CHAPTER
1
FINANCIAL ACCOUNTING AND
ACCOUNTING STANDARDS
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-1
Financial Accounting vs. Managerial Accounting
Chapter
1-2
Financial
Accounting
Focused on the
needs of external
users (e.g. investors
and creditors)
Managerial
Accounting
Focused on the
needs of internal
users
(management)
Accounting and Capital Allocation
“MACRO Level Importance”
Resources are limited. Efficient use of resources often determines
whether the economy and an individual business thrives. (Buy auto
stocks? Invest in investment banks? Buy bank stocks? Invest in
the BRIC countries? Lend money to AIG Insurance?)
Financial
Reporting
Information to help
users with capital
allocation decisions.
To whom do you
lend money?
Which company’s
stock would you
buy?
Chapter
1-3
Users of
Financial
Information
Investors, creditors,
and other users
Capital Allocation
The process of
determining how and
at what cost (interest
rate on loan; stock
price willing to pay)
money is allocated
among competing
interests.
Need to Develop Standards
Various users
need financial
information
The accounting profession
has attempted to develop a
set of standards that are
generally accepted and
“universally” practiced.
Chapter
1-4
Financial Statements
Income Statement
Statement of Stockholders’ Equity
Balance Sheet
Statement of Cash Flows
Note Disclosure
Generally Accepted
Accounting Principles
(GAAP)
aka. “Cleverly Rigged
Accounting Ploys”
(CRAP)
Financial Statements and Financial Reporting
Chapter
1-5
Financial Statements
Additional Information
Income Statement
President’s letter
Statement of Changes in
Prospectuses,
Stockholders’ Equity
SEC Reporting (10K, 10Q)
Balance Sheet
News releases
Statement of Cash Flows
Forecasts
Environmental Reports
Note Disclosures
Etc.
GAAP
Not GAAP
Standard Setting
CPAs and
Accounting Firms
AICPA (AcSEC)
Financial
Community
FASB
(e.g., FEI)
Government
Academicians
(SEC, IRS, other
agencies)
Investing Public
Chapter
1-6
Preparers
Accounting standards,
interpretations, and bulletins
are subject to INTENSE
“Political Pressure”
Industry
Associations
Challenges Facing Financial Accounting
Nonfinancial Measurements—order backlog,
contracts for future sales, customer
satisfaction ratings
Forward-looking Information—forecasts and
projections
Soft Assets—including ‘intellectual assets’;
value of Coca-Cola’s trade name, secret
formula
Timeliness--annual, quarterly, daily, real-time
Chapter
1-7
Financial Accounting Standards Board Concept
Statement #1--Objectives of Financial Accounting
Financial reporting should provide information that:
(a) is useful to present and potential INVESTORS and
CREDITORS and other users in making rational investment,
credit, and similar decisions.
(b) helps potential investors and creditors and other users in
ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY
of prospective CASH FLOWS.
(c) clearly portrays the Economic Resources of an enterprise,
the Claims to those Resources, and the effects of
transactions, events, and circumstances that Change its
Resources and Claims to those Resources.
Chapter
1-8
Parties Involved in Standard Setting
Four organizations:
 Securities and Exchange Commission (SEC)
 American Institute of Certified Public
Accountants (AICPA)
 Financial Accounting Standards Board (FASB)
 International Accounting Standards Board
(IASB)
Chapter
1-9
Securities and Exchange (SEC) Commission
Established by federal government (why?)
Governs Accounting and Reporting for public companies
SEC requires public companies to adhere to GAAP
SEC has power to set GAAP but has “allowed” the private
sector to do it (so far!)
Enforcement (what happened to Arthur Andersen?)
Securities Act of
1933
(New Securities
issue)
Chapter
1-10
Securities Act of
1934
(Annual 10K reporting)
American Institute of CPAs
National professional organization
Established the following:
Committee on
Accounting
Procedures
Chapter
1-11
Accounting
Principles Board

1939 to 1959

1959 to 1973

Issued 51 Accounting
Research Bulletins
(ARBs)

Issued 31 Accounting
Principle Board
Opinions (APBOs)

Problem-by-problem
approach failed

Wheat Committee
recommendations
adopted in 1973
Financial Accounting Standards Board
Mission is to establish and improve standards of
financial accounting and reporting. Differences
between FASB and predecessor AICPA include FASB is:
Full-time, Paid position
Increased Independence--must ‘quit’ other jobs
Broader Representation--NOT all CPAs
Chapter
1-12
FASB’s Due Process
Responsive to entire economic community (‘everyone’ gets to
voice their views--good or bad?)
Operates in full view of the public (transparency)
Step 1 = Topic placed on agenda
Step 2 = Research conducted and Discussion Memorandum
issued.
Step 3 = Public hearing
Step 4 = Board evaluates research, public response and
issues Exposure Draft
Step 5 = Board evaluates responses and issues final
Statement of Financial Accounting Standard
Step 6 = Those that ‘lose’ seek redress in Congress!!!
Chapter
1-13
Types of Pronouncements
FASB Standards (over 160), Interpretations (48--some
over 100 pages long), and Staff Positions (over 50).
Above are all “official GAAP”
ARBs and APBs issued by the AICPA that have not
been superceded also are “official GAAP”
FASB Financial Accounting Concepts (part of the
“Conceptual Framework Project--NOT ‘official’ GAAP)
Emerging Issues Task Force (EITF) Statements
covering new and unusual transactions (e.g., how to
report losses from Hurricane Katrina) after review and
approval by FASB are ‘preferred GAAP’
Chapter
1-14
GAAP Codification
1.) With over 2,000 GAAP documents in the last
60 years, it has become very difficult even to
‘research’ a topic in GAAP and feel assured
you have the most recent, ‘correct’ answer to
your inquiry.
2.) The FASB’s GAAP codification project (just
completed in July 2009) is an attempt to
alleviate the problem and make GAAP
research much more effective and efficient
Chapter
1-15
GAAP Codification (Continued)
The Codification includes ALL authoritative
U.S. GAAP in a single location, organized into
90 accounting topics and is available FREE
(electronically accessible at
http://asc.fasb.org/home)
Each topic has subsections such as:




Overview and background
Recognition
Initial measurement
Disclosure
The topical structure is consistent with IFRS
The codification will include real-time updates
Chapter
1-16
YOU Will Be Researching the Codification for selected
homework assignments!
Changing Role of AICPA
AICPA no longer issues authoritative accounting guidance for
public companies (now done by FASB; SEC)
AICPA no longer develops auditing standards (now done by
Public Companies Accounting Oversight Board--PCAOB)
AICPA continues to develop and grade the CPA examination.
Is the CPA exam impossible to pass?
Is it easier to pass in one state than another?
What are the requirements for becoming a CPA?
What are the education requirements in Penna.?
What about the experience requirements?
What’s the 150-hour requirement?
Chapter
1-17
International Accounting Standards Board
International Financial Reporting Standards (IFRS or iGAAP), are
issued by the IASB:
Your textbook refers to them as “iGAAP”
Every other source I’ve seen refers to them as IFRS
US GAAP is ‘identified’ as being “rules based” (over 2,000
documents related to GAAP issued in last 60 years) while IFRS
are ‘identified’ as being “principles based”
Currently IFRS adopted by over 100 countries around the world:
SEC has proposed time-table ‘forcing’ US public companies
to switch to IFRS. Decision currently scheduled to be made in
2011. (Link to article on Comments)
FASB and IASB have been working on ‘convergence’ project to
Chapter
1-18combine the two sets of GAAP into the best of both.
Ethics in the Environment of Financial Accounting
You are a member of top management and your goal is to ‘maximize
shareholder wealth’. Your annual performance bonus (and
whether you keep your job or get fired) is based on meeting
predetermined financial reporting and market goals--e. g.,
dollar amount of net income, earnings per share, better
balance sheet.
1)
2)
Would you like reported earnings be calculated with standards
that are:
a)
Biased to produce higher earnings?
b)
Designed to describe what really happened?
Would you like the balance sheet to:
Chapter
1-19
a)
Omit some ‘questionable’ liabilities?
b)
Report all liabilities?
You are Company management
3.) Would you like the company’s auditors to be:
a.) Understanding of management’s needs and willing to
help out?
b.) Focused on getting useful information into the hands
of the financial statement users, even if they have to be
very tough in dealing with you (their client--who hires and
pays their fee)
4.) Would you prefer that earnings results be:
a.) Smoothed and normalized to remove any volatility?
b.) reported as they occur and let the users of the
financial statements decide whether and how to smooth or
normalize earnings?
Chapter
1-20
Now assume you are the financial statement
analyst trying to forecast future cash flows
1)
Would you like reported earnings be calculated with standards
that are:
a) Biased to produce higher earnings?
b) Designed to describe what really happened?
2)
Would you like the balance sheet to:
a) Omit some ‘questionable’ liabilities?
b) Report all liabilities?
3)
Would you like the company’s auditors to be:
a.) Understanding of management’s needs and willing to help
out?
b.) Focused on getting useful information into the hands of the
financial statement users, even if they have to be very tough
in dealing with company management (their client--who hires
and pays their fee)
Chapter
1-21
Now assume you are the financial statement
analyst trying to forecast future cash flows
4.) Would you prefer that earnings results be:
a.) Smoothed and normalized to remove any volatility?
b.) reported as they occur and let you, the users of the
financial statements, decide whether and how to smooth
or normalize earnings?
Chapter
1-22
Sarbanes-Oxley Legislation
(“SOX”)





Chapter
1-23
Establishes an oversight board for accounting practices.
The Public Company Accounting Over-sight Board
(PCAOB) has oversight and enforcement authority and
establishes auditing, quality control, and independence
standards and rules.
Implements stronger independence rules for auditors.
Audit partner rotation; prohibited from offering certain
types of consulting services to audit clients.
Requires CEOs and CFOs to personally certify that
financial statements and disclosures are accurate
Requires codes of ETHICS for senior financial officers.
In addition, requires public companies’ management to
attest to the effectiveness of their internal controls over
financial reporting (AND auditors need to ‘audit’ it and
report on it).
Class Assignment Review Questions and
Homework for Ch. 1
Class Assignment Questions #1, 3, 5, 28, 32
(pages 22-23)
Homework (pages 25-26):
CA 1-12, CA 1-13, CA 1-15
Chapter
1-24
CHAPTER
2
CONCEPTUAL FRAMEWORK
UNDERLYING FINANCIAL
ACCOUNTING
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-25
Conceptual Framework
The Need for a Conceptual Framework
(a Constitution for Financial Accounting)
To develop a coherent set of standards and rules
To solve new and emerging practical problems
Chapter
1-26
FASB’s Conceptual Framework Project

Both the FASB and the IASB have “Conceptual
Frameworks”—with many similarities


MAJOR Difference = Measurement methods used in
recognizing elements of the financial statements (e.g.,
option to use ‘fair value’ much more extensive in IFRS)
Some Other Differences:




Chapter
1-27
“Consistency NOT included in IFRS ‘qualitative’
characteristics
Stewardship as an Objective in IASB Conceptual
Framework
Accrual accounting explicitly listed as an ‘assumption’ in
IASB Conceptual Framework
FASB & IASB working on a ‘common’ conceptual
framework as part of their ongoing ‘convergence
project’
Development of Conceptual Framework
The FASB has issued six Statements of Financial
Accounting Concepts (note that #3 has been superceded
by #6)
SFAC No.1 - Objectives of Financial Reporting (covered in Ch. 1)
SFAC No.2 - Qualitative Characteristics of Accounting Information
SFAC No.3 - Elements of Financial Statements (superceded by
SFAC No. 6)
SFAC No.4 - Objectives of Financial Reporting by Non-business
Organizations
SFAC No.5 - Recognition and Measurement in Financial Statements
SFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3)
SFAC
Chapter
1-28
No.7 - Using Cash Flow Information and Present Value in
Accounting Measurements
ASSUMPTIONS
PRINCIPLES
1. Continuity (aka.
“Going concern”)
1. Principle of revenue
recognition
2. Economic entity
2. Matching
3. Monetary unit-stable
3. Disclosure is full and
fair
4. Timeliness (aka.
“Periodicity”)
Relevance
Reliability
Illustration 2-7
Conceptual Framework
for Financial Reporting
(page 50 in textbook)
Comparability
Consistency
I do NOT differentiate among
Assumptions, Principles, and
Constraints (and I ‘move’
Consistency from Qualitative
Characteristic level to join
assumptions, principles, and
constraints)
1. Cost-benefit
2. Materiality
3. Industry practice
Third
level
4. Conservatism
4. Cost--Historic cost
measurement
QUALITATIVE
CHARACTERISTICS
Chapter
1-29
CONSTRAINTS
ELEMENTS
Assets, Liabilities, and Equity
Investments by owners
Distribution to owners
Comprehensive income
Revenues and Expenses
Gains and Losses
OBJECTIVES
1. Useful in investment and credit
decisions
2. Useful in assessing timing,
amount, and uncertainty of future
cash flows
3. About enterprise resources,
claims to resources, and changes
in them
Second level
First level
Qualitative Characteristics Making
Accounting Information Useful
Relevance – making a difference in a decision.
Predictive value
Feedback value
Timeliness
Reliability
Verifiable
Representational faithfulness
Neutral - free of error and bias
Reliability often clashes with Relevance—Manhattan
Island example (which is better valuation: an average
of 20 real estate appraisers or $24 for Investment in
Manhattan Island? As an auditor, would you like to
Chapter
1-30
give an opinion on which valuation??
Mnemonic to Help Remember the
Assumptions, Principles, and Constraints
Disclosure--full
 Cost/Benefit
 Continuity (“Going-Concern”)
 Consistency
 Cost--Historic
 Monetary Unit is Stable
 Matching
 Materiality
 Conservatism
 Economic Entity
 Principle of Revenue Recognition
 Timeliness (“Periodicity”)
Chapter (Add “Industry Exceptions” to above Mnemonic)
1-31

ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Disclosure – Financial reports should include “any” information that could
affect decisions made by external users.



Parenthetical comments on face of statements
Note disclosures
Supplemental financial statements
Cost/Benefit -- “any” (for example in the above disclosure requirement)
must be tempered with the COST/BENEFIT CONSIDERATION
Chapter
1-32
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
“Continuity” (“Going concern”) - the entity's life extends beyond
the current period.
a. Fundamental: assets are assumed to have
future economic benefit.
b. A business is assumed to continue
“indefinitely” (long enough for company to
use up it’s assets in normal operations).
NEED TO EVALUATE VERY CLOSELY IN TODAY’S
ECONOMIC ENVIRONMENT!
Chapter
1-33
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Consistency Principle - business entities should use the same
accounting methods from one period to the next.
a. Allows comparisons of performance and
position across time.
b. Changes in methods may signal manipulation.
(This does NOT mean a company can never
change accounting methods)
Chapter
1-34
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Cost--Historic - financial accounting information must be verifiable
and reliable (objectively determined where possible rather
than subjectively determined)
a. Results can be “duplicated”—ask 20 historians what was
the historic cost of Manhattan Island. You get 20 people
saying $24.
b. Opposite of “subjective measurement”. You get 20 people
with 20 different answers if asked what is current ‘market
value’ of Manhattan Island.
c. Measurements continue to move away from historic cost:
Market values increasing being used—marketable securities,
derivatives, (IFRS – option to use Fair Market Value for PP&E)
Chapter
1-35
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Monetary unit is stable - measuring unit (e.g. dollar) is stable over time.
Inflation “does NOT exist”
Matching Principle - the effects of a given period (expenses)
should be matched against the benefits (revenues) that result
from them. “Let the expense follow the revenues.”
(Example = Cost of Goods Sold Expense)
(a) Focus on the income statement.
(b) Associate cause and effect, match expenses with
revenues to which they relate.
(c) Key decision to be made is when to recognize (record)
revenue—THEN Match Expense against Revenue
(d) Not all Expenses can be ‘directly’ matched against
Revenue. Some Expenses are ‘indirect’—costs in general of
running the business for the period! (janitor’s salary,
depreciation of computer)
Chapter
1-36
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Materiality Concept - only those transactions dealing with dollar
amounts large enough to make a difference to financial statement
users need to be accounted for in a manner consistent with the
principles of financial accounting.
(a) Size of transaction is relative.
(b) Example: expense vs. depreciate (pencil sharpener).
(c) Materiality requires judgment (NOT much help in professional
literature).
(d) User must be considered in determining materiality.
(e) Consider “qualitative” aspects as well as “quantitative”
($10,000 bribe to Saudi Government official by GM).
(f) SEC’s Staff Accounting Bulletin (SAB) #99 states “exclusive
reliance on quantitative benchmarks to assess materiality in
preparing financial statements is inappropriate”.
Chapter
1-37
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Conservatism Concept - "When in doubt, understate rather than
overstate an entity's value.”
(a) Only when significant uncertainty about the value
of transaction exists, should the most
conservative alternative be chosen.
(b) Conservatism in its own right is NOT a desirable
characteristic of accounting. It can be just as
misleading as “being overly optimistic”.
(“Big Bath” manipulation!)
(c) Justification: legal liability of managers, directors,
and auditors.
(d) Example: LCM used in inventory valuation.
Chapter
1-38
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Economic entity - an individual company is
separate and distinct from both its owner and all
other entities.
a. Ralph’s Used Car Company (a ‘proprietorship’)
b. Parent and four subsidiaries
(The economic entity may NOT necessarily be the same as the
legal entity!)
Chapter
1-39
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Principle of Revenue Recognition
Four criteria must be met before revenue can be shown in the
income statement:
(1) Production and sales efforts for product
significantly completed.
(2) Revenue amount can be objectively measured.
(3) The major costs have been incurred and the
rest can be reasonably estimated.
(4) Eventual collection of cash is reasonably
assured.
In Summary, RECORD REVENUE when EARNED:
Earnings Process is virtually complete—critical
revenue producing activity has occurred (normally
sale/delivery) AND remaining events (like collection of
cash) are highly estimatable)
Chapter
1-40
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Timeliness (“Periodicity”) - time periods during
which performance is measured for the economic
entity.
a. Based on users' need for timely information.
b. Artificial time periods for reports (calendar,
fiscal year, quarterly, ‘real-time on-line’).
c. Timely (short period) vs. objective (longer
period) tradeoffs.
Chapter
1-41
ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Industry Exceptions - the peculiar nature of some industries
and business concerns sometimes requires departure
from basic accounting theory.
Examples: revenue recognition for agricultural products,
installment sales, long-term construction accounting
Chapter
1-42
Elements of Fin. Statements

Page 39 in textbook has the “fancy” definitions
from FASB Concept Statement #6.

Let’s quickly go through them and add
‘simplified’ common wordage alternative
definitions for the elements that make up the
financial statements.
Chapter
1-43
Class Assignment Review Questions and
Homework for Ch. 2
Class Assignment Questions #2, 3, 5, 8, 9, 14,
16, 20, 25, 28 (pages 53-54)
Homework (pages 57-58):
Ex. 3, 4, 7
Chapter
1-44
CHAPTER
3
THE ACCOUNTING
INFORMATION
SYSTEM
(The Accounting Cycle)
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-45
THE “MECHANICS” OF FINANCIAL ACCOUNTING
(A Summary of Ch. 3)








Review the fundamental accounting equation.
Discuss the two criteria required for entering an economic event
into the accounting cycle.
Explain the debit/credit scheme
Discuss and illustrate the role of the Journal Entry, Journals,
Posting to Ledger Accounts, and Trial Balances.
Review the use of Adjusting Journal Entries.
Explain how Financial Statements are prepared at the end of the
accounting cycle.
Illustrate the use of an Accounting Worksheet
Describe and illustrate the procedures involved in the Closing
Process and its importance.
Chapter
1-46
THE FUNDAMENTAL ACCOUNTING EQUATION
Assets = Claims to Assets
Assets = Liabilities + Stockholders’ Equity
Assets = Liabilities + (Contributed Capital + RE)
Characteristics:
a. This equality must always be maintained.
b. Equality is a necessary, but not sufficient condition.
c. Equality is maintained by the double entry system of
bookkeeping.
Ending RE = Beginning RE + NI – Dividends
Net Income = Revenues - Expenses
Chapter
1-47
TWO CRITERIA FOR RECORDING
ECONOMIC EVENTS
Criteria for recording a business or exchange transaction (economic
event) in the accounting cycle.
1. Event Relevancy - economically significant and
affects a firm's financial condition. (Assets, Liabilities,
and/or Stockholders’ Equity are Affected!)
2. Objectivity - dollar values assigned to accounts
(categories) in the Financial Statements must result from
exchange transactions (involving firm and an “outside
party”) that are backed by documented evidence.
Chapter
1-48
Debit/Credit Scheme
Follow along on the board as I use the basic
“Accounting Equation” of:
(Assets = Liabilities + Owners’ Equity)
to demonstrate how to learn the
debit/credit scheme.
Chapter
1-49
The Accounting Equation
Relationship among the assets, liabilities, and
stockholders’ equity of a business:
The equation must be in balance after every
transaction. For every Debit there must be a Credit.
Chapter
1-50
Accounting Cycle Summarized (After having
completed the “Transaction Analysis”)
1.
Enter the transactions of the period in appropriate journals.
2. Post from the journals to the ledger.
3. Prepare a trial balance (unadjusted trial balance).
4. Prepare adjusting journal entries and post to the ledger.
5. Prepare a trial balance after adjusting (adjusted trial balance).
6. Optional--Prepare an Accountant’s Worksheet
7. Prepare the financial statements from the adjusted trial
balance or Accountant’s Worksheet
8. Prepare closing journal entries and post to the ledger.
9. Prepare a trial balance after closing (post-closing trial
balance).
10. Optional--Prepare reversing entries and post to the ledger.
Chapter
1-51
The Accounting Cycle
Transactions
9. Optional--Reversing
entries
1. Journalization
8. Post-closing trail balance
2. Posting to Ledger
7. Closing entries
3. Trial balance
6. Financial Statements
Optional
Work
Sheet
5. Adjusted trial balance
Chapter
1-52
4. Adjustments
Transaction Analysis
First UNDERSTAND THE BUSINESS EVENT THAT
OCCURRED!! THEN:
a. Which financial statement accounts
are affected by the transaction?
b. What is the direction of the account
effect? (Increase or Decrease)
c. What is the dollar value of the transaction?
(use the balance sheet valuation methods:)
1.) Historical Cost (Land)
2.) Lower of Cost or Market (Inventory)
3.) Net Realizable Value (Accounts Receivable)
4.) Fair Market Value (Trading Portfolio of
Investments)
5.) Present Value (Capitalized Lease)
Chapter
1-53
JOURNALS AND LEDGERS
1.
The Journal (general journal) - contains a chronological list of the transactions
entered into by a company, usually in journal entry form.
a.
b.
c.
d.
e.
2.
Enter date of transaction.
List the accounts to be debited/credited.
Include the dollar amounts of debits/credits.
Provide a brief explanation of the transaction.
Enter a posting reference to the appropriate ledger accounts (discuss next).
The Ledger - contains a running balance for each asset, liability, stockholders'
equity, and temporary retained earnings account--revenue, expense, and dividend
accounts. (“T” ledger accounts usually are used in the textbook and lectures
instead of the 3-column running balance format of ledger account)
Posting to the ledger accounts occurs throughout the accounting period (with
computer systems—posting occurs at the same time that the journal entry is
made).
Chapter
1-54
1. Journalizing
General Journal – a chronological record of transactions.
Journal Entries are recorded in the journal.
September 1: Stockholders invested $15,000 cash in the
corporation in exchange for shares of stock.
Chapter
1-55
2. Posting
Posting – the process of transferring amounts from the
journal to the ledger accounts.
Chapter
1-56
2. Posting
Posting – Transferring amounts from journal to ledger.
Chapter
1-57
3. Unadjusted Trial Balance
Trial Balance –
A list of each
account and its
balance; used
to prove
equality of
debit and
credit
balances.
Chapter
1-58
ILLUSTRATION

Use Class Problem #1 on next slide to
illustrate:





Chapter
1-59
Transaction Analysis
Debits/Credits
Journal Entries
Posting to Ledger Accounts
“Unadjusted” Trial Balance
Chapter
1-60
Link to Solution to Class Prob. 3-1
ADJUSTING JOURNAL ENTRIES
1. Definition - Journal entries recorded at the END of the accounting
period to ensure that the financial statements will be correct—
routine transactions recorded during the period may not result in
proper presentation of the financial statements.
2. Characteristics of Adjusting Entries:
a. Entered in the records at the end of the period.
b. Involve both a temporary retained earnings account (aka.
“nominal account”) and a permanent balance sheet account.
3. Types of adjusting journal entries
a. Accruals
b. Deferrals
c. Revaluations
Chapter
1-61
“ACCRUALS” TYPE OF ADJUSTING ENTRY
1. Adjusting journal entries that ensure revenues earned and
expenses incurred during the current period are recorded.
Because the cash has not been received or paid yet, the
routine entries already made during the period would NOT
have recognized these revenues and expenses (and the
related asset or liability)
2. Examples include:
a. Accrued interest on Bank CD (and receivable)
Interest Receivable AND Interest Revenue
b. Accrued wages earned by employees (and payable).
Salaries Expense AND Salaries Payable
Chapter
1-62
“DEFERRALS” TYPE OF ADJUSTING ENTRY
Deferrals - the process of “converting” either:
1.) a deferred cost (i.e., asset) into an expense:
a. Supplies inventory (Dr Supplies expense, Cr Supplies)
b. Merchandise inventory (Dr Cost of goods sold, Cr Inventory)
c. Prepaid expenses (Dr Expense account, Cr Prepaid expense)
d. Property, plant, and equipment (Dr Depreciation expense,
Cr Accumulated depreciation)
e. Definitive-Lived Intangibles (Dr Amortization expense, Cr Intangibles)
2.) a deferred revenue (i.e. liability) until revenue earned.
a. Unearned revenues (Dr Unearned revenue, Cr Fees earned)
Note that with Deferral type Adjusting Entries—a previously recorded event (usually the
result of a cash transaction) is being ‘updated’.
Chapter
1-63
“REVALUATIONS”
TYPE OF ADJUSTING ENTRY
1. Revaluation adjustments – Adjusting Journal Entries designed to bring
the dollar amounts of certain accounts in line with the existing facts.
2. Examples:
a. Bad debt estimates.
b. Adjustments due to bank reconciliations.
c. Revaluations of inventories to apply LCM.
Chapter
1-64
ILLUSTRATION OF ADJUSTING ENTRIES

Use Class Problem #2 on next slide to
illustrate:



Chapter
1-65
Accrual Adjusting Journal Entries
Deferral Adjusting Journal Entries
Valuation Adjusting Journal Entries
Prepare adjusting entries based on the unadjusted trial balance above and the information below:
1.) The buildings have an estimated useful life of 50 years with no salvage value. Use straight-line depreciation.
2.) The equipment is depreciated at 10% of original cost per year
3.) Prepaid insurance totaling $1,500 ‘expired’ during the year
4.) It is estimated that 10% of the accounts receivable will NOT be collected
5.) Accrued salaries at year-end were $1,500
6.) Unearned rent revenue balance at year-end should be $1,200
Link to Solution to Class Prob. 3-2
Chapter
1-66
THE ACCOUNTANT’S WORKSHEET
(See Appendix 3C—page 109)
The Worksheet - used at the end of an accounting period by the accountant to
prepare an ‘informal’ trial run through the end of the period accounting steps.
a.
Advantages
(1) Easier to trace/track your work.
(2) Aids in finding posting and math errors.
b.
Worksheet step-by-step process:
(1) Prepare Unadjusted Trial Balance - the list of accounts and end-ofperiod account balances copied from the general ledger to the
worksheet (the first step).
(2) Post adjusting entries - journal entries recorded at period end-Accruals, Deferrals, & Valuation adjustments (the second step).
(3) Prepare “Adjusted Trial Balance” columns (the third step)
(4) Prepare “Financial Statement” columns (the fourth step)
Add another financial statement set of columns for the Retained
Earnings Statement--locate it between the Income Statement set of
columns and the Balance Sheet set of columns! (The beginning
Retained Earnings, Dividends Declared, and Net Income should be
extended to the Retained Earnings set of columns, NOT the
Balance Sheet set of columns.)
Chapter
1-67
Preparation of the Accountant’s Worksheet will be one of the homework
assignments for Ch. 3
Illustration of Accountant’s Worksheet
Link to first six columns on an Accountant’s
Worksheet
Link to last 8 columns on an Accountant’s
Worksheet
Chapter
1-68
PREPARING THE FINANCIAL STATEMENTS
Preparing the Financial Statements:
1. Income statement - prepare from adjusted trial balance or
accountant’s end of period worksheet
Chapter
1-69
2.
Statement of retained earnings - prepare from retained earnings
general ledger account (after closing entries) or from the
accountant’s end of period worksheet.
3.
Balance sheet - prepare from adjusted trial balance or the
accountant’s end of period worksheet.
4.
Statement of cash flows - prepare by analyzing the change in
every account but the Cash account.
ILLUSTRATION OF FOUR FINANCIAL
STATEMENTS
Click on link to view an illustration of the four
financial statements.

Chapter
1-70
Point out—’interrelationships’ among the four
financial statements. How they ‘interconnect’!
THE CLOSING JOURNAL ENTRY PROCESS
1. AFTER adjusted trial balance and financial statements have been
completed, THEN:
2. Closing journal entries - transfer end-of-period balances
in the Revenue, Expenses, and Dividends Declared accounts (the temporary
retained earnings accounts; aka. the ‘nominal’ accounts) to the permanent Retained
Earnings account. (Do NOT use the “Income Summary” account)
a. Closing process procedures.
(1) Close Revenue accounts to Retained Earnings
(2) Close Expense accounts to Retained Earnings
(3) Close Dividends Declared to Retained Earnings.
b. WHY need closing journal entries????
3. Prepare the post-closing trial balance (aka. “after-closing trial balance”) – contains
end-of- period balances for the permanent (balance sheet) accounts. Also
represents beginning balances for next accounting period.
Chapter
1-71
ILLUSTRATION OF CLOSING ENTRIES

Use Class Problem #3 to illustrate:


Closing Journal Entries
Post closing Trial Balance
(First Show Adjusted Trial Balance – basis for
preparing Closing Entries)
Chapter
1-72
9. Reversing Entries
After preparing the financial statements
and closing the books, a company may
reverse some of the adjusting entries
before recording the regular transactions
of the next period.
Chapter
1-73
Summary of Reversing Entries (IF Used!)
1.
All accrual adjusting entries would be reversed.
2. All adjusting entries for deferrals where the company debited
or credited the original cash transaction to an expense or
revenue account would be reversed.
Recognize that reversing entries do not have to be used.
They may be necessary if a “poorly” designed accounting software
package (or ‘inexperienced’ bookkeeper) that:
i.) will be unable to properly account for subsequent
cash received or paid in situation #1 above
ii.) ‘records’ deferral situation in #2 incorrectly
back at time of cash receipt or cash payment
Chapter
1-74
Accounting Cycle Summarized
1.
Enter the transactions during the period in the journal.
2. Post from the journal to the ledger.
3. Prepare an unadjusted trial balance.
4. Prepare adjusting journal entries and post to the ledger.
5. Prepare a trial balance after adjusting (adjusted trial balance).
6. Optional--Prepare an Accountant’s Worksheet
7. Prepare the financial statements from the adjusted trial
balance or the Accountant’s Worksheet
8. Prepare closing journal entries and post to the ledger.
9. Prepare a trial balance after closing (post-closing trial
balance).
10. Optional--Prepare reversing entries and post to the ledger.
Chapter
1-75
Class Assignment Review Questions and
Homework for Ch. 3
Class Assignment Questions -- # 4, 10, 11, 12, 21, and 22 (page 111)
Homework -- Proprietary Problem
A preformatted Excel worksheet is provided with some columns of
the Accountant’s Worksheet already completed.
Required:
a.) Complete the Accountant’s Worksheet using Excel
b.) Prepare an Income Statement, Retained Earnings Statement,
and ‘classified’ Balance Sheet
c.) Record in journal entry form the adjusting entries
d.) Record in journal entry form the closing entries
e.) Prepare a post-closing (aka. ‘after-closing’) trial balance
Chapter
1-76
CHAPTER
4
INCOME STATEMENT AND
INFORMATION
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-77
RELATED
Summary of Chapter 4
1.
Understand the uses and limitations of an income statement.
2.
Prepare a single-step income statement.
3.
Prepare a multiple-step income statement.
4.
Explain how to report ‘special items’:
a.) Discontinued operations
b.) Extraordinary items.
5.
Explain “intraperiod tax allocation”.
6.
Identify where to report earnings per share (EPS)
information.
7.
Prepare a retained earnings statement.
8.
Explain how to report other comprehensive income.
Chapter
1-78
Income Statement (aka. “Operating Statement)
Usefulness
Evaluate past performance.
Predicting future performance.
Help assess the risk or uncertainty
of achieving future cash flows.
Chapter
1-79
Income Statement
“Quality” of Earnings
Companies have incentives to manage income to
meet or beat Wall Street expectations, so that
market price of stock increases
value of stock options increase
bonus is bigger
keep from being fired
Chapter
1-80
Format of the Income Statement
Revenues for the period:
Selling price of goods sold or services rendered
Gross INCREASE in Retained Earnings component of
stockholders’ equity
Examples of Revenue Accounts
Sales revenue
Fees earned
Interest revenue
Dividend revenue
Chapter
1-81
Rent revenue
Format of the Income Statement
Expenses for the period:
Costs incurred to run the business and generate the revenue
Gross DECREASE in Retained Earnings component of
stockholders’ equity
Examples of Expense Accounts
Cost of goods sold
Depreciation expense
Interest expense
Rent expense
Salary expense
Chapter
1-82
Format of the Income Statement
Gains
– Increases in income from “peripheral” or incidental
transactions
Losses - Decreases in income from “peripheral” or
incidental transactions.
Examples of Gains and Losses
Sale of investment in Microsoft shares,
Sale of old delivery truck,
Impairment losses.
Chapter
1-83
Single-Step Format
The single-step statement
has few categories or
subtotals:
Revenues
Expenses
Net Income
Chapter
1-84
SingleStep
Income Statement (in thousands)
Revenues:
Sales
Interest revenue
Total revenue
$ 285,000
17,000
302,000
Expenses:
Cost of goods sold
Selling expense
Administrative expense
Interest expense
Income tax expense
Total expenses
149,000
10,000
43,000
21,000
24,000
247,000
Net income
$ 55,000
Earnings per share
$
0.75
Multiple-Step Format
More categories and
subtotals than
‘single step’ format
1. Operating Section
2. Nonoperating
Section
3. Income tax
Chapter
1-85
Income Statement (in thousands)
Sales
$ 285,000
Cost of goods sold
Gross profit
149,000
136,000
Operating expenses:
Selling expenses
Administrative expenses
Total operating expense
10,000
43,000
53,000
Income from operations
83,000
Other revenue (expense):
Interest revenue
Interest expense
Total other
Income before taxes
Income tax expense
17,000
(21,000)
(4,000)
79,000
24,000
Net income
$ 55,000
Earnings per share
$
0.75
Reporting “Special” Items
1.) Discontinued Operations
occurs when, there is no
significant continuing involvement in a component of the
business. (Own restaurants, steel mill, and shoe store--and
sell the restaurants on June 12, 2010)
Discontinued Operations must be reported in its own
separate section of the income statement (following
‘Income from continuing operations’).
The Discontinued Operations section would include both the
results of operating the component of the business up to the
disposal date and the gain or loss on the disposal.
Discontinued items must be shown “net of tax.”
Chapter
1-86
EPS must be shown for Discontinued Operations
Reporting Discontinued Operations
Illustration: KC Corporation had after tax income from continuing
operations of $5,000,000 in 2010. Prior to disposal, the restaurants
operated at a pretax loss of $450,000 in 2010. On June 12, 2010,
KC disposed of its restaurant division at a pretax loss of $270,000.
Assume a tax rate of 30%. A partial income statement for KC:
Income from continuing operations
$5,000,000
Discontinued operations:
Loss from operations, net of $135,000 tax benefit 315,000
Loss on disposal, net of $81,000 tax benefit
189,000
Total loss on discontinued operations
504,000
Net income
$4,496,000
Earnings per share:
Income from continuing operations
Discontinued operations
Chapter
1-87
Net income
$5.00
.50
$4.50
Reporting Irregular Items
2.) Extraordinary items must be both of an
Unusual Nature and
Occur “Infrequently”
Company must consider the environment in which it operates.
Extraordinary items must be shown “net of tax.”
Earnings per Share (EPS) must be shown for Extraordinary
items
Chapter
1-88
Reporting Extraordinary Items
Are these items Extraordinary?
(a) A large portion of a tobacco manufacturer’s
crops are destroyed by a hail storm. Severe
damage from hail storms in the locality where
the manufacturer grows tobacco is rare.
YES
(b) A citrus grower's Florida crop is damaged by
frost.
NO
(c) Damage from Hurricane Katrina.
NO
Chapter
1-89
Reporting Extraordinary Items
Illustration: KC Corporation had after tax income from
continuing operations of $4,000,000 in 2011. In addition, it
suffered an unusual and infrequent pretax GAIN of $770,000
from a volcano eruption. The corporation’s tax rate is 30%.
Prepare a partial income statement for KC Corporation
beginning with income from continuing operations.
Income from continuing operations
Extraordinary gain, net of $231,000 tax
$4,000,000
539,000
Net income
$4,539,000
Earnings per share:
Income from continuing operations
Extraordinary gain
Chapter
Net income
1-90
$4.00
.54
$4.54
Items NOT Getting ‘Special’ (Separate) Section
Unusual Gains and Losses
Material items that are unusual or infrequent
(considering the company’s ‘environment’), but not both,
should be reported in a separate section just above
“Income from continuing operations before income taxes.”
Examples can include:
Write-downs of inventories
Impairment losses
These items are NOT shown net-of-tax nor do they have
own EPS
As Management--would you ‘claim’ a loss was
Chapter
1-91 “extraordinary” or just ‘unusual’? What if it were a gain?
Illustration of “Unusual Gains & Losses”
Chapter
1-92
ACCOUNTING CHANGES
(Covered in more detail in Ch. 22)
1.) Changes in Accounting Principles (or “method”)
Restate prior years’ financial statements that are being
presented for comparative purposes (If impact goes
back further than years presented, adjust beginning
retained earnings balance for earliest year presented)
Approach preserves comparability among years
Examples include:
 change from FIFO to weighted-average cost
 change from the percentage-of-completion to the
completed-contract method
Chapter
1-93
ACCOUNTING CHANGES
2. Changes in Accounting Estimate
Accounted for in the period of change and future periods
Not handled retrospectively (i.e., do NOT restate prior
years’ financial statements presented for comparative
purposes)
Examples include:
 Useful lives and salvage values of depreciable assets
 Allowance for bad debts
Chapter
1-94
Change in Estimate – An Illustration
Arcadia HS, purchased equipment for $510,000 which was
estimated to have a useful life of 10 years with a salvage value of
$10,000 at the end of that time. Depreciation has been recorded
for 7 years on a straight-line basis. In 2010 (year 8), it is
determined that the total estimated life should be 15 years with a
salvage value of $5,000 at the end of that time.
Questions:


Chapter
1-95
What is the journal entry to correct the prior years’
depreciation?
No Entry
Required
Prepare the journal entry in 2010 to record depreciation.
Change in Estimate Example
Equipment cost
Salvage value
Depreciable base
Useful life (original)
Annual depreciation
Equipment
After 7 years
First, establish
remaining
depreciable amount
at date of change in
estimate.
$510,000
- 10,000
500,000
10 years
$ 50,000 x 7 years = $350,000
$510,000
Accumulated depreciation
350,000
$160,000
Revised salvage value
(5,000)
Remaining depreciable amount $155,000
Chapter
1-96
Change in Estimate Example
Remaining depreciable base $155,000
Divide by remaining life
8 years
New depreciation
$ 19,375
After 7 years
Depreciation
Expense calculation
for 2010.
Journal entry for 2010
Depreciation expense
Accumulated depreciation
19,375
19,375
In how many of the 15 years, will the depreciation
expense account be the “correct” $33,667 dollar
amount? ([$510,000 Cost - $5,000 S.V.] / 15 years)
Chapter
1-97
Why ‘might’ management have ‘claimed’ the estimated
useful life had increased from 10 years to 15 years?
Accounting Changes
3.) Corrections of Errors
Result from:
mathematical mistakes
 mistakes in application of accounting principles
 oversight or misuse of facts

Corrections treated as prior period adjustments
Retroactively correct any prior year’s
financial statements being presented
Chapter
1-98
Adjust the beginning balance of retained
earnings for the earliest year’s financial
statements presented if error goes back
further than earliest year
Correction of Errors -- Illustrated
In 2011, Hillsboro Co. determined that it incorrectly
overstated its accounts receivable and sales revenue by
$100,000 in 2010. In 2011, Hillboro makes the following
entry to correct for this error (ignore income taxes).
Retained earnings
Accounts receivable
100,000
100,000
Note: Can’t debit Sales Revenue account (because 2010’s Sales
Revenue account was ‘closed out to zero’ at the end of 2010)
If the 2010 financial statements are presented for
comparative purposes with the 2011 statements, the 2010
statements would be corrected for the error.
Chapter
1-99
Intraperiod Tax Allocation
Relates the income tax expense to the specific items that
give rise to the amount of the tax expense.
Income tax is allocated (within the accounting period) to the
following items:
(1) Income from continuing operations before tax
(2) Discontinued operations
(3) Extraordinary items
(4) Changes in accounting principle
(5) Correction of errors
Chapter
1-100
Earnings Per Share (EPS)
(Ch. 16 provides detail coverage of EPS)
Net income - Preferred dividends
Weighted average number of shares outstanding
Measures the dollars earned by each share of
common stock.
Most often ‘quoted’ financial ratio.
Must be disclosed on the the income statement for
income from continuing operations, discontinued
operations, extraordinary items, and net income.
Often divided into Market Price per share to get
the Price/Earnings (P/E) ratio.
Chapter
1-101
Calculating EPS--An Example
Compute EPS for 2009
Net Income $1,357,000; $50,000 cash dividend paid on preferred stock
Shares of common stock:
Issued and outstanding on January 1, 2009 = 500,000 shares
April 1, 2009 -- issued additional 48,000 shares at $72. per share
October 1, 2009 – 52,800 shares reacquired and retired at $65. per share
Calculate denominator (the ‘weighted-average’ common shares outstanding):
500,000 (500,000 X 12/12)
36,000 (48,000 X 9/12)
(13,200) (52,800 X 3/12)
522,800 Weighted Average Common Shares Outstanding
Calculate earnings per share:
$2.50 EPS ($1,357,000 Net Income minus $50,000 Preferred Dividend)
522,800 Weighted Average Common Shares Outstanding
Chapter
1-102
EPS Illustration
Chapter
1-103
Illustration
Illustration of
of Retained
Retained Earnings
Earnings Statement
Statement
Woods, Inc.
Inc.Earnings
StatementWoods,
of Retained
of Retained
Earnings
ForStatement
the Year Ended
December
31, 2011
For the Year Ended December 31, 2011
Balance, January 1, as previously reported
$
Prior period
adjustment
- error correction *
Balance,
January
1
1, as -restated
PriorBalance,
period January
adjustment
error correction
Net income
Balance, January 1 (restated)
Dividends
Net income
Balance, December 31
$
Dividends
* The prior period adjustment would be 'net of tax'
Balance, December 31
Chapter
4-49
Chapter
1-104
1,050,000
*
$ (50,000)
1,050,000
1,000,000
(50,000)
360,000
1,000,000
(300,000)
360,000
1,060,000
$
(300,000)
1,060,000
Retained Earnings
Appropriated vs. Unappropriated Retained Earnings
Companies may have a ‘large’ Retained Earnings
account balance (and a relatively large Cash
balance) yet the board of directors may not want
to pay cash dividends. To inform investors of the
possible reason(s) for not paying dividends:
1.) Disclose the reasoning in the Notes that accompany
the financial statements or
2.) “Appropriated Retained Earnings”--divide the total
Retained Earnings balance on the Balance Sheet into
Chapter
1-105
Appropriated and Unappropriated components
Comprehensive Income
Comprehensive Income -- includes all changes in
stockholders’ equity during a period except those resulting
from investments by owners and dividends paid to
stockholders
Comprehensive Income thus includes:

Net income--all revenues and gains, expenses and losses
included on the Income Statement, AND

Other gains and losses that ‘bypass’ net income but are
included as “Other Comprehensive Income or Loss” component
of Stockholders’ Equity on the Balance Sheet (e.g., Unrealized
Gain or Losses on Available for Sale security investment;
Unamortized Prior Service cost related to defined benefits
pension plan)
Chapter
1-106
Comprehensive Income
Three approaches to reporting Comprehensive Income:
A second separate income statement;
A combined statement of comprehensive income; or
As part of the statement of stockholders’ equity
Each of the three approaches is illustrated on the next slides
Chapter
1-107
Comprehensive Income--Illustrated
Illustration 4-19
A “Second”
separate
income
statement
Chapter
1-108
Comprehensive Income
Combined
income
statement
V. Gill Inc.
Combined Statement of Comprehensive Income
For the Year Ended December 31, 2010
Sales revenue
Cost of goods sold
600,000
Gross profit
200,000
Operating expenses
90,000
Net income
110,000
Unrealized holding gain, net of tax
30,000
Comprehensive income
Chapter
1-109
$ 800,000
$ 140,000
Comprehensive Income
Include as part of Statement of Stockholder’s Equity
Illustration 4-20
Chapter
1-110
Comprehensive Income
Balance Sheet Presentation
Illustration 4-21
The Accumulated Other Comprehensive Income of $90,000 is
reported in the stockholders’ equity section of the Balance Sheet.
Chapter
1-111
GAAP vs. IFRS Differences

Presentation of the income statement under U.S. GAAP follows
either a single-step or multiple-step format. International Financial
Reporting Standard (IFRS) does not mention a single-step or
multiple-step approach.

In addition, under U.S. GAAP, companies must report an item as
extraordinary if it is unusual in nature and infrequent in occurrence
considering the ‘environment’ of the company. Extraordinary items
are prohibited under IFRS (iGAAP).
Chapter
1-112
Class Assignment Review Questions and
Homework for Ch. 4
Class Assignment Questions--#16 (skip ‘d’), 21,
22, 23, 30, 37 (pages 158-159)
Homework: (pages 167 and 175)
Prob. 4-7
Professional Research Assignment--using
FASB Codification
Chapter
1-113
CHAPTER
5
BALANCE SHEET AND
STATEMENT
OF CASH FLOWS
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-114
Summary of Chapter 5
1.
Explain the uses and limitations of a Balance Sheet.
2.
Identify the elements appearing on a Balance Sheet.
3.
Prepare a “classified” Balance Sheet.
4.
Identify balance sheet items requiring “disclosure” and various
ways the required disclosure can be accomplished.
5.
Indicate the purpose and content of the Statement of Cash
Flows.
6.
Prepare a simply Statement of Cash Flows (Chapter 23 will
provide extensive coverage of the preparation of the
Statement of Cash Flows).
Chapter
1-115
Balance Sheet
Usefulness of the Balance Sheet
Evaluating the capital structure (debt and equity
sources).
Assess risk and future cash flows.
Analyze the company’s:
Chapter
1-116

Liquidity (various assets’ “nearness to cash”)

Solvency (ability to pay the bills when due)

Financial flexibility (‘free’ cash availability to
meet crises and take advantage of opportunities)
Balance Sheet
Limitations of the Balance Sheet
Most assets and liabilities are reported at
historical cost.
Use of judgments and estimates.
Many items of financial value are omitted.
Chapter
1-117
Balance Sheet
Classification in the Balance Sheet
Three General Classifications
Assets, Liabilities, and Stockholders’ Equity
Companies further divide these classifications:
Chapter
1-118
Balance Sheet
Current Assets
Cash and other assets a company expects to
convert into cash, sell, or consume within one year
or in the operating cycle, whichever is longer.
Chapter
1-119
Balance Sheet – “Current Assets”
Cash & Cash Equivalents
Generally Cash = any monies available “on demand.”
Cash equivalents - short-term highly liquid
investments that mature within three months or less.
Restrictions or commitments must be disclosed.
Chapter
1-120
Balance Sheet – “Current Assets”
Short-Term Investments
Portfolios
Type
Valuation
Classification
Held-toMaturity
Debt
Amortized
Cost
Current or
Non-current*
Trading
Debt or Equity
Fair Value
Current
Fair Value
Current or
Non-current*
Availablefor-Sale
Chapter
1-121
Debt or Equity
*The “Held-to-Maturity” and “Available-for-Sale” could be either Current
Assets OR Non-Current Assets depending on “Management’s Intent”
Balance Sheet – “Current Assets”
Receivables
Claims held against customers and others for money,
goods, or services.
Accounts receivable – oral promises
Notes receivable – written promises
Question: What is the proper valuation for Receivables?
Answer:
Net Realizable Value
Chapter
1-122
Balance Sheet – “Current Assets”
Accounts Receivable – Presentation Options
1
2
Chapter
1-123
Current Assets:
Cash
Accounts receivable
Less allowance for doubtful accounts
Inventory
Total current assets
Current Assets:
Cash
Accounts receivable, net of $25 allowance
Inventory
Total current assets
$ 346
500
25
475
812
$1,633
$ 346
475
812
$1,633
Balance Sheet – “Current Assets”
Inventories
Questions:
1.) What is the proper valuation for Inventories?
Answer:
Lower-of-cost-or-market (LCM)
2.) Any required disclosure related to valuation method?
Answer:
Method of determining cost (e.g., FIFO or LIFO).
Chapter
1-124
Balance Sheet – “Current Assets”
Prepaid Expenses
Cash Payment
BEFORE
Expense Recorded
Prepayments often occur in regard to:
insurance
supplies
rent
advertising
Question: How can Prepaid Expenses be classified as a current
asset (they will not be converted into cash within the next
year or operating cycle if longer)?
Answer: They will be ‘consumed’ within the next year and will
NOT require reduction in cash since already ‘paid for’.
Chapter
1-125
Balance Sheet – “Current Assets”
Current Assets - “Summary”
Cash and other assets a
company expects to
 convert into cash,
 sell, or
 consume
either in one year or in
the operating cycle,
whichever is longer.
Chapter
1-126
Balance Sheet
Current assets
Cash
Short-Term Investments
Accounts receivable
Inventory
Prepaid expenses
Total current assets
$ 285,000
140,000
777,000
402,000
170,000
1,774,000
Balance Sheet – “Noncurrent Assets”
Long-Term Investments
Generally consists of four types:
Securities – Available for Sale; Hold-to-Maturity
Debt Securities
Land held for investment, Long-term Notes
Receivable
Special funds (e.g. Bond Sinking Fund)
Nonconsolidated subsidiaries or affiliated
companies.
Chapter
1-127
Balance Sheet – “Noncurrent Assets”
Long-Term Investments
Investments:
Investments in bonds and stocks*
Long-term Notes Receivable and Land held
for Speculation
Special Funds
Nonconsolidated Subs, Affiliated Companies
Chapter
1-128
Invesment in ABC bonds
Investment in UC Inc.
Notes receivable
Land held for speculation
Sinking fund
Pension fund
Cash surrender value
Investment in Uncon. Sub.
Total investments
321,657
253,980
150,000
550,000
225,000
653,798
84,321
457,836
2,696,592
*“Held-to-Maturity” and “Available-for-Sale” Investments could be either
Current Assets OR Long-Term Assets depending on “Management’s Intent”
*
*
Balance Sheet – “Noncurrent Assets”
Property, Plant, and Equipment
Tangible,
Long-lived,
Used in the regular
operations of the
business.
Property, Plant, and Equip.
Building
1,375,778
Land
975,000
Machinery and equipment234,958
Capital leases
384,650
Leasehold improvements 175,000
Accumulated depreciation
(975,000)
Total PP&E
2,170,386
Question: What is the proper valuation for PP&E?
Answer: US GAAP = Depreciated Cost
Chapter
1-129
IFRS = Choice of Depreciated Cost or FMV!
Balance Sheet – “Noncurrent Assets”
Lack physical substance
and are not financial
instruments. Get their
value from their
economic/legal rights.
Limited-Life intangibles
are amortized.
Indefinite-Life
intangibles are tested
annually for impairment.
Intangibles
Intangibles
Goodwill
Patents
Trademark
Franchises
Copyright
Total intangibles
2,000,000
177,000
40,000
125,000
55,000
2,397,000
IFRS Valuation = Choice of Amortized Cost or FMV!
Chapter
1-130
Balance Sheet – “Noncurrent Assets”
Other Assets
This section should
include only unusual
items sufficiently
different from assets
in the other
categories.
Other assets
Prepaid pension costs
Deferred income tax
Total other
133,000
40,000
173,000
Both “Prepaid Pension Cost” and “Deferred Income
Taxes” will be covered in detail in Intermediate II.
Chapter
1-131
Balance Sheet – “Current Liabilities”
Current Liabilities
“Obligations that a
company reasonably
expects to liquidate
either through the use
of current assets or the
creation of other
current liabilities.”
Notes payable*
Accounts payable
Salaries payable
Unearned revenue
Income tax payable
Current maturities LT debt
Total current liabilities
$ 233,450
131,800
43,000
17,000
23,400
121,000
569,650
* To be classified as a Current Liability, the Note Payable must
be due within one year or operating cycle whichever is longer
Chapter
1-132
Balance Sheet – “Long-Term Liabilities”
Long-Term Liabilities
“Obligations that a
company does not
reasonably expect to
liquidate within one year
or the normal operating
cycle whichever is
longer.”
Long-term liabilities
Long-term debt
979,500
Obligations capital lease
345,800
Deferred income taxes
77,909
Total long-term
liabilities 1,403,209
Stockholders'
equity
All covenants and restrictions
must be disclosed.
Chapter
1-133
Balance Sheet – “Stockholders’ Equity”
Stockholders’ Equity
Three parts,
(1) Capital Stock,
(2) Additional Paid-In Capital, and
(3) Retained Earnings.
Chapter
1-134
Balance Sheet - Format
Account Form
Chapter
1-135
Report Form
Chapter
1-136
LO 3
Ways to Accomplish Required Disclosure
Terminology and Classification – what you
‘call’ the item on the Balance Sheet and
where you ‘put it’ discloses information (e.g.,
Accounts Receivable shown as a current
asset)
Parenthetical Explanations
Disclosure Notes (including Significant
Accounting Policies)
Supporting Schedules
Cross-Referencing
Chapter
1-137
Use of Contra and Adjunct Accounts
The Statement of Cash Flows
Purpose of the Statement of Cash Flows
To provide relevant information about the cash
receipts and cash payments of an enterprise during
a period.
The statement provides answers to the following
questions:
1. Where did the cash come from?
2. What was the cash used for?
3. What was the change in the cash balance?
Chapter
1-138
The Statement of Cash Flows
Content and Format
Three different activities:
Investing,
Operating,
Chapter
1-139
Financing
The Statement of Cash Flows
Three Categories of Cash Flows
Operating
Investing*
Financing
Cash inflows
and outflows
from “day-in,
day-out”
normal
operations.
Cash inflows
and outflows
from purchase
and later sale
of
noncurrent
assets.
Cash inflows
and outflows
from
non-current
liabilities and
equity.
*Investing activities is the investing activities of the COMPANY (NOT the Stockholders)
Chapter
1-140
Chapter 5 presents only a ‘brief’ introduction to the Statement of Cash Flows;
Chapter 23 (to be covered in Intermediate II) is devoted entirely to an extensive
coverage of the Statement of Cash Flows.
The Statement of Cash Flows
Chapter
1-141
IFRS classifies some cash flows differently than GAAP (we’ll look at the
differences in Intermediate II)
The Statement of Cash Flows
Information Needed:
(1) comparative balance sheets,
(2) the current income statement, and
(3) selected transaction data.
“Process” – Steps to follow:
(1) complete the heading and last three lines of
Statement of Cash Flows
(2) complete Operating Activities section by converting
accrual basis Income Statement to Cash Flows
(3) complete analysis by ‘examining’ change in every account
balance during the year EXCEPT CASH account
Chapter
1-142
Class Problem on next page.
Information for Class Problem
Paradise Consulting Company
Assets
Dec. 31, 2010 Dec. 31, 2009 Inc. or (Dec.)
Cash
$
22,000
$
13,000
$
9,000
Accounts Receivable
106,000
88,000
18,000
Office Equipment
37,000
22,000
15,000
Accum. Depr.
(17,000)
(11,000)
6,000
Total Assets $
148,000
$
112,000
Liabilities and S.E.
Salaries Payable
Common Stock
Retained Earnings
Total Liabilities & S. E.
$
$
20,000
100,000
28,000
148,000
$
$
15,000
80,000
17,000
112,000
Income Statement for 2010
Consulting Fees Earned
Expenses:
Salaries Expense
$
68,000
Depreciation Expense
6,000
Net Income
$
5,000
20,000
11,000
$
108,000
$
74,000
34,000
New office equipment was purchasde in 2010; none was sold
Dividends were paid in 2010
PREPARE THE STATEMENT OF CASH FLOWS
Chapter
1-143
Link to Solution for Ch. 5 Class Problem
The Statement of Cash Flows
Significant Noncash Activities
Significant financing and investing activities that do
not affect cash are reported in either a separate
schedule at the bottom of the statement of cash
flows or in the notes.
Examples include:
Issuance of common stock to purchase assets.
Conversion of bonds into common stock.
Issuance of debt to purchase assets.
Chapter
1-144
Usefulness of the Statement of Cash Flows
Without cash, a company will not survive.
Cash flow from Operations:
High amount - company able to generate
sufficient cash to pay its bills and take
advantage of opportunities (“Cash is King”).
Low or negative amount - company may have to
borrow or issue equity securities to pay bills.
Would you lend money to the company?
Would you buy the new issue of equity securities?
Chapter
1-145
Ratio Analysis
Analysts and other interested parties can gather
qualitative information from financial statements by
examining relationships between items on the
statements and identifying trends in these
relationships.
Selected ratios related to topics already covered are on the
next few slides. Other ratios will be covered as topics are
Chapter
1-146
covered in subsequent chapters.
Ratio Analysis
Financial Liquidity
Current Cash
to Debt
Coverage
Ratio
=
Net Cash Provided by
Operating Activities
Average Current Liabilities
Ratio indicates whether the company can pay off its
current liabilities from its operations. A ratio near
1:1 is good.
Chapter
1-147
Ratio Analysis
Financial Flexibility
Cash Debt
Coverage
Ratio
=
Net Cash Provided by
Operating Activities
Average Total Liabilities
This ratio indicates a company’s ability to repay its
liabilities from net cash provided by operating
activities, without having to liquidate the assets
employed in its operations.
What is going to happen to the company if it has to
Chapter
1-148 ‘liquidate its assets to repay its liabilities?
Ratio Analysis
Free Cash Flow
The amount of discretionary cash flow a company has
for purchasing additional investments, retiring its
debt, purchasing treasury stock, or simply adding to
its liquidity.
Chapter
1-149
Ratio Analysis -- Rate of Return on Assets
Rate of Return on Assets measures a firm’s success in using assets
to generate earnings. It is calculated based on dollar amounts from
the Income Statement (CH. 4) and the Balance Sheet (this chapter).
Rate of Return on Assets =
Net Income
Average Total Assets
Rate of Return on Assets =
$51.6
$812.7 + 791.6 / 2
Chapter Rate
1-150
of Return on Assets = 6.4%
(Is 6.4% ‘good’? Compare it to what?)
Ratio Analysis
The analyst obtains further insight into the behavior of
Return of Assets by disaggregating it into components of
profit margin on sales and asset turnover as follows:
Rate of Return
on Assets
Net Income
Average Total Assets
Chapter
1-151
=
=
Profit Margin on
Sales
Net Income
x
x
Asset
Turnover
Net Sales
Net Sales
“Pennies of profit
on each dollar of
sales”
Average Total Assets
Ability to generate
sales revenue from
use of assets
Grocery store vs.
Fur salon
Grocery store vs.
Fur Salon
Ratio Analysis
The analyst obtains further insight into the behavior of ROA
by disaggregating it into components of profit margin on
sales and asset turnover as follows:
Rate of Return
on Assets
$64.2
=
=
($811.8 + 665.3) / 2
8.7%
Chapter
1-152
Profit Margin on
Sales
$64.2
x
x
15.28%
$420.1
($811.8 + 665.3) / 2
$420.1
=
Asset
Turnover
x
.569
Class Assignment Review Questions and
Homework for Ch. 5
Class Assignment Questions #2, 6, 7, 21, 22,
28, 32, 36 (pages 239-241)
Homework: (pages 239-250)
CE 5-4
Ex. 5-15
Prob. 5-1
Chapter
1-153
CHAPTER
6
ACCOUNTING AND THE
TIME VALUE OF MONEY
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-154
Summary of Chapter 6
1.
Distinguish between simple and compound interest.
2.
Use appropriate compound interest tables.
3.
Identify the ‘variables’ needed to solve time-value-of-money
problems.
4.
Draw Time-Line Diagrams
5.
Solve future and present value of single amount problems.
6.
Solve future value of ordinary annuity problems.
7.
Solve present value of ordinary and annuity due problems.
8.
Calculate issuance price of bonds, prepare amortization schedule,
and record related journal entries.
Chapter
1-155
Simple Interest
vs.
Compound Interest
Simple Interest
• principal sum
stays the same
from period to
period
Chapter
1-156
Compound Interest
• computed by adding
the interest earned in
one period to the
amount on which
interest is computed
in future periods
Simple Interest Illustrated
Ron Marshall invests $10,000 in an investment that
will return 8% SIMPLE INTEREST per year. The
investment is for 3 years.
What total amount will Marshall receive?
Simple Interest Principal  Rate  T ime
8
360
 $10,000

X 3 years
100 360
$800 times 3 years = $2,400 total interest
The total that Marshall will receive is $12,400.
($10,000.00 principal + $2,400. SIMPLE interest)
Chapter
1-157
Compound Interest Illustrated
Ron Marshall invests $10,000 in an investment that
will return 8% COMPOUND INTEREST per year.
The investment is for 3 years.
What total amount will Marshall receive?
Beginning
"Compound
Year
Investment
Interest Earned"
"Ending Investment"
1
$10,000
$ 800
$10,800
2
10,800
864
11,664
3
11,664
933
12,597
The total that Sanchez will receive is $12,597.
($10,000. principal + $2,597. COMPOUND interest)
Chapter
1-158
Most business situations use Compound Interest
Time Value of Money
1.) Two slides illustrating the IMPACT of time
value of money in “Investing for
Retirement” situations
2.) “Let’s Make a Deal” (Illustration of
importance of considering TIMING of cash
flow, not just dollar amount of cash flow)
3.) “Time-line diagrams” and my ‘formula’
slides for time-value-of-money
Chapter
1-159
Example #1—Investing for Retirement
If you invest $10,000 TODAY to earn interest
at 20% compound annual interest rate,
what total dollar amount will you have
when you are ready to retire 30 YEARS
FROM NOW?
Answer = $2,373,763.
Chapter
1-160
Example #2—Investing for Retirement
If you invest $200 per month starting today (at
age 45), that earns 20% compounded
annually, you would have invested a total of
$48,000 by age 65. At 65, when you retire,
you would have $494,402.
If you had started saving $200 per month at
age 40 (and thus invested $12,000 extra over
those 5 years), how much would you have at
age 65?
Answer = $1,249,278
Chapter
1-161
Quote from Albert Einstein:
“The most awesome power of the universe is that
of COMPOUND INTEREST”
Let’s Make a Deal
(I’ll tell you what’s behind each of the three
doors before you have to pick!)
Chapter
1-162
DOOR # 1
TODAY, I’LL GIVE YOU $10.
Chapter
1-163
DOOR #2
THREE YEARS FROM TODAY, I PROMISE TO
GIVE YOU $10.
Chapter
1-164
DOOR #3
THREE YEARS FROM TODAY, I PROMISE TO
GIVE YOU $12.60.
Chapter
1-165
SUMMARY



DOOR #1 = TODAY GET $10.
DOOR #2 = GET PROMISE OF $10 TO BE
RECEIVED 3 YEARS FROM NOW
DOOR #3 = GET PROMISE OF $12.60 TO BE
RECEIVED 3 YEARS FROM NOW
Which Door “Don’t” You Want? WHY?
Assuming 8% COMPOUND, annual interest; do you
want Door #1 OR Door #3?
Chapter
1-166
Choosing an Appropriate Interest Rate
Three Components of Interest:
“Pure” Rate of Return
Expected Inflation Rate
Credit Risk Rate
Chapter
1-167
1.) Future Value of
(Single Present Amount)
•
•
Now
1
2
$10.
3
?
F = P (Factor: n=3, i (8%), Table 6-1 on page 309)
F = $10. (1.25971)
F = $12.60
YOU DO NOT HAVE TO USE THE FORMULAS IN THE TEXTBOOK,
YOU CAN USE ‘MY FORMULAS’ IF YOU WISH!!!
Chapter
1-168
Time Periods (‘n’ rows) and Interest Rate Column (‘i)
•
•
When using tables, the left-hand column refers to
the number of interest compounding periods (n)
The columns on the tables are the interest rate per
compounding period (i)
•
•
Interest can, of course, be paid on a quarterly or
semiannual basis
To use the tables in these cases, it is necessary to:
•
•
Chapter
1-169
(a) divide the annual interest rate by the number of
compounding periods in the year to find the
appropriate interest rate column (i)
(b) multiply the number of compound interest periods
in one year by the number of years to find (n)
Example of Future Value of
(Single Present Amount)
Clock Corporation has $1,000,000 in cash to invest for 1 year. The
money is placed in an account that pays 8 percent annual interest -compounded quarterly. How much cash will the company have at
the end of the year?
Put “time-line diagram” on the board.
F = P (factor, n = 4; i=2%; Table 6-1 page 308))
F = $1,000,000 times 1.08243
F = $1,082,430
The company will have $1,082,430 at the end of the year.
Chapter
1-170
2.) Present Value of
(Single Future Amount)
•
Now
?
•
•
1
2
3
$12.60
P = F (Factor: n=3; i (8%); Table 6-2 on page 311)
P = $12.60 (.79383)
P = $10.
Chapter
1-171
Example of a Present Value of
(Single Future Amount)
Don Smith wants to have $2,000 at the end of three
years. How much must he invest today in a 5 percent
investment (annual compound interest) to achieve
this goal?
Put “time-line diagram” on the board
P = F (factor, n=3; i=5%; Table 6-2 Page 310)
P = $2,000 times .86384
P = $1,728
Chapter
1-172
Don must invest $1,728 today to have the
$2,000 he will need at the end of three years.
Annuities
Annuity requires:
(1)
Periodic payments or receipts (called rents) of the
same amount each period,
(2) Same-length interval between such rents, and
(3) Same interest rate applies to all the rents.
Two
Types
Chapter
1-173
Ordinary annuity - rents occur at the end of each period.
Annuity Due - rents occur at the beginning of each period.
3.) Future Value of an
“Ordinary” Annuity
•
Now
$10
•
•
•
2
$10
3
$10
?
Fa = A (Factor: n=3; i (8%); Table 6-3 on page 313)
Fa = $10 (3.24640)
Fa = $32.46
Chapter
1-174
1
Example of Future Value of an
“Ordinary Annuity”
Your parents agree to set aside cash at the end of each year to pay off your
$10,000 college loan due in 5 years. They will make 5 annual
contributions by the time the loan is due. The fund is projected to earn 8
percent, compounded annually. What must be the amount that your
parents must save annually (1st savings one year from now--ordinary
annuity when cash flows are at the end of each period)?
Use Future Value of Ordinary Annuity Formula, but solve for “A” the
annual annuity amount.
Put “time-line diagram” on the board
Fa = A (factor, n=5; i=8%; Table 6-3, Page 313)
$10,000 = A (5.86660)
A = $10,000/5.86660 = $1,705
Chapter
1-175
The required annual payment to the fund is $1,705.
4.) Present Value of an
“Ordinary” Annuity
•
•
Now
?
1
$10
2
$10
3
$10
Pa = A (Factor: n = 3; i (8%), Table 6-4 on page 315)
Pa = $10 (2.57710)
Pa = $25.77
Chapter
1-176
Example of Present Value
of an “Ordinary Annuity”
Cathy Crosby sold a piece of property and is to receive
three equal annual payments of $5,000 beginning one
year from today. What is the present value of this sale if
the current interest rate is 4 percent, compounded
annually?
Put “time-line diagram” on the board
Pa = A (factor, n=3; i=4%; Table 6-4 on page 314)
Pa = $5,000 times 2.77509
Pa = $13,875
The present value of the $5,000 annuity stream is $13,875
Chapter
1-177
5.) Present Value of an
“Annuity Due”
Periodic rents occur at the BEGINNING of the period.
Now
1
2
3
• $10
$10
$10
•
?
Pad = A (Factor: n = 3; i (8%), Table 6-5 on page 317)
Pad = $10 (2.78326)
Pad = $27.83
Chapter
1-178
Example of Present Value of an
“Annuity Due”
Space Odyssey, Inc., leases a communications satellite for
4 years with annual rental payments of $4.8 million to be
made at the beginning of each year. If the relevant annual
interest rate is 11%, what is the present value of the
rental obligations?
Put “time-line diagram” on the board
Pad = A (factor, n=4; i=11%; Table 6-5 on page 317)
Pad = $4.8 million times 3.44371
Pad = $16,529,808
The present value of the $4.8 million annuity stream is $16,529,808
Chapter
1-179
Deferred Annuities
-You are NOT Responsible for Deferred
Annuities
Rents begin after a specified number of periods.
Present Value
Future Value
100,000
100,000
100,000
.....
0
Chapter
1-180
1
2
3
4
19
20
Bonds Payable Liability--Issue Date
Bond Selling Price (CASH)
Bond Certificate
at Face (“Maturity”) Value
Corporation
Bond Issue
Date
Chapter
1-181
Bond Investors
Bonds Payable--Interest Payments
Bond Interest
Payments (CASH)
Corporation
Bond Issue
Date
Chapter
1-182
Bond Interest Payments
Investors
Cash Interest Payment =
Principal × Cash Interest Rate × Time
Bonds Payable--Maturity Date
Bond Face Value (CASH)
at Maturity Date
Corporation
Bond Issue
Date
Chapter
1-183
Investors
Bond
Maturity
Date
Selling Price of Bonds Payable
The selling price of a bond is determined by the
“market” based on the time value of money.
Two Cash Flows to be paid:
$12,000 annual cash interest payments
$200,000 cash payment at maturity
today
1
2
3……….10
$?
Selling
Price = $?
Chapter
1-184
$12,000 $12,000
$12,000.........$12,000
interest payments
$200,000
Principal
Payment
.
Illustration--Bonds Payable Issued at “Discount”
XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The bonds
pay interest annually on December 31. The market rate of interest on
bonds of a similar default risk is 10% on the date the bonds are issued.
Requirements:
1.) Calculate the issuance (selling price) of the bonds:
a.) Using ‘formulas’
b.) Using “PV” function in Excel
2.) Prepare an amortization table for the 10 interest payments
3. Prepare the required "journal entry" to record:
a.) The issuance of the bonds payable on January 2, 2008
b.) The first annual interest payment on Dec. 31, 2008 (USING THE
EFFECTIVE INTEREST METHOD—NOT STRAIGHT LINE--TO
AMORTIZE THE BOND DISCOUNT)
c.) The retirement of the bonds on the maturity date
Link to Excel worksheet with Solutions to Class Problem
Chapter
1-185
Summary of Time Value of Money Situations You
Are Responsible For
Single Dollar
Amounts
Future value of a
single present
amount
Present value of a
single future amount
Solving for other
unknowns (i.e., ‘n’
the number of
interest periods and
‘i’ the interest rate
per interest period)
Chapter
1-186
Annuities
Future value of ordinary annuity
Future value of annuity due* (NOT
Responsible for this one)
Present value of ordinary annuity
Present value of annuity due
Solving for other unknowns (i.e.,
‘n’ the number of interest periods;
‘i’ the interest rate per interest
period); ‘A’ the annuity amount)
* Your textbook does NOT provide a
Table for Future Value of an
Annuity Due (and we are NOT
going to create the Table)
Deferred Annuities
(That You are NOT Responsible For)
Rents begin after a specified number of periods.
Future Value - Calculation same as the future value of an
annuity not deferred.
Present Value - Must recognize the interest that accrues
during the deferral period.
Present Value
Future Value
100,000
100,000
100,000
.....
0
Chapter
1-187
1
2
3
4
19
20
Class Assignment Review Questions and Homework
for Ch. 6
Class Assignment Questions #3, 4, 6, 9, 17
(skip ‘b’), 18 (page 295)
Homework: (pages 297-301)
Ex. 3; Prob. 2 (skip ‘b’); and
Proprietary Problem on next slide (similar to
class problem--BUT Market interest rate on
date bonds were issued for the homework is
4%)
Chapter
1-188
Proprietary Ch. 6 Homework Problem
XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The
bonds pay interest annually on December 31. The market rate of
interest on bonds of a similar default risk is 4% on the date the
bonds are issued.
Requirements:
1.) Calculate the issuance (selling price) of the bonds:
a.) Using ‘formulas’
b.) Using “PV” function in Excel
2.) Prepare an amortization table for the 10 interest payments
3. Prepare the required "journal entry" to record:
a.) The issuance of the bonds payable on January 2, 2008
b.) The first annual interest payment on Dec. 31, 2008 (USING THE
EFFECTIVE INTEREST METHOD—NOT STRAIGHT LINE--TO
AMORTIZE THE BOND PREMIUM)
c.) The retirement of the bonds on the maturity date
Chapter
1-189
CHAPTER
7
CASH AND RECEIVABLES
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-190
Cash and Receivables -- Summary of Chapter 7
Cash
What is cash?
Reporting cash
Petty cash fund
Bank reconciliation
Receivables
Recognition and
valuation of accounts
receivable
Recognition and
valuation of notes
receivable
Disposition of accounts
and notes receivable
Ratio analysis
Impairment of long-term
receivable (loans)
Chapter
1-191
What is Cash?
Cash Examples: coins, currency, checking accounts,
money orders, certified checks, cashier’s checks, personal
checks, and savings accounts.
What about ‘posted-dated checks’, IOUs, postage stamps--are
they included in Cash?
Cash Equivalents: short-term, highly liquid investments
that are both: a.) readily convertible to cash, and b.) so near
their maturity (within 90 days) that they present insignificant
risk of changes in interest rates.
Examples: Treasury bills, Commercial paper, and Money market funds.
With the market drying up for ‘auction securities’ (a cash
equivalent) during the credit crises, the combining of cash and
cash equivalents on the balance sheet may become infrequent!
Chapter
1-192
Reporting Cash
Restricted Cash
Companies segregate restricted cash from “regular”
cash for reporting purposes.
Examples, restricted for: (1) plant expansion, (2)
retirement of long-term debt, and (3) compensating
balances -- ‘legally restricted’.
Bank Overdrafts
When a company writes a check for more than the
amount in its cash account, it generally is reported as a
current liability.
Offset against cash account only when available cash is
present in another account in the same bank on which the
Chapter overdraft occurred.
1-193
The Imprest Petty Cash System (part of
Internal Control System over Cash)
Used to pay small amounts for miscellaneous expenses.
1. Record $300 transfer of funds to petty cash to
establish the petty cash fund:
Petty Cash
Cash
300
300
2. The petty cash custodian obtains signed receipts from
each individual to whom he or she pays cash from the
fund, BUT no journal entries are made to record the
disbursements as they are made from the fund.
Chapter
1-194
The Imprest Petty Cash System (Continued)
3. Custodian receives a company check to replenish the
fund.
Office Supplies Expense
42
Postage Expense
53
Entertainment Expense
76
Cash Over and Short
Cash
2
173
IF material--adjusting entry needed at end of accounting
period for any unreplenished disbursements in the petty
cash fund.
Chapter
1-195
Bank Reconciliation
Schedule explaining any differences between the
bank’s and the company’s records of cash.
Reconciling Items:
1. Deposits in transit.
2. Outstanding checks.
Time Lags
3. Bank charges and credits.
4. Bank or Depositor errors.
We will use the ‘dual’ format bank reconciliation used in your
textbook (Appendix 7A):
1.) Bank balance reconciled to correct bank balance
Chapter
1-196
2.) Book balance reconciled to correct book balance
Bank Reconciliation -- Example (Also journal entries based on
completed reconciliation)
Chapter
1-197
Completed Bank Reconciliation
Chapter
1-198
Journal Entries for Bank Reconciliation Example
Nov. 30
Cash
Interest revenue
600
Accounts payable
180
Accounts receivable
Bank service charge expense
Cash
Chapter
1-199
780
220
18
238
Receivables
Claims held against customers and others
money, goods, or services.
for
Oral promises of the
customer to pay for
goods and services sold.
Written promises to pay
a sum of money on a
specified future date.
Accounts Receivable
(aka.“Trade
Receivable”)
Notes Receivable
Chapter
1-200
Receivables
Non-trade Receivables (i.e., Misc. Receivables)
1.
2.
3.
4.
5.
6.
Advances to officers and employees.
Advances to subsidiaries.
Deposits to cover potential damages or losses.
Deposits as a guarantee of performance or payment.
Dividends and interest receivable.
Claims against:
a)
b)
c)
d)
e)
f)
Chapter
1-201
Insurance companies for casualties sustained.
Defendants under suit.
Governmental bodies for tax refunds.
Common carriers for damaged or lost goods.
Creditors for returned, damaged, or lost goods.
Customers for returnable items (crates, containers, etc.).
Accounts Receivables
“Trade Discounts”
Reductions from the list
price
Not recognized in the
accounting records
Customers are billed net
of trade discounts
Chapter
1-202
10 %
Discount for
Wholesalers
Accounts Receivables
“Cash Discounts”
(aka. Sales Discounts)
Inducements for prompt
payment
Payment
terms are
2/10, n/30
As the buyer, would you take your money out of an
investment where it is earning 8% to take advantage of a
cash discount of 2/10,n30?
Chapter
1-203
As a seller, why would you offer ‘cash discounts’ to
your customers?
Accounts Receivables
Non-recognition of Interest on Accounts Receivable
GAAP specifically excludes from present value
considerations “receivables arising from
transactions with customers in the normal course
of business which are due in customary trade terms
not exceeding approximately one year.”
Chapter
1-204
Short-term Accounts Receivables do however need
to be presented at Net Realizable Value (NRV) which
necessitates an adequate Allowance for Doubtful
Accounts (aka. “Allowance for Bad Debts” or just
plain “Allowance”)
Accounts Receivable
Assets
Current Assets:
Cash
Accounts receivable
Less: Allowance for doubtful accounts
Inventory
Prepaids
Total current assets
Fixed Assets:
Office equipment
Furniture & fixtures
Less: Accumulated depreciation
Total fixed assets
Total Assets
Chapter
1-205
$
500
(25)
346
475
812
40
1,673
$
5,679
6,600
(3,735)
8,544
10,217
What is the NRV of the accounts receivable on the partial
Balance Sheet above?
Valuation of Accounts Receivable
Methods of Accounting for Uncollectible Accounts
Direct Write-Off
Theoretically undesirable:
No matching
Receivable not stated at
net realizable value
Not GAAP
Chapter
1-206
Allowance Method
Losses are Estimated:
Percentage-of-sales (aka. “income
statement approach”)
Percentage-of-receivables/”aging”
(aka. “balance sheet approach”)
GAAP
Uncollectible Accounts Receivable
Summary
Percentage of Sales (income statement approach):
Bad debt expense estimate is related to an income
statement account (Sales Revenue), any balance in the
allowance account is ignored.
Achieves a proper matching of expenses and revenues.
Percentage of Receivables (balance sheet approach):
Results in a more accurate valuation of receivables on the
balance sheet.
Method may also be applied using an aging schedule.
Chapter
1-207
Class Example
The Ex., Why, Zee Company began operations on Jan. 1, 2008.
Record journal entries for the following:







Chapter
1-208
Monthly sales on account of $20,000
Monthly estimated bad debts of 1% of sales on account
Write off of John Jones’s individual account receivable for
$150 when it ultimately proves uncollectible.
Write off of Janice Smith’s individual account receivable for
$280 when it ultimately proves uncollectible
Unexpectantly recover the amount due from Mr. Jones when he
sends to Ex., Why, Zee Company a check for $150.
Collect $175,000 of Accounts Receivable (in addition to the
above $150 from Mr. Jones)
At December 31, 2008 year-end, the adjusting entry to revise
Allowance account to the current estimated balance of $1,400.
Link to the Solution for Bad Debt Accounting
Recording of Notes Receivable
Short-Term Note
Record at Face Value, set up
Allowance
Long-Term
Record at Present Value*
of cash expected to be collected
Interest Rates
Note Issued at
Stated cash interest rate = Market rate
Face Value
Stated rate interest rate > Market rate
Premium
Stated rate interest rate < Market rate
Discount
Subsequent to receipt of note receivable:
a.) Note disclosure is required showing Fair Market Value of Note
b.) Option to actually ‘revalue’ Note to Fair Market Value
Chapter
1-209 c.)
Test for ‘impairment’ loss
Non (or Zero)-Interest-Bearing Note
Illustration: Jeremiah Company receives a three-year,
$10,000 zero-interest-bearing note. The market rate of
interest for a note of similar risk is 9 percent. How does
Jeremiah record the receipt of the note?
i = 9%
$10,000
0
$0
$0
$0
1
3
3
n=3
Chapter
1-210
Principal
Interest
Zero-Interest-Bearing Note
PV of Principal
P = F (factor)
P = $10,000 x
P = $7,721.80
Chapter
1-211
.77218
Zero-Interest-Bearing Note
Journal Entries for Zero-Interest-Bearing note
Present value of expected future cash flows
($10,000. principal and zero interest) = $7,721.80
Date
Jan. yr. 1
Dec. yr. 1
Account Title
Notes receivable
Credit
10,000.00
Discount on notes receivable
2,278.20
Cash
7,721.80
Discount on notes receivable
Interest revenue
($7,721.80 x 9%)
Chapter
1-212
Debit
694.96
694.96
Zero-Interest-Bearing Note
Chapter
1-213
Unrealistically Low Interest-Bearing Note
Illustration: Morgan Corp. makes a loan to Marie Co. and
receives in exchange a three-year, $10,000 note bearing
interest at 10 percent annually. The market rate of interest
for a note of similar risk is 12 percent. How does Morgan
record the receipt of the note?
i = 12%
0
Principal
Interest
$1,000
1,000
1,000
1
2
3
n=3
Chapter
1-214
$10,000
Unrealistically Low Interest-Bearing Note
PV of INTEREST
Pa = A (factor)
Pa = $1,000 x
Pa = $2,402
Chapter
1-215
2.40183
Unrealistically Low Interest-Bearing Note
PV of PRINCIPAL
P = F (factor)
P = $10,000 x
P = $7,118
Chapter
1-216
.71178
Interest
Principal
Total present value = $9,520 ($2,402 + $7,118)
Unrealistically Low Interest-Bearing Note
Journal Entries
Date
Beg. yr. 1
Account Title
Notes receivable
Debit
10,000
Discount on notes receivable
480
Cash ($2,402 + $7,118)
End. yr. 1
Cash
Discount on notes receivable
Interest revenue
($9,520 x 12%)
Chapter
1-217
Credit
9,520
1,000
142
1,142
Unrealistically Low Interest-Bearing Note
Chapter
1-218
Notes Received for Property, Goods, or Services
In a “bargained transaction” entered into at arm’s length,
the stated cash interest rate is presumed to be fair unless:
1. No interest rate is stated, or
2. Stated interest rate is unreasonable, or
3. Face amount of the note is materially different from
the current cash sales price.
Chapter
1-219
Illustration
Oasis Development Co. sold a corner lot to Rusty Pelican as a
restaurant site. Oasis accepted in exchange a five-year note
having a face (maturity) value of $35,247 and no stated
interest rate. The land originally cost Oasis $14,000. At the
date of sale the land had a fair market value of $20,000.
Oasis uses the fair market value of the land, $20,000, as the
present value of the note. Oasis therefore records the sale
as:
Notes Receivable
35,247
Discount on Notes Receivable ($35,247 - $20,000) 15,247
Land
14,000
Gain on Sale of Land
6,000
Chapter
1-220
Note: “Gain” of $6,000 recorded at time of ‘sale’ while $15,247
of Interest Revenue will be recorded over life of note.
Illustration (recording fair value option)
Assume that Escobar Company has notes receivable that
have a fair value of $810,000 and a carrying amount of
$620,000. Escobar decides on December 31, 2010, to use the
fair value option for these receivables. This is the first
valuation of these recently acquired receivables. At
December 31, 2010, Escobar makes an adjusting entry to
record the increase in value of Notes Receivable and to
record the unrealized holding gain, as follows.
Notes Receivable
190,000
Unrealized Holding Gain or Loss—Income
Chapter
1-221
190,000
Disposition of Accounts and Notes Receivable
Owner may transfer accounts or notes receivables to
another company for cash:
 Competition (‘industry characteristic’)
 Sell receivables because money is tight.
 Billing / collection are time-consuming and costly.
Transfer accomplished by:
1. Borrow using receivables as collateral for the loan
2. Sale of receivables -- a sale occurs only if the seller
surrenders control of the receivables to the buyer.
Chapter
1-222
Illustration of Secured Borrowing
On April 1, 2010, Prince Company assigns $500,000 of its
accounts receivable to the Third National Bank as collateral for a
$300,000 loan due July 1, 2010. The assignment agreement calls for
Prince Company to continue to collect the receivables. Third National
Bank assesses a finance charge of 2% of the accounts receivable, and
interest on the loan is 10% (a realistic rate of interest for a note of
this type).
Instructions:
a)
Prepare the April 1, 2010, journal entry for Prince Company.
b) Prepare the journal entry for Prince’s collection of $350,000 of
the accounts receivable during the period from April 1, 2010,
through June 30, 2010.
c)
Chapter
1-223
On July 1, 2010, Prince paid Third National all that was due from
the loan it secured on April 1, 2010.
Illustration of Secured Borrowing - Continued
Date
(a)
Account Title
Cash
Finance Charge
Debit
Credit
290,000
10,000
Notes Payable
300,000
($500,000 x 2% = $10,000)
(b)
Cash
350,000
Accounts Receivable
(c)
Notes Payable
350,000
300,000
Interest Expense
Cash
7,500
307,500
(10% x $300,000 x 3/12 = $7,500)
Chapter
1-224
Which category of Cash Flow (Operating or Financing) for ‘a’ and ‘c’?
Sales of Receivables
Sale Without Recourse
The ‘Factor’ (finance company or bank that purchases
the receivables) assumes risk of collection (i.e., bad
debts)
Transfer is outright sale of receivable
Seller records loss on sale
Seller uses “Due from Factor” (asset account) to
cover for possible discounts, returns, and allowances
Sale With Recourse
Seller guarantees payment to purchaser
Estimated liability (“Recourse Obligation”) for possible
uncollectible accounts set up)
Chapter
1-225
Sales of Receivables -- WITHOUT RECOURSE
Illustration: Crest Textiles, Inc. factors $500,000 of accounts
receivable with Commercial Factors, Inc., on a without recourse
basis. Commercial Factors assesses a finance charge of 3
percent of the amount of accounts receivable and retains an
amount equal to 5 percent of the accounts receivable (for
probable adjustments). Crest Textiles makes the following
journal entry for the receivables transferred without recourse.
Cash ($500,000 less 3% finance charge and 5% ‘holdback’)
460,000
Due from Factor (the ‘holdback’ of 5% of $500,000)
25,000
Loss on Sale of Receivables (3% x $500,000)
15,000
Accounts Receivable
Chapter
1-226
500,000
Sales of Receivables -- WITH RECOURSE
Illustration: Assume Crest Textiles sold the receivables on a with recourse
basis. Crest Textiles determines that this recourse obligation has a fair value
of $6,000. To record the sale of the receivables with recourse, Crest Textiles
records the following journal entry:
Cash
460,000
Due from factor (“holdback”)
25,000
Loss on Sale of Receivables (3% of $500,000 plus the Recourse Liab.) 21,000
Accounts Receivable
500,000
Recourse Liability (Crest would have to ‘make good’ if bad
6,000
debts proved to be abnormally high)
Chapter
1-227
Presentation of Receivables
General rules in classifying receivables are:
1.
Segregate the different types of receivables that a company
possesses, if material.
2. Appropriately offset the valuation accounts (Allowances)
against the proper receivable accounts.
3. Determine that receivables classified in the current assets
section will be converted into cash within the year or the
operating cycle, whichever is longer.
4. Disclose any loss contingencies that exist on the receivables.
5. Disclose any receivables designated or pledged as collateral.
6. Disclose all significant concentrations of credit risk arising
from receivables.
Chapter
1-228
Ratio Analysis of Receivables
This Ratio used to:
Assess the liquidity of the receivables.
Is an average collection period of 39.7 days ‘good’? What
would you compare it to?
Industry average (or ‘best competitors’ average)
Prior years
Chapter
1-229
“Expected” or “forecasted”
Impairment of Receivables
Companies evaluate their receivables to determine their
ultimate collectibility.
Allowance method is appropriate when:
 probable that an asset has been impaired and
 amount of the loss can be reasonably estimated.
For long-term receivables (such as loans) that are
identified as impaired, companies perform an additional
impairment evaluation.
The impairment test -- Impairment loss is calculated as the
difference between the investment in the loan (generally the
principal plus accrued interest) and the expected future cash
flows discounted at the loan’s historical effective interest rate.
Chapter
1-230
Illustration
At December 31, 2009, Ogden Bank recorded an investment of
$100,000 in a loan to Carl King. The loan has an historical
effective-interest rate of 10 percent, the principal is due in full at
maturity in three years, and interest is due annually. The loan
officer performs a review of the loan’s expected future cash flows
and utilizes the present value method for measuring the required
impairment loss.
Chapter
1-231
Illustration: Computation of Impairment Loss
Recorded investment
$100,000
Less: Present value of ‘estimated’ cash flows:
P = F (factor) P = $100,000 (.75132) $75,132
Pa = A (factor) Pa = $5,000 (2.48685) 12,431 87,563
LOSS ON IMPAIRMENT
$12,437
Recording Impairment Losses
Bad Debt Expense
Allowance for Doubtful Accounts
Chapter
1-232
12,437
12,437
Subprime Loan Crisis.

From 2000 to 2005 home prices appreciated at rapid rate.

Low interest rates also encouraged speculation, as many believed
that home prices would continue to increase.

Speculators (“flippers”) intended to sell the house in a short
period.

Many adjustable-rate debt with short-term low teaser rates that
would adjust to higher market rates after two or three years.

Many lending institutions gave loans to individuals whose financial
condition would make it difficult for them to make the payments
over the life of the loan. These loans, often referred to as
subprime loans.
Chapter
1-233
Background -
Beyond the
subprime
loans was the
practice of
securitization
Chapter
1-234
Example: Subprime loan crisis
Class Assignment Review Questions and
Homework for Ch. 7
Class Assignment Questions # 1, 4, 5, 8, 11, 15,
16, 19, 21, 28 (pages 358-359)
Homework (pages 359-371):
BE7-1
Ex. 7-16 (part ‘b’ only), Ex. 7-17 (part ‘a’ only),
Ex. 7-27
Prob. 7-2, Prob. 7-12
Chapter
1-235
CHAPTER
8
VALUATION OF INVENTORIES:
A COST-BASIS APPROACH
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-236
Why Inventory is so Important

INVENTORIES—just another specific asset we will
cover—right???
Answer = WRONG!!! UNDERSTAND.
1. Very important asset if firm sells a product
(GM, Wal-Mart, Dell Computers)
2. Results in biggest EXPENSE on Income Statement!
3. Buy for $200 from vendor, sell to customer for
$180—how are we doing?
4. Buy from catalog for $80 (which is less than $82
charged by local vendor). Then pay $6. shipping
charge—how are we doing?
Chapter
1-237
Importance of Inventories (cont’d.)
5. Run out of inventory and production line shuts down. How we
doing? (“Just-in-Time” inventory levels)
6. Obsolete/overstocked inventory on hand. How are we
doing?
7. “More efficient supply chain” (EDI)—let supplier access
your computer inventory records to determine when and how
much to ship to you—good idea?
8. Inventory returns by customers to us and from us back to
vendors—how are we doing?
9. Cash discounts for prompt payment—good idea?
10. Inventory errors—common? Any impact on Financial
Statements?
Chapter
1-238
Summary of Chapter 8
1.
Identify major classifications of inventory for merchandising company and
a manufacturing company.
2.
Distinguish between perpetual and periodic inventory systems.
3.
Identify the effects of inventory errors on the current year’s and
following year’s financial statements.
4.
Understand the items to include as inventory cost (all reasonable and
necessary costs of acquiring the inventory and getting it ready for sale).
5.
Describe and compute inventory and cost of goods sold expense for the
various inventory cost flow methods (Specific Identification, FIFO, LIFO,
Weighted-Average Cost).
6.
Identify the major advantages and disadvantages of the various inventory
cost flow methods.
7.
Explain the significance and use of a LIFO reserve.
8.
Explain the dollar-value LIFO method.
Chapter
1-239
Classification of Inventories
Merchandiser
Merchandise Inventory
Manufacturer
or
Raw Materials
Work in Process
Finished Goods
Chapter
1-240
Inventory Cost Flow
Chapter
1-241
IMPORTANT ‘FORMULA’ TO UNDERSTAND
Companies must allocate the cost of all the goods
available for sale between the goods that are still on
hand (i.e., Ending Inventory) and the goods that were
sold during the period (i.e., COST OF GOODS SOLD
EXPENSE)
Chapter
1-242
‘Formula’ Inputs for Ending Inventory
Quantity of inventory on hand--the inventory that the
company has legal title to on the date of the financial
statements (goods on hand, goods in transit
[depending on shipping terms], consigned goods,
special sales agreements).
Costs to include for inventory (all reasonable and
necessary costs of acquiring the inventory and getting
it ready for sale).
Cost flow assumption selected (Specific
Identification, FIFO, LIFO, Weighted-Average Cost)
Chapter
1-243
Systems for maintaining inventory records
Perpetual system or Periodic system
Perpetual System
1.
Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and
allowances and purchase discounts (cash discounts) are
credited to Inventory.
3. Cost of goods sold is debited and Inventory is credited for
each sale.
4. Subsidiary records show quantity and cost of each type of
inventory on hand.
The perpetual inventory system provides a continuous
record of Inventory and Cost of Goods Sold.
Chapter
1-244
Systems for maintaining inventory records
Perpetual system or Periodic system
Periodic System
1. Purchases of merchandise are debited to “Purchases”.
2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold:
Beginning inventory
Purchases, net
800,000
Goods available for sale
900,000
Ending inventory
125,000
Cost of goods sold (“plug”)
Chapter
1-245
$ 100,000
$ 775,000
Perpetual vs. Periodic -- An Illustration
Festive Company had the following transactions during the current year.
Record these transactions using the Perpetual and Periodic
systems.
Chapter
1-246
Perpetual vs. Periodic -- An Illustration
Illustration:
Inventory
Cash (or Accounts Payable)
5,400
Accounts Receivable
Sales Revenue
7,200
5,400
5,400
Purchases
Cash (or Accounts Payable)
7,200
7,200
Accounts Receivable
Sales Revenue
Cost of Goods Sold Expense (600 x $6.) 3,600
Inventory
3,600
No entry necessary to adjust inventory
The Inventory account shows the correct ending balance
of $2,400 ($600 bb + $5,400 bought - $3,600 sold)
Chapter
1-247
5,400
7,200
NO Entry
Inventory (ending per count)
2,400
Cost of Goods Sold Expense (plug) 3,600
Purchases
Inventory (beginning)
5,400
600
Errors in Measuring Ending Inventory

Misstatements in inventory will cause errors in the
following areas:
 Income Statement


Balance Sheet


Chapter
1-248
Cost of Goods Sold, Gross Profit, Taxes, Net Income
Inventory, Retained Earnings
Because the ending inventory of one period
becomes the beginning inventory of the next
period, ending inventory errors affect two
accounting periods (two Income Statements but only
one Balance Sheet).
Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6.
Sales
C of G. Sold:
Begin. Inv.
+Purchases
Gds. Avail.
- Ending Inv.
=C. of G. Sold
Gross Profit
As Reported
Year 1 Year 2
100
As Corrected
Year 1 Year 2
100
12
58
70
16
54
12
58
70
10
60
46
40
• What were the effects of the error on the Yr. 1 Financial Statements:
Income Statement?
Chapter
1-249
Balance Sheet?
Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6.
Sales
C of G. Sold:
Begin. Inv.
+Purchases
Gds. Avail.
- Ending Inv.
=C of G. Sold
Gross Profit
As Reported
Year 1 Year 2
140
As Corrected
Year 1 Year 2
140
16
54
16
74
90
8*
82
10
60
10
74
84
8*
76
46
58
40
64
• *No ‘new’ error in calculating Year 2’s ending inventory!
• What were the effects of the error on the Yr. 2 Financial Statements:
Chapter
1-250
Income Statement?
Balance Sheet?
What was the effect of OVERSTATING the Year 1
ending inventory by $6? (ignore taxes)
Sales
Year 1
No effect
Year 2
No effect
Begin. Inventory
No effect
Overstated $6
No effect
No effect
+ Purchases
Goods Avail. 4 Sale No effect
- Ending Inventory
Overstated $6
Overstated $6
No effect
Cost of Goods Sold Understated $6 Overstated $6
Gross Profit
Overstated $6
Understated $6
Net Income
Overstated $6
Understated $6
Ret. Earn, end. Bal. Overstated $6
No effect (why?)
Does Bal. Sheet Balance?
Chapter
1-251
Does Bal. Sheet Balance?
Accounting for Purchase (Cash) Discounts
Using the Periodic System
Purchases
Accounts Payable
10,000
10,000
Accounts Payable
Purchase Discounts
Cash
4,000
Accounts Payable
Cash
6,000
* $4,000 x 2% = $80
** $10,000 x 98% = $9,800
Chapter
1-252
80*
3,920
6,000
Purchases
Accounts Payable
Accounts Payable
Cash
**
9,800
9,800
3,920
3,920
Accounts Payable
5,880
Purchase Discounts Lost (‘stupidity exp.) 120
Cash
6,000
Which Cost Flow Assumption to Adopt?
FIFO
LIFO
Cost Flow Assumption Adopted
does NOT need to be the same as the
Physical Movement of Goods
Weight-Average Cost
Specific Identification
We’ll illustrate the calculations then discuss
which inventory cost flow method is ‘correct’!
Chapter
1-253
HAPPY HARRY’S USED CARS

Purchase 1965 VW Beetle for $400.
Purchase 2009 Rolls Royce for $350,000.

Inventory Count at year end = 1 car




What is the only inventory “costing”
method that makes any sense?

Chapter
1-254
What is Cost of Ending Inventory?
What is Cost of Goods Sold Expense?
SPECIFIC IDENTIFICATION!
Specific Identification Method
Units in the ending inventory are identified as coming from specific purchases
Inventory Data
June 1
Inventory
6
Purchase
25
Purchase
Goods available 4 sale
80 units @ $10.00
220 units @ $12.50
200 units @ $14.00
500 units
Sales
On hand June 30
280 units
220 units
$ 800
2,750
2,800
$6,350
Specific Identification Method
50 units @ $10.00 $ 500 Cost of goods avail. for sale
1,250 Less June 30 inventory
100 units @ $12.50
980 Cost of goods sold
70 units @ $14.00
220 units at cost of $2,730
Chapter
1-255
$6,350
2,730
$3,620
Specific Identification
Used when a company’s
inventory consists of many
high priced items that are easy
to differentiate (e.g., a car
dealer)
What about the 10,000 test
tubes in the ending inventory
of a scientific apparatus
warehouse? Would specific
identification work as an
inventory costing method?
Chapter
1-256
FIFO
FIFO = First-In, First-Out
First COSTS into inventory are the first COSTS out of inventory:

Question: Where are the costs going when they leave
inventory?

Answer = To COST OF GOODS SOLD EXPENSE on the Income
Statement
Thus under FIFO--The first (earliest) costs into inventory are
transferred to Cost of Goods Sold Expense when inventory items
are sold.
Thus under FIFO--The last (most recent) inventory purchase COSTS
remain in ending inventory. ENDING INVENTORY IS WHAT YOU
WANT TO CALCULATE; THEN YOU CAN “PLUG” COST OF
GOODS SOLD EXPENSE!
Chapter
1-257
FIFO/LIFO Comparison
(My Simple Example)
FIFO
Chapter
1-258
LIFO
Beg. 1 unit @ $3.
Beg. 1 unit @ $3.
Purchases:
1 unit @ $4.
1 unit @ $5.
1 unit @ $6.
Available
$18.
1 unit End.Inv. ?
3 units CofGS ?
Purchases:
1 unit @ $4.
1 unit @ $5.
1 unit @ $6.
Available
$18.
1 unit End.Inv. ?
3 units CofGS ?
FIFO (My Simple Example)
FIFO
Beg. 1 unit @ $3.
Purchases:
1 unit @ $4.
1 unit @ $5.
1 unit @ $6.
Available
$18.
1 unit End Inv. - 6.
3 units CofGS $12.
Chapter
1-259
$12 Cost of Goods Sold Expense
First-In, First-Out (FIFO) Method
An Illustration
Assumes that
the first costs
into inventory
will be the first
costs out of
inventory for
the units sold.
Ending
inventory is
thus composed
of inventory
costs from the
LAST (most
recent)
purchases.
Chapter
1-260
Inventory Data
June 1
Inventory
6
Purchase
25
Purchase
Goods available 4 sale
80 units @ $10.00
220 units @ $12.50
200 units @ $14.00
500 units
Sales
On hand June 30
280 units
220 units
$ 800
2,750
2,800
$6,350
First-In, First-Out (FIFO) Method
200 units @ $14.00 from purchase of June 25 $2,800
20 units @ $12.50 from purchase of June 6
250
220 units in Ending Inventory at a cost of
$3,050
Cost of goods avail. for sale
Less June 30 inventory (calculate)
Cost of goods sold (plug)
$6,350
3,050
$3,300
LIFO
LIFO = Last-In, First-Out
Last COSTS into inventory are the first COSTS out of inventory:

Question: Where are the costs going when they leave
inventory?

Answer = To COST OF GOODS SOLD EXPENSE on the Income
Statement
Thus under LIFO--The last (most recent purchase) costs into
inventory are transferred to Cost of Goods Sold Expense when
inventory items are sold.
Thus under LIFO--The first (earliest) inventory purchase (including
beginning inventory) COSTS remain in ending inventory. ENDING
INVENTORY IS WHAT YOU WANT TO CALCULATE; THEN YOU
CAN “PLUG” COST OF GOODS SOLD EXPENSE!
Chapter
1-261
FIFO/LIFO Comparison
(My Simple Example)
FIFO
Chapter
1-262
LIFO
Beg. 1 unit @ $3.
Beg. 1 unit @ $3.
Purchases:
1 unit @ $4.
1 unit @ $5.
1 unit @ $6.
Available
$18.
1 unit End.Inv. ?
3 units CofGS ?
Purchases:
1 unit @ $4.
1 unit @ $5.
1 unit @ $6.
Available
$18.
1 unit End.Inv. ?
3 units CofGS ?
LIFO (My Simple Example)
LIFO
Beg.
1 unit @ $3.
Purchases:
1 unit @ $4.
1 unit @ $5.
1 unit @ $6.
Available
$18.
1 unit End. Inv. - 3._
3 units CofGS $15.
Chapter
1-263
$3 Ending Inventory
$15 Cost of Goods Sold
Expense
Last-In, First-Out (LIFO) Method
An Illustration
Inventory Data
Ending inventory is
priced using the earliest
purchases (Including
Beg. Inventory)
June 1
Inventory
6
Purchase
25
Purchase
Goods available 4 sale
80 units @ $10.00
220 units @ $12.50
200 units @ $14.00
500 units
Sales
On hand June 30
280 units
220 units
Last-In, First-Out (LIFO) Method
80 units @ $10.00 from June 1 inventory
140 units @ $12.50 from purchase of June 6
220 units in Ending Inventory at a cost of
Cost of goods avail. for sale
Less June 30 inventory
Cost of goods sold
© Royalty Free C Squared Studios/ Getty Images
Chapter
1-264
$6,350
2,550
$3,800
$800
2,750
2,800
$6,350
$ 800
1,750
$2,550
Weighted-Average Cost Method
Inventory Data
Inventory is priced
at the weighted
average cost of the
goods available for
sale during the
period
June 1
6
25
Inventory
Purchase
Purchase
80 units @ $10.00
220 units @ $12.50
200 units @ $14.00
Goods available 4 sale
500 units
Sales
On hand June 30
280 units
220 units
$800
2,750
2,800
$6,350
Cost of Goods Available for Sale ÷ Units Available for Sale = Weighted-Average Unit Cost
$6,350 ÷ 500 units = $12.70
Ending Inventory = 220 units @ $12.70 = $2,794
Cost of goods avail. for sale
Less June 30 inventory
Cost of goods sold
Chapter
1-265
$6,350
2,794
$3,556
© Royalty Free C Squared Studios/ Getty Images
Impact of Inventory Costing Methods Alternatives
Which method would you chose if it were your company? WHY?
Chapter
1-266
Limit your choices to just FIFO or LIFO!
LIFO “LIQUIDATION”
Illustration: Basler Co. has 30,000 pounds of steel in its inventory
on December 1, 2010, with cost determined as shown below. The
CEO says she needs YOU (the controller) to ‘do something’ in order
to utilize an NOL Carryforward that is scheduled to expire on
December 31, 2010. Will a LIFO Liquidation accomplish the CEO’s
goal and save your job? Legal? Ethical?
LIFO Inventory existing at December 1, 2010
From 2007 8,000 pounds at $4. $32,000
From 2008 10,000 pounds at $6.
60,000
From 2009 7,000 pounds at $9.
63,000
From 2010 5,000 pounds at $10. 50,000
30,000
Chapter
1-267
$205,000
LIFO Liquidation (Continued)
STOP BUYING INVENTORY (LIFO liquidation) Result is that as sales
are made in December, the old (low) inventory costs leave inventory.
At the end of 2010, only 6,000 pounds of steel remain in inventory.
Chapter
1-268
Select FIFO Method
(In a period of Rising Prices)
•
Practical Advantages:
•
•
•
Theoretical Advantage:
•
•
Ending inventory on balance sheet is closest to
current values = realistic view of inventory
DISADVANTAGES:
•
Chapter
1-269
Higher net income (and earnings per share) in a
period of rising prices. Higher stock price?
Which also may mean higher bonus for
management and/or increase in value of the
shares of stock (and stock options) they own!
“Phantom FIFO Profit”--does not provide a good
matching of current costs and revenues
• Pay higher taxes to government than LIFO
Select LIFO Method
(In a period of Rising Prices)
•
Practical Advantages:
•
•
•
Theoretical Advantage:
•
•
Pay less income taxes in a period of rising prices
(thus keep more cash—rather than pay it to IRS)
Opportunity to ‘manage income’ (LIFO Liquidation)
Best suited for the income statement because it
matches revenues and cost of goods sold
DISADVANTAGES:
Lower net income
• ‘Terrible’ current balance sheet value of inventory,
particularly during a prolonged period of price
Chapter
increases and decreases
1-270
•
Each Year, Can you switch ‘back and forth’ from One
Inventory Costing Method to Another ???
NO -- the Consistency concept requires
that companies use the same accounting methods from
year to year. The consistency assumption allows
financial statement users to compare the company’s
current year’s results with those of prior years.
This does NOT mean a company can never change
accounting methods. We covered changes in
Accounting Principles back in Chapter 4 —
Retrospectively go back and change the prior years’
financial statements to make them comparable with the
method used in the current year.
(Note: A change from FIFO to LIFO does NOT result in
restating prior years’ financial statements)
Chapter
1-271
Can you Get the “Best of Both Worlds” (FIFO on
‘books’ and LIFO on the Corporate Tax
Return)????
NO, because of LIFO CONFORMITY RULE—passed by
Congress:
If a company uses LIFO for
tax purposes, the IRS requires
the same method for financial
reporting (i.e., ‘the books’)
What will happen if the U.S. switches to IFRS—
which does NOT allow LIFO?
Chapter
1-272
Remaining “Miscellaneous” Topics in Ch. 8



Chapter
1-273
“Perpetual” calculations of Inventory for
FIFO and LIFO (vs. “Periodic” calculations
previously illustrated)
LIFO Reserve
“Dollar Value LIFO (vs. ‘specific units’ LIFO
calculations previously illustrated)
Perpetual Calculations Compared to Periodic
Calculations – An Illustration
Call-Mart Inc. had the following transactions in its first
month of operations.
Purchases:
2,000 x $4.00
$ 8,000
6,000 x $4.40
26,400
2,000 x $4.75
9,500
Cost of Goods Available for Sale
Chapter
1-274
$43,900
Need to allocate the $43,900 between Ending Inventory
(calculate) and Cost of Goods Sold Expense (plug)
First-In, First-Out (FIFO) -- Periodic
FIFO -- Periodic Method (previously covered)
2,000 @ $4.75
4,000 @ $4.40
$9,500
17,600
$27,100
27,100
$16,800
Chapter
1-275
First-In, First-Out (FIFO) -- Perpetual
FIFO -- Perpetual Method
Note: FIFO Perpetual always will yield the same Ending
Inventory and Cost of Goods Sold as FIFO Periodic
Chapter
1-276
Last-In, First-Out (LIFO) -- Periodic
LIFO -- Periodic Method (previous covered)
2,000 @ $4.00
4,000 @ $4.40
25,600
$18,300
Chapter
1-277
$8,000
17,600
$25,600
Last-In, First-Out (LIFO) -- Perpetual
LIFO -- Perpetual Method
Note: LIFO Perpetual can result in different answer than LIFO Periodic
Chapter
1-278
Special Issues Related to LIFO
Many companies use
LIFO Reserve
LIFO for tax and external financial reporting purposes
FIFO for internal reporting purposes and required disclosure of
‘what inventory and earnings would have been’ if FIFO had been
used
The dollar amount in the “LIFO Reserve” at the end of the year:

Makes it relatively easy to ‘convert’ an ending inventory
calculated under LIFO to what it would have been using FIFO.
Changes in the dollar amount in the “LIFO Reserve” from one period to
the next:

Chapter
1-279
Makes it relatively easy to ‘convert’ Cost of Goods Sold
Expense (and thus Gross Profit) calculated under LIFO to what
it would have been using FIFO
Special Issues Related to LIFO
Dollar-Value LIFO
Changes in the total dollar value of a “pool of
inventory items” are used to determine inventory;
not physical quantity on a per unit basis.
Advantages:
Much easier than costing each different inventory
item for companies that have a large number of
inventory items.
Government provides ‘price indices’ so companies do
NOT have to calculate their own ‘indices’
Chapter
1-280
Used by major retail stores (called “Dollar-ValueRetail-Lifo”)
Special Issues Related to LIFO
Dollar-Value LIFO Process
1st Step in Process: separate the increased dollar amount of ending
inventory (computed using FIFO) into TWO components:
1.) Increase in inventory due to increase in inventory prices during year
2.) “Quantity Increase (or decrease) due to actual increase (or decrease) in
inventory quantities during year (year-end inventory in “base year prices”
compared to prior’s year inventory at base year prices)
2nd Step in Process: calculate the incremental “layer” for the year (Quantity
change times price index for current year)
3rd Step in Process: Add incremental layer to prior year inventory
(Note: If there is a decrease in inventory quantity = reduce previous
year(s) layers in a LIFO pattern)
Chapter
1-281
Illustration on next slide
Dollar-Value LIFO -- Illustrated
Chapter
1-282
Class Assignment Review Questions and Homework
for Ch. 8
Class Assignment Questions #1, 3, 6, 7, 8, 16,
18 (skip ‘c’), 19, 20 (pages 413-414)
Homework (pages 415-422):
BE 4, 5
Ex. 17, 25
Chapter
1-283
CHAPTER
9
INVENTORIES:
ADDITIONAL VALUATION ISSUES
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-284
Summary of Chapter 9
1. Describe and apply the lower-of-cost-or-market
rule.
2. Discuss accounting issues related to purchase
commitments.
3. Estimating ending inventory using the gross profit
method.
4. Determine ending inventory by applying the retail
inventory method.
5. Inventory ratios.
Chapter
1-285
Lower-of-Cost-or-Market (LCM)
LCM
A company abandons the historical cost principle when
the future utility (revenue-producing ability) of the
asset drops below its original cost.
Market = Replacement Cost
Lower of Cost or Replacement Cost (subject to two
constraints—ceiling and floor)
Loss should be recorded when loss occurs, not in the
period of sale.
Chapter
1-286
Lower-of-Cost-or-Market (LCM)
Conservatism Concept
Decline in the Replacement Cost of the inventory usually
means there also has been a decline in the expected selling
price of inventory (aka. ”loss of economic utility”)
Ceiling and Floor Refinements to Replacement Cost:
Chapter
1-287

Ceiling - net realizable value—expected selling price less any
costs of selling (e.g., inventory item owed is damaged)

Floor - net realizable value less a normal profit margin (e.g.,
company has a legally enforceable agreement with a customer
so that the selling price will NOT drop as much as a low
replacement cost indicates).
In the lower-of-cost-or-market test for inventory valuation, IFRS
defines market as net realizable value. IFRS does NOT consider
replacement cost or the ‘floor’ constraint.
Lower-of-Cost-or-Market (LCM)
Historical cost = $100.
Replacement cost at end of Year 1= $80
LCM over Two Years – Ignoring Ceiling or Floor Refinements
Year 1
LCM Write down:
Loss on Inventory 20
Inventory
20
(from $100 to $80)
Conservative for Year 1?:
Income Statement Loss of $20
will lower Net Income
Balance Sheet Asset Inventory
reduced to $80.
Chapter
1-288
Year 2
If Sell for $200 at beginning of Year 2:
Accounts Rec.
200
Sales Revenue
200
Cost of Good Sold 80
Inventory
80
Conservative for Year 2?:
Income Statement shows ‘income’ of
$120. What would the income have
been IF the ‘conservative’ LCM had
NOT been followed in Year 1?
(CAN “CONSERVATISM CONCEPT”
Possibly Lead to “BIG BATH”
Accounting????)
Lower-of-Cost-or-Market (LCM)
“Market” number to use to compare
to cost will be the MIDDLE number
of the three market numbers
Ceiling = NRV
Not
>
Cost
Market
Replacement
Cost
Not
<
GAAP
LCM
Chapter
1-289
Floor =
NRV less Normal
Profit Margin
Lower-of-Cost-or-Market (LCM)
How LCM Works – An Illustration
Individual Items Basis
Chapter
1-290
Lower-of-Cost-or-Market (LCM)
How LCM Works – An Illustration
Individual Items, Major Categories, Total Inventory
Chapter
1-291
Individual Items method is most ‘conservative’ of the three
Lower-of-Cost-or-Market (LCM)
Ending inventory (cost)
$ 415,000
Ending inventory (LCM—Individual items) 350,000
Adjustment to LCM
$ 65,000
Recording LCM – Journal Entry
Two possible ways to record ‘write-down’
Loss on inventory
65,000
Inventory (or Allowance on inventory) 65,000
Cost of goods sold
Inventory
Chapter
1-292
65,000
65,000
In U.S. GAAP, inventory written down under the lower-of-costor-market valuation may NOT be written back up to its original
cost in a subsequent period. Under IFRS, the write-down may be
reversed in a subsequent period.
Lower-of-Cost-or-Market (LCM)
Extending LCM to Purchase “Commitments”
Generally seller retains title to the inventory until the actual
sale to the customer (buyer) takes place.
LCM for buyer -- If the contract selling price ($10. cost) is
greater than the current market price ($8. replacement
cost), AND the buyer expects that losses will occur when the
actual inventory purchase occurs, the buyer should recognize
losses under the purchase commitment NOW in the same
manner as if the buyer had already purchased the inventory.
(The buyer can protect himself/herself by ‘hedging’ -entering into a ‘selling contract’ for the same quantity of the
same inventory item held under the purchase commitment)
If material, the buyer should disclose details of purchase
commitments and any ‘hedges’ in a footnote.
Chapter
1-293
Lower-of-Cost-or-Market (LCM)
Purchase Commitments
Illustration: St. Regis Paper Co. signed timber-cutting
contracts to be executed in 2012 at a price of $10,000,000.
Assume further that the market price of the timber cutting
rights on December 31, 2011, dropped to $7,000,000. St.
Regis would make the following entry on December 31, 2011.
Unrealized Holding Loss (Income Statement) 3,000,000
Estimated Liability on Purchase Commitments
3,000,000
When St. Regis cuts the timber at a cost of $10 million,
it would make the following entry.
Inventory
7,000,000
Estimated Liability on Purchase Commitments 3,000,000
Cash
10,000,000
Chapter
1-294
Estimating Inventory -- Gross Profit Method
(1) Provides an estimate of ending inventory for
management and auditor.
(2) Uses past gross profit percentages in calculation.
(3) A single blanket gross profit rate may not be
representative.
(4) Only acceptable for interim (generally quarterly)
reporting purposes.
Chapter
1-295
Estimating Inventory--Gross Profit Method
Illustration: Cetus Corp. has a beginning inventory of $60,000 and
purchases of $200,000, both at cost. Sales at selling price amount to
$280,000. The gross profit on selling price is 30 percent*.
Cetus applies the gross profit (aka. ‘gross margin’) method as follows.
Beginning Inventory
Purchases
Cost of Goods Available for Sale
$ 60,000
+ 200,000
$260,000
Estimated Cost of Goods Sold Exp. - 196,000 (70% x $280,000 Sales)
Estimated Cost of Ending Inventory
$64,000
*It is possible the gross profit percent could be a
percentage ‘mark-up on cost’ (A method for Cost Accounting)
Chapter
1-296
Estimating Inventory -- Gross Profit Method Another
Illustration
Astaire Company uses the gross profit method to estimate
inventory for monthly reporting purposes. Presented below is
information for the month of May.
Inventory, May 1
Purchases (gross)
Freight-in
Sales
Sales returns
Purchase discounts
$
160,000
640,000
30,000
1,000,000
70,000
12,000
Instructions:
Compute the estimated inventory at May 31, assuming that the gross
profit is 25% of net sales.
Chapter
1-297
Estimating Inventory -- Gross Profit Method
Solution to the 2nd Illustration
Compute the estimated inventory assuming gross profit is 25% of net sales
Inventory, May 1
Purchases (gross)
Purchase discounts
Freight-in
$ 160,000
640,000
(12,000)
30,000
Cost of Goods Available for Sale
$ 818,000
Estimated Cost of Goods Sold (75% of $930,000*)
Estimated ending inventory, May 31
Sales (at selling price)
Sales returns (at selling price)
ChapterNet
1-298
sales (at selling price)
658,000
(697,500)
$ 120,500
$1,000,000
(70,000)
930,000*
Retail Inventory Method
A method used by retailers:
1.) To estimate ending inventory without a physical count
2.) As a ‘check’ to compare to the physical inventory ‘count’
Requires retailers to keep records of:
(1) the total cost and retail value of goods purchased,
(2) the total cost and retail value of the goods available
for sale, and
(3) the sales for the period.
Chapter
1-299
Some companies refine the retail method by computing inventory
separately by departments or class of merchandise
Retail Inventory Method – An Illustration
Fuque Inc. uses the retail inventory method to estimate
ending inventory for its monthly financial statements. The
following data pertain to a single department for the month
of October 2011.
Beg. inventory, Oct. 1
Purchases
Freight in
Purchase returns
Additional markups
Markup cancellations
Markdowns (net)
Normal spoilage
Sales
Chapter
1-300
COST
$
52,000
272,000
16,600
5,600
RETAIL
$ 78,000
423,000
8,000
9,000
2,000
3,600
10,000
390,000
Prepare a schedule
computing estimated
ending inventory
following the
conventional retail
method (lower of
average cost or
market)
Retail Inventory - LCM Method
Conventional Retail at Lower of Cost or Market
COST
52,000
272,000
16,600
(5,600)
RETAIL
$ 78,000
423,000
Beg. inventory
$
Purchases
Freight in
Purchase returns
(8,000)
Markups, net
7,000
Current year additions
283,000
422,000
Goods available for sale
335,000 /
500,000
Markdowns, net
(3,600)
Normal spoilage
(10,000)
Sales
(390,000)
Estimated Ending inventory at retail
$ 96,400
Estimated Ending inventory at Cost:
$
96,400 x 67.00% = $
Chapter
1-301
Cost to
Retail %
=
67.00%
64,588
To calculate ending inventory at ‘cost’ – move “markdowns, net” up
with markups (and thus included in cost to retail percentage)
Presentation and Analysis
Presentation:
Accounting standards require disclosure of:
(1) composition of the inventory,
(2) financing arrangements, and
(3) costing methods employed.
Ratio Analysis:
Common ratios used in the management and evaluation of
inventory levels are inventory turnover and average days
to sell the inventory.
Chapter
1-302
Ratios -- Inventory Turnover &
Average Days to Sell Inventory
INVENTORY TURNOVER -- Measures the number of times on
average a company sells the inventory during the period.
NUMBER OF DAYS SUPPLY OF INVENTORY ON HAND (aka. “Average
Days to Sell”) -- Measures the average number of days between when a
company acquires inventory and when they sell it.
Average Days to Sell = 365 days / 7.5 times = 48.7 days
Is 48.7 days supply of inventory on hand too little or too
much? What would you compare the 48.7 days to?
Chapter
1-303
Summary of IFRS vs. GAAP Differences
Related to Inventories

U.S. GAAP permits the use of LIFO for inventory valuation. IFRS
prohibits its use.

In the lower-of-cost-or-market test for inventory valuation, IFRS
defines market as net realizable value. U.S. GAAP defines market
as replacement cost subject to the ceiling and floor constraints.

In U.S. GAAP, inventory written down under the lower-of-cost-ormarket valuation may not be written back up to its original cost in a
subsequent period. Under IFRS, the write-down may be reversed in
a subsequent period.
Chapter
1-304
Class Assignment Review Questions and
Homework for Ch. 9
Class Assignment Questions #1, 2, 6, 9, 10, 15,
17, 18 (page 468)
Homework (pages 469-479):
BE 1, 2, 3, 5, 6, 7, 9
Prob. 6
Chapter
1-305
CHAPTER
10
ACQUISITION AND DISPOSITION OF
PROPERTY, PLANT, AND EQUIPMENT
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-306
Summary of Chapter 10
1.
What should be included in the asset classification of property, plant,
and equipment?
2.
Understand the “capitalize” as asset or expense decision.
3.
Identify the costs to include in initial acquisition of property, plant, and
equipment.
4.
Describe the accounting problems associated with self-constructed
assets – including ‘interest capitalization’.
5.
Describe the accounting treatment for costs subsequent to acquisition
(post-acquisition expenditures).
6.
Describe the accounting treatment for the disposal of property, plant,
and equipment.
Chapter
1-307
Property, Plant, and Equipment ASSETS
Property, plant, and equipment includes land, buildings,
and equipment (machinery, furniture, tools).
Three Major characteristics include:
“Used in operations” and not for resale (i.e. NOT Inventory
or Land Held as an Investment).
Long-term in nature and usually depreciated.
Possess physical substance.
Chapter
1-308
“Capitalize” as Asset or Expense
Asset (benefit more than current period)
Ppd. Ins.
Del. Truck Coal Mine
Patent
Ins. Exp.
Depr. Exp. Depletion Amortization
Expenditure vs.
Exp.
Exp.
Expense (benefit just the current period)
Chapter
1-309
Acquisition of PP&E
(Recorded at Cost or Fair Market Value?)
U.S. GAAP = Value at Historical Cost (Subsequently
to be depreciated—except for Land)
Historical cost is reliable.
Companies should not anticipate gains and losses but
should recognize gains and losses only when the asset
is sold.
U.S. GAAP states: “property, plant, and
equipment should not be written up to reflect
appraisal, market, or current values which are
above cost.”
Chapter
1-310
IFRS allows either Historical Cost OR Fair Market Value (If Fair
Value is selected--property, plant, or equipment must be REVALUED
TO CURRENT VALUE regularly)
Acquisition of PP&E – What Costs to Include in
Acquisition Cost?
ALL REASONABLE AND NECESSARY COST OF ACQUIRING
THE ASSET AND GETTING IT READY FOR ITS INTENDED USE
SHOULD BE ADDED TO THE ASSET.
WHY?:
MATCHING (If expenditure is related to the asset and the
‘benefits’ from the expenditure will be obtained over the
life of the asset, then the cost should be spread over the
life of the asset (i.e., matched with the revenue being
generated by using the asset over its life).
Or is the above ‘hogwash’ that doesn’t provide ‘relevant’ information
to help financial statement readers make better decisions?
Chapter
1-311
If you are considering lending money to Ford Motor Company (or
buying their stock) does the depreciated cost of Ford’s Dearborn,
Michigan factory—built in 1955--of any relevancy to you?
Cost of Land and Buildings
Cost of Land
Includes all costs to acquire land
and ready it for use. Costs
typically include:
(1)
closing costs, such as title to the
land, attorney’s fees, and recording
fees;
(2)
costs of grading, filling, draining, and
clearing;
(3)
assumption of any liens, mortgages,
or encumbrances on the property;
and
(4)
the purchase price;
(5)
Additional land improvements that
an indefinite life.
Chapter
1-312 have
Cost of Buildings
Includes all costs related
directly to acquisition or
construction. Costs include:
(1) materials, labor, and
overhead costs incurred
during construction;
(2) professional fees and
building permits.
What about Interest Cost
incurred on funds borrowed
to finance construction of
the building?
Cost of Equipment
Cost of Equipment
Include all costs incurred in acquiring the equipment
and preparing it for use.
Costs typically include:
(1) purchase price,
(2) freight and handling charges
(3) insurance on the equipment while in transit,
(4) cost of special foundations if required,
(5) assembling and installation costs, and
(6) costs of conducting trial runs.
Chapter
1-313
Cost of Self-Constructed Assets
Self-Constructed Assets
Costs typically include:
(1) Materials and direct labor
(2) Overhead can be handled in two ways:
1. Assign no fixed overhead
2. Assign a portion of all overhead to the
construction process.
Companies use the second method extensively.
Chapter
1-314
What about Interest Cost incurred on funds borrowed to
finance construction of the building, bridge, submarine?
Interest Costs During Construction
Three approaches have been suggested to account for the
interest incurred in financing the construction.
Should Financing Costs During Construction be
Capitalized as part of the Cost of the Asset?
$ ?
$ 0
Capitalize NO
interest
during
construction
It’s Interest
Expense
Chapter
1-315
Capitalize actual
debt financing costs
incurred during
construction (with
modification)
Capitalize all
financing costs
incurred during
construction
BOTH “Debt” and
“Equity” costs of
financing
GAAP
construction
IFRS recently changed their rules to parallel U.S.
GAAP—as part of the ‘convergence project’
Interest Costs During Construction
GAAP requires — capitalizing interest cost incurred
during construction (with modification).
Consistent with historical cost — all costs incurred to
bring the asset to the condition for its intended use.
Capitalization considers three items:
1. Qualifying assets.
2. Capitalization period.
3. Amount to capitalize.
Chapter
1-316
Interest Costs During Construction
Qualifying Assets:
Assets requiring a LONG period of time to get them
ready for their intended use (e.g., nuclear power
plant, submarine, bridge, factory building).
Two types of assets:
Assets under construction for a company’s own use
(e.g., constructing their own building which they plan
to occupy).
Assets intended for sale or lease that are
constructed or produced as discrete projects (e.g.,
Chapter
1-317
building a bridge for the state government).
Interest Costs During Construction
Capitalization Period:
Begins when:
1.
Expenditures for the asset have begun.
2.
Interest costs are being incurred.
Ends when:
The asset is substantially complete and ready for use.
Chapter
1-318
Interest Costs During Construction-- Illustrated
KC Corporation borrowed $200,000 at 12% interest from State
Bank on Jan. 1, 2011, for the specific purpose of constructing
special-purpose equipment (qualifies for interest capitalization).
Construction on the equipment began on Jan. 1, 2011, and the
following expenditures were made prior to the project’s completion
on Dec. 31, 2011 (capitalization period = from 1/1/11 to 12/31/11)
All other general debt
existing on Jan. 1, 2011:
Actual Expenditures:
January 1, 2011
April 30, 2011
150,000
November 1, 2011
300,000
December 31, 2011
100,000
Total expenditures
Chapter
1-319
$100,000
$650,000
$500,000, 14%, 10-year
bonds payable
$300,000, 10%, 5-year
note payable
1
Interest Costs During Construction-- Illustrated
Step 1-Determine whether asset qualifies for capitalization
of interest = YES
Step 2-Determine the capitalization period = Jan. 1, 2011 to
Dec. 31, 2011
Step 3-Compute weighted-average accumulated
expenditures*
Weighted
Date
Jan. 1
Apr. 30
Nov. 1
Dec. 31
Chapter
1-320
Weighted
Average
Actual
Capitalization Accumulated
Expenditures
Period
Expenditures*
$ 100,000
150,000
300,000
100,000
$ 650,000
12/12
8/12
2/12
0/12
$ 100,000
100,000
50,000
$ 250,000
Interest Costs During Construction-- Illustrated
Step 4 - Compute the Interest to Capitalize on
the $250,000 weighted-average expenditures:
$24,000 interest ($200,000 @ 12% interest rate of specific debt)
+ 6,250 interest ($50,000 @ 12.5%* weighted-average rate on other debt)
$30,250 Total Interest to Capitalize
Journal entry to Capitalize Interest
Equipment
Interest expense
All other debt:
30,250
Weighted-average interest
rate on all other debt
$500,000
14%
$70,000
+300,000
10%
+30,000
$100,000 interest
$100,000
$800,000 principal
Total $800,000
Chapter
1-321
30,250
12.5%*
Other Issues in Recording Acquisition of PP&E
Cash Discounts: whether taken or not — generally considered a reduction
in the cost of the asset (capitalized cost of PP&E should include all
“reasonable and necessary” costs of acquiring the asset and getting it
ready for use).
Deferred-Payment Contracts — Assets, purchased through long-term
credit, are recorded at the present value of the consideration exchanged.
Contributions of PP&E -- Record asset at fair market value and record
revenue
Lump-Sum Purchases aka. ‘basket purchases’ — Allocate the total cost
among the various assets on the basis of their fair market values (really a
‘joint-cost allocation problem’—similar to using relative sales value to
allocate cost in previous textbook chapter)
Issuance of Stock — The market value of the stock issued is a fair
indication of the cost of the property acquired.
Chapter
1-322
“Contributions” of PP&E
Hasty Auto Company receives ‘free’ title to land and
factory building from Poor City in exchange for
establishing a new manufacturing operations.
Hasty should:
use the fair value of the asset to establish its
value on the books and
should recognize contributions received as
revenues in the period received.
Chapter
1-323
Basket Purchase Allocation
(aka. “Joint Cost” Allocation Situation)
Matrix, Inc. purchased land and a building for $5,000,000
cash. An independent appraiser estimated that the land has
a fair market value of $2,000,000, and the building has a fair
market value of $6,000,000. How will we assign the
$5,000,000 cost between the land and building?
First However—”Don’t lose site of the forest for the trees”
Amount
%
Fair market value of building $ 6,000,000
75%
Fair market value of land
2,000,000
25%
Total fair market value
$ 8,000,000
100%
Chapter
1-324
Assign to building
Assign to land
Cost
$ 5,000,000
5,000,000
%
75%
25%
100%
Allocation
$ 3,750,000
1,250,000
$ 5,000,000
Post-Acquisition Expenditures
In general, post-acquisition costs incurred to achieve
the original estimated useful life and salvage value are
recorded as expense (repairs and maintenance) when
incurred.
To capitalize post-acquisition costs, one of the
following conditions must be present:
“Efficiency” of asset must have increased:
Quantity of units produced from asset must be
increased.
Quality of units produced from asset must be
enhanced.
Chapter
1-325
Useful life of the asset must have increased.
Post-Acquisition Expenditures
Costs that Are Expensed
The cost of routine maintenance and minor repairs that
are incurred to keep an asset in good working order are
expensed as incurred.
Assume Radar Inc. spent $200 cash for routine
maintenance on machinery.
Account Title
Maintenance Expense
Cash
Chapter
1-326
Debit
200
Credit
200
Post-Acquisition Expenditures
Costs that Are Capitalized—”Improvement”
Expenditures that improve the “efficiency” (either “quality
or quantity”) of an asset are capitalized as part of the
cost of that asset.
Assume Rary Co. spent $5,000 cash for a major overall of
equipment to improve efficiency.
Account Title
Equipment
Cash
Chapter
1-327
Debit
5,000
Credit
5,000
Post-Acquisition Expenditures
Costs that “Extend the Life” of an Asset
The amount of the expenditure should reduce the
balance in the accumulated depreciation account.
Assume Matrix, Inc. spent $8,000 cash to rebuild major
components of the equipment that extended the life of
equipment four years.
Account Title
Accumulated Depreciation - Equipment
Cash
Chapter
1-328
Debit
8,000
Credit
8,000
Disposition of PP&E
A company may retire plant assets voluntarily or dispose of
them by
 sale,
 involuntary conversion,
 exchange, or
 abandonment.
Depreciation must be taken up to the date of disposition.
Chapter
1-329
SALE of PP&E Assets
Ottawa Corporation owns machinery that cost $20,000 when
purchased on July 1, 2007. Depreciation has been recorded
at a rate of $2,400 per year, resulting in a balance in
Accumulated Depreciation of $8,400 at December 31, 2010.
The machinery is sold on September 1, 2011, for $10,500.
Journal Entries on September 1, 2011
Depreciation expense ($2,400 x 8/12) 1,600
Accumulated depreciation
Cash
Accumulated depreciation
Machinery
Gain on sale
Chapter
1-330
1,600
10,500
10,000*
20,000
500
* $8,400 + $1,600 = $10,000
Involuntary Conversion of PP&E
Sometimes an asset’s service is terminated through some type of
involuntary conversion such as fire, flood, theft, or
condemnation.
Companies report the difference between the amount recovered
(e.g., from a condemnation award or insurance recovery), if any,
and the asset’s book value as a gain or loss.
Gains or losses may qualify as “extraordinary items” if unusual and
infrequent considering the company’s environment.
Chapter
1-331
Summary of Gain and Loss Recognition on Exchanges
of Non-Monetary Assets
Chapter
1-332
The FASB recently changed from a ‘similar’/’dissimilar’ method of
recording exchanges of non-monetary assets to an ‘economic substance’
approach that parallels IFRS handling of non-monetary asset exchanges.
Accounting for Exchanges of PP&E that Have
Commercial (Economic) Substance
Arc, Inc. trades its used machine for a new model. The exchange has
commercial (economic) substance.
The used machine has a book value of $8,000 (original cost $12,000 less
$4,000 accumulated depreciation) and a fair market value (FMV) of $6,000.
Arc Inc. gives $7,000 Cash plus their old machine for the new machine.
Journal Entry to Record Exchange of Non-Monetary Asset
Equipment ($6,000 FMV of asset given up, plus $7,000 cash paid) 13,000
Accumulated Depreciation—Equipment
4,000
Loss on Disposal of Equipment ($8,000 book value vs. $6,000 FMV) 2,000
Equipment -- old
12,000
Cash
7,000
How would the journal entry have been different if the FMV of the used
machine traded was $11,000?
Chapter
1-333
Gain on Disposal of $3,000; and Equipment acquired $18,000
Exchanges that Lack Commercial (Economic)
Substance
1.) If LOSS is indicated (Loss if book value > FMV) = Record
the Loss on exchange
2.) If GAIN is indicated (i.e., book value < FMV):
•No cash received – Do NOT record gain, decrease cost basis
of newly acquired asset for amount of unrecognized gain
•Some cash received – Record ‘portion’ of gain related to cash
(“boot”) received , decrease cost basis of newly acquired asset
for amount of unrecognized gain. Portion of gain recorded:
Chapter
1-334
If cash is 25% or more of the fair value of the exchange,
recognize entire gain because earnings process is complete.
Practice Problem on Non-Monetary Exchanges
of PP&E
CA 10-5 (page 533) as example of exchange of
non-monetary assets
Link to Solution
Chapter
1-335
Disposition of Plant Assets
Miscellaneous Problems
If a company scraps or abandons an asset without any cash
recovery, it recognizes a loss equal to the asset’s book
value.
If scrap value exists, the gain or loss that occurs is the
difference between the asset’s scrap value and its book
value.
If an asset still can be used even though it is fully
depreciated, it may be kept on the books at historical cost
less accumulated depreciation.
Chapter
1-336
Class Assignment Review Questions and
Homework for Ch. 10
Class Assignment Questions #1, 2, 7, 8, 10, 12,
16 (pages 515-516)
Homework (pages 519-530):
Ex. 5, 16, 23
Prob. 9
Chapter
1-337
CHAPTER
11
DEPRECIATION, IMPAIRMENTS,
AND DEPLETION
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-338
Summary of Chapter Eleven
1.
Explain the concept of depreciation.
2. Identify the factors involved in the depreciation
process.
3. Compare activity, straight-line, accelerated, and
MACRS methods of depreciation.
4. Explain the accounting issues related to asset
impairment.
5. Explain the accounting procedures for depletion of
natural resources.
6. Explain how to report property, plant, equipment, and
Chapter natural resources on the financial statements.
1-339
Depreciation = Cost Allocation
Depreciation is the accounting process of allocating
the cost of tangible assets to expense in a systematic
and rational manner to those periods expected to
benefit from the use of the asset.
Allocating costs of long-term assets:
P&E (this chapter) = Depreciation expense
Intangibles (Ch. 12) = Amortization expense
Natural resources (this chapter) = Depletion expense
Chapter
1-340
Factors Involved in the Depreciation Calculation
1)
What is the asset’s cost?
(all reasonable and necessary costs of acquiring the asset and
getting it ready for its intended use--Chapter 10)
2)
What is the asset’s ESTIMATED useful life?
(Estimated useful life of an asset often differs from its
physical life (obsolescence to consider)).
3)
What is the asset’s ESTIMATED salvage value?
(What amount of the asset’s cost will be recouped upon
disposal at the end of its use)
4)
Which method of cost allocation is best?
(Methods listed on next slide)
Chapter
1-341
Depreciation - Methods of Cost Allocation
The profession requires the depreciation method
employed be “systematic and rational.” Examples include:
(1)
Activity method (units of use or production).
(2) Straight-line method.
(3) Sum-of-the-years’-digits.*
(4) Declining-balance method.
(5) Group and composite methods.
(6) Hybrid or combination methods.
Accelerated methods
Special methods
We will also cover “MACRS” depreciation method used for tax purposes
Chapter
1-342
* Some textbooks no longer cover the ‘sum-of-theyears-digits’ method of depreciation.
Activity Method of Depreciation
Facts
First: Calculate depreciation rate per unit:
$500,000 cost - $50,000 estimated salvage value
30,000 hours estimated useful life
Second: Calculate depreciation amount
Multiply actual usage (assume 4,000 hours) during the
period times the $15. rate = $60,000 depreciation
Chapter
1-343
$15.
Straight-Line Depreciation Method
Facts
Calculate straight-line depreciation:
Cost - Estimated Salvage Value
Estimated Useful Life in Years
$500,000 - $50,000
5 Years
$90,000
Chapter
1-344
“Accelerated” Depreciation Methods
(Sum-of-the-Years’-Digits)
Facts
First: Calculate ‘fraction’ for the current year
Numerator is number of years of estimated life remaining as
of the beginning of the year
Denominator is “sum” of the ‘digits’ in the asset’s life (e.g.,
for a 5-year estimated life, the denominator of the fraction
would be 15 (1 + 2 + 3 + 4 + 5) OR “n(n+1) / 2”
Second: Calculate depreciation by multiplying fraction times the
(cost minus the estimated salvage value)
First year: 5 times ($500,000 - $50,000) = $150,000
15
Chapter
1-345
“Accelerated” Depreciation Methods
(Sum-of-the-Years’-Digits)
Sum-of-the-Years’-Digits--All Five Years
Chapter
1-346
“Accelerated” Depreciation Methods
(Declining Balance)
Facts
Declining-Balance Method

Utilizes a depreciation rate (percentage) that is some multiple of
the straight-line method (most often double the straight-line rate)

Does not deduct the salvage value in computing the depreciation
base.

Chapter
1-347
Does NOT depreciate below salvage value--depreciation ceases
when salvage value is reached
“Accelerated” Depreciation Methods
(Declining Balance)
Double-Declining-Balance Method
First: Calculate depreciation rate
(the straight-line rate is 20%; so DDB rate is 40%)
Second: Calculate depreciation amount
(Multiply the DDB rate times the BOOK VALUE AT
THE BEGINNING OF THE CURRENT YEAR)!!
Chapter
1-348
Modified Accelerated Cost Recovery System
(MACRS)
MACRS (depreciation for tax return purposes) differs from
GAAP in three respects:
1. a mandated tax life, which is generally shorter than the
economic life;
2. mostly accelerated depreciation (double-declining balance
for assets with a class life of 3, 5, 7, and 10 years) -- with
a ‘built-in’ ½ year convention); and
3. an assigned salvage value of zero.
Chapter
1-349
Modified Accelerated Cost Recovery System
(MACRS)
Chapter
1-350
* “Built-in” automatic switch to straight-line method
Modified Accelerated Cost Recovery System
(MACRS) -- An Illustration
Assume that, on 1/1/X1, MILO acquired equipment with an estimated useful life of four (4) years
with no salvage value at a cost of $850,000. The depreciation schedule for tax and books shows
20X1
20X2
20X3
20X4 TOTAL
Depreciation for tax purposes--accelerated 340,000 250,000 170,000 90,000 850,000
Depreciation for book purposes--straight-line 212,500 212,500 212,500 212,500 850,000
Excess ("deficit") of tax vs. book depreciation 127,500 37,500 (42,500) (122,500) 0
Assume that book income before taxes for the same four years was as follows:
Book Income before taxes
20X1
20X2
20X3
20X4
350,000 370,000 420,000 650,000
ASSUME THAT THE INCOME TAX RATE FOR EACH YEAR WAS 35%
Chapter
1-351
Link to Income Tax Journal Entry for all four years.
Special Depreciation Methods
(Commonly used in a Specific Industry [e.g., Utilities])
Group method used when the assets are similar in
nature and have approximately the same useful lives
(e.g., railroad ties, telephone poles).
Composite approach used when the assets are
dissimilar and have different lives (e.g., rowboats, pedal
boats, float tubes, and kayaks).
Companies are also free to develop tailor-made
depreciation methods, provided the method results in
the allocation of an asset’s cost in a systematic and
rational manner (Hybrid or Combination Methods).
Chapter
1-352
Special Depreciation Issues
(1)
How should companies compute depreciation for partial periods?
Companies normally compute depreciation on the basis of the
nearest full month.
Other methods are acceptable (e.g., 1/2 year convention; nearest
full year; full year in year of acquisition; nothing in first year)
(2)
Does depreciation provide for the replacement of assets?
CASH is needed to replace the assets (Debit to: Depreciation
Expense and Credit to: Accum. Depr. does NOT directly set aside
any CASH). [However, there is a Cash “Savings” due to fact
depreciation expense is deductible on the corporate tax return.]
(3)
How should companies handle revisions in depreciation rates?
Change in Accounting Estimates handled “retrospectively”.
Covered back in Ch. 4 (and will be covered again in Ch. 22)
Chapter
1-353
Of what value is depreciated book value to the
financial statement reader?????
Depletion
Natural resources, often called wasting assets, include
petroleum, natural gas, minerals, and timber.
The accounting for Natural Resources is similar to the
Accounting for PP&E:
 Cost includes all reasonable and necessary cost of
acquiring the natural resource and getting it ready
for sale: (i.e., Acquisition cost of the deposits and
development costs). [Unlike PP&E, an additional
“restoration” cost might be incurred for natural
resources related to ‘environmental’ concerns.]

Chapter
1-354
Depletion (rather than depreciation) is the term
used for the process of allocating the cost of
natural resources. (Depletion calculation parallels
the ‘activity method’ of depreciation)
Depletion Calculation -- An Illustration
Company purchased 9,000 acres of timberland in 2009 at a cost of $1,200 per
acre. At the time of purchase the land without the timber was valued at $200
per acre. During 2009, Hernandez selectively logged and sold 700,000 board
feet of timber, of the estimated 3,000,000 board feet.
First: Calculate the depletion rate per board foot of timber
Total cost – Est. salvage value
Total estimated units available
$9,000,000 Cost - $ -03,000,000 board feet
= Depletion cost per unit
= $3. Depletion per board foot
Second: Calculate the depletion dollar amount for the period
Units extracted x Cost per unit
Chapter
1-355
=
Depletion
700,000 board feet extracted X $3. = $2,100,000
Depletion -- Miscellaneous Issues
Liquidating dividends -- distributing dividends in excess of earnings
(usually as the result of a company’s only asset generating a
tremendous amount of cash and the asset will NOT be replaced
when its life is over)
Oil & Gas Industry:
•
Full cost concept -- capitalize the cost of drilling ‘dry’ wells
(used by ‘smaller’ exploration companies)
•
Successful efforts concept -- only capitalize the cost of the
wells that prove to be productive and expense the cost of
drilling the ‘dry’ wells (used by large international oil companies)
Want to buy some shares of Derstine Oil Drilling Inc.?
Chapter
1-356
First year’s net income was phenomenal!
Presentation of Property, Plant, Equipment, and
Natural Resources
(Including Disclosures)
Disclosures
Chapter
1-357
Basis of valuation (cost)
Pledges, liens, and other commitments
Depreciation expense for the period.
Balances of major classes of depreciable
assets.
Accumulated depreciation.
A description of the depreciation
methods used.
Impairments
When the carrying amount of an asset (including PP&E, Natural
Resources, and Intangibles) is not recoverable, a company
records a write-down of the asset and the records an
impairment loss.
Impairments refer to ‘other than temporary’ declines in
asset’s value.
Examples of events leading to an impairment:
Chapter
1-358
a.
Decrease in the market value of an asset (e.g., sub-prime
mortgages held as an investment).
b.
Adverse change in legal factors or in the business climate.
c.
An accumulation of costs in excess of the amount originally
expected to acquire or construct an asset (e.g., loss on long-term
construction project).
d.
A forecast that demonstrates continuing losses associated with
an asset.
Measuring Impairments
o
Review events for possible impairment.
o
If the review indicates impairment, apply (under U.S. GAAP)
the following TWO step process*:
1) The “recoverability test” -- If the sum of the
expected future net cash flows (NOT discounted)
from the long-lived asset is less than the book value
of the asset, an impairment has occurred.
2) Assuming an impairment, the impairment loss is the
amount by which the book value of the asset exceeds
the fair value of the asset (its market value--the
present value of expected future net cash flows).
*IFRS uses only the 2nd step, thus resulting in more impairment
Chapter
1-359
losses being recorded (more conservative approach)
Impairment Flowchart
Note that U.S. GAAP does NOT
permit ‘restoration’ of impairment
loss on assets held for use. IFRS
does permit ‘restoration’ if
subsequent events indicate the loss
has been reversed.
Chapter
1-360
Impairments Illustrated
Turet Company at December 31, 2010 owns the following
equipment and plans to continue to use this asset in the
future. As of December 31, 2010, the equipment has a
remaining useful life of 4 years.
Cost of equipment
Cost
of equipment
Accumulated depreciation
$
$ 9,000,000
to date
Expected future net cash flows (undiscounted)
Accumulated
depreciation to date
Fair value (discounted future cash flows)
1,000,000
7,000,000
4,400,000
9,000,000
1,000,000
Expected future net cash flows (undiscounted)
7,000,000
Fair value (discounted future cash flows)
4,400,000
Questions to answer on next slide
Chapter
1-361
Impairments Illustrated
(a) Apply ‘recoverability’ test to determine if there is ‘impairment’
YES -- $8,000,000 book value > $7,000,000 Undiscounted future
cash flows
(b) Prepare the journal entry to record the impairment of the asset
Loss on impairment
3,600,000
Accumulated depreciation
3,600,000
($8,000,000 vs. $4,400,000 fair value [discounted future cash flows])
(c) Prepare the journal entry to record depreciation expense for 2011.
Depreciation expense
1,100,000
Accumulated depreciation
1,100,000
($4,400,000 “new cost basis” divided by 4 years remaining life)
(d) The fair value of the equipment at December 31, 2011, is $5,100,000.
Prepare the journal entry (if any) necessary to record this increase in
fair value.
NOT permitted under U.S. GAAP
Chapter
1-362
U.S. GAAP vs. IFRS -- PP&E
Similarities
 Under both IFRS and U.S. GAAP, interest costs
incurred during construction must be capitalized.
 IFRS, like U.S. GAAP, capitalizes all direct costs in
self-constructed assets.
 The accounting for exchanges of nonmonetary assets
has recently converged between IFRS and U.S. GAAP.
 IFRS permits the same depreciation methods
(straight-line, accelerated, units-of-production) as U.S.
GAAP.
Chapter
1-363
U.S. GAAP vs. IFRS -- PP&E
Differences
 IFRS permits PP&E asset revaluations to market value
(which are not permitted in U.S. GAAP).
 In accounting for impairment losses, IFRS does not use
the first-stage recoverability test used under U.S.
GAAP—comparing the undiscounted cash flows to the
book value. Thus, the IFRS test is more strict than
U.S. GAAP.
 IFRS allows for the subsequent recovery of an
impairment loss write-down. U.S. GAAP does NOT
allow for a subsequent recovery on assets used in the
business.
Chapter
1-364
Class Assignment Review Questions and
Homework for Ch. 11
Class Assignment Questions # 1, 2, 3, 5, 10, 13,
14, 16, 17, 31, 33 (pages 568-569)
Homework (pages 571-576):
Ex. 5, 18, 21, 25
Chapter
1-365
CHAPTER
INTANGIBLE
12
ASSETS
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-366
Summary of Chapter 12
1.
2.
3.
4.
5.
6.
7.
8.
9.
Describe the characteristics of intangible assets.
Identify the costs to capitalize for intangible assets.
Describe the types of intangible assets.
Explain the procedure for amortizing ‘definitive-lived’ intangible
assets.
Explain the accounting issues related to intangible-asset
impairments.
Explain the conceptual issues related to goodwill.
Describe the accounting procedures for recording goodwill.
Identify the conceptual issues and accounting for research and
development costs and similar costs.
Indicate the financial statement presentation of intangible assets
and related items.
Chapter
1-367
Characteristics of Intangible Assets
Intangible Assets:
(1) Are long-lived, lack physical existence, and are not financial
instruments
(2) Get their value from their exclusive legal/economic rights.
Two Types of Intangibles and Accounting Treatment
Definitive (Limited) Life
Indefinite Life
Amortize & 2-step Impair.Test
Do NOT Amortize and 1-step Impair. Test
Patents
Trademarks or trade names
Copyrights
Goodwill (has ‘unique’ 2-step
impairment test)
Franchises or licenses
Chapter
1-368
Recording Acquisition of Intangible Assets
Purchased Intangibles:
Recorded at cost.
Includes all costs reasonable and necessary costs to
acquire the intangible asset and get it ready for its
intended use.
Internally Created Intangibles:
Generally expensed.
Chapter
1-369
Accounting for Intangibles -- A Summary
Chapter
1-370
Intangibles with Definitive Life
(Amortize and 2-step Impairment Test)
Franchise (or license) with a limited life should be amortized to
expense over the life of the franchise.
Copyright is granted for the life of the creator plus 70 years.
Amortize over estimated useful life -- which may be shorter
than legal life.
Customer lists, order or production backlogs, and both
contractual and non-contractual customer relationships.
Amortize over estimated useful life.
Patent gives the holder exclusive use for a period of 20 years.
Amortize over estimated useful life.
(Legal fees incurred successfully defending a patent are
capitalized to Patent account.)
Chapter
1-371
Impairment of Definitive-Life Intangibles
Same as the 2-step impairment for PP&E assets in Chapter 11.
1. ‘Recoverability test’--If the sum of the expected future
net cash flows (NOT discounted) is less than the book
value of the asset, an impairment has occurred.
2. ‘Fair value test’--The impairment loss is the amount by
which the book value of the asset exceeds the fair value -market value of the asset. If a market value is not
available, Discounted expected future net cash flows can
be used to estimate fair value of the asset.
The loss is reported as part of income from continuing
operations, “Other expenses and losses” section.
Why do you believe companies argued (successfully) with the FASB
for the ‘recoverability’ test’s provision of using Undiscounted
expected future cash flows?
Chapter
1-372
Impairment of Definitive-Life Intangible Asset
(An Illustration)
Presented below is information related to a copyright owned by Carmello
Company at December 31, 2010.
Cost
$ 8,600,000
Book value
4,300,000
Expected future net cash flows (not discounted)
4,000,000
Fair value (present value of future cash flows)
3,200,000
The copyright has a remaining useful life of 10 years.
(a) Perform step-1 -- the ‘recoverability test’ (is an impairment loss
indicated)?
(b) Perform step-2 -- the ‘fair value test’ to determine the dollar
amount of the impairment loss to record.
(c) Prepare the journal entry to record the impairment loss at
December 31, 2010.
Chapter
1-373
Impairment of Definitive-Life Intangible Asset
(An Illustration)
Recoverability test: If the sum of the UNDISCOUNTED
expected future net cash flows is less than the book value of
the asset, an impairment has occurred.
Undiscounted expected future cash flow
$ 4,000,000
Book value (aka. 'carrying value')
4,300,000
Asset is Impaired
$
(300,000)
Fair Value Test: What is the dollar amount of the
impairment loss to be recorded? Prepare journal entry.
Fair value test:
Book value
$
Fair value (Discounted future cash flows)
Loss on Impairment
Chapter
1-374
Loss on impairment
Copyrights
4,300,000
3,200,000
$
(1,100,000)
1,100,000
1,100,000
Intangibles with Indefinite Life
(Do NOT amortize; 1-step Impairment Test)
Trademark or trade name has legal protection for
indefinite number of 10-year renewal periods.
Franchise with an indefinite life should be carried at
cost and not amortized.
“Purchased” Goodwill (we will cover Goodwill after
reviewing the impairment test procedures for
indefinite-life intangible assets -- other than
goodwill). You also will study goodwill in Advanced
Accounting course.
Chapter
1-375
Impairment of Indefinite-Life Intangibles (Other
than Goodwill)
Should be tested for impairment at least annually.
 ‘Recoverability test’ is NOT used.
 Impairment test is the ‘Fair Value Test’.
If the fair value of asset (market value--can use
discounted cash flows as estimate of market
value if market value is not available) is less than
the book value, an impairment loss is recognized
for the difference.
Illustration on next slide.
Chapter
1-376
Impairment of Indefinite-Life Intangibles (Other
than Goodwill -- An Illustration)
Mohemath Oil Company has just been notified by the government of
the country of Korveniran that its franchise “in perpetuity” to drill for
oil will be revoked in two years. Mohemath Oil Company, which had
recorded the franchise as an indefinite-life intangible asset, expects
discounted cash flows for the remaining two years of the franchise to
be $3,000,000. The book value of the franchise is $4,000,000.
‘Recoverability’ Test:
NONE should be preformed
‘Fair Value Test’:
Indicates an impairment loss of $1,000,000
($4,000,000 book value > $3,000,000 fair value
Journal Entry to Record Impairment Loss
Loss on impairment 1,000,000
Chapter
1-377
Franchise asset
1,000,000
Goodwill
Goodwill is evidenced when a company has ‘excess earnings’
(i.e., the company’s rate of return on assets is greater
than the industry average).
Goodwill can be attributed to a number of different reasons
(e.g., skilled labor force, great management team, superior
product quality, excellent customer service, etc.)
 Goodwill only is recorded when an entire business is purchased
because goodwill cannot be separated from the business as a whole.
 Goodwill is recorded as the excess of the cost of purchasing another
company over the FMV of the identifiable net assets of the company
acquired. (C > FMV for NA acquired).
 Internally created goodwill should NOT be capitalized.
One company ‘generates’ goodwill (“excess earnings”) internally, while
another company ‘buys’ goodwill. Will their financial statements
differ? How will they differ?
Chapter
1-378
Would internally generated goodwill impact the Stock Price (even
though it is not shown as a asset)?
Recording Goodwill -- An Illustration
Marshall Co. pays $400,000 cash to purchase the net assets of
Tractorling Company--whose Balance Sheet is presented below.
The FAIR VALUE of Tractorling’s Net Assets are
Chapter
1-379
Recording Goodwill -- An Illustration (Continued)
Remember that Goodwill is C > FMV of NA acquired
Chapter
1-380
Recording Goodwill -- An Illustration (Continued)
Marshall Co.’s Journal Entry to record purchase of Tractorling
Goodwill of $50,000 = $400,000 Cost - $350,000 FMV of Net Assets Acquired
Notice in the above journal entry that the identifiable net assets
acquired from Tractorling are being recorded at their Fair Market
Value -- NOT their ‘cost basis’ on Tractorling’s books!
Chapter
1-381
What will be the accounting in the future for the Goodwill Asset
now on Marshall’s financial statements?
“Negative” Goodwill
(Cost < FMV of Net Assets Acquired)
“Bargain Purchase”
Purchase price less than the fair value of net
assets acquired (e.g., ‘forced sale’ of business
when owner dies).
Amount is recorded as a gain by the purchaser.
Chapter
1-382
Impairment of Goodwill
‘Different’
two-step process used to test Goodwill
for impairment
Step 1: If fair value is less than the book value of the net
assets (including goodwill), then perform a second step
to determine possible goodwill impairment.
Step 2: Determine the fair value of the goodwill (“implied
value” of goodwill) and compare to book value of
goodwill.
Chapter
1-383
Impairment of Goodwill -- An Illustration
Presented below is net asset information related to Marshall’s
Tractorling unit as of December 31, 2011 (one year after Marshall
acquired Tractorling for $400,000--including $50,000 for Goodwill):
Cash
$
60,000
Receivables
200,000
Inventory
190,000
Property, plant, and equipment, net
2,550,000
Goodwill
Less: Liabilities
Net assets
50,000
(2,700,000)
$
350,000
*
At December 31, 2011, Marshall estimates the discounted future cash flows
from the Tractorling unit to be approximately $335,000. Marshall also has
received an offer to sell the Tractorling division for $335,000. Both are
indicators of fair value of the Tractorling division at December 31, 2011.
Chapter
1-384
*All identifiable assets’ and liabilities’ book and fair value
amounts are the same as of December 31, 2011.
Impairment of Goodwill -- An Illustration
(Continued)
Step 1: The $335,000 fair value of the Tractorling unit is below its
$350,000 book value (including goodwill). Therefore, an impairment has
occurred.
Step 2: Calculate and record journal entry for the impairment of Goodwill.
$
Fair value
Book value, net of goodwill
Implied goodwill
Book value of goodwill
Loss on impairment
Loss on impairment
Goodwill
Chapter
1-385
$
15,000
15,000
335,000
300,000
35,000
50,000
(15,000)
Impairment of Goodwill -- An Illustration
(Continued)
At December 31, 2012, it is estimated that the
Tractorling unit’s fair value increased to $345 million.
Prepare the journal entry (if any) to record this increase
in fair value.
No entry.
Subsequent reversal of recognized impairment losses
is not permitted under U.S. GAAP
Would a journal entry have been required to record the recovery
in fair value under IFRS?
Chapter
1-386
Answer = NO (although IFRS permits recording recovery of
previously recorded impairment losses in other situations, it does
NOT allow it for Goodwill).
Summary of Impairment Tests
Chapter
1-387
Research and Development (R&D) Costs
R&D expenditures frequently result in something that
a company patents or copyrights and sells, such as:
new product,
process,
idea,
formula,
composition, or
literary work.
Because of difficulties related to identifying R&D
costs with particular saleable products and
determining the dollar amount and timing of future
benefits (if any), Research & Development (R & D)
costs are expensed when incurred.
Chapter
1-388
Other Costs Similar to R & D Costs
Expensed as Incurred
Start-up costs for a new operation.
Initial operating losses.
Advertising costs.
“Industry exception”
Some computer software development costs
are capitalized -- see next slide.
Chapter
1-389
Accounting for Computer Software Costs
Capitalize or Part of Research & Development Expense (R&D):
1. Until a company has established technological
feasibility for a software product, it should charge
to R&D expense the costs incurred in creating the
software.
2. Once technological feasibility is established (when
the company has completed a detailed program
design or a working model), then subsequent
development costs are capitalized.
Reporting Software Costs:
Chapter
1-390
 Unamortized software costs.
 The total amount charged to expense
 The amounts, if any, written down to net
realizable value.
Presentations of Intangibles and R&D
Balance sheet
Intangible assets shown as a separate
classification.
Contra accounts normally not used for intangible
assets.
Income statement
Report amortization expense and impairment
losses in continuing operations.
Total R&D costs charged to expense must be
disclosed.
Chapter
1-391
Presentations of Intangibles
Chapter
1-392
Presentations of R&D Costs
Chapter
1-393
Review Question
Indicate how items on the list below would generally be reported in
the financial statements.
Item
1.
2.
3.
4.
5.
6.
Investment in a subsidiary company
Timberland
Cost of engineering activity
required to advance the design of a
product to the manufacturing stage.
Lease prepayment
Cost of equipment obtained under a
capital lease.
Cost of searching for applications of
new research findings.
Chapter
1-394
Reported As
1.
2.
3.
Long-term investments
Natural resources
R & D expense
4.
5.
Prepaid rent
PP&E (Chapter 21 covers
Leases)
R & D expense
6.
Review Question (Continued)
Indicate how items on the list below would generally be reported in
the financial statements.
Item
7.
Cost incurred in the formation of a
corporation.
8. Operating losses incurred in the
start-up of a business.
9. Training costs incurred in start-up
of new operation.
10. Purchase cost of a franchise.
11. Goodwill generated internally.
12. Cost of testing in search of product
alternatives.
Chapter
1-395
Reported As
7.
Expense
8.
Operating loss
9.
Expense
10. Intangible
11. Not recorded
12. R & D expense
Review Question (Continued)
Indicate how items on the list below would generally be reported in
the financial statements.
Item
13. Goodwill acquired in the purchase
of a business.
14. Cost of developing a patent.
15. Cost of purchasing a patent from
an inventor.
16. Legal costs incurred in securing a
patent.
Chapter
1-396
Reported As
13. Intangible
14. R & D Expense
15. Intangible
16. Intangible
Review Question (Continued)
Indicate how items on the list below would generally be reported in
the financial statements.
Item
Reported As
17. Cost of purchasing a copyright.
17. Intangible
18. Research and development costs.
18. R & D Expense
19. Cost of developing a trademark.
19. Expensed
20. Cost of purchasing a trademark.
20. Intangible
Chapter
1-397
Class Assignment Review Questions and
Homework for Ch. 12
Class Assignment Questions # 3, 4, 8, 9, 12, 23,
24 (pages 619-620)
Homework (pages 622-626):
Ex. 3, 4, 13, 14
Chapter
1-398
CHAPTER
13
CURRENT LIABILITIES AND
CONTINGENCIES
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
1-399
Summary of Chapter 13
1.
Describe the nature, type, and valuation of current
liabilities.
2.
Explain the classification issues of short-term debt
expected to be refinanced.
3.
Identify types of employee-related liabilities.
4.
Identify the criteria used to account for and disclose
gain and loss contingencies.
5.
Explain the accounting for different types of loss
contingencies.
6.
Indicate how to present and analyze liabilities and
contingencies.
Chapter
1-400
What is a Liability?
FASB, defines liabilities as:
“Probable Future Sacrifices of Economic Benefits
arising from present obligations of a particular entity
to transfer assets or provide services to other
entities in the future as a result of past transactions
or events.”
I define liabilities as “debts or obligations to
‘outsiders’ “(outsiders = anyone but the owners;
therefore employees -- Salaries Payable -- are
‘outsiders’)
Chapter
1-401
What is a Current Liability?
Current liabilities are “obligations whose liquidation is
reasonably expected to require use of existing resources
properly classified as current assets, or the creation of
other current liabilities.”
(My definition = debts due within one year, or operating
cycle if longer, requiring use of current assets)
Typical Current Liabilities
Chapter
1-402
Accounts payable.
Notes payable ?.
Current maturities of longterm debt (“Wheaties Bond”).
Short-term obligations
expected to be refinanced.
Dividends payable.
Customer deposits.
Unearned revenues.
Sales taxes payable.
Income taxes payable.
Employee wage withholdings.
Employer payroll taxes
payable.
Accounts Payable
Accounts Payable (trade accounts payable)
Balances owed to others for goods, supplies, or
services purchased on open account.
Arise because of time lag between receipt of
goods or services and the payment for them.
The terms of the sale (e.g., 2/10, n/30) state
period of extended credit.
Chapter
1-403
Notes Payable
Notes Payable
Written promises to pay a certain sum of money on a
specified future date.
Arise from purchases, financing, or other
transactions.
Notes classified as short-term or long-term.
Notes may be interest-bearing or zero-interestbearing (i.e., ‘discounted note).
Chapter
1-404
Notes Payable -- “Interest-Bearing Note” Illustrated
On June 1, 2009, Golden Inc. borrows $50,000 from the bank and
gives the bank a one-year, 6% note. Principal and Interest due on
May 31, 2010. Golden’s accounting year ends on December 31.
Prepare journal entries related to the note.
Golden Inc.’s Journal Entries for 2009 and 2010
6/1/09
12/31/09
5/31/10
Chapter
1-405
Cash
Note Payable
Interest Expense
Interest Payable
Note Payable
Interest Payable
Interest Expense
Cash
50,000
1,750
50,000
1,750
1,250
50,000
1,750
50,000
Notes Payable -- “Zero-Interest-Bearing Note”
Illustrated
On June 1, 2009, Golden Inc. borrows $50,000 from the bank and
gives the bank a one-year, zero-interest-bearing note. The
‘discount rate’ (“implicit interest rate” is 6%). The $50,000 face
amount is due on May 31, 2010--the maturity date. Golden’s
accounting year ends on December 31.
Golden Inc.’s Journal Entries for 2009 and 2010
6/1/09
Cash
47,000
Discount on Note Payable 3,000
Note Payable
50,000
12/31/09
Interest Expense
1,750
Discount on Note Payable
1,750
5/31/10
Interest Expense
1,250
Discount on Note Payable
1,250
Chapter
1-406
Note Payable
Cash
50,000
50,000
Notes Payable -- “Zero-Interest-Bearing Note”
Illustrated
The Discount on Notes Payable is a contra liability
account to Notes Payable.
Golden’s Dec. 31, 2009 Balance Sheet (partial)
Current liabilities:
Notes Payable
Less: Discount on Notes Payable
$50,000
1,250* $48,750
(* $1,250 = $3,000 original balance less $1,750 amortized to
interest expense on Dec. 31, 2009)
What ‘interest rate’ did Golden actual pay on the “zero-interestbearing note?
Chapter
Answer: 6.4% $3,000 interest/$47,000 cash received
1-407
Debts Maturing in Next Year NOT requiring Use of
Current Asset to “Pay it off”
Exclude debts maturing in next year from current
liabilities IF maturing liabilities are to be:
1.
Retired by assets accumulated that have not been shown as
current assets,
2. Refinanced, or retired from the proceeds of a new debt issue, or
3. Converted into capital stock.
To be excluded from current liabilities, management must
demonstrate BOTH the intent and ability to refinance on a
long-term basis. “Ability to refinance on a long-term basis”
may be demonstrated by actually having refinanced on a
Chapter
1-408
long-term basis, or entered into a non-cancelable long-term
refinancing agreement with reputable party.
Current Obligations Expected to be Refinanced
Debts Expected to be Refinanced
Mgmt. Intends of Refinance
NO
Current
Liability
YES
Demonstrates Ability to Refinance
YES
Actual Refinancing after
balance sheet date but before
issue date
or
NO
Financing Agreement
Noncancellable with Capable
Lender
Exclude Debt from Current Liabilities and
Reclassify as LT Debt
Chapter
1-409
Classify as
Current Obligations Expected to be Refinanced
On December 31, 2010, Alexander Company had $1,200,000 of
short-term debt in the form of notes payable due February 2, 2011.
On January 21, 2011, the company issued 25,000 shares of its
common stock for $36 per share, receiving $900,000 proceeds
after brokerage fees and other costs of issuance. On February 2,
2011, the proceeds from the stock sale, supplemented by an
additional $300,000 cash, are used to liquidate the $1,200,000
debt. The December 31, 2010, balance sheet is issued on February
23, 2011.
Instructions
Show how the $1,200,000 of short-term debt should be presented
on the December 31, 2010, balance sheet.
Chapter
1-410
Current Obligations Expected to be Refinanced
Alexander Company
Balance Sheet (Partial)
December 31, 2010
Current liabilities:
Notes payable
Long-term debt:
Notes payable refinanced
Total liabilities
Note disclosure should include:
Chapter
1-411
•
•
•
$ 300,000
900,000
$1,200,000
A general description of the financing agreement.
The terms of any new obligation incurred or to be incurred.
The terms of any equity security issued or to be issued.
Current Obligations Expected to be Refinanced
Actual Refinancing of Short-Term Debt
Chapter
1-412
Dividends Payable
Amount owed by a corporation to its stockholders
as a result of board of directors’ authorization.
(Chapter 15 in Intermediate Accounting II)
Generally paid within three months.
Undeclared dividends on cumulative preferred stock
are not recognized as a liability (but must be
disclosed).
Dividends payable in the form of shares of stock are
not recognized as a liability. Reported in equity.
Chapter
1-413
Customer Deposits
Customer Deposits
Include returnable cash deposits received from
customers (e.g., utility customers with poor credit
may be required to post a refundable deposit,
landlord requires deposit of one or two months
rent from tenant).
May be classified as current or long-term
depending on the circumstances.
Chapter
1-414
Unearned Revenues
Payment received before delivering goods or rendering
services (e.g., Magazine Publisher)
Unearned and Earned Revenue Accounts
Chapter
1-415
Unearned Revenues -- An Illustration
The publishers of “Fly Fishing for Carp” Magazine sold
12,000 annual subscriptions on August 1, 2010, for $18 each.
Prepare August 1, 2010, journal entry and the
December 31, 2010, annual adjusting entry.
Aug. 1
Cash
216,000
Unearned revenue
216,000
(12,000 x $18)
Dec. 31
Unearned revenue
Subscription revenue
Chapter
1-416
($216,000 x 5/12 = $90,000)
90,000
90,000
Sales Taxes Payable
Sales Taxes Payable-- Retailers must collect sales taxes from
customers on sales of certain products and certain services and then
remit the sales tax collected to the proper governmental authority.
Example: Dillons Corporation made credit sales of $30,000 which
are subject to 6% sales tax. The corporation also made cash sales
which totaled $20,670 including the 6% sales tax. (a) prepare the
entry to record Dillons’ credit sales. (b) Prepare the entry to
record Dillons’ cash sales.
(a) Accounts receivable
31,800
Sales
30,000
Sales tax payable ($30,000 x 6% = $1,800)
1,800
(b) Cash
Sales ($20,670  1.06 = $19,500)
Sales tax payable
Chapter
1-417
20,670
19,500
1,170
Income Tax Payable
Corporations must prepare a corporate income tax
return* and compute the income tax payable
resulting from the operations of the current
period.
Taxes payable are a current liability
Corporations must make periodic estimated tax payments
throughout the year.
Differences between taxable income and accounting income
sometimes occur (Chapter 19).
[* Corporations (Subchapter ‘S’ and LLCs) recognized by the
Chapter
1-418
IRS as partnerships do NOT pay corporate income taxes]
Employee Payroll Related Current Liabilities
Amounts owed to employees for salaries or wages are
reported as a current liability (i.e., “Salaries Payable”)
Also reported as current liabilities would be payroll
deductions withheld from employees’ pay checks (Fed.
income Tax, FICA and Medicare, State & Local income
tax; pension contributions; medical, dental, vision
contributions, etc.)
Employer Payroll Related Current Liabilities
Payroll Taxes incurred by Employer:
FICA & Medicare (matching employee withholding)
Unemployment Taxes (State & Federal)
Chapter
1-419
Payroll -- Current Liability ( An Illustration)
Assume a weekly payroll of $10,000 entirely subject to F.I.C.A. and
Medicare (7.65%), federal (0.8%) and state (4%) unemployment taxes,
with income tax withholding of $1,320 and union dues of $88 deducted.
Journal entry to record salaries and wages paid
Salaries and wages expense
10,000
Withholding taxes payable
1,320
F.I.C.A taxes payable
765
Union dues payable
88
Cash
7,827
Journal entry to record employer payroll taxes
Payroll tax expense
F.I.C.A taxes payable
Federal unemployment tax payable
State unemployment tax payable
Chapter
1-420 Employees’
1,245
765
80
400
take-home pay of $7,827 vs. $11,245 payroll cost to Employer!
Accrue for Compensated Absences
Current Liability
Accrue throughout the year, a current liability for paid
absences for vacation, illness, and holidays; and bonuses
if all the following conditions exist:
The obligation relates to rights that vest or accumulate.
The employer’s obligation is attributable to employees’
services already rendered.
Payment of the compensation is probable.
The amount can be reasonably estimated.
Chapter
1-421
Accrue = Spread expense throughout the year; not all
recorded as expense when paid!
Contingencies
“An existing condition, situation, or set of
circumstances involving uncertainty as to possible
gain (gain contingency) or loss (loss contingency) to
an enterprise that will ultimately be resolved when
one or more future events occur or fail to occur.”
Chapter
1-422
Gain Contingencies
Typical GAIN Contingencies are:
1. Possible receipts of monies from gifts and donations.
2. Possible refunds from the government in tax disputes.
3. Pending court cases with a probable favorable
outcome.
4. Tax loss carryforwards (Chapter 19).
Gain contingencies are usually not recorded. (Why not?)
Disclosed only if probability of receipt is high.
Chapter
1-423
Loss Contingencies
Loss Contingency ‘May” be Recorded
The likelihood that the future event will confirm
the incurrence of a loss and a liability can range
from probable to remote.
Three degrees of probability:
Probable.
Reasonably possible.
Remote.
Chapter
1-424
Loss Contingencies
Chapter
1-425
Probability
Accounting
Probable
Accrue
Reasonably
Possible
Disclose
Remote
Ignore
Loss Contingencies
Cone Inc. is involved in a lawsuit at December 31, 2010.
Prepare the December 31 entry, if any, assuming:
(a) it is probable that Cone will be liable for $900,000
(b) it is reasonably possible--not probable--that Cone will be
liable for any payment as a result of this suit.
(c) It is only a very remote possibility that Cone will be liable
for any payment as a result of the lawsuit.
(a)
Lawsuit loss
900,000
Lawsuit liability
900,000
(b) No entry is necessary. Disclosure required.
(c) No entry or disclosure is necessary.
Chapter
1-426
Do you believe that Loss Contingencies would be a difficult or easy
area to audit?
Loss Contingencies
Note the first item listed below as a “Loss Contingency” that Usually
is Accrued—but does NOT result in a liability being recorded!
Chapter
1-427
Loss Contingencies
Litigation, Claims, and Assessments
Companies must consider the following factors, in
determining whether to record a liability with
respect to pending or threatened litigation and
actual or possible claims and assessments.
Time period in which the action occurred.
Probability of an unfavorable outcome.
Ability to make a reasonable estimate of the loss.
Chapter
1-428
Loss Contingencies
Environmental Liabilities
A company must recognize an asset retirement
obligation (ARO) when it has an existing legal
obligation associated with the retirement of a long-
lived asset and when it can reasonably estimate the
amount of the liability.
NOTE: The SEC argues that if the liability is within a range, and no
amount within the range is the best estimate, then management should
recognize the minimum amount of the range.
Chapter
1-429
Loss Contingencies -- Environmental Liabilities
Environmental Liabilities--existing legal obligations, which
require recognition of a liability include, but are not limited to:

decommissioning nuclear facilities,

dismantling, restoring, and reclamation of oil and gas
properties,

certain closure, reclamation, and removal costs of mining
facilities,

Chapter
1-430
closure and post-closure costs of landfills.
Loss Contingencies -- Environmental Liabilities
(An Illustration)
On January 1, 2010, Wildcat Oil Company erected an oil platform.
Wildcat is legally required to dismantle and remove the platform at
the end of its useful life, estimated to be five years. Wildcat
estimates this will cost $1,000,000. Based on a 10 percent discount
rate, the fair value of the asset retirement obligation on January 1,
2010 is estimated to be $620,920 ($1,000,000 x .62092).
Journal Entry to records this Asset Retirement Obligation (ARO)
Drilling platform
Asset retirement obligation
Chapter
1-431
620,920
620,920
Over the next five years: (1) the $620,920 Drilling Platform
Asset will be depreciated AND (2) interest needs to be
recognized as the ARO Liability ‘grows’ until it is $1,000,000
in five years.
Loss Contingencies -- Environmental Liabilities
(An Illustration)
Using the straight-line method, Wildcat makes the following journal
entry each of the next five years to record depreciation of the
Drilling Platform.
Depreciation expense ($620,920 / 5)
124,184
Accumulated depreciation
124,184
Wildcat also needs to record interest expense and the related
increase in the asset retirement obligation. The first year’s journal
entry on December 31, 2010 would be:
Interest expense ($620,092 x 10%)
Asset retirement obligation
62,092
62,092
Similar entries would be made each year--based on an amortization schedule
Chapter
1-432
If the actual cost to demolish the drilling platform differs from the
ARO liability amount--the difference is recorded as a gain or loss.
Loss Contingencies
Self-Insurance
Self-insurance is not insurance, but risk assumption.
There is little theoretical justification for the
establishment of a liability based on a hypothetical
charge to insurance expense.
Self-Insurance ‘reserves’ (“cookie jars”) have been improperly
used in the past by management to ‘manage earnings’
Chapter
1-433
Disclosure Requirements for Contingencies
Disclosure should include:
 Nature of the contingency.
 An estimate of the possible loss or range of loss.
Companies should disclose certain other contingent liabilities.
1.
Guarantees of indebtedness of others.
2.
Obligations of commercial banks under “stand-by letters of credit.”
3.
Guarantees to repurchase receivables (or any related property) that
have been sold or assigned.
Chapter
1-434
Disclosure Requirements for Contingencies
(An Illustration)
Disclosure of Loss Contingency through Litigation
Chapter
1-435
Balance Sheet Presentation of Current Liabilities
Chapter
1-436
Ratio Analysis
Analysis of Current Liabilities
Liquidity regarding a liability is the expected time
to elapse before its payment. Two ratios to help
assess liquidity are:
Current Ratio =
Acid-Test Ratio
(aka. “Quick
Ratio”)
Chapter
1-437
=
Current Assets
Current Liabilities
Cash + Marketable Securities +
Net Receivables
Current Liabilities
Ratio Analysis -- An Illustration
Costner Company has been operating for several years, and on
December 31, 2010, presented the following balance sheet.
Balance Sheet (in thousands)
Compute the current ratio:
Assets
Cash
Accounts recievables, net
Inventories
Plant assets, net
Total assets
$ 40,000
75,000
95,000
220,000
$ 430,000
Liabilities and Equity
Accounts payable
Mortgage payable
Common stock, $1 par
Retained earnings
Total liabilities and equity
Chapter
1-438
$ 70,000
140,000
160,000
60,000
$ 430,000
$210,000
70,000
=
3.0 to 1
Compute the acid-test ratio:
$115,000
70,000
= 1.64 to 1
“Window Dressing”!!!!!!
Class Assignment Review Questions and
Homework for Ch. 13
Class Assignment Questions #1, 3, 7, 9, 13, 20,
21, 22, 26, 30 (page 669)
Homework (pages 668-673):
CE 13-1, CE 13-2
Ex. 1, 2, 8, 13
Chapter
1-439