization expense* (+E, SE)..........................................
Leasehold improvements (A) ...........................................
($375,000 x 1/10 year lease = $37,500)
37,500
37,500
* Some accountants prefer to label this Rent Expense or Depreciation of Leasehold
Improvements. The cost of the improvement should be allocated over the shorter of
the life of the improvement or the lease term.
8-26
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–20.
Item
Location
1.
Depreciation expense.
(a)
(b)
(c)
Income statement, or
Statement of cash flows, or
Notes to the financial statements
2.
The detail on major classifications (a)
of long-lived assets.
(b)
Balance sheet, or
Notes to the financial statements
3.
Prior year’s accumulated
depreciation.
(a)
(b)
Balance sheet, or
Notes to the financial statements
4.
The accounting method(s) used
for financial reporting purposes.
Notes to the financial statements
5.
Net amount of property, plant,
and equipment.
(a)
(b)
Balance sheet, or
Notes to the financial statements
6.
Whether the company has had
any capital expenditures for the
year.
(a)
(b)
(c)
Statement of cash flows
Increase in assets on the balance sheet
Notes to the financial statements
7.
Policies on amortizing intangibles. Notes to the financial statements
8.
Any significant gains or losses on
disposals of fixed assets.
(a)
(b)
(c)
9. The amount of assets written off as (a)
impaired during the year.
(b)
(c)
8-27
Income statement, or
Statement of cash flows, or
Note to the financial statements
Income statement, or
Statement of cash flows, or
Notes to the financial statements
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–21.
December 31, 2011:
Adjusting entry for 2011 depreciation:
Depreciation expense (+E, SE) ........ ……………….
Accumulated depreciation, equipment (+XA, A)
8,000
8,000
Computation:
($58,000 net book value - $10,000 residual value) x 1/6 = $8,000
Net book value computation:
$100,000 original cost
(54,000) accumulated depreciation through 2010
12,000 capitalized overhaul on January 2, 2011
$ 58,000 net book value on January 2, 2011
Remaining life computation:
15 years estimated life
($54,000 accumulated depreciation  $6,000 expense) – 9 years used
6 years remaining
($100,000 original cost - $10,000 residual value) x 1/15 = $6,000 per year through 2010
8-28
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–22.
Req. 1
Equipment (+A) ................................................................
Cash (A)....................................................................
15,500
15,500
Req. 2
Age of Machine A at December 31, 2012:
($30,000 cost – $4,500 residual value) x 1/5 years = $5,100 depreciation per year.
$10,200 accumulated depreciation  $5,100 = 2 years old at December 31, 2012.
Req. 3
Depreciation expense (for 2013) (+E, SE)......................
Accumulated depreciation, machinery (+XA, A) .......
4,800
4,800
Computations:
Cost when acquired ..............................................................................
$30,000
Less: Accumulated depreciation (2 years) ...........................................
10,200
Undepreciated balance .........................................................................
19,800
Add: Major renovation cost ...................................................................
15,500
Total ..................................................................................................
$35,300
Annual depreciation:
($35,300 net book value - $6,500 new residual value) x 1/6 years of remaining useful
life (8 years total useful life – 2 years used) = $4,800
Req. 4
Requirement (1) assumed that the major renovation and improvement cost was a
capital expenditure rather than a revenue expenditure. Because capital expenditures
benefit future periods, the expenditure is added to the net book value of the asset and
then is depreciated over the remaining life of the asset.
Requirement (3) recognized an accounting change due to a change in estimate (both
estimated life and residual value). A change in estimate is not an error correction;
consequently it is treated prospectively. That is, the effect is spread over the current
year and the future remaining life of the asset. This approach means that the
undepreciated balance at the date of the change in estimate is depreciated over the
remaining life using the revised estimates.
8-29
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
E8–23.
Req. 1
Depreciation expense prior to the change in estimates:
($330,000 cost – $30,000 residual value) x 1/50 = $6,000 annual depreciation
Req. 2
Depreciation expense after the change in estimates:
Step 1 – Age of the asset: $78,000 accumulated depreciation  $6,000 annual expense
= 13 years of depreciation to date.
The building has been depreciated over 13 years as of the beginning of the
year.
Step 2 – Net book value: $330,000 cost  $78,000 accum. deprec. = $252,000
Step 3 – Computation:
(Net book value  new residual value) x 1/remaining life = Deprec. expense
($252,000  $22,500) x 1/17 = $13,500 depreciation expense per year
This was an accounting change due to a change in estimate (both remaining useful life
and residual value). A change in estimate is not an error correction; the remaining book
value is depreciated over the remaining useful life using the revised estimates.
Req. 3
The depreciation expense increases by $7,500 each year for the next 17 years.
Therefore, net income will be lower by $7,500 (ignoring taxes) each year; this in turn will
lower Retained Earnings on the balance sheet. Also on the balance sheet, the asset’s
net book value will be lowered by an additional $7,500 each year for 17 years.
However, since depreciation is a noncash expense, there are no cash flow implications
(again ignoring income tax considerations).
8-30
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
PROBLEMS
P8–1.
Req. 1
Long-lived assets are tangible and intangible resources owned by a business and used
in its operations over several years. Tangible assets (such as property, plant, and
equipment or natural resources) are assets that have physical substance. Intangible
assets (such as goodwill or patents) are assets that have special rights but not physical
substance.
Req. 2
January 2 purchase:
Equipment (1) (+A) ............................................................
Accounts payable(2) (+L) .............................................
Note payable (+L) .......................................................
Common stock(3) (+SE) ..............................................
Additional paid-in capital(4) (+SE) ..............................
Cash (A)....................................................................
January 15 payment:
Accounts payable (L)......................................................
Financing expense (+E, SE) .........................................
Cash (A) ...................................................................
Computations:
(1) Equipment:
86,410
32,010
45,000
2,000
5,000
2,400
32,010
990
33,000
$85,000 invoice – $990 (3% of $33,000 cash to be paid*)
+ $2,400 installation
* Assets are recorded at the cash equivalent price
(2) Balance payable:
$85,000 invoice – $45,000 note payable
– $7,000 common stock and additional paid-in capital –
$990 (3% of $33,000 cash to be paid)
(3) Common stock:
$1 par value x 2,000 shares
(4) Additional paid-in capital: ($3.50 market value - $1 par value) x 2,000 shares
8-31
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–1. (continued)
Req. 3
Date
Jan 2
Assets
Equipment
Liabilities
+86,410 Note payable
Cash
-2,400 Accounts
payable
Jan 15 Cash
-33,000 Accounts
payable
Stockholders’ Equity
+45,000 Common stock
+2,000
+32,010 Additional paid-in
capital
+5,000
-32,010 Financing
expense
-990
Req. 4
Cost of the machinery includes installation costs. Freight was excluded because it was
an expense paid by the vendor. No discount was taken because Cruz Company paid
the cash balance due after the discount period ended. The lost discount is treated as a
financing expense. Common stock is valued at $3.50 per share—for accounting
purposes, this amount is allocated between the Common Stock account for the par
value ($1 per share) and the Additional Paid-In Capital account for the remaining value
($2.50 per share in excess of par value).
8-32
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–2.
Req. 1
Balance 1/1/11
Depreciation
for 2011
Balance prior to
expenditures
a.
b.
c.
Balance 12/31/11
Building
$820,000
820,000
NE
+122,000
+230,000
$1,172,000
Accum.
Deprec.
$410,000
Deprec.
Expense
41,000
$41,000*
451,000
NE
NE
NE
$451,000
41,000
NE
NE
NE
$41,000
Repairs
Expense
Cash
NE
+$7,000
NE
NE
$7,000
$7,000
122,000
230,000
* ($820,000 cost - $0) x 1/20 years = $41,000 depreciation expense per year.
Req. 2
Book Value of Building on December 31, 2011:
Building ($820,000 + $122,000 + $230,000) ......................... $1,172,000
Less: Accumulated depreciation ($410,000 + $41,000) ........
451,000
Net book (or carrying) value .............................................
$721,000
Req. 3
Depreciation is a noncash expense. Unlike most expenses, no cash payment is made
when the expense is recognized. The cash outflow occurred when the related asset
was acquired. For companies selecting the indirect method of preparing a statement of
cash flows (reconciling net income on the accrual basis to cash from operations),
depreciation expense is added back to net income because the expense reduces net
income, yet is not a cash outlay.
8-33
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–3.
Req. 1
Cost of each machine:
A
Purchase price ....................................
Installation costs ..................................
Renovation costs .................................
Total cost .........................................
$11,000
500
2,500
$14,000
Machine
B
$30,000
1,000
1,000
$32,000
C
$8,000
500
1,500
$10,000
Total
$49,000
2,000
5,000
$56,000
Req. 2
Computation of depreciation at the end of year 1 for each machine:
Machine
Method
Computation
A
Straight-line
($14,000  $1,000) x 1/5 = $2,600
B
Units-of-production
($32,000  $2,000)  60,000 hours = $0.50
$0.50 x 4,800 hours = $2,400
C
Double-declining-balance
($10,000 $0) x 2/4 = $5,000
Adjusting entry:
Depreciation expense ($2,600 + $2,400 + $5,000) (+E, SE)
Accumulated depreciation, Machine A (+XA, A)
Accumulated depreciation, Machine B (+XA, A)
Accumulated depreciation, Machine C (+XA, A)
8-34
10,000
2,600
2,400
5,000
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–4.
Req. 1
Depreciation expense of $464 recorded in the current year is inferred from the
activities affecting the Accumulated Depreciation account:
Accumulated Depreciation
2,302
Beg. bal.
Asset sales
0
464 Deprec. Exp.
2,766
End. bal.
Req. 2
Recording depreciation at the end of the period increases expenses (and thus
decreases net income and stockholders’ equity) and decreases the net book value of
the property and equipment accounts. Failing to record depreciation creates the
opposite effects.
Effect on Ratio of Failing to
Record Depreciation Expense
Ratio
Computation
Earnings per
share
Net income
Number of shares of stock
outstanding
Net income will be overstated
with no change in the
denominator  Overstated
Fixed asset
turnover
Sales
Average net fixed asset balance
Numerator does not change;
however, the denominator is
overstated  Understated
Current
ratio
Current assets
Current liabilities
Neither the numerator nor the
denominator are affected by
depreciation expense, since
accumulated depreciation affects
only long-lived assets on the
balance sheet  No effect
Return on
assets
Net income
Average total assets
Net income is overstated and so
is average total assets although
at a lower amount due to
averaging  Overstated
8-35
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–5.
Req. 1
a. Straight-line:
Year
Computation
At acquisition
1
($106,000 - $2,000) x 1/13
2
($106,000 - $2,000) x 1/13
Depreciation
Expense
Accumulated
Depreciation
$8,000
$8,000
$ 8,000
16,000
Net
Book Value
$106,000
98,000
90,000
b. Units-of-production: ($106,000 – $2,000)  200,000 = $0.52 per unit of output
Depreciation Accumulated
Net
Year
Computation
Expense
Depreciation
Book Value
At acquisition
$106,000
1
$0.52 x 20,000 units
$10,400
$10,400
95,600
2
$0.52 x 16,000 units
8,320
18,720
87,280
c. Double-declining-balance:
Year
Computation
At acquisition
1
($106,000 - $0) x 2/13
2
($106,000 - $16,308) x 2/13
Depreciation
Expense*
Accumulated
Depreciation
Net
Book Value
$106,000
$16,308
$16,308
89,692
13,799
30,107
75,893
*Rounded to the nearest dollar.
Req. 2
Cash flow—For tax purposes, the declining-balance (DB) method usually is viewed as
preferable because an early tax deduction is preferable to a later tax deduction. DB
depreciation expense is highest; therefore, it yields lower taxable income and therefore
lower income tax payable (and lower cash outflow) in the early years. In later years, this
effect would reverse. Other than cash outflows for taxes, cash flows are unaffected by
the method chosen by management for financial reporting purposes. Companies may
select different methods for tax and financial reporting.
Fixed asset turnover—The DB method would be most favorable for fixed asset turnover.
Because this depreciation method yields the highest amount of depreciation expense, it
yields the lowest level of net fixed assets and thus the highest fixed asset turnover
during the early years. In later years, this effect would reverse.
EPS—In terms of EPS, straight-line (SL) depreciation would be favorable. This
depreciation method yields the lowest amount of depreciation expense, the highest net
income, and therefore the highest EPS during the early years when compared with the
accelerated methods. In later years, this comparative effect would reverse.
8-36
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–5. (continued)
Recommendation to Ford Motor Company’s management—Companies may choose a
different method for tax purposes than for financial reporting purposes. The goal of
reducing taxes in year 1 is best accomplished by using the double-declining-balance
method. The ease of use of the straight-line depreciation method for financial reporting
would result in the highest EPS for year 1 (assuming no other method better reflects
matching expenses with revenues). As time goes on (in years 2 and later), the relative
advantages of one method over another will reverse. However, accounting methods
should be used consistently over time. Changing methods in the future would require
reasonable justification.
8-37
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–6.
Req. 1
a. Machine A - Sold on Jan. 1, 2012:
(1) Depreciation expense in 2012 - none recorded because disposal
date was Jan. 1, 2012.
(2) To record disposal:
Cash (+A) ..........................................................................
Accumulated depreciation, Machine A (XA, +A)..............
Loss on disposal of machine (+Loss, SE) .......................
Equipment (Machine A) (A).......................................
7,200
13,500
300
b. Machine B – Sold on December 31, 2012:
(1) To record depreciation expense for 2012:
Depreciation expense (+E, SE) .......................................
Accumulated depreciation, Machine B (+XA, A) .......
($41,000 – $4,000)  10 years = $3,700.
3,700
(2) To record disposal:
Cash (+A) ..........................................................................
Note receivable (+A)..........................................................
Accumulated depreciation, Machine B ($29,600 + $3,700)
(XA, +A) ..........................................................................
Gain on disposal of machine (+Gain, +SE) ................
Equipment (Machine B) (A).......................................
21,000
3,700
2,500
6,000
33,300
800
41,000
c. Machine C – Disposal on January 1, 2012:
(1) Depreciation expense in 2012 - none recorded because disposal
date was Jan. 1, 2012.
(2) To record disposal:
Accumulated depreciation, Machine C (XA, +A) ............
Loss on disposal of machine (+Loss, SE) .......................
Equipment (Machine C) (A) ......................................
56,000
19,000
75,000
Req. 2
Machine A: Disposal of a long-lived asset with the price below net book value results in
a loss.
Machine B: Disposal of a long-lived asset with the price above net book value results in
a gain.
Machine C: Disposal of a long-lived asset due to damage results in a loss equal to
remaining book value.
8-38
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–7.
Req. 1
Fixed Assets
Beg. balance
Acquisitions
24,839.2
4,418.0
End. balance
25,127.9
4,129.3
Disposals/transfers
Accumulated Depreciation
Disposals/transfers
8,365.1
1,812.3
1,083.3
41.4
9,135.5
Beg. balance
Depreciation expense
Impairment loss
End. balance
Req. 2
Net book value of the disposals and transfers:
$4,129.3 cost  $1,083.3 accumulated depreciation
Add: Surplus on sale of fixed assets (on statement of cash flows)
Cash proceeds from disposals and transfers
$3,046.0
62.7
$3,108.7
Req. 3
Percentage depreciation expense to cash flows from operations
= ($1,812.3 / $1,445.4) x 100% = 125.4%
Depreciation expense is 1.25 times greater than cash generated from operations. This
suggests that the result of adding back the noncash expense (depreciation) contributed
significantly to the positive operating cash flows. This indicates the high level of capital
assets needed for the airline’s operations.
8-39
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–8.
Req. 1
a.
b.
c.
d.
Date
Assets
Jan. 1 Patent
Cash
Jan. 1 Assets (not detailed)
Goodwill
Cash
Dec. 31 Leasehold improvements
Cash
2011 Cash
e. Dec. 31 Accumulated depreciation,
machine A(1)
Cash
Machine A
Accumulated depreciation,
Machine A(2)
f. Dec. 31 Cash
Machine B
Liabilities
+28,000
–28,000
+154,000
+10,000
–164,000
+15,600
–15,600
– 5,500
– 4,000
+6,000
–25,000
+20,000
Stockholders’ Equity
Repair and
-5,500
maintenance
expense
Depreciation
–4,000
expense
Gain on
+1,000
disposal of
long-lived
asset(3)
–5,000
+5,000
(1)
($25,000 - $5,000) x 1/5 = 4,000
(2)
Accumulated depreciation to Jan. 1, 2011 ...................
Add: Depreciation expense for 2011 ............................
Total accumulated depreciation ...............................
$16,000
4,000
$20,000
(3)
Cash proceeds of disposition.......................................
Net book value of Machine A ($25,000 – $20,000)......
Gain on disposal of long-lived asset ........................
$6,000
5,000
$1,000
Req. 2 December 31, 2011 depreciation and amortization:
a. Patent: $28,000  7 years = $4,000 amortization expense.
b. Goodwill: No amortization due to indefinite life.
c. Leasehold improvements: No amortization since constructed on December 31.
d. This transactions involved a revenue expenditure and not an intangible or capitalized
asset.
e. Machine A: Machine A was sold on December 31, 2011. Depreciation expense
was recorded prior to the sale. No additional depreciation is necessary.
f. Machine B: ($31,000 - $7,000) x 1/15 = $1,600 depreciation expense.
8-40
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–9.
Req. 1
January 5, 2010:
Cash purchase price .............................................................
Less market value of identifiable assets:
Accounts receivable……………………………………. $ 41,000
Inventory…………………………………………………. 200,000
Fixed assets .............................................................. 50,000
Other assets .............................................................. 10,000
Difference (Goodwill) .............................................................
$500,000
301,000
$199,000
Req. 2
December 31, 2010:
a. Depreciation expense on fixed assets acquired: ($50,000 - $0) x 1/10 years = $5,000.
Depreciation expense (+E, -SE) . . . . . . . . . . . . 5,000
Accumulated depreciation (+XA, -A) . . . .
5,000
b. Goodwill has an indefinite life and is not amortized.
8-41
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–10.
Req. 1
a. Patent amortization for one year, $55,900  13 years = $4,300.
b. Copyright amortization for one year, $22,500  10 years = $2,250.
c. Franchise amortization for one year, $14,400  10 years = $1,440.
d. License amortization for one year, $14,000  5 years = $2,800.
e. Goodwill has an indefinite life and is not amortized.
Req. 2
Net Book Value on December 31, 2012:
a.
b.
c.
d.
e.
Item
Date Acquired
Patent ..........................
Jan. 1, 2011
Copyright .....................
Jan. 1, 2011
Franchise .....................
Jan. 1, 2011
License ........................
Jan. 1, 2010
Goodwill .......................
Jan. 1, 2008
Total book value...........
Book Value
Computations
$55,900 – ($4,300 x 2)
$22,500 – ($2,250 x 2)
$14,400 – ($1,440 x 2)
$14,000 – ($2,800 x 3)
$40,000 (not amortized)
Book Value
Dec. 31, 2012
$ 47,300
18,000
11,520
5,600
40,000
$122,420
Req. 3
The book value of the copyright on January 1, 2013 ($18,000) exceeds the expected
future cash flows ($17,000). Therefore, the asset is impaired.
Book value of copyright ..........................................................................
Fair value of copyright ............................................................................
Impairment loss to be recorded, January 2, 2013 ..................................
8-42
$18,000
16,000
$ 2,000
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
P8–11.
Req. 1
(a) Cost of press ..........................................................................................
Residual value ........................................................................................
Amount to depreciate over 20 years.......................................................
$400,000
50,000
$350,000
Annual depreciation expense recorded in 2010 ($350,000  20 years) .
$17,500
(b) Cost of press ..........................................................................................
Less: Accumulated depreciation for 6 years ($17,500 x 6 years) ...........
Net book (carrying) value at end of 2010 ...............................................
$400,000
105,000
$295,000
Req. 2
Cost of press ................................................................................................ $400,000
Accumulated depreciation at end of 2010 (from Req. 1) ..............................
105,000
Net book value (undepreciated amount at the beginning of 2011) ...........
295,000
Less: Revised residual value ........................................................................
73,000
Remaining balance to depreciate ................................................................. $222,000
Annual depreciation for 2011 [$222,000  (25 years – 6 years = 19 years)] * $11,684
*Rounded to the nearest dollar
Remaining life
Req. 3
December 31, 2011—Adjusting entry:
Depreciation expense (+E, SE) ..............................................
Accumulated depreciation (+XA, A) ....................................
8-43
11,684
11,684
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
ALTERNATE PROBLEMS
AP8–1.
Req. 1
Long-lived assets are tangible and intangible resources owned by a business and used
in its operations over several years. Tangible assets (such as property, plant, and
equipment or natural resources) are assets that have physical substance. Intangible
assets (such as goodwill or patents) are assets that have special rights but not physical
substance.
Req. 2
On June 1, 2012:
Equipment (+A) ....................................................................
(1) (1)61,500
Cash (A) .........................................................................
Common stock (+SE) ........................................................
(2)
Additional paid-in capital (+SE) .........................................
(3)
Note payable (+L) .............................................................
(4)
1,500
4,000
8,000
48,000
On September 2, 2012:
Note payable (L) ................................................................. 48,000
(5)
1,440
Interest expense (+E, SE) ..................................................
Cash (A) ..........................................................................
49,440
Computations:
(1) Equipment:
$60,000 invoice + $1,500 installation
(2) Common stock:
$2 par value x 2,000 shares
(3) Additional paid-in capital: ($6 market value - $2 par value) x 2,000 shares
(4) Balance payable:
$60,000 invoice – $12,000 common stock and additional
paid-in capital
(5) Interest expense:
$48,000 x 12% x 3/12
8-44
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
AP8–1. (continued)
Req. 3
Date
Assets
June 1 Equipment
Cash
Sept 2 Cash
Liabilities
+61,500 Note payable
-1,500
Stockholders’ Equity
+48,000 Common stock
+4,000
Additional paid-in +8,000
capital
-49,440 Note payable
-48,000 Interest expense
-1,440
Req. 4
Cost of the machinery includes installation costs. Freight should not be included
because it was paid by the vendor. The $1,440 interest is not a part of the cost of the
machinery—it must be recorded as interest expense because it is a cost of financing.
Common stock is valued at $6 per share—for accounting purposes, this amount is
allocated between the common stock account for the par value ($2 per share) and the
additional paid-in capital account for the remaining value ($4 per share in excess of par
value).
8-45
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
AP8–2.
Req. 1
Balance 1/1/2013
Depreciation
for 2013
Balance prior to
expenditures
a.
b.
c.
Balance 12/31/2013
Building
$330,000
330,000
NE
+ 17,000
+ 70,000
$417,000
Accum.
Deprec.
$82,500
Deprec.
Expense
16,500
(1)$16,500
99,000
NE
NE
NE
$99,000
16,500
NE
NE
NE
$16,500
Repairs
Expense
Cash
NE
+$5,000
NE
NE
$5,000
$5,000
17,000
70,000
(1) $330,000 cost  20 years = $16,500 per year
Req. 2
Book Value of Building on Dec. 31, 2013:
Building ($330,000 + $17,000 + $70,000) .............................
Less: Accumulated depreciation ($82,500 + $16,500) ..........
Net book (carrying) value ...................................................
$417,000
99,000
$318,000
Req. 3
Depreciation is a noncash expense. Unlike most expenses, no cash payment is made
when the expense is recognized. The cash outflow occurred when the related asset
was acquired. For companies selecting the indirect method of preparing a statement of
cash flows (reconciling net income on the accrual basis to cash from operations),
depreciation expense is added back to net income because the expense reduces net
income, yet is not a cash outlay.
8-46
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
AP8–3.
Req. 1
Cost of each machine:
A
Purchase price ....................................
Installation costs ..................................
Renovation costs .................................
Total cost .........................................
$12,200
800
600
$13,600
Machine
B
$32,500
1,100
1,400
$35,000
C
$21,700
1,100
1,600
$24,400
Total
$66,400
3,000
3,600
$73,000
Req. 2
Computation of year 1 depreciation expense for each machine:
Machine
Method
Computation
A
Straight-line
($13,600  $1,000) x 1/8 = $1,575
B
Units-of-production
($35,000  $2,000)  33,000 hours = $1.00
$1.00 x 7,000 hours = $7,000
C
Double-declining-balance
($24,400  $0) x 2/5 = $9,760
Depreciation expense ($1,575 + $7,000 + $9,760) (+E, SE)…. 18,335
Accumulated depreciation, Machine A (+XA, A)………
Accumulated depreciation, Machine B (+XA, A)………
Accumulated depreciation, Machine C (+XA, A)………
8-47
1,575
7,000
9,760
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
AP8–4.
Req. 1
Depreciation expense of $643 million recorded in the current year is inferred from the
activities affecting the Accumulated Depreciation account:
Accumulated Depreciation (in millions)
Impairments
0
4,053
Beg. bal.
Asset sales
384
643 Deprec. Exp.
4,312
End. bal.
Req. 2
Recording depreciation at the end of the period increases expenses (and thus
decreases net income and stockholders’ equity) and decreases the net book value of
the property and equipment accounts. Failing to record depreciation creates the
opposite effects.
Effect on Ratio of Failing to
Record Depreciation Expense
Ratio
Computation
Earnings per
share
Net income
Number of shares of stock
outstanding
Net income will be overstated
with no change in the
denominator  Overstated
Fixed asset
turnover
Sales
Average net fixed asset balance
Numerator does not change;
however, the denominator is
overstated  Understated
Current
ratio
Current assets
Current liabilities
Neither the numerator nor the
denominator are affected by
depreciation expense, since
accumulated depreciation affects
only long-lived assets on the
balance sheet  No effect
Return on
assets
Net income
Average total assets
Net income is overstated and so
is average total assets, although
at a lower amount due to
averaging  Overstated
8-48
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
AP8–5.
Req. 1
a. Machine A – Sold on Jan. 1, 2011:
(1) Depreciation expense in 2011 - none recorded because disposal
date was Jan. 1, 2011.
(2) To record disposal:
Cash (+A) ..........................................................................
Accumulated depreciation, Machine A (XA, +A)..............
Gain on disposal of machine (+Gain, +SE) ................
Machine A (A) ...........................................................
b. Machine B – Sold on December 31, 2011:
(1) To record depreciation expense for 2011:
Depreciation expense (+E, SE) .......................................
Accumulated depreciation, Machine B (+XA, A) .......
($16,500 – $5,000) x 1/10 years = $1,150.
(2) To record disposal:
Cash (+A) ..........................................................................
Note receivable (+A)..........................................................
Accumulated depreciation, Machine B ($8,050 + $1,150)
(XA, +A) ..........................................................................
Loss on disposal of machine (+Loss, SE) .......................
Machine B (A) ...........................................................
6,750
17,600
350
24,000
1,150
1,150
2,000
5,000
9,200
300
16,500
c. Machine C – Disposal on January 1, 2011:
(1) Depreciation expense in 2011 - none recorded because disposal
date was Jan. 1, 2011.
(2) To record disposal:
Accumulated depreciation, Machine C (XA, +A) ............
Loss on disposal of machine (+Loss, SE) .......................
Machine C (A) ..........................................................
48,000
11,200
59,200
Req. 2
Machine A - January 1, 2011: Disposal of a long-lived asset with the price above net
book value, resulting in a gain.
Machine B – December 31, 2011: Disposal of a long-lived asset with the price below
net book value, resulting in a loss.
Machine C - January 1, 2011: Disposal of a long-lived asset due to damage, resulting
in a loss.
8-49
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
AP8–6.
Req. 1
Assets
Liabilities
Jan. 1 (a) License
+7,200
Cash
–7,200
Jan. 1 (b) Leasehold
+17,800
improvements
Cash
–17,800
(1)
July 1 (c) Assets
+115,000 Liabilities
(not detailed)
Goodwill
Cash
Dec. 31 (d1) Accumulated
depreciation,
Machine A (2)
Dec. 31 (d2) Cash
Equipment
Accumulated
depreciation,
Machine A(3)
2012 (e) Cash
Stockholders’ Equity
+24,000
(not detailed)
+29,000
–120,000
–4,500
+6,000
–21,500
+18,000
–6,700
Dec. 31 (f) Cash
Equipment
Depreciation
expense
–4,500
Gain on
disposal of
long-lived
asset(4)
+2,500
Repair and
maintenance
expense
–6,700
–8,000
+8,000
Computations for Acquisition:
(1)
Purchase price ............................................................. $120,000
Less: Market value of net assets ($115,000 - $24,000) 91,000
Goodwill ....................................................................... $ 29,000
Computations for Machine A:
(2)
Depreciation expense for 2012:
($21,500 - $3,500) x 1/4
$4,500
(3)
Accumulated depreciation to Jan. 1, 2012 ...................
Add: Depreciation expense for 2012 (above) ...............
Total accumulated depreciation ...............................
$13,500
4,500
$18,000
(4)
Cash proceeds from disposition ...................................
Net book value of Machine A ($21,500 – $18,000).......
Gain on disposal of long-lived asset .........................
$6,000
3,500
2,500
8-50
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
AP8–6. (continued)
Req. 2 December 31, 2012 depreciation and amortization expense:
a. License: $7,200  4 years = $1,800
b. Leasehold improvements:
Amortize over shorter of:
(a) remaining lease term = 10 years
or
(b) life of the asset = 5 years
Amortization for 2012: $17,800 x 1/5 = $3,560
c. Goodwill: No amortization since it has an indefinite life.
d. Machine A:
Machine A was sold on December 31, 2012. Depreciation
expense was computed up to the date of disposal. No
additional depreciation is necessary.
e. This transaction involved a revenue expenditure and not an
intangible or capitalized asset.
f. Machine B:
($18,000 - $2,000) x 1/4 = $4,000 depreciation expense for 2012
The $8,000 capital expenditure was made on December 31, 2012; no depreciation
expense is recorded in 2012 since the reconditioned machine has not yet been
used.
8-51
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
AP8–7.
Req. 1
a. Patent amortization for one year, $18,600  10 years = $1,860.
b. Copyright amortization for one year, $24,750  30 years = $825.
c. Franchise amortization for one year, $19,200  12 years = $1,600.
d. License amortization for one year, $21,700  7 years = $3,100.
e. Goodwill is not amortized since it has an indefinite life.
Req. 2
Net book value on January 1, 2015:
a.
b.
c.
d.
e.
Item
Date Acquired
Patent ..........................Jan. 1, 2012
Copyright .....................Jan. 1, 2012
Franchise .....................Jan. 1, 2012
License ........................Jan. 1, 2011
Goodwill .......................Jan. 1, 2013
Total net book value.....
Book Value
Computations
$18,600 – ($1,860 x 3)
$24,750 – ($825 x 3)
$19,200 – ($1,600 x 3)
$21,700 – ($3,100 x 4)
$75,000 (not amortized)
Net Book Value
Jan. 1, 2015
$ 13,020
22,275
14,400
9,300
75,000
$133,995
Req. 3
The net book value of the franchise on January 2, 2015 ($14,400) is greater than the
expected future cash flows ($13,500). The asset is impaired.
The loss due to impairment is computed as the difference between net book value
($14,400) and its fair value ($12,000). The impairment loss to be recorded is $2,400.
8-52
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
COMPREHENSIVE PROBLEM (Chapters 6, 7, and 8)
COMP8-1.
Case A
Req. 1 (in millions)
Allowance for uncollectible accounts (XA, +A) 1 .............
Accounts receivable (A)............................................
12
12
Req. 2
Cash collections for 2008 2 were $5,711 million.
Accounts Receivable
Beg.
558
Sales 5,710 ? Collections
? Write-offs
End.
545
-
Allowance for
Uncollectible Accounts
20
Beg.
5 Bad debt
Write-offs ?
expense
13
End.
= Net Realizable Value
538
532
1 Beg. allowance $20 + Bad debt expense $5 – Write-offs ? = End. Allowance $13
Write-offs = $12
2 Beg. accounts receivable $558 + Sales $5,710 – Write-offs $12 – Collections ? =
End. accounts receivable $532
Collections = $5,711
Req. 3
Net Income
÷
Net Sales
= Net Profit Margin
2006
510
4,700
10.85%
2007
497
5,695
8.73%
2008
$(312)
$5,710
(5.46)%
The company’s net profit margin has fallen each year while net sales have risen,
with a net loss reported in 2008. This suggests that, although Dr Pepper Snapple’s
management has generated increasing sales revenue over time, it is having greater
difficulty each year controlling costs and expenses.
8-53
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
COMP8-1. (continued)
Case B
Req. 1
The company should record bad debt expense of $13,900 for 2011.
Req. 2
Under current assets on the 2011 balance sheet:
Accounts receivable, net of the allowance for
doubtful accounts of $12,400
Accounts Receivable
-
End. 620,000
Allowance for Uncollectible
Accounts
1,500
Unadj. bal.
Bad debt
13,900 expense
12,400
End.
$607,600
Net
= Realizable Value
607,600
Unadj. allowance bal. $(1,500) + Bad debt expense ? = End. bal. $12,400
Bad debt expense = $13,900
Case C
Req. 1
The company should record bad debt expense of $481,350 for 2012.
Req. 2
Under current assets on the 2012 balance sheet:
Accounts receivable, net of the allowance for
doubtful accounts of $490,550
Accounts Receivable
End. 5,840,000
-
Allowance for Uncollectible
Accounts
9,200 Unadj. bal.
Bad debt
481,350 expense
490,550
End.
$5,349,450
Net
= Realizable Value
5,349,450
Sales revenue
$160,450,000
x Bad debt rate
x
.003
Bad debt expense $
481,350
Unadj. allowance bal. $9,200 + Bad debt expense $481,350 = End. bal. $490,550
8-54
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
COMP8-1. (continued)
Case D
Req. 1
11/13 Purch
11/4 Purch
Beg.
500
300
100
@ $21 = $10,500
@ $19 = $ 5,700
@ $18 = $ 1,800
Units
100
800
900
(700)
200
Beginning
Purchases
Available for sale
Less: Sales
Ending
Cost
$ 1,800
16,200
$18,000
a. FIFO
Cost of ending inventory:
Layer  200 units x $21 = $4,200
Cost of goods sold:
Layers (100 x $18) + (300 x $19) + (300 x $21) =
$1,800 + $5,700 + $6,300 = $13,800
OR
Cost of goods available for sale
Less: Cost of ending inventory
Cost of goods sold
$18,000 ($1,800 beg. + $16,200 purch.)
4,200
$13,800
b. LIFO
Cost of ending inventory:
Layers  (100 units x $18) + (100 units x $19)
$1,800 +
$1,900
= $3,700
Cost of goods sold:
Layers (500 x $21) + (200 x $19) =
$10,500 + $3,800 = $14,300
OR
Cost of goods available for sale
Less: Cost of ending inventory
Cost of goods sold
8-55
$18,000 ($1,800 beg. + $16,200 purch.)
3,700
$14,300
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
COMP8-1. (continued)
Case D (continued)
c. Weighted average
Cost of ending inventory:
Cost of goods available for sale
÷ Number of goods available
Cost per unit
$18,000 ($1,800 beg. + $16,200 purch.)
÷ 900 units
$20 per unit
200 units ending inventory x $20 per unit cost = $4,000 ending inventory
cost
Cost of goods sold:
700 units sold x $20 per unit cost = $14,000 cost of goods sold
OR
Cost of goods available for sale
Less: Cost of ending inventory
Cost of goods sold
$18,000 ($1,800 beg. + $16,200 purch.)
4,000
$14,000
Req. 2
a. Gross profit under FIFO method
Sales revenue (700 units sold x $50)
Less: Cost of goods sold
Gross profit
$35,000
13,800
$21,200
Gross profit percentage = $21,200 gross profit ÷ $35,000 sales
= .6057 or 60.57%
b. Net income under LIFO method
Sales revenue
Less: Cost of goods sold
Gross profit
Operating expenses
Pretax income
Income tax expense
Net income
$35,000
14,300
20,700
16,000
4,700
1,410
$3,290
c. The LIFO method should be recommended to Stewart for tax and financial
reporting purposes. Prices of inventory are rising. When prices rise, LIFO
yields the highest cost of goods sold, lowest net income, and, for tax
purposes, the lowest tax amount. When a company chooses LIFO to save
taxes (reduce cash outflows), the LIFO Conformity Rule indicates a company
must also use LIFO for financial reporting purposes, even though it reports
the lowest net income.
8-56
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
COMP8-1. (continued)
Case D (continued)
Req. 2
For valuation purposes, ending inventory is to be reported at the lower of cost
or market, a conservative approach so that assets are not overstated, thus
reducing net income. When Stewart applied the LCM method, the following
comparisons were made:
FIFO cost as calculated
$4,200
Replacement cost (200 units x $19.50)
3,900
Since replacement cost (market) is lower than FIFO cost, Stewart should
report the $3,900 on the balance sheet at the end of the month. The $300
difference will increase cost of goods sold, which will reduce net income for
the month.
Case E
Req. 1 Partial depreciation schedules:
a. Office equipment using double-declining-balance method
Year
Computation
2011
($50,000 - $0) x 2/3
33,333
33,333
16,667
2012
($50,000 - $33,333) x 2/3
11,111
44,444
5,556
1,667
35,000
15,000
residual value
0
35,000
15,000
2013
Depreciation Accumulated
Expense
Depreciation
Fully depreciated
Net Book
Value
b. Factory equipment using units-of-production method
(Cost – Residual Value) / Total estimated production =Depreciation rate
($840,000 - $0) / 100,000 hours = $8.40 per hour
Year
Computation
Depreciation Accumulated
Expense
Depreciation
2011
$8.40/hour x 8,000 hours
67,200
67,200
772,800
2012
$8.40/hour x 9,200 hours
77,280
144,480
695,520
2013
$8.40/hour x 8,900 hours
74,760
219,240
620,760
8-57
Net Book
Value
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
COMP8-1. (continued)
Case E
Req. 2
Cash (+A)..............................................................................
Accumulated depreciation, factory equipment(XA, +A) .......
Factory equipment (A) ..............................................
Gain on sale of equipment (+Gain, +SE) ...................
700,000
219,240
840,000
79,240
Req. 3
Net book value of patent = $300,000 cost – ($20,000 annual expense x 3 years)
= $240,000
$300,000 cost x 1/15 = $20,000 amortization expense per year
Test for possible asset impairment:
Net book value of patent  $240,000
Future cash flows 
$210,000
Impaired
Since the net book value of the patent exceeds its future cash flows, the patent is
impaired and must be reduced to its fair value.
Computation of impairment loss:
Net book value of patent  $240,000
Fair value 
$190,000
Impairment loss
$ 50,000 reported on the income statement
8-58
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CASES AND PROJECTS
ANNUAL REPORT CASES
CP8–1.
1.
The company spent $265,335,000 on property and equipment in the 2008 year
(this information is disclosed on the Statement of Cash Flows).
2.
The estimated useful life of leasehold improvements is the lesser of 5 to 10 years
or the term of the lease (disclosed in Note 2 Summary of Significant Accounting
Policies under the heading Property and Equipment).
3.
The original cost of furniture, fixtures, and equipment held by the company at the
end of the most recent reporting year was $536,009,000 (disclosed in Note 6).
4.
Current depreciation and amortization expense is $133,141,000 (disclosed on the
Statement of Cash Flows; note that the amount reported on the Income Statement
is $131,219,000 because part of the $133,141,000 is included in cost of sales), but
accumulated depreciation and amortization increased by only $92,647,000
($558,389,000 – $465,742,000, disclosed in Note 6). The difference of
$92,647,000 may be due to write-offs of capital assets (impairment losses) of
$6,713,000 reported on the Statement of Cash Flows.
5.
Fixed asset
turnover
=
(in thousands)
Net Sales
=
$2,988,866
= 4.38
Average Net Fixed Assets
($625,568 + $740,240)/2
Net sales is found on the Income Statement, and net fixed assets are found under
“Property and Equipment” on the Balance Sheet.
8-59
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CP8–2.
1. The company uses the straight-line method of depreciation. This is disclosed in
Note 2 Summary of Significant Accounting Policies, under the heading “Property and
Equipment.”
2. Accumulated depreciation and amortization was $355,957,000. This is disclosed in
Note 5.
3. Furniture and fixtures have estimated useful lives of 5 years. This is disclosed in
Note 2 Summary of Significant Accounting Policies, under the heading “Property and
Equipment.”
4. The original cost of the leasehold improvements was $486,959,000. This is
disclosed in Note 5.
5. Depreciation and amortization expense was $81,949,000. This is disclosed on the
Statement of Cash Flows.
6.
(in thousands)
Fixed asset
=
Net Sales
=
$1,834,618
= 3.69
turnover
Average Net Fixed
($488,889 + $505,407)/2
Assets
This ratio measures how efficiently Urban Outfitters utilizes its investment in
property, plant, and equipment over time. Net Sales is disclosed on the Income
Statement, and net fixed assets are disclosed on the Balance Sheet under “Property
and Equipment”.
CP8–3.
1.
Fixed assets as a
% of total assets
American Eagle
Outfitters
Urban
Outfitters
37.7%
38.0%
($740,240 / $1,963,676)
($505,407 / $1,329,009)
If one examines the balance sheets for the two firms, American Eagle and Urban
Outfitters have nearly the same percentage of current assets to total assets as well
as nearly the same percentage of fixed assets to total assets.
8-60
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CP8–3. (continued)
2.
American Eagle
Outfitters
Urban
Outfitters
43.0%
41.3%
($558,339 accum. depr. /
$1,298,629 cost.)
($355,957 accum. depr. /
$861,364 cost)
Percent of gross
fixed assets that
have been
depreciated
These percentages are somewhat similar. Differences are potentially due to
Urban Outfitters having slightly newer fixed assets and also depreciating
buildings over 39 years rather than 25 years as American Eagle does.
3.
Fixed Asset
Turnover
American Eagle
Outfitters
Urban
Outfitters
4.38
3.69
$2,988,866 /
($625,568 + $740,240)/2
$1,834,618/
($488,889 + $505,407)/2
American Eagle appears to have the higher efficiency level for fixed assets. The
company generates more than one and one-half times as much in net sales as
Urban Outfitters, but has only one and one-third times more in net fixed assets.
4.
Fixed Asset
Turnover
Industry
Average
American Eagle
Outfitters
Urban
Outfitters
5.76
4.38
3.69
Both American Eagle Outfitters and Urban Outfitters have a fixed asset turnover
ratio that is below the industry average, with Urban Outfitters having the lower
fixed asset turnover ratio. This suggests that both companies are less efficient in
generating sales with fixed assets than the average company in the industry.
This could be due to both companies continuing growth strategies of investing in
new stores which have yet to reach their potential to generate sales.
8-61
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
FINANCIAL REPORTING AND ANALYSIS CASES
CP8–4.
More than three competitors are listed in each of the following industries.
Examples include:
Industry
Company name (Symbol, if available)
1. Airline
Delta Air Lines,Inc. (DAL)
AMR Corporation (AMR)
Continental Airlines Inc. (CAL)
2. Hotels & Motels
Wyndham Worldwide (WYN)
Starwood Hotels and Resorts (HOT)
Marriott International Inc. (MAR)
3. Footwear
Brown Shoe Company, Inc. (BWS)
Skechers USA, Inc. (SKX)
The Timberland Company (TBL)
4. Computer Hardware
Hewlett-Packard (HPQ)
Western Digital Corp. (WDC)
EMC Corporation (EMC)
CP8–5.
Req. 1
Depreciable assets:
Buildings and improvements ....
$ 2,818,300
Fleet and equipment ................
2,072,116
Computer hardware and software
569,669
Total .....................................
$5,460,085
Depreciation expense ..........
 361,062
Estimated useful life
15.12 years
Req. 2
Accumulated depreciation ........
Depreciation expense ..............
Average age
$ 2,788,213
 361,062
7.72 years
At best, these are very rough estimates but they are probably the best that can be made
as an analyst. Some prefer to use an average of several years which is an acceptable
alternative. Likewise, dividing Accumulated Depreciation (used cost) by the total cost of
the fixed assets yields the percentage of the assets’ cost that have been allocated
($2,788,213 ÷ $5,460,085 = 51% used).
8-62
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CP8–6.
Req. 1
The cost of the property, plant, and equipment at the end of the current year is $3,911
million computed as follows:
Cost – accumulated depreciation = Net book value
?
– $1,178 million (from the notes) = $2,733 million (from the balance sheet)
Cost = $3,911 million
Req. 2
The approximate age of the property on that date was 4 years, computed as follows:
$1,178 accumulated depreciation  $289 depreciation expense = 4.076 years
Req. 3
Current year fixed asset turnover ratio:
Sales  [(Beginning net fixed assets + Ending net fixed assets)  2)]
$9,714  [($2,559 + $2,733)  2] = 3.7 times
This ratio is a measure of a company’s efficiency in utilizing fixed assets to generate
revenues. To evaluate Cain’s ratio, it should be compared to ratios in previous years
and also to other companies in the industry.
Req. 4
Cain reported $3,076 million as goodwill that represents the amount Cain paid above
fair market value for the net assets of other companies Cain purchased.
Req. 5
The amortization and depreciation amounts, totaling $497 million, are added to income
from continuing operations because these are noncash expenses. No cash is paid
when these amounts are recognized. To determine cash provided by continuing
operations, all noncash expenses, losses, revenues, and gains need to be adjusted out
of income accounted for on the accrual basis. Since noncash expenses reduce accrualbased income, they need to be added to income to determine cash-based income.
8-63
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CP8–7.
Consider the kinds of transactions that make Property, Plant, and Equipment and
Accumulated Depreciation change during a period:
(in millions)
Property, Plant, and Equipment
Beg. bal. 7,327
Acquire
254
?
Disposal
End. bal. 6,805
Accumulated Depreciation
5,516 Beg. bal.
Disposal
?
420 Depr. Exp.
5,254 End. bal.
Property, Plant, and Equipment (at cost):
Beg. bal., $7,327 + Acquisitions, $254  Disposals, ? = $6,805
Disposals = $ 776
Accumulated Depreciation (used):
Beg. bal., $5,516 + Depreciation expense, $420  Disposals, ? = $5,254
Disposals = $ 682
Net book value of disposals ($776 cost – $682 accumulated depreciation)
Gain on disposal of property
Cash proceeds when property was sold
$ 94
14
$ 108
CRITICAL THINKING CASES
CP8–8.
Req. 1
The interest coverage ratio is a measure of the ability of a company to meet its
obligatory interest payments from current operations. A company with a large coverage
ratio has a greater ability to meet its interest obligations than a company with a small
ratio (other things being equal).
Req. 2
Hess did not include the capitalized interest in its reported interest expense. Instead this
amount was included in an asset account and will be included in depreciation expense
over the life of the asset.
Most analysts include interest expense and capitalized interest when calculating the
coverage ratio. Interest must be paid to the creditor whether it is listed as an expense or
capitalized. This case is a good example of why users of financial statements must
understand accounting and where to find information in the statements.
8-64
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CP8–9.
Req. 1
Amounts in millions of
US dollars
Property and
equipment, net
Q1 Year 1
(March 31)
With
Without
the
the
entries
entries
$ 38,614 $37,843
Q2 Year 1
(June 30)
With
Without
the
the
entries
entries
$ 35,982
Q3 Year 1
(September 30)
With
Without
the
the
entries
entries
$34,651 $ 38,151
Q4 Year 1
(December 31)
With
Without
the
the
entries
entries
$36,077 $ 38,809
Q1 Year 2
(March 31)
With
Without
the
the
entries
entries
$35,794 $ 39,155
$35,322
Sales revenues
8,825
8,825
8,910
8,910
8,966
8,966
8,478
8,478
8,120
8,120
Operating expenses
7,628
8,399
8,526
9,086
7,786
8,529
7,725
8,666
7,277
8,095
Operating income
1,197
426
384
(176)
1,180
437
753
(188)
843
25
The above table shows that the “special journal entries” had the effect of reducing
operating expenses and increasing property and equipment in each quarter. The
reduction in operating expenses directly increased operating income, in some instances
allowing the company to report positive earnings rather than losses (see Q2 and Q4 of
Year 1).
Note: Because Property and Equipment is a balance sheet account that carries its
balance forward from one period to the next, the computation of its book value
“without the entries” must take into consideration the cumulative effects of the entries,
calculated as:
Q1: $37,843 = $38,614 - $771 (Q1)
Q2: $34,651 = $35,982 - $771 (Q1) - $560 (Q2)
Q3: $36,077 = $38,151 - $771 (Q1) - $560 (Q2) - $743 (Q3)
Q4: $35,794 = $38,809 - $771 (Q1) - $560 (Q2) - $743 (Q3) - $941 (Q4)
Q1Y2: $35,322 = $39,155 - $771 (Q1) - $560 (Q2) - $743 (Q3) - $941 (Q4) - $818
8-65
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CP8-9. (continued)
Req. 2
Fixed Asset
Turnover
Ratio
=
Net Sales
Average Net
Fixed Assets
Q2 Yr 1
Q3 Yr 1
Q4 Yr 1
Q1 Yr 2
=
$8,910
$37,298*
$8,966
$37,067+
$8,478
$38,480^
$8,120
$38,982†
=
0.24
0.24
0.22
0.21
37,298* = (38,614 + 35,982)/2
37,067+ = (35,982 + 38,151)/2
38,480^ = (38,151 + 38,809)/2
38,982† = (38,809 + 39,155)/2
The trend across the four quarters shows a gradual and steady decline, suggesting the
company is becoming less efficient in the use of its assets. This decline is somewhat
consistent with the drop in operating income between Q3 and Q4 of Year 1. However,
the trends between operating income and fixed asset turnover are not entirely
consistent because operating income shows a big increase from Q2 to Q3 in Year 1 and
a small increase between Q4 of Year 1 and Q1 of Year 2 at a time when the fixed asset
turnover ratio shows decreases in operating efficiency. This inconsistency is puzzling.
8-66
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CP8-9. (continued)
Req. 3
Looking back, there are a number of questions that might have been raised:

Why you? It’s unusual that the CFO chose someone who doesn’t have
experience with transactions of that magnitude.

Why a new account? It’s unusual that a new account has been created for these
special advance payments, when an “equipment deposit” account already
existed for transactions supposedly of a similar nature.

Why process the transactions through the operating division? The CFO didn’t
offer a clear reason why the transactions were posted in an abnormal manner,
requiring an unusual end-of-period adjustment. (Adjustments like this made at
the request of management are sometimes called “top-side adjustments.”)

Why no support for the amounts? If these truly represented contractual
prepayments for equipment, they would be supported by a copy of the contract or
a cashed check.

Why were the sources of information untraceable? Anonymous Post-it notes and
easily deleted voicemail messages might lead you to wonder if someone is being
careful to cover their tracks.

Why were the amounts so big in comparison to the existing property and
equipment balances and other equipment purchases that period?

Why weren’t the prepayments ever reduced? The length of time to complete the
prepaid equipment deals had exceeded a year, when a normal prepayment was
outstanding for only a few weeks at a time.

Why did the CFO always compliment you and promise big promotion
opportunities for what you must have thought was merely doing your job?
8-67
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CP8-9. (continued)
Req. 4
As a staff person, you can’t doubt or mistrust every assignment you are given. If you
did, you’d likely find yourself out of a job. So, instead, you need to be able to tell the
difference between routine/ordinary requests and unusual requests. When you are
confronted with unusual requests, attempt to understand and evaluate the reasons for
those requests. Consider who is benefited and who is harmed by the actions you are
asked to take. If you are concerned about the ethical or legal implications of your
actions, consult with colleagues independent of the person asking you to take those
actions. Finally, be sure to read and follow your company’s code of ethical conduct.
Many companies make it easy for you to bring ethical concerns to the attention of an
oversight committee.
Req. 5
Clearly, the investors in WorldCom (or World-Con, as it was being called) were
devastated by the news. In the days following the announcement that the company
would restate its 2001 and 2002 financial results, WorldCom’s stock price lost about
90% of its value. Ultimately, stockholders would lose all that they had invested, when
the company entered into and emerged from bankruptcy. This meant that millions of
working people and retirees no longer had the investment income for which they had
saved and on which they had made their retirement plans. It also meant that money
invested in kids’ college funds was gone—more than likely, you or one of your
classmates has to work a part-time job this term to pay for tuition that could have been
funded by your parents’ investments had it not been for the WorldCom fraud.
WorldCom’s creditors also were severely harmed. Soon after the company’s true
financial condition became known, WorldCom filed for bankruptcy protection. This legal
maneuver gave the company time to restructure its operations and propose new
financing arrangements that would keep the company alive. Existing creditors
eventually resigned themselves to the fact that they would have to forgive $36 billion of
the company’s debt if the company was to survive. This meant that the average creditor
was repaid only 42% of what was owed by WorldCom.
The company’s external auditors also were severely hurt because they had failed to
detect the fraud. Undetected fraud is always bad news for external auditors, but this
situation was even worse because WorldCom’s external auditors had been Arthur
Andersen—the same firm that had failed to detect and report the Enron fraud just one
year earlier. Just as Andersen was bracing for a whirlwind of Enron-related lawsuits,
WorldCom’s problems were discovered and that was the end of Arthur Andersen.
These are just three of the groups directly affected by WorldCom’s fraud. Countless
others were adversely affected as well, as the effects of WorldCom’s fraud and
business failure spread through the economy like the ripple of a stone dropped in a
pond. Employees were laid off, other companies lost WorldCom as one of their primary
customers, the confidence of investors in other companies was shaken (causing other
losses in investment value), and the government held numerous meetings to discuss
how to protect the American economy from shocks like this in the future.
8-68
Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
CP8–10.
Req. 1
a. Cash flows: Because cash was paid for interest, cash decreases (-). However, the
amount of interest expense that was capitalized caused expenses to be lower and
net income to be higher.
b. Fixed asset turnover ratio is lower (-) because the denominator is higher due to
interest capitalization.
Req. 2
Because the fixed asset turnover ratio has decreased due to the additional interest
capitalization, all other things equal, one would infer that Marriott management’s
effectiveness in utilizing fixed assets has also decreased.
Req. 3
Although the fixed asset turnover ratio decreased due to the interest capitalization, this
does not indicate a real change in asset efficiency. The same asset is used to generate
the same level of net sales, regardless of whether the interest is capitalized or
expensed. This highlights the need to adjust for the effects of differences in accounting
policies when evaluating a company and making comparisons across time or across
different companies.
FINANCIAL REPORTING AND ANALYSIS TEAM PROJECT
CP8–11. Due to the nature of this project, responses will vary.
8-69
Chapter 09 - Reporting and Interpreting Liabilities
Chapter 09
Reporting and Interpreting Liabilities
ANSWERS TO QUESTIONS
1.
Liabilities are obligations that result from past transactions that require future
payment of assets or the future performance of services, that are definite in amount
or are subject to reasonable estimation. A liability usually has a definite payment
date known as the maturity or due date. A current liability is a short-term liability;
that is, one that will be paid during the coming year or the current operating cycle of
the business, whichever is longer. It is assumed that the current liability will be paid
out of current assets. All other liabilities are defined as long-term liabilities.
2.
External parties have difficulty determining the amount of liabilities of a business in
the absence of a balance sheet. Therefore, about the only sources available to
external parties for determining the number, type, and amounts of liabilities of a
business are the published financial statements. These statements have more
credibility when they have been audited by an independent CPA.
3.
A liability is measured at acquisition at its current cash equivalent amount.
Conceptually, this amount is the present value of all of the future payments of
principal and interest. For a short-term liability the current cash equivalent usually is
the same as the maturity amount. The current cash equivalent amount for an
interest-bearing liability at the going rate of interest is the same as the maturity
value. For a long-term liability, the current cash equivalent amount will be less than
the maturity amount: (1) if there is no stated rate of interest, or (2) if the stated rate
of interest is less than the going rate of interest.
4.
Most debts specify a definite amount that is due at a specified date in the future.
However, there are situations where it is known that an obligation or liability exists
although the exact amount is unknown. Liabilities that are known to exist but the
exact amount is not yet known must be recorded in the accounts and reported in
the financial statements at an estimated amount. Examples of a known obligation of
an estimated amount are estimated income tax at the end of the year, property
taxes at the end of the year, and obligations under warranty contracts for
merchandise sold.
9-1
Chapter 09 - Reporting and Interpreting Liabilities
5.
Working capital is computed as total current assets minus total current liabilities. It
is the amount of current assets that would remain if all current liabilities were paid,
assuming no loss or gain on liquidation of those assets.
6.
The quick ratio is the percentage relationship of quick assets (cash, marketable
securities, and accounts receivable) to current liabilities. It is computed by dividing
quick assets by current liabilities. For example, assuming quick assets of $50,000
and current liabilities of $100,000, the quick ratio would be $50,000/$100,000 = 0.5
(for each dollar of current liabilities there is $0.50 of quick assets). The quick ratio is
influenced by the amount of current liabilities. Therefore, it is particularly important
that liabilities be considered carefully before classifying them as current versus long
term. The shifting of a liability from one of these categories to the other often may
affect the quick ratio significantly. This ratio is used by creditors because it is an
important index of ability to meet short-term obligations. Thus, the proper
classification of liabilities is particularly significant.
7.
An accrued liability is an expense that was incurred before the end of the current
period but has not been paid or recorded. Therefore, an accrued liability is
recognized when such a transaction is recorded. A typical example is wages
incurred during the last few days of the accounting period but not recorded because
no payroll was prepared and paid that included these wages. Assuming wages of
$2,000 were incurred, the adjusting entry to record the accrued liability and the
wage expense would be as follows:
December 31:
Wage expense (+E, -SE)……………………………………
Wages payable (+L) ...... …………………………………..
9-2
2,000
2,000
Chapter 09 - Reporting and Interpreting Liabilities
8.
A deferred revenue (usually called unearned revenue or revenue collected in
advance) is a revenue that has been collected in advance of being earned and
recorded in the accounts by the entity. Because the amount already has been
collected and the goods or services have not been provided, there is a liability to
provide goods or services to the party who made the payment in advance. A typical
example is the collection of rent on December 15 for one full month to January 15
when the accounting period ends on December 31. At the date of the collection of
the rent the following entry usually is made:
December 15:
Cash (+A) ...................................................................
Rent revenue (+R, +SE) ........................................
4,000
4,000
On the last day of the period, the following adjusting entry should be made to
recognize the deferred revenue as a liability:
December 31:
Rent revenue (-R, -SE) ...............................................
Deferred rent revenue (or Rent revenue collected in
advance) (+L) ......................................................
2,000
2,000
The deferred rent revenue (credit) is reported as a liability on the balance sheet
because two weeks’ occupancy is owed in the next period for which the lessee
already has made payment.
9.
A note payable is a written promise to pay a stated sum at one or more specified
dates in the future. A secured note payable is one that has attached to it (or
coupled with it) a mortgage document which commits specified assets as collateral
to guarantee payment of the note when due. An unsecured note is one that does
not have specific assets pledged, or committed, to its payment at maturity. A
secured note carries less risk for the note holder (creditor).
10. A contingent liability is not an effective liability; rather it is a potential future liability.
A contingent liability arises because of some transaction or event that has already
occurred which may, depending upon one or more future events, cause the
creation of a true liability. A typical example is a lawsuit for damages. Whether the
defendant has a liability depends upon the ultimate decision of the court. Pending
that decision there is a contingent liability (and a contingent loss). This contingency
must be recorded and reported (debit, loss; credit, liability) if it is “probable” that the
decision will require the payment of damages that can be reasonably estimated. If it
is only “reasonably possible” that a loss will be incurred, only footnote disclosure is
required.
9-3
Chapter 09 - Reporting and Interpreting Liabilities
11. $4,000 x 12% x 9/12 = $360.
12. The time value of money is another way to describe interest. Time value of money
refers to the fact that a dollar received today is worth more than a dollar to be
received at any later date because of interest.
13. Future value—The future value of a number of dollars is the amount that it will
increase to in the future at i interest rate for n periods. The future value is the
principal plus accumulated interest compounded each period.
Present value—The present value of a number of dollars, to be received at some
specified date in the future, is that amount discounted to the present at i interest
rate for n periods. It is the inverse of future value. In compound discounting, the
interest is subtracted rather than added as in compounding.
14. $8,000 x .3855 = $3,084.
15. An annuity is a term that refers to equal periodic cash payments or receipts of an
equal amount each period for two or more periods. In contrast to a future value of
$1 or a present value of $1 (which involve a single contribution or amount), an
annuity involves a series of equal contributions for a series of equal periods. An
annuity may refer to a future value or a present value.
9-4
Chapter 09 - Reporting and Interpreting Liabilities
16.
Concept
PV of $1
PV of annuity of $1
i = 5%; n =4
.8227
3.5460
Table Values
i = 10%; n =7
.5132
4.8684
i = 14%; n = 10
.2697
5.2161
17. $18,000 – $3,000 = $15,000 ÷ 4.9173 = $3,050.
ANSWERS TO MULTIPLE CHOICE
1. c)
6. a)
2. e)
7. c)
3. d)
8. b)
9-5
4. c)
9. b)
5. c)
10. d)
Chapter 09 - Reporting and Interpreting Liabilities
Authors’ Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
5
3
5
4
5
5
5
6
5
7
5
8
5
9
10
10
10
11
5
Exercises
No.
Time
1
30
2
30
3
30
4
30
5
20
6
20
7
20
8
20
9
30
10
20
11
20
12
15
13
20
14
20
15
10
16
20
17
20
18
20
19
20
20
15
21
20
22
20
23
15
24
20
25
20
26
20
Problems
No.
Time
1
35
2
45
3
30
4
25
5
45
6
30
7
30
8
40
9
40
10
25
11
40
12
30
13
35
14
30
Alternate
Problems
No.
Time
1
45
2
40
3
40
4
30
5
30
6
35
7
35
8
45
Cases and
Projects
No.
Time
1
30
2
30
3
30
4
20
5
45
6
20
7
30
8
*
* Due to the nature of this project, it is very difficult to estimate the amount of time
students will need to complete the assignment. As with any open-ended project, it is
possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time to discussing research strategies. When we want the
students to focus on a real accounting issue, we offer suggestions about possible
companies or industries.
9-6
Chapter 09 - Reporting and Interpreting Liabilities
MINI-EXERCISES
M9–1.
1st Year
$600,000  .11 1/12 = $5,500
2nd Year
$600,000  .11  2/12 = $11,000
M9–2.
October 1
Cash (+A) .......................................................................
Note payable (+L) .......................................................
290,000
December 31
Interest expense (+E, -SE) .............................................
Interest payable (+L)...................................................
7,250
9-7
290,000
7,250
Chapter 09 - Reporting and Interpreting Liabilities
M9–3.
1. Computed from balance sheet data
2. Balance sheet
3. Notes to the statements
4. Not reported but can be computed from balance sheet and income statement
data.
5. Statement of cash flows
M9–4.
Quick Ratio: $20,000 / $90,000 = 0.22
Working Capital: $ 120,000 - $ 90,000 = $ 30,000
M9–5.
Quick Ratio
Working Capital
a. Decrease
Remain the same
b. Decrease
Decrease
c. Increase
Remain the same
d. Decrease
Remain the same
M9–6.
2011
Buzz does not have to record or disclose the liability because the chance
of the liability occurring is remote.
2012
Buzz must disclose the liability in a note because the liability is reasonably
possible.
2013
Buzz must disclose the liability in a note since the existence of a liability is
reasonably possible. If the lawyers believe that the case will be lost on
appeal, a liability should be recorded.
2014
Buzz must record the loss and the liability because the out of court
settlement made the $150,000 loss probable.
9-8
Chapter 09 - Reporting and Interpreting Liabilities
M9–7.
$500,000  0.4632
=
$231,600
$15,000  6.1446
=
$92,169
=
$118,000
+ $129,000  0.9524
=
122,860
+ $ 27,500  5.0757
=
139,582
Total
=
$380,442
$27,500  5.9847
=
$164,579
$16,250  15.1929
=
$246,885
M9–8.
M9–9.
$118,000
M9–10.
It is much better to save $16,250 for 10 years.
M9–11.
$125,000
$17,039
=
X (7.3359)
=
X
EXERCISES
9-9
Chapter 09 - Reporting and Interpreting Liabilities
E9–1.
Req. 1
(a) Current assets ...............................................................
Current liabilities:
Accounts payable .......................................................
Income taxes payable ................................................
Liability for withholding taxes ......................................
Rent revenue collected in advance ............................
Wages payable ..........................................................
Property taxes payable...............................................
Note payable, 10% (due in 6 months) ........................
Interest payable ..........................................................
Working capital ..............................................................
$168,000
$56,000
14,000
3,000
7,000
7,000
3,000
12,000
400
(102,400)
$ 65,600
(b) Quick ratio: ($70,000  $102,400) = 0.68.
Working capital is critical for the efficient operation of a business. Current assets
include cash and assets that will be collected in cash within one year or the normal
operating cycle of the company. A business with insufficient working capital may
not be able to pay its short term creditors on a timely basis.
The quick ratio is a measure of liquidity. It helps analysts assess a company’s
ability to meet its obligations.
Req. 2
No, contingent liabilities are reported in the notes, not on the balance sheet.
Therefore, they are not included in the required computations.
9-10
Chapter 09 - Reporting and Interpreting Liabilities
E9–2.
Req. 1
March 31
Salary and wage expense (+E, -SE) ......................................
Liability for income taxes withheld-employees (+L) ............
Liability for insurance premiums withheld-employees (+L) .
FICA taxes payable-employees (+L) ..................................
Cash (-A) ............................................................................
Payroll for March including employee deductions.
200,000
40,000
1,000
15,000
144,000
Req. 2
March 31
Payroll tax expense (+E, -SE) ................................................
FICA taxes payable-employer (+L) .....................................
Employer payroll taxes on March payroll.
Req. 3
Liability for income taxes withheld-employees (-L) .................
Liability for insurance premiums withheld-employees (-L) ......
FICA taxes payable-employees (-L) .......................................
FICA taxes payable-employer (-L) .........................................
Cash (-A) ............................................................................
Remittance of payroll taxes and deductions for March payroll.
9-11
15,000
15,000
40,000
1,000
15,000
15,000
71,000
Chapter 09 - Reporting and Interpreting Liabilities
E9–3.
Req. 1
The additional labor expense was $6,000, which is the total of payroll taxes that must
be paid by the employer. The $10,000 income taxes and the $6,000 FICA taxes paid
by the employees did not add to the labor cost of the employer. The total labor cost to
the company was $86,000 + $6,000 = $92,000. The employees’ take-home pay was
$70,000; that is, the total of salaries and wages less the deductions paid by the
employees (i.e., $86,000 – $10,000 – $6,000).
Req. 2
Balance sheet liabilities:
Liability for income taxes withheld .......................................................... $ 10,000
FICA taxes payable ($6,000 + $6,000)...................................................
12,000
Total ................................................................................................... $22,000
Req. 3
Both managers and analysts would understand that a 10% increase in salaries is more
expensive than a 10% increase in the employer’s share of FICA (or any other benefit).
The reason is that many benefits are stated as a percentage of salary. As a result, the
cost of a 10% increase in salaries is an increase in both salaries and fringe benefits.
9-12
Chapter 09 - Reporting and Interpreting Liabilities
E9–4.
Req. 1
November 1
Cash (+A) ....................................................................... 4,800,000
Note payable (+L) .......................................................
Borrowed on 6-month, 8%, note payable.
4,800,000
Req. 2
December 31 (end of the accounting period):
Interest expense (+E, -SE) .............................................
Interest payable (+L)...................................................
Adjusting entry for 2 months’ accrued interest
($4,800,000 x 8% x 2/12 = $64,000).
64,000
64,000
Req. 3
April 30 (maturity date):
Note payable (-L) ........................................................... 4,800,000
Interest payable (per above) (-L) ....................................
64,000
Interest expense ($4,800,000 x 8% x 4/12) (+E, -SE) .... 128,000
Cash (-A) ....................................................................
Paid note plus interest at maturity.
4,992,000
Req. 4
It is doubtful that long-term borrowing would be appropriate in this situation. After the
Christmas season, Neiman Marcus will collect cash from its credit sales. At this point, it
does not need borrowed funds. It would be costly to pay interest on a loan that was not
needed. It might be possible to borrow for a longer term at a lower interest rate and
invest idle cash to offset the interest charges. Neiman Marcus should explore this
possibility with its bank but in most cases it would be better to borrow on a short-term
basis to meet short-term needs.
9-13
Chapter 09 - Reporting and Interpreting Liabilities
E9–5.
Req.1
Assets
Liabilities
Stockholders’
Equity
November 1
Cash +
Note Payable +
Not Affected
December 31
Not Affected
Interest Payable +
Interest Expense –
April 30
Cash –
Note Payable –
Interest Expense –
Date
Interest Payable –
Req. 2
It is doubtful that long-term borrowing would be appropriate in this situation. After the
Christmas season, Neiman Marcus will collect cash from its credit sales. At this point, it
does not need borrowed funds. It would be costly to pay interest on a loan that was not
needed. It might be possible to borrow for a longer term at a lower interest rate and
invest idle cash to offset the interest charges. Neiman Marcus should explore this
possibility with its bank but in most cases it would be better to borrow on a short-term
basis to meet short-term needs.
E9–6.
Analysts want to evaluate the short-term obligations of a business in order to assess
liquidity or the ability to satisfy a liability that must be paid in the near future. If PepsiCo
had to pay the $3.6 billion immediately, the analysts would want to know the source of
the needed cash. Because PepsiCo plans to refinance the debt, it will not have to pay it
immediately. Therefore, an analyst would be less concerned about this type of debt.
The key condition that must be satisfied for a short-term borrowing to be classified as
long term is the assurance that the debt can be refinanced. A desire or a plan is not
sufficient. There must be evidence that the company has the capability to do so.
9-14
Chapter 09 - Reporting and Interpreting Liabilities
E9-7
Quick ratio = 0.6 = $120,000 / X
X = $120,000 / 0.6
X = $200,000
E9–8.
Req. 1
Date
Assets
Liabilities
Stockholders’
Equity
January 10
Inventory +
Accounts Payable +
Not Affected
March 1
Cash +
Note Payable +
Not Affected
Req. 2
August 31
Cash Paid:
$47,250 (Principal plus interest)
Req. 3
Transaction (a) has no impact on cash flows because there is neither an inflow nor
an outflow of cash. Transaction (b) results in an inflow of cash from financing
activities. The August 31 payment is an outflow of cash. (Note to instructor: If you
have emphasized the Statement of Cash Flows, you should discuss the specific
nature of these cash flows. The repayment of principal is a cash flow from financing
activities and the payment of interest expense is a component of cash flows from
operating activities.)
9-15
Chapter 09 - Reporting and Interpreting Liabilities
E9–9.
The note does not give us sufficient information to reach a definitive conclusion but
there a several factors that should be discussed. No obligation for future payments
is recorded if the lease is short term, but the note indicates that the leases are long
term and are designed to provide long-term occupancy rights. The critical issue is
whether the leases meet one of the criteria to be classified as a capital lease in
which case the present value of the lease payments would be recorded as a
liability. We find that students enjoy talking about why McDonald’s buys some
properties but leases others and how the accounting treatments differ.
E9–10.
The question of whether a lease will be recorded as a liability depends on the
specific facts and circumstances associated with the lease. In the most simple
terms, a short-term lease probably would not have to be recorded as a liability
but a long-term lease would probably be recorded as a liability. The assistant is
correct in the sense that assets could be acquired under a lease and, if the
transaction is structured in the proper manner, no liability would be recorded.
In class, we like to use this question to explore two issues: (1) Should managers
structure transactions to meet the business needs of the company or to comply
with rules associated with a preferred accounting treatment, and (2) Do users of
financial statements react to the manner in which a transaction is reported or to
the underlying economic reality of the transaction?
9-16
Chapter 09 - Reporting and Interpreting Liabilities
E9–11.
A liability is “a probable future sacrifice of economic benefits that arises from past
transactions.” To be recorded, the amount of a liability must be subject to a
reasonable estimate. The employees of American Airlines earn their retirement
benefits by performing work for the company. These benefits are a form of
deferred compensation and are directly related to a past transaction (exchanging
work for compensation). Clearly, American Airlines has an economic obligation to
pay for health care and life insurance in the future. It is difficult, however, to
determine the exact amount of the liability for these benefits. To do so, American
Airlines would have to know the number of employees who will actually retire, the
number of years that they will live during retirement, and the cost of health care
and life insurance during those retirement years. Under GAAP, it is not
necessary to know the “exact” amount of a liability in order to record it. The
liability must be one that can be reasonably estimated. The FASB requires
companies to record liabilities for these benefits because, in their judgment,
reasonable estimates can be developed. Many managers disagree with this view
but, nevertheless, American Airlines reported this obligation as a liability on its
balance sheet.
9-17
Chapter 09 - Reporting and Interpreting Liabilities
E9–12.
Req. 1
Income taxes payable
Year 2011
Year 2012
$250,000
$290,000
54,000
58,000
$304,000
$348,000
Increase in deferred tax liability
Income tax expense
Req. 2.
Tax expense is based on income reported on the income statement while tax liability is
based on income reported on the tax return. Because different rules govern the
preparation of the two statements, the tax expense and taxes currently payable are
usually different.
E9–13.
Req. 1
Income tax payable:
Income tax expense
Less: increase in deferred taxes
Income taxes payable
$580,000
108,000
$472,000
Req. 2
There are separate rules governing the determination of tax expense (GAAP)
and the amount of taxes currently payable (IRS regulations). Companies are
required to keep separate records. Fortunately, most companies are able to
reduce the amount of taxes currently payable by maintaining two sets of books.
This savings justifies the additional bookkeeping costs.
9-18
Chapter 09 - Reporting and Interpreting Liabilities
E9–14.
Req. 1
For each year, income tax expense is less than income taxes currently payable. It
is important for students to recognize that deferred taxes do not always result in
lower taxes payable when compared to tax expense.
Req. 2
This note explains the difference between taxes currently payable and tax expense
for each year. It is not the amount of deferred taxes reported on the balance sheet.
E9–15.
Req. 1
$50,000 x 0.7513
=
$37,565
$10,000 x 2.4869
=
$24,869
Req. 2
It is better to pay in three installments because the economic cost is less.
Req. 3
$40,000 x 0.5132
=
$20,528
$15,000 x 6.1446
=
$92,169
Req. 4
9-19
Chapter 09 - Reporting and Interpreting Liabilities
E9–16.
Present value of annuity: $10,100 x 4.8684 = $49,171
Because the present value of the annuity is less than the immediate cash
payment, the winner should select the cash payment.
E9–17.
Present value of future amount: $900,000 x 0.5019 = $451,710
Because the client already has $200,000 in the account, she needs to deposit an
additional $251,710.
E9–18.
Present value of annuity: $13,000 x 3.2397 = $42,116
E9–19.
Present value of unequal payments:
$11,000 x 0.9091 = $10,000
30,000 x 0.8264 =
24,792
50,000 x 0.7513 =
37,565
$72,357
E9–20.
Present value of cash payments:
$15,000 x 5.9713 = $89,570
120,000 x 0.5820 = 69,840
$159,410
E9–21.
Present value of annuity: $55,000 x 6.8017 = $374,094
9-20
Chapter 09 - Reporting and Interpreting Liabilities
E9–22.
$25,000 x 5.0330 = $125,825 (purchase price)
E9–23.
Req. 1
$6,000 x 2.5937 = $15,562
Req. 2
$15,562 – $6,000 = $9,562 (time value of money, or interest)
Req. 3
1st year: $6,000 x 10% = $600 (interest)
2nd year: ($6,000 + $600) x 10% = $660 (interest)
E9–24.
Req. 1
$58,800 x 1.3605 = $79,997
Req. 2
Savings account (+A) ..................................................... 58,800
Cash (-A) ....................................................................
58,800
Req. 3
$79,997 – $58,800 = $21,197 (time value of money or interest)
Req. 4
December 31
2011
2012
Savings account (+A) ............................. 4,704
5,080
Interest revenue (+R, +SE) .................
4,704
5,080
Computations:
2011: $58,800 x 8% = $4,704.
2012: ($58,800 + $4,704) x 8% = $5,080.
9-21
Chapter 09 - Reporting and Interpreting Liabilities
E9–25.
Req. 1
December 31
Savings account (+A) .....................................................
Cash (-A) ....................................................................
2,000
2,000
Req. 2
$2,000 x 15.1929 = $30,386 (balance)
Req. 3
$30,386 - ($2,000 x 10) = $10,386 (time value of money or interest)
Req. 4
1st year: $2,000 x 9% = $180
2nd year: ($2,000 + $2,000 + $180) x 9% = $376
Req. 5
Savings account (+A) .............................
Cash (-A) ............................................
Interest revenue (+R, +SE) ................
December 31
2012
2013
2,180
2,376
2,000
2,000
180
376
E9–26.
Req. 1
$3,500 x 4.3746 = $15,311 (balance in the fund)
Req. 2
$15,311 – ($3,500 x 4) = $1,311 (time value of money or interest)
Req. 3
1st year: No interest because the deposit was at year-end.
2nd year: $3,500 x 6% = $210 (interest)
3rd year: ($3,500 + $3,500 + $210) x 6% = $433
4th year: ($3,500 + $3,500 + $3,500 + $210 + $433) x 6% = $669
9-22
Chapter 09 - Reporting and Interpreting Liabilities
PROBLEMS
P9–1.
Req. 1
January 15:
Purchases (+A) ..............................................................
Cash (-A) ....................................................................
14,200
April 1:
Cash (+A) .......................................................................
Note payable, short term (+L) .....................................
700,000
June 14:
Cash (+A) .......................................................................
Unearned revenue (+L) ..............................................
15,000
July 15:
Unearned revenue (-L) ...................................................
Service revenue (+R, +SE) .........................................
3,750
December 12:
Electric expense (+E, -SE) .............................................
Electric payable (+L) ...................................................
27,860
December 31:
Wage expense (+E, -SE). ..............................................
Wages payable (+L) ...................................................
15,000
9-23
14,200
700,000
15,000
3,750
27,860
15,000
Chapter 09 - Reporting and Interpreting Liabilities
Req. 2
December 31:
Interest expense (+E, -SE). ............................................
Interest payable (+L)...................................................
42,000
42,000
($700,000 x 8% x 9/12 = $42,000).
P9–2.
Req. 1
January 8:
Purchases (+A) ..............................................................
Accounts payable (+L) ................................................
14,860
January 17:
Accounts payable (-L) ....................................................
Cash (-A) ....................................................................
14,860
April 1:
Cash (+A) .......................................................................
Note payable, short term (+L) .....................................
35,000
June 3:
Purchases (+A) ..............................................................
Accounts payable (+L) ................................................
17,420
9-24
14,860
14,860
35,000
17,420
Chapter 09 - Reporting and Interpreting Liabilities
July 5:
Accounts payable (-L) ....................................................
Cash (-A) ....................................................................
August 1:
Cash (+A) .......................................................................
Rent revenue ($6,000 x 5/6) (+R, +SE) ......................
Deferred rent revenue ($6,000 x 1/6) (+L) ..................
17,420
17,420
6,000
5,000
1,000
December 20:
Cash (+A) .......................................................................
Liability-deposit on trailer (+L) ....................................
100
December 31:
Wage expense (+E, -SE). ..............................................
Wages payable (+L) ...................................................
9,500
9-25
100
9,500
Chapter 09 - Reporting and Interpreting Liabilities
P9–2. (continued)
Req. 2
December 31:
Interest expense (+E, -SE). ............................................
Interest payable (+L)...................................................
3,150
3,150
($35,000 x 12% x 9/12 = $3,150).
Req. 3
Balance Sheet, December 31
Current Liabilities
Note payable, short term ............................................
Deposit on trailer ........................................................
Wages payable ...........................................................
Interest payable ..........................................................
Deferred rent revenue ...............................................
Total ........................................................................
Req. 4
Transaction
Effect
January 8
No effect
January 17
Decrease
April 1
Financing activity (no effect
on operating activities)
June 3
No effect
July 5
Decrease
August 1
Increase
December 20
Increase
December 31
No effects for either entry
9-26
$35,000
100
9,500
3,150
1,000
$48,750
Chapter 09 - Reporting and Interpreting Liabilities
P9–3.
Req. 1
Date
Assets
Liabilities
Stockholders’ Equity
January 8
Purchases +
Accounts Payable +
No effect
January 17
Cash –
Accounts Payable –
No effect
April 1
Cash +
Note Payable +
No effect
June 3
Purchases +
Accounts Payable +
No effect
July 5
Cash –
Accounts Payable –
No effect
August 1
Cash +
Deferred Revenue +
Revenue +
December 20
Cash +
Deposit +
No effect
December 31
No effect
Wages Payable +
Wage Expense -
December 31
No effect
Interest Payable +
Interest Expense -
9-27
Chapter 09 - Reporting and Interpreting Liabilities
Req. 2
Transaction
Effect
January 8
No effect
January 17
Decrease
April 1
Financing activity (no effect
on operating activities)
June 3
No effect
July 5
Decrease
August 1
Increase
December 20
Increase
December 31
No effects for either entry
9-28
Chapter 09 - Reporting and Interpreting Liabilities
P9–4.
Req. 1
(a)
December 31
Wage expense (+E, -SE) ...............................................
Wages payable (+L) ...................................................
4,000
(b) January 6
Wages payable (-L) ........................................................
Cash (-A) ....................................................................
4,000
4,000
4,000
Req. 2
(a) December 10
Cash (+A) .......................................................................
Rent revenue (+R, +SE) .............................................
Collection of rent revenue for one month.
(b) December 31
Rent revenue (-R, -SE) ..................................................
Rent revenue collected in advance (or Deferred rent
revenue) (+L) ..........................................................
Unearned rent (10/30 x $2,400 = $800).
2,400
2,400
800
800
Alternatively, the collection could have been originally recorded as follows, which
would not require an adjusting entry:
Cash (+A) .......................................................................
Rent revenue (+R, +SE) .............................................
Rent revenue collected in advance(+L) ......................
2,400
1,600
800
Req. 3
Balance sheet at December 31
Current Liabilities:
Wages payable ...........................................................
Rent revenue collected in advance ............................
9-29
4,000
800
Chapter 09 - Reporting and Interpreting Liabilities
Req. 4
Accrual-based accounting is more beneficial to financial analysts because it
records revenues when they are earned and expenses when they are incurred,
regardless of when the related cash is received or paid. A financial analyst is
looking towards the future of the company, so it is helpful to know how much cash
will be coming into and out of the company at later dates.
P9–5.
Req. 1
Date
Assets
Liabilities
Stockholders’
Equity
(a) December 31
No impact
Wages Payable +
Wages Expense -
(b) January 6
Cash -
Wages Payable -
No impact
(c) December 10
Cash +
No impact
Rent Revenue +
(d) December 31
No impact
Deferred Rent +
Rent Revenue -
Req. 2
Accrual-based accounting is more beneficial to financial analysts because it
records revenues when they are earned and expenses when they are incurred,
regardless of when the related cash is received or paid. A financial analyst is
looking towards the future of the company, so it is helpful to know how much cash
will be coming into and out of the company at later dates.
9-30
Chapter 09 - Reporting and Interpreting Liabilities
P9–6.
1.
2.
December 31
Warranty expense (+E, -SE) ..........................................
Warranty payable (+L) ................................................
500,000,000
Total effect of various transactions during 2012:
Warranty payable (-L) ....................................................
Cash (-A) ....................................................................
500,000,000
Total effect of various transactions during 2011:
Cash (+A) .......................................................................
Unearned revenue (+L) ..............................................
90,000,000
For 2012:
Unearned revenue (-L) ...................................................
Revenue (+R, +SE) ....................................................
54,000,000
500,000,000
500,000,000
90,000,000
54,000,000
3.
The company should report litigation expense and the related liability after the jury
awarded damages. If lawyers for Brunswick are confident of their grounds for
appeal, the company might simply report a contingent liability.
4.
The quick ratio for Disney is 0.35. To properly interpret the ratio, analysts would
look at much more information. For example, Disney was able to generate over $6
billion in cash from its operations. Analysts would also compare the ratio to similar
companies. For example, the quick ratios for many similar companies are close to
the ratio for Disney. This brief exercise is intended to open a discussion concerning
the need to avoid placing too much emphasis on a specific accounting number or
ratio.
5.
As an oil and gas company, Halliburton can be expected to have some adverse
impact on our environment. In many cases, federal law requires these companies
to rectify these negative effects. Halliburton records the cost of future
environmental cleanup efforts in the year that the damage is done instead of the
year that the work is performed. This policy is consistent with the matching
principle. Environmental damage can be thought of as a necessary cost of
producing oil and gas. The cost should be matched with the revenue generated by
the sale of gas and oil instead of being recorded as an expense in the period in
which the cleanup work actually takes place.
9-31
Chapter 09 - Reporting and Interpreting Liabilities
P9–7.
Req. 1 Not reported---Amount not subject to estimate
Req. 2 Not reported---No reason to believe that loss is probable
Req. 3 Report liability---Amount can be estimated and loss seems probable
Req. 4 Judgment call depending on circumstances. A footnote disclosure might be
sufficient, but some auditors would insist on a liability.
Req. 5 Report liability--- Amount is known and loss is probable
P9–8.
a.
Remain the same
b.
Decrease
c.
Remain the same
d.
Remain the same (because it is a financing activity)
e.
Remain the same
f.
Decrease
g.
Remain the same
h.
Remain the same
i.
Increase
9-32
Chapter 09 - Reporting and Interpreting Liabilities
P9–9.
The current liability classification is based on the expectation that the company will pay
the liabilities during the subsequent year. Analysts are interested in this classification
because it provides important information to use when predicting future cash flows. If
management has the intent and the ability to refinance a short-term liability, then it will
not result in a cash outflow. In this circumstance, it is appropriate to reclassify the debt
as long term.
The quick ratio for PepsiCo should be compared over time and to other companies
before the analyst makes a determination. In the case of PepsiCo, the company is not
experiencing a liquidity problem. It generates large cash flows from operations and has
a significant line of credit available if it needs additional funds. Furthermore, the industry
traditionally operates with a relatively low quick ratio. It is therefore unlikely that
P9–9. (continued)
management made the reclassification simply to increase its quick ratio. Instead the
company was probably trying to get a better balance between short-term and long-term
borrowings.
Because management has the ability and intent to refinance the borrowings on a longterm basis, the quick ratio should be based on the reclassification. The analyst might
want to use the ratio before reclassification if he or she thought that the reclassification
was only intended to manipulate the ratio (which does not appear to be the case). The
analyst should use caution when comparing the ratio for the current year (after
reclassification) with the ratio for the previous year (before reclassification).
P9–10.
Req. 1
GAAP Depreciation:
$1,000,000 ÷ 20 years = $50,000
Tax Depreciation:
$1,000 000 × 10% = $100,000
Book Value:
2011
GAAP
Cost
Acc. Dep
Book Value
2012
Tax
GAAP
Tax
$1,000,000 $1,000,000 $1,000,000 $1,000,000
50,000
100,000
$ 950,000
$ 900,000
9-33
100,000
$ 900,000
200,000
$ 800,000
Chapter 09 - Reporting and Interpreting Liabilities
Deferred tax liability 2011:
($950,000 - $900,000) × 34% = $17,000
Deferred tax liability 2012:
($900,000 - $800,000) × 34% = $34,000
The difference is a liability because additional income taxes must be paid in the
future. This is a result of lower depreciation deductions in the tax return for the
future; that is, lower tax deductions means more income tax in the future on other
taxable amounts.
P9–10. (continued)
Req. 2: Income tax expense 2011:
Taxes payable
$400,000
Deferred taxes
17,000
Income tax expense
$417,000
Income tax expense 2012:
Taxes payable
$625,000
Deferred taxes
17,000
Income tax expense
$642,000
9-34
Chapter 09 - Reporting and Interpreting Liabilities
P9–11.
Req. 1
Present value of debt:
$115,000 x 0.6227 = $71,611
$8,050 x 5.3893 = 43,384
$114,995
Req. 2
Single sum to deposit:
$490,000 x .5820 = $285,180
Interest revenue:
$490,000 - $285,180 = $204,820
Req. 3
Present value of payments:
$75,000 x 0.9346 = $70,095
$112,500 x 0.8734 = 98,258
$150,000 x 0.8163 = 122,445
$290,798
P9–11. (continued)
Req. 4
Equal annual payments on note payable:
$130,000  4.1002 = $31,706
Interest expense:
($31,706 x 5) - $130,000 = $28,530
9-35
Chapter 09 - Reporting and Interpreting Liabilities
P9–12.
Option 1:
$1,250,000  6.1446
=
$7,680,750
=
$10,000,000
=
$8,144,600
Option 2:
$10,000,000
Option 3:
$2,000,000 + ($1,000,000  6.1446)
Option 2 is the best option because it provides the greatest present value when all
options are discounted.
P9–13.
Req. 1
$120,000  4.4399 = $27,028 (annual deposits)
Req. 2
$120,000 - ($27,028 x 4) = $11,888 (time value of money or interest)
Req. 3
1st year: None because the first deposit was at the end of the year.
2nd year: $27,028 x 7% ........................................................................
3rd year: ($27,028 + $1,892 + $27,028) x 7% ......................................
4th year: ($27,028 + $1,892 + $27,028 + $3,916 + $27,028) x 7% ......
Total interest revenue (differs from above because of rounding) ......
9-36
$ 1,892
3,916
6,082
$11,890
Chapter 09 - Reporting and Interpreting Liabilities
P9–14.
Req. 1
Future Value of Deposit:
$50,000  1.2653 = $63,265
Interest Earned:
$63,265 - $50,000 = $13,265
Req. 2
Future Value of Deposits:
$130,000  7.3359 = $953,667
Interest Earned:
$953,667 - $780,000 = $173,667
Req. 3
Future Value of Deposit:
$250,000  1.5869 = $396,725
Interest Earned:
$396,725 - $250,000 = $146,725
9-37
Chapter 09 - Reporting and Interpreting Liabilities
ALTERNATE PROBLEMS
AP9–1.
Req. 1
January 15
Tax expense (+E, -SE) ...................................................
Taxes payable (+L) .....................................................
Deferred tax liability (+L) .............................................
125,000
93,000
32,000
January 31
Interest payable (-L) .......................................................
Cash (-A) ....................................................................
52,000
April 30
Cash (+A) .......................................................................
Note payable (+L) .......................................................
550,000
June 3
Inventory (+A) ................................................................
Accounts payable (+L) ................................................
75,820
July 5
Accounts payable (-L) ....................................................
Cash (-A) ....................................................................
75,820
August 31
Cash (+A) .......................................................................
Revenue (+R, +SE) ....................................................
Deferred revenue (+L) ................................................
9-38
52,000
550,000
75,820
75,820
12,000
8,000
4,000
Chapter 09 - Reporting and Interpreting Liabilities
Req. 2
December 31
Interest expense (+E, -SE) .............................................
Interest payable (+L)...................................................
44,000
44,000
Long-term liability (-L) ....................................................
Current liability (+L) ....................................................
100,000
Wage expense (+E, -SE) ...............................................
Wages payable (+L) ...................................................
85,000
100,000
85,000
AP9–1. (continued)
Req. 3
Balance Sheet:
CURRENT LIABILITIES
Wages Payable
$85,000
Taxes Payable
93,000
Deferred Tax Liability
32,000
Interest Payable
44,000
Deferred Revenue
Note Payable
4,000
550,000
Current Portion of Longterm Debt
100,000
TOTAL CURRENT
LIABILITIES
$908,000
9-39
Chapter 09 - Reporting and Interpreting Liabilities
Req. 4
Cash from Operating Activities:
January 15
No effect
January 31
Decreased
April 30
No effect
June 3
No effect
July 5
Decreased
August 31
Increased
All December 31 transactions
No effect
9-40
Chapter 09 - Reporting and Interpreting Liabilities
AP9–2.
Req. 1
Date
Assets
Liabilities
Stockholders’
Equity
January 15
No effect
Deferred Tax Liability +
Taxes Payable +
Expense –
January 31
Cash –
Interest Payable –
No effect
April 30
Cash +
Note Payable +
No effect
June 3
Inventory +
Accounts Payable +
No effect
July 5
Cash –
Accounts Payable –
No effect
August 31
Cash +
Deferred Revenue +
Revenue +
December 31
No effect
Interest Payable +
Interest
Expense –
December 31
No effect
Long-term Liability –
No effect
Current Liability +
December 31
No effect
Wages Payable +
Req. 2
Cash from Operating Activities:
January 15
No effect
January 31
Decreased
April 30
No effect
June 3
No effect
July 5
Decreased
August 31
Increased
All December 31 transactions
No effect
9-41
Wage
Expense –
Chapter 09 - Reporting and Interpreting Liabilities
AP9–3.
Req.1
Warranty Expense
+$3.9 billion
Warranty Liability
+($3.9 billion –$4 billion)
Cash
- $4 billion
Req. 2
In year 2011, no revenue has been earned. The liability is $23 million.
Using an estimated life of 39 months, Bally may report $589,744 in revenue each
month ($23 million ÷ 39) or $7,076,923 for the year. The balance sheet in 2012
would report Unearned revenue in the amount of $15,923,077.
Req. 3
While the trend for the quick ratio is downward, it is doubtful that
ExxonMobil is experiencing financial difficulty. The company has a
reputation for aggressive cash management. It would be useful to study
the Statement of Cash Flows to determine if ExxonMobil is generating
significant cash resources from operating activities.
Req. 4
The company estimates future costs and records them as a current
expense. The matching concept dictates that all costs related to earning
revenue should be reported in the same accounting period as the
revenue.
9-42
Chapter 09 - Reporting and Interpreting Liabilities
AP9–4.
a. Decrease
b. Decrease
c. Decrease
d. Remain the same
e. Decrease
f. Remain the same
g. Decrease
h. Decrease
i. Remain the same
AP9–5.
The contractual agreement that General Mills entered into allows them to reclassify the
current borrowings as noncurrent debt. Management would want to do this in order to
improve measures of liquidity. A financial analyst’s answer would not be different. A
financial analyst would not be concerned because the company has the ability to extend
the maturity dates of the debt beyond the current year.
9-43
Chapter 09 - Reporting and Interpreting Liabilities
AP9–6.
Req. 1
$2,000,000 X 0.6806
=
$1,361,200
$150,000 X 3.9927
=
598,905
$1,960,105
Req. 2
$1,000,000  .4632
=
$463,200
The total amount of interest earned = $536,800
Req. 3
$350,000  3.3121
=
$105,673
$422,692 - $350,000
=
$72,692 The total amount of interest
AP9–7.
Option 1:
$750,000
=
$750,000
=
$688,194
$50,000  7.3601
=
$368,005
+ 80,000  7.3601  0.5584
=
328,790
Total
=
$696,795
Option 2:
$60,000  11.4699
Option 3:
Option one is the best because it gives you the highest return. The time value of
money makes a dollar received today worth more than a dollar received one year
from now.
9-44
Chapter 09 - Reporting and Interpreting Liabilities
AP9–8.
Req. 1
$320,000 x 3.2781 = $1,048,992
Req. 2
Fund Accumulation Schedule
Date
12/31/2011
12/31/2012
12/31/2013
Total
Cash
Payment
(cr)
$320,000
320,000
320,000
$960,000
Interest Revenue
(prior balance x 9%)
(cr)
Fund
Fund
Balance
Increase
(dr)
$ 320,000 $ 320,000
$320,000 x 9% = $28,800
348,800
668,800
668,800 x 9% = 60,192
380,192 1,048,992
$88,992 $1,048,992
9-45
Chapter 09 - Reporting and Interpreting Liabilities
CASES AND PROJECTS
FINANCIAL REPORTING AND ANALYSIS CASES
CP9–1.
Req. 1
Accrued compensation and payroll taxes are $29,417,000.
Req. 2
Accounts payable decreased by $5,860,000. This change decreased
operating cash flows.
Req. 3
Long-term liabilities (called non-current in this report) are $152,882,000.
Req. 4
The note under the caption Gift Cards states that the company determines
an estimated gift card breakage (the amount customers will never use).
This amount is included in revenue. The Company recorded $12.2 million
of revenue related to gift card breakage during fiscal 2008.
CP9–2.
Req. 1
The amount of accrued compensation is $11,975,000.
Req. 2
Accounts payable decreased by $11,065,000. This change decreased
operating cash flows.
Req. 3
Long-term liabilities are $134,084,000.
Req. 4
The amount of gift cards and store merchandise credits that customers
have not redeemed is $22,307,000 as of January 31, 2009. This
information is found in note 6.
9-46
Chapter 09 - Reporting and Interpreting Liabilities
CP9–3.
Req. 1
Urban Outfitters
Quick
Ratio
=
Quick
Assets
Current
Liabilities
$402,373
= 2.9
$141,150
American Eagle
$525,324
= 1.3
$401,763
Req. 2
Quick Ratio =
Industry
Average
1.4
Urban Outfitters
American Eagle
2.9
1.3
The quick ratio for American Eagle is near the industry average but the one for Urban
Outfitters is substantially higher than the average. While liquidity for both companies is
good, further analysis is needed to determine if Urban Outfitters is effectively utilizing its
liquid assets.
Req. 3
Urban Outfitters
Accounts
Cost of
Payable
Goods Sold
=
Turnover
Avg. Accts
Ratio
Payable
$1,121,140
= 16.4
$68,488*
*$(62,955 + 74,020)/2 = $68,488
**$(152,068 + 157,928)/2 = $154,998
9-47
American Eagle
$1,814,765 = 11.7
$154,998**
Chapter 09 - Reporting and Interpreting Liabilities
CP9–3. (continued)
Req. 4
Payable Turnover =
Industry
Average
6.4
Urban Outfitters
American Eagle
16.4
11.7
Both companies’ payable turnover ratios are above the industry average. Based on the
payable turnover ratio, both of these companies are doing better than the average
company in their industry at paying trade creditors.
Req. 5
Both companies have strong quick ratios and good payable turnover ratios. They
generate significant cash flow from operating activities. Both are expending
significant resources for capital expenditures, but they have sufficient resources
available to continue to invest in marketable securities. On balance, liquidity
looks strong for both.
CP9–4.
Req. 1
In business transactions, it usually is unreasonable to assume that one party will
lend money to an unrelated party without charging interest. It is likely that the
advertised selling price of the home included the true cash selling price plus an
amount equal to the time value of money (interest) for the four-year period.
Therefore, to evaluate the offer, the required payments must be analyzed (as in 2
below).
Req. 2
If the monthly payments actually include principal and interest, the cash selling
price can be found by calculating the present value of the monthly payments:
$3,125 x 37.9740 = $118,669
9-48
Chapter 09 - Reporting and Interpreting Liabilities
CRITICAL THINKING CASES
CP9–5.
Quick Ratio
Working Capital
Liquidity
a.
Decrease
No Change
Short-term
improvement
b.
Increase
Increase
Improvement
c.
Increase
Increase
Improvement
d.
Increase
No Change
No Change
e.
No Change
No Change
Improvement
9-49
Chapter 09 - Reporting and Interpreting Liabilities
CP9–6.
While the question focuses on ethics, we believe that students should analyze the
proposed strategy. Refusing to accept merchandise would result in a higher quick
ratio. By not purchasing inventory, management avoids increasing liabilities without
any change in the amount of quick assets. Management could actually improve the
quick ratio by shipping merchandise to customers because accounts receivable (a
quick asset) would increase along with the reduction in inventory (which is not a
quick asset).
There are legitimate ethical issues raised when management alters the operations
of a business to achieve an accounting result. Students should understand,
however, that management in many organizations engages in behaviors designed
to affect accounting reports.
In class discussions, we have included strategies for affecting ratios as well as
reported profits. We have found some students believe some strategies are ethical
but others are not. In such situations, we have been able to have very meaningful
discussions concerning situational ethics.
9-50
Chapter 09 - Reporting and Interpreting Liabilities
CP9–7.
The jackpot does not have a present value of $3 million. The payments include
interest earned by the state while it makes payments over the 20-year period.
We believe that this form of advertising is misleading. We think that lottery jackpots
should be advertised at their cash value today (i.e., present value) not the total of
future payments.
FINANCIAL REPORTING AND ANALYSIS PROJECT
CP9–8.
The response to this case will depend on the companies selected by the students.
9-51
Chapter 10 - Reporting and Interpreting Bonds
Chapter 10
Reporting and Interpreting Bonds
ANSWERS TO QUESTIONS
1.
A bond is a liability that may or may not be secured by a mortgage on specified
assets. Bonds usually are in denominations of $1,000 or $10,000, are transferable
by endorsement, and may be bought and sold daily by investors. A bond specifies
a maturity date and rate of interest that will be paid on the principal amount. Bonds
usually are issued to obtain cash for long-term asset acquisitions (operational
assets) and expansion of the entity.
2.
A bond indenture is an agreement drawn up by a company planning to sell a bond
issue. The indenture specifies the legal provisions of the bond issue such as
maturity date, rate of interest, date of interest payments, and any conversion
privileges. When a bond is sold, an investor receives a bond certificate (i.e., a
bond). All of the bond certificates for a single bond issue are identical in most
respects. That is, each certificate states the same maturity date, interest rate,
interest dates, and other provisions of the bond issue.
3.
Secured bonds are supported by a mortgage or pledge of specific assets as a
guarantee of payment. Secured bonds are designated on the basis of the type of
asset pledged, such as real estate mortgage bonds and equipment trust bonds.
Unsecured bonds are not supported by a mortgage or pledge of specific assets as
a guarantee of payment at maturity date. Unsecured bonds usually are called
debentures.
10-1
Chapter 10 - Reporting and Interpreting Bonds
4.
Callable bonds—bonds that may be called for early retirement at the option of the
issuer.
Convertible bonds—bonds that may be converted to other securities of the issuer
(usually common stock) after a specified future date at the option of the
bondholder.
5.
Several important advantages of bonds compared with capital stock benefit the
issuer. The issuance of bonds establishes a fixed amount of liability and a fixed rate
of interest on the bond, and interest payments to the bondholders are deductible on
the income tax return of the issuer. This deduction for tax purposes reduces the net
cost of borrowing. For example, a corporation with a 40% average tax rate and
bonds payable with a 10% interest rate would incur a net interest rate of 10% x
60% = 6%.
6.
The higher the tax rate is, the lower the net cost of borrowing money because the
interest paid on borrowed money is deductible on the income tax return of the
borrower. The higher the income tax rate the less the net cost of interest for the
borrower. For example, a corporation with an average tax rate of 40% and debt
with 10% interest per annum incurs a net interest rate of 10% x 60% = 6%. In
contrast, the same corporation with a 20% average tax rate incurs a net interest
rate of 10% x 80% = 8%.
7.
At the date of issuance, bonds are recorded at their current cash equivalent
amount; that is, the amount of cash received for the bonds when issued. The
recording is in conformity with the cost principle.
8.
When a bond is issued (sold) at its face amount, it is issued at par. In contrast,
when a bond is sold at an amount lower than the par amount, it is issued at a
discount, and conversely, when it is sold at a price above par, it is issued at a
premium. A bond will sell at a discount when the market, or effective, rate of
interest is higher than the stated rate of interest on the bond. In contrast, when the
market or effective rate of interest is lower than the stated rate, the bond will sell at
a premium. Discounts or premiums on bonds payable are adjustments to the
effective interest rate on the bonds. Therefore, the discount or premium is
amortized over the life of the bonds as an increase or decrease in the amount of
interest expense for each period.
9.
The stated rate of interest is the rate specified on a bond, whereas the effective
rate of interest is the market rate at which the bonds are selling currently.
10. When a bond is sold at par, the stated interest rate and the effective or market
interest rate are identical. When a bond is sold at a discount, the stated rate of
interest is lower than the effective rate of interest on the bond. In contrast, when a
bond is sold at a premium, the stated rate of interest is higher than the effective
rate of interest.
10-2
Chapter 10 - Reporting and Interpreting Bonds
11. A bond issued at par will have a book or carrying value, or net liability, equal to the
par or principal of the bond. This amount should be reported as the carrying value
on each balance sheet date. When a bond is sold at a premium or discount, the
premium or discount must be amortized over the outstanding life of the bond. When
there is bond discount or premium, the par amount of the bond less the
unamortized discount, or plus the unamortized premium, must be reported on the
balance sheet as the net liability as follows:
Bonds payable ...................................... $100,000
Less: Unamortized discount ..................
12,000
Plus: Unamortized premium ..................
Book value (net liability) ........................ $ 88,000
$100,000
12,000
$112,000
12. The basic difference between straight-line amortization and effective-interest
amortization of bond discount and premium is that, under straight-line amortization,
an equal amount of premium or discount is amortized to interest expense each
period. Straight-line amortization per interest period is computed by dividing the
total amount of the premium or discount by the number of periods the bonds will be
outstanding. Under effective-interest amortization, the amount of premium or
discount amortized is different each period. Effective-interest amortization of bond
premium and discount correctly measures the current cash equivalent amount of
the bonds and the interest expense reported on the income statement based on the
issuance entry. It measures the amount of amortization by relating the market
(yield) rate to the net liability at the beginning of each period. For this reason
interest expense and the bond carrying value are measured on a present value
basis. The straight-line method can be used only when the results are not
materially different from the results of the effective-interest method.
ANSWERS TO MULTIPLE CHOICE
1. c)
6. b)
2. c)
7. c)
3. b)
8. c)
10-3
4. d)
9. a)
5. c)
10. c)
Chapter 10 - Reporting and Interpreting Bonds
Authors’ Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
5
3
5
4
5
5
5
6
5
7
5
8
5
9
5
10
5
11
5
12
5
Exercises
No.
Time
1
10
2
10
3
10
4
15
5
15
6
15
7
10
8
20
9
20
10
20
11
15
12
15
13
20
14
25
15
30
16
20
17
20
18
20
19
25
20
30
21
25
22
10
23
10
24
10
Problems
No.
Time
1
40
2
30
3
30
4
40
5
50
6
45
7
45
8
50
9
35
10
40
11
40
12
25
13
35
14
30
15
20
Alternate
Problems
No.
Time
1
20
2
30
3
35
4
40
5
40
6
35
7
25
Cases and
Projects
No.
Time
1
25
2
20
3
20
4
30
5
30
6
25
7
*
* Due to the nature of this project, it is very difficult to estimate the amount of time
students will need to complete the assignment. As with any open-ended project, it is
possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time to discussing research strategies. When we want the
students to focus on a real accounting issue, we offer suggestions about possible
companies or industries.
10-4
Chapter 10 - Reporting and Interpreting Bonds
MINI-EXERCISES
M10–1.
1. Balance Sheet
2. Income Statement
3. Statement of Cash Flows
4. May be in notes
5. Not at all
6. May be in notes
M10–2.
Principal
$600,000  0.4564
=
$273,840
Interest
$ 24,000  13.5903
=
326,167
Issue Price
=
$600,007*
*Issue price should be exactly $600,000. The $7 difference is the result of
rounding the present value factors at four digits.
M10–3.
Principal
$900,000  0.4350
=
$391,500
Interest
$ 27,000  13.2944
=
358,949
Issue Price
=
$750,449
M10–4.
January 1, 2011:
Cash (+A) ..............................................................................
Discount on Bonds Payable (+XL, -L) ...................................
Bonds Payable (+L) ..........................................................
June 30, 2011:
Interest Expense (+E, -SE) ($940,000  11%  1/2) ............
Discount on Bonds Payable (-XL, +L) ...............................
Cash (-A) ($1,000,000  10%  1/2) .................................
10-5
940,000
60,000
1,000,000
51,700
1,700
50,000
Chapter 10 - Reporting and Interpreting Bonds
M10–5.
January 1, 2011:
Cash (+A) ..............................................................................
Discount on Bonds Payable (+XL, -L) ...................................
Bonds Payable (+L) ...........................................................
June 30, 2011:
Interest Expense (+E, -SE) ...................................................
Discount on Bonds Payable (-XL, +L) ...............................
Cash (-A) ...........................................................................
580,000
20,000
600,000
31,000
1,000
30,000
M10–6.
Principal
$500,000  0.4564
=
$228,200
Interest
$ 25,000  13.5903
=
339,758
Issue Price
=
$567,958
M10–7.
January 1, 2011:
Cash (+A) ..............................................................................
Premium on Bonds Payable (+L) ......................................
Bonds Payable (+L) ..........................................................
December 31, 2011:
Interest Expense (+E, -SE) ...................................................
Premium on Bonds Payable (-L) ...........................................
Cash (-A) ...........................................................................
620,000
20,000
600,000
52,000
2,000
54,000
M10–8
January 1, 2011:
Cash (+A) ..............................................................................
Premium on Bonds Payable (+L) ......................................
Bonds Payable (+L) ..........................................................
December 31, 2011:
Interest Expense (+E, -SE) ($910,000  7%) ........................
Premium on Bonds Payable (-L) ...........................................
Cash (-A) ($850,000  8%) ................................................
10-6
910,000
60,000
850,000
63,700
5,700
68,000
Chapter 10 - Reporting and Interpreting Bonds
M10–9.
The debt-to-equity ratio and times interest earned ratio are both measures of the
risk associated with using debt in the capital structure of a company. A company
could have a high debt-to-equity ratio with relatively little risk if it generated a high
level of stable earnings. On the other hand, a company with a low debt-to-equity
ratio might be risky if it was unable to earn any profits. For this reason, most
analysts look to the times interest earned ratio as a measure of a company’s
ability to meet its required interest payments.
M10–10.
If the interest rates fall after the issuance of a bond, the bond’s price will
increase. The company will report a loss on the debt retirement. On the balance
sheet, cash and bonds payable will decrease. On the income statement, a loss
would be recorded.
M10–11.
When a company issues a bond at a discount, the interest expense each period
will be more than the cash payment for the interest. When a company issues a
bond at a premium, the interest expense will be less than the cash payment for
the interest. Neither is affected by the method used to amortize the discount or
premium.
M10–12.
Cash paid to retire a bond would be reported in the financing activities section of
the Statement of Cash Flows while cash paid for interest payments would be
reported in the operating activities section.
10-7
Chapter 10 - Reporting and Interpreting Bonds
EXERCISES
E10–1.
1.
2.
3.
4.
5.
6.
7.
Bond principal, par value, or face value
Par value or face value
Face value or par value
Stated rate, coupon rate, or contract rate
Debenture
Callable bonds
Convertible bonds
E10–2.
The AT&T bonds have a coupon interest rate of 6.5%. If bonds with a $10,000 face
value were purchased, the issue price would be $8,950 and they would provide a cash
yield of 7.3%. A decline in value after issuance would have no impact on AT&T’s
financial statements.
E10–3.
When a bond offers a conversion feature, its value will be affected by the value of the
common stock. As the price of the stock goes up, the bond becomes more valuable. In
the case of the Wynn bond, each $1,000 face value bond can be converted into
43.4782 shares of stock. Given that the stock now sells for $90 per share, each bond is
worth at least $3,913 based on this conversion feature. A bondholder who needs cash
can simply sell the bond rather than converting it to stock and then selling the stock. In
many cases, it is better to hold a company’s bond than its stock. Such is the case with
Wynn. The company’s stock does not pay dividends but the bonds do pay periodic
interest. Therefore, holders of bonds can participate in the appreciation of the stock
while earning interest on their investment.
10-8
Chapter 10 - Reporting and Interpreting Bonds
E10–4.
CASE A:
$100,000 x 0.5835 ........................................................ $ 58,350
$8,000 x 5.2064 ............................................................
41,651
Issue price (market and stated rate same) ................... $100,001 (at par; $1
rounding error)
CASE B:
$100,000 x 0.6651 ........................................................ $ 66,510
$8,000 x 5.5824 ............................................................
44,659
Issue price (market rate less than stated rate).............. $111,169 (at a premium)
CASE C:
$100,000 x 0.5132 ........................................................ $ 51,320
$8,000 x 4.8684 ............................................................
38,947
Issue price (market rate more than stated rate) ............ $ 90,267 (at a discount)
E10–5.
CASE A:
$500,000 x 0.6730 ........................................................ $ 336,500
$15,000 x 16.3514 ........................................................
245,271
Issue price (market rate less than stated rate).............. $581,771 (at a premium)
CASE B:
$500,000 x 0.5537 ........................................................
$15,000 x 14.8775 ........................................................
Issue price (market rate and stated rate same) ............
CASE C:
$500,000 x 0.4564 ........................................................
$15,000 x 13.5903 ........................................................
Issue price (market rate more than stated rate) ............
$ 276,850
223,163
$500,013 (at par, $13
rounding error)
$ 228,200
203,855
$ 432,055 (at a discount)
E10–6.
Applied Technologies’ ratios look better than Innovative Solutions’ ratios.
Applied Technologies has a lower debt-to-equity ratio than Innovative Solutions.
This means that they have less debt in their capital structure, and therefore, are a
less leveraged company and have less risk than Innovative Solutions. Applied
Technologies’ times interest earned ratio is higher than the ratio for Innovative
Solutions. This also makes Applied Technologies a less risky company than
Innovative Solutions because Applied Technologies generates a larger amount of
income compared to its obligatory payments to creditors than Innovative
Solutions.
10-9
Chapter 10 - Reporting and Interpreting Bonds
E10–7.
Computations:
Interest:
$100,000 x 6% x 1/2
=
Present value:
$100,000 x 0.6756
$ 3,000 x 8.1109
Issue price
=
=
=
$3,000
67,560
24,333
$91,893
E10–8.
Computations:
Interest:
$750,000 x 8%
= $ 60,000
Present value:
$750,000 x 0.4224
$ 60,000 x 6.4177
Issue price
= 316,800
= 385,062
= $701,862
Req. 1
January 1:
Cash (+A) ..............................................................................
Discount on Bonds Payable (+XL, -L) ...................................
Bonds Payable (+L) ...........................................................
701,862
48,138
750,000
Req. 2
December 31:
Interest Expense (+E, -SE) ...................................................
Discount on Bonds Payable (-XL, +L) ...............................
Cash (-A) ...........................................................................
10-10
64,814
4,814
60,000
Chapter 10 - Reporting and Interpreting Bonds
Req. 3
December 31, 2011:
Income statement:
Interest expense
$ 64,814
Balance sheet:
Long-term Liabilities
Bonds payable
Less: Unamortized discount ($48,138 - $4,814)
$750,000
43,324
$706,676
E10–9.
Computations:
Interest:
$600,000 x 7.5% x 1/2
= $ 22,500
Present value:
$600,000 x 0.7168
$ 22,500 x 6.6638
Issue price
= 430,080
= 149,936
= $580,016
Req. 1
January 1:
Cash (+A) ..............................................................................
Discount on Bonds Payable (+XL, -L) ...................................
Bonds Payable (+L) ...........................................................
580,016
19,984
600,000
Req. 2
June 30:
Interest Expense* (+E, -SE) .................................................
Discount on Bonds Payable (-XL, +L) ...............................
Cash (-A) ...........................................................................
*($580,016 x 8.5% x ½)
10-11
24,651
2,151
22,500
Chapter 10 - Reporting and Interpreting Bonds
Req. 3
June 30, 2011:
Income statement:
Interest expense
$ 24,651
Balance sheet:
Long-term Liabilities
Bonds payable
Less: Unamortized discount ($19,984 – $2,151)
$600,000
17,833
$582,167
E10–10.
Computations:
Interest:
$600,000 x 7.5% x 1/2
= $ 22,500
Present value:
$600,000 x 0.7168
$ 22,500 x 6.6638
Issue price
= 430,080
= 149,936
= $580,016
Req. 1
January 1:
Cash (+A) ..............................................................................
Bonds Payable (+L) ...........................................................
580,016
580,016
Req. 2
June 30:
Interest Expense* (+E, -SE) .................................................
Bonds Payable (+L)...........................................................
Cash (-A) ...........................................................................
10-12
24,651
2,151
22,500
Chapter 10 - Reporting and Interpreting Bonds
*($580,016 x 8.5% x ½)
Req. 3
June 30, 2011:
Income statement:
Interest expense
$ 24,651
Balance sheet:
Long-term Liabilities
Bonds payable
$582,167
E10–11.
Req. 1
Issue price:
1.
Par, $300,000 – Carrying value at end of 1 year, $281,100 = $18,900 (unamortized
discount for 9 remaining years).
2.
$18,900  9 years = $2,100 discount amortization per year (straight line).
3.
$281,100 – $2,100 = $279,000 issue price (discount $21,000).
Issuance entry:
Cash (+A) ..............................................................................
Discount on bonds payable (+XL, -L) ....................................
Bonds payable (+L) ...........................................................
279,000
21,000
300,000
Req. 2
Coupon (stated interest) rate:
1.
Reported interest expense, $23,100 – Discount amortized, $2,100 = $21,000 (cash
interest).
2.
$21,000 ÷ $300,000 = 7% coupon (stated interest) rate.
Interest expense:
Interest expense (+E, -SE) .................................................... 23,100
Discount on bonds payable ($21,000 ÷ 10 years) (-XL, +L)
Cash ($300,000 x 7%) (-A) ................................................
10-13
2,100
21,000
Chapter 10 - Reporting and Interpreting Bonds
E10–12.
1.
Issue price: $948. Stated rate, 6%; effective or yield rate, 8% (both were given).
2.
Discount: $1,000 – $948 = $52.
3.
$1,000 x 6% = $60.
4.
2011, $76; 2012, $77; 2013, $79.
5.
Balance sheet:
2011
$ 964
2012
$ 981
2013
$1,000
6.
(immediately before retirement)
Effective-interest amortization was used.
E10–12. (continued)
7.
(a) $1,000 x 6% = $60.
(b) $964 x 8% = $77 (rounded).
(c) $77 – $60 = $17.
(d) $964 + $17 = $981.
8.
Effective-interest amortization measures the amount of interest expense and net
liability for each period on a present value basis. The interest expense and related
amortization are based on the actual unpaid balance of the debt and the effective
interest rate. Straight-line amortization is an approximation that does not take
these factors into consideration. The effective-interest method is conceptually
preferable but the straight-line method is used widely in practice because of
computational simplicity and the materiality concept.
E10–13.
The effective interest rate for a bond is determined by market forces and not the
company. American was able to specify the coupon rate for the bonds which
determines the periodic interest payments. It appears that American intended to
sell the bonds close to par value which would be achieved by having a coupon rate
that was the same as the market rate. The market rate of interest continually
changes as the result of such factors as inflation expectations and the level of
business activity. It is virtually impossible to issue a bond at a point when the
coupon rate and the market rate are exactly the same.
10-14
Chapter 10 - Reporting and Interpreting Bonds
E10–14.
Students will typically offer one of two explanations:

Normally, bonds that offer less than the market rate sell at a discount that
results in a bond yield equal to the market rate of interest. While this is
generally true, we do not think it explains the low interest rate for the Disney
bond.

The Disney bond includes a feature not seen in most bonds. It provides
investors with the opportunity to participate in stock price appreciation while
holding a more conservative investment. The conversion feature permits
bond holders to convert their bonds into stock at a price of $29.46 per share.
When this problem was written, Disney stock was selling for $33 per share.
This conversion feature enhances the potential return for investors and
permits the issuer to pay a lower rate of interest.
E10–15.
Assuming that both companies offer the same business risk, many people might
prefer the bond that had the slightly higher yield which is Walt Disney at 9.5%. If
interest rates were to fall significantly, companies might decide to call their bonds
and issue new ones at a lower interest rate. In this case, a zero coupon bond offers
an extra margin of protection. A zero is sold at a deep discount (say 60% of par). It
would be very unusual to see a company call such a bond if it were callable at par.
In this case, the PepsiCo bond would be preferred.
Many people who are retired desire to have a steady income without engaging in
time-consuming transactions. These people would probably not want to buy a zero
coupon bond which paid interest only at maturity.
E10–16.
Computations:
Interest:
$1,400,000 x 8% x 1/2 =
$ 56,000
Present value:
$1,400,000 x 0.7894
$ 56,000 x 7.0197
1,105,160
393,103
=
=
10-15
Chapter 10 - Reporting and Interpreting Bonds
Issue price
= $1,498,263
Req. 1
January 1:
Cash (+A) .............................................................................. 1,498,263
Premium on Bonds Payable (+L) ......................................
Bonds Payable (+L) ..........................................................
98,263
1,400,000
Req. 2
June 30:
Interest Expense (+E, -SE) ...................................................
Premium on Bonds Payable (-L) ...........................................
Cash (-A) ...........................................................................
43,717
12,283
56,000
E10–16. (continued)
Req. 3
June 30, 2011:
Income statement:
Interest expense
$ 43,717
Balance sheet:
Long-term Liabilities
Bonds payable
Plus: Unamortized premium ($98,263 – $12,283)
E10–17.
Computations:
Interest:
$2,000,000 x 5%
= $ 100,000
Present value:
$2,000,000 x 0.4350
$ 100,000 x 13.2944
Issue price
=
870,000
= 1,329,440
= $2,199,440
Req. 1
10-16
$1,400,000
85,980
$1,485,980
Chapter 10 - Reporting and Interpreting Bonds
January 1:
Cash (+A) .............................................................................. 2,199,440
Premium on Bonds Payable (+L) ......................................
Bonds Payable (+L) ..........................................................
199,440
2,000,000
Req. 2
June 30:
Interest Expense (+E, -SE) ($2,199,440 x 4.25%) ...............
Premium on Bonds Payable (-L) ...........................................
Cash (-A) ...........................................................................
93,476
6,524
100,000
Req. 3
June 30, 2011:
Income statement:
Interest expense
$ 93,476
Balance sheet:
Long-term Liabilities
Bonds payable
Plus: Unamortized premium ($199,440 – $6,524)
$2,000,000
192,916
$2,192,916
E10–18.
Computations:
Interest:
$2,000,000 x 5%
= $ 100,000
Present value:
$2,000,000 x 0.4350
$ 100,000 x 13.2944
Issue price
=
870,000
= 1,329,440
= $2,199,440
Req. 1
January 1:
Cash (+A) .............................................................................. 2,199,440
Bonds Payable (+L)...........................................................
Req. 2
June 30:
Interest Expense (+E, -SE) ($2,199,440 x 4.25%) ...............
Bonds Payable (-L) ...............................................................
10-17
93,476
6,524
2,199,440
Chapter 10 - Reporting and Interpreting Bonds
Cash (-A) ...........................................................................
100,000
Req. 3
June 30, 2011:
Income statement:
Interest expense
$ 93,476
Balance sheet:
Long-term Liabilities
Bonds payable
$2,192,916
E10–19.
Req. 1
Date
1/1/2011
12/31/2011
12/31/2012
12/31/2013
Cash
Interest
Interest Expense
Premium
Amortization
$500
500
500
$10,278 x 4% = $411
$10,189 x 4% = $408
$10,097 x 4% = $404
$89
92
96
Net Liability
Balance
$10,278
10,189
10,097
10,001*
* $1 rounding error
Present value computation:
Principal:
$10,000 x .8890
Interest:
500 x 2.7751
Issue price
$ 8,890
1,388
$10,278
Req. 2
December 31:
Interest expense...................
Bond liability………………….
2011
2012
2013
$411
$10,189
$408
$10,097
$404
$10,000*
*Immediately before repayment of principal
10-18
Chapter 10 - Reporting and Interpreting Bonds
E10–20.
Req. 1
Cash is increased on the balance sheet. The statement of cash flows shows an
inflow from financing activities. Bonds payable and premium on bonds payable
are increased on the balance sheet. The debt-to-equity ratio will be higher.
January 1:
Cash (+A) ..............................................................................
Premium on bonds payable (+L) .......................................
Bonds payable (+L) ...........................................................
376,774
76,774
300,000
Principal: $300,000 x .7441 ..................................................
Interest: $18,000 x 8.5302 ....................................................
Issue (sale) price ......................................................
$223,230
153,544
$376,774
E10–20. (continued)
Req. 2
The interest expense will be increased on the income statement and the cash will
be decreased on the balance sheet. The premium on bonds payable will be
decreased on the balance sheet. The debt-to-equity ratio will be decreased and
the times interest earned ratio will be lower.
December 31:
Interest expense (+E, -SE) ....................................................
Premium on bonds payable ($76,774 10 periods) (-L) ........
Cash ($300,000 x 6%) (-A) ................................................
Req. 3
December 31, 2011:
Income Statement:
10-19
10,323
7,677
18,000
Chapter 10 - Reporting and Interpreting Bonds
Interest Expense
$10,323
Balance Sheet:
Long-term Liabilities
Bonds Payable
$300,000
Add: Unamortized premium ($76,774 - $7,677)
69,097
$369,097
E10–21.
Req. 1
Computations:
Interest:
$1,000,000 x 10%
= $100,000 ÷ 2 = $50,000
Present value
$ 1,000,000 x .4564
$ 50,000 x 13.5903
=
=
456,400
679,515
$ 1,135,915
June 30:
Cash (+A) .............................................................................. 1,135,915
Bonds payable (+L) ...........................................................
Premium on bonds payable(+L) .......................................
10-20
1,000,000
135,915
Chapter 10 - Reporting and Interpreting Bonds
Req. 2
The amortization of bond premium does not affect cash flows directly but does
result in cash payments for interest that are higher than reported interest expense
for the period.
E10–22.
Bonds payable (-L) ................................................................
Loss on bond call (+Loss, -SE) .............................................
Cash (-A) ...........................................................................
600,000
30,000
630,000
E10–23.
Bonds payable (-L) ................................................................
Loss on bond call (+Loss, -SE) .............................................
Discount on bonds payable (-XL,+ L) ................................
Cash (-A) ...........................................................................
E10–24.
10-21
500,000
60,000
25,000
535,000
Chapter 10 - Reporting and Interpreting Bonds
1. Impacts Statement of Cash Flows (SCF) : report $960,000 inflow in financing
section
2. Does not impact SCF
3. Impacts SCF : report $54,000 payment in operating activities section
4. Impacts SCF : report $940,000 payment in financing section
10-22
Chapter 10 - Reporting and Interpreting Bonds
PROBLEMS
P10–1.
Req. 1—Comparison of results:
Actual Results
for 2011
Item
(a)
(b)
(c)
(d)
(e)
(f)
(g)
Total debt .................................................
Total assets .............................................
Total stockholders’ equity ........................
Interest expense (total at 10%) ................
Net income...............................................
Return on total assets ..............................
Earnings available to stockholders:
(1) Amount ...............................................
(2) Per share ............................................
(3) Return on stockholders’ equity ...........
Results with an Increase
in Debt and a Decrease in
Stockholders’ Equity
$ 40,000
360,000
320,000
4,000
60,000
17.3%
$90,000
360,000
270,000
9,000
57,000
17.3%
$ 60,000
2.61
18.75%
$ 57,000
3.17
21.11%
Computations:
(a)
Given
(b)
Given
(c)
Given
(d)
$90,000 x 10% = $9,000.
(e)
($100,000 + $4,000 – $9,000) = $95,000, pretax; $95,000 x (100% – 40%) =
$57,000.
(f)
$60,000 + [$4,000 x (100% – 40%) = $2,400] = $62,400; $62,400 ÷ $360,000 =
17.3%.
$57,000 + [$9,000 x (100% – 40%) = $5,400] = $62,400; $62,400 ÷ $360,000 =
17.3%.
(g–1) From Item (e)
(g–2) $60,000  23,000 shares = $2.61 EPS.
$57,000  18,000 shares = $3.17 EPS.
(g–3) $60,000  $320,000 = 18.75%.
$57,000  $270,000 = 21.11%.
10-23
Chapter 10 - Reporting and Interpreting Bonds
P10–1. (continued)
Req. 2 Interpretation:
The recommendation provided higher financial leverage compared with actual
financial leverage. This increase in positive financial leverage was because the
company had a net of tax interest rate on debt that was lower than the return on
total assets. This increase is favorable to the stockholders because their potential
dividends (based on retained earnings) and total owners’ equity are much higher.
The disadvantage of higher debt is the cash required to pay interest and principal.
This company appears to have the potential for future success. Therefore, the
higher debt leverage seems advisable.
P10–2.
Req. 1
Interest:
$300,000 x 8%
Present value
$ 300,000 x .6756
$ 12,000 x 8.1109
Issue price
=
=
=
$
24,000 ÷ 2 = $12,000
202,680
97,331
$300,011
The exact present value is $300,000. The $11 difference is due to rounding the
present value factors at four digits.
Req. 2
June 30
2011
$12,000
Dec. 31
2011
$12,000
June 30
2011
$12,000
Dec. 31
2011
$12,000
2011
Bonds payable ....................................... $300,000
2012
$300,000
Interest expense.....................................
Req. 3
Cash paid ...............................................
Req. 4
10-24
Chapter 10 - Reporting and Interpreting Bonds
P10–3.
Case A
a. Cash received at issue .......................................... $500,000
b. Bond interest expense (pretax) .............................. $ 35,000
Case B Case C
$475,000 $515,000
$ 37,500 $ 33,500
c.
d.
e.
f.
Bonds payable, 7% ................................................ $500,000 $500,000 $500,000
Unamortized discount (deduct) ** ..........................
22,500
Unamortized premium (add) ** ..............................
13,500
Net liability ............................................................. $500,000 $477,500 $513,500
**Balance in discount or premium account
(January 1, 2011) ...............................................
$ 25,000 $ 15,000
Amortization during 2011 ......................................
(2,500)) (1,500)
Unamortized balance on December 31, 2011 ....
$ 22,500 $ 13,500
g. Stated rate of interest (given).................................
7%
7%
7%
P10–4.
Req. 1
December 31, 2011—Financial statements:
a.
b.
c.
d.
e.
f.
Interest expense .....................................
Bonds payable ........................................
Unamortized premium or discount ..........
Net liability ..............................................
Stated rate of interest .............................
Cash interest paid ...................................
Case A
At Par,
100
Case B
Case C
At 99
At 104
$ 10,000
$100,000
$ 10,100
$100,000
(900)
$ 99,100
10%
$ 10,000
$ 9,600
$100,000
3,600
$103,600
10%
$ 10,000
$100,000
10%
$ 10,000
10-25
Chapter 10 - Reporting and Interpreting Bonds
P10–4. (continued)
Req. 2—Explanation of differences:
Item a, interest expense, is different (in this situation) from Item f, cash interest paid, by
the amount of any bond discount or premium amortized for the period. This divergence
reflects the fact that discount and premium are adjustments of interest expense
because of a difference between the market and stated interest rates at date of
issuance of bonds.
Req. 3
The letter should explain that most bonds pay a fixed rate of interest by contract. As
market interest rates change over time, the price of the bond changes. When the market
interest rates increase, the price of the bond will fall. When rates decrease, the bond
price will increase. A discount simply means that the bond is selling for less than par; a
premium occurs when the bond sells for more than par. There is no advantage to
purchasing a bond at a discount because all bonds will adjust in price to yield the
market rate of interest.
10-26
Chapter 10 - Reporting and Interpreting Bonds
P10–5.
1.
Computation of the amount of the bond liability when issued:
$200,000 x .4632 = $92,640
$ 12,000 x 6.7101 =
80,521
Issue Price
$173,161
2.
Computation of interest expense recorded on December 31, 2011:
$173,161 x 8% = $13,853
3.
Managers are normally relatively indifferent between the straight-line and effectiveinterest methods. The two methods typically produce very similar financial results.
In such cases, most managers would select the method that is simpler to use,
which would be the straight-line method.
4.
Date
Debt-to-Equity
Times Interest Earned
Issue date
Increase
No effect
Interest payment date
Increase
Decrease
10-27
Chapter 10 - Reporting and Interpreting Bonds
P10–6.
Req. 1
Computations:
Interest:
$700,000 x 8% x 1/2
Present value
$ 700,000 x 0.3769
$ 28,000 x 12.4622
Issue Price
= $
=
=
28,000
263,830
348,942
$612,772
Req. 2
June 30
Interest expense.....................................
$32,361*
December
31
$32,361*
*$700,000 - $612,772 = $87,228  20 periods = $4,361 + $28,000 = $32,361
Req. 3
June 30
Cash paid ...............................................
$28,000
December
31
$28,000
Req. 4
June 30
Bonds payable ....................................... $617,133*
*$612,772 + $4,361 = $617,133
**$617,133 + $4,361 = $621,494
10-28
December
31
$621,494**
Chapter 10 - Reporting and Interpreting Bonds
P10–7.
Req. 1
Computations:
Interest:
$1,000,000 x 10% x 1/2 =
Present value
$ 1,000,000 x 0.3118
$ 50,000 x 11.4699
Issue Price
Req. 2
=
=
$
50,000
311,800
573,495
$885,295
June 30
Interest expense.....................................
$53,118*
December
31
$53,305**
$885,295 x 12% x ½ = $53,118
**[$885,295 + ($53,118 - $50,000)] x 12% x ½= $53,305
Req. 3
June 30
December
31
Cash paid ............................................... $50,000
$50,000
Req. 4
June 30
Bonds payable ....................................... $888,413*
*$885,295 + $3,118 = $888,413
**$888,413+ $3,305 = $891,718
10-29
December
31
$891,718**
Chapter 10 - Reporting and Interpreting Bonds
P10–8.
Req. 1
Principal:
Interest:
$800,000 x 0.5674 ...............................................................
$ 64,000 x 3.6048 ................................................................
Bond issue price ...............................................................
$453,920
230,707
$684,627
The stated rate of interest is used only to compute the periodic cash interest payments
of $64,000. This amount is necessary because it is discounted to PV using the effective
interest rate. The effective-interest rate is used to discount the two future cash flows:
principal and cash interest. The discounting must be based on the effective-interest rate
because the selling (issue) price is the PV of the future cash flows.
Req. 2—Straight-line amortization:
2011
a. Cash interest payment
($800,000 x 8%) ...................
b. Amortization of discount
($115,373  5 years) ............
c. Bond interest expense .............
2012
2013
2014
2015
$64,000
$64,000 $64,000 $64,000 $64,000
23,075
$87,075
23,075 23,075 23,075 23,075
$87,075 $87,075 $87,075 $87,075
Req. 3 —Effective-interest amortization:
Bond Amortization Schedule
Date
1/1/2011
12/31/2011
12/31/2012
12/31/2013
12/31/2014
12/31/2015
$115,373
*Rounded
Cash
Payment
$64,000
64,000
64,000
64,000
64,000
Interest Expense
$684,627 x
702,782 x
723,116 x
745,890 x
771,397 x
12%
12%
12%
12%
12%
Amortization of
Discount
=
$82,155
$18,155
= 84,334
20,334
= 86,774
22,774
= 89,507
25,507
= 92,603 * 28,603
Net
Liability
$684,627
702,782
723,116
745,890
771,397
800,000
A constant interest rate can be demonstrated each year by dividing interest expense by
the net liability – the answer on all lines will be the effective rate (12%).
Req. 4
Effective-interest amortization is preferable to straight-line because it better measures
interest expense (on the income statement) and the net liability (on the balance sheet).
The effective-interest approach is conceptually sound because interest expense is
based on the unpaid balance of the liability. In this case, interest expense as a percent
of the net liability is 12% each period (the effective or true rate) only if the effective-
10-30
Chapter 10 - Reporting and Interpreting Bonds
interest approach is used. If the straight-line approach is used, the interest percent
changes each year and ranges from 11.21% to 12.72%.
P10–9.
Req. 1
Computations:
Interest:
$2,000,000 x 10% x 1/2 =
Present value
$ 2,000,000 x 0.4564
$ 100,000 x 13.5903
Issue price
=
=
$
100,000
912,800
1,359,030
$2,271,830
Req. 2
June 30
Interest expense.....................................
$86,408*
December
31
$86,408*
*$2,271,830 - $2,000,000= $271,830  20 periods = $13,592
$100,000 - $13,592 = $86,408
Req. 3
June 30
Cash paid ............................................... $100,000
December
31
$100,000
Req. 4
June 30
Bonds payable ....................................... $2,258,238*
*$2,271,830- $13,592 = $2,258,238
**$2,258,238- $13,592 = $2,244,646
10-31
December
31
$2,244,646**
Chapter 10 - Reporting and Interpreting Bonds
P10–10.
Req. 1
Computations:
Interest:
$700,000 x 13% x 1/2
Present value
$ 700,000 x 0.5584
$ 45,500 x 7.3601
Issue Price
=
=
=
$
45,500
390,880
334,885
$725,765
Req. 2
June 30
Interest expense.....................................
$43,546*
December
31
$43,429**
$725,765 x 12% x ½ = $43,546
**[$725,765 - ($45,500- $43,546)] x 12% x ½= $43,429
Req. 3
June 30
Cash paid ...............................................
$45,500
December
31
$45,500
Req. 4
June 30
Bonds payable ....................................... $723,811*
*$725,765 – ($45,500 – $43,546) = $723,811
**$723,811 – ($45,500 - $43,429) = $721,740
10-32
December
31
$721,740**
Chapter 10 - Reporting and Interpreting Bonds
P10–11.
Req. 1
Principal:
Interest:
$300,000 x 0.6209 .............................................................
$33,000 x 3.7908 ...............................................................
Issue (sale) price ................................................................
$186,270
125,096
$311,366
Req. 2
January 1, 2011:
Cash (+A) ..............................................................................
Premium on bonds payable (+L) .......................................
Bonds payable (+L) ...........................................................
Sale of bonds at a premium.
311,366
11,366
300,000
Req. 3
December 31, 2011:
Bond interest expense (+E, -SE) ...........................................
Premium on bonds payable (-L) ............................................
Cash (-A) ...........................................................................
Interest payment plus premium amortization.
30,727
2,273
33,000
Req. 4
Income Statement for 2011:
Interest expense: $30,727
Balance Sheet at December 31, 2011:
Long-term Liabilities:
Bonds payable ................................................................... $300,000
Add: Unamortized premium
($11,366 – $2,273) .........................................................
9,093
10-33
$309,093
Chapter 10 - Reporting and Interpreting Bonds
P10–12.
1.
Missing amounts are underlined:
Date
Cash
Jan. 1, 2011 .............................
End of Year 2011 ..................... $3,600
End of Year 2012 ..................... 3,600
End of Year 2013 ..................... 3,600
End of Year 2014 ..................... 3,600
Interest
Amortization
$3,417
3,404
3,390
3,381
$183
196
210
219*
Balance
$48,808
48,625
48,429
48,219
48,000
Calculations:
Effective interest rate: $3,417  $48,808 = 7%
Interest: 7% x Previous balance
Amortization: Cash payment – Interest
Balance: Previous balance – Amortization
*$6 rounding error
2.
Maturity (par) amount: $48,000 from last column at end of the last year.
3.
Cash received: $48,808 from last column at January 1, 2011.
4.
Premium: $48,808 – $48,000 = $808.
5.
Cash disbursed for interest: $3,600 per period x 4 years = $14,400 total.
6.
Effective-interest amortization: Evident from the computations in the schedule.
The amortization amount is different each year.
7.
Stated rate of interest: $3,600  $48,000 = 7.5%.
8.
Yield or effective rate of interest: $3,417  $48,808 = 7%.
9.
Interest expense: 2011, $3,417; 2012, $3,404; 2013, $3,390; 2014, $3,381.
10. Balance sheet:
2011
Long-Term Liabilities
Bonds payable, 7.5%
Maturity amount $48,000, plus unamortized
premium ......................................................... $48,625
2012
2013
$48,429 $48,219* $48,000*
* At the end of 2013 and during the last year of the term of the bonds before
retirement they would be reported as a current liability on the balance sheet.
10-34
2014
Chapter 10 - Reporting and Interpreting Bonds
P10–13.
When a bond is sold for a premium, the amount of cash collected is greater than the
maturity value. This extra amount is called a bond premium. The recorded value for this
liability is the maturity value plus the unamortized amount of the premium.
Bond premiums are amortized over the life of a bond, using either the straight-line or
effective-interest method. When bond premium amortization is recorded, the amount of
bond premium is reduced. The reduction reported in the note is the result of the
required amortization of the bond premium.
P10–14.
Req. 1
The company used cash on hand to retire their bonds prior to their maturity date.
Req. 2
Most likely, the bonds were callable with a $49 million premium. The payment of the
premium on retirement is reported as an expense.
P10–15.
1. Financing, inflow
2. It is reported as an operating activity.
3. Financing, outflow
4. It is reported as an operating activity.
5. Financing, outflow
6. No effect
10-35
Chapter 10 - Reporting and Interpreting Bonds
ALTERNATE PROBLEMS
AP10–1.
Req. 1
Interest:
$2,000,000 x 10%
Present value
$ 2,000,000 x .6139
$ 100,000 x 7.7217
Issue price
=
$
200,000 ÷ 2 = $100,000
=
=
1,227,800
772,170
$1,999,970
The exact present value is $2,000,000. The $30 difference is due to rounding the
present value factors at four digits.
Req. 2
June 30
2011
Interest expense..................................... $100,000
Dec. 31
2011
$100,000
Req. 3
June 30
2011
Cash paid ............................................... $100,000
Dec. 31
2011
$100,000
Req. 4
2011
Bonds payable ....................................... $2,000,000
10-36
2012
$2,000,000
Chapter 10 - Reporting and Interpreting Bonds
AP10–2.
(000’s):
At
At
At
At
End
End
End
End
of 2011 of 2012 of 2013 of 2014
Case A: Sold at Par
Interest expense on the
income statement
10
10
10
10
100
100
100
100
Case B: Sold at a discount
Interest expense on the
income statement
11
11
11
11
Net liability on balance sheet
96
97
98
99
Case C: Sold at a premium
Interest expense on the
income statement
8
8
8
8
108
106
104
102
Net liability on balance sheet
Net liability on balance sheet
10-37
Chapter 10 - Reporting and Interpreting Bonds
AP10–3.
Req. 1
Computations:
Interest:
$1,000,000 x 7%
= $
Present value
$ 1,000,000 x 0.6499 =
70,000 x
3.8897 =
Issue Price
70,000
649,900
272,279
$922,179
Req. 2
Interest expense.....................................
2011
$85,564*
2012
$85,564*
*$1,000,000 - $922,179 = $77,821  5 years = $15,564 + $70,000 = $85,564
Req. 3
Cash paid ...............................................
2011
$70,000
2012
$70,000
Req. 4
2011
Bonds payable ....................................... $937,743*
*$922,179 + $15,564 = $937,743
**$937,743+ $15,564 = $953,307
10-38
2012
$953,307**
Chapter 10 - Reporting and Interpreting Bonds
AP10–4.
Req. 1
Computations:
Interest:
$2,000,000 x 6%
Present value
$ 2,000,000 x 0.7130
$ 120,000 x 4.1002
Issue Price
= $
=
=
120,000
1,426,000
492,024
$1,918,024
Req. 2
2011
Interest expense..................................... $134,262*
2012
$135,260**
$1,918,024 x 7% = $134,262
**[$1,918,024 + ($134,262- $120,000)] x 7% = $135,260
Req. 3
2011
Cash paid ............................................... $120,000
2012
$120,000
Req. 4
2011
Bonds payable ....................................... $1,932,286*
*$1,918,024 + $14,262 = $1,932,286
**$1,932,286 + $15,260 = $1,947,546
10-39
2012
$1,947,546**
Chapter 10 - Reporting and Interpreting Bonds
AP10–5.
Req. 1
Computations:
Interest:
$900,000 x 10%
=
Present value
$ 900,000 x 0.6499
$ 90,000 x 3.8897
=
=
$
90,000
584,910
350,073
$934,983
Req. 2
Interest expense.....................................
2011
$83,003*
2012
$83,003*
*$934,983 - $900,000= $34,983  5 years = $6,997
$90,000 - $6,997 = $83,003
Req. 3
Cash paid ...............................................
2011
$90,000
2012
$90,000
Req. 4
2011
Bonds payable ....................................... $927,986*
*$934,983 - $6,997 = $927,986
**$927,986 - $6,997 = $920,989
10-40
2012
$920,989**
Chapter 10 - Reporting and Interpreting Bonds
AP10–6.
Req. 1
Computations:
Interest:
$4,000,000 x 9%
Present value
$ 4,000,000 x 0.7473
$ 360,000 x 4.2124
Issue Price
= $
=
=
360,000
2,989,200
1,516,464
$4,505,664
Req. 2
2011
Interest expense..................................... $270,340*
2012
$264,960**
$4,505,664 x 6% = $270,340
**[$4,505,664 - ($360,000 - $270,340)] x 6% = $264,960
Req. 3
2011
Cash paid ............................................... $360,000
2012
$360,000
Req. 4
2011
Bonds payable ....................................... $4,416,004
*$4,505,664 - $89,660 = $4,416,004
**$4,416,004 - $95,040 = $4,320,964
10-41
2012
$4,320,964**
Chapter 10 - Reporting and Interpreting Bonds
AP10–7.
Req. 1
Cash (+A) .............................................................................. 52,720,000
Bonds payable (11 7/8%) (+L) ...........................................
Bonds payable (13.6%) (-L) .................................................. 50,000,000
Loss on bond retirement (+Loss, -SE)................................... 2,720,000
Cash (-A) ...........................................................................
52,720,000
52,720,000
Req. 2
The loss on this transaction would be reported on the income statement as a loss.
Req. 3
There are a number of reasons why a bond may be retired early. For example, the bond
may include a restrictive covenant that can only be overcome by retirement. The
present case does not mention any reasons of this nature. The most likely explanation
is cash flow. The old bonds required interest payments of $6,800,000 per year (13.6% x
$50,000,000). The new bonds (assuming they were issued at an amount close to par)
require $6,260,500 (11 7/8% x $52,720,000) for a savings of $539,500 per year over the
life of the bonds.
10-42
Chapter 10 - Reporting and Interpreting Bonds
CASES AND PROJECTS
FINANCIAL REPORTING AND ANALYSIS CASES
CP10–1.
Req. 1
The company paid $1,947,000 for interest. See “Supplemental Disclosures of Cash
Flow Information” in the notes for the answer to this question.
.
Req. 2
Bonds must be reported unless the company has not issued any. Therefore, the
company must not have issued bonds.
Req. 3
Note 7 describes the company’s credit arrangements. The company has borrowing
arrangements with two separate financial institutions under which it may borrow an
aggregate of $350.0 million.
CP10–2.
Req. 1
Companies are not required to report immaterial amounts. Most likely, the amount of
cash interest paid by Urban Outfitters was immaterial. This question is related to the
next one.
Req. 2
Bonds must be reported unless the company has not issued any. Therefore, the
company must not have issued bonds.
Req. 3
The notes disclose that the company has established an unsecured line of credit.
10-43
Chapter 10 - Reporting and Interpreting Bonds
CP10–3.
Req. 1
The primary source of cash flow for both companies is from their operating activities.
From examining the financing activities section of the statement of cash flows, it is
apparent that neither company relies on borrowed funds to a significant degree.
Req. 2
Accounting ratios are useful in most circumstances but not all. The capital structures for
these two companies are unusual and have relatively little debt. As a result, they have
minimal related interest costs. The debt/equity ratios reflect these low debt levels.
Because of the correspondingly low interest costs, a times interest earned ratio cannot
be computed.
CP10–4.
Req. 1
Most bond indentures specify two types of cash outflows during the life of a bond issue:
(1) periodic interest payments, and (2) payment of par value at maturity. When the
stated interest rate is less than the effective-interest rate, bonds will sell at a discount.
This means that when the bond matures, the investor will receive more cash than was
paid for the bond when it was purchased. The discount on the bond compensates the
investor for the difference between a stated interest rate that is less than the effective
rate of interest. The JCPenney bonds sold at a “deep discount” because the stated rate
of interest was zero. If investors want 15% effective interest, they would be willing to
pay only $326.90 for a $1,000 JCPenney bond; the present value of the bond is
computed as follows:
Principal: $1,000 x.3269
=
$326.90
Req. 2
Principal: $400,000,000 x 0.3269 =
$130,760,000
The bonds would sell for 32.69% of par value, which is $130,760,000 for bonds with a
$400,000,000 face value.
10-44
Chapter 10 - Reporting and Interpreting Bonds
CRITICAL THINKING CASES
CP10–5.
People invest in different securities for a variety of reasons. Bondholders are
interested in fixed income and low risk. They are willing to give up higher returns
for lower risk. While the president of the company may be confident of a high
return on the investment, in reality there is always risk. It is not unethical to offer
an investor a lower-risk, lower-return investment.
CP10–6.
Obviously, there is no right answer to this question. We have found that some
students approach this question from the perspective that people’s jobs are more
important than people’s money. We try to point out that both the current workers
and the retired investors are dependent on income from the corporation in order
to survive. Nevertheless, some students will not budge from the belief that
workers have a higher priority than suppliers of capital. Once this part of the
discussion winds down, we like to shift to the issues of fiduciary responsibility.
Even if students believe that the needs of the workers should take priority, a
question remains concerning the portfolio manager’s professional obligation.
Given that he has been hired to protect the interests of the investors, how high a
priority can be placed on another group that will be affected by a potential
bankruptcy?
FINANCIAL REPORTING AND ANALYSIS PROJECTS
CP10–7.
The response to this case will depend on the companies selected by the
students.
10-45
Chapter 11 - Reporting and Interpreting Owners’ Equity
Chapter 11
Reporting and Interpreting Owners’
Equity
ANSWERS TO QUESTIONS
1.
A corporation is a separate legal entity (authorized by law to operate as an individual).
It is owned by a number of persons and/or entities whose ownership is evidenced by
shares of capital stock. Its primary advantages are: (a) transferability of ownership, (b)
limited liability to the owners, and (c) the ability to accumulate large amounts of
resources.
2.
The charter of a corporation is a legal document from the state that authorizes its
creation as a separate legal entity. The charter specifies the name of the entity, its
purpose, and the kinds and number of shares of capital stock it can issue.
3.
(a) Authorized capital stock—the maximum number of shares of stock that can be
sold and issued as specified in the charter of the corporation.
(b) Issued capital stock—the total number of shares of capital stock that have
been issued by the corporation at a particular date.
(c) Outstanding capital stock—the number of shares currently owned by the
stockholders.
4.
Common stock—the usual or normal stock of the corporation. It is the voting stock
and generally ranks after the preferred stock for dividends and assets distributed
upon dissolution. Often it is called the residual equity. Common stock may be either
par value or no-par value.
Preferred stock—when one or more additional classes of stock are issued, the
additional classes are called preferred stock. Preferred stock has modifications that
make it different from common stock. Generally, preferred stock has both favorable
and unfavorable features in comparison with common stock. Preferred stock
usually is par value stock and usually specifies a dividend rate such as “6%
preferred stock.”
11-1
Chapter 11 - Reporting and Interpreting Owners’ Equity
5.
Par value is a nominal per share amount established for the common stock and/or
preferred stock in the charter of the corporation, and is printed on the face of each
stock certificate. The stock that is sold by a corporation to investors above par
value is said to have sold at a premium, while stock that is sold below par is said to
have sold at a discount. The laws of practically all states forbid the initial sale of
stock by a corporation to investors below par value. No-par value stock does not
have an amount per share specified in the charter. As a consequence, it may be
issued at any price without involving a discount or a premium. It avoids giving the
impression of a value that is not present.
6.
The usual characteristics of preferred stock are: (1) dividend preferences, (2)
conversion privileges, (3) asset preferences, and (4) nonvoting specifications.
7.
The two basic sources of stockholders’ equity are:
Contributed capital—the amount invested by stockholders by purchase from the
corporation of shares of stock. It is comprised of two separate elements: (1) the par
or stated amount derived from the sale of capital stock (common or preferred) and
(2) the amount received in excess of par or stated value.
Retained earnings—the accumulated amount of all net income since the
organization of the corporation, less losses and less the accumulated amount of
dividends paid by the corporation since organization.
8.
Stockholders’ equity is accounted for in terms of source. This means that several
accounts are maintained for the various sources of stockholders’ equity, such as
common stock, preferred stock, contributed capital in excess of par, and retained
earnings.
9.
Treasury stock is a corporation’s own capital stock that was sold (issued) and
subsequently reacquired by the corporation. Corporations frequently purchase
shares of their own capital stock for sound business reasons, such as to obtain
shares needed for employees’ bonus plans, to influence the market price of the
stock, to increase earnings per share amounts, and to have shares on hand for use
in the acquisition of other companies. Treasury stock, while held by the issuing
corporation, confers no voting, dividend, or other stockholder rights.
10. Treasury stock is reported on the balance sheet under stockholders’ equity as a
deduction; that is, as contra stockholders’ equity. Any “gain or loss” on treasury
stock that has been sold is reported on the financial statements as an addition to
contributed capital if a gain; if a loss, it is deducted from any previous contributed
capital, or otherwise from retained earnings.
11-2
Chapter 11 - Reporting and Interpreting Owners’ Equity
11. The two basic requirements to support a cash dividend are: (1) cash on hand or the
ability to obtain cash sufficient to pay the dividend and (2) a sufficient balance in
retained earnings, because the dividend represents a return of earnings to the
stockholders. A cash dividend reduces both the assets of a corporation and
stockholders’ equity by the amount of the dividend.
12. Cumulative preferred stock has a dividend preference such that, should the
dividends on the preferred stock for any year, or series of years, not be paid,
dividends cannot be paid to the common stockholders until all such dividends in
arrears are paid to the preferred stockholders. Noncumulative preferred stock does
not have this preference; therefore, dividends not paid in past periods will never be
paid to the preferred stockholders.
13. A stock dividend involves the issuance to the stockholders of a dividend in the
corporation’s own stock (rather than cash). A stock dividend is significantly different
from a cash dividend in that the corporation does not disburse any assets, while in
the case of a cash dividend, cash is decreased by the amount of the dividend. A
cash dividend also reduces total stockholders’ equity by the amount of the dividend.
In contrast, a stock dividend does not change total stockholders’ equity.
14. The primary purposes for issuing a stock dividend are: (1) to maintain dividend
consistency; that is, to pay dividends each year either in cash or in capital stock,
and (2) to capitalize retained earnings; that is, a stock dividend requires a transfer
from the Retained Earnings account to the permanent contributed capital accounts
for the amount of the dividend. Although this transfer does not change
stockholders’ equity in total, it does cause a shift from retained earnings to
contributed capital.
15. When a dividend is declared and paid, the three important dates are:
Declaration date—the date on which the board of directors votes the dividend. In
the case of a cash dividend, a dividend liability comes into existence on this date
and must be recorded as a debit to Retained Earnings and as a credit to Dividends
Payable.
Date of record—this date usually is about one month after the date of declaration. It
is the date on which the corporation extracts from its stockholders’ records the list
of individuals owning shares. The dividend is paid only to those names listed on the
record date. No entry in the accounts is made on this date.
Date of payment—the date on which the cash is disbursed to pay the dividend. It
follows the date of record as specified in the dividend announcement. The entry to
record the cash disbursement for the dividend is a debit to Dividends Payable and
a credit to Cash.
11-3
Chapter 11 - Reporting and Interpreting Owners’ Equity
16. Retained earnings is the accumulated amount of all net income of the corporation
less all losses and less the accumulated amount of all dividends declared to date.
The primary components of retained earnings are: beginning balance, plus net
income, less net losses, minus dividends declared, equals the ending balance.
ANSWERS TO MULTIPLE CHOICE
1. c)
6. b)
2. d)
7. c)
3. b)
8. c)
11-4
4. a)
9. d)
5. c)
10. a)
Chapter 11 - Reporting and Interpreting Owners’ Equity
Authors’ Recommended Solution Time
(Time in minutes)
Alternate
Problems
No.
Time
1
45
2
30
3
30
4
20
5
50
Mini exercises
No.
Time
1
5
2
5
3
5
4
5
5
5
6
5
7
5
8
5
9
5
10
5
Cases and
Projects
No.
Time
1
30
2
30
3
20
4
20
5
20
6
30
7
*
Exercises
Problems
No.
Time
No.
Time
1
15
1
45
2
15
2
45
3
30
3
45
4
30
4
60
5
20
5
30
6
20
6
30
7
45
7
30
8
15
8
30
9
30
9
45
10
15
10
20
11
20
11
30
12
20
12
30
13
20
13
45
14
30
15
30
16
30
17
20
18
30
19
20
20
15
21
15
22
20
23
20
24
15
25
15
26
15
27
20
28
20
* Due to the nature of this project, it is very difficult to estimate the amount of time
students will need to complete the assignment. As with any open-ended project, it is
possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time to discussing research strategies. When we want the
students to focus on a real accounting issue, we offer suggestions about possible
companies or industries.
11-5
Chapter 11 - Reporting and Interpreting Owners’ Equity
MINI- EXERCISES
M11–1.
Stockholders may:
a) Vote in the stockholders’ meeting (or by proxy) on major issues concerning
management of the corporation.
b) Participate proportionately with other stockholders in the distribution of the
corporation’s profits.
c) Share proportionately with other stockholders in the distribution of corporate
assets upon liquidation.
Being able to vote is the most important of the rights because this ensures that the
owners have an input at the stockholders’ meeting and some control of the
management of the corporation, thus enabling them to protect their rights as
stockholders.
M11–2.
Unissued shares = 90,000 (268,000 – 178,000)
M11–3.
3,570,000
Cash (170,000  $21) (+A) ....................................................
Common Stock (170,000  $1) (+SE) ...............................
Capital in Excess of Par (+SE) ..........................................
170,000
3,400,000
The journal entry would be different if the par value were $2:
3,570,000
Cash (170,000  $21) (+A) ....................................................
Common Stock (100,000  $2) (+SE) ...............................
Capital in Excess of Par (+SE) ..........................................
11-6
340,000
3,230,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
M11–4.
Common stock is the basic voting stock issued by a corporation. It ranks after
preferred stock for dividends and assets distributed upon liquidation of the
corporation. The dividend rate for common stock is determined by the board of
directors, and is based on the company’s profitability. The dividend rate for
preferred stock is fixed by a contract. Common stock has more potential for growth
than preferred stock if the company is profitable. On the other hand, the investor
may lose more money with common stock than with preferred stock if the company
is not profitable.
It is advisable to invest in the common stock. If the company is profitable, common
stock will receive a higher return on the $100,000 than preferred stock would.
M11–5.
Assets
Liabilities
Stockholders’
Equity
Net Income
Purchased
20,000 shares
of treasury
stock
Decrease by
$900,000
No change
Decrease by
$900,000
No change
Sold 5,000
shares
Increase by
$250,000
No change
Increase by
$250,000
No change
Sold 10,000
shares
Increase by
$370,000
No change
Increase by
$370,000
No change
M11–6.
200,000 X $0.65
=
11-7
$130,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
M11–7.
April 15:
Retained Earnings (-SE) .......................................................65,000
Dividends Payable (+L) .....................................................
65,000
June 14:
Dividends Payable (-L) ..........................................................65,000
Cash (-A) ...........................................................................
65,000
M11–8.
Past Year
200,000 shares  $2
=
$400,000
Current Year
200,000 shares  $2
=
$400,000
Total to Preferred Stockholders
$800,000
M11–9.
Stock Dividend
Stock Split
No change in assets
No change in assets
No change in liabilities
No change in liabilities
Increase in common stock
No change in common stock
No change in stockholders’ equity:
decrease retained earnings and
increase contributed capital by the same
amount.
No change in stockholders’ equity
Decreases market value
Decrease in market value
M11–10.
Retained Earnings (-SE) .......................................................
800,000
Common Stock (+SE) .......................................................
11-8
800,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
EXERCISES
E11–1.
Computation of End of Year Balance for Treasury Stock:
Beginning balance
380,474,028
Net decrease
( 5,047,286)
Ending balance
375,426,742
Computation of Shares Outstanding:
Issued shares
2,805,961,317
Treasury stock
( 375,426,742)
Shares Outstanding
2,430,534,575
E11–2.
Req. 1 The number of authorized shares is specified in the corporate charter: 200,000.
Req. 2 Issued shares are the shares sold to the public: 160,000
Req. 3
Issued shares
160,000
Treasury stock
(20,000)
Outstanding shares
140,000
11-9
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–3.
Req. 1
Stockholders’ Equity
Contributed capital:
Preferred stock, authorized 4,000 shares,
issued and outstanding, 3,000 shares ......................................................
Common stock, authorized 103,000 shares,
issued and outstanding, 20,000 shares ....................................................
Capital in excess of par, preferred ..............................................................
Capital in excess of stated value, no-par common .....................................
Total contributed capital ..........................................................................
Retained earnings ..........................................................................................
Total Stockholders’ Equity.......................................................................
$ 24,000
200,000
36,000
120,000
380,000
40,000
$420,000
Req. 2
The answer would depend on the profitability of the company and the stability of its
earnings. The preferred stock has a 9% dividend rate. If the company earns more than
9%, the additional earnings would accrue to the current stockholders. If the company
earns less than 9%, it would pay a higher rate to the preferred stockholders.
E11–4.
Req. 1 ($20 x 90,000 shares) - $1,600,000 = $200,000
Req. 2 $900,000 - $1,000,000 + $800,000 = $700,000
Req. 3 90,000 shares – 80,000 shares = 10,000 shares
Req. 4 EPS = $1,000,000  80,000 = $12.50
11-10
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–5.
Req. 1
a. Cash (5,600 shares x $20) (+A) ............................................
Common stock (5,600 shares x $10) (+SE) ......................
Capital in excess of par, common stock (+SE) ..................
Sold common stock at a premium.
b. Cash (1,000 shares x $25) (+A) ............................................
Common stock (1,000 shares x $10) (+SE) ......................
Capital in excess of par, common stock (+SE) ..................
Sold common stock at a premium.
112,000
56,000
56,000
25,000
10,000
15,000
Req. 2
Stockholders’ Equity
Contributed capital:
Common stock, par $10, authorized 11,500 shares,
outstanding 6,600 shares ....................................................................
Contributed capital in excess of par ........................................................
Total contributed capital ..........................................................................
Retained earnings (deficit) .........................................................................
Stockholders’ equity ...................................................................................
$ 66,000
71,000
137,000
(6,000)
$131,000
Req. 3
The company has a negative balance in retained earnings, which, in most cases, would
preclude the payment of dividends. Dividends are a distribution of earnings to the
owners. In the absence of retained earnings, dividends should not be paid.
11-11
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–6.
Req. 1
Common stock, class A at par value: 116,560,308 X $0.01 = $1,166 (thousand)
Req. 2
Number of shares outstanding 2009: 116,560,308 shares issued minus 47,116,748
shares held as treasury stock = 69,443,560.
Number of shares outstanding 2008: 116,445,495 shares issued minus 45,290,148
shares held as treasury stock = 71,155,347.
Req. 3
(In thousands) Retained earnings for 2008: $2,427,727 plus net loss for 2009 $241,065
plus dividends for 2009 $11,898 = $2,680,690
Req. 4
As of 2009, treasury stock had decreased corporate resources by $942,001 (thousand).
Req. 5
For 2009, treasury stock transactions decreased stockholders’ equity by $17,441
(thousand) ($942,001 - $924,560).
Req. 6
For 2009, treasury stock cost per share: $942,001,000 ÷ 47,116,748 shares = $19.99.
11-12
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–7.
Req. 1
a. Cash (50,000 shares x $50) (+A) ..........................................
Common stock (50,000 shares x $2) (+SE) ......................
Capital in excess of par, common stock (+SE) ..................
Sold common stock at a premium.
2,500,000
b. Treasury stock (1,000 shares x $52) (+XSE, -SE) ................
Cash (-A) ...........................................................................
Bought treasury stock.
100,000
2,400,000
52,000
52,000
Req. 2
Stockholders’ Equity
Contributed capital:
Common stock, par $2, authorized 80,000 shares,
issued 50,000 shares .......................................................................... $ 100,000
Contributed capital in excess of par ........................................................ 2,400,000
Total contributed capital .......................................................................... 2,500,000
Treasury stock............................................................................................
(52,000)
Stockholders’ equity ................................................................................... $2,448,000
E11–8.
Shareholders’ equity (deficit) in thousands:
Common stock, par value $.01 per share; 100,000,000 shares authorized,
23,215,356 shares issued and outstanding at December 31, 2007,
23,337,986 shares issued and outstanding at December 31, 2008
Additional paid-in capital
Accumulated deficit
Total shareholders’ equity
2007
233
233
168,431 171,389
(80,597) (134,480)
88,067
11-13
2008
37,142
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–9.
Stockholders’ Equity
Contributed capital:
Preferred stock, 8%, par $50, authorized 59,000 shares,
issued and outstanding, 20,000 shares ...............................................
Common stock, par $10, authorized 98,000 shares,
issued, 78,000 shares .........................................................................
Capital in excess of par, preferred stock .................................................
Capital in excess of par, common stock ..................................................
Treasury stock .....................................................................................
Retained earnings*.........................................................................................
Total stockholders’ equity........................................................................
$1,000,000
780,000
600,000
780,000
(80,000)
60,000
$3,140,000
*($90,000 – $30,000 = $60,000.)
E11–10.
Req. 1
a. Cash (20,000 shares x $20) (+A) ..........................................
Common stock, no-par (+SE) ............................................
.
400,000
400,000
b. Cash (6,000 shares x $40) (+A) ............................................
Common stock, no-par (+SE) ...........................................
240,000
c. Cash (7,000 shares x $30) (+A) ............................................
Preferred stock (7,000 shares x $10) (+SE) ......................
Capital in excess of par, preferred (+SE) ..........................
210,000
240,000
70,000
140,000
Req. 2
Yes, it is ethical as long as there is a full disclosure of relevant information. In any arm’s
length transaction, an informed buyer will pay the market value of the stock.
11-14
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–11.
Req. 1
Number of preferred shares issued: $100,000  $20 = 5,000
Req. 2
Number of preferred shares outstanding: 5,000 shares issued minus 500 shares held as
treasury stock = 4,500.
Req. 3
Average sales price per share of preferred stock when issued: ($100,000 + $15,000) ÷
5,000 shares = $23.00.
Req. 4
Decreased corporate resources by $9,500 - $1,500 = $8,000.
Req. 5
Treasury stock transactions decreased stockholders’ equity by $8,000 (same as the
decrease in corporate resources in 4 above).
Req. 6
Treasury stock cost per share: $9,500 ÷ 500 shares = $19.00.
Req. 7
Total stockholders’ equity: $741,000.
Req. 8
Issue price of common stock $600,000 ÷ 8,000 shares = $75.00.
11-15
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–12.
Req. 1
The number of shares that have been issued is computed by dividing the common stock
account ($4,002 million) by the par value of the shares ($1 per share) or approximately
4,002,000,000 shares.
Req. 2
Retained earnings end of 2007 ............
Net income for 2008 ............................
Dividends for 2008 ...............................
Retained earnings end of 2008 ............
$41,797,000,000
12,075,000,000
(5,802,900,000)
$48,069,100,000
The amount of retained earnings is an estimate because we do not know the exact
number of shares outstanding (because we do not know the number of shares in
treasury stock. This number is needed to determine the amount of dividends paid during
2008. We based the dividends on the estimate calculated in the previous requirement.
E11–13.
Req. 1
Assets
- $133,750,000
Stockholders’ Equity
- $133,750,000
The treasury stock account is a contra equity account, meaning that it subtracts
from the total stockholders’ equity. Cash also decreases on the balance sheet by
the same amount.
Req. 2
Many companies repurchase common stock in order to develop an employee bonus
plan that provides workers with shares of the company’s stock as part of their
compensation. Because of SEC regulations concerning newly issued shares,
companies find it cheaper to give their employees shares of stock that were purchased
from stockholders than to issue new shares. In this case, the company mentions the
goal of enhancing shareholders’ value. If the company maintains its current level of
income, earnings per share will increase with fewer shares outstanding. The
management expects that the increase in EPS will be reflected in an increase in stock
price.
Req. 3
11-16
Chapter 11 - Reporting and Interpreting Owners’ Equity
Shares that are held in treasury stock do not participate in dividend payments. As a
result, the purchase of treasury stock will reduce the amount of dividends that the
company must pay in future years.
E11–14.
Req. 1
Stockholders’ Equity
Contributed capital:
Common stock, authorized 100,000 shares, issued 34,000 shares, of
which 2,000 shares are held as treasury stock ..................................
Capital in excess of par ........................................................................
Total contributed capital ....................................................................
Retained earnings ...................................................................................
Total ..................................................................................................
Less: Cost of treasury stock .................................................................
Total Stockholders’ Equity .............................................................
$680,000
163,000
843,000
89,000
932,000
25,000
$907,000
Req. 2
The dividend yield ratio is 2.24% ([$16,000  32,000 shares]  $22.29). While this yield
seems small, it is a typical return on common stock. Investors receive a return from both
dividends and stock price appreciation.
Treasury stock does not receive dividends. As a result, dividends should be paid on
32,000 shares.
E11–15.
Req. 1
a. Treasury stock (200 shares x $20) (+XSE, -SE) ...................
Cash (-A) ...........................................................................
Bought treasury stock.
4,000
4,000
b. Cash (40 shares x $25) (+A) .................................................
Treasury stock (40 shares x $20) (-XSE, +SE) .................
Capital in excess of par (+SE) ...........................................
Sold treasury stock.
1,000
c. Cash (30 shares x $15) (+A) .................................................
450
Capital in excess of par (-SE) ...............................................
Treasury stock (30 shares x $20) (-XSE, +SE) ................
Sold treasury stock.
150
Req. 2
11-17
800
200
600
Chapter 11 - Reporting and Interpreting Owners’ Equity
It is not possible to make a “profit” or “loss” on treasury stock transactions. Therefore,
these transactions do not affect the income statement.
E11–16.
Req. 1
Feb. 1:
Treasury stock, common (160 shares x $20) (+XSE, -SE)
Cash (-A)........................................................................
July 15:
Cash (80 shares x $21) (+A) .............................................
Treasury stock, common (-XSE, +SE) ...........................
Capital in excess of par (+SE) .......................................
Sept. 1:
Cash (50 shares x $19) (+A) .............................................
Capital in excess of par (-SE) ............................................
Treasury stock, common (50 shares x $20) (-XSE, +SE)
.
3,200
3,200
1,680
1,600
80
950
50
1,000
Req. 2
Dividends are not paid on treasury stock. Therefore, the amount of total cash dividends
paid is reduced when treasury stock is purchased.
Req. 3
The sale of treasury stock for more or less than its original purchase price does not
have an impact on net income. The transaction affects only balance sheet accounts.
The cash received from the sale of treasury stock is a cash inflow which would affect
the Statement of Cash Flows in the financing activities section.
11-18
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–17.
Req. 1
Case 1: When companies unexpectedly announce increases in dividends, stock
prices typically increase. Depending on course objective, the instructor may want to
discuss research in finance concerning dividend policy.
Case 2: Stock price is based on expectations. If the increase in operating
performance was not expected, the stock price should increase. It is not necessary
to increase dividends to have a favorable stock price reaction.
Case 3: Stock dividends do not provide any economic value but they may have a
signal effect and are often associated with increases in cash dividends. As a result,
stock dividends do not appear to directly cause an increase in stock price but are
often associated with factors that do impact favorably on price.
Req. 2
Stock prices react to underlying economic events and not changes in reporting
methods, per se. Markets are relatively effective in recognizing the difference
between profits generated by operations and profits generated by the use of liberal
accounting policies.
11-19
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–18.
Req. 1
a) Noncumulative:
Preferred ($50,000 x 10%) ......................................
Balance to common ($65,000 – $5,000) .................
Per share ................................................................
Preferred
Common
(5,000
Shares)
(30,000
Shares)
$ 5,000
$60,000
$ 5,000 $60,000
$1.00
$2.00
b) Cumulative:
Preferred, arrears ($50,000 x 10% x 2 years) ......... $ 10,000
Preferred, current year ($50,000 x 10%) .................
5,000
Balance to common ($65,000 – $10,000 – $5,000)
$50,000
$15,000 $50,000
Per share ................................................................
$3.00
$1.67
Total
$ 5,000
60,000
$65,000
$ 10,000
5,000
50,000
$65,000
Req. 2
The total dividend amount and dividends per share of common stock were less under
the second assumption because the preferred stock preferences increased while at the
same time the total dividend amount remained stable.
Req. 3
Larger total dividend distributions are more favorable for the common stockholders.
11-20
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–19.
Item
Assets
Liabilities
Stockholders’
equity
Effect of Cash Dividend (Preferred)
Effect of Stock Dividend (Common)
–No effect on declaration date.
–Decreased by the amount of the
dividend ($7,200) on payment
date.
–Increased on declaration date
($7,200).
–Decreased on payment date
($7,200).
Decreased by the amount of the
dividend (retained earnings
decreased by $7,200).
No effect because no assets are
disbursed.
No effect—no entry on declaration
date because no contractual liability
is created (no assets are
disbursed).
–Total stockholders’ equity not
changed.
–Retained earnings reduced and
contributed capital increased by
same amount ($120,000).
E11–20.
July 15
Retained earnings (-SE) ........................................................ 119,900,000
Cash (-A) ...........................................................................
Declaration and payment of preferred dividends.
Retained earnings (-SE) ........................................................ 691,688,600
Cash (-A) ...........................................................................
Declaration and payment of common dividends.
Computation of shares outstanding:
Shares issued ...................... 387,514,300
Treasury stock......................
41,670,000
Shares outstanding .............. 345,844,300
Dividends paid:
345,844,300 x $2 = $691,688,600
E11–21.
11-21
119,900,000
691,688,600
Chapter 11 - Reporting and Interpreting Owners’ Equity
Req. 1
Duke Energy is a utility company that is very established. They have very little
opportunity for growth and they have stable business operations. Therefore, they have
the ability to have a high dividend yield. On the other hand, Starbucks is a fairly new
company with a high opportunity for growth. Due to the fact that they are retaining all of
their earnings to invest into their growth, they have a 0.0% dividend yield.
Req. 2
The companies will attract two different types of investors. Duke Energy will attract
investors who want and/or need current income, such as someone who is retired.
Starbucks will attract investors who want appreciation on their stock price, such as
those who are planning for their retirement in 25 years.
11-22
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–22.
Req. 1
Stockholders’ Equity
Before Stock
After Stock
Dividend
Dividend
Contributed capital:
Common stock, authorized 65,000 shares
Outstanding: 30,000 shares, par $12 .............
Outstanding: 48,000 shares, par $12 .............
Capital in excess of par value ............................
Retained earnings ................
Total stockholders’ equity...............................
$360,000
120,000
736,000
$1,216,000
$576,000
120,000
520,000
$1,216,000
Req. 2
Item
Assets
Liabilities
Stockholders’
equity
Effects of Stock Dividend
No change because no assets were disbursed.
No change because no liability was created (no assets were to be
disbursed).
–Total stockholders’ equity not changed.
–Retained earnings was reduced by the amount of the dividend.
–The common stock account was increased by the same amount.
E11–23.
July 13, 2009
Retained earnings (-SE)........................................................
1,320,000,000
Dividends payable (+L) .....................................................
1,320,000,000
3,000 (million) shares x $0.44= $1,320,000,000
July 24, 2009
No journal entry required.
August 17, 2009
Dividends payable (-L) ..........................................................
1,320,000,000
Cash (-A)...........................................................................
11-23
1,320,000,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–24.
Comparative results:
Items
Common stock account
Par per share
Shares outstanding
Capital in excess of par
Retained earnings
Total stockholders’ equity
Before Dividend
and Split
$600,000
$3
200,000
$ 900,000
$ 700,000
$2,200,000
After Stock
Dividend
$900,000
$3
300,000
$900,000
$ 400,000
$2,200,000
After Stock
Split
$600,000
$2.50
240,000
$ 900,000
$ 700,000
$2,200,000
Comments: Neither the stock dividend nor stock split changed total stockholders’ equity
because neither involved the disbursement of assets. The stock dividend capitalized
retained earnings and increased the common stock account by the same amount; it
increased shares outstanding but did not change par value per share. The stock split
did not change any account balances; its only effects were to (1) increase shares
outstanding and (2) decrease par value per share.
E11–25.
Req. 1
February 12, 2007---No entry
February 20, 2007---No entry
March 16, 2007
Retained earnings (-SE)........................................................
760,000
Common stock (+SE) ........................................................
760,000
Req. 2
Without additional information, one cannot determine the impact on future cash
dividends. In some cases, the company will maintain its dividend per share payout, in
which case total dividends will increase. In other cases, the company may reduce the
dividends per share and maintain the same total payout. In the case of GameStock, the
company is not currently paying cash dividends, so there is no immediate effect.
11-24
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–26.
Comparative results:
Items
Common stock account
Par per share
Shares outstanding
Capital in excess of par
Retained earnings
Total stockholders’ equity
Before Dividend
and Split
$640,000
$8
80,000
$ 280,000
$ 1,300,000
$2,220,000
After Stock
Dividend
$896,000
$8
112,000
$ 280,000
$ 1,044,000
$2,220,000
After Stock
Split
$640,000
$ 4.80
133,333
$ 280,000
$ 1,300,000
$2,220,000
Comments: Neither the stock dividend nor stock split changed total stockholders’ equity
because neither involved the disbursement of assets. The stock dividend reduced
retained earnings and increased the common stock account by the same amount; it
increased shares outstanding but did not change par value per share. The stock split
did not change any account balances; its only effects were to (1) increase shares
outstanding and (2) decrease par value per share.
E11–27.
Req. 1
A corporation does not need to earn net income in a given year in order to declare and
pay dividends. There are two requirements 1) the balance of retained earnings should
be sufficient to pay dividends, and 2) there must be sufficient cash on hand.
Req. 2
Clearly the board determined that the balances in retained earnings and cash were
sufficient to pay dividends. The board probably analyzed cash flow for the current year
and the future to determine whether the payment of dividends would create any
problems in subsequent years. The board also probably took into consideration the
impact of skipping a dividend. If the company did not pay a dividend, many investors
might assume that the board concluded that the company might lose money for several
years. This lack of confidence could have a significant impact on the price of the
company’s stock. By paying a dividend, the company sent a signal to the market that
the board had confidence in the long-term health of the company.
11-25
Chapter 11 - Reporting and Interpreting Owners’ Equity
E11–28.
The fact that dividends are in arrears indicates that the company has been experiencing
some financial difficulty. Most companies do not want to suspend dividend payments
because it will erode investor confidence. Typically, companies are experiencing severe
cash flow problems when they take this type of drastic action. The investor assumed
that he would get a large cash payment “when Archon started paying dividends again.”
The student should have realized that he was making a large assumption; a financially
troubled company may never pay dividends again.
11-26
Chapter 11 - Reporting and Interpreting Owners’ Equity
PROBLEMS
P11–1.
1. Shares authorized (given) .........................................................................
Shares issued ($2,125,000  $17) ............................................................
Shares outstanding (125,000 – 3,000) ......................................................
200,000
125,000
122,000
2. Capital in excess of par: $2,125,000 – (125,000 shares issued x $10 par) =
$875,000.
3. Earnings per share: $118,000  122,000 shares = $.97 (rounded).
4. Dividend per share: $73,200  122,000 shares = $0.60.
5. Treasury stock: Stockholders’ equity, as a deduction in the amount of 3,000 shares
x $20 cost = $60,000.
6. Stock split, 100%: Par value per share after the split, $10  2 = $5. Outstanding
shares before split (per 1 above), 122,000 x 2 = 244,000 shares outstanding after
the split.
7.
Entry for the stock split—None, because the total par value amount before and
after the split is the same; retained earnings are not capitalized in a stock split.
8.
Entry for stock dividend (capitalize retained earnings for market value of $21 per
share):
Retained earnings (122,000 shares x 10% x $21) (-SE) .......
Common stock (122,000 shares x 10% x $10) (+SE)........
Capital in excess of par
(122,000 shares x 10%) x ($21 – $10)(+SE) ...................
11-27
256,200
122,000
134,200
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–2.
Stockholders’ Equity
Contributed capital:
Preferred stock authorized 21,000 shares; issued and outstanding,
6,500 shares ......................................................................................
Common stock authorized 50,000 shares; issued and outstanding,
43,000 shares ....................................................................................
Capital in excess of par, preferred ........................................................
Capital in excess of par, common.........................................................
Total contributed capital ....................................................................
Retained earnings ....................................................................................
Total stockholders’ equity .....................................................................
$ 65,000
344,000
49,000
181,000
639,000
51,000
$690,000
P11–3.
(a) Cash (66,000 shares x $9)(+A) .............................................
Common stock (66,000 shares x $5) (+SE) .....................
Contributed capital in excess of par, common (66,000 x
$4) (+SE) ........................................................................
.
594,000
(b) Cash (9,000 shares x $20) (+A) ............................................
Preferred stock (9,000 shares x $10) (+SE) ......................
Contributed capital in excess of par, preferred (+SE) ........
.
180,000
(c) Cash (1,000 shares x $20) + (1,500 shares x $10) (+A) ......
Preferred stock (1,000 shares x $10) (+SE) ......................
Common stock (1,500 shares x $5) (+SE) ........................
Contributed capital in excess of par, preferred (+SE) ........
Contributed capital in excess of par, common (+SE) ........
35,000
11-28
330,000
264,000
90,000
90,000
10,000
7,500
10,000
7,500
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–4.
Req. 1 (in millions)
(a) Cash (+A) ..............................................................................
Common stock (+SE) .......................................................
.
136.5
136.5
.
Req. 2 (in millions)
(a) Cash (+A) ..............................................................................
Common stock (+SE) .........................................................
Capital in excess of par (+SE)……………………………….
136.5
2.1
134.4
Req. 3
In most cases, stockholders should not care whether stock is issued as par or no-par
value stock. The various types of stock do not offer any real economic advantages to
investors.
11-29
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–5.
Stockholders’ Equity
Contributed capital:
Common stock, par $1, authorized 200,000 shares; issued 100,000
shares, of which 15,000 shares are held as treasury stock ...................... $ 100,000
Capital in excess of par .............................................................................. 1,115,000
Total contributed capital .......................................................................... 1,215,000
Retained earnings ..........................................................................................
475,000
Less: Treasury stock held (15,000 shares x $15) .......................................
(225,000)
Total stockholders’ equity ........................................................................... $1,465,000
P11–6.
(a)
Treasury Stock (+XSE, -SE) .................................................
165,258
Cash (-A) ...........................................................................
(b)
Retained Earnings (-SE) .......................................................66,086
Dividends Payable (+L) .....................................................
Dividends Payable (-L) ..........................................................66,086
Cash (-A) ...........................................................................
(c)
Cash (+A) ..............................................................................
903,825
Common Stock (+SE) .......................................................
Capital in Excess of Par (+SE) ..........................................
11-30
165,258
66,086
66,086
50,000
853,825
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–7.
Req. 1
A stock dividend is a dividend paid in additional stock of the issuing company while
a cash dividend is paid in cash.
Req. 2
Stock dividends are classified as either large or small. A large stock dividend
involves the distribution of additional shares that are more than 20–25% of the
currently outstanding shares. A small stock dividend involves additional shares that
are less than 20–25% of the outstanding shares.
Req. 3
The sale of treasury stock for more than cost has no impact on the reported income
for a company. The sale does affect the Statement of Cash Flows because it is an
inflow of cash from financing activities.
Req. 4
There are a number of strategic reasons why a corporation may want to purchase
its own stock from existing stockholders. A common reason is the existence of an
employee bonus plan that provides workers with shares of the company’s stock as
part of their compensation. Because of Securities and Exchange Commission
regulations concerning newly issued shares, most companies find that it is less
costly to give their employees shares of stock that were purchased from
stockholders than to issue new shares.
P11–8.
Req. 1
Treasury Stock (+XSE, -SE) ................................................. 625.8
Cash (-A) ...........................................................................
625.8
Req. 2
Cash (+A) .............................................................................. 10.5
Treasury Stock (-XSE, +SE) .............................................
Capital in Excess of Par (+SE) ..........................................
9.0
1.5
Req. 3
While there would be an economic loss on this transaction, an accounting loss would
not be recorded. Instead, Capital in Excess of Par would be reduced.
11-31
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–9.
Req. 1
Case A—Preferred is noncumulative (total amount to distribute, $31,000):
Preferred
Common
(8,000
(35,000
shares)
shares)
Preferred ($120,000 x 10%) .........................................
$ 12,000
Balance to common ($31,000 – $12,000) ....................
$19,000
$ 12,000
$19,000
Per share .....................................................................
$1.50
Case B—Preferred is cumulative (total amount to distribute, $25,000):
Preferred:
Arrears ($120,000 x 10% x 2 years) .........................
$ 24,000
Current year ($120,000 x 10%) ................................
1,000
$25,000
Per share .....................................................................
$3.13
Case C—Preferred is cumulative (total amount to distribute, $67,000):
Preferred:
Arrears ($120,000 x 10% x 2 years) .........................
$ 24,000
Current year ($120,000 x 10%) ................................
12,000
Balance to common ($67,000 – $36,000)
$36,000
Per share .....................................................................
11-32
$4.50
Total
$ 12,000
19,000
$31,000
$0.54
–0–
–0–
$ 24,000
1,000
$25,000
$ –0–
$31,000
$31,000
$0.89
$ 24,000
12,000
31,000
$67,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–9. (continued)
Req. 2
Item
Assets
Liabilities
Stockholders’
equity
Schedule of Comparative Differences (with comments)
Amount of Dollar Increase (Decrease)
Cash Dividend – Case C
Stock Dividend
$67,000 decrease to cash
No assets were disbursed.
Current liabilities increased
No effect – no contractual liability
$67,000 on declaration date and was created.
decreased $67,000 on payment
date. The net effect is zero.
$67,000 decrease (debit to
No effect on total stockholders’
retained earnings).
equity. Decreased retained
earnings and increased common
stock by same amount ($84,000).
Summary comment:
(1) A cash dividend decreases assets and stockholders’ equity by the amount of the
dividend because resources were disbursed.
(2) A stock dividend does not change total assets or total stockholders’ equity because
no resources are disbursed; only the internal content of stockholders’ equity is
changed.
P11–10.
Req. 1
Heather feels some concern about whether Scott is looking in the right place on the
Statement of Cash Flows (SCF) for dividends. She shouldn’t be concerned; dividends
paid are reported in the financing activities section of the SCF.
While cash flows from operating activities have declined for the current year, the
reduction has to do with the fact that cash flows were positively affected in the previous
year by the one time $2 billion reduction in inventory and accounts receivable. Heather
is wrong when she implies that the company’s cash flows will not support the payment
of dividends.
Req. 2
Dell has a very aggressive program to repurchase stock from investors. Some
companies elect to pay out extra cash in dividends while others use the cash to
repurchase their stock. Because fewer shares are outstanding, reported earnings per
share will be higher which may be reflected in a higher stock price.
11-33
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–11.
Item
Comparative Effects Explained
Cash Dividend on Preferred
Stock Dividend on Common
a) Through December 31, 2011:
Assets
None—No cash yet disbursed. None—No entry (no assets to
be disbursed).
Liabilities
Increased current liabilities by
None—No entry made on
the amount of the dividend
declaration date.
Stockholders’ Decreased by the amount of
None—No entry.
equity
the dividend.
b) On February 15, 2012:
Assets
Decreased by the amount of
None—No assets are
the dividend (credit cash
disbursed.
$40,000).
Liabilities
Decreased by the amount of
None—No liability was
the dividend (debit dividends
created.
payable $40,000).
Stockholders’ No change since Dec. 31. The
(1) Total stockholders’ equity
equity
effect was recorded in the
not changed.
previous year.
(2) Retained earnings
reduced by the amount of
the dividend (i.e., par
value of the stock issued,
$156,000).
(3) Common stock is
increased by the amount
of the dividend.
c) Overall Effects From December 1 through February 15:
Assets
Decreased $40,000.
No effect.
Liabilities
No effect.
No effect.
Stockholders’ Decreased $40,000.
No effect on total.
equity
11-34
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–12.
Req. 1
March 9
No journal entry is required for the declaration of a stock dividend.
May 21
No journal entry is required.
June 18 (millions)
Retained earnings* (-SE) ..................................................
Common stock (+SE) .....................................................
Capital in excess of par (+SE) .......................................
12,500
250
12,250
* 2,500 million shares x 10% x $50 = $12,500 million.
Req. 2
This simple question can give the instructor an excellent opportunity to discuss the
relevancy of dividend policy. There is a strong theoretical argument to be made that
dividend policy is irrelevant. There are several real world factors that make the question
more difficult to answer (e.g., the impact of taxes, information content of dividends, and
the clientele effect). The level of the discussion of this issue will depend on the amount
of finance that has been introduced during the instructor’s lectures.
Req. 3
The board must consider the impact of the stock dividend and the increase in cash
dividends on the price of the stock. They made the decision with the expectation that it
would have a favorable impact on the long-term value of the stock.
11-35
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–13.
Req. 1
Case A: Sole Proprietorship, closing entries:
A, Capital ...........................................................................
Individual revenue and expense accounts .....................
A, Capital ...........................................................................
A, Drawings ....................................................................
20,000
20,000
9,000
9,000
Case B: Partnership, closing entries:
A, Capital ...........................................................................
B, Capital ...........................................................................
Individual revenue and expense accounts .....................
A, Capital ...........................................................................
B, Capital ...........................................................................
A, Drawings ....................................................................
B, Drawings ....................................................................
10,000
10,000
20,000
5,000
7,000
5,000
7,000
Case C: Corporation, closing entry:
Retained earnings .............................................................
Individual revenue and expense accounts .....................
11-36
20,000
20,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
P11–13. (continued)
Req. 2
Case A: Sole Proprietorship
Statement of Owner’s Equity
A, Capital, January 1 .............................................................
Less: Net loss........................................................................
Total ..................................................................................
Less: Withdrawals .................................................................
A, Capital, December 31 .......................................................
$52,000
20,000
32,000
9,000
$23,000
Case B: Partnership
Partners’ Equity
A, Capital ..............................................................................
B, Capital ..............................................................................
Total Partners’ Equity ........................................................
Statement of Partners’ Equity
A
Partners’ equity, January 1 ............................... $43,000
Deduct: Net loss ................................................
10,000
Total ..............................................................
33,000
Deduct: Withdrawals .........................................
5,000
Partners’ Equity, December 31 ......................... $28,000
$28,000
26,000
$54,000
B
$43,000
10,000
33,000
7,000
$26,000
Total
$86,000
20,000
66,000
12,000
$54,000
Case C: Corporation
Stockholders’ Equity
Contributed capital:
Common stock, par $10, authorized 30,000 shares,
outstanding 14,000 shares ..............................................
Capital in excess of par .....................................................
Total contributed capital .................................................
Retained earnings .................................................................
Total Stockholders’ Equity ..........................................
$140,000
9,000
149,000
42,000
Statement of Retained Earnings
Retained earnings, balance Jan. 1 ...........................................................
Less: Net loss ..........................................................................................
Retained earnings, balance Dec. 31 ........................................................
11-37
$191,000
$62,000
20,000
$42,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
ALTERNATE PROBLEMS
AP11–1.
Req. 1
Common Stock $1,500,000 / $1
=
Issued Shares
1,500,000
Treasury Stock
(100,000)
Shares Outstanding
1,400,000
1,500,000 shares
Req. 2
The balance in the Capital in Excess of Par Account appears to be $118,500,000.
[($80-$1) x 1,500,000 shares]
Req. 3
EPS on net income is $3.43 (rounded)
$4,800,000 / 1,400,000 shares = $3.43
Req. 4
Total dividends paid on common stock during the year is $2,800,000.
1,400,000 shares  $2.00 per share = $2,800,000
Req. 5
Treasury stock should be reported on the balance sheet under the major caption
Stockholders’ Equity, as a deduction in the amount of $6,000,000.
100,000 shares  $60 per share = $6,000,000
11-38
Chapter 11 - Reporting and Interpreting Owners’ Equity
AP11–2.
(a) Cash (30,000 shares x $40) + (5,000 shares x $26) (+A) .....
Common stock, (30,000 shares x $40) (+SE) ...................
Preferred stock (5,000 shares x $5) (+SE) ........................
Capital in excess of par, preferred
(5,000 shares x $21) (+SE) .............................................
Sold stock.
1,330,000
(b) Cash (2,000 shares x $32) (+A) ............................................
64,000
1,200,000
25,000
105,000
Preferred stock (2,000 shares x $5) (+SE) ........................
Contributed capital in excess of par, preferred
($64,000 - $10,000) (+SE) ................................................
Sold preferred stock.
(c) Treasury stock, common (3,000 shares x $38) (+XSE, -SE)
Cash (-A) ...........................................................................
Purchased treasury stock, common, at $38 per share.
10,000
54,000
114,000
114,000
AP11–3.
Stockholders’ Equity
Contributed capital:
Common stock, par $5, authorized 1,000,000 shares; issued 700,000
shares, of which 25,000 shares are held as treasury stock ......................
Capital in excess of par, common...............................................................
Total contributed capital ..........................................................................
Retained earnings ..........................................................................................
Total ........................................................................................................
Less: Treasury stock held (25,000 shares x $50) .......................................
Total stockholders’ equity ...........................................................................
11-39
$ 3,500,000
34,300,000
37,800,000
429,000
38,229,000
(1,250,000)
$36,979,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
AP11–4.
a. Cash (+A) .............................................................................272,900
Common stock (+SE) .......................................................
272,900
b. Treasury stock (+XSE, -SE) .................................................. 99,964
Cash (-A) ...........................................................................
99,964
c. Retained earnings (-SE) .......................................................340,867
Dividend payable (+L) .......................................................
Dividend payable (-L) ............................................................340,867
Cash (- A) ..........................................................................
340,867
340,867
AP11–5.
Req. 1
Case A—Preferred is noncumulative (total amount to distribute, $25,000):
Preferred Common
(21,000
(500,000
shares)
shares)
Preferred ($210,000 x 8%) ............................................
Balance to common ($25,000 – $16,800) .....................
Per share ......................................................................
$16,800
$16,800
$8,200
$8,200
$.80
$.016
Case B—Preferred is cumulative (total amount to distribute, $25,000):
Preferred:
Arrears ($210,000 x 8% x 2 years = $33,600) ...........
$25,000
Current year ($210,000 x 8%) ...................................
$25,000
–0–
Per share ......................................................................
$1.19
11-40
$2.40
$16,800
8,200
$25,000
$25,000
$25,000
$ –0–
Case C—Preferred is cumulative (total amount to distribute, $75,000):
Preferred:
Arrears ($210,000 x 8% x 2 years) ............................
$33,600
Current year ($210,000 x 8%) ...................................
16,800
Balance to common ($75,000 – $50,400) .....................
$24,600
$50,400 $24,600
Per share ......................................................................
Total
$.049
$33,600
16,800
24,600
$75,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
AP11–5. (continued)
Req. 2
Item
Assets
Liabilities
Stockholders
equity
Schedule of Comparative Differences (with comments)
Amount of Dollar Increase (Decrease)
Cash Dividend – Case C
Stock Dividend
$75,000 decrease
No assets were disbursed.
Current liabilities increased
No effect – no contractual liability
$75,000 on declaration date and was created.
decreased $75,000 on payment
date. The net effect is zero.
$75,000 decrease (debit to
No effect on total stockholders’
retained earnings).
equity. Decreased retained
earnings and increased common
stock by same amount.
Summary comment:
(1) A cash dividend decreases assets and stockholders’ equity by the amount of the
dividend because resources were disbursed.
(2) A stock dividend does not change total assets or total stockholders’ equity because
no resources are disbursed; only the internal content of stockholders’ equity is
changed.
11-41
Chapter 11 - Reporting and Interpreting Owners’ Equity
Comprehensive Review Problem (Chapter 9, 10, 11)
Case A
Req. 1
Preferred stock dividend --- $2,160 = 3,000 shares x $8 x 9%
Common stock dividend---$7,840 = $10,000 - $2,160
Req. 2
35,000 shares (40,000 shares issued – 5,000 shares treasury stock)
Req. 3
The sale of treasury stock does not affect the income statement. Rogers would record
an increase in cash from the sale. In stockholders’ equity, the treasury stock account
would be reduced by the cost of the shares sold with the difference between the cash
collected and the cost of the shares recorded as an increase in capital in excess of par.
Req. 4
A journal entry is not required to record a stock split. Instead, the par value of the stock
is adjusted. After a 2-for-1 stock split, the par value for Rogers stock would be $5 per
share.
Case B
Quick Ratio
Working Capital
a. Decrease
Remain the same
b. Decrease
Decrease
c. Remain the same
Remain the same
d. Decrease
Remain the same
Case C
Req. 1
$1,000,000 x 0.6139 ..................................................... $ 613,900
$50,000 x 7.7217 ..........................................................
386,085
Issue price .................................................................... $999,985 (at par)*
11-42
Chapter 11 - Reporting and Interpreting Owners’ Equity
*$15 rounding error---issue price is par value, or $1,000,000
Comprehensive Review Problem (continued)
Req. 2
$1,000,000 x 0.6756 ..................................................... $ 675,600
$50,000 x 8.1109 ..........................................................
405,545
Issue price .................................................................... $1,081,145
Req. 3
$1,000,000 x 0.5584 ..................................................... $ 558,400
$50,000 x 7.3601 ..........................................................
368,005
Issue price .................................................................... $ 926,405
Case D
Req. 1
Computations:
Interest:
$1,000,000 x 5%
=
Present value:
$1,000,000 x 0.4564
$ 50,000 x 13.5903
Issue price
=
456,400
=
679,515
= $1,135,915
$ 50,000
Cash (+A) .............................................................................. 1,135,915
Premium on Bonds Payable (+L) ......................................
Bonds Payable (+L) ..........................................................
Req. 2
Cash (+A) .............................................................................. 1,125,000
Common stock (+SE) .......................................................
Capital in excess of par, common stock (+SE) ..................
11-43
135,915
1,000,000
45,000
1,080,000
Chapter 11 - Reporting and Interpreting Owners’ Equity
CASES AND PROJECTS
FINANCIAL REPORTING AND ANALYSIS CASES
CP11–1.
Req. 1
There are 43,248 (thousand) shares in treasury stock.
Req. 2
The dividend per share for the current year was $0.40.
Req. 3
The Company both bought and sold treasury stock during the current
year.
Req. 4
Par value is $.01 per share
CP11–2.
Req. 1
200,000,000 shares authorized; 167,712,088 shares issued and
outstanding.
Req. 2
The company does not pay dividends.
Req. 3
The company does not have any treasury stock.
Req. 4
No, the company has not issued a stock dividend or stock split over the
reporting period.
Req. 5
Par value is $0.0001.
11-44
Chapter 11 - Reporting and Interpreting Owners’ Equity
CP11–3.
Req.1
The stock price of a company will immediately adjust downward. Each share is worth
less after a split because there are more shares outstanding. Some companies believe
that higher stock prices might make the stock less attractive to some investors. By
splitting the stock, the stock price is lowered making the stock potentially more attractive
to some investors.
Req. 2
Urban Outfitters
Dividends per share
Market price per share
0
American Eagle
0%
0.40
$28
2.7%
$15
Req. 3
Many investors are interested in the appreciation of stock rather than the amount of
dividends. Note that although American Eagle paid dividends, its dividend yield ratio is
low; thus, investors would still be relying on American Eagle’s stock appreciating in
value.
Req. 4
Dividend
Yield
Example
Company
Retail Apparel
Pharmaceuticals
Electric Utilities
1.1%
2.6%
The GAP
Eli Lilly
3.8%
American Electric
Power
The dividend yield ratio increases across the three industry groups. An investor that
wants regular dividend payments would be more interested in investing in an electric
utility company than a retail store. Often these investors are retirees that use the
income stream from dividends to supplement their income after they stop working.
11-45
Chapter 11 - Reporting and Interpreting Owners’ Equity
CP11–4.
Number of common shares outstanding.
Total par value = $298.3 million = 119.32 million shares
Par per share
2.50
Less treasury stock
(12.8 million) shares
106.52 million
106.52 million shares x $1 per share = $106.52 million
CRITICAL THINKING CASES
CP11–5.
The payment of a stock dividend is a cosmetic solution with no cash flow effects. If the
stock is valued by the market for its steady dividends, a stock dividend will not prevent a
negative response. Unfortunately, there is no easy way to solve this problem. We find
that most students think the priority should be on maintaining the long-term health of the
company.
CP11–6.
We do not have an easy answer to this question. We use this case to discuss corporate
governance and responsibilities.
FINANCIAL REPORTING AND ANALYSIS PROJECTS
CP11–7.
Student response depends on the company selected.
11-46
Chapter 13 - Statement of Cash Flows
Chapter 13
Statement of Cash Flows
ANSWERS TO QUESTIONS
1.
The income statement reports revenues earned and expenses incurred during a
period of time. It is prepared on an accrual basis. The balance sheet reports the
assets, liabilities, and equity of a business at a point in time. The statement of cash
flows reports cash receipts and cash payments of a business, from three broad
categories of business activities: operating, investing, and financing.
2.
The statement of cash flows reports cash receipts and cash payments from three
broad categories of business activities: operating, investing, and financing. While
the income statement reports operating activities, it reports them on the accrual
basis: revenues when earned, and expenses when incurred, regardless of the
timing of the cash received or paid. The statement of cash flows reports the cash
flows arising from operating activities. The balance sheet reports assets, liabilities,
and equity at a point in time. The statement of cash flows and related schedules
indirectly report changes in the balance sheet by reporting operating, investing, and
financing activities during a period of time, which caused changes in the balance
sheet from one period to the next. In this way, the statement of cash flows reports
information to link together the financial statements from one period to the next, by
explaining the changes in cash and other balance sheet accounts, while
summarizing the information into operating, investing, and financing activities.
3.
Cash equivalents are short-term, highly liquid investments that are purchased
within three months of the maturity date. The statement of cash flows does not
separately report the details of purchases and sales of cash equivalents because
these transactions affect only the composition of total cash and cash equivalents.
The statement of cash flows reports the change in total cash and cash equivalents
from one period to the next.
4.
The major categories of business activities reported on the statement of cash flows
are operating, investing, and financing activities. Operating activities of a business
arise from the production and sale of goods and/or services. Investing activities
arise from acquiring and disposing of property, plant, and equipment and
investments. Financing activities arise from transactions with investors and
creditors.
13-1
Chapter 13 - Statement of Cash Flows
5.
Cash inflows from operating activities include cash sales, collections on accounts,
and notes receivable arising from sales, dividends on investments, and interest on
loans to others and investments. Cash outflows from operating activities include
payments to suppliers and employees, and payments for operating expenses,
taxes, and interest.
6.
Depreciation expense is added to net income to adjust for the effects of a noncash
expense that was deducted in determining net income. It does not involve an inflow
of cash.
7.
Cash expenditures for purchases and salaries are not reported on the statement of
cash flows, indirect method, because that method does not report cash inflows and
outflows for each operating activity. Rather, it reports only net income, changes in
accounts payable and wages payable, and net cash flow from operating activities.
8.
The $50,000 increase in inventory must be used in the statement of cash flows
calculations because it increases the outflow of cash all other things equal. It is
used as follows:
Direct method—added to cost of goods sold, accrual basis (the other adjustment
would involve accounts payable) to compute cost of goods sold, cash basis.
Indirect method—subtracted from net income as a reconciling item to obtain cash
flows from operating activities.
9.
The two methods of reporting cash flows from operating activities are the direct
method and the indirect method. The direct method reports the gross amounts of
cash receipts and cash payments arising from the revenues and expenses reported
on the income statement. The indirect method reports the net amount of cash
provided or used by operating activities, by reporting the adjustments to net income
for the net effects of noncash revenues and expenses, and changes in accruals
and deferrals. The two approaches differ in the way they report cash flows from
operating activities, but net cash provided by operating activities is the same
amount.
10. Cash inflows from investing activities include cash received from sale of operational
assets, sale of investments, maturity value of bond investments, and principal
collections on notes receivable. Cash outflows from investing activities include cash
payments to purchase property, plant, and equipment and investments, and to
make loans.
11. Cash inflows from financing activities include cash received from issuing stock, the
sale of treasury stock, and borrowings. Cash outflows from financing activities
include cash payments for dividends, the purchase of treasury stock, and principal
payments on borrowing.
13-2
Chapter 13 - Statement of Cash Flows
12. Noncash investing and financing activities are activities that would normally be
classified as investing or financing activities, except no cash was received or paid.
Examples of noncash investing and financing include the purchase of assets by
issuing stock or bonds, the repayment of loans using noncash assets, and the
conversion of bonds into stock. Noncash investing and financing activities are not
reported in the statement of cash flows, because there was no cash received or
cash paid; however, the activities are disclosed in a separate schedule.
13. When equipment is sold, it is considered an investing activity, and any cash
received is reported as a cash inflow from investing activities. When using the
indirect method, the gain on sale of equipment must be reported as a deduction
from net income, because the gain was included in net income, but did not provide
any cash from operating activities. When using the indirect method, the loss on sale
of equipment is added to net income because the loss was included in net income
but did not require an operating cash outflow.
ANSWERS TO MULTIPLE CHOICE
1. d)
6. b)
2. d)
7. d)
3. a)
8. a)
13-3
4. a)
9. d)
5. a)
10. c)
Chapter 13 - Statement of Cash Flows
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises
No.
Time
1
5
2
5
3
5
4
5
5
5
6
5
7
5
Exercises
No.
Time
1
10
2
10
3
15
4
15
5
15
6
15
7
20
8
20
9
20
10
10
11
15
12
10
13
20
14
25
15
20
16
25
17
25
18
15
19
15
20
20
21
35
22
35
Problems
No.
Time
1
35
2
35
3
35
4
40
5
40
6
45
Alternate
Problems
No.
Time
1
35
2
35
3
35
Cases and
Projects
No.
Time
1
20
2
15
3
25
4
45
5
35
6
35
7
*
* Due to the nature of these cases and projects, it is very difficult to estimate the amount
of time students will need to complete the assignment. As with any open-ended project,
it is possible for students to devote a large amount of time to these assignments. While
students often benefit from the extra effort, we find that some become frustrated by the
perceived difficulty of the task. You can reduce student frustration and anxiety by
making your expectations clear. For example, when our goal is to sharpen research
skills, we devote class time discussing research strategies. When we want the students
to focus on a real accounting issue, we offer suggestions about possible companies or
industries.
13-4
Chapter 13 - Statement of Cash Flows
MINI–EXERCISES
M13–1.
F
F
I
O
O
O
1.
2.
3.
4.
5.
6.
Purchase of stock. (This involves repurchase of its own stock.)
Principal payment on long-term debt.
Proceeds from sale of properties.
Inventories (decrease).
Accounts payable (decrease).
Depreciation, depletion, and amortization.
+
–
+
–
+
1.
2.
3.
4.
5.
Accrued expenses (increase).
Inventories (increase).
Accounts receivable (decrease).
Accounts payable (decrease).
Depreciation, depletion, and amortization.
O
F
F
I
F
O
1.
2.
3.
4.
5.
6.
Receipts from customers.
Dividends paid.
Payment for share buy-back.
Proceeds from sale of property, plant and equipment.
Repayments of borrowings (bank debt).
Net interest paid.
M13–2.
M13–3.
M13–4.
Quality of income ratio = Cash flow from operations = $52,500
Net income
$86,000
= 0.61 (61%)
The quality of income ratio measures the portion of income that was generated in
cash. A low ratio indicates a likely need for external financing.
M13–5.
Investing Activities
Sale of used equipment
Purchase of short-term investments
Cash used in investing activities
$ 250
(285)
$ (35)
Financing Activities
Additional short-term borrowing from bank
Dividends paid
Cash provided by financing activities
$950
(900)
$ 50
M13–6.
13-5
Chapter 13 - Statement of Cash Flows
M13–7.
Yes
No
No
Yes
Purchase of building with mortgage payable
Additional short-term borrowing from bank
Dividends paid in cash
Purchase of equipment with short-term investments
EXERCISES
E13–1.
F
F
O
F
O
NA
F
O
I
O
1. Dividends paid
2. Repayments of long-term debt
3. Depreciation and amortization
4. Proceeds from issuance of common stock to employees
5. [Change in] Accounts payable and accrued expenses
6. Cash collections from customers
7. Net repayments of notes payable to banks
8. Net income
9. Payments to acquire property and equipment
10. [Change in] Inventory
E13–2.
I
O
F
O
F
F
O
O
I
NA
1. Proceeds from sale of property, plant and equipment
2. Interest received
3. Repayments of loans
4. Income taxes paid
5. Proceeds from ordinary share [stock] issues
6. Dividends paid
7. Payments in the course of operations
8. Receipts from customers
9. Payments for property, plant and equipment
10. Net income
13-6
Chapter 13 - Statement of Cash Flows
E13–3.
1.
NE
Salaries expense
Accrued salaries payable
2.
– NCFI
Plant and equipment
Cash
3.
+ NCFO
Cash
Accounts receivable
4.
– NCFO
Interest expense
Cash
5.
– NCFF
Retained earnings
Cash
6.
+ NCFI
Cash
Accumulated depreciation
Plant and equipment
7.
– NCFO
Prepaid expenses (rent)
Cash
8.
– NCFF
Short-term debt
Cash
9.
NE
10.
– NCFO
Inventory
Accounts payable
Accounts payable
Cash
13-7
Chapter 13 - Statement of Cash Flows
E13–4.
1.
NE
Inventory
Accounts payable
2.
– NCFO
Prepaid expenses (rent)
Cash
3.
NE
Plant and equipment
Note payable
4.
NE
Expense
Prepaid expense
NCFO
Income tax expense
Cash
5.
–
6.
– NCFI
Investment securities
Cash
7.
+ NCFF
Cash
Common stock
Additional paid-in capital
8.
+ NCFO
Cash
Accounts receivable
9.
+ NCFI
Cash
Plant and equipment (net)
10.
+ NCFF
Cash
Long-term debt
13-8
Chapter 13 - Statement of Cash Flows
E13–5.
Comparison of Statement of Cash Flows--direct and indirect reporting
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Cash Flows
(and related changes)
Accounts payable increase or decrease
Payments to employees
Cash collections from customers
Accounts receivable increase or decrease
Payments to suppliers
Inventory increase or decrease
Wages payable, increase or decrease
Depreciation expense
Net income
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Net increase or decrease in cash during the period
Statement of Cash Flows
Method
Direct
Indirect
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
The direct method reports cash flows from operating activities individually for each
major revenue and expense. In contrast, the indirect method reports a reconciliation of
net income to cash flow from operating activities. The two methods report the investing
and financing activities in exactly the same way.
13-9
Chapter 13 - Statement of Cash Flows
E13–6.
Cash flows from operating activities—indirect method
Net income...............................................................................................
Depreciation expense ..............................................................................
Accounts receivable decrease ($10,500 – $12,000) ...............................
Inventory increase ($14,000 – $8,000) ...................................................
Salaries payable increase ($1,750 – $800) .............................................
Net cash provided by operating activities ...........................................
$12,625
8,500
1,500
(6,000)
950
$17,575
E13–7.
Req. 1
Cash flows from operating activities—indirect method
Net loss ....................................................................................................
Depreciation expense ..............................................................................
Amortization of copyrights........................................................................
Accounts receivable decrease ($8,000 – $15,000) .................................
Salaries payable increase ($15,000 – $1,000) ........................................
Other accrued liabilities decrease ($1,000 – $5,100)...............................
Net cash provided by operating activities ...........................................
($4,900)
7,000
200
7,000
14,000
(4,100)
$19,200
Req. 2
The first reason for the net loss was the depreciation expense. This is a non-cash
expense. Depreciation expense, along with decreased working capital requirements
(current assets - current liabilities), turned the net loss into positive operating cash flow
from operations. The reasons for the difference between net income and cash flow are
important because they help the financial analyst determine if the trends are sustainable
or whether they represent one-time events.
E13–8.
Cash flows from operating activities—indirect method
Net income...............................................................................................
Depreciation expense ..............................................................................
Loss on sale of equipment ......................................................................
Accounts receivable decrease ................................................................
Salaries payable increase ........................................................................
Other accrued liabilities decrease ............................................................
Net cash provided by operating activities ...........................................
13-10
$ 8,000
7,300
1,700
12,000
9,000
(4,000)
$34,000
Chapter 13 - Statement of Cash Flows
E13–9.
Req. 1
Cash flows from operating activities—indirect method
Net loss ...................................................................................................
Depreciation, amortization, and impairments ..........................................
Decrease in receivables..........................................................................
Increase in inventories ............................................................................
Decrease in accounts payable ................................................................
Cash flows from operating activities ..................................................
($13,402)
34,790
1,245
(5,766)
(445)
$16,422
Note: The additions to equipment do not affect cash flows from operating activities.
Req. 2
The primary reason for the net loss was the depreciation, amortization, and impairments
expense. These represent non-cash expenses. Large depreciation, amortization, and
impairments expense, offset partially by increased working capital requirements, turned
Time Warner’s net loss into positive operating cash flow. The reasons for the difference
between net income and cash flow from operations are important because they help the
financial analyst determine if the trends are sustainable or whether they represent onetime events.
13-11
Chapter 13 - Statement of Cash Flows
E13–10.
Account
Receivables
Inventories
Other current assets
Payables
Change
Increase
Increase
Increase
Increase
E13–11.
Account
Accounts receivable
Inventories
Other current assets
Accounts payable
Deferred revenue
Other current liabilities
Change
Increase
Decrease
Increase
Increase
Increase
Decrease
E13–12.
Req. 1
Cash flows from investing activities
Year 1
Year 2
Proceeds from sale of equipment ........
$17,864
$12,163
The amount reported in the cash flow from investing activities section of the statement
of cash flows is the total cash proceeds from the sale of the equipment, regardless of
the amount of any gain or loss.
Req. 2
Any gain on the sale of the equipment is subtracted from net income to avoid double
counting of the gain. Any loss on the sale of the equipment is added to avoid double
counting of the loss.
Cash flows from operating activities
Year 1
Year 2
Loss (Gain) on sale of equipment ........
$16,751
$(2,436)
Computations:
Plant and equipment (at cost)
Accumulated depreciation
Net book value
Cash Proceeds – Net book value =
Gain (Loss) on sale
13-12
Year 1
$75,000
40,385
34,615
(16,751)
Year 2
$13,500
3,773
9,727
2,436
Chapter 13 - Statement of Cash Flows
E13–13.
Req. 1
Beg. Bal.
End. Bal.
Equipment
19,000
6,900*
12,100
Sold
Sold
Accumulated Depreciation
1,800 Beg. Bal.
720*
820 Dep. Exp.
1,900 End. Bal.
*plug figures
Cost of equipment sold = $6,900
Accumulated depreciation on sold equipment = $720
Book value of sold equipment ...............
Less: Loss on sale (given) ....................
Cash received from sale ......................
$6,180
(4,400)
$1,780
Req. 2
Any gain on the sale of the equipment is subtracted from net income to avoid double
counting of the gain. Any loss on the sale of the equipment is added to avoid double
counting of the loss. The loss of $4,400 would be added.
Req. 3
The amount of cash received is added in the computation of Net Cash Flow from
Investing Activities, regardless of whether the sale results in a gain or loss. The cash
inflow if $1,780 would be added.
13-13
Chapter 13 - Statement of Cash Flows
E13–14.
Req. 1
Cash flows from operating activities—indirect method
Net income...............................................................................................
Depreciation and amortization .................................................................
Increase in accounts receivable ...............................................................
Increase in inventory ................................................................................
Increase in prepaid expense ....................................................................
Increase in accounts payable ..................................................................
Decrease in taxes payable.......................................................................
Increase in other current liabilities ...........................................................
Cash flows from operating activities ..................................................
$5,142
1,543
(549)
(345)
(68)
718
(180)
738
$6,999
Note: The cash dividends paid and treasury stock purchased are not related to
operating activities and do not affect cash flows from operating activities.
Req. 2
Quality of income ratio = Cash flow from operations =
Net income
$6,999
$5,142
= 1.36
Req. 3
The reason the quality of income ratio was greater than one was primarily because of
large non-cash depreciation charges.
E13–15.
The investing and financing sections of the statement of cash flows for Oering’s
Furniture:
Cash flows from investing activities:
Purchase of property, plant & equipment ...........................
Sale of marketable securities ...............................................
Proceeds from sale of property, plant & equipment .........
Net cash flows from investing activities ........................
$(1,071)
219
6,894
Cash flows from financing activities:
Borrowings under line of credit ............................................
Proceeds from issuance of stock .........................................
Payments on long-term debt ................................................
Payment of dividends ............................................................
Purchase of treasury stock ...................................................
Net cash flows from financing activities ........................
1,117
11
(46)
(277)
(2,583)
13-14
$6,042
(1,778)
Chapter 13 - Statement of Cash Flows
E13–16.
DEEP WATERS COMPANY
Statement of Cash Flows
For the Year Ended December 31, 2012
Cash flows from operating activities:
Net income......................................................................
Adjustments to reconcile net income to net cash
provided by operating activities:
Increase in accounts receivable .....................................
Increase in prepaid expenses .......................................
Decrease in wages payable ...........................................
Net cash provided by (used for) operating activities ..
Cash flows from investing activities:
Cash paid for equipment
Net cash provided by (used for) investing activities ..
Cash flows from financing activities:
Cash proceeds from issuing stock ..................................
Net cash provided by financing activities ....................
Net increase (decrease) in cash during the year ...................
Cash balance, January 1, 2012.............................................
Cash balance, December 31, 2012 .......................................
13-15
$ 300
(100)
(50)
(650)
(500)
(400)
(400)
600
600
(300)
4,000
$3,700
Chapter 13 - Statement of Cash Flows
E13–17.
Req. 1
The investing and financing sections of the statement of cash flows for Gibraltar
Industries:
Cash flows from investing activities:
Acquisitions (investments in other companies)
(8,724)
Proceeds from sale of other equity investments
34,701
Purchases of property, plant and equipment
(21,595)
Net proceeds from sale of property and equipment
2,692
Net cash provided by (used in) investing activities
7,074
Cash flows from financing activities:
Long-term debt reduction
Proceeds from long-term debt
Net proceeds from issuance of common stock
Payment of dividends
Net cash provided by (used in) financing activities
(185,567)
53,439
250
(5,985)
(137,863)
Req. 2
Capital acquisitions ratio = Cash flow from operations =
Cash paid for plant &
equipment
$107,874 = 5.00
$21,595
The capital acquisitions ratio measures the company's ability to finance plant and
equipment purchases from operations. Since this amount was more than 1 (5.00), the
company has generated more than enough to finance plant and equipment purchases
from operations.
Req. 3
Gibraltar’s management is using the cash proceeds from the sale of other equity
investments, along with the excess cash generated by operations (see Req. 2) mainly to
pay down long-term debt. Note that most of the new long-term debt issuances are also
being used to pay off existing long-term debt.
13-16
Chapter 13 - Statement of Cash Flows
E13–18.
Req. 1
Both of these transactions are considered noncash investing and financing activities,
and are not reported on the statement of cash flows. The transactions must be
disclosed in a separate schedule or in the footnotes. The information disclosed in the
separate schedule would state:
a. Equipment valued at $36,000 was acquired by giving a $15,000, 12%, two-year
note, and common stock with a market value of $21,000.
b. A machine valued at $12,700 was acquired by exchanging land with a book value
of $12,700.
Req. 2
The capital acquisitions ratio measures the company's ability to finance plant and
equipment purchases from operations. Since neither of these transactions enters the
numerator or denominator of the ratio, they would have no effect. Many analysts
believe that these transactions represent important capital acquisitions, and thus should
be included in the denominator of the ratio to indicate what portion of all (not just cash)
acquisitions are being financed from operations.
13-17
Chapter 13 - Statement of Cash Flows
E13–19.
Cash flows from operating activities—direct method
Cash collected from customers1
Cash payments to suppliers of inventory2
Cash payments to employees 3
Net cash provided by operating activities ...........................................
$86,500
(57,875)
(11,050)
$17,575
1. Cash collected from customers = Sales revenue + Decrease in Accounts receivable
$85,000 + $1,500 = $86,500
2. Cash payments to suppliers of inventory = Cost of goods sold + Increase in Inventory
$51,875 + $6,000 = $57,875
3. Cash payments to employees = Salaries expense – Increase in Salaries payable
$12,000 – $950= $11,050
E13–20.
Req. 1
Cash flows from operating activities—direct method
Cash collected from customers1
Cash payments to employees2
Cash paid for other expenses3
Net cash provided by operating activities ...........................................
$60,000
(27,000)
(13,800)
$19,200
1. Cash collected from customers = Sales revenue + Decrease in Accounts receivable
$53,000 + $7,000 = $60,000
2. Cash payments to employees = Salaries expense – Increase in Salaries payable
$41,000 – $14,000 = $27,000
3. Cash paid for other expenses = Other expenses + Decrease in Other accrued liabilities
$9,700 + $4,100 = $13,800
Req. 2
The first reason for the net loss was the depreciation expense. This is a non-cash
expense. Depreciation expense, along with decreased working capital requirements
(current assets - current liabilities), turned the net loss into positive operating cash flow.
The reasons for the difference between net income and cash flow are important
because they help the financial analyst determine if the trends are sustainable or
whether they represent one-time events.
13-18
Chapter 13 - Statement of Cash Flows
E13–21.
Req. 1
Cash flows from operating activities—direct method
Cash collected from customers1
Cash payments to employees
Cash payments to suppliers2
Cash payments for other expenses3
Cash payments for income tax4
Net cash provided by operating activities
$146,670
(56,835)
(52,575)
(9,164)
(700)
$27,396
1. Cash collected from customers = Revenues + Decrease in Accounts receivable
$146,500 + $170 = $146,670
2. Cash payments to suppliers: Cost of sales – Decrease in Inventories
– Increase in Accounts payable
$55,500 – $643 – $2,282 = $52,575
3. Cash payments for other expenses = Other expense + Increase in Prepaid expenses
+ Decrease in Accrued liabilities
$7,781 + $664 + $719 = $9,164
4. Cash payments for income tax = Income tax expense – Increase in income taxes
payable
$2,561 – $1,861 = $700
Req. 2
The primary reason for the net loss was the depreciation and amortization expense.
These represent non-cash expenses. Large depreciation and amortization expense,
along with decreased working capital requirements, turned Huanca’s net loss into
positive operating cash flow. The reasons for the difference between net income and
cash flow from operations are important because they help the financial analyst to
determine if the trends are sustainable or whether they represent one-time events.
13-19
Chapter 13 - Statement of Cash Flows
E13–22.
Item
Cash
Noncash accounts:
Accounts receivable (net) ............
Merchandise inventory ................
Investments, long-term ................
Equipment ...................................
Total ...........................................
Accumulated depreciation ...........
Accounts payable ........................
Wages payable ...........................
Income taxes payable .................
Bonds payable ............................
Balances
12/31/2012
20,500
Debit
22,000
68,000 h
d
114,500 b
225,000
32,000 i
17,000 e
2,500 f
3,000
54,000
Common stock, no par ................
100,000
Retained earnings .......................
Total ...........................................
16,500 k
225,000
Statement of Cash Flows
Conversion of net income to cash flow
from operating activities:
Net income
Depreciation expense
Accounts payable decrease
Wages payable decrease
Income taxes payable increase
Inventory increase
Analysis
Credit
l
1,700
7,000
15,000
19,000
15,000
3,000
1,000
10,000
i
21,000
c
5,000
g
1,500
j
b
3,600
19,000
a
18,200
Inflows
a
c
g
Cash flows from investing activities:
Long-term investment purchased
Sale of equipment
Cash flows from financing activities:
Sale of capital stock
Dividends paid
Net increase (decrease) in cash
Totals
122,600
24,700
243,300
Outflows
e
f
3,000
1,000
h
7,000
d
15,000
1,500
6,000
j
3,600
1,700
106,000
13,700
(9,000)
k
13-20
22,000
75,000
15,000
112,500
243,300
22,000
14,000
1,500
4,500
54,000
18,200
5,000
i
l
Balances
12/31/2013
18,800
10,000
(6,400)
106,000
(1,700)
Chapter 13 - Statement of Cash Flows
PROBLEMS
P13–1.
Req.1
Related Cash
Flow Section
Δ in Cash
O
O
I
O
Balance sheet at December 31
2012
Cash
$68,250
Accounts receivable
15,250
Merchandise inventory
22,250
Property and equipment 209,250
Less: Accumulated
(59,000)
depreciation
$256,000
2011
$63,500
22,250
18,000
150,000
Change
+4,750
-7,000
+4,250
+59,250
(45,750)
-13,250
2
Add to NI because depreciation expense does not
affect cash
Subtract from net income the decrease in Accounts
Payable
Add to net income the increase in Wages payable
Cash used for repayment of note principal
Issuance of stock for cash
Increased for net income amount of $46,750
Decreased for dividends declared & paid $12,650
10
3
4
7
$208,000
O
Accounts payable
$9,000 $19,000
-10,000
5
O
Wages payable
Note payable, long-term
Contributed capital
4,000
59,500
98,500
1,200
71,000
65,900
+2,800
-11,500
+32,600
6
Retained earnings
85,000
50,900
+34,100
1
F
F
O,F
Net increase in cash
Add to net income the decrease in A/R
Subtract from net income the increase in Inventory
Payment in cash for equipment
$256,000 $208,000
Income statement for 2012
Sales
$195,000
Cost of goods sold
92,000
Depreciation expense
13,250
Other expenses
43,000
Net Income
$46,750
13-21
8
9
Chapter 13 - Statement of Cash Flows
P13-1 (continued)
HiDef Films, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2012
Cash flows from operating activities:
Net income
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense
Decrease in accounts receivable
$13,250
7,000
Increase in merchandise inventory
Decrease in accounts payable
Increase in wages payable
(4,250)
(10,000)
2,800
Net cash provided by operating activities
Cash flows from investing activities:
Cash payments to purchase fixed assets
Cash flows from financing activities:
Cash payments on long-term note
Cash payments for dividends
Cash receipts from issuing stock
Net cash provided by financing activities
Net increase in cash during the year
Cash balance, January 1, 2012
Cash balance, December 31, 2012
$46,750
1
2
3
4
5
6
8,800
55,550
(59,250)
(11,500)
(12,650)
32,600
7
8
1
9
8,450
4,750 10
63,500
$68,250
Req. 2
An overall increase in cash of $4,750 came from inflows of $55,550 from operating
activities and a stock issuance of $32,600. A large percentage of the cash inflows were
invested in equipment ($59,250), with $11,500 used to pay down long-term financing
and $12,650 for dividends.
13-22
Chapter 13 - Statement of Cash Flows
P13–2.
Req. 1
Related
Cash
Flow
Section
Δ in Cash
O
O
I
O
O
Balance sheet at December 31
Cash
Accounts receivable
Merchandise inventory
Property and equipment
Less: Accumulated
depreciation
Accounts payable
2013
$37,000
32,000
41,000
132,000
2012
$29,000
28,000
38,000
111,000
Change
+8,000
+4,000
+3,000
+21,000
(41,000)
(36,000)
-5,000
2
$201,000
$170,000
$36,000
$27,000
+9,000
5
10
3
4
7
O
Accrued wage expense
1,200
1,400
-200
6
F
F
O,F
Note payable, long-term
Contributed capital
Retained earnings
38,000
88,600
37,200
$201,000
44,000
72,600
25,000
$170,000
-6,000
+16,000
+12,200
8
Income statement for 2013
Sales
Cost of goods sold
Other expenses
Net Income
$120,000
70,000
37,800
$12,200
13-23
9
1
Net increase in cash
Subtract from net income the increase in A/R
Subtract from net income the increase in Inventory
Payment in cash for equipment
Add back to NI because depreciation expense does
not affect cash
Add to net income the increase in Accounts Payable
Subtract from net income the decrease in accrued
wage expense
Cash used for repayment of note principal
Issuance of stock for cash
Increased for net income amount
Chapter 13 - Statement of Cash Flows
P13–2. (continued)
BG Wholesalers
Statement of Cash Flows
For the Year Ended December 31, 2013
Cash flows from operating activities:
Net income
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense
Increase in accounts receivable
Increase in merchandise inventory
Increase in accounts payable
Decrease in accrued expenses
Net cash provided by operating activities
Cash flows from investing activities:
Cash payments to purchase fixed assets
Cash flows from financing activities:
Cash payments on long-term note
Cash receipts from issuing stock
Net cash provided by financing activities
Net increase in cash during the year
Cash balance, January 1, 2013
Cash balance, December 31, 2013
$12,200
$ 5,000
(4,000)
2
(3,000)
9,000
(200)
4
1
3
5
6
6,800
19,000
(21,000)
(6,000)
16,000
7
8
9
10,000
8,000
29,000
$37,000
10
Req. 2
There was an increase in cash for BG Wholesalers this year of $8,000. Operating
activities provided a positive cash flow of $19,000. This inflow of cash from operating
activities, combined with the stock issuance for $16,000 cash, allowed the company to
invest $21,000 in fixed assets and pay down a long-term note by $6,000.
13-26
Chapter 13 - Statement of Cash Flows
P13–3.
Req.1
O
Balance sheet at December 31
2012
Cash
$68,250
Accounts receivable
15,250
Merchandise inventory
22,250
Property and equipment 209,250
Less: Accumulated
(59,000)
depreciation
$256,000
Accounts payable
$9,000
O
Wages payable
F
F
Note payable, long-term
Contributed capital
59,500
98,500
71,000
65,900
-11,500
+32,600
8
Retained earnings
85,000
50,900
+34,100
1
Related Cash
Flow Section
Δ in Cash
O
O
I
O
O,F
2011
$63,500
22,250
18,000
150,000
Change
+4,750
-7,000
+4,250
+59,250
(45,750)
-13,250
2
Depreciation expense does not affect cash
$208,000
$19,000
-10,000
5
4,000
1,200
+2,800
6
Add to CGS to compute payments to suppliers
Subtract from Other expenses to compute payments
for wages
Cash used for repayment of note principal
Issuance of stock for cash
Increased for net income amount of $46,750
Decreased for dividends declared & paid $12,650
$256,000 $208,000
Income statement for 2012
Sales
$195,000
Cost of goods sold
92,000
Depreciation expense
13,250
Other expenses
43,000
Net Income
$46,750
13-25
10
3
4
7
9
Net increase in cash
Add to sales to compute collections from customers
Add to CGS to compute payments to suppliers
Payment in cash for equipment
Chapter 13 - Statement of Cash Flows
P13-3. (continued)
HiDef Films Inc.
Statement of Cash Flows
For the Year Ended December 31, 2012
Cash flows from operating activities:
Collections from customers ($195,000 +
$7,000)
Payments to suppliers ($92,000 + $4,250
+ $10,000)
Payments for wages ($43,000 – $2,800)
Net cash provided by operating activities
Cash flows from investing activities:
Cash payments to purchase fixed assets
Cash flows from financing activities:
Cash payments on long-term note
Cash payments for dividends
Cash receipts from issuing stock
$202,000
3
(106,250)
4, 5
(40,200)
6
55,550
(59,250)
(11,500)
(12,650)
32,600
Net cash provided by financing activities
Net increase in cash during the year
Cash balance, January 1, 2012
Cash balance, December 31, 2012
7
8
1
9
8,450
4,75010
63,500
$68,250
13 26
Chapter 13 - Statement of Cash Flows
Req. 2
An overall increase in cash of $4,750 came from an inflow of $55,550 from operating activities and a stock issuance of
$32,600. A large percentage of the cash inflow was invested in equipment ($59,250), with $11,500 used to pay down
long-term financing and $12,650 for dividends.
P13–4.
Req. 1
ALPHA COMPANY
Cash Flows from Operating Activities
Direct Method
Cash flows from operating activities:
Cash receipts from customers ................................................................
Cash payments to suppliers ...................................................................
Cash payments for salaries ....................................................................
Cash payments for rent ..........................................................................
Cash payments for insurance .................................................................
Cash payments for utilities .....................................................................
Cash payments for bond interest ............................................................
Net cash provided by operating activities .........................................
13-27
$20,890
(9,016)
(4,062)
(2,801)
(910)
(720)
(600)
$2,781
Chapter 13 - Statement of Cash Flows
Req. 2
ALPHA COMPANY
Cash Flows from Operating Activities
Indirect Method
Cash flows from operating activities:
Net loss ..........................................................................
Adjustments to reconcile net loss to net cash
provided by operating activities:
Depreciation expense ....................................................
Loss on sale of investments ..........................................
Decrease in accounts receivable ...................................
Increase in merchandise inventory ................................
Increase in accounts payable ........................................
Increase in salaries payable ..........................................
Decrease in rent payable ...............................................
Decrease in prepaid rent ...............................................
Increase in prepaid insurance .......................................
Total adjustments .........................................................
Net cash provided by operating activities ..................
13 28
$ (870)
$2,900
650
90
(19)
33
8
(4)
3
(10)
3,651
$2,781
Chapter 13 - Statement of Cash Flows
P13–5.
Req. 1
Related
Cash
Flow
Section
Δ in Cash
O
O
Balance sheet at December 31
Cash
Accounts receivable
Merchandise inventory
2011
$ 34,000
35,000
41,000
2010
$ 29,000
28,000
38,000
Change
+5,000
+7,000
+3,000
10
3
4
I
Property and equipment
121,000
100,000
+21,000
7
O
Less: Accumulated
depreciation
(30,000)
(25,000)
-5,000
2
$201,000
$ 36,000
$170,000
$ 27,000
+9,000
5
O
O
F
F
O, F
Accounts payable
Wages payable
Note payable, long-term
Contributed capital
Retained earnings
Income statement for 2011
Sales
Gain on sale of equipment
Cost of goods sold
Other expenses
Net Income
1,200
1,400
-200
6
38,000
88,600
37,200
$201,000
44,000
72,600
25,000
$170,000
-6,000
+16,000
+12,200
8
$120,000
10
1,000
70,000
38,800
$ 12,200
13-29
9
1
Net increase in cash
Subtract from net income the increase in A/R
Subtract from net income the increase in Inventory
Payment in cash for equipment $31,000
Original cost of equipment sold ($10,000)
Accumulated depreciation on equipment sold $7,000
Add back $12,000 to NI because depreciation expense
does not affect cash
Add to net income the increase in Accounts payable
Subtract from net income the decrease in Wages
payable
Cash used for repayment of note principal
Issuance of stock for cash
Increased for net income amount
Chapter 13 - Statement of Cash Flows
P13–5. (continued)
XS Supply Company
Statement of Cash Flows
For the Year Ended December 31, 2011
Cash flows from operating activities:
Net income
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense
Gain on sale of equipment
$12,200
$ 12,000
(1,000)
2
10
Increase in accounts receivable
(7,000)
3
Increase in merchandise inventory
Increase in accounts payable
Decrease in wages payable
(3,000)
9,000
(200)
4
Net cash provided by operating activities
Cash flows from investing activities:
Cash payments to purchase equipment
Cash received from sale of equipment
Net cash used by investing activities
Cash flows from financing activities:
Cash payments on long-term note
Cash receipts from issuing stock
1
5
6
9,800
22,000
(31,000)
4,000
7
(27,000)
(6,000)
16,000
Net cash provided by financing activities
Net increase in cash during the year
Cash balance, January 1, 2011
Cash balance, December 31, 2011
8
9
10,000
5,000
29,000
$34,000
10
Req. 2
There was an increase in cash for XS Supply Company this year of $5,000. Operating
activities provided a positive cash flow of $22,000. This inflow of cash from operating
activities, combined with the $4,000 proceeds from sale of equipment and the stock
issuance for $16,000 cash, allowed the company to invest $31,000 in new equipment
and pay down a long-term note by $6,000.
13 30
Chapter 13 - Statement of Cash Flows
P13–6.
Req.1
Statement of Cash Flows Spreadsheet
Forrest Company
For the Year Ended December 31, 2013
12-31-2012
BALANCE SHEET
Cash
Accounts receivable
Merchandise inventory
Fixed assets-net
Total
Accounts payable
Wages payable
Note payable, long-term
Common stock-no par
Retained earnings
Total
18,000
29,000
36,000
72,000
155,000
22,000
1,000
48,000
60,000
24,000
155,000
DR
CR
26,000 (k)
10,000 (g)
3,000 (b)
6,000 (c)
6,000 (e)
3,000 (d)
200 (f)
10,000 (h)
3,800 (j)
20,000 (i)
12,000 (a)
12-31-2013
44,000
26,000
30,000
76,000
176,000
25,000
800
38,000
80,000
32,200
176,000
STATEMENT OF CASH FLOWS-INDIRECT METHOD
Inflow
Cash flows from operating activities:
Net income
Adjustments to net income
Decrease in accounts receivable
Decrease in merchandise inventory
Increase in accounts payable
Depreciation expense
Decrease in wages payable
Outflow
12,000 (a)
3,000
6,000
3,000
6,000
(b)
(c)
(d)
(e)
Cash flows from investing activities:
Cash payment to purchase fixed assets
Cash flows from financing activities:
Cash payments on long-term note
Cash receipts from issuing stock
Cash payments for dividends
200 (f)
29,800
10,000 (g)
(10,000)
10,000 (h)
20,000 (i)
Increase (decrease) in cash during the year
Totals
Cash balance, Jan. 1
Cash balance, Dec. 31
100,000
3,800 (j)
6,200
26,000 (k)
100,000
26,000
18,000
44,000
13-31
Chapter 13 - Statement of Cash Flows
P13–6. (continued)
Req. 2
FORREST COMPANY
Statement of Cash Flows
For the Year Ended December 31, 2013
Cash flows from operating activities:
Net income......................................................................
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense ....................................................
Decrease in accounts receivable ...................................
Decrease in merchandise inventory ...............................
Increase in accounts payable ........................................
Decrease in wages payable ...........................................
Total adjustments ...........................................................
Net cash provided by operating activities ..................
Cash flows from investing activities:
Cash payments to purchase fixed assets .......................
Cash flows from financing activities:
Cash payments on long-term note ..................................
Cash receipts from issuing stock ....................................
Cash payments for dividends..........................................
Net cash provided by financing activities ...................
Net increase in cash during the year .....................................
Cash balance, January 1, 2013.............................................
Cash balance, December 31, 2013 .......................................
$12,000
$ 6,000
3,000
6,000
3,000
(200)
17,800
29,800
(10,000)
(10,000)
20,000
(3,800)
Req. 3
There were no noncash investing and financing activities during 2013.
13 32
6,200
26,000
18,000
$44,000
Chapter 13 - Statement of Cash Flows
ALTERNATE PROBLEMS
AP13–1.
Req. 1
Related
Cash
Flow
Section
Δ in Cash
O
O
I
O
O
O
F
F
O,F
Balance sheet at December 31
Cash
Accounts receivable
Merchandise inventory
Property and equipment
Less: Accumulated
depreciation
Accounts payable
Wages payable
Note payable, long-term
Contributed capital
Retained earnings
2012
$34,000
45,000
32,000
121,000
2011
$29,000
28,000
38,000
100,000
(30,000)
(25,000)
$202,000 $170,000
$36,000 $27,000
2,200
1,400
40,000
46,000
86,600
70,600
37,200
25,000
$202,000 $170,000
Income statement for 2012
Sales
$135,000
Cost of goods sold
70,000
Other expenses
37,800
Net Income
$ 27,200
13-33
Change
+5,000
+17,000
–6,000
+21,000
10
3
4
7
Net increase in cash
Subtract from net income the increase in A/R
Add to net income the decrease in Inventory
Payment in cash for equipment
–5,000
2
Add back to NI because depreciation expense does not
affect cash
+9,000
+800
–6,000
+16,000
5
+12,200
1
Add to net income the increase in Accounts payable
Add to net income the increase in Wages payable
Cash used for repayment of note principal
Issuance of stock for cash
Increased for net income of $27,200 and decreased
for dividends declared and paid of $15,000
6
8
9
Chapter 13 - Statement of Cash Flows
AP13–1. (continued)
Ingersol Construction Supply Company
Statement of Cash Flows
For the Year Ended December 31, 2012
Cash flows from operating activities:
Net income
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense
Increase in accounts receivable
Decrease in merchandise inventory
Increase in accounts payable
Increase in wages payable
Net cash provided by operating activities
Cash flows from investing activities:
Cash payments to purchase fixed assets
Cash flows from financing activities:
Cash payments for dividends
Cash payments on long-term note
Cash receipts from issuing stock
Net cash provided by financing activities
Net increase in cash during the year
Cash balance, January 1, 2012
Cash balance, December 31, 2012
$27,200
$ 5,000
(17,000)
6,000
9,000
800
1
2
3
4
5
6
3,800
31,000
(21,000) 7
(15,000)
(6,000)
16,000
1
8
9
(5,000)
5,00010
29,000
$34,000
Req. 2
There was an increase in cash for Ingersol Construction Supply Company this year of
$5,000. Operating activities provided a positive cash flow of $31,000. This inflow of
cash from operating activities, combined with the stock issuance for $16,000 cash,
allowed the company to invest $21,000 in fixed assets, pay down a long-term note by
$6,000, and pay dividends of $15,000.
13 34
Chapter 13 - Statement of Cash Flows
AP13–2.
Req.1
Related Cash
Flow Section
Δ in Cash
O
O
I
O
Balance sheet at December 31
Cash
Accounts receivable
Inventory
Property and equipment
Less: Accumulated
depreciation
O
Accounts payable
O
Taxes payable
F
F
Note payable, long-term
Contributed capital
O,F
Retained earnings
2013
$64,000
15,000
22,000
210,000
2012
$65,000
20,000
20,000
150,000
Change
-1,000
-5,000
+2,000
+60,000
(60,000)
(45,000)
-15,000
2
$251,000
$210,000
$8,000
$19,000
-11,000
5
2,000
1,000
+1,000
6
86,000
75,000
75,000
70,000
+11,000
+5,000
8
80,000
$251,000
45,000
$210,000
+35,000
1
Income statement for 2013
Sales
$190,000
Cost of goods sold
90,000
Other expenses
60,000
Net Income
$40,000
13-35
10
3
4
7
9
Net decrease in cash
Add to net income the decrease in A/R
Subtract from net income the increase in Inventory
Payment in cash for equipment
Add to NI because depreciation expense does not
affect cash
Subtract from net income the decrease in Accounts
payable
Add to net income the increase in Taxes payable
Borrow additional note principal
Issuance of stock for cash
Increased for net income ($40,000) / decreased for
dividends ($5,000)
Chapter 13 - Statement of Cash Flows
AP13–2. (continued)
Audio House Inc.
Statement of Cash Flows
For the Year Ended December 31, 2013
Cash flows from operating activities:
Net income
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense
Decrease in accounts receivable
Increase in inventory
Decrease in accounts payable
Increase in taxes payable
Net cash provided by operating activities
Cash flows from investing activities:
Cash payments to purchase fixed assets
Cash flows from financing activities:
Cash receipts from borrowing on long-term
note
Cash receipts from issuing stock
Cash dividends paid
$40,000
$15,000
5,000
2
(2,000)
(11,000)
1,000
4
3
5
6
8,000
48,000
(60,000)
11,000
8
5,000
9
( 5,000)
Net cash provided by financing activities
Net decrease in cash during the year
Cash balance, January 1, 2013
Cash balance, December 31, 2013
7
1
11,000
( 1,000)
65,000
$64,000
13 36
1
10
Chapter 13 - Statement of Cash Flows
Req. 2
There was an overall decrease in cash of $1,000. This resulted from an inflow of
$48,000 from operating activities, borrowing on a long-term note of $11,000, and a
stock issuance of $5,000. A large percentage of the cash inflow was invested in
equipment ($60,000) and $5,000 was paid as dividends.
13-37
Chapter 13 - Statement of Cash Flows
AP13–3.
Req. 1
Related
Cash
Flow
Section
Δ in Cash
Balance sheet at December 31
Cash
O
Accounts receivable
O
I
Merchandise inventory
Property and equipment
Less: Accumulated
depreciation
O
O
Accounts payable
O
Wages payable
F
F
O,F
2012
$34,000
2011
Change
$29,000
+5,000
10
Net increase in cash
Subtract from sales to compute collections from
customers
Subtract from CGS to compute payments to suppliers
Payment in cash for equipment
45,000
28,000
+17,000
3
32,000
121,000
38,000
100,000
-6,000
+21,000
4
(30,000)
(25,000)
-5,000
2
Depreciation expense does not affect cash
$202,000 $170,000
$36,000 $27,000
+9,000
5
Subtract from CGS to compute payments to suppliers
Subtract from Wage expense to compute payments for
wages
Cash used for repayment of note principal
Issuance of stock for cash
Increased for net income of $27,200 and decreased
for dividends declared and paid of $15,000
7
2,200
1,400
+800
6
Note payable, long-term
Contributed capital
38,000
88,600
44,000
72,600
-6,000
+16,000
8
Retained earnings
37,200
25,000
+12,200
1
$202,000 $170,000
Income statement for 2012
Sales
$135,000
Cost of goods sold
70,000
Other expenses
37,800
Net Income
$27,200
13 38
9
Chapter 13 - Statement of Cash Flows
AP13–3. (continued)
Ingersol Construction Supply Company
Statement of Cash Flows
For the Year Ended December 31, 2012
Cash flows from operating activities:
Collections from customers ($135,000 –
$17,000)
Payments to suppliers ($70,000 – $6,000 –
$9,000)
Payments for wages ($20,000 – $800)
Payments for other expenses
Payments for taxes
$118,000
3
(55,000)
4,5
(19,200)
6
(6,800)
(6,000)
Net cash provided by operating activities
Cash flows from investing activities:
Cash payments to purchase fixed assets
Cash flows from financing activities:
Cash payments for dividends
Cash payments on long-term note
Cash receipts from issuing stock
Net cash provided by financing activities
Net increase in cash during the year
Cash balance, January 1, 2012
Cash balance, December 31, 2012
31,000
(21,000) 7
(15,000)
(6,000)
16,000
1
8
9
(5,000)
5,00010
29,000
$34,000
Req. 2
There was an increase in cash for Ingersol Construction Supply Company this year of
$5,000. Operating activities provided a positive cash flow of $31,000. This inflow of
cash from operating activities, combined with the stock issuance for $16,000 cash,
allowed the company to invest $21,000 in fixed assets, pay down a long-term note by
$6,000, and pay dividends of $15,000.
13-39
Chapter 13 - Statement of Cash Flows
CASES AND PROJECTS
ANNUAL REPORT CASES
CP13–1.
Req. 1:
Depreciation and amortization was the largest item. The $133,141 expense was
added to net income in the reconciliation because it is a noncurrent deferred
expense which does not cause a cash outflow when it is recorded.
The increase in prepaid expenses and other was the largest change in operating
assets or liabilities. The increase of $24,781 was subtracted from net income in the
reconciliation because the cash payments for the prepaid expenses were more than
the amount recorded for expenses resulting from the expiration of prepaid expenses.
Req. 2:
American Eagle Outfitters’ three largest investing and financing uses of cash over
the past three years have been purchasing investments, purchases of property and
equipment (capital expenditures), and repurchases of common stock. The two
major sources of cash for these activities has been cash flow provided by operating
activities and sales of investments.
Req. 3: Free Cash Flow was negative $45,536 thousand, calculated as (in thousands):
Cash Flows from Operating Activities
less Dividends
less Capital Expenditures (purchase of PPE)
Free Cash Flow
$302,193
(82,394)
(265,335)
$(45,536)
This implies that the company lacks the financial flexibility to consider additional
capital expenditures or other means of expansion without increasing its debt.
13-40
Chapter 13 - Statement of Cash Flows
CP13–2.
Req. 1 The company uses the indirect method.
Req. 2 Tax payments of $115,040 thousand were made (located near the bottom of
the Statement of Cash Flows).
Req. 3 “Share-based compensation” is an expense paid with common stock rather
than cash. Since it does not use cash, it is added back to net income to
determine cash flows from operations. Depreciation and amortization are also
expenses that do not involve a cash outflow as they are incurred. Thus, both
of these expenses are added back to net income to determine the cash flow
from operations.
Req. 4 The company has not paid cash dividends during the last three years, or in any
year since its initial public offering. (Any dividends paid would be a financing
cash outflow.) This information can be found under the “Dividend Policy”
heading in the section of the annual report entitled “Item 5. Market for
Registrant’s Common Equity, Related Shareholder Matters and Issuer
Purchases of Equity Securities”.
Req. 5 Free Cash Flow was $139,017 thousand, calculated as (in thousands):
Cash Flows from Operating Activities
less Dividends
less Capital Expenditures
Free Cash Flow
13-41
$251,570
0
112,553
$139,017
Chapter 13 - Statement of Cash Flows
CP13–3.
Req. 1
American Eagle
Outfitters
Urban Outfitters
Quality of
= Cash flow from operations
income ratio
Net income
$302,193 = 1.69
$179,061
$251,570 = 1.26
$199,364
American Eagle Outfitters has a higher, and therefore better, quality of income ratio
than does Urban Outfitters.
Req. 2
Quality of Income =
Industry
Average
0.72
American Eagle
Outfitters
1.69
Urban Outfitters
1.26
Both Urban Outfitters and American Eagle have a higher than average (and therefore
better) quality of income ratio.
Req. 3
American Eagle
Outfitters
Urban Outfitters
Capital
= Cash flow from operations
acquisitions
Cash paid for plant &
ratio
equipment
$302,193 = 1.14
$265,335
$251,570 = 2.24
$112,553
Urban Outfitters has a higher capital acquisitions ratio than does American Eagle
Outfitters. This implies that Urban Outfitters has a greater ability to fund additional
capital expenditures from the cash flow provided by its operating activities.
Req. 4
Capital Acquisitions =
Industry
Average
1.93
American Eagle
Outfitters
1.14
Urban Outfitters
2.24
Urban Outfitters’ capital acquisitions ratio is higher and American Eagle Outfitters’ is
lower than the industry average. This implies their relative ability to fund additional
capital expenditures from the cash flow provided by their operating activities compared
to the average company in the industry.
13-42
Chapter 13 - Statement of Cash Flows
FINANCIAL REPORTING AND ANALYSIS CASES
CP13–4.
ROCKY MOUNTAIN CHOCOLATE FACTORY, INC.
Statement of Cash Flows
For the Quarter Ended May 31
Cash flows from operating activities:
Net income.......................................................................
Add (deduct) to reconcile net income to net cash flow:
Depreciation expense ...........................................................
Amortization expense ...........................................................
Accounts receivable increase .............................................
Inventories increase..............................................................
Other current assets increase .............................................
Accounts payable increase..................................................
Accrued liabilities increase ..................................................
Income taxes payable decrease .........................................
Long-term accounts receivable decrease .........................
Net cash inflow from operating activities ....................
$ 163,837
276,304
5,901
(138,681)
(243,880)
(357,507)
280,935
164,087
(43,031)
11,382
$ 119,347
Cash flows from investing activities:
Fixed assets purchased ................................................. (1,081,121)
Other assets decrease .........................................................
50,055
Net cash outflow from investing activities
(1,031,066)
Cash flows from financing activities:
Repayment of short-term debt ....................................... (1,000,000)
Repayment of long-term debt.............................................. (2,355,029)
Issuance of long-term debt............................................. 4,659,466
Net cash inflow from financing activities .....................
Net increase in cash during the quarter ................................
Cash, February 29 ................................................................
Cash, May 31 ........................................................................
1,304,437
392,718
528,787
$ 921,505
13-43
Chapter 13 - Statement of Cash Flows
CP13–5.
Date:
To:
From:
Re:
(today’s date)
Supervising Analyst
(your name)
Evaluation of Carlyle Golf, Inc.’s Planned Expansion
While many companies experience losses and negative cash flows during the early
years of their operations, the cash situation for Carlyle Golf is a major concern. The
company has announced plans to increase inventory by $2.2 million but there is no
obvious source to finance the acquisition of this inventory. The statement of cash flows
shows that the company has to make cash deposits with its suppliers. It is unlikely that
these suppliers will be a major source of financing for Carlyle's inventory. The company
obviously does not have enough cash on hand to finance its expansion of inventory.
The planned expansion of inventory has additional implications. The company must
have plans to expand its sales volume. There is no information in the company's report
concerning whether this expansion will require additional expenditures, such as
increased advertising or hiring new sales people. In any case, the expansion will most
likely require an increase in accounts receivable. Most companies underestimate the
amount of resources that must be tied up in inventory and accounts receivable when
they expand sales volume.
Carlyle should seek additional capital to support an increased level of operations.
Without this extra capital, it is unlikely that Carlyle can continue in business.
Instructor's note: Subsequent to this date, Carlyle sought new financing through an
initial public offering. However, the company was unable to develop a niche in this very
competitive market and was subsequently liquidated.
13-44
Chapter 13 - Statement of Cash Flows
CRITICAL THINKING CASES
CP13–6.
Req. 1
The payment from Merrill Lynch to Enron does not automatically make the Nigerian
barge transaction a sale. When a loan is established between a lender and borrower, a
similar cash payment is made between the two parties. Two other features of the
Nigerian barge transaction resemble a loan. First, the requirement that Enron arrange
for Merrill Lynch to be paid only six months after the “sale” is similar to a possible
requirement that a borrower repay a lender six months after a borrower receives cash in
conjunction with signing a promissory note. Second, the “hefty fee” paid by Enron for
temporarily obtaining the use of Merrill Lynch’s funds is similar to interest that is paid by
a borrower for temporarily obtaining the use of a lender’s funds.
The four revenue recognition criteria discussed in Chapter 3 are:
1) delivery has occurred or services have been rendered,
2) there is persuasive evidence of an arrangement for customer payment,
3) the price is fixed or determinable, and
4) collection is reasonably assured.
Without knowing about the secret side deal, it’s not obvious which of the four criteria
have not been fulfilled. Knowing about the side deal, however, makes it clear that the
first criterion has not been fulfilled. At the time of the initial transaction (and receipt of
cash from Merrill Lynch) Enron had a continuing obligation to ensure that Merrill Lynch
was repaid six months later. In other words, Enron had not performed all of the acts
promised to Merrill Lynch.
Req. 2
By recording the transaction as a regular sale, Enron reports the cash received as a
cash inflow from an operating activity. Had the transaction been recorded as a loan,
Enron would have reported the cash received as a cash inflow from a financing activity.
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Chapter 13 - Statement of Cash Flows
Req. 3
Most financial statement users view cash flows from operating activities as recurring
sources of cash into the future. If $100,000 of cash is generated from operations this
year, it’s often reasonable to expect that a similar amount will be generated next year
and the year after that and the year after that. Financing activities, on the other hand,
are not as readily recurring in the future, particularly as a company takes on more and
more debt. Eventually, lenders will stop lending if a company’s liabilities grow too large.
Given these different perceptions, financial statement users attach more value to cash
generated from operating activities than from financing activities. Thus, when the
transaction is recorded as a sale, financial statement users will perceive the company’s
value as greater than when the transaction is recorded as a loan.
FINANCIAL REPORTING AND ANALYSIS PROJECTS
CP13–7.
The solutions to this case will depend on the company and/or accounting period
selected for analysis.
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