Financial Accounting Foundations Summary Notes Basic Functions of an Accounting System Interpret and record business transactions. Classify similar transactions into useful reports. Summarize and communicate information to decision makers. External Users of Accounting Information •Owners •Creditors •Potential investors •Labor unions •Governmental agencies •Suppliers •Customers •Trade associations •General public Objectives of External Financial Reporting Provide specific information about economic resources, claims to resources, and changes in resources and claims. Provide information useful in assessing amount, timing and uncertainty of future cash flows. Provide general information useful in making investment and credit decisions. Users of Internal Accounting Information • Board of directors • Chief executive officer (CEO) • Chief financial officer (CFO) • Vice presidents • Business unit managers • Plant managers • Store managers • Line supervisors Introduction to Financial Statements Balance Sheet Income Statement Statement of Cash Flows Describes where the enterprise stands at a specific date. Introduction to Financial Statements Balance Sheet Income Statement Statement of Cash Flows Depicts the revenue and expenses for a designated period of time. Introduction to Financial Statements Balance Sheet Income Statement Statement of Cash Flows Depicts the ways cash has changed during a designated period of time. Assets Vagabond Travel Agency Balance Sheet December 31, 2011 Assets Liabilities & Owners' Equity Cash $ 22,500 Liabilities: Notes receivable 10,000 Notes payable $ 41,000 Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities $ 80,000 Building 90,000 Owners' Equity: Office equipment 15,000 Capital stock 150,000 Retained earnings 70,000 Total $ 300,000 Total $ 300,000 Assets are economic resources that are owned by the business and are expected to benefit future operations. Assets These accounting principles support cost as the basis for asset valuation. Stable-Dollar Assumption Cost Principle Objectivity Principle Going-Concern Assumption Liabilities Vagabond Travel Agency Balance Sheet December 31, 2011 Assets Liabilities & Owners' Equity Cash $ 22,500 Liabilities: Notes receivable 10,000 Notes payable $ 41,000 Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities $ 80,000 Building 90,000 Owners' Equity: Office equipment 15,000 Capital stock 150,000 Retained earnings 70,000 Total $ 300,000 Total $ 300,000 Liabilities are debts that represent negative future cash flows for the enterprise. Owners’ Equity Vagabond Travel Agency Balance Sheet December 31, 2011 Assets Liabilities & Owners' Equity Cash $ 22,500 Liabilities: Notes receivable 10,000 Notes payable $ 41,000 Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities $ 80,000 Building 90,000 Owners' Equity: Office equipment 15,000 Capital stock 150,000 Retained earnings 70,000 Total $ 300,000 Total $ 300,000 Owners’ equity represents the owners’ claims on the assets of the business. The Accounting Equation Assets = Liabilities + Owners’ Equity $300,000 = $80,000 + $220,000 Vagabond Travel Agency Balance Sheet December 31, 2011 Assets Liabilities & Owners' Equity Cash $ 22,500 Liabilities: Notes receivable 10,000 Notes payable $ 41,000 Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities $ 80,000 Building 90,000 Owners' Equity Office equipment 15,000 Capital stock 150,000 Retained earnings 70,000 Total $ 300,000 Total $ 300,000 Debit and Credit Entries Debits and credits affect accounts as follows: A = L + OE ASSETS Debit for Increase Credit for Decrease LIABILITIES Debit Credit for for Increase Decrease EQUITIES Debit for Decrease Credit for Increase Double Entry AccountingThe Equality of Debits and Credits A = L + OE = Debit balances Credit balances In the double-entry accounting system, every transaction is recorded by equal dollar amounts of debits and credits. The Matching Principle: When To Record Revenue Matching Principle Revenue should be recognized at the time goods are sold and services are rendered. The Matching Principle: When To Record Expenses Matching Principle Expenses should be recorded in the period in which they are used up. Debit and Credit Rules for Revenue and Expenses Expenses decrease owners’ equity. EQUITIES Debit for Decrease EXPENSES Debit for Increase Credit for Decrease Credit for Increase Revenues increase owners’ equity. REVENUES Debit for Decrease Credit for Increase JJ's Lawn Care Service Unadjusted Trial Balance May 31, 2011 Cash $ 3,925 Accounts receivable 75 Tools & equipment 2,650 Truck 15,000 Notes payable $ Accounts payable Capital stock Dividends 200 Sales revenue Gasoline expense 50 Total $ 21,900 $ 13,000 150 8,000 750 21,900 All balances are taken from the ledger accounts on May 31 after considering all of JJ’s transactions for the month. Adjusting Entries Adjusting entries are needed whenever revenue or expenses affect more than one accounting period. Every adjusting entry involves a change in either a revenue or expense and an asset or liability. Types of Adjusting Entries Converting assets to expenses Converting liabilities to revenue Accruing unpaid expenses Accruing uncollected revenue Converting Assets to Expenses End of Current Period Prior Periods Transaction Paid cash in advance of incurring expense (creates an asset). Current Period Future Periods Adjusting Entry Recognizes portion of asset consumed as expense, and Reduces balance of asset account. Converting Assets to Expenses $2,400 Insurance Policy Coverage for 12 Months $200 Monthly Insurance Expense Jan. 1 Dec. 31 On January 1, Webb Co. purchased a oneyear insurance policy for $2,400. Converting Liabilities to Revenue End of Current Period Prior Periods Transaction Collect cash in advance of earning revenue (creates a liability). Current Period Future Periods Adjusting Entry Recognizes portion earned as revenue, and Reduces balance of liability account. Converting Liabilities to Revenue $6,000 Rental Contract Coverage for 12 Months $500 Monthly Rental Revenue Jan. 1 Dec. 31 On January 1, Webb Co. received $6,000 in advance for a one-year rental contract. Accruing Unpaid Expenses End of Current Period Prior Periods Current Period Adjusting Entry Recognizes expense incurred, and Records liability for future payment. Future Periods Transaction Pay cash in settlement of liability. Accruing Unpaid Expenses $3,000 Wages Expense Monday, May 29 Wednesday, May 31 Friday, June 2 On May 31, Webb Co. owes wages of $3,000. Payday is Friday, June 2. Accruing Uncollected Revenue End of Current Period Prior Periods Current Period Adjusting Entry Recognizes revenue earned but not yet recorded, and Records receivable. Future Periods Transaction Collect cash in settlement of receivable. Accruing Uncollected Revenue $170 Interest Revenue Saturday, Jan. 15 Monday, Jan. 31 Tuesday, Feb. 15 On Jan. 31, the bank owes Webb Co. interest of $170. Interest is paid on the 15th day of each month. Effects of the Adjusting Entries Income Statement Adjustment Type I Converting Assets to Expenses Type II Converting Liabilities to Revenue Type III Accruing Unpaid Expenses Type IV Accruing Uncollected Revenue Revenue Expenses No effect Increase Increase Assets Liabilities Decrease Decrease No effect No effect Increase No effect Increase Increase Net Income Balance Sheet No effect Decrease Decrease No effect Increase No effect Increase Increase No effect Owners' Equity Decrease Increase Decrease Increase JJ's Lawn Care Service Unadjusted Trial Balance May 31, 2011 Cash $ 3,925 Accounts receivable 75 Tools & equipment 2,650 Truck 15,000 Notes payable $ Accounts payable Capital stock Dividends 200 Sales revenue Gasoline expense 50 Total $ 21,900 $ 13,000 150 8,000 750 21,900 All balances are taken from the ledger accounts on May 31 after considering all of JJ’s transactions for the month. Adjusted Trial Balance JJ's Lawn Care Service Adjusted Trial Balance May 31, 2011 Cash $ 3,925 Accounts receivable 75 Tools & equipment 2,650 Accum. depreciation: tools & eq. $ 50 Truck 15,000 Accum. depreciation: truck 250 Notes payable 13,000 Accounts payable 150 Capital stock 8,000 Dividends 200 Sales revenue 750 Gasoline expense 50 Depreciation exp.: tools & eq. 50 Depreciation exp.: truck 250 Total $ 22,200 $ 22,200 All balances are taken from the ledger accounts on May 31 after preparing the two depreciation adjusting entries. JJ's Lawn Care Service Adjusted Trial Balance May 31, 2011 Cash $ Accounts receivable 3,925 75 Tools & equipm ent Accum ulated depreciation: tools & equipm ent 2,650 $ Truck 15,000 Accum um lated depreciation: truck 250 Notes payable 13,000 Accounts payable 150 Capital stock 8,000 Dividends 200 Sales revenue 750 Gasoline expense 50 Depreciation expense: tools & equipm ent 50 Depreciation expense: truck Total 50 250 $ 22,200 $ 22,200 Now, let’s prepare the financial statements for JJ’s Lawn Care Service for May. The Income Statement JJ's Lawn Care Service Income Statement For the month ending May 31, 2011 Sales revenue $ 750 Operating expenses: Gasoline expense Depreciation: tools & equipment Depreciation: truck Net income $ 50 50 250 350 $ Net income also appears on the Statement of Retained Earnings. 400 The Statement of Retained Earnings JJ's Lawn Care Service Statement of Retained Earnings For the Month Ended May 31, 2011 Retained earnings, May 1 Add: Net income Subtotal Less: Dividends Retained earnings, May 31 $ 400 $ 400 200 $ 200 Now, let’s prepare the Balance Sheet. The Balance Sheet JJ's Lawn Care Service Balance Sheet May 31, 2011 Assets Cash Accounts receivable Tools & equipment $ 2,650 Less: Accumulated depreciation 50 Truck $ 15,000 Less: Accumulated depreciation 250 Total assets Liabilities & Stockholders' Equity Liabilities: Notes payable Accounts payable Total liabilities Stockholders' equity: Capital stock $ 8,000 Retained earnings 200 Total stockholders' equity Total liabilities & stockholders' equity $ 3,925 75 2,600 $ $ 14,750 21,350 $ 13,000 150 13,150 $ 8,200 21,350 Relationships among the Financial Statements JJ's Lawn Care Service Income Statement For the month ending May 31, 2011 JJ's Lawn Care Service Balance Sheet May 31, 2011 Assets Cash Accounts receivable Tools & equipment $ 2,650 Less: Accumulated depreciation 50 Truck $ 15,000 Less: Accumulated depreciation 250 Total assets Liabilities & Stockholders' Equity Liabilities: Notes payable Accounts payable Total liabilities Stockholders' equity: Capital stock $ 8,000 Retained earnings 200 Total stockholders' equity Total liabilities & stockholders' equity $ 3,925 75 2,600 $ $ 14,750 21,350 $ 13,000 150 13,150 $ 8,200 21,350 Sales revenue Operating expenses: Gasoline expense Depreciation: tools & equipment Depreciation: truck Net income $ $ 750 $ 350 400 50 50 250 JJ's Lawn Care Service Statement of Retained Earnings For the Month Ended May 31, 2011 Retained earnings, May 1 Add: Net income Subtotal Less: Dividends Retained earnings, May 31 $ 400 $ 400 200 $ 200 Closing the Temporary Accounts Close Revenue accounts to Income Summary. Close Expense accounts to Income Summary. Close Income Summary account to Retained Earnings. Close Dividends to Retained Earnings. The closing process gets the temporary accounts ready for the next accounting period. Closing the Temporary Accounts JJ's Lawn Care Service Adjusted Trial Balance May 31, 2011 Cash $ 3,925 Accounts receivable 75 Tools & equipment 2,650 Accum. depreciation: tools & eq. $ 50 Truck 15,000 Accum. depreciation: truck 250 Notes payable 13,000 Accounts payable 150 Capital stock 8,000 Dividends 200 Sales revenue 750 Gasoline expense 50 Depreciation exp.: tools & eq. 50 Depreciation exp.: truck 250 Total $ 22,200 $ 22,200 Closing Entries for Revenue Accounts Since Sales Revenue has a credit balance, the closing entry requires a debit to the Sales Revenue account. GENERAL JOURNAL Date Account Titles and Explanation May 31 Sales Reveune Income Summary To close the revenue account. Debit Credit 750 750 Closing Entries for Expense Accounts Since expense accounts have a debit balance, the closing entry requires a credit to the expense accounts. GENERAL JOURNAL Date Account Titles and Explanation May 31 Income Summary Debit Credit 350 Gasoline Expense 50 Depreciation Exp.: Tools & Equipment 50 Depreciation Exp.: Truck To close the expense accounts. 250 Closing the Income Summary Account Since Income Summary has a $400 credit balance, the closing entry requires a debit to Income Summary. GENERAL JOURNAL Date Account Titles and Explanation May 31 Income Summary Retained Earnings To close Income Summary. Debit Credit 400 400 Closing the Dividends Account Since the Dividends account has a debit balance, the closing entry requires a credit to the Dividends account. GENERAL JOURNAL Date Account Titles and Explanation May 31 Retained Earnings Dividends To close the Dividends account. Debit Credit 200 200 After-Closing Trial Balance JJ's Lawn Care Service After-Closing Trial Balance May 31, 2011 Cash $ 3,925 Accounts receivable 75 Tools & equipment 2,650 Accum. depreciation: tools & eq. $ 50 Truck 15,000 Accum. depreciation: truck 250 Notes payable 13,000 Accounts payable 150 Capital stock 8,000 Retained earnings 200 Total $ 21,650 $ 21,650 Operating Cycle of a Merchandising Company Income Statement of a Merchandising Company Computer City Condensed Income Statement For the Year Ended December 31, 2011 Revenue from sales $ 900,000 Less: Cost of goods sold 540,000 Gross profit $ 360,000 Less: Expenses 270,000 Net income $ 90,000 Cost of goods sold represents the expense of goods that are sold to customers. Gross profit is a useful means of measuring the profitability of sales transactions. Closing Entries in a Perpetual Inventory System Close Revenue accounts (including Sales) to Income Summary. Close Expense accounts (including Cost of Goods Sold) to Income Summary. Close Income Summary account to Retained Earnings. Close Dividends to Retained Earnings. The closing entries are the same! Credit Terms and Cash Discounts When manufacturers and wholesalers sell their products on account, the credit terms are stated in the invoice. Read as: “Two ten, net thirty” 2/10, n/30 Percentage of Discount # of Days Discount Is Available Otherwise, the Full Amount Is Due # of Days when Full Amount Is Due Recording Purchases at Net Cost On July 6, Jack & Jill, Inc. purchased $4,000 of merchandise on credit with terms of 2/10, n/30 from Kid’s Clothes. Prepare the journal entry for Jack & Jill, Inc. GENERAL JOURNAL Date Account Titles and Explanation July 6 Inventory Accounts Payable (Kid's Clothes) $4,000 98% = $3,920 Debit Credit 3,920 3,920 Transactions Related to Sales Computer City Partial Income Statement For the Year Ended December 31, 2011 Revenue Sales Less: Sales returns and allowances $ Sales discounts Net sales $ 912,000 8,000 4,000 12,000 $ 900,000 Credit terms and merchandise returns affect the amount of revenue earned by the seller. The Valuation of Financial Assets Basis for Valuation in Type of Financial Assets the Balance Sheet Cash (and cash equivalents) Face amount Short-term investments Current market value (marketable securities) Receivables Net realizable value Estimated collectible amount Presentation of Marketable Securities in the Balance Sheet Reflecting Uncollectible Accounts in the Financial Statements At the end of each period, record an estimate of the uncollectible accounts. GENERAL JOURNAL Date Account Titles and Explanation Uncollectible Accounts Expense Credit $$$$ Allowance for Doubtful Accounts Selling expense Debit $$$$ Contra-asset account The Allowance for Doubtful Accounts The net realizable value is the amount of accounts receivable that the business expects to collect. Accounts receivable Less: Allowance for doubtful accounts Net realizable value of accounts receivable Monthly Estimates of Credit Losses At the end of each month, management should estimate the probable amount of uncollectible accounts and adjust the Allowance for Doubtful Accounts to this new estimate. Two Approaches to Estimating Credit Losses 1. Balance Sheet Approach 2. Income Statement Approach Estimating Credit Losses — The Balance Sheet Approach Year-end Accounts Receivable is broken down into age classifications. Each age grouping has a different likelihood of being uncollectible. Compute a separate allowance for each age grouping. Estimating Credit Losses — The Balance Sheet Approach At December 31, the receivables for EastCo, Inc. were categorized as follows: EastCo, Inc. Schedule of Accounts Receivable by Age Days Past Due Current 1 - 30 31 - 60 Over 60 December 31, 2009 Accounts Estimated Estimated Receivable Bad Debts Uncollectible Balance Percent Amount $ $ 45,000 15,000 5,000 2,000 67,000 1% $ 3% 5% 10% $ 450 450 250 200 1,350 Estimating Credit Losses — The Balance Sheet Approach EastCo’s unadjusted balance in the allowance account is $500. Per the previous computation, the desired balance is $1,350. Allowance for Doubtful Accounts 500 850 1,350 GENERAL JOURNAL Date Account Titles and Explanation Dec. 31 Uncollectible Accounts Expense Allowance for Doubtful Accounts Debit Credit 850 850 Estimating Credit Losses — The Income Statement Approach Uncollectible accounts’ percentage is based on actual uncollectible accounts from prior years’ credit sales. Net Credit Sales % Estimated Uncollectible Amount of Journal Entry Estimating Credit Losses — The Income Statement Approach In the current year, EastCo had credit sales of $60,000. Historically, 1% of EastCo’s credit sales has been uncollectible. For the current year, the estimate of uncollectible accounts expense is $600. ($60,000 × .01 = $600) GENERAL JOURNAL Date Account Titles and Explanation Dec. 31 Uncollectible Accounts Expense Allowance for Doubtful Accounts Debit Credit 600 600 Notes Receivable and Interest Revenue The interest formula includes three variables: Interest = Principal × Interest Rate × Time When computing interest for one year, “Time” equals 1. When the computation period is less than one year, then “Time” is a fraction. For example, if we needed to compute interest for 3 months, “Time” would be 3/12. Notes Receivable and Interest Revenue On November 1, Hall Company loans $10,000 to Porter Company on a 3 month note earning 12 percent interest. On December 31st, Hall Company needs an adjusting entry to record the interest revenue on the Porter Company note. Date Description Dec. 31 Interest Receivable Interest Revenue Debit Credit 200 $10,00012% 2/12 = $200 200 Notes Receivable and Interest Revenue What entry would Hall Company make on February 1, the maturity date? $10,00012% 3/12 = $300 Date Description Feb. 1 Cash Interest Receivable Interest Revenue Notes Receivable Debit Credit 10,300 200 100 10,000 The Flow of Inventory Costs BALANCE SHEET Purchase costs (or manufacturing costs) Asset Inventory INCOME STATEMENT Revenue Cost of goods sold Gross profit Expenses Net income as goods are sold Inventory Valuation Methods: A Summary Costs Allocated to: Valuation Cost of Goods Method Sold Inventory Comments Specific Actual cost of Actual cost of units Parallels physical flow identification the units sold remaining Logical method when units are unique May be misleading for identical units Average cost Number of units Number of units on Assigns all units the same sold times the hand times the average unit cost average unit cost average unit cost Current costs are averaged in with older costs First-in, First-out Cost of earliest Cost of most Cost of goods sold is based (FIFO) purchases on recently on older costs hand prior to the purchased units Inventory valued at current sale costs May overstate income during periods of rising prices; may increase income taxes due Last-in, First-out Cost of most Cost of earliest Cost of goods sold shown at (LIFO) recently purchases recent prices purchased units (assumed still in Inventory shown at old (and inventory) perhaps out of date) costs Most conservative method during periods of rising prices; often results in lower income taxes Importance of an Accurate Valuation of Inventory Average-Cost Method On August 14, TBC sold 20 bikes for $130 each. Purchases Date Units Unit Cost Total Cost of Goods Sold Unit Cost Units Total Inventory Balance Units Unit Cost Aug. 1 10 @ $ 91 = $ 910 10 @ $ Aug. 3 15 @ $ 106 = $ 1,590 25 @ $ 5 @ $ Aug. 14 The average cost per unit must be computed prior to each sale. 20 @ $ 100 = $ 2,000 Total 91 = $ 910 100 = $ 2,500 100 = $ 500 $2,500 25 = $100 avg. cost Average-Cost Method Additional purchases were made on August 17 and August 28. On August 31, an additional 23 units were sold. Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Purchases Unit Cost Units Total Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 91 = $ 910 10 @ $ 15 @ $ 106 = $ 1,590 25 @ $ 100 = $ 2,500 5 @ $ 100 = $ 20 @ $ 100 = $ 2,000 91 = $ 910 500 20 @ $ 115 = $ 2,300 25 @ $ 112 = $ 2,800 10 @ $ 119 = $ 1,190 35 @ $ 114 = $ 3,990 12 @ $ 114 = $ 1,368 23 @ $ 114 = $ 2,622 $114 = $3,990 35 Average-Cost Method Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units Income Statement 20 @ $ 100 = $ 2,000 COGS = $4,622 23 @ $ 114 = $ 2,622 10 @ $ 91 = $ 910 25 @ $ 100 = $ 2,500 5 @ $ 100 = $ 25 @ $ 112 = $ 2,800 35 @ $ 114 = $ 3,990 12 @ $ 114 = $ 1,368 500 Balance Sheet Inventory = $1,368 First-In, First-Out Method (FIFO) On August 14, TBC sold 20 bikes for $130 each. Date Aug. 1 Aug. 3 Aug. 14 Purchases Unit Cost Units Total Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 91 = $ 910 10 @ $ 91 15 @ $ 106 = $ 1,590 10 @ $ 91 15 @ $ 106 5 @ $ 106 10 @ $ 91 10 @ $ 106 = $ 1,970 = $ 910 = $ 2,500 = $ The Cost of Goods Sold for the August 14 sale is $1,970, leaving 5 units, with a total cost of $530, in inventory. 530 First-In, First-Out Method (FIFO) Additional purchases were made on Aug. 17 and Aug. 28. On August 31, an additional 23 units were sold. Date Aug. 1 Aug. 3 Purchases Unit Cost Units Total 10 @ $ 91 = $ 910 10 @ $ 91 15 @ $ 106 = $ 1,590 10 @ $ 91 15 @ $ 106 5 @ $ 106 Aug. 14 Aug. 17 Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 20 @ $ 115 = 10 @ $ 91 10 @ $ 106 = $ 1,970 $ 2,300 5 @ 20 Aug. 28 Aug. 31 10 @ $ 119 = $ 1,190 5 @ $ 106 18 @ $ 115 = $ 2,600 $ 106 @ $ 115 5 @ $ 106 20 @ $ 115 10 @ $ 119 2 @ $ 115 10 @ $ 119 = $ 910 = $ 2,500 = $ 530 = $ 2,830 = $ 4,020 = $ 1,420 First-In, First-Out Method (FIFO) Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 91 10 @ $ 106 = $ 1,970 10 @ $ 91 10 @ $ 91 15 @ $ 106 5 @ $ 106 5 @ Income Statement COGS = $4,570 5 @ $ 106 18 @ $ 115 = $ 2,600 20 $ 106 @ $ 115 5 @ $ 106 20 @ $ 115 10 @ $ 119 2 @ $ 115 10 @ $ 119 = $ 910 = $ 2,500 = $ 530 = $ 2,830 = $ 4,020 Balance Sheet = $ 1,420 Inventory = $1,420 Last-In, First-Out Method (LIFO) On August 14, TBC sold 20 bikes for $130 each. Date Aug. 1 Aug. 3 Aug. 14 Purchases Unit Cost Units Total Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 91 = $ 910 10 @ $ 91 15 @ $ 106 = $ 1,590 10 @ $ 91 15 @ $ 106 5 @ $ 15 @ $ 106 5 @ $ = $ 2,045 91 = $ 910 = $ 2,500 = $ 455 91 The Cost of Goods Sold for the August 14 sale is $2,045, leaving 5 units, with a total cost of $455, in inventory. Last-In, First-Out Method (LIFO) Additional purchases were made on Aug. 17 and Aug. 28. On Aug. 31, an additional 23 units were sold. Date Aug. 1 Aug. 3 Purchases Unit Cost Units Total 10 @ $ 91 = $ 910 10 @ $ 91 15 @ $ 106 = $ 1,590 10 @ $ 91 15 @ $ 106 5 @ $ 91 $ 91 Aug. 14 Aug. 17 Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 20 @ $ 115 = 15 @ $ 106 5 @ $ = $ 2,045 Aug. 31 10 @ $ 119 = 910 = $ 2,500 = $ 455 91 $ 2,300 5 @ 20 Aug. 28 = $ $ 1,190 @ 5 @ 10 @ $ 119 13 @ $ 115 = $ 2,685 $ 91 20 @ $ 115 10 @ $ 119 5 @ $ 7 $ 115 @ = $ 2,755 $ 115 91 = $ 3,945 = $ 1,260 Last-In, First-Out Method (LIFO) Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 15 @ $ 106 5 @ $ = $ 2,045 10 @ $ 91 10 @ $ 91 15 @ $ 106 5 @ $ 91 $ 91 = $ 910 = $ 2,500 = $ 455 91 5 @ Income Statement COGS = $4,730 10 @ $ 119 13 @ $ 115 = $ 2,685 20 @ 5 @ $ 115 $ 91 20 @ $ 115 10 @ $ 119 5 @ $ 7 $ 115 @ = $ 2,755 91 = $ 3,945 Balance Sheet = $ 1,260 Inventory = $1,260 Major Categories of Plant Assets Tangible Plant Assets Intangible Assets Natural Resources Long-term assets having physical substance. Noncurrent assets with no physical substance. Sites acquired for extracting valuable resources. Land, buildings, equipment, furniture, fixtures. Patents, copyrights, trademarks, franchises, goodwill. Oil reserves, timber, other minerals. Accountable Events in the Lives of Plant Assets 1. Acquisition. 2. Allocation of the acquisition cost to expense over the asset’s useful life (depreciation). 3. Sale or disposal. Acquisition of Plant Assets Cost = Asset price + Reasonable and necessary costs . . . . . . for getting the asset to the desired location. . . . for getting the asset ready for use. Capital Expenditures and Revenue Expenditures Capital Expenditure Revenue Expenditure Any material expenditure that will benefit several accounting periods. Expenditure for ordinary repairs and maintenance. To capitalize an expenditure means to charge it to an asset account. To expense an expenditure means to charge it to an expense account. Depreciation The allocation of the cost of a plant asset to expense in the periods in which services are received from the asset. Balance Sheet Purchase cost as assets purchased Assets: Plant and equipment Income Statement Revenues: Expenses: Depreciation as the services are received Depreciation Book Value Cost – Accumulated Depreciation Depreciation Contra-asset Represents the portion of an asset’s cost that has already been allocated to expense. Causes of Depreciation Physical deterioration Obsolescence Straight-Line Depreciation Depreciation Expense per Year = Cost - Residual Value Years of Useful Life Straight-Line Depreciation On January 2, S&G Wholesale Grocery buys a new delivery truck. The truck cost $24,000, has an estimated residual value of $3,000, and an estimated useful life of 5 years. Compute annual depreciation using the straight-line method. Cost – Residual Value $ 24,000 – $ 3,000 = Years of Useful Life 5 = $ 4,200 per year Straight-Line Depreciation S&G will record $4,200 depreciation each year for five years. Total depreciation over the estimated useful life of the equipment is: Year First Second Third Fourth Fifth Depreciation Expense (debit) $ $ 4,200 4,200 4,200 4,200 4,200 21,000 Accumulated Depreciation (credit) $ $ 4,200 4,200 4,200 4,200 4,200 21,000 Accumulated Depreciation Balance $ 4,200 8,400 12,600 16,800 21,000 Salvage Value Undepreciated Balance (book value) $ 24,000 19,800 15,600 11,400 7,200 3,000 Declining-Balance Method Depreciation in the early years of an asset’s estimated useful life is higher than in later years. Accelerated Depreciation Remaining = × Depreciation Expense Book Value Rate The double-declining balance depreciation rate is 200% of the straight-line depreciation rate of (1÷Useful Life). Declining-Balance Method On January 2nd , S&G buys a new delivery truck paying $24,000 cash. The truck has an estimated residual value of $3,000 and an estimated useful life of 5 years. Compute depreciation for the first year using the double-declining balance method. First Year Expense = = = = Remaining × Book Value $ 24,000 × $ 24,000 × $ 9,600 Accelerated Depreciation Rate 2 × 1/5 40% Declining-Balance Method Total depreciation over the estimated useful life of an asset is the same using either the straight-line method or the decliningbalance method. Year Computation First $ 24,000 × 40% Second 14,400 × 40% Third 8,640 × 40% Fourth 5,184 × 40% Fifth Plug year # 5 Total Depreciation Depr. Accumulated Book Expense Depreciation Value $ 9,600 $ 9,600 $ 14,400 5,760 15,360 8,640 3,456 18,816 5,184 2,074 20,890 3,110 110 21,000 3,000 $ 21,000 Disposal of Plant and Equipment If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. Recording cash received (debit). Removing accumulated depreciation (debit). Recording a gain (credit) or loss (debit). Removing the asset cost (credit). Disposal of Plant and Equipment Assume that a machine costing $10,000, had accumulated depreciation of $8,000 and book value of $2,000 (10,000 - $8,000) at the time it was sold for $3,000 cash. Determine the gain or loss on sale of this machine. Cost of machine Accumulated depreciation Book value at time of sale Cash received Gain on sale of machine $ 10,000 (8,000) 2,000 3,000 $ 1,000 Disposal of Plant and Equipment Assume that a machine costing $10,000, had accumulated depreciation of $8,000 and book value of $2,000 (10,000 - $8,000) at the time it was sold for $3,000 cash. Determine the gain or loss on sale of this machine. Description Cash Accumulated Depreciation: Machinery Gain on Disposal of Plant Asset Machinery Debit Credit 3,000 8,000 1,000 10,000 Trading in Used Assets for New Ones Assume that Essex Company exchanges a used earthmover and $35,000 cash for a new earthmoving machine. The old machine originally cost $40,000, had up-to-date accumulated depreciation of $30,000, and a fair value of $4,000. + $35,000 Trading in Used Assets for New Ones Cost of equipment Accumulated derpreciation: Equipment $ 40,000 30,000 Book value of equipment Fair market value of equipment Loss on disposal of plant asset $ 10,000 4,000 6,000 Description Equipment (New earthmover) Accumulated depreciation: Equipment Loss on Disposal of Asset Equipment (Old earthmover) Cash $ Debit Credit 39,000 30,000 6,000 40,000 35,000 Intangible Assets Noncurrent assets without physical substance. Often provide exclusive rights or privileges. Characteristics Useful life is often difficult to determine. Usually acquired for operational use. Intangible Assets Record at current cash equivalent cost, including purchase price, legal fees, and filing fees. • • • • Patents Copyrights Leaseholds Leasehold Improvements • Goodwill • Trademarks and Trade Names The Nature of Liabilities Defined as debts or obligations arising from past transactions or events. Maturity = 1 year or less Maturity > 1 year Current Liabilities Noncurrent Liabilities Distinction Between Debt and Equity The acquisition of assets is financed from two sources: DEBT Funds from creditors, with a definite due date, and sometimes bearing interest. EQUITY Funds from owners. Current Liabilities: Accounts Payable Short-term obligations to suppliers for purchases of merchandise and to others for goods and services. Merchandise inventory invoices Office supplies invoices Examples Shipping charges Utility and phone bills Current Liabilities: Notes Payable When a company borrows money, a note payable is created. Current Portion of Notes Payable The portion of a note payable that is due within one year, or one operating cycle, whichever is longer. Current Notes Payable Total Notes Payable Noncurrent Notes Payable Accrued Liabilities Accrued liabilities arise from the recognition of expenses for which payment will be made in the future. Accrued liabilities are often referred to as accrued expenses. Examples include: 1. Interest payable, 2. Income taxes payable, and 3. Accrued payroll liabilities. Payroll Liabilities Gross Pay Net Pay Less Deductions: Social Security and Medicare Workman’s Compensation Federal Income Tax State and Local Income Taxes Voluntary Deductions Unearned Revenue Cash is sometimes collected from the customer before the revenue is actually earned. As the earnings process is completed Cash is received in advance. Deferred revenue is recorded. a liability account. Earned revenue is recorded. Long-Term Liabilities Relatively small debt needs can be filled from single sources. Banks or Insurance Companies or Pension Plans Long-Term Liabilities Large debt needs are often filled by issuing bonds. Installment Notes Payable Long-term notes that call for a series of installment payments. Each payment covers interest for the period AND a portion of the principal. With each payment, the interest portion gets smaller and the principal portion gets larger. Allocating Installment Payments Between Interest and Principal 1. Identify the unpaid principal balance. 2. Interest expense = Unpaid Principal × Interest rate. 3. Reduction in unpaid principal balance = Installment payment – Interest expense. 4. Compute new unpaid principal balance. On January 1, Year 1, King’s Inn purchased furnishings at a cost of $7,581.57. The loan was a five-year loan and had an interest rate of 10%. The annual payment is $2,000. Let’s prepare an amortization table for King’s Inn. Preparing an Amortization Table Date Payment Jan 1, Year 1 Dec. 31, Year 1 $ 2,000.00 Dec. 31, Year 2 2,000.00 Dec. 31, Year 3 2,000.00 Dec. 31, Year 4 2,000.00 Dec. 31, Year 5 2,000.00 Interest Expense $ 758.16 633.97 497.37 347.11 181.82 Reduction in Unpaid Balance $ 1,241.84 1,366.03 1,502.63 1,652.89 1,818.18 Unpaid Balance $ 7,581.57 6,339.73 4,973.70 3,471.07 1,818.18 0.00 $7,581.57 × 10% = $758.16 $2,000 - $758.16 = $1,241.84 $7,581.57 - $1,241.84 = $6,339.73 Using the Amortization Table The information needed for the journal entry can be found on the amortization table. The cash payment amount, the interest expense, and the principal reduction amount are all in the table. Date Description Dec. 31 Interest Expense Interest Payable Debit 758.16 Credit 758.16 Using the Amortization Table On January 1, Year 2, the first annual payment will be made on the installment note. Refer to the previous entry and amortization for the amounts shown. Date Jan. 1 Description Interest Payable Note Payable Cash Debit 758.16 1,241.84 Credit 2.000.00 Bonds Payable • Bonds usually involve the borrowing of a large sum of money, called principal. • The principal is usually paid back as a lump sum at the end of the bond period. • Individual bonds are often denominated with a par value, or face value, of $1,000. Bonds Payable • Bonds usually carry a stated rate of interest, also called a contract rate. • Interest is normally paid semiannually. • Interest is computed as: Principal × Stated Rate × Time = Interest Bonds Payable • Bonds are issued through an intermediary called an underwriter. • Bonds can be sold on organized securities exchanges. • Bond prices are usually quoted as a percentage of the face amount. For example, a $1,000 bond priced at 102 would sell for $1,020. Types of Bonds Mortgage Bonds Debenture Bonds Convertible Bonds Junk Bonds Accounting for Bonds Payable On March 1, 2011, Wells Corporation issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each March 1 and September 1. Assume the bonds are issued at face value. Record the issuance of the bonds. Date Description Mar. 1 Cash Bonds Payable Debit Credit 1,500,000 1,500,000 Accounting for Bonds Payable Record the interest payment on September 1, 2011. Date Description Sep. 1 Interest Expense Cash $1,500,000 × 12% × ½ = $90,000 Debit Credit 90,000 90,000 Bonds Issued Between Interest Dates • • Bonds are often sold between interest dates. The selling price of the bond is computed as: Present value of the bond + Accrued interest since the last interest payment = Selling price of the bond Bonds Issued at a Discount or a Premium The selling price of the bond is determined by the market based on the time value of money. Stated interest rate is Above market rate Equal to market rate The bonds sells: At a premium (Cash received is greater than face amount) At face amount (Cash received is equal to face amount) At a discount Below market rate (Cash received is less than face amount) Bonds Issued at a Discount Wells, Corp. issues bonds on January 1, 2011. Principal = $1,000,000 Issue price = $950,000 Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2030 (20 years) Principal $1,000,000 Cash Proceeds Discount - $ 950,000 = $ 50,000 Bonds Issued at a Discount To record the bond issue, Well, Inc. would make the following entry on January 1, 2011: Date Description Jan. 1 Cash Discount on Bonds Payable Bonds Payable Debit Credit 950,000 50,000 1,000,000 Bonds Issued at a Discount Partial Balance Sheet as of January 1, 2011 Long-term Liabilities: Bonds Payable Less: Discount on Bonds Payable $ 1,000,000 50,000 $ 950,000 Maturity Value Carrying Value Bonds Issued at a Discount Amortizing the discount over the term of the bond increases Interest Expense each interest payment period. Using the straight-line method, the discount amortization will be $1,250 every six months. $50,000 ÷ 40 periods = $1,250 Amortization of the Discount Interest paid every six months is calculated as follows: $1,000,000 × 9% × ½ = $45,000 We prepare the following journal entry to record the first interest payment. Date Description Jun. 30 Interest Expense Discount on Bonds Payable Cash Debit Credit 46,250 1,250 45,000 Bonds Issued at a Discount $50,000 – $1,250 – $1,250 Partial Balance Sheet as of December 31, 2011 Long-term Liabilities: Bonds Payable Less: Discount on Bonds Payable $ 1,000,000 47,500 $ 952,500 Maturity Value The carrying value will increase to exactly $1,000,000 on the maturity date. Carrying Value Bonds Issued at a Discount Wells Corporation will repay the principal amount on December 31, 2030 with the following entry: Date Description Dec. 31 Bonds Payable Cash Debit Credit 1,000,000 1,000,000