Financial Accounting [15 ed.] 0077328701, 9780077328702

Table of contents :
Tittle
Contents
1 Accounting: Information for Decision Making
Accounting from a User’s Perspective
Types of Accounting Information
Accounting Systems
Determining Information Needs
The Cost of Producing Accounting Information
Basic Functions of an Accounting System
Who Designs and Installs Accounting Systems?
Components of Internal Control
Financial Accounting Information
External Users of Accounting Information
Objectives of External Financial Reporting
Characteristics of Externally Reported Information
Management Accounting Information
Users of Internal Accounting Information
Objectives of Management Accounting Information
Characteristics of Management Accounting Information
Integrity of Accounting Information
Institutional Features
Professional Organizations
Competence, Judgment, and Ethical Behavior
Careers in Accounting
Public Accounting
Management Accounting
Governmental Accounting
Accounting Education
What about Bookkeeping?
Accounting as a Stepping-Stone
But What about Me? I’m Not an Accounting Major
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
Assignment Material
2 Basic Financial Statements
A Starting Point: Statement of Financial Position
Assets
Liabilities
Owners’ Equity
The Accounting Equation
The Effects of Business Transactions: An Illustration
Effects of These Business Transactions on the Accounting Equation
Income Statement
Statement of Cash Flows
Relationships among Financial Statements
Financial Analysis and Decision Making
Forms of Business Organization
Sole Proprietorships
Partnerships
Corporations
Reporting Ownership Equity in the Statement of Financial Position
The Use of Financial Statements by External Parties
The Need for Adequate Disclosure
Management’s Interest in Financial Statements
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
Assignment Material
3 The Accounting Cycle: Capturing Economic
The Role of Accounting Records
The Ledger
The Use of Accounts
Debit and Credit Entries
Double-Entry Accounting—The Equality of Debits and Credits
The Journal
Posting Journal Entries to the Ledger Accounts (and How to “Read” a Journal Entry)
Recording Balance Sheet Transactions: An Illustration
Ledger Accounts after Posting
What Is Net Income?
Retained Earnings
The Income Statement: A Preview
Revenue
Expenses
The Accrual Basis of Accounting 1
Debit and Credit Rules for Revenue and Expenses
Dividends
Recording Income Statement Transactions: An Illustration
The Journal
February’s Ledger Balances
The Trial Balance
Uses and Limitations of the Trial Balance
Concluding Remarks
The Accounting Cycle in Perspective
Ethics, Fraud & Corporate Governance
End-of-Chapter Review
Assignment Material
4 The Accounting Cycle: Accruals and Deferrals
The Need for Adjusting Entries
Types of Adjusting Entries
Adjusting Entries and Timing Differences
Characteristics of Adjusting Entries
Year-End at Overnight Auto Service
Converting Assets to Expenses
The Concept of Depreciation
Converting Liabilities to Revenue
Accruing Unpaid Expenses
Accruing Uncollected Revenue
Accruing Income Taxes Expense: The Final Adjusting Entry
Adjusting Entries and Accounting Principles
The Concept of Materiality
Effects of the Adjusting Entries
Concluding Remarks
Ethics, Fraud & Corporate Governance
End-of-Chapter Review
Assignment Material
5 The Accounting Cycle: Reporting Financial Results
Relationships among the Financial Statements
Drafting the Notes That Accompany Financial Statements
What Types of Information Must Be Disclosed?
Closing the Temporary Accounts
Closing Entries for Revenue Accounts
Closing Entries for Expense Accounts
Closing the Income Summary Account
Closing the Dividends Account
Summary of the Closing Process
After-Closing Trial Balance
A Last Look at Overnight: Was 2011 a Good Year?
Financial Analysis and Decision Making
Preparing Financial Statements Covering Different Periods of Time
Ethics, Fraud & Corporate Governance
Concluding Remarks
Supplemental Topic: The Worksheet
Isn’t This Really a Spreadsheet?
How Is a Worksheet Used?
The Mechanics: How It’s Done
What If: A Special Application of Worksheet Software
End-of-Chapter Review
Assignment Material
The Income Statement
The Statement of Retained Earnings
The Balance Sheet
Equipment Rentals
6 Merchandising Activities
Perpetual Inventory Systems
Taking a Physical Inventory
Closing Entries in a Perpetual Inventory System
Periodic Inventory Systems
Operation of a Periodic Inventory System
Closing Process in a Periodic Inventory System
Comparison of Perpetual and Periodic Inventory Systems
Selecting an Inventory System
Transactions Relating to Purchases
Credit Terms and Cash Discounts
Returns of Unsatisfactory Merchandise
Transportation Costs on Purchases
Transactions Relating to Sales
Sales Returns and Allowances
Sales Discounts
Delivery Expenses
Accounting for Sales Taxes
Modifying an Accounting System
Special Journals Provide Speed and Efficiency
Financial Analysis and Decision Making
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
The Operating Cycle of a Merchandising Company
Income Statement of a Merchandising Company
Accounting System Requirements for Merchandising Companies
Two Approaches Used in Accounting for Merchandise Inventories
Assignment Material
7 Financial Assets
The Valuation of Financial Assets
Cash
Reporting Cash in the Balance Sheet
Cash Management
Internal Control over Cash
Bank Statements
Reconciling the Bank Statement
Short-Term Investments
Accounting for Marketable Securities
Purchase of Marketable Securities
Recognition of Investment Revenue
Sale of Investments
Adjusting Marketable Securities to Market Value
Accounts Receivable
Uncollectible Accounts
The Allowance for Doubtful Accounts
Writing Off an Uncollectible Account Receivable
Monthly Estimates of Credit Losses
Recovery of an Account Receivable Previously Written Off
Direct Write-Off Method
Factoring Accounts Receivable
Credit Card Sales
Notes Receivable and Interest Revenue
Nature of Interest
Accounting for Notes Receivable
Financial Analysis and Decision Making
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
Assignment Material
8 Inventories and the Cost of Goods Sold
The Flow of Inventory Costs
Which Unit Did We Sell?
Data for an Illustration
Specific Identification
Cost Flow Assumptions
Average-Cost Method
First-In, First-Out Method
Last-In, First-Out Method
Evaluation of the Methods
Do Inventory Methods Really Affect Performance?
The Principle of Consistency
Just-in-Time (JIT) Inventory Systems
Taking a Physical Inventory
Recording Shrinkage Losses
LCM and Other Write-Downs of Inventory
The Year-End Cutoff of Transactions
Periodic Inventory Systems
International Financial Reporting Standards
Importance of an Accurate Valuation of Inventory
Techniques for Estimating the Cost of Goods Sold and the Ending Inventory
The Gross Profit Method
The Retail Method
“Textbook” Inventory Systems Can Be Modified
Financial Analysis and Decision Making
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
Assignment Material
Guitar Universe, Inc.
Financial Analysis and Decision Making
Natural Resources
Accounting for Natural Resources
Depreciation, Amortization, and Depletion— A Common Goal
Plant Transactions and the Statement of Cash Flows
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
Assignment Material
9 Plant and Intangible Assets
Acquisitions of Plant Assets
Determining Cost: An Example
Some Special Considerations
Capital Expenditures and Revenue Expenditures
Depreciation
Allocating the Cost of Plant and Equipment over the Years of Use
Causes of Depreciation
Methods of Computing Depreciation
The Straight-Line Method
The Declining-Balance Method
Which Depreciation Methods Do Most Businesses Use?
Financial Statement Disclosures
The Impairment of Plant Assets
Other Depreciation Methods
The Units-of-Output Method
MACRS
Sum-of-the-Years’ Digits
Decelerated Depreciation Methods
Depreciation Methods in Use: A Survey
Disposal of Plant and Equipment
Gains and Losses on the Disposal of Plant and Equipment
Trading in Used Assets for New Ones
International Financial Reporting Standards
Intangible Assets
Characteristics
Operating Expenses versus Intangible Assets
Amortization
Goodwill
Patents
Trademarks and Trade Names
Franchises
Copyrights
Other Intangibles and Deferred Charges
Research and Development (R&D) Costs
Major Categories of Plant Assets
Accountable Events in the Lives of Plant Assets
10 Liabilities
Current Liabilities
Accounts Payable
Notes Payable
The Current Portion of Long-Term Debt
Accrued Liabilities
Payroll Liabilities
Unearned Revenue
Long-Term Liabilities
Maturing Obligations Intended to Be Refinanced
Installment Notes Payable
Bonds Payable
What Are Bonds?
Tax Advantage of Bond Financing
Accounting for Bonds Payable
Bonds Issued at a Discount or a Premium
Accounting for a Bond Discount: An Illustration
Accounting for a Bond Premium: An Illustration
Bond Discount and Premium in Perspective
The Concept of Present Value
Bond Prices after Issuance
Early Retirement of Bonds Payable
Estimated Liabilities, Loss Contingencies, and Commitments
Estimated Liabilities
Loss Contingencies
Commitments
Evaluating the Safety of Creditors’ Claims
Methods of Determining Creditworthiness
How Much Debt Should a Business Have?
Financial Analysis and Decision Making
Ethics, Fraud & Corporate Governance
Special Types of Liabilities
Lease Payment Obligations
Operating Leases
Capital Leases
Liabilities for Pensions and Other Postretirement Benefits
Deferred Income Taxes
Concluding Remarks
End-of-Chapter Review
Assignment Material
11 Stockholders’ Equity: Paid-In Capital
Formation of a Corporation
Stockholder Records in a Corporation
Paid-In Capital of a Corporation
Authorization and Issuance of Capital Stock
Common Stock and Preferred Stock
Characteristics of Preferred Stock
Book Value per Share of Common Stock
Market Value
Market Price of Preferred Stock
Market Price of Common Stock
Book Value and Market Price
Stock Splits
Treasury Stock
Recording Purchases of Treasury Stock
Reissuance of Treasury Stock
Stock Buyback Programs
Financial Analysis and Decision Making
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
Assignment Material
Why Businesses Incorporate
Publicly Owned Corporations
12 Income and Changes in Retained Earnings
Developing Predictive Information
Reporting Irregular Items: An Illustration
Continuing Operations
Discontinued Operations
Extraordinary Items
Earnings per Share (EPS)
Financial Analysis and Decision Making
Other Transactions Affecting Retained Earnings
Cash Dividends
Dividend Dates
Liquidating Dividends
Stock Dividends
Statement of Retained Earnings
Prior Period Adjustments
Comprehensive Income
Statement of Stockholders’ Equity
Stockholders’ Equity Section of the Balance Sheet
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
Assignment Material
13 Statement of Cash Flows
Purposes of the Statement
Example of a Statement of Cash Flows
Classification of Cash Flows
Preparing a Statement of Cash Flows
Operating Activities
Investing Activities
Financing Activities
Cash and Cash Equivalents
Cash Flows from Operating Activities
Cash Payments for Merchandise and for Expenses
Cash Flows from Investing Activities
Cash Flows from Financing Activities
Relationship between the Statement of Cash Flows and the Balance Sheet
Reporting Operating Cash Flows by the Indirect Method
Reconciling Net Income with Net Cash Flows
The Indirect Method: A Summary
Indirect Method May Be Required in a Supplementary Schedule
The Statement of Cash Flows: A Second Look
Financial Analysis and Decision Making
Managing Cash Flows
Budgeting: The Primary Cash Management Tool
What Priority Should Managers Give to Increasing Net Cash Flows?
Some Strategies for Permanent Improvements in Cash Flow
Ethics, Fraud & Corporate Governance
A Worksheet for Preparing a Statement of Cash Flows
Data for an Illustration
The Worksheet
Entry
Concluding Remarks
End-of-Chapter Review
Assignment Material
14 Financial Statement Analysis
Tools of Analysis
Dollar and Percentage Changes
Trend Percentages
Component Percentages
Ratios
Standards of Comparison
Quality of Earnings
Quality of Assets and the Relative Amount of Debt
Measures of Liquidity and Credit Risk
A Classified Balance Sheet
Working Capital
Current Ratio
Quick Ratio
Debt Ratio
Evaluating Financial Ratios
Liquidity, Credit Risk, and the Law
Measures of Profitability
Classifications in the Income Statement
Multiple-Step Income Statements
Earnings per Share
Price-Earnings Ratio
Single-Step Income Statements
Evaluating the Adequacy of Net Income
Return on Investment (ROI)
Return on Assets (ROA)
Return on Equity (ROE)
Comprehensive Illustration: Seacliff Company
Analysis by Common Stockholders
Return on Investment (ROI)
Leverage
Analysis by Long-Term Creditors
Analysis by Short-Term Creditors
Cash Flow Analysis
Usefulness of Notes to Financial Statements
International Financial Reporting Standards
Summary of Analytical Measurements
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
Assignment Material
15 Global Business and Accounting
Home Depot, Inc.
Environmental Forces Shaping Globalization
Political and Legal Systems
Economic Systems
Culture
Technology and Infrastructure
Harmonization of Financial Reporting Standards
International Financial Reporting Standards: Adoption or Convergence
Foreign Currencies and Exchange Rates
Exchange Rates
Accounting for Transactions with Foreign Companies
Currency Fluctuations—Who Wins and Who Loses?
Consolidated Financial Statements That Include Foreign Subsidiaries
Ethics, Fraud & Corporate Governance
Concluding Remarks
End-of-Chapter Review
Assignment Material
Global Sourcing
Foreign Corrupt Practices Act
APPENDIX A Home Depot 2009Financial Statements
APPENDIX B The Time Value of Money Future Amounts and Present Values
Index

Citation preview

15th Edition

Financial Accounting Jan R. Williams Susan F. Haka Mark S. Bettner Joseph V. Carcello

Published by McGra Cop

usiness unit of The McGraw-Hill Companies, Inc., 1221 Av uted in an w-Hill Companies, Inc., including, b

v . 1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 5 4 3 2 1 ISBN 978-0-07-732870-2 MHID 0-07-732870-1 Vice president and editor-in-chief: Brent Gordon Stewart Mattson Publisher: Tim Vertovec Executive editor: huetz Executive director of development: Ann Torbert Dev Rebecca Mann V eting: Robin J. Zwettler eting director: Brad Parkins eting manager: Michelle Heaster V Lori Koetters hi Lead project manager: y Yep Senior buyer: Michael R. McCormick Cover and interior designer: Pam Verros Senior photo research coordinator: Keri Johnson Photo researcher: Ira Roberts Senior media project manager: Allison Souter Ron Nelms Cover image: ges/Alex Loc T ace: 10/12 Times Roman Compositor: Laserwords Private Limited

ess Cataloging-in-Publication Data illiams . . . [et al.].—15th ed. p. cm. Includes index. ISBN-13: 978-0-07-732870-2 (alk. paper) ISBN-10: 0-07-732870-1 (alk. paper) 1. Accounting. I. Williams, Jan R. HF5636.F5315 2012

w York, NY, 10020. w-Hill Companies, Inc. y means, or stored in a database or retrieval y network or

To Ben and Meg Wishart and Asher, Lainey, and Lucy Hunt, who have taught me the joys of being a grandfather.

For Cliff, Abi, and my mother, Fran.

To my parents, Fred and Marjorie.

To Terri, Stephen, Karen, and Sarah, whose sacrifices enabled me to participate in writing this book. Thank you—I love you!

Jan R. Williams h

cat

Susan F. Haka ma t

o

iv

Meet the Authors

Mark S. Bettner

g

Joseph V. Carcello

e

v

REACHING

GREAT HEIGHTS BEGINS WITH A

SOLID BASE As our eyes are drawn upward to the skyline of great cities, it’s important to remember that these impressive constructions are able to reach such heights only because their foundations are strong. In much the same way, being successful in the business world begins with fundamental courses like financial accounting. It is only when students have a firm grasp of concepts like the accounting cycle that they have a base on which to stand, a strong foundation on which to grow.

In this edition, as before, the Williams team has revised the text with a keen eye toward the principle of helping students establish the foundation they will need for future success in business. However, through new coverage of International Financial Reporting Standards and a revised globalization chapter, the Williams book also introduces students to larger themes and evolving concerns. This dual emphasis allows students to keep their eyes trained upward even as they become solidly grounded in accounting fundamentals.

The Williams book continues to rest on a bedrock of four key components:

well balanced textbook

Balanced Coverage. The 16th edition of Williams provides the most balanced coverage of financial and managerial topics on the market. By giving equal weight to financial and managerial topics, the authors emphasize the need for a strong foundation in both aspects of accounting.

clearly a superior choice.

Clear Accounting Cycle Presentation. In

Excellent book

the first five chapters of Financial & Managerial Accounting, the authors present the Accounting Cycle in a clear, graphically interesting four-step process. Central to this presentation is the dedication of three successive chapters to three key components of the cycle: recording entries (Chapter 3), adjusting entries (Chapter 4), and closing entries (Chapter 5). The Williams team places easy-to-read margin notes explaining each equation used in particular journal entries.

Student Motivation. The Williams team has put together a marketleading student package that will not only motivate your students, but help you see greater retention rates in your accounting courses. Vital pieces of technology supplement the core curriculum covered in the book: the Online Learning Center provides supplemental tools for both students and instructors; and McGraw-Hill Connect Accounting uses endof-chapter material pulled directly from the textbook to create static and algorithmic questions that can be used for homework and practice tests. The full Financial & Managerial Accounting package encourages students to apply what they’re learning and improve their grades.

excellent student and instructor resources.

Problem-Solving Skills. Financial I wish the texts had been this well written

& Managerial Accounting challenges your students to think about real-world situations and put themselves in the role of the decision maker through Case In Point, Your Turn, and Ethics, Fraud & Corporate Governance boxes. Students reference the Home Depot Financial Statements—included in the text as an appendix—to further hone problem-solving skills by evaluating real world financial data. The authors show a keen attention to detail when creating high-quality end-of-chapter material, such as the Critical Thinking Cases and Problems, ensuring that all homework is tied directly back to chapter learning objectives. vii

How Does Williams Help Students Step-by-Step Process for the Accounting Cycle Financial & Managerial Accounting was the FIRST text to illustrate Balance Sheet and Income Statement transactions using the four-step process described below. This hallmark coverage has been further revised and refined in the 15th edition. The Williams team breaks down the Accounting Cycle into three full chapters to help students absorb and understand this material: recording entries (Chapter 3), adjusting entries (Chapter 4), and closing entries (Chapter 5). Transactions are demonstrated visually to help students conquer recording transactions by showing the four steps in the process:

1

A

2

ebit/Credit Rules—helps tudents to remember whether the account should be debited/ credited.

3

4

—shows which accounts ded with an increase/ decrease. red

Entry—shows the result f the two previous steps. Ledger T-Accounts—shows tudents what was recorded and where.

Jan. 20

80,000 80,000

1/20 80,000

1/20 80,000

The Williams team puts the Accounting Equation (A ⴝ L ⴙ OE) in the margin by transaction illustrations to show students the big picture! Jan. 21

52,000 52,000

1/21 52,000

viii

1/21 52,000

Build a Strong Foundation? Robust End-of-Chapter Material Brief Exercises

accounting

LO1

LO2

T

LO5

LO9

Brief Exercises supplement the exercises with shorter, single-concept exercises that test the basic concepts of each chapter. These brief exercises give instructors more flexibility in their homework assignments.

LO10

An Alternate Problem Set provides students with even more practice on important concepts.

Problem Set B LO1

E T F

LO6

COMPREHENSIVE PROBLEM

Four Comprehensive Problems, ranging from two to five pages in length, present students with real-world scenarios and challenge them to apply what they’ve learned in the chapters leading up to them.

1

Susquehanna Equipment Rentals A COMPREHENSIVE ACCOUNTING CYCLE PROBLEM

Defined Key Terms and Self-Test Questions review and reinforce chapter material.

Self-Test Questions

ASSIGNMENT MATERIAL

Demonstration Problems and their solutions allow students to test their knowledge of key points in the chapters.

Discussion Questions

Critical Thinking Cases and Problems put students’ analytical skills to the test by having them think critically about key concepts from the chapter and apply them to business decisions. TWO sets of Problems and a full set of Exercises in EACH chapter give Financial Accounting the edge in homework materials.

Demonstration Problem

Critical Thinking Cases LO7

Ethics Cases in each chapter challenge students to explore the ethical impact of decisions made in business.

LO10

LO6

LO7

F

The 2009 Home Depot Financial Statements are included in Appendix A. Students are referred to key aspects of the 10-K in the text material and in end-of-chapter material to illustrate actual business applications of chapter concepts.

LO10

LO6 F

Home Depot

accounting

Excel Templates

Connect Accounting System

Ethical

roup Activities

riting

Internet

Internationa ix

The Williams Pedagogy Helps C HA P TE R 1 2

Income and Changes in Retained Earnings

d

YOUR TURN

A FT E R S TU DYI N G TH IS C HA P T E R , YOU S HO U L D B E A BL E TO :

Learning Objectives

D

© Shannon Stapleton/Corbis

CHAPTER OPENER

YOUR TURN

LO1

LO2

LO3

LO4

LO5

LO6 LO7

LO8

LO9

Exhibit 7–1

Students will love it.

D

EXHIBITS

Students Reach Great Heights PROCTER & GAMBLE COMPANY

Students like it better than any other text I have used. Procter & Gamble Company P&G

I saw immediate improvement in their understanding and grades

P&G

P&G

CASE IN POINT

Microsoft Corporation

■

D CASE IN POINT

Ethics, Fraud & Corporate Governance

d ETHICS, FRAUD & CORPORATE GOVERNANCE

Enron Enron

Enron Enron

S e tt i n g S t a n d a r d s McGraw-Hill Connect Accounting accounting

i n O n l i n e Te c h n o l o g y

xiii

Tegrity Campus: Lectures 24/7

McGraw-Hill Higher Education and Blackboard have teamed up. What does this mean for you?

Improve Student Learning Outcomes and Save Instructor Time with ALEKS®

CourseSmart

McGraw-Hill Customer Care Contact Information

Supplements for Financial Accounting INSTRUCTOR SUPPLEMENTS

comprehensive accounting book

more student and instructor resources

STUDENT SUPPLEMENTS

What’s New about the 15th Edition of Financial Accounting? The following list of revisions is a testament to the enthusiastic response of dozens of reviewers who contributed their considerable expertise. In doing so they have helped make the 15th edition of Financial Accounting the best book of its kind.

Chapter

Chapter

1 2

Chapter

3

Chapter

4

Chapter

Chapter

Chapter

12

Chapter

13

8

9

Chapter

5

Chapter

14

Chapter

6

Chapter

15

Chapter

7

Chapter

10

Chapter

11

We are grateful . . .

Acknowledgments Many of our colleagues reviewed Financial Accounting. Through their time and effort, we are able to continually improve and update the book to meet the needs of students and professors. We sincerely thank each of you for your valuable time and suggestions.

Brief Contents 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Contents 1 Accounting: Information for Decision Making

3 The Accounting Cycle: Capturing Economic Events

2 Basic Financial Statements

5 The Accounting Cycle: Reporting Financial Results

4 The Accounting Cycle: Accruals and Deferrals

COMPREHENSIVE PROBLEM 1 Susquehanna Equipment Rentals

6 Merchandising Activities

241

8 Inventories and the Cost of Goods Sold

7 Financial Assets

COMPREHENSIVE PROBLEM 2 Guitar Universe, Inc.

381

9 Plant and Intangible Assets

10 Liabilities

11 Stockholders’ Equity: Paid-In Capital

13 Statement of Cash Flows

COMPREHENSIVE PROBLEM 3 McMinn Retail, Inc.

12 Income and Changes in Retained Earnings

519

14 Financial Statement Analysis COMPREHENSIVE PROBLEM 4 Home Depot, Inc.

15 Global Business and Accounting

680

A B

Home Depot 2009 Financial Statements

The Time Value of Money: Future Amounts and Present Values

A

B

Financial Accounting

CHA P TER 1

Accounting

© Ramin Talaie/Getty Images

Information for Decision Making

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO:

LO1

LO2

LO3

LO4

LO5

LO6

LO7

LO8

BEAR STEARNS

Bear Stearns

Bear Stearns Bear Stearns’ JP Morgan Chase

Bear Stearns

Bear Stearns

Bear Stearns

Bear

Stearns Bear Stearns’ Bear Stearns’

■

4

Chapter 1 Accounting: Information for Decision Making

y business venue, net income, cost, expense, operating margin, and w hav amiliar to you at this point, to become an activ usiness world, you must gain a basic understanding of these and other accounting concepts. Our objective in this book is to provide those who both vided to e

these tw hav

ve dif utes in common. For e

ve an interest in a company is some-

e different audiences, they

the company’ y’s net income by subtracting its expenses from its rev . This may appear to be a simple process of keeping accounting records ut a great deal of judgment is required. For e veral years be recognized as an expense in the company’ for management, b ution because of the potential competitive disadvantage that might result? These are among the many complex issues that business faces on a day-to-day basis and which have a critical impact on the company’s responsibility to its owners, creditors, the gov As we be eep in mind that business does not exist solely vestors and creditors that supply a company’ . We begin our development of these ideas in this chapter, and continue their emphasis throughout this text.

Accounting Information: A Means to an End ve of accounting is to pro not an end, but rather it is a means to an end.

Learning Objective

LO1

wners, managey other groups that

ment, creditors, gov hav

usiness activity, it is somelanguage of business. Costs, prices, sales v on investment are all accounting measurements. Investors, creditors, managers, and others who hav and concepts if the vernmental agencies, ganizations, and individuals in much the same manner as it is by business organizations.

ACCOUNTING FROM A USER’S PERSPECTIVE Man sional accountants. In reality, nearly ev you manage a business, make inv you are w

. Accounting vents. Whether w you receive and use your money,

5

Accounting Information: A Means to an End

v wing: • • The assumptions and measurement techniques involved in developing accounting •

vant for making v Exhibit 1–1 illustrates how economic acti

w into the accounting process. The ers in making eco-

activities that continue the cycle.

Exhibit 1–1 THE ACCOUNTING PROCESS

Actions (decisions)

of Actions (decisions)

TYPES OF ACCOUNTING INFORMATION Just as there are man

b

y types of accounting , management accounting, and tax accounting

.

Financial Accounting

Financial accounting ganization to describe an entity’ results of operations to describe its

or an indi .

CASE IN POINT Sony Corporation

Financial accounting information is designed primarily to assist investors and creditors in deciding where to place their scarce inv

Accounting links decision makers with economic activities—and with the results of their decisions

6

Chapter 1 Accounting: Information for Decision Making

, because the

v wth.

f

y dif

Management Accounting

Management (or managerial) accounting involves the

dev agement in operating the b overall goals, ev

y’s viduals, deciding whether

A company’s managers and emplo business operations. For example, the

y in the company’s y’s ware-

house; and the amounts o ut is organized in a manner relating directly to the decision at hand.

Tax Accounting accounting. To a great e ever requirements. W

w-

y’s gal requirements that relate to es. Laws and regulations gov-

a company’

tax accounting is quite complex, we defer coverage of tax accounting subjects to subsequent accounting courses.

Accounting Systems Learning Objective

LO2

An system an organization (1) to dev to decision makers. The design and capabilities of these systems v ganization to another. In small businesses, accounting systems may consist of little more than a cash register . In large businesses, v

v to meet the organization’

ciently as possible. Many f

ganizay’s needs for accounting information and (2) the resources available for operation of the system. accounting pro that is pro

e other courses in b

v

Exhibit 1–2. While usiness and xte, however, that

y kinds of valuation and resource allocation, among others. These relationships are consistent with what we hav , that accounting

7

Accounting Systems

Exhibit 1–2 ACCOUNTING AS AN INFORMATION SYSTEM

DETERMINING INFORMATION NEEDS y develops v actors as the size of the organization, whether it is publicly o agement. The need for some types of accounting information may be prescribed by law. For example, income tax regulations require every business to have an accounting system that can measure the company’s taxable income and explain the nature and source of ev item in the company’ ws require publicly owned

vailable to the public. . For example, every business needs to know the amounts owed to it by each customer and the amounts owed by the company to each creditor clearly is essential to business operations, management still has man veloped. For example, should the accounting ferhow useful management cost of dev

THE COST OF PRODUCING ACCOUNTING INFORMATION Accounting systems must be that is, the value of the information produced should exceed the cost of producing it. Management has no choice b wever, management may use cost-effectiveness In recent years, the development and installation of computer hav v .

BASIC FUNCTIONS OF AN ACCOUNTING SYSTEM In dev

vities of a business, ev

1. Interpret and record the effects of business transactions. 2. the ef v totals and subtotals

-

8

Chapter 1 Accounting: Information for Decision Making

3. Summarize and communicate makers. y, and speed

ut it is too slow and cumbersome to meet the needs of most business organizations. In a large business, transactions may v veral thousand per hour. To keep pace with such a rapid gely computerxt. Understanding manual systems allows users to understand the needs that must be met in a computerized system.

WHO DESIGNS AND INSTALLS ACCOUNTING SYSTEMS? The design and installation of lar ut e

volves not y

by a team of people with many specialized talents. Large businesses have a staf who work full-time in designing and improving the accounting system. Medium-size companies often hire a CP usinesses with limited companies in their line of business. These packaged systems are av are manuf

COMPONENTS OF INTERNAL CONTROL1 In dev

velInternal control is a process designed to provide

reasonable assurance that the or applicable laws and re ve manner. A company’ ged with dev v cussed in Internal Control–Integrated Framework ganizations of the Treadway Commission), are the control environment, risk assessment, control activities, information and communication, and monitoring. An organization’s control environment verall tone for the organization. F y’s vironment are: (1) the integrity, ethical values, and competence of the company’s personnel, (2) management’ s assignment (5) oversight by the board of directors. The control en ve control environment. Risk assessment involv vement of the organization’s objectives. For example, a company should v e steps to minimize those risks. The situation described in the chapter opener involving Bear vides an e ailed. Control activities vities include approvals, authorizations, v vie physical safeguarding of assets, and segregation of duties. Information and communication involves dev

1 en from Internal Control–Integrated Fr of Sponsoring Organizations of the Treadw

Committee

9

Financial Accounting Information

the business. Effectiv ve control system is designed to f wnyees), upstream (from employees to management), and across the organization. Employees must receive the message that top management views tem and the roles of others. ev

Monitoring enables the company to ver time. Monitoring is generally vities, as well as by periodic ge organizations hav v

v

separate ev

control. As a result of the lar Enron and WorldCom, the U.S. Congress passed, and President George W. Bush signed, the Sarbanes-Oxley Act (SOX) of 2002. SOX has been described as the most far-reaching securities law since the 1930s. One of the SOX y have an effectiv v indicate whether the entity’ cial statements will be prepared in accordance with laws and re v y’s e the auditor believes that the company’s internal control system is effective. These requirements are contained in Section 404 of SOX; therefore, many businesspeople describe the abov ess has been extremely expensive and time-consuming, and some businesspeople believe that

Financial Accounting Information Financial accounting is an important subject for students who need only an introduction to e man ers—investors and creditors.

EXTERNAL USERS OF ACCOUNTING INFORMATION tion are indi

• • • • •

external users and who are they? External users v ut that are not involved in the day-to-day operations of that enterwing:

Owners Creditors Potential investors Labor unions Gov agencies

• • • •

Suppliers Customers Trade associations General public

Each of these groups of e to mak

or e w them to assess the quality of the products they buy and the f v cies such as the Federal Trade Commission may hav v . The general public may be interested in the e xample, does not pollute the environment). Pro ge set of div o groups—investors and creditors. As you will soon see, investors

Learning Objective

LO3

10

Chapter 1 Accounting: Information for Decision Making

hand, are indi or e prise, or a supplier may hav pay for those goods later of investors and creditors, we pro

ve loaned mone

wes money, goods, -

y other users of

For these reasons, we sometimes refer to inv e these, keep in mind that we are talkvestors and creditors and those indi may become inv

OBJECTIVES OF EXTERNAL FINANCIAL REPORTING If you had invested in a company, or if you had loaned money to a company, what would be y? You probably would be interested in two things, both of which make up the company’s cash w prospects. You would be interested vested or loaned. We refer to this as the return of your investment. In addition, you would expect the company to pay you something for the use of your funds, either as an owner or a creditor. We refer to this as the return on your investment. company’s ability to provide you with what you e of on v tion about ospects. Assume that you have a friend who w usiness and needs some help getting the money required to rent space and acquire the needed assets to operate the business (for

YOUR TURN

example, deliv yees for their work before the doors open and customers begin paying for the products the company plans to sell. You are in a our intent is not to be a vestor or co-owner of the business, b v ve the use of your $100,000 for one year and, if you had not loaned this amount to him, you could hav y in another investment. In addition to w wing how much risk you are taking with regard to your $100,000. You e and to also pay you an additional amount of $8,000 ($100,000 ⫻ money vestment ($100,000) back to you one year later, added to the amount you expect to receive for his having used your money for a year ($8,000), is shown in . Pro w commitver $108,000 to you one year from the time you loan him the $100,000. While this is a relatively simple example,

11

Financial Accounting Information

Exhibit 1–3 INVESTMENT ANALYSIS

e v ves of e v makers. These general objectives are displayed in Exhibit 2

ve is the most general and is to pro investment and credit decisions. As we indicated earlier, investors and creditors are the prie believ of investors and creditors, we pro y other The second objectiv ws. As we discussed ws to them, so an important

earlier, inv objectiv analysis.

ve of e s resources, claims to those resources, and how both the resources and claims to

Exhibit 1–4 OBJECTIVES OF FINANCIAL REPORTING: BUILDING FROM THE SPECIFIC

resources change ov

assets, and the

and owners equity. ays inv to mak 2

FASB Statement of Financial Accounting Concepts No. 1, “Objectiv

12

Chapter 1 Accounting: Information for Decision Making

In the general sense of the word, a statement is simply a declaration of something believed statement, believ y y believe fairly vities. xample, for Throughout this te y’ ver. wing: •

The balance sheet is a position statement that shows where the compan • Income statement. The income statement is an acti ws details and results of the company’ xample, a month, •

The ws is an activity statement that shows the details of the company’s activities involving cash during a period of time. v or balance sheet, for example, is sometimes

described as a snapshot of the b looks lik ws is v ws depicts the ways cash has changed v ws to themselv v xpected to understand these w prospects of a com-

w the pany

xt chapter. Thereafter a great deal about how these statements are prepared and ho them can be used to help you understand the underlying business activities they represent.

CHARACTERISTICS OF EXTERNALLY REPORTED INFORMATION vestors, creditors, and others e ve maximum usefulness. Some of these qualities are discussed in the following paragraphs.

Financial Reporting—A Means come of pro e achieved.

, ve the quality of decision making by es are simply a means by which that end is

Financial Reporting versus Financial Statements

Financial reporting is

ay vestors, creditors, and other e ariety of ways in addition to its xample, press releases sent directly to investors and creditors, The Wall Street Journal, and more recently vestors, creditors, and other e e adv y sources of information that are av

13

Management Accounting Information

Historical in Nature cal in nature. It looks back in time and reports the results of events and transactions that already hav wever, in recent years, accounting standard setters are requiring greater use of fair values, rather than historical costs,

Inexact and Approximate Measures may have a look of great precision, but in fact much of it is based on estimates, judgments, or example, assume a compan usiness. To account for that asset y’s e tion, some assumptions must be made about how long it will be used by the company—how many years it will be used, how man vide, and so on. The fact that a misunderstood.

General-Purpose Assumption pro mation needs of other e

As we have already mentioned, we assume that, by vestors and creditors, we also meet the infore might be able to pro wever, and we instead opt for preparing information that we believe is useful to multiple user

Usefulness Enhanced via Explanation The accounting profession believes that the value of e

xplanations v

cial numbers that are presented. F statements, is accompanied by a number of notes and other explanations that help explain and

Management Accounting Information Learning Objective

ers emplo xclusive use inside the organization but ers. For example, in order to meet a production sched-

also to share with e

help the producer meet its objectiv

utor of the accounter

e er wever, are not made available to e ers. Long-range plans, research and development results, capital budget details, and competitiv

USERS OF INTERNAL ACCOUNTING INFORMATION Ev e

xecutiv

yees are paid, and their paychecks are wever, the amount of use and, in par. ws:

ticular, the involv Examples of internal users • • • •

Board of directors Chief executive of Chief of V

(CEO) (CFO)

• • • •

Business managers Plant managers Store Line supervisors

LO4

14

Chapter 1 Accounting: Information for Decision Making

Employees hav ve its overall strate

ves that are designed to help the enterganization arious employees

Exhibit 1–5

will differ widely tion systems to ensure the inte wever div employees. Man ment and other designated emplo reports, including required e

s

arehousing approach for the creation of accounting -friendly software, allows manageor e

tion costs. A process design engineer and emplo

y. Finally, ves-

tors and creditors.

OBJECTIVES OF MANAGEMENT ACCOUNTING INFORMATION xplicit goals and objectives. Man statement that describes their goals. These goals can v

ve a mission

ganizations, where goals are directed toward maximizing the owners’ objectives. For example, the American Cancer Society, wing mission:

15

Management Accounting Information

The American Cancer Society is the nationwide community-based voluntary health organization dedicated to eliminating cancer as a major health problem by preventing cancer, saving liv ocacy, 3

Procter & Gamble, a for

wing

We will pro the lives of the world’s consumers, no

alue that improve 4

Procter & Gamble’ vides more detail on how the company will achieve its mission. Procter & Gamble’s design for growth was explained in P&G’s annual letter to its shareholders and includes: • gies. • • Rigorous cash and cost discipline. • The most diverse and e

. .5

The of these organizations receive e tion that helps them assess the progress being made in achieving these goals and objectives. In the case of Procter & Gamble, mation is provided to shareholders. The American Cancer Society is required gulators. Pro ents evaluativ v

© Stephanie Bart

achiev uted regularly. To motivate managers to achieve or also used to evaluate and rew compares the plan or budget to the actual outcomes for a period, it creates a signal about the udget. In man agement creates a reward system link Thus the objectiv gin at the most general level with the objectiv ganizational goals create a need for inforand e

ers who have authority over s resources and who will be evaluated and rewarded based on their decision outcomes.

CHARACTERISTICS OF MANAGEMENT ACCOUNTING INFORMATION ning and control decisions. Because the goal of creating and using management accounting fers from the reasons for producing e

gy. For example, because e statements, management monitors those obligations closely. These pension-related obligations impact labor negotiations and labor gies. Another e hav vailable inside of companies

3 4 5

www.cancer.org www.pg.com

16

Chapter 1 Accounting: Information for Decision Making

As you read the chapters of this book, we will remind you about ho gies. The follo

Importance of Timeliness

usiness pro. The competitive environment faced by

man this demand by creating computerized databases that link to e associations, to their suppliers and b opment and launch of ne .

ime lines for the devel, making

monitoring and controlling ongoing activities. If a process or activity goes out of control, the or example, recalls of products can be v xpensive for a company. If the company can monitor processes and prevent low-quality or defective products from reaching its customers, it can e vings.

Identity of Decision Maker processes needs to be provided to those who hav lems. Reporting scrap and rew

orkers without providing them the ve. However, a self-directed work team v ork-related activwork and scrap if team members control the process

ities can hav causing the problems.

Oriented toward the Future ve is to motivate management to make future decisions that are ves, and mission.

Measures o the ef

ectiveness

y and effectiv

s resource v y, an assessment can be made of how effective management is in achieving the organization’s mission. The accounting system uses money as a common unit to achiev

Management Accounting Information—A Means of itself. The ultimate objectiv ment achieve the goals and objectiv

Integrity of Accounting Information v e the as? How can management be sure that avor one outcome over another? The word integrity refers to the following qualities: complete, unbroken, unimpaired, sound, honest, and sincere. Accounting information must have these qualities because of the sigcompany’

Learning Objective

decisions. The inte

ays. First, certain

LO5

or

veral professional accounting , vior of

17

Integrity of Accounting Information

to ensure that users of accounting information—investors, creditors, managers, and others—can rely on the information to be a f represent.

INSTITUTIONAL FEATURES Standards for the Preparation of Accounting Information

Accounting vestors, creditors, and other users must be prepared in accordance with standards that are understood by both the preparers and users of e call these standards generally accepted accounting principles, shortened to GAAP. These principles pro w and presented. GAAP includes broad principles of measurement and presentation, as well as

Accounting principles are not like physical laws; they do not exist in nature waiting to be discovered. Rather, they are developed by people, in light of what we consider to be the most v y ways, accounting principles are similar etball. For example, • • • sometimes • May change ov •

v .

. The phrase “generally accepted accounting principles (GAAP)” refers to the accounting concepts in use in the orld in order to facilitate business acti . In the United States, three or ing principles—the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (F

Securities and Exchange Commission The Securities and Exchange Commission is a governmental agency with the legal power to establish accounting principles and ASB (discussed below), rather than develop its own set of accounting principles. Thus, accounting principles continue to be developed in the private sector but are given the force of law when they are adopted by the SEC. To ensure widespread acceptance of new accounting standards, the FASB needs the support of the SEC. Therefore, the two organizations work closely together in developing new accounting standards. The SEC also revie vent that a publicly o ails to comply with these requirements, the SEC may initiate legal action viduals. Thus the SEC enforces compliance with ASB.

Financial Accounting Standards Board F

Today, the most authoritative source of Financial Accounting Standards Board. The , consisting of seven members from the accounting ge research staff.

18

Chapter 1 Accounting: Information for Decision Making

The F

Accounting

xpressions of generally accepted accounting principles. ASB has completed a project describing a conceptual framework framew ASB’s views as to the: • Objectives of • Desired characteristics of accounting information (such as relevance, reliability, and understandability). • • • V work is to provide guidance to the FASB in developing ne ing each ne

work, the FASB believes that the Accounting . vate sector of the economy—it is not a governmental agency.

The F The dev

vate sector, although the gov

xercises consid-

International Accounting Standards Board beyond the borders of its o or e ties. Similarly mark

y buys or sells products

, is increasingly popular. Business activities that cross borders cre-

As a result of increasing cross-border activities, ef ay to harmonize accounting standards around the world. The International Accounting Standards Board (IASB) wledge of accounting methods used in the most vibrant capital markets. The IASB issues International Financial Reporting Standards (IFRSs). The European Union requires listed companies in its member states to follow IASB standards. In addition, man ve plans to require their

U.S. stock exchange, and is considering allo statements using either U.S. GAAP (based on FASB standards) or IASB standards. In addition, the AICP v vate company reporting, accepts either F v vergence and Global Accounts belief that a single set of high-quality, v s However, the SEC indicates that there remain obstacles to the adoption of IFRS in the United

decides to require U.S. public companies to use IFRS, this would be a major development because IASB standards are less detailed and prescriptive than existing FASB standards. The SEC has indicated that if IFRS were to be required in the United States any such change would not occur before 2015.

19

Integrity of Accounting Information

CASE IN POINT

Public Company Accounting Oversight Board The Public Company Accounting Oversight Board (PCAOB) is a quasi-gov ged with overas created as a result of the SarbanesOxley Act of 2002 and began operations in the spring of 2003. The PCAOB has extensive powers in ov y accounty must register with the PCAOB. The PCAOB sets auditing standards for audits of publicly traded companies, an activity that previously w vestigations and administers penalties when substandard audit work is alleged. The PCA ashington, D.C., and has re v v and are eligible to be reappointed once. No more than two members of the Board can be PCA y’s market value relative to overall stock market value in the United States.

Audits of Financial Statements cial statements issued by management pro pany’ audit of the company’ tants (CPAs). These auditors are e of the compan An audit is an investigation of a company’ f

v vided by an independent

fair

ples, and are not misleading. standard by which those statements are judged. For the auditor to reach the conclusion that air representations of a company’ ws, the statements must comply in all important ways with generally

Legislation As discussed previously

y Act in 2002. visions of Sarbanes-Oxley is the creation of the Public Compan ersight Board described earlier in this chapter vividing man vity required of auditors in rendering opinions re vestors and creditors rely. Sarbanes-Oxle gard to their oversight of e xecutiv of the company’

20

Learning Objective

LO6

Chapter 1 Accounting: Information for Decision Making

PROFESSIONAL ORGANIZATIONS Several professional accounting organizations play an active role in improving the quality of vestors, creditors, management, and others. In addi, the American Institute of CPAs, Accounting Association, and the Committee of Sponsoring Organizations of the Treadway

American Institute of CPAs (AICPA) The American Institute of CPAs is a provide members with vide v pates in many aspects of the accounting profession. The AICPA conducts accounting research and works closely with the F A’ Board has dev PCAOB has accepted man

v A also , the AICPA is responsible A examination, which is discussed later in this chapter.

Institute of Management Accountants (IMA) The mission of the Institute of Management Accountants is to provide members personal and professional development

IMA sponsors a number of educational activities for its members, including national seminars and conferences, regional and local programs, self-study courses, and in-house and online vidual’s competence and e

Institute of Internal Auditors (IIA) W

ver 100 countries, the nal Auditors tion dedicated to the promotion and dev vides ® professional dev Program and leadingedge conferences and seminars; research through the IIA Research F Standards for the Professional Practice of Internal Auditing; profession. The IIA also pro grams, as well as quality assurance revie

American Accounting Association (AAA)

Membership in the American y pracancing accounty of the AAA’s activities is on improving accounting education by better preparing accounting professors and on advancing knowledge in the accounting discipline through research and Accounting Association

aculty on the man

ge

C ee of Sponsoring Organizations of the Treadway Commission (COSO) COSO is a v vate sector organization dedicated to improving the usiness ethics, effectiv tional gov

ganiza-

21

Integrity of Accounting Information

Commissioner James C. Treadway, Jr.). The National Commission on Fraudulent Financial series of recommendations for impro A, Financial Executiv tional, the IIA, and the IMA. wn for its work in dev v public companies now need to ev

v y Act, v

v

v tors’ ev v v for evaluating the effectiv v COSO’s 1992 publication, Internal Control–Integrated Framework. COSO has also issued a document, Guidance for Smaller Public Companies Reporting on Internal Control over Financial Reporting, that seeks to pro usinesses in work.

COMPETENCE, JUDGMENT, AND ETHICAL BEHAVIOR Preparing and presenting accounting information is not a mechanical task that can be perven by well-trained clerical personnel. A characteristic w, and accounting, is the need for competent individual practitioners to solve problems using their professional judgment and applying strong ethical standards. The problems encountered in the practice of a profession are often comple y cases, the well-being ork of a professional. T vior in wing complex issues that must be •

ver a long period ay? • What constitutes adequate disclosure of information that would be expected by a • At what point are a company’ able to remain in b

• When have ef

ve (that is, “windo

misleading to investors and creditors? Judgment always involv lessness or ine mak do not work out as e If the public is to hav

v as prepared.

competence. Both the accounting profession and state gov ve taken steps to assure the public of public accountants (CPAs). CPAs are licensed by the states, in much the same manner as states license physicians and attorneys. The licensing requirements v ut in general, an individual must be of good character, have completed 150 semester hours of college work with a major in accounting, pass a rigorous examination, and have accounting experience. In addition, most states require all CPAs to spend at least 40 hours per year in continuing professional education throughout their careers. Management accountants are not required to be licensed as CPAs. However, they voluntarManagement Accountant (CMA) or a Internal Auditor (CIA) as e

Learning Objective

LO7

22

Chapter 1 Accounting: Information for Decision Making

respectively. The requirements for becoming a CMA and CIA are similar to those for becoming a CPA. Inte doing the right thing. For a professional accountant, ethical behavior is just as important as competence. However, it is f Many professional organizations have codes of ethics or professional conduct that direct the activities of their members. The AICPA, for example, has a code of professional conduct that expresses the accounting profession’s recognition of its responsibilities to the public, to A members in the xpresses the basic tenets of ethical and professional behavior and is enforced in conjunction with state professional societies of CPAs, although state re e precedence in regulating the CPA license. 1–6 contains e A code of professional conduct. One of the principles expressed in the AICPA’ As

YOUR TURN

to the public interest, sho

ve welles. Other principles , objecti

ance of one’s duties.

ganizations that were utes of competence, professional judgment, and ethical behavior ultimately ensure the quality and In this te problems, and cases that emphasize the general concepts of honesty, f

xercises, ed to make judg-

justice logo appearing in the margin.)

Careers in Accounting w

Learning Objective

LO8

ve several characteristics in common.

23

Careers in Accounting

Exhibit 1–6 EXCERPTS FROM THE AICPA CODE OF PROFESSIONAL CONDUCT

First, all professions involve a complex and evolving body of knowledge. In accounting, the complexity and the ever usiness w requirements, management’s demands for increasingly comple la e ants to ex wever public’s best interest, e from the f The practice of medicine, for e public safety

sonal advantage. This responsibility stems wledge in the professions, yet fair and s health, safety, or well-being. s well-being in many ways, because accounting . Thus, account-

ants have a basic social contract to av

ing, (2) management accounting, (3) gov

PUBLIC ACCOUNTING viduals may work in a CP The w tax w xtend well beyond tax planning and accounting matters; CPAs advise management on such div gers, manufacturing

24

Chapter 1 Accounting: Information for Decision Making

processes, and the introduction of new products. CPAs assist management because consider usiness decision. A great many CPAs mov ve directly into such top management positions as controller .

The CPA Examination To become a CPA, a person must meet several criteria, including an extensive university education requirement, passing the CPA examination, and meeting a practice experience requirement. CP irgin Islands, Washington, D.C., and the Mariana Islands). The CPA examination is a rigorous examination that covers a v and business subjects that allo wledge and skills in areas believ xam is computer based and is offered at man

MANAGEMENT ACCOUNTING es man v

w

ganization usually is called the c controller has been used to emphasize the fact that one basic usiness operations. The CAO or controller usiness, setting its objectives, and seeing that these objectives are met. In addition to developing information to assist managers, management accountants are responsible for operating the company’ (CAO) or controller.

Because the responsibilities of management accountants are so broad, many areas of specialization have dev

GOVERNMENTAL ACCOUNTING Gov trolling their operations. Therefore, the need for management accountants in gov agencies is similar to that in business or

The GAO: Who Audits the Government? (GAO) audits many agencies of the federal gov nizations doing business with the gov GAO inv

The Government Accountability vate orga-

valuate the ef

y of an entity’s operav

The IRS: Audits of Income Tax Returns Another gov

y that perxtensive auditing work is the Internal Revenue (IRS). The IRS handles the viduals and business organizations and

The SEC: The “Watchdog” of Financial Reporting

The SEC works closely wned . If the SEC believes that a company’ y way, it conducts an investigation. If the SEC concludes that federal securities laws have been violated, it initiates legal action viduals. Many other gov with the F

gov gulations and to investigate suspected criminal activity. People beginning their careers in gov v ve positions.

25

Careers in Accounting

ACCOUNTING EDUCATION xtbook, have chosen to pursue careers in accounting education. A position as an accounting faculty member offers veloping indi y w v

WHAT ABOUT BOOKKEEPING? Some people think that the work of professional accountants consists primarily of bookkeeping. Actually, it doesn’t. In fact, many professional accountants do little or no bookkeeping. Bookkeeping is the clerical side of accounting—the recording of routine transactions and day-to-day record keeping. T Professional accountants are involved more with the interpretation and use of accounting ork includes evaluating the ef y of operations, resolving comple little that is “routine” about the work of a professional accountant. eeper in a few weeks or months. To become a wever, is a f ,e We will illustrate and explain a number of bookkeeping procedures in this te in the next sev eeping skills is not pose of this text is to dev understand and use today’s business world.

-

ACCOUNTING AS A STEPPING-STONE We have mentioned that many professional accountants leave their accounting careers for key positions in management or administration. An accounting background is invaluable in such positions, because top management w

hav y different business organizations, which makes them particularly well suited for top management positions in other organizations.

BUT WHAT ABOUT ME? I’M NOT AN ACCOUNTING MAJOR wever

accounting concepts if they seek positions in inv lar rate di

v valu-

eting students often take positions in sales. It is imperative that mark venue recognition, as well as the obligations of a public company under the U.S. securities laws. A lack of this understanding has led many a marketing/sales executive to become involved in improper revy of these executives have been subject to civil and criminal prosecution.

26

Chapter 1 Accounting: Information for Decision Making

Ethics, Fraud & Corporate Governance

Enron WorldCom HealthSouth Adelphia Communications Tyco Qwest Parmalat

Tyco

Finally wledge is helpful in many aspects of your personal lives. Accounting concepts are integral to such everyday decisions as personal budgeting, retirement and college planning, lease versus buy decisions, ev valuation of inv e better economic decisions, you will be using these skills for the rest of your life. The only question is the degree of skill with which you will apply these concepts.

Concluding Remarks v

w

ve vestors and creditors, and how accounting pro e have v veral things that build integrity. Looking ahead, in Chapter 2 we begin to look in greater depth ou will be introduced vestors and creditors. As the te vide and ho e important decisions.

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

LO1

iscuss accounting as the language of business f accounting information in making onomic decisions.

LO5

LO6 LO2

iscuss the significance of accounting systems in ting reliable accounting information and erstand the five components of internal

LO7

LO3

I entify and discuss several professional organizations that play important roles in eparing and communicating accounting tion.

iscuss the importance of personal competence, fessional judgment, and ethical behavior on t f accounting professionals.

lain the importance of financial accounting formation for external parties—primarily vestors and creditors—in terms of the objectives teristics of that information.

LO8

LO4

iscuss elements of the system of external and i ternal financial reporting that create integrity eported information.

lain the importance of accounting information or internal parties—primarily management—in terms of the objectives and the characteristics of ormation.

escribe various ounting.

career

opportunities

in

Key Terms Introduced or Emphasized in Chapter 1

Demonstration Problem Intel Corporation www.intc.com/secfiling.cfm?filingID=950123-10-15237 Intel Corp Intel

Solution to the Demonstration Problem Intel Corporation Intel Corporation Intel Corporation Intel Corporation

Self-Test Questions

http://

ASSIGNMENT MATERIAL

Discussion Questions

B ief Exercises

accountin

Exercises

accounting

LO1

LO3

Boeing Company

LO4

California Public Employees Retirement System China Airlines Boeing International Aerospace Machinists LO3

LO6

Boeing

LO6

LO3

LO3

LO5

LO7

LO6

LO3

LO4

LO4

LO6

LO5

LO5

LO7

LO8

LO1

LO3

Home Depot, Inc. Home Depot Home Depot

LO5

Critical Thinking Cases LO5

Fannie Mae Fannie Mae

LO3

LO2

LO7

LO6

LO7

http://www.yahoo.com

Answers to Self-Test Questions

CHA P TER 2

© Intel Corporation

Basic Financial Statements

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO: LO1 LO2

LO3 LO4

LO5

LO6

LO7

LO8 LO9

INTEL

Intel

Intel Intel

Intel Intel

Intel Microsoft Cisco Systems

■

38

Chapter 2 Basic Financial Statements

If you were a person with considerable wealth who wanted to invest in a forward-looking company in today’ ww w whether Intel or any other company is a wise inv ould you seek out to help you decide where to place your inv y’s y cases more frequently, pro y and how successful the compan , you ws. ying presentations, these vide for inv xtbook is about, and in this chapter you receiv how they may be used to better understand a company.

Introduction to Financial Statements v

ws

that they expect to receiv y have made loans or sold merchandise on credit, to meet its pay, investors are interested in the market value of their stock holdings, as well as di while they o ays inv will be able to mak s statement is simply a declaration of what is believ y believe f activities. In this chapter • • Income statement. • Statement of cash

ws. usiness o corpoganization that allows many o ger than would be possible based on the usinesses of any size may

ration. their resources into a b be or ge b for a lar Later in this chapter we introduce tw

v Learning Objective

LO1

E g fi

The names each. The statement of shot of the b

usiness organization makes possible. usiness organization—the sole propriusiness

position, or balance sheet, e” at a

As businesses operate, they engage in transactions that create revenues and incur expenses venues. An income statement is an activity statement that shows the revenues and e venues already have resulted in positiv ws, or are e actions with customers. For example, a company might sell a product for $100. This revenue transaction results in an immediate positiv

39

cash at the time of the transaction. An e tion in which payment is to be received later. Expenses hav w out

w. Revenues result in positive cash expenses result in negative cash ws

y xpected or example, if a company w takes place. xpected future

ws

Positive and negative net income (or net loss) is simply the difs revenues and e

The

ws v

ws v venues xpenses and other acquisitions ws to

shows the w v themselv v

ws to them.

A Starting Point: Statement of Financial Position w

mation. F they relate to each other. The way the we will say more about later in this chapter.

strate where the compan see later in this chapter position and show ho Be

articulation,

y’

ver time.

statements. Ev usiness prepares a balance sheet at the end of the year, and many companies prepare one at the end of each month, week, or even day. It consists of a listing of the assets, the liabilities, and the o usiness. The date tion of a business may change quickly. sho agabond Travel Agency at December 31, 2011.

VAGABOND TRAVEL AGENCY STATEMENT OF FINANCIAL POSITION DECEMBER 31, 2011

Exhibit 2–1 STATEMENT OF FINANCIAL POSITION

A balance sheet shows financial position at a specific date

40

Chapter 2 Basic Financial Statements

v

Exhibit 2–1

distinct sections: assets, liabilities,

owner

.

wed by notes receiv receivable, supplies, and any other assets that will soon be converted into cash or used up in business operations. Follo buildings, and equipment. Moving to the right side of the balance sheet, liabilities are shown before owners’ equity. listed separately, follo Owners’ equity is separated into tw tal stock represents the amount that owners originally paid into the company to become owners. It consists of individual shares and each owner has a set number of shares. Notice in this illustration that capital stock totals $150,000. This means that the assigned value of the shares held by owners, multiplied by the number of shares, equals $150,000. For example, assuming an assigned value of $10 per share, there would be 15,000 shares ($10 15,000 vely, the assigned value might be $5 per share, in which case there would be 30,000 shares ($5 30,000 vious years that remain wners and v usiness. Finally, notice that the amount of total assets ($300,000) is equal to the total amount of liabilities and owners’ equity (also $300,000). This relationship always exists—in fact, the balance sheet. Learning Objective

The Concept of the Business Entity f

E

LO2 fi

cept is called the A business

Generally accepted accounting principles . This con-

.

usiness activities. For usiness entity is regarded as separate from the personal activities of its owners. For example, Vagabond is a business organization operating as a travel agency. Its owners may hav ven other businesses. These items are not involved in the operation of the travel agency and do not appear in Vagabond’s If the owners were to commingle their personal activities with the transactions of the busiould f vities of the business organization. Distinguishing business from personal activities of the owners may require judgment by the accountant.

ASSETS Assets are economic resources that are owned by a business and are e tiv ws. The positiv ws may come directly as the asset is conv vable) or indirectly as the asset is used in operating the business to create other assets that result in positiv ws (buildings and land used to manufacture a product for sale). Assets may hav such as buildings, machinery, or an inventory of merchandise. On the other hand, some assets e ut in the form of valuable legal claims or rights; examples are amounts due from customers, investments in gov patent rights. One of the most basic and at the same time most controversial problems in accounting is usiness. At present, generaluation of some assets in a balance sheet at cost, the basis for asset valuation are discussed below.

41

A Starting Point: Statement of Financial Position

The Cost Principle

Assets such as land, buildings, merchandise, and equipment are y economic resources that are required in producing revenue for the business. The prev w is that such assets should be presented at their cost. When we say that an asset is shown in the balance sheet at its historical cost, we mean the original amount the b from what it w . For e usiness buys a tract of land for use as a building site, payet, a fair estimate of the market value of the land 10 years later might be $250,000. Although the mark v , the amount sho y’s accounting records and in its balance sheet would continue unchanged at the cost of $100,000. This polic cost principle Exceptions to the cost principle are found in some of the most liquid assets (that is, assets that are expected to soon become cash). Amounts receivable from customers are generally included in the balance sheet at their net realizable value, which is an amount that approximates the cash that is expected to be received when the receivable is collected. Similarly, certain inv et value if management’s plan includes conv eep in mind that the dollar amounts listed for man the does not show how much the b in being able to calculate such a value.

The Going-Concern Assumption

Why don’t accountants change the recorded

is that assets like land and buildings are being used to house the business and were acquired for use and not for resale; in f business. The balance sheet of a business is prepared on the assumption that the business is a going Consequently assets lik gest dollar amounts of a company’s assets.

The Objectivity Principle

et values in accounting for man actual basis for valuation. The cost of land, buildings, and many other assets that hav objective aluations that are factual and can be v or example, if land is shown on the balance sheet at cost, any CP usiness w ve evidence that the land w hand, estimated market values for assets such as b f ve. Market values are constantly changing, and estimates of the prices at which assets could be sold are lar

YOUR TURN

42

Chapter 2 Basic Financial Statements

At the time an asset is acquired, the cost and market value are usually the same. With the passage of time, however et value of assets is likely to differ considerably sheet as the value changes. For other assets, we retain historical cost as the basis of the asset in the balance sheet.

The Stable-Dollar Assumption is that the value of the monetary unit or dollar is not always stable. purchase less than it did previously. , which the v did previously. Typically, countries like the United States have e vere, historical cost amounts for assets lose their relevance as a basis for making business decisions. dollar is a stable unit of measurement, as is the gallon, the acre, or the mile. The cost principle and the stable-dollar assumption w ut are less satisfacor example, if a company bought land 20 years ago of land shown by the accounting records would be $600,000 follo act that dollars spent 20 years ago had greater purchasing power than today’s dollar o wer.

I N T E R N AT I O N A L CA S E I N P O I N T

lar

LIABILITIES y represent negativ ws for the ganization to whom the debt is owed is called a creditor. All businesses have liabilities; even the lar chases are called accounts payable. Many b w mone xpansion or the purchase of high-cost assets and pay for them over time. When obtaining a loan, the borro note payable is a written promise to repay the amount o Accounts payable, in contrast to notes payable, involve no written promises and generally do not call for interest payments. In essence, a note payable is a more formal arrangement than an account payable, but they are similar in that they require the company to make payLiabilities

43

Liabilities are usually listed in the order in which they are expected to be repaid.1 Liabilities that are similar may be combined to av For example, if a company had several expenses payable at the end of the year (for example, wages, interest, taxes), it might combine these into a single line called accrued expenses. The word xpenses has wer’s assets. As we shall see, the o a business also have claims on the company’s assets. But in the eyes of the law, creditors’ claims tak over those of the owners. This means that creditors are entitled to be paid in full, ev ould exhaust the assets of the business and leave nothing for its owners.

OWNERS’ EQUITY Owners’ equity represents the owners’ claims on the assets of the business. Because liabilities or creditors’ claims have legal priority over those of the owners, owners’ equity is a residual amount. If you are the owner of a business, you are entitled to assets that are left after the claims of creditors hav wners’ equity is always equal to total assets minus total liabilities. For e sheet of Vagabond Travel Agency 2–1):

not Rather, it is the owners’ ov

Increases in Owners’ Equity

y. The o

usiness comes from two

1. Investments of cash or other assets by owners. 2. Earnings usiness.

Decreases in Owners’ Equity

Decreases in o

o

ways: 1. Payments of cash or transfers of other assets to o 2. Losses usiness. Accounting for payments to o

THE ACCOUNTING EQUATION v always equals the total of liabilities plus owners’ equity. This agreement or balance of total assets with the total of liabilities and o statement a balance sheet. But why do total assets equal the total of liabilities and o o sides of the balance sheet are always equal because they represent ws of the same business. The listing of assets shows us what things the business owns; the listing of liabilities and o business and how much each group supplied. Ev usiness owns has been supplied to it either by creditors or by the owners. Therefore, the total claims of the creditors plus the claims of the owners always equal the total assets of the business. 1

Learning Objective

LO3

44

Chapter 2 Basic Financial Statements

The equality of the assets on the one hand and the claims of the creditors and the owners on the other hand is expressed in the following accounting equation: Assets $300,000

The accounting equation

Liabilities $80,000

Owners’ Equity $220,000

The amounts listed in the equation were tak Exhibit 2–1. The balance sheet is simply a detailed statement of this equation. To illustrate this relationship, compare the balance sheet of Vagabond Travel Agency with the above equation. Every business transaction, no matter how simple or how complex, can be expressed in

Regardless of whether a b ws or contracts, the equality between the assets and the claims on the assets is always maintained. Any increase in the amount of total assets is increase in either the liabilities or the o equality of the tw business as an e

. Any decrease in total assets is necessarily wners’ equity. The continuing w fects of v

THE EFFECTS OF BUSINESS TRANSACTIONS: AN ILLUSTRATION Ho to e past business transactions that has been captured by the company’s information system and or y stands at the transactions in which the company has engaged. The balance sheets of two separate companies would almost alw timing, and dollar amounts of each company’s business transactions. T w a balance sheet comes about, and later to show how the ws relate to the balance sheet, we use an example of a small auto repair business, Ov

The Business Entity mechanic, opens his own automotive repair business, Ov A distinctiv s operations is that all repair work is done at v in the evening and picking them up the follo Operating at night also enables Ov of hiring full-time employees, Ov fers part-time work to mechanics who already have day jobs at major automobile dealerships. This eliminates the need for costly emplo health insurance and emplo emplo

Overnight’s Accounting Policies ing and maintains Ov way. He believes the vestors and creditors. He believ

en sev ws that small businesses ut he prepares them anyusiness. In addition, if Ov vided vestment capital.

The Company’s First Transaction 2011. On that day, he receiv tion whose owners consisted of himself and several family members. Capital stock issued to

45

A Starting Point: Statement of Financial Position

these inv the name of Ov v issuance of the capital stock. This transaction provided Ov o usiness entity. See the balance sheet showing the company’ position after this initial transaction in . OVERNIGHT AUTO SERVICE BALANCE SHEET JANUARY 20, 2011

Exhibit 2–2 BALANCE SHEET, JAN. 20

Beginning balance sheet of a new business

Ov operations.

s next two transactions involved the acquisition of a suitable site for its business

Purchase of an Asset for Cash

Representing the business, McBryan negotiated eresa and the Metropolitan Transit Authority (MTA) to purchase an abandoned bus garage. (The MTA o wned the land.) $52,000 cash. tion had two immediate ef y’ s cash was reduced by $52,000; and second, the company acquired a new asset—Land. We show the company’ Exhibit 2–3. OVERNIGHT AUTO SERVICE BALANCE SHEET JANUARY 21, 2011

Exhibit 2–3 BALANCE SHEET, JAN. 21

Balance sheet totals unchanged by purchase of land for cash

Purchase of an Asset and Financing Part of the Cost

erransit Authority for $36,000. Ov wn payment of $6,000 and issued a 90-day non-interest-bearing note payable for the $30,000 balance owed. As a result of this transaction, Ov w asset, Building, which cost $36,000; and (3) a new liability, Notes Payable, in the amount of $30,000. Exhibit 2–4. OVERNIGHT AUTO SERVICE BALANCE SHEET JANUARY 22, 2011

Exhibit 2–4 BALANCE SHEET, JAN. 22

Totals increased equally by debt incurred in acquiring assets

46

Chapter 2 Basic Financial Statements

Purchase of an Asset on Account automotiv

yT

Exhibit 2–5

as $13,800, due within .

OVERNIGHT AUTO SERVICE BALANCE SHEET JANUARY 23, 2011

BALANCE SHEET, JAN. 23

Totals increased equally by debt incurred in acquiring assets

Sale of an Asset

After taking deliv w tools and equipment, Ov found that it had purchased more than it needed. Ace Towing, a neighboring b to buy the excess items. On January 24, Overnight sold some of its new tools to Ace for $1,800, a price equal to Ov s cost.2 Ace made no down payment but agreed to pay the amount due within 45 days. This transaction reduced Ov s tools and equipment by $1,800 and created a new asset, Accounts Receiv .

Exhibit 2–6

OVERNIGHT AUTO SERVICE BALANCE SHEET JANUARY 24, 2011

BALANCE SHEET, JAN. 24

Collection of an Account Receivable from Ace To caused an increase in Ov v 2

ved $600 v s cash but a decrease of the same amount in accounts receivalue; there is no change in the

Sales of assets at prices above or below cost result in gains or losses. Such transactions are discussed in later chapters.

47

Exhibit 2–7.

OVERNIGHT AUTO SERVICE BALANCE SHEET JANUARY 26, 2011

Exhibit 2–7 BALANCE SHEET, JAN. 26

Totals unchanged by collection of a receivable

Payment of a Liability on its account payable to Snappy Tools. This transaction reduced Ov s cash and ving total assets and the total of liabilities plus owners’ equity in balance. Ov Exhibit 2–8.

OVERNIGHT AUTO SERVICE BALANCE SHEET JANUARY 27, 2011

Exhibit 2–8 BALANCE SHEET, JAN. 27

Both totals decreased by paying a liability

Earning of Revenue Ov

gan to pro

were $2,200, all of which was received in cash. venue represents the creation of value by Ov y. As a result, cash is increased by $2,200 and o o distinguish owners’ equity vested by the owners, the account Retained Earnings is used in the owners’ equity section of the balance sheet. The balance sheet in Exhibit 2–9 wners’ equity v ved in cash during the last week of , but before the payment of expenses (see next section).

48

Chapter 2 Basic Financial Statements

Exhibit 2–9

OVERNIGHT AUTO SERVICE BALANCE SHEET JANUARY 31, 2011

BALANCE SHEET, JAN. 31

Revenues increase assets

Learning Objective

LO4

E o r s

Payment of Expenses

In order to earn the $2,200 of revenue that we have just recorded, Ov decided to pay all operating expenses at the end of the month. F , he owed $200 for utilities and $1,200 for wages to his emplo Paying e venues on the o y— their inv xpenses also results in a decrease of cash. ages, is presented in .

Exhibit 2–10

OVERNIGHT AUTO SERVICE BALANCE SHEET JANUARY 31, 2011

Expenses reduce assets

Notice that the expenses of $1,400 ($200 for utilities and $1,200 for wages) reduce the senting the rev between the rev

. It is no xpenses that Overvenues wners while expenses diminish or reduce the

interest of o

EFFECTS OF THESE BUSINESS TRANSACTIONS ON THE ACCOUNTING EQUATION As we learned earlier expression of the accounting equation: Assets

Liabilities

Owners’ Equity

49

Income Statement

As we hav

v

To review, Ov ance sheet indicated in parentheses: Jan. 20 Jan. 21 Jan. 22 Jan. 23 Jan. 24 Jan. 26 Jan. 27 Jan. 31 Jan. 31

ws, with the resulting bal-

usiness by depositing $80,000 received from the sale of capital stock in a compan Exhibit 2–2). Purchased land for $52,000, paying cash (Exhibit 2–3). Purchased a building for $36,000, paying $6,000 in cash and issuing a note payable for the remaining $30,000 ( ). Purchased tools and equipment on account, $13,800 (Exhibit 2–5). Sold some of the tools at a price equal to their cost, $1,800, collectible within 45 days ( ). Receiv v tools (Exhibit 2–7). P Exhibit 2–8). Received $2,200 of sales revenue in cash (Exhibit 2–9). Paid $1,400 of operating expenses in cash—$200 for utilities and $1,200 for wages 2–10).

The expanded accounting equation in Exhibit 2–11 shows the ef the “balances,” sho Exhibits 2–2

wn in red. Notice that s balance sheets in 2–10. Notice also that the accounting equation is in balance after each

While this table represents the impact of Ov wn in its balance sheet, we can now see how , the income ws ho tion changed as a result of its revenue and e ws shows how the company’

Multiple transactions significantly change the enterprise’s financial position

Income Statement The income statement is a summarization of the company’s revenue and expense transactions y’s owners, creditors, and other y will succeed or f venues in excess of its expenses. Once the company’s assets are acquired and business commences, revenues and e the company’s operations. Revenues are increases in the company’ directed activities, and they result in positiv ws. Expenses are decreases in the company’ vities, and they result in negativ ws. Net income is the difference between the revenues and e Should a compan ving e vnet loss. Ov vely simple because the company 3 did not have a large number of complex revenue and e T Exhibit 2–11, and separating the total

3

In this illustration, only revenue and expense transactions change the amount of owners’ equity from the original $80,000 investment of the owner. Examples of other events and transactions that affect the amount of owners’ equity, but that are not included in net income, are the sale of additional shares of capital stock and the payment of dividends to shareholders. These subjects are covered in later chapters.

Learning Objective

LO5

50 1,800

$1,800 600

600

6,800

2,200

1,400

Jan. 26

Jan. 27

Jan. 31

Jan. 31

$36,000

Jan. 24

6,000

Jan. 22

$52,000

$13,800

52,000

Jan. 21

Jan. 23

$80,000

OVERNIGHT AUTO SERVICE EXPANDED ACCOUNTING EQUATION JANUARY 20–31, 2011

EXPANDED ACCOUNTING EQUATION

Jan. 20

Exhibit 2–11

$30,000

6,800

$13,800

$80,000

1,400

$2,200

51

Statement of Cash Flows

expenses of $1,400 into wages of $1,200 and utilities of $200, we can prepare the company’s income statement as shown in Exhibit 2–12.

Exhibit 2–12

OVERNIGHT AUTO SERVICE INCOME STATEMENT FOR THE PERIOD JANUARY 20 – 31, 2011

INCOME STATEMENT

An income statement displays revenues and expenses for a period of time

Notice that the heading for the income statement refers to a period of time rather than a point in time, as w v xpenses over a period of time and e w the company’ the be

Statement of Cash Flows We already hav ws of the compan

ws to investors and creditors and that vestors’ and creditors’

Learning Objective

LO6

w a company’

o points in time

We can use the entire Cash column of the analysis in Exhibit 2–11 to create a statement ws for Ov ws into three categories—operating, inv gories to the be ws from operating activities are the cash effects of revenue and expense transactions that are included in the income statement.4 ws from investing activities ws from acti wners investing in the company and creditors loaning money to the company and the repayment of either or both. ws for Ov presented in Exhibit 2–13. Notice that the operating, inv gories include both positive and negativ ws. (The negativ ws are in parentheses.) Also notice that the combined total of the three categories of the statement (increase of $16,600) explains the total change in cash from the be balance was zero because the company w . Sev of transactions had no cash effects and, therefore, are not included in the statement of cash ws. For e uilding for $36,000, only $6,000 of which was paid in cash. The remaining $30,000 is not included in the statement of cash ws because it did not af -

4

because all of Ov e

vided by operating activities and net income are equal. This is s revenues and e ways venues and ved or paid.

52

Chapter 2 Basic Financial Statements

Exhibit 2–13

OVERNIGHT AUTO SERVICE STATEMENT OF CASH FLOWS FOR THE PERIOD JANUARY 20 – 31, 2011

STATEMENT OF CASH FLOWS

A statement of cash flows shows how cash changed during the period

CASE IN POINT

Carnival Corporation

cash ef T in this text, even though the

noncash in

ws. ansactions. In xplain later y.

Relationships among Financial Statements Learning Objective

LO7

E o s

As our discussion of Ov ws are all based on the same transactions, but the ws” of the company. They should not be ves to each other; rather ey y. The diagram in Exhibit 2–14 explains ho period of time they cover. The horizontal line represents time (for example, a month or a year). At the beginning and ending points in time, the compan cial position (balance sheet) that giv y stands. The other tw ws—cov ening period of time between the two balance sheets and help explain

53

Relationships among Financial Statements

Date at beginning

Date at end

Exhibit 2–14 FINANCIAL REPORTING TIME LINE

Statement of financial position (Balance sheet)

Income statement Statement of cash flows

Statement of financial position (Balance sheet)

closely tied to time periods

If we understand where a compan

o points in time, and if we y’s vities (income statement) and its cash acti ws), w a great deal about the company that is v ws— vestors, creditors, management, and others. ws are derived ” meaning that they relate closely to each other. The diagram in Exhibit 2–15 indicates relationships that we have discussed in this chapter as we hav ments. The dollar amounts are taken from the Ov xample presented earlier in this chapter , plant, and equipment amount of $100,000 represents the total of land ($52,000), b ($12,000).

Exhibit 2–15 FINANCIAL STATEMENT ARTICULATION

Financial statements are based on the same underlying transactions

The balance sheet represents an expansion of the accounting equation and explains the various categories of assets, liabilities, and owners’ equity. The income statement explains

54

Chapter 2 Basic Financial Statements

revenue and expense transactions. The resulting number, net income, represents an addition to the o ws explains the ways cash s operating, investing, vities. While these three ke y do not y. For example, look again at Ov s acti . We could have prepared a w liabilities changed or how the T

be presented and that w

ws that could ve developed

this text. At this point, we hav

, can be thought of as a lens w a business. (See .) A lens allows you to see things from a distance that you would not otherwise be able to see; it also allows you to focus in vesting and credit cial statements.

Exhibit 2–16 FINANCIAL REPORTING AND FINANCIAL STATEMENTS

55

Forms of Business Organization

Financial Analysis and Decision Making

YOUR TURN

Forms of Business Organization In the United States, most b ships, or corporations.

ganized as sole proprietorships, partnerganization.

SOLE PROPRIETORSHIPS usiness owned by one person is called a sole proprietorship. owner also acts as the manager usiness or stores, f w f . From an accounting vie garded as a business entity separate fr . From a legal viewpoint, however, the

Learning Objective

LO8

56

Chapter 2 Basic Financial Statements

business and its owner are not regarded as separate entities. Thus, the owner is personally liable for the debts of the business. If the b tors can force the o an adv ganization is its simplicity, this unlimited antage to the owner.

PARTNERSHIPS usiness owned by two or more persons v (co-o partnership. P e sole proprietorships, are widely used for small businesses. In addition, some large professional practices, including CP la wners usiness. From an accounting wed as a b airs of its owners.5 v ger amounts of capital inv wners.

CORPORATIONS A corporation usiness organization that is recognized under the law as an entity separate from its owners. Therefore, the o not personally liable for the debts of the business. These o y have invested in the b wn as . This concept is one of the principal v usiness organization to many investors. Ov ers are called wing the number of shares that he or she o vestors at any time. This transfer of ownership v ganization, because investors can more easily get their money out of the b ven greater opporwners. There are man ut most large businesses are or usiness or dollar volume of business acti usiness, vestors and other outsiders.

REPORTING OWNERSHIP EQUITY IN THE STATEMENT OF FINANCIAL POSITION usiness organization. Some differences arise, however, in the presenta.

tion of the o

Sole Proprietorships A sole proprietorship is owned by only one person. Therefore, the owner’s equity section of the balance sheet includes only one item—the equity of the o . If Ov ganized as a sole proprietorship with Michael wner, o ould appear as follows:

proprietorship

Partnerships

A partnership has two or more o ner instead of o equity in the business. If, for e

5

o

personal wners ultimately are responsible for paying the debts of the business.

parts

usiness

57

sister

uted an equal ould have been presented as follows: ...

Corporations In a business or

corporation, it is not . In the case of lar impractical because these businesses may have several million indi W stockholders’ equity is presented in tw sheet appears as follows:

w sepaould be ganized as a cor-

. . . and in a corporation

Capital stock vested in the business in exchange for shares of the company’s stock. Retained earnings, in contrast, represents the increase in owners’ equity that has accumulated ov operations.

The Use of Financial Statements by External Parties v cial decisions—that is, in selecting those companies in which they will invest resources or to which they will extend credit. F meet the needs of creditors and investors. Two f investors are the and pr of a business organization. Creditors are interested in liquidity—the ability of the business to pay its debts as they val of a business organization—a business that usiness may be tors), and eventually go out of existence. Investors also are interested in the liquidity of a business organization, but often they are ev . Pr ations increase the value of the owners’ in the business. A compan v xhaust its resources and be forced out of e these statements carefully for clues to the company’ .

The Short Run versus the Long Run may be independent of each other. A b

ut nev y may operate ven year yet still have enough cash from previous periods to pay its

bills and remain liquid. Ov wever v

usiness is to .

58

Chapter 2 Basic Financial Statements

Evaluating Short-Term Liquidity

As discussed earlier in this chapter, one key s liquid assets and the liabilities requiring payment in the near future. y’s assets, pate whether the company is likely to hav y short-term creditors. Evaluating longalways read the accompanying notes and the auditors’

THE NEED FOR ADEQUATE DISCLOSURE The concept of adequate disclosure oper interpretation notes accompanying these statements. It is not unusual es. Among the ev or e s building is destro

to Ov would be done with a note like the following:

contain vital information

y vent.” This disclosure usually

at $36,000 was destro y has insurance on this f ment expects to recover only approximately $30,000 of the loss.

, manage-

vents, man wsuits against the company, vable ge future cash

from of outlays. There is no single comprehensive list of the items and events that may require discloould consider ments. Ev

oper interpretation do not

MANAGEMENT’S INTEREST IN FINANCIAL STATEMENTS Learning Objective

LO9 t

v vestors and creditors, the management of a business or the b ws. Therefore, management is anxious to receiv e action to improve areas of weak performance. Most large organizations provide managers with prepared on a weekly, daily, or even hourly basis are possible. Managers have a special interest in the annual ments are used by decision makers outside of the organization. For example, if creditors view y will be more willing to extend credit to the business than if they regard the company’ v interested in how investors and creditors react to the company’

59

ws relatively little debt and large v ment is one that shows large revenues relative to the e venues. ws is one that not only shows a strong cash balance but also indicates that cash is being generated by operations. Demonstrating that these positive characteristics of the compan vestors and creditors. e steps that are ve the company’ For example, cash purchases of assets may be delayed until the be xt accounting period so that lar ws. On the other hand, if the compan cash position, liabilities due in the near future may be paid early, replaced with longer liabilities, or even replaced by additional investments by o negativ ws will not be as great as the . These actions are sometimes called window dressing—measures taken by management to make the compan air representations of the y usiness throughout the , managee the company appear as strong as is reasonably possible. As a result, many creditors re ven monthly) as pro window-dress and make a compan

Ethics, Fraud & Corporate Governance

HealthSouth

HealthSouth

60

Chapter 2 Basic Financial Statements

Concluding Remarks xt, we emphasize ho usiness decisions. In this chapter, you have been introduced to business transactions and how they ws. s work, and they provide inv ful for decision making. w business transactions are actually recorded, how they move through an accounting system, and how they ev ve receiv ve into a more sophisticated discussion of business transactions and how they impact a company’ ws.

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

lain the nature and general purpose of finanstatements.

LO1

LO2

i

lain certain accounting principles that are t for an understanding of financial statets and how professional judgment by accouny affect the application of those principles.

LO3

emonstrate how certain business transactions ffect the elements of the accounting equation: sets Liabilities Owners’ Equity.

LO4

lain how the statement of financial position, ften referred to as the balance sheet, is an expans f the basic accounting equation.

LO7

LO8

LO9

lain how the statement of financial position ome statement, and statet of cash flows relate to each other.

lain common forms of business ownership—sole orship, partnership, and corporation—and emonstrate how they differ in terms of their pretatement of financial position.

iscuss the importance of financial statements to ompany and its investors and creditors and why gement may take steps to improve the f the company in its financial statements.

lain how the income statement reports an terprise’s financial performance for a period of t erms of the relationship of revenues and expenses. LO5

Key Terms Introduced or Emphasized in Chapter 2 LO6

t

lain how the statement of cash flows presents or a period of time in terms of ompany’s operating, investing, and financing

Demonstration Problem

Solution to the Demonstration Problem CRYSTAL AUTO WASH BALANCE SHEET SEPTEMBER 30, 2011

Self-Test Questions

ASSIGNMENT MATERIAL

Discussion Questions

Brief xercises LO3

T

LO3

T

LO4

LO4

LO5

LO5

LO6

LO8

LO8

LO7

accounting

Exercises LO3

accounting

E T

American Airlines

Boston

Celtics American Airlines LO4

E P

DIXIE TRANSPORTATION SERVICE MANAGER’S REPORT 8 P.M. THURSDAY

LO4

E P

LO2

E A

Boston Celtics

LO3 U

LO3 T

LO3 E

LO8 F

LO9 F

LO2 P

LO6 S

LO5

LO5

YARNELL COMPANY AUGUST 31, 2011

LO6 S

LO9

LO4

Home Depot, Inc.

o

F

LO6

LO5

McKesson Corporation A

Problem Set A LO4 P

LO3 I

accounting

LO3

P R

LO3

P A

LO4 P

LO4 P

LO3

LO4

LO6

P S o E T

LO4

P

LO6

P S B

LO4

P

LO8

P S A

BERKELEY PLAYHOUSE BALANCE SHEET SEPTEMBER 30, 2011

LO2 LO4

P S A

BIG SCREEN SCRIPTS BALANCE SHEET NOVEMBER 30, 2011

Problem Set B LO4

P P

LO3

P I

accounting

LO3

LO3 A

LO4

P P

LO4

P P

LO3

LO4

LO6

P P S o E T

LO4

LO6

P S B

LO4

P

LO8

S A

OLD TOWN PLAYHOUSE BALANCE SHEET SEPTEMBER 30, 2011

LO2

LO4

P S A

HIT SCRIPTS BALANCE SHEET NOVEMBER 30, 2011

Critical Thinking Cases LO4

C C

LO4 U S

LO6

LO4 U

MOON CORPORATION BALANCE SHEET JULY 31, 2011

STAR CORPORATION BALANCE SHEET JULY 31, 2011

LO6 U

LO4 E

LO4 P

LO4

LO5

www.sec.gov

Cisco Systems

http://www.yahoo.com

Answers to Self-Test Questions

CHA P TER 3

The Accounting Cycle Capturing Economic Events

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO:

LO1

Learning Objectives

LO2 LO3 LO4 LO5 LO6 LO7 LO8 LO9 LO10

KRAFT FOODS, INC.

Kraft Foods, Inc.

Kraft Foods, Inc.

■

86

Chapter 3 The Accounting Cycle: Capturing Economic Events

Although Ov chapter

veral business transactions in the previous w these ev w accounting systems record

economic events related to a variety of business transactions.

The Accounting Cycle Learning Objective

LO1

I a d a

In Chapter 2, we illustrated several transactions of Ov diately follo not prepare ne

usinesses do

v , the accounting records. Then, at re

als, the

The sequence of accounting procedures used to record, classify, and summarize accounting accounting cycle. The accounting cycle begins with the initial recording of b cycle indicates that these procedures must be repeated continuously to enable the business to prepare new, up-toals. The accounting c , we illustrate how b ycle will be addressed in Chapters 4 and 5. They include (4) making end-of-period adjustments, -closing trial balance.

THE ROLE OF ACCOUNTING RECORDS The c does far more than f of a b poses as:

yees -

1. Establishing vidual’ 2. Keeping track of routine business activities—such as the amounts of money in company wed to suppliers. 3. 4. Evaluating the efficiency and performance of various departments within the organization. 5. vidence of the company’s business activities. (For example, tax la tax

The Ledger Learning Objective

LO2

a

statements. For example, a separate record is kept for the asset cash, showing all increases and decreases in cash resulting from the many transactions in which cash is received or paid. A similar record is kept for ev v , for o , and for ev venue and e The record used to k is termed a “ledger account” or, simply, an account. The entire group of accounts is kept ledger. Exhibit 3–8 of Ov

87

Debit and Credit Entries

The Use of Accounts An account is a means of accumulating in one place all the information about changes in . For example, the Cash vides a company’ of its cash disbursements. is called the debit side; and (3) a right side, which is called the credit w and on the follo T account because of its resemblance to the letter “T. .

A T account—a ledger form

Debit and Credit Entries debit, Likewise, any amount entered on the right, or credit, side is called a credit,

. .

of an account. To illustrate the recording of debits and credits in an account, let us go back to the eight cash transactions of Ov ments are listed on the credit side. The dates of the transactions may also be listed, as sho in the following illustration:

Cash transactions entered in ledger account

ment. The amount of cash owned by the business at a given date is equal to the balance of the account on that date.

Determining the Balance of a T Account xceeds the credit total, the account has a debit balance; if the credit total exceeds the debit total, the account has a credit balance. wing the

has a debit balance of $16,600 This debit balance is entered in the debit side of the account just belo result of all the pre

net w shows the amount of

88

Chapter 3 The Accounting Cycle: Capturing Economic Events

cash owned by the b amount of $16,600 would be listed as an asset.

Debit Balances in Asset Accounts In the preceding illustration of a Cash account,

Learning Objective

LO3

U s

as a debit balance in the account. normally have debit balances. It is hard to imagine an account for an asset such as land having a credit balance, as this would indicate that the business had disposed of more land than it had ever acquired. (For some assets, such as cash, it is possible to acquire a credit balance—but such balances are only tempor .) The fact that assets are located on the left side of the balance sheet is a conv left (debit) side of the balance.

Asset accounts normally have debit balances

Credit Balances in Liability and Owners’ Equity Accounts

Increases in liability and owners’ equity accounts are recorded by credit entries and decreases in these ws: (1) liabilities and owners’ equity belong on the right side of the balance sheet, (2) an increase in a liability or an owners’ equity account is recorded on the right wners’ ve credit (right-hand) balances.

credit balances

Concise Statement of the Debit and Credit Rules The use of debits and credits to record changes in assets, liabilities, and o

ws:

Debit and credit rules

DOUBLE-ENTRY ACCOUNTING—THE EQUALITY OF DEBITS AND CREDITS e ansaction is recorded by equal dollar amounts of debits and credits. The reason for this equality lies in the relationship of the

Debit Balances

Liabilities

Owners’ Equity

y

s

Assets

Credit Balances

89

The Journal

If this equation is to remain in balance, any change in the left side of the equation (assets) must be accompanied by an equal change v the equation (assets) are recorded by debits, while increases in the right side (liabilities and o credits, as illustrated below: Assets

Liabilities

Learning Objective

LO4

Owners’ Equity

This system is often called accounting. The phrase double-entry refers to the need for both debit entries and credit entries, v v usiness or gardless of whether the company’s accounting records are maintained manually or by computer. Later in this chapter

The Journal In the preceding discussion we illustrated ho accounting are applied in the recording of economic ev effects that business transactions have on individual asset, liability, and owners’ equity y’s general ledger. It is important to realize, however, that directly usiness transaction is initially recorded in an accounting record called the journal. later the general ledger. usiness transactions. At convenient accounts in the ledger e as the basis for preparing the company’ T general journal, let us examine the v usiness transaction of Ov amily invested $80,000 in exchange for capital stock. Thus, the asset Cash increased by $80,000, and the owners’ equity account Capital Stock increased by the same amount. viously, we know that increases in assets are recorded by debits, whereas increases in o this event requires a debit to Cash and a credit to Capital Stock in the amount of $80,000. The y’ Exhibit 3–1. Note the 1. appears in the left-hand money column. 2. The name of the account credited (Capital Stock) appears below the account debited and is 3. A brief description of the transaction appears immediately belo recorded. However way to conceptualize the manner in which economic ev y’

. ve

Learning Objective

LO5

90

Chapter 3 The Accounting Cycle: Capturing Economic Events

Exhibit 3–1

GENERAL JOURNAL

RECORDING A TRANSACTION IN THE

Af tool for analyzing and describing the impact of v ab

usiness.

POSTING JOURNAL ENTRIES TO THE LEDGER ACCOUNTS (AND HOW TO “READ” A JOURNAL ENTRY) We have made the point that transactions are recorded rst in the journal. Ledger accounts are updated later, . occur instantaneously, rather than later.) Posting simply means updating the ledger accounts for the effects of the transactions ie

entry aloud, you would say: “Debit Cash, $80,000; credit Capital Stock, $80,000.” That’s credit the Capital Stock account for $80,000. The posting of Ov Exhibit 3–2. Notice that no ne volves copying into the already has been recorded in the journal. In manual accounting systems, this can be a tedious and time-consuming process, but in computer-based systems, it is done instantly and automatically. In addition, computerized posting greatly reduces the of

Exhibit 3–2

GENERAL JOURNAL

FROM THE JOURNAL TO LEDGER ACCOUNTS

GENERAL LEDGER

Recording Balance Sheet Transactions: An Illustration T transactions related to changes in the company’

91

Recording Balance Sheet Transactions: An Illustration

its balance sheet. The revenue and e addressed later in the chapter. in assets, liabilities, and o

. Second, we follo

side. For convenience in the follo transaction under discussion are sho in black.

wn on the

red.

amily invested $80,000 cash in exchange for capital

Jan. 20 stock.

Owners invest cash in the business Liabilities

Jan. 20

80,000 80,000

1/20 80,000

Jan. 21

1/20 80,000

Representing Ov eresa and Metropolitan T A) to purchase an abandoned bus garage. (The city owned the land, but the MTA owned the b Ov

Purchase of an asset for cash Owners’ Assets

Jan. 21

52,000 52,000

1/21 52,000

1/21 52,000

Liabilities

92

Chapter 3 The Accounting Cycle: Capturing Economic Events

Jan. 22

Ov abandoned b made a $6,000 cash do payable for the remaining $30,000.

usiness location by purchasing the as $36,000; Ov , non-interest-bearing note

Purchase of an asset, making a small down payment Owners’ Liabilities $ 6,000

Jan. 22

36,000 6,000 30,000

1/22 36,000 1/22

6,000

1/22 30,000

Jan. 23

Ov purchase price was $13,800, due in 60 days.

y Tools. The

Credit purchase of an asset Liabilities $13,800

Jan. 23

13,800 13,800

1/23 13,800

Jan. 24

1/23 13,800

Ov sold the e owing at a price of $1,800. The tools were sold at a price equal to their cost, so there w

Credit sale of an asset (with no gain or loss) Owners’ Assets

Jan. 24

Liabilities

1,800 1,800

1/24 1,800

Jan. 26

Ov Towing.

1/24 1,800

ved $600 in partial collection of the account receiv

Collection of an account receivable Owners’ Liabilities $600 $600

Jan. 26

600 600

1/26 600 1/26

Jan. 27

600

Ov

y Tools. Payment of an account payable Liabilities

Jan. 27

6,800 6,800

1/27 6,800 1/27

6,800

93

94

Chapter 3 The Accounting Cycle: Capturing Economic Events

Ledger Accounts after Posting The sev Exhibit 3–3.

Exhibit 3–3

OVERNIGHT AUTO SERVICE GENERAL JOURNAL JANUARY 20–27, 2011

ENTRIES: JANUARY 20 THROUGH 27

have been posted, Ov

s ledger accounts

appear as shown in wed by liabilities and o running balance , however, ve debit balances, and liability and owners’ ve credit balances. In the ledger accounts in , we have not yet included any of Ov s revenue and expense transactions discussed in Chapter 2. All of the company’s revenue and expense revenue and expense accounts, a more in-depth discussion of net income is w

95

Ledger Accounts after Posting

CASH

Exhibit 3–4 LEDGER SHOWING TRANSACTIONS

ACCOUNTS RECEIVABLE

LAND

BUILDING

TOOLS AND EQUIPMENT

NOTES PAYABLE

ACCOUNTS PAYABLE

CAPITAL STOCK

96

Chapter 3 The Accounting Cycle: Capturing Economic Events

What Is Net Income? Learning Objective

LO6

E i

As previously noted, net income is an increase in owner esulting from the pr operation of the business. Net income does not consist of any cash or an Rather, net income is a computation of the ov y business transactions on owner . The ef follows: Assets Increase

Net income is not an asset—it’s an increase in

Liabilities

Owners’ Equity Increase

Decrease

Increase

OR . . .

As income is earned, either an asset is increased or a liability is decreased.

Net income always results in the increase of Owners’ Equity.

Our point is that net income represents an increase in owner relationship to the types or amounts of assets on hand. Even a b

and has no direct

In the balance sheet, the changes in o Retained Earnings. The assets and liabilities of the business that change as a result of income-related activities appear in their respective sections of the balance sheet.

RETAINED EARNINGS ings account to increase. However, man

w a polic

uting to their utions of this

dividends, and the

The balance in the Retained Earnings account represents the total net ver the entire lifetime of the business, less all of the di ve been retained wth. Some of the lar ve become large by consistently retaining in the b tions. For instance, a recent annual report of Walmart Stores, Inc., shows © The McGraw-Hill Companies, Inc./John Flournoy, photographer/DAL

nearly $64 billion account for over 98 percent of the company’

.

THE INCOME STATEMENT: A PREVIEW An income statement

usiness

sales prices costs usiness in deliv net income are revenue and expenses. Therefore, accountants say that net income is equal to revenue minus expenses. Should expenses exceed revenue, a net loss results. A sample income statement for Ov 2011, is shown in Exhibit 3–5. In Chapter 5, we show exactly how this income statement was

97

What Is Net Income?

developed from the company’ or now, however, the illustration will assist us in discussing some of the basic concepts involved in measuring net income.

OVERNIGHT AUTO SERVICE INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

Income Must Be Related to a Specified Period of Time

Notice that our sample income statement covers a period of time—namely, the year 2011. A balance sheet sho usiness at a particular date. We cannot evaluate net income or example, if an executive says, “My b usiness is unclear. Does it

CASE IN POINT

Accounting Periods The period of time covered by an income statement is termed the company’s accounting period. To pro information, net income is measured for relativ This concept, called the time period principle, v statements. The length of a company’ w frequently managers, investors, and other interested people require information about the company’s performance.

Exhibit 3–5 A PREVIEW OF OVERNIGHT’S INCOME STATEMENT

98

Chapter 3 The Accounting Cycle: Capturing Economic Events

Ev ver a three-month period and are prepared by all lar year. used by most companies coincides with the calendar year and ends on December 31. Some businesses, however For example, The Walt Disney Company or one reason, September and October are relatively slow months at the company’s theme parks. summer, which is the company’s busiest season. Most large retailers, such as Walmart and JCPenney, Man xact 52-week ve out of ev Let us now e revenue and expenses in more detail.

REVENUE Re

Revenue always causes an

Learning Objective

LO7

endered during a given accounting period. venue causes owners’ equity to increase. When a business renders services or sells merchandise to its customers, it usually receives cash or acquires an account receiv the customer w of cash and receiv company; on the other side of the accounting equation, o increase in total assets. Thus, rev increase in owner resulting from operation of the business. V venue. For example, a business that sells merchandise rather than services, such as Walmart or General Motors, uses Sales to describe its revenue. In the professional practices of physicians, CPAs, and ys, revenue usually is called Fees Earned. wever, might call its revenue Commissions Earned. Ov s income statement reveals that the company records its revenue in two separate accounts: (1) venue and (2) Rent Revenue Earned. A profesve separate rev Ticket Sales, Concessions Revenue, and Revenue from Television Contracts. v y businesses is Interest Revenue vable, and interest-bearing investments.

The Realization Principle: When to Record Revenue

a

ognized at the time goods ar

a

measured objectively. At an

venue realization principle indicates that revenue should be rece rendered. At this point, the business has

customer, usually a relativ vent. To illustrate, assume that on July 25 a radio station contracts with a car dealership to air in August, but payment for the ads is not received until September, in which month should the station recognize the adv venue? The answer is August, the month in which it rendered the services venue. In other words, revenue is recognized when it is earned, without re pro ved.

EXPENSES Expenses are the costs of the goods and services used up in the process of earning revenue. Examples include the cost of employees’ salaries, advertising, rent, utilities, and the

99

What Is Net Income?

depreciation of buildings, automobiles, and of venue. Expenses are often called the “costs of doing business,” that is, the cost of the various acti business. An expense always causes a decrease in owner . The related changes in the accounting equation can be either (1) a decrease in assets or (2) an increase in liabilities. An expense xpense will not be paid until later, as, for example, the purchase of adv recording of the expense will be accompanied by an increase in liabilities.

The Matching Principle: When to Record Expenses A relationship exists between revenue and e purpose of producing revenue. In the measurement of net income for a period, revenue should be offset by all the expenses incurred in producing that revenue. xpenses against rev matching principle. T actor in matching (offsetting) revenue with the related expenses. For e fset this month’s expenses against this month’s revenue. W s expenses against last month’s rev o. y’s mark garded as expenses—July or August? The answer is July, because July is the month in which the marketing team’ helped to produce revenue. Just as revenue and cash receipts are not one and the same, e an e , or in the same period that rev when to report an expense in the income statement, the critical question is, “In what period does the cash expenditure help to produce revenue?”—not, occur?” Expenditures Benefiting More than One Accounting Period Many expenfor example, usually cover a period of 12 months. If a company prepares monthly income statements, a portion of the cost of such a policy should be allocated to insurance expense each month that the policy is in force. In this case, apportionment of the cost of the policy by months is an easy matter. If the 12-month policy costs $2,400, for e expense for each month amounts to $200 ($2,400 cost 12 months). vided so precisely by accounting periods. The purchase of a b , a computer, or an automobile pro the business ov ance exactly how man ved from such long-lived assets. Nev usiness for a period of one year or less, accountants must estimate ved assets is applicable to . Since the allocations of these costs are estimates rather than precise measurements, it follows that income statements should be re approximations of net For some expenditures, such as those for employee training programs, it is not possible to estimate objectively the number of accounting periods over which revenue is likely to be be charged immediately to expense. This treatment is based upon the accounting principle of objectivity and the concept of atism. Accountants require that an expenditure will produce rev y will view the e creating an asset. When this objective evidence does not exist, they follow the conservative practice of recording the expenditure as an expense. in this context, means lowest (most conservative) estimate of

Expenses always cause a decrease

100

Chapter 3 The Accounting Cycle: Capturing Economic Events

I N T E R N AT I O N A L CA S E I N P O I N T

THE ACCRUAL BASIS OF ACCOUNTING The policy of recognizing revenue in the accounting records when it is earned and recognizing expenses when the related goods or services are used is called the accrual basis of . economic activities conducted volv matching principle. Revvenue, thus providing a measure of the ov . An alternativ cash basis accounting. Under cash basis accounting, rev , rather than when the compan usiness operations. The cash basis of accounting measures the amounts of cash receiv ut it does not provide a good measure of the pr en during the period. Exhibit 3–6 b prior to or after rev

Exhibit 3–6 CASH FLOW VERSUS INCOME STATEMENT RECOGNITION

but ...

but ...

DEBIT AND CREDIT RULES FOR REVENUE AND EXPENSES We hav venue increases owners’ equity and that expenses decrease o equity venue and e are a natural e wners’ equity ously stated for recording increases and decreases in o ws: • Increases in o credits. • Decreases in owners’ equity are recorded by debits.

vi-

101

Recording Income Statement Transactions: An Illustration

w extended to cover revenue and e • Revenue increases owners’ equity; therefore, revenue is recorded by credits. • Expenses decrease owners’ equity; therefore, expenses are recorded by debits.

Dividends A dividend is a distrib some respects, dividends are similar to expenses—they reduce both the assets and the owners’ equity in the business. However, dividends are not an expense e not deducted from revenue in the income statement. The reason why dividends are not viewed as an expense is e to generate revenue. Rather, they are a distribution of pr to the owners of the business. Since the declaration of a di , the dividend could be wever, a clearer record is created if a separate Di di venue, expenses, and di w:

Debit–credit rules related Decreases

Debits

Expenses

Debits

Dividends

Debits

Increases

Credits

Revenue

Credits

Recording Income Statement Transactions: An Illustration Learning Objective

In Chapter 2, we introduced Ov s balance

LO8

Ov volving revenue and expenses were recorded by Ov 31, 2011. The following illustrations provide an analysis of each transaction. Jan. 31

Recorded revenue of $2,200, all of which was received in cash. Revenue earned and collected Owners’ Assets $2,200

Jan. 31

2,200 2,200

1/31 2,200 1/31

2,200

$2,200

Jan. 31

Paid employees’ w

, $1,200.

Incurred an expense, paying cash Assets

Liabilities $1,200

Jan. 31

1,200 1,200

1/31 1,200

Jan. 31

Paid for utilities used in

1/31 1,200

, $200.

Incurred an expense, paying cash Owners’ Liabilities $200

Jan. 31

200 200

1/31 200 1/31

Having analyzed and recorded all of Ov the company’ vities. Ov and recorded as follows: Feb. 1 Paid Daily Tribune $360 cash for newspaper adv

200

xt we focus upon

.

Incurred an expense, paying cash Liabilities

Feb. 1

360 360

102

2/1

360

2/1

360

103

Recording Income Statement Transactions: An Illustration

Feb. 2

Purchased radio adv $470, payable within 30 days.

. The cost was

Incurred an expense to be paid later Owners’ Assets

Liabilities $470

Feb. 2

$470

470 470

2/2

Feb. 4

470

2/2

470

arious shop supplies (such as grease, solv A Auto P to meet Ov s needs for three or four months.

xpected

When a purchase clearly periods, it’s an asset, not an expense Liabilities $1,400

Feb. 4

1,400 1,400

2/4

1,400 2/4

1

If the supplies are expected to be used within the current directly to the Supplies Expense account, rather than to an asset account.

1,400

Equity

104

Chapter 3 The Accounting Cycle: Capturing Economic Events

Feb. 15

Collected $4,980 cash for repairs made to v

Revenue earned and collected Owners’ Assets

Liabilities

$4,980

Feb. 15

4,980 4,980

2/15

4,980

2/15

4,980

Feb. 28 pro . The agreement with Harbor Cab calls for payment to be received by March 10.

Revenue earned but not yet collected Owners’ Assets

Liabilities

Feb. 28

5,400 5,400

2/28

5,400 2/28

5,400

105

Recording Income Statement Transactions: An Illustration

Feb. 28

Paid employees’ w

, $4,900. Incurred an expense, paying cash Owners’ Liabilities $4,900

Feb. 28

4,900 4,900

2/28

YOUR TURN

4,900

2/28

4,900

$4,900

106

Chapter 3 The Accounting Cycle: Capturing Economic Events

Feb. 28 Incurred an expense to be paid later Owners’ Assets

Liabilities $1,600

Feb. 28

1,600 1,600

2/28

1,600 2/28

1,600

Feb. 28 Ov vidend of 40 cents per share to the owners of its 8,000 shares of capital stock—a total of $3,200.2 A Dividends account signifies a reduction in —but it is not an expense Owners’ Assets $3,200

Liabilities $3,200

Feb. 28

3,200 3,200

2/28

3,200 2/28

2

3,200

As explained earlier, dividends are not an expense. In Chapter 5, we will show how the balance in the Di v section of the balance sheet.

107

THE JOURNAL wn in a v Exhibit 3–7

made in Ov

explanations credit transactions and the names of customers and creditors.

Exhibit 3–7

OVERNIGHT AUTO SERVICE GENERAL JOURNAL JANUARY 31–FEBRUARY 28, 2011

ENTRIES: JANUARY 31 THROUGH FEBRUARY 28

Journal entries contain more information than just dollar amounts

February’s Ledger Balances s ledger accounts appear as shown in Exhibit 3–8. T v

e space, we hav or convenience,

108

Bal. $12,000

Bal. $36,000

Bal. $52,000

Bal. $1,400

Bal. $6,600

Bal. $13,120

Exhibit 3–8

Bal. $1,800

Bal. $6,100

Bal. $830

Bal. $3,200

OVERNIGHT AUTO SERVICE THE LEDGER

OVERNIGHT AUTO SERVICE’S LEDGER ACCOUNTS

Bal. $12,580

Bal. $80,000

Bal. $10,470

Bal. $30,000

109

The Trial Balance

we show in red the F The accounts in this illustration appear in der—that is, balance wners’ equity), followed by the income statement accounts (revenue and expenses).

The Trial Balance v tion recorded, the sum of all the debits in the ledger must be equal to the sum of all the credits. If the computation of account balances has been accurate, it follows that the total of the

Learning Objective

LO9

Before using the account balances to prepare a balance sheet, it is desirable to prove that the total of accounts with debit balances is in fact equal to the total of accounts with credit balances. This proof of the equality of debit and credit balances is called a trial balance. A in the order in whic er wn in Exhibit 3–9.

Exhibit 3–9

OVERNIGHT AUTO SERVICE TRIAL BALANCE FEBRUARY 28, 2011

OVERNIGHT AUTO SERVICE’S TRIAL BALANCE

$ 13,120 6,600 1,400 52,000

A trial balance proves

36,000

credits—but it also gives you a feel for how the business stands; but wait— there’s more to consider

12,000 $ 30,000 10,470 80,000 0 3,200 12,580 830 6,100 1,800 $133,050

$133,050

ves the equality of the debit and credit entries in the company’s accountzero. It is zero because no debit or credit entries were made to the Retained Earnings account in J . Overnight, like most companies, updates its Retained Earnings balance only once each year. In Chapter 5, we will show ho at year-end on December 31.3 3

ve ev usiness acti have a balance other than $0.

y is y trial xpected to

110

Chapter 3 The Accounting Cycle: Capturing Economic Events

USES AND LIMITATIONS OF THE TRIAL BALANCE vides proof that the ledger is in balance. The agreement of the debit and ves assurance that: 1. Equal debits and credits have been recorded for all transactions. 2.

.

Suppose that the debit and credit totals of the trial balance do not agree. This situation ve been made. T of a debit as a credit, or vice v ying account balances into the trial balance; (4) listing a debit balance in the credit column of the trial balance, or vice v balance. not prov v recorded by debiting the Land account instead of the Cash account, the trial balance would ould the trial balance proves only one aspect of the ledger edits.

Concluding Remarks THE ACCOUNTING CYCLE IN PERSPECTIVE Learning Objective

LO10

a

We view the accounting cycle as an ef clude the accounting cycle in Chapters 4 and 5, please don’ amiliarity with wledge of accounting. The accounting cycle is but one vely simple one at that. Computers now free accountants to focus upon the more analytical aspects of their discipline. These include, for example: • • • • • • •

ers. Designing systems to pro . Evaluating the ef y of operations throughout the organization. Assisting decision mak Forecasting the probable results of future operations. Tax planning.

We will emphasize such topics in later chapters of this te point from Chapter 1: The need for some familiarity with accounting concepts and processes is not limited to indi oday, an understanding of usiness world go hand in hand. Y w much about one without understanding quite a bit about the other.

111

Concluding Remarks

Ethics, Fraud & Corporate Governance

Enron Enron

Enron Enron

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

LO1

I entify the steps in the accounting cycle and s the role of accounting records in an organization.

lain the nature of net income, revenue, and penses.

LO6

t

LO7

ly the realization and matching principles in ecording revenue and expenses.

LO8

erstand how revenue and expense transace recorded in an accounting system.

escribe a ledger account and a ledger. LO2

LO3

a

i r

erstand how balance sheet accounts are eased or decreased.

LO9

l c

epare a trial balance and explain its uses and tions.

lain the double-entry system of accounting. LO4

t

LO10

LO5

lain the purpose of a journal and its elationship to the ledger. a

istinguish between accounting cycle procedures knowledge of accounting.

Key Terms Introduced or Emphasized in Chapter 3

Demonstration Problem

Solution to the Demonstration Problem EPLER CONSULTING SERVICES, INC. GENERAL JOURNAL

Bal. $0

Bal. $2,000

Bal. $200

Bal. $15,000

Bal. $100

Bal. $50,000

Bal. $2,000

Bal. $400

Bal. $300

Bal. $34,600

EPLER CONSULTING SERVICES, INC. THE LEDGER JANUARY 20 –31, 2011

EPLER CONSULTING SERVICES, INC. TRIAL BALANCE JANUARY 31, 2011

Self-Test Questions

ASSIGNMENT MATERIAL

Discussion Questions

Brief Exercises LO1

LO2

T

LO5

LO9

LO10

LO3

LO5

R T a

accounting

LO7

LO8

R T

LO3 LO8

D

LO3

LO6

LO6 LO7

LO6

LO7

R

LO6 E LO7

LO6

LO7

R

LO6

LO7

Exercises LO1 A T

LO10

LO6

LO7

T P D

accounting

LO2 R

LO5

A

LO9 P

LO6

LO8

Apple Computer, Inc. N E

Apple Computer Apple Computer Apple Computer

LO2

LO6

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Home Depot, Inc.

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accounting

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SANLUCAS, INC. TRIAL BALANCE JUNE 1, 2011

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CLOWN AROUND, INC. TRIAL BALANCE FEBRUARY 1, 2011

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AHUNA, INC. TRIAL BALANCE MARCH 1, 2011

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Critical Thinking Cases LO7 LO10

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PC Connection

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Answers to Self-Test Questions

CHA P TER 4

The Accounting Cycle

© Bill Bachmann/Photoedit

Accruals and Deferrals

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO: LO1 LO2 LO3 LO4 LO5 LO6 LO7 LO8 LO9

CARNIVAL CORPORATION

Carnival

Carnival Corporation

Carnival Corporation

Carnival Corporation

■

140

Chapter 4 The Accounting Cycle: Accruals and Deferrals

For most companies, revenue is not alw ognition of revenue and e examine ho

ved, nor is an expense ws and the recand deferrals. In this chapter, we

ycle were discussed in Chapter 3. They included (1) recording transactions, (2) posting transactions, and (3) preparing a trial balance. In this chapter usiness income. The remaining steps of the cycle are covered in Chapter 5.

Adjusting Entries There is more to the measurement of business income than merely recording simple revenue and e venue or expenses of or more venue and expense. For example, Ov veral xpense associated with the shop supplies that Ov uses each month.

THE NEED FOR ADJUSTING ENTRIES Learning Objective

LO1

E a

F usiness is divided into a series of accounting periods. This practice enables decision makers to compare v But measuring net income for a relativ even a year—poses a problem because, as mentioned above, some business acti the revenue and expenses of multiple accounting periods. Therefore, adjusting entries are venue and e y’s income statement. For example, magazine publishers often sell two- or three-year subscriptions to their publications. At the end of each accounting period, these publishers make adjusting entries recance receipts that hav y’s ver transactions affect the revenue or expenses of more venues to the period in which they are earned, and e used. , a business could make adjusting entries on a daily basis. But as a practical matter, these entries are made only at the end of each accounting period. For most companies,

TYPES OF ADJUSTING ENTRIES Learning Objective

y’s business activities. However gories:1

LO2 a

all into

1. Converting assets to expenses. A cash e than one accounting period usually is recorded by debiting an asset account (for 1

as mark Chapter 7.

vable. These valuation adjustments are e

141

Adjusting Entries

example, Supplies, Unexpired Insurance, and so on) and by crediting Cash. The asset account created actually represents the deferral (or the postponement) of an e ing entry is made to allocate a portion of the asset’s cost from the balance sheet to the income statement as an e the appropriate expense account (for example, Supplies Expense or Insurance Expense) and crediting the related asset account (for example, Supplies or Unexpired Insurance). 2. Converting liabilities to revenue. A business may collect cash in adv ransactions of this nature are usually recorded vedeferral (or the postponement) of a rev income statement to recognize the rev venue) and by crediting 3. Accruing unpaid expenses. An e ev

accrued expenses xpense account (for example, Interest xample, Interest

Payable or Salaries Payable). 4. Accruing uncollected revenue. Rev rent period, ev venue, for which no cash has been received, requires an adjusting the appropriate asset (for example, Accounts Receivable or Interest Receivable) and by crediting the appropriate revenue account (for example, Service Rev Interest Earned).

ADJUSTING ENTRIES AND TIMING DIFFERENCES timing differences ws and the recognition of expenses or revenue. A company can pay cash in adv xpenses or receive cash before rev ewise, it can incur xpenses before paying an venue before any cash is received. below. •

v

xpenses result from cash being paid prior to an

e •

v

v

ved prior to

rev •

xpenses result from e cash is paid.

•

v

v

cash is received. ing periods related to these timing dif ws to current xpenses, (2) prior (3) current xpenses to future period cash ws.

, they link: (1) prior ws to current period revenue, ws, and (4) current period revenue to future

142

Exhibit 4–1

Chapter 4 The Accounting Cycle: Accruals and Deferrals

ADJUSTING ENTRIES PROVIDE LINKS BETWEEN ACCOUNTING PERIODS

Prior periods

Current period

Prior periods

Current period

End of current period

Future periods

expenses (e.g., apportioning the cost of equipment, supplies, and insurance policies)

revenue (e.g., apportioning advance collections for season tickets, customer deposits, and magazine subscriptions)

Accruing unpaid expenses (e.g., unpaid salaries, est)

Accruing uncollected revenue (e.g., interest earned but not received and work completed but not yet billed to the customer)

e periods

CHARACTERISTICS OF ADJUSTING ENTRIES Keep in mind tw v involves the recognition of either revenue or expenses. Revenue and expenses represent changes in owners’ equity. However, owners’ equity cannot change by itself; there also must be a corresponding change in either assets or liabilities. Thus ev both an income statement account (revenue or e not upon monthly bills or month-end transactions. No one sends Ov “Shop Supply Expense for the month is $500.” Yet, Ov

ware of the need to

143

Adjusting Entries

record the estimated cost of shop supplies consumed if it is to measure income properly for concepts than does the recording of routine business transactions. In many businesses, the by the re

YEAR-END AT OVERNIGHT AUTO SERVICE To illustrate the v xample involving Ov 28, 2011 (the end of the company’s second month of operations). We will now skip ahead to December 31, 2011—the end of Ov year of operations. This will enable us to illustrate the preparation of annual ver only a single month. Most companies mak v month. W been follo y’s unadjusted December 31, 2011, appears in Exhibit 4–2 because Ov November 30; to make adjusting entries for the month of December.

Exhibit 4–2

OVERNIGHT AUTO SERVICE TRIAL BALANCE DECEMBER 31, 2011

UNADJUSTED TRIAL BALANCE

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 18,592

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6,500

Shop supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,800

Unexpired insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,500

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52,000

Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

36,000

Accumulated depreciation: building . . . . . . . . . . . . . . . . . . . . . . . . . . . Tools and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

1,500

12,000

Accumulated depreciation: tools and equipment . . . . . . . . . . . . . . . . .

2,000

Notes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,690

Income taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,560

Unearned rent revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

9,000

Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0 14,000

Repair service revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

171,250

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,900

Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56,800

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6,900

Depreciation expense: building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,500

Depreciation expense: tools and equipment . . . . . . . . . . . . . . . . . . . .

2,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19,400

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13,500

Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22,608 $272,000

$272,000

In the next few pages we illustrate sev entries. Both are sho o help distinguish between transactions and adjusting entries, transactions are printed in blue adjusting entries in red.

144

Chapter 4 The Accounting Cycle: Accruals and Deferrals

CONVERTING ASSETS TO EXPENSES usiness makes an e

Learning Objective

LO3 e

e asset account to an e v

xpense consists of a debit to an expense prepaid expenses

depreciation expense.

Prepaid Expenses Payments in advance often are made for such items as insurance, represents an asset rather than an expense. The cost of this asset will be allocated to e , prepaid expenses are assets; they become expenses only as the

Shop Supplies To illustrate, consider Ov

s accounting policies for shop sup-

is not practical to mak v w minutes as supplies are used. Instead, an estimate is made of the supplies remaining on hand at the end of each month; the supplies that are “missing” are assumed to have been used. s Shop Supplies account is $1,800. The balance of this asset account represents shop supplies on hand on November 30. The Supplies Expense account shows a balance of $6,900, which represents vember 30. Assume that approximately $1,200 of shop supplies remain on hand at December 31. This suggests that supplies costing about $600 have been used in December; thus, the following adjusting entry is made: Dec. 31

Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

600

Shop Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . cost of supplies used from an asset account to an expense

600

December Shop Supplies adjusting entry.

es tw ges to expense the cost of supplies used in December amount of supplies estimated to be on hand at December 31.

Insurance Policies

xpense. These policies prov insurance policy es—that is, it is used up in business operations. T ance policy providing comprehensiv age to customers’ vehicles while in Ov s facilities. This expenditure (a transaction) was debited to an asset account, as follo not

Purchase 12 months of insurance coverage

Mar. 1

Unexpired Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

18,000 18,000

Purchased an insurance policy providing coverage for the next 12 months.

This $18,000 expenditure provides insurance cov

. Therexpense ev

145

Adjusting Entries

policy that has e vember 30 ($1,500/mo. ⫻ 9 months). The $4,500 amount of unexpired insurance sho vember 30 ($1,500/mo. ⫻ 3 months). By December 31, y has expired. Thus, the insurance expense for December is recorded by the following at month-end: Dec. 31

Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,500

Unexpired Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,500

December Insurance Expense adjusting entry.

required to record the cost of insurance coverage expiring in December

Notice the similarities between the effects pre Exhibit 4–3.

Exhibit 4–3 AN EXPIRED ASSET BECOMES AN EXPENSE

Cost of supplies and insurance policies that will benefit future periods As supplies and e used or expire

YOUR TURN

Recording Prepayments Directly in the Expense Accounts In our illusvering more than one period were debited to asset accounts. However, some companies follo ve policy of debiting xpense account, such as Supplies Expense. At the end of the ould be to debit Shop Supplies and credit Supplies Expense for the cost of supplies that had not been used. ve method leads to the same results as does the procedure used by Ov expense,

ard in the balance sheet as an asset.

146

Chapter 4 The Accounting Cycle: Accruals and Deferrals

In this text, we will follow Ov

s practice of recording prepayments in asset accounts xpense accounts as the assets expire.

cial statements. That is, a prepayment is

ve ” which standard-

end of the period. Remember, our goal in this course is to dev v The idea of shop supplies and insurance policies being used up over several months is easy uildings and equipment. These assets are conv depreciation.

THE CONCEPT OF DEPRECIATION Depreciable assets are physical objects that retain their size and shape but that eventually wear out or become obsolete. The plies, b ver time. Examples of depreciable assets include b ven railroad tracks. Land, however, is not viewed as a depreciable asset, as it has an unlimited useful life. expires. depreciation expense.

What Is Depreciation?

depreciation means the systematic allocation of the cost of a depreciable asset to expense over the asset’s useful life. This process is illustrated in . Notice the similarities between and Exhibit 4–3. Depreciation is not s market v et value of some depreciable assets may even increase, but the process of depreciation continues anyway. The rationale for depreciation lies in the matching principle. Our s cost against revenue in each period of the asset’s useful life.

Exhibit 4–4 THE DEPRECIATION PROCESS

Cost of a depreciable asset

As the asset’s useful life expires

Depreciation e

ver the life of the asset, but there are no daily xpense is paid in advance when the asset adjusting entries are needed at the end of each accounting s cost to depreciation expense.

Depreciation Is Only an Estimate The appropriate amount of depreciation expense is only an estimate.

uilding or a piece of equipment

147

Adjusting Entries

and determine precisely how much of its economic usefulness has expired during the The most widely used means of estimating periodic depreciation expense is the straightline method of depreciation. equal portion of the asset’s cost is allocated to depreciation expense in ev s estimated useful life. xpense by the straight-line method is:2 Depr

expense (per period) ⴝ

Cost of the asset Estimated useful life

The use of an estimated useful life is the major reason that depreciation expense is only an estimate. w in advance exactly how long the asset will remain in use.

CASE IN POINT

Depreciation of Overnight’s Building

Ov uilding for uilding was old, its estimated remaining useful life is only 20 years. Therefore, the building’s monthly depreciation expense is $150 ($36,000 cost ⫼ 240 months). We will assume that Ov not record any depreciation e uilding’s $1,500 depreciation e on page 143 represents 10 full months vember 30 ($150/mo. ⫻ 10 months). An additional $150 of depreciation expense is still needed on the b statement for the year to $1,650). The to record depreciation expense on Ov s building for the month of December is:

Dec. 31

Depreciation Expense: Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation: Building . . . . . . . . . . . . . . . . . . . . . . .

150 150

December building depreciation adjusting entry ($36,000 ⫼ 240 mo.).

The Depreciation Expense: Building account will appear in Overnight’s income statement along with other expenses for the year ended December 31, 2011. The balance in the 2

y possible residual value that might be recovered upon disposal of the asset. Residual values are discussed in Chapter 9. We will assume that Ov y residual values.

The adjusting entry required to record monthly depreciation on the building

148

Chapter 4 The Accounting Cycle: Accruals and Deferrals

Accumulated Depreciation: sheet as a deduction from the Building Account, as shown below. How accumulated depreciation appears in the balance sheet

Accumulated Depreciation: Building is an example of a contra-asset account because (1) it has a credit balance, and (2) it is offset against an asset account (Building) to produce the book v book value (or ) aluation of an asset in a company’s accounting records. For depreciable assets, such as buildings and equipment, book value is equal to the cost of the asset, less the Depreciation: Building account is much the same as if the credit had been made directly to alue reported in the balance sheet for the building is reduced from $36,000 to $34,350. Book v v v an indication of the age of a company’s depreciable assets (older assets tend to have larger amounts of accumulated depreciation associated with them than ne to realize that the computation of book value is based upon an asset’s historical cost. Thus, book value is not intended to represent an asset’ market value.

Depreciation of Tools and Equipment

Ov equipment ov ve years (60 months) using the straight-line method. The December 31 trial balance shows that the company owns tools and equipment that cost $12,000. Therefore, the to record December’s depreciation expense is: Dec. 31

The adjusting entry required to record the monthly depreciation on tools and equipment

Depreciation Expense: Tools and Equipment . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation: Tools and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

200 200

December tools and equipment adjusting entry ($12,000 ⫼ 60 months ⫽ $200/mo.).

Again, we assume that Overnight did not record depreciation expense for tools and related $2,000 depreciation e s trial balance in Exhibit 4–2 on page 145 represents 10 full months vember 30 ($200/mo. ⫻ 10 months). The tools and equipment still require an additional $200 of depreciation for December (bringing the total to be reported in the income statement for the year to $2,200). alue of Ov s tools and equipment at December 31, 2011? If you 3 said $9,800, you’

Depreciation—A Noncash Expense Depreciation is a noncash expense. We hav w of cash or any other asset. Rather, it is a computation of the ov usiness transactions on owners’ equity. The recognition of depreciation e expire, depreciation expense is recorded, net income is reduced, and owners’ equity declines, b or this reason, depreciation is called a noncash e gest difference between net income and w from business operations. 3

.

149

Adjusting Entries

CONVERTING LIABILITIES TO REVENUE

Learning Objective

pay in advance ing periods. For example, a football team collects much of its revenue in advance through the sale of season tickets. Health clubs collect in adv y of their tickets well in adv F ance do not represent revenue, because these amounts have not yet been earned. ance are recorded by debiting the Cash account and crediting an unearned r account. Unearned revenue also may be called deferred r . When a company collects money in advance from its customers, it has an obligation to venue account is considit appear not in the income statement. v worked off rather than . ge y to its customers. When a company renders the services for which customers have paid in advance, it is w venue. At the end of the

LO4

venue account to a rev venue) and a credit to a revenue account. For instance, The New York Times Company called Une v wspaper deliveries. The liability is conv venue y’s income statement as the actual deliv . T in Ov sb to record this transaction on December 1 w Dec. 1

not an adjusting

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

9,000

Unearned Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

9,000

Collected in advance from Harbor Cab for rental of storage space for three months.

venue is a not a revenue account. Ov venue gradually over a three-month period as it provides storage facilities for Harbor Cab. At the end of each of these three months, Ov e an adjusting entry, v rev v s income statement. wing : Dec. 31

Unearned Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rent Revenue Earned. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,000 3,000

December adjusting entry to convert Unearned Rent Revenue to Rent Revenue Earned ($9,000 ⫼ 3 mo.).

venue account will have a $6,000 credit balance. This balance represents Ov s obligation to render $6,000 w ver the ne o months and will appear in the liability section of the company’s balance sheet. The Rent Rev s income statement.

An “advance”—it’s not revenue; it’s a liability

An adjusting entry showing that some unearned revenue was earned in December

150

Chapter 4 The Accounting Cycle: Accruals and Deferrals

The conv

v

venue is illustrated in

.

Exhibit 4–5 UNEARNED REVENUE BECOMES EARNED REVENUE

Value of goods or services to be provided in future periods

As the goods are provided

Recording Advance Collections Directly in the Revenue Accounts We hav enue. However, some companies follo lections directly to rev rev payments not yet earned. v

ance represent liabilities, not revy of crediting these adv v

In this text, we will follo

ance

ance payments venue account.

Learning Objective

LO5

a

ACCRUING UNPAID EXPENSES xpenses that will be paid in future transactions; therefore, no cost has yet been recorded in the accounting records. Salaries of employees and interwed mone xamples of expenses that accumulate from day to day but that usually are not recorded until they are paid. These expenses are said to accrue over should be made to record any expenses that hav ut that have not yet been recorded. Since these e expense account and a credit to a liability account. We shall now use the example of Over.

Accrual of Wages (or Salaries) Expense Ov e many businesses, pays its employees ev . This month, however, ends on a T the next scheduled payday. Thus Ov s employees have worked for more than a week in December for which they have not yet been paid. Time cards indicate that since the last payroll date, Ov s employees have worked a total of 130 hours. Including payroll taxes, Ov s wage expense averages about $15 per hour. Therefore, at December 31, the company owes its employees approximately $1,950 for w .4 The following should be made to record this amount both as wages e Dec. 31

Adjusting entry required to accrue wages owed at the end of the month

Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,950 1,950

Adjusting entry to accrue wages owed but unpaid as of December 31. 4

es must be computed “down to the last cent.” But this is not a payroll; it is an amount to be used in the company’ is discussed later in this chapter.

151

Adjusting Entries

s wages expense for 2011 and also creates a liability—wages payable—that will appear in the December 31 balance sheet. On Friday that this payroll amounts to $2,397. In this case, the transaction 5 lows (again, this is a transaction, not 2012 Jan. 3

Payment of wages earned Wages Expense (for January) . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

447

Wages Payable (accrued in December) . . . . . . . . . . . . . . . . . . . . . .

1,950

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,397

Biweekly payroll, $1,950 of which had been accrued at December 31, 2011.

Accrual of Interest Expense

uild-

ing, an old b wed. Ov as no interest e payable was non-interest-bearing. On November 30, 2011, Ov ing an interest-bearing vember wing transaction Nov. 30

not

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,000

Borrowed cash from American National Bank, issuing a 9%, $4,000 note payable, due in three months.

wed, plus $90 interest ($4,000 ⫻ .09 ⫻ 3/12). The $90 interest charge covers a period of three months. xpense is incurred Exhibit 4–6.

Exhibit 4–6 Total interest owed

Total three months’ interest expense

The follo

Dec. 31

s interest expense

Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusting entry to accrue December Interest Expense ($4,000 ⫻ .09 ⫻ 1Ⲑ12).

5

ACCRUAL OF INTEREST

interest expense

30 30

to record interest expense accrued in December

152

Chapter 4 The Accounting Cycle: Accruals and Deferrals

The $30 interest e s 2011 income statement. Both the $30 interest payable and the $4,000 note payable to American National Bank will appear as liabilities in the December 31, 2011, balance sheet. Ov e a second xpense transaction including $90 in interest charges, is (ag not Payment of interest expense accrued over three months

2012 Feb. 28

Notes Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,000

Interest Payable (from December and January) . . . . . . . . . . . . . .

60

Interest Expense (February only) . . . . . . . . . . . . . . . . . . . . . . . . . .

30

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,090

Repaid $4,000 note payable to American National Bank, including $90 in interest charges.

Learning Objective

ACCRUING UNCOLLECTED REVENUE Ab

v

ut not bill the customer

LO6

rev T

, in which case the bill might not be prepared until all y revenue that has been earned but not recorded . vable and a credit to the appropriate accrued revenue venue that has been ut that has not been recorded prior to the closing date. , Ov veral vans o -

vice. Ov

rendered. Ov December 15, b will not be receiv at December 31 to record the revenue earned Dec. 31 accrue revenue earned but not yet billed or collected

e the following adjust-

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

750

Repair Service Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

750

Adjusting entry to record accrued Repair Service Revenue earned in December.

2012. Of this $1,500 cash receipt, half represents collection of the receivable recorded on December 31; the other half represents rev . Thus, the transaction to (ag action, not 2012 of accrued revenue

Jan. 15

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,500

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

750

Repair Service Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

750

Cash collected from Airport Shuttle for van maintenance provided December 15 through January 15.

153

Adjusting Entries

vide the revenue from sv

ACCRUING INCOME TAXES EXPENSE: THE FINAL ADJUSTING ENTRY es expense, and also a liability estimated

to gov quarterly payments.

December 15; b January 15 of the following year.6 Exhibit 4–2 on page 143), Ov ws income taxes expense of $22,608. This is the income taxes e (the date Ov usiness) through November 30, 2011. Income tax through September 30 have already been paid. Thus, the $1,560 liability for income taxes payable represents only the income tax October and November. es e y given month is only an estimate. The y prepares its annual es expense at 40 per . We also assume that taxable income is equal to income befor a subtotal often shown in an income statement. This subtotal is total revenue less all expenses other than income taxes.

I N T E R N AT I O N A L C A S E I N P O I N T

In 2011, Ov es of $66,570 (see the income statement in Exhibit 5–2, page 194, in Chapter 5). Therefore, income taxes expense for the entire year is estimated at $26,628 ($66,570 ⫻ 40 percent). Given that income taxes expense recognized through November 30 amounts to $22,608 (see the unadjusted trial balance in Exhibit 4–2), an additional $4,020 in income taxes expense must hav December ($26,628 ⫺ $22,608). The adjusting entry to record this expense is: Dec. 31

Income Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,020 4,020

Adjusting entry to record income taxes accrued in December.

6

expense.

es in December in the same manner as in other months. es for this month would be recorded as a mid-month transaction, rather than in an es is an e ut unpaid,

Adjusting entry required to record income taxes accrued in December

154

Chapter 4 The Accounting Cycle: Accruals and Deferrals

axes Expense account to the $26,628 income taxes payable to $5,580 ($1,560 ⫹ $4,020). The transaction not 2012 Jan. 15

Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,580

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,580

Payment of the remaining 2011 income tax liability.

Income tax benefit can reduce a pretax loss

Income Taxes in Unprofitable Periods What happens to income taxes expense when losses y recognizes a “negative amount” of income taxes e es at the end of an unpr able debit to Income Taxes Payable and a credit to Income Taxes Expense. “Negative” income taxes expense means that the company may be able to recover from the 7 gov es recognized as e If the Income Taxes P debit balance at year asset, called “Income Tax Refund Receivable.” A credit balance in the Income Taxes Expense account is wn in Exhibit 4–7.

Exhibit 4–7 PARTIAL INCOME STATEMENT

Income (loss) before income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit (recovery of previously recorded taxes) . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$(20,000) 8,000 $(12,000)

We have already seen that income taxes expense Notice now that income tax pretax loss. Thus, income taxes reduce the size of both

pr

Adjusting Entries and Accounting Principles Learning Objective

LO7

E o

realization and matching venues are recognized as they are earned, and expenses are recognized as resources are used or consumed in producing the related revenue. In most cases, the realization principle indicates that revenue should be recognized at the time goods are sold or services are rendered. At this point the business has essentially comtively. At an , and this is usually a relativ

vent. xpired insurance policies.

All end-of-the-period adjusting entries involving e matching principle.

7

T the compan

v

y “negative tax expense”

155

Adjusting Entries and Accounting Principles

Costs are matched with revenue in one of two ways: 1. Dir evenue transactions. The ideal method of matching revenue with e xpense associated with v wever, this approach works only for those costs and e v paid to salespeople are an example of costs that can be directly associated with the revenue 2. Systematic allocation of costs over the useful life of the expenditure. Many e contrib venue for a number of accounting periods b venue transactions. Examples include the costs of insurvenue and expenses by systematically allocating the cost to expense over its useful life. Straightline depreciation is an example of a systematic technique used to match the cost of an asset with the related rev ver its useful life.

THE CONCEPT OF MATERIALITY materiality. an item or an ev ably

Learning Objective

refers to the relative importance of wledge of the item might reason-

However

—that is, the value of the

accorded to immaterial items is of little or no consequence to decision makers. Therefore, easiest and most convenient manner.

Materiality and Adjusting Entries veral ways. For example: 1. Businesses purchase many assets that have a v w cost or that will be consumed quickly in business operations. Examples include wastebaskets, lightbulbs, and janitorial supplies. directly to expense accounts, veniently eliminates the need to prepare adjusting entries to depreciate these items. 2. Some expenses, such as telephone bills and utility bills, may be charged to expenses as the bills are paid, echnically this treatment violates the matching principle. However v v receiv xpense recorded each month is actually based on the prior month’s bill. 3. xpenses or unrecorded rev ignored if the dollar amounts are immaterial.

Materiality Is a Ma er of Professional Judgment or ev professional judgment. In making these judgments, accountants consider several factors. First, what constitutes a material amount varies with the size of the organization. For example, a $1,000 e small business but not to the statements of a lar General Electric.8 There are no of ut most accountants

8

This point is emphasized by the fact that General Electric rounds the dollar amounts sho

LO8

156

Chapter 4 The Accounting Cycle: Accruals and Deferrals

would consider amounts of less than 2 percent or 3 percent of net income to be immaterial, unless there were other factors to consider. One such other factor is the cumulative effect of numerous immaterial events. Each of a dozen items may be immaterial when considered by itself. When viewed together, however, the combined effect of all 12 items may be material. Finally, materiality depends on the nature of the item, as well as its dollar amount. Assume, for example, that several managers systematically have been stealing mone pany that the ould consider this f ven if the dollar amounts were small in relation to the company’s total resources.

YOUR TURN

Note to students:

ying this textbook, you are to con-

materiality.

EFFECTS OF THE ADJUSTING ENTRIES volve fects of these adjustment Exhibit 4–8.

Exhibit 4–8

THE EFFECTS OF ADJUSTING ENTRIES ON THE FINANCIAL STATEMENTS

made by Ov Exhibit 4–9. (Ov of December described in Chapter 3.)

adjusting entries y transactions throughout the month

157

Adjusting Entries and Accounting Principles

Exhibit 4–9

OVERNIGHT AUTO SERVICE GENERAL JOURNAL DECEMBER 31, 2011

ADJUSTING ENTRIES

2011 Dec. 31

Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

600

Shop Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

600

Adjusting entries are recorded only at the end of the period

December shop supplies adjustment. 31

Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,500

Unexpired Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,500

December Insurance adjustment. 31

Depreciation Expense: Building . . . . . . . . . . . . . . . . . . . . . . . . . .

150

Accumulated Depreciation: Building . . . . . . . . . . . . . . . . . . .

150

December depreciation adjustment on buildings ($36,000 ⫼ 240 mo.). 31

Depreciation Expense: Tools and Equipment . . . . . . . . . . . . . . . .

200

Accumulated Depreciation: Tools and Equipment . . . . . . . . .

200

December depreciation adjustment on tools and equipment ($12,000 ⫼ 60 mo.). 31

Unearned Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,000

Rent Revenue Earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,000

December unearned revenue adjustment ($9,000 ⫼ 3 mo.). 31

Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,950

Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,950

December adjustment to accrue wages payable. 31

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

December adjustment to accrue interest payable ($4,000 ⫻ .09 ⫻ 1Ⲑ12). 31

Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

750

Repair Service Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . .

750

December adjustment to accrue repair service revenue. 31

Income Taxes Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income Taxes Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,020 4,020

December adjustment to accrue income taxes payable.

, Ov 9 to-date (e The company’s adjusted trial balance at December 31, 2011, appears in . (For emphasis, those accounts adjusting entries are shown in red.) Ov the order of the accounts: All balance sheet accounts are followed by the statement of retained xactly how these statements are prepared.

9

discussed in Chapter 5.

Learning Objective

LO9

158

Chapter 4 The Accounting Cycle: Accruals and Deferrals

Exhibit 4–10

OVERNIGHT AUTO SERVICE ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

ADJUSTED TRIAL BALANCE

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 18,592

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7,250

Shop supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,200

Unexpired insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52,000

Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

36,000

Accumulated depreciation: building . . . . . . . . . . . . . . . . . . . . . . . . . . . Tools and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Balance sheet accounts

h

$ 1,650 12,000

Accumulated depreciation: tools and equipment . . . . . . . . . . . . . . . . .

2,200

Notes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,690

Wages payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,950

Income taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,580

Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

Unearned rent revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6,000

Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80,000

Retained earnings

Statement of retained d earnings accounts

0 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Income statement accounts

h

14,000

Repair service revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

172,000

Rent revenue earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,000

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,900

Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58,750

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7,500

Depreciation expense: building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,650

Depreciation expense: tools and equipment . . . . . . . . . . . . . . . . . . . .

2,200

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19,400

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26,628 $279,100

$279,100

Concluding Remarks Throughout this chapter differences

timing ws and revenue or e

venue and e y’s income statement. In Chapter 5, we continue with our illustration of Ov ho y’ Later chapters e tors and creditors in estimating the timing and amounts of a company’ also illustrate ho to plan for future operations.

vesws. We udget and

159

Concluding Remarks

Ethics, Fraud & Corporate Governance Waste Management

Waste Management

Enron

WorldCom Waste Management

Waste Management Waste Management

Waste Management

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

lain the purpose of adjusting entries. LO1

e

escribe and prepare the four basic types of djusting entries.

LO2

e

LO6

epare adjusting entries to accrue uncollected evenue. c

LO7

lain how the principles of realization and tching relate to adjusting entries.

epare adjusting entries to convert assets to LO3

e

lain the concept of materiality. LO8

epare adjusting entries to convert liabilities to evenue.

LO4

a

LO9

epare adjusting entries to accrue unpaid LO5

t

epare an adjusted trial balance and describe i purpose. its t

Key Terms Introduced or Emphasized in Chapter 4

Demonstration Problem

INTERNET CONSULTING SERVICE, INC. UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 49,100

Consulting fees receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23,400

Prepaid office rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6,300

Prepaid dues and subscriptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

300

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

600

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

36,000

Accumulated depreciation: equipment . . . . . . . . . . . . . . . . . . . . . . . . .

$ 10,200

Notes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,000

Income taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12,000

Unearned consulting fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,950

Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32,700 60,000

Consulting fees earned. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

257,180 88,820

Telephone expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,550

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22,000

Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51,000

Dues and subscriptions expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

560

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,600

Depreciation expense: equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6,600

Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,200 $353,030

$353,030

Solution to the Demonstration Problem

INTERNET CONSULTING SERVICE, INC. GENERAL JOURNAL DECEMBER 31, 2011

INTERNET CONSULTING SERVICE, INC. ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

Self-Test Questions

ASSIGNMENT MATERIAL

Discussion Questions

Carnival Corporation

Brief Exercises LO3

LO4

P a

accounting

LO3

E P

LO4

LO3 E S

LO3 E

LO6 E

LO4 E

LO5 E

LO5 E

LO5 E

LO8 E

Exercises LO1 through

A

LO9

LO1 through

E

LO6 LO9

LO1 through

LO7

E A a

accounting

LO1 through

LO7

E

Carnival Corporation

P E A a

Carnival Corporation

Carnival Corporation

Carnival Corporation

LO1

E

through

LO7

LO1

E

American Airlines

LO2 LO4

American Airlines LO1

E

through

P A

LO6

LO9

LO1

LO2

LO5

LO1 through

A

LO7 LO9

LO1

Microsoft Corporation A

LO3

LO4 LO5

LO7

Microsoft Corporation

Microsoft Corporation

LO1 LO4 LO7

America West Corporation The New York Times Company Carnival Corporation Devry, Inc. Clear Channel Communications, Inc. AFLAC Incorporated Bally Total Fitness Corporation

LO1

E

through

LO7

E B

LO9

LO1

E

through

E

LO6

TINKER CORPORATION TRIAL BALANCES DECEMBER 31, 2011

LO1 through

A

LO8

LO1

LO2

Home Depot, Inc. S

Home

Problem Set A LO1 through

E

LO7

accounting

LO1 through

LO6

LO9

P P A o

LO1 through

LO7

LO9

A

LO1 through

LO7

LO9

P P B

CAMPUS THEATER UNADJUSTED TRIAL BALANCE AUGUST 31, 2011 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 20,000

Prepaid film rental . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31,200

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

120,000

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

168,000

Accumulated depreciation: building . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixtures and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 14,000 36,000

Accumulated depreciation: fixtures and equipment . . . . . . . . . . . . . . .

12,000

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

180,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,400

Unearned admissions revenue (YMCA) . . . . . . . . . . . . . . . . . . . . . . .

1,000

Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,740

Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

46,610 15,000

Admissions revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

305,200

Concessions revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14,350

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

68,500

Film rental expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

94,500

Utilities expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

9,500

Depreciation expense: building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,900

Depreciation expense: fixtures and equipment . . . . . . . . . . . . . . . . . .

4,200

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10,500

Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40,000 $622,300

$622,300

LO1

P

through

LO7

LO9

TERRIFIC TEMPS UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1 through

LO7

LO9

P E

ALPINE EXPEDITIONS UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1 through

LO7

LO9

KEN HENSLEY ENTERPRISES, INC. UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1 through

LO7

LO9

Problem Set B LO1 through

LO7

LO1 through

LO6

LO9

A o

accounting

LO1 through

LO7

LO9

LO1 through

LO7

LO9

OFF-CAMPUS PLAYHOUSE UNADJUSTED TRIAL BALANCE SEPTEMBER 30, 2011

LO1 through

LO7

LO9

MARVELOUS MUSIC UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1 through

LO7

LO9

P E

MATE EASE UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1 through

LO7

LO9

STILLMORE INVESTIGATIONS UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1 through

LO7

LO9

U E

Critical Thinking Cases LO1 through

S

LO7

LO8

C T

Avis Rent-a-Car Avis Avis

LO3

LO7

LO8

LO1

I

Hershey’s

www.hersheys.com

through

Hershey’s

LO6 E

www.yahoo.com

Answers to Self-Test Questions

C HA PTER 5

The Accounting Cycle Reporting Financial Results A F TE R ST U DY IN G THI S CH AP TE R , YO U S HO U LD B E A BL E TO :

LO1

LO2

LO3

LO4

LO5

LO6

LO7

LO8

Learning Objectives

BEST BUY

Best Buy

Best Buy CPW

Best Buy

Best Buy

■

192

Chapter 5 The Accounting Cycle: Reporting Financial Results

In this chapter, we examine ho used by investors, creditors, and managers. In addition, we discuss ho vents are disclosed in the notes that accompan e also illustrate several methods of ev ing how Ov transactions to its general ledger, and (3) prepared an unadjusted

vents, (2) posted these ycle in Chapter 4 y’s

adjusted -end. In this chapter, we complete the accounting c y’s after-closing trial balance.

Preparing Financial Statements Learning Objective

LO1

s r b

Publicly owned companies—those with shares listed on a stock exchange—have obligations companies don’ includes comparativ y’ prospects. (For illustrativ

y publish annual reports. veral years and a wealth usiness operations, and future Home Depot, Inc. appear in audited by a

As). Publicly o

The acti ne

acti focus on the prepar

es several months before vailable for distribution. Thus, man usy season.”1 We cannot adequately discuss all of the . Thus, here we

amounts shown in this adjusted trial balance. F

v

Exhibit 5–1. The income directly from the ve made marginal

balance sheet. Note that we have not included Ov

ws with the

of Chapter 13.

THE INCOME STATEMENT Learning Objective

LO2

E s s e

ve titles for the income statement include earnings statement, statement of operations, and pr However, income statement operating results of a business by matching the rev ven period of time with the e venue. 1

companies do

usiness acti

. However, most

193

Preparing Financial Statements

Exhibit 5– 1

OVERNIGHT AUTO SERVICE ADJUSTED TRIAL BALANCE DECEMBER 31, 2011 $ 18,592

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7,250

Shop supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,200

Unexpired insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52,000

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

36,000

Accumulated depreciation: building . . . . . . . . . . . . . . . . . . . . . . . . . . . Tools and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 1,650 12,000

Accumulated depreciation: tools and equipment . . . . . . . . . . . . . . . . .

2,200

Notes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,690

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,950

Income taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,580

Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

Unearned rent revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6,000

Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80,000

h

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ADJUSTED TRIAL BALANCE

Balance sheet accounts

Retained earnings d

0 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Statement of retained earnings accounts

14,000

Repair service revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

172,000

Rent revenue earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,000 3,900

Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58,750

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7,500

Depreciation expense: building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,650

Depreciation expense: tools and equipment . . . . . . . . . . . . . . . . . . . .

2,200

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19,400

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30 26,628 $279,100

h

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$279,100

The revenue and expenses sho s income statement are taken directly from the company’s adjusted trial balance. Ov s 2011 income statement shows that revenue exceeded expenses for the year, thus producing a net income of $39,942. Bear in mind, however, that this measurement of net income is not absolutely accurate or precise due to the assumptions and estimates or instance, the amounts shown for depreciation e ves of the company’s building and equipment. Also, the income statement includes only those events that have been evidenced , Ov s adv tant step tow wever, the development of a customer base is not objectively

Income statement accounts

Exhibit 5–2 OVERNIGHT AUTO SERVICE’S FINANCIAL STATEMENTS

OVERNIGHT AUTO SERVICE INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

Amounts are taken directly from the adjusted trial balance

Net income also appears in the statement of retained earnings

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 39,942

OVERNIGHT AUTO SERVICE STATEMENT OF RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2011

The ending balance in the Retained Earnings account also appears in the balance sheet

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

39,942

Retained earnings, Dec. 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$25,942

OVERNIGHT AUTO SERVICE BALANCE SHEET DECEMBER 31, 2011

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

194

25,942

195

Preparing Financial Statements

transactions tak to the users of a company’

THE STATEMENT OF RETAINED EARNINGS Retained earnings cash. usiness vidends. wing relationships: Retained Earnings at the beginning of the period

Net Income

Dividends

Retained Earnings at the end of the period wn at the top of the statey dividends

beginning ment. Ne

end xample) appears at the bottom of the statement and also in the company’s year-end balance sheet. be 2011) was $0.

as the

y’ st year of Ov

s business

for the following year.

A Word about Dividends In Chapter 3, the declaration and payment of a cash dividend were treated as a single ev with only a few stockholders may choose to declare and pay a dividend on the same day. In lar vidends Payable, comes into existence when the dividend is declared and is discharged when the dividend is paid. Because Ov vidends payable in its adjusted trial balance, we may assume that it declared and paid the entire $14,000 on December 31, 2011.2 Finally not the income statement as an e vidend is not included in the computation of income.

THE BALANCE SHEET The balance sheet lists the amounts of the company’s assets, liabilities, and owners’ equity at the end of the accounting period. The balances of Overnight’ are tak Exhibit 5–1. The amount of retained statement of retained earnings. ties and owners’ equity accounts appearing on the right. They may also be presented in report form, with liabilities and owners’ equity listed below stockholders’ equity.

2

vidends are discussed in Chapter 12.

Statement of retained earnings

196

Chapter 5

Separate Balance Sheet Subtotals

Many companies group together as separate balance sheet subtotals those assets and liabilities that are considered current. T current asset, an asset must already be cash or must be capable of being converted into cash within a relativ or most companies, this period of time is usually one year or less. Those assets that get used up quickly (e.g., insurance policies and of Overnight’s $126,192 in total assets shown in Exhibit 5–2, the current assets vable, Shop Supplies, and Unexpired Insurance. Thus, $30,042 of Overnight’s total assets is considered current. A current liability is an existing debt or obligation that a company expects to satisfy relativ debt, venue is often All of Ov s $20,250 in total liabilities shown in Exhibit 5–2

© The McGraw-Hill Companies, Inc./Andrew Resek, photographer/DAL

v valuating a company’s ability to pay its debts as they come due (see this chapter’ ments of Home Depot, Inc., in Appendix A at the end of this textbook illustrate ho the balance sheet. Coverage of several other balance sheet subtotals appears in Chapter 14.

I N T E R N AT I O N A L C A S E I N P O I N T

Relationships among the Financial Statements related to one another. These relationships are emphasized by the arrows in the right-hand margin of Exhibit 5–2.

Learning Objective

DRAFTING THE NOTES THAT ACCOMPANY FINANCIAL STATEMENTS T

adequate disclosure

LO3

panied by an

interpreted properly.

Relationships among the Financial Statements

Most disclosures appear within the numerous pages of notes that accompan statements. Drafting these notes can be one of the most challenging tasks confronting accounwn directly from the accounting records. Rather, they require an in-depth understanding of the company

Two items alw ods in use and the due dates of major liabilities. Thus Ov should at least include the following notes: Note 1: Depreciation policies Depreciation e ves are 20 years for the b Note 2: Maturity dates of liabilities The Company’ the coming year alue of this note, including interest charges, will amount to $4,090.

Note 1 abov

y may need to replace or instance, given that the estimated useful life of Overnight’s building is 20 years, and only $1,650 of its $36,000 initial cost has been depreciated, it is reasonable for one to assume that it will not need to be replaced in the v , the bank will w w if Ov ve enough o months. The company’ wever, several other liabilities will require an outlay of cash in e y has an $18,000 insurance policy to renew on March 1. Thus, even though Ov income of $39,942, the company’s balance sheet suggests that the company may not have adequate liquid assets to satisfy all of its upcoming obligations.

WHAT TYPES OF INFORMATION MUST BE DISCLOSED? There is no comprehensive list ments. The adequac y should disclose any f ould coninterpreted properly. Thus, businesses often disclose such things as: • Lawsuits pending against the business. • Scheduled plant closings. • v after the balance sheet date b are actually issued. • Customers that account for 10 percent or more of the company’s revenues. • y and its ke ve a damaging effect on the business. For example, a manufacturer may need to disclose that it is being sued by customers who have been injured by its products. The fact that a disclosure might prove ven damaging to the business—is not a valid reason for not disclosing the information. The concept of adequate disclosure demands a good faith effort by management to k y’s operations. F Home Depot, Inc.,

197

198

Chapter 5 The Accounting Cycle: Reporting Financial Results

YOUR TURN

Closing the Temporary Accounts Learning Objective

As previously stated, rev

xpenses and dividends as a balance sheet,

LO4 t

account. However, owners, managers, investors, and others need to kno revenues and e separate ledger accounts venue and expense, and to account for dividends declared. Revenue, expense, and dividends accounts are called tempor , or nominal, accounts, because they accumulate the transactions of only one accounting period. At the end of es two purposes. First, it updates the balance of the Retained Earnings account for changes occurring during the accounting period. Second, it returns the balances of the temporary accounts to zero, so that the venue, expenses, and dividends of the next accounting period. permanent, or real, accounts, because their balances continue to exist be T called the closing process accounts are called closing entries. Revenue and expense accounts are closed at the end of each accounting period by transferring their balances to an account called the Income Summary. After the credit balances of the revenue accounts and the debit balances of the expense accounts have all been transferred to the Income Summary account, its balance will be the net income or net loss for the period. If revenues (credit balances) exceed expenses (debit balances), the ve a credit balance representing net income. Conversely, if expenses exceed rev ve a debit balance repwners’ equity are recorded by credits and decreases are recorded by debits. accounts only once each year. of Ov On the following pages, Ov We have eliminated the detail of ev year. Therefore, each account sho adjusted trial balance in The closing process is relativ involv v

ard and , (2) closing

199

all e Di

CLOSING ENTRIES FOR REVENUE ACCOUNTS Revenue accounts have credit balances. Therefore, closing a rev venue account in an amount equal to its credit balance, with an of returns the balance of the rev balance of the rev Ov o rev venue, which had a credit balance of $172,000 at December 31, 2011, and (2) Rent Rev balance of $3,000 at December 31, 2011. Tw these accounts, but the use of one is an easier, time-saving method of s rev is displayed in Exhibit 5–3.

Exhibit 5–3

OVERNIGHT AUTO SERVICE GENERAL JOURNAL DECEMBER 31, 2011

o rev

CLOSING OF REVENUE ACCOUNTS

ve zero balances, .

Exhibit 5–4 172,000 172,000

TRANSFERRING REVENUE ACCOUNT BALANCES TO THE INCOME SUMMARY

3,000 3,000

175,000

CLOSING ENTRIES FOR EXPENSE ACCOUNTS Expense accounts have debit balances. Closing an e xpense, therefore, consists of a credit to the e There are nine expense accounts in Ov Exhibit 5–1 Exhibit 5–5.

200

Chapter 5

Exhibit 5–5

OVERNIGHT AUTO SERVICE GENERAL JOURNAL DECEMBER 31, 2011

CLOSING OF EXPENSE ACCOUNTS

credit balance of $39,942 ($175,000 credit posted minus the $135,058 debit posted), and the nine expense accounts each have zero balances as shown in Exhibit 5–6. This $39,942 credit balance equals the net income ernight’s income statement. Had the company’ net loss for the year ould have a debit balance

Exhibit 5–6 TRANSFERRING EXPENSE ACCOUNT BALANCES TO THE INCOME SUMMARY

3,900

3,900

58,750 58,750 7,500

7,500

1,650

1,650 135,058

2,200

2,200

19,400 19,400 15,000 15,000 30

30

26,628 26,628

201

CLOSING THE INCOME SUMMARY ACCOUNT s owners’ Exhibit 5–7.

Exhibit 5–7

OVERNIGHT AUTO SERVICE GENERAL JOURNAL DECEMBER 31, 2011

CLOSING THE INCOME SUMMARY ACCOUNT

and the net income for the year ended December 31, 2011, appears as an increase (or credit wn in .

Exhibit 5–8

INCOME INCREASES RETAINED EARNINGS

39,942

39,942

CLOSING THE DIVIDENDS ACCOUNT As explained earlier in the chapter, dividends to stockholders are not considered an expense of the business; therefore, they are not period. Since dividends are not an expense, the Dividends account is not closed to the Income wn in Exhibit 5–9.

OVERNIGHT AUTO SERVICE GENERAL JOURNAL DECEMBER 31, 2011

Exhibit 5–9 CLOSING THE DIVIDENDS ACCOUNT

202

Chapter 5

v

vidends account will have a zero balance, wn

in Exhibit 5–10.

Exhibit 5–10

DIVIDENDS DECREASE RETAINED EARNINGS

14,000

14,000

Summary of the Closing Process As illustrated, the closing process involves four simple steps: 1. Closing the various revenue 2. Closing the various expense 3. Closing the Income Summary 4. Closing the Dividends The entire closing process is illustrated in

using T accounts.

Exhibit 5–11 FLOWCHART OF THE CLOSING PROCESS

3,900

3,900

172,000 172,000

3,000 3,000

58,750 58,750 7,500

7,500

1,650

1,650

1 2 2,200

2,200

135,058 175,000 39,942 39,942

19,400 19,400 15,000 15,000 30

3

30

26,628 26,628

14,000 39,942 25,942 4

14,000 14,000

203

After-Closing Trial Balance

After-Closing Trial Balance v ve been closed, it is desirable to prepare an after-closing trial balance that consists solely of balance sheet accounts. There is always the ve upset the equality of debits and credits in the ledger -closing trial balance, or post-closing trial balance as it is . It gives assurance that the accounts are in balance and ready for recording transactions in the ne -closing trial balance of Ov wn in Exhibit 5–12.

LO5

Exhibit 5–12

OVERNIGHT AUTO SERVICE AFTER-CLOSING TRIAL BALANCE DECEMBER 31, 2011 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Learning Objective

AFTER-CLOSING TRIAL BALANCE $ 18,592

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7,250

Shop supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,200

Unexpired insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52,000

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

36,000

Accumulated depreciation: building . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

Tools and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,650

12,000

Accumulated depreciation: tools and equipment . . . . . . . . . . . . . . . . .

2,200

Notes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,690

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,950

Income taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,580

Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

Unearned rent revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6,000

Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80,000

Retained earnings, Dec. 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25,942 $130,042

$130,042

Exhibit 5–1 ance contains only balance sheet has a zero balance. Through the closing of the revenue, expense, and dividends accounts, the up-to-date.

A LAST LOOK AT OVERNIGHT: WAS 2011 A GOOD YEAR? Let us no

Evaluating Profitability $80,000 investment. This is a v amount of risk by inv on in they inv Probably not. But in ev is likely to do in the future. T

. In 2011, Ov

Learning Objective

$40,000.

v amily) have tak usiness. Does a 50 percent return ferently, could

, the real question is not how the business did, but how it v s rental contract with Harbor Cab

LO6

204

Chapter 5

Company is also promising. In 2011, only $3,000 in revenue was earned by renting storage space to the company for its cabs (December’s rent). In 2012, Ov months of rent rev if Harbor Cab stores its cabs in Ov s garage, Ov ely candidate to perform an

Evaluating Liquidity

refers to a company’s ability to meet its cash obliga-

tions as the v

ve potential w problems. In the e cash expenditures for the following items:

Items requiring cash payment in near future

These outlays exceed the company’s liquid assets (cash and accounts receiv its December 31, 2011, balance sheet. v Ov s point in time. Thus, while these ver the cash e ely to generate revenue in excess of $40,000 during the next sev revenue is received in cash, and expenses are k become more liquid than it appears to be now.

Financial Analysis and Decision Making Measures of Profitability

Measures of Liquidity

PREPARING FINANCIAL STATEMENTS COVERING DIFFERENT PERIODS OF TIME Many b v , as well as at year-end. In addition, the vering other time periods, such as one month or the year-to-date. When a business closes its accounts only at year-end, the revenue, expense, and dividends accounts have balances representing the activities of the year-to-date. Thus, at June 30, these vities recorded over the past six months. Year cial statements can be prepared directly from an adjusted trial balance. But how might this business prepare interim statements cov

ance in Ov as shown:

Learning Objective

LO7

subtraction. As an example, assume that the adjusted balvenue account at the ends of the following months was

March 31 (end of the first quarter) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$38,000

May 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

67,000

June 30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80,000

Revenue amounts are for the year-to-date

At each date, the account balance represents the rev March 31 balance represents three months’ rev ve months’ revenue; and the June 30 balance, the rev ver a period of six months. To prepare an income statement for the six months balance in the rev $80,000. But to prepare an income statement for the month ended June 30, we would hav ance as of May 31. The remainder, $13,000, represents the amount of revenue recorded in the $67,000 $13,000). To prepare an income statement for the quarter ended June 30, we would subtract from the June 30 balance in this revenue account its balance as of March 31. Thus the rev$42,000 ($80,000 $38,000 $42,000). Computations like these are not required for the balance sheet accounts. A balance sheet alw at the balance sheet date. Therefore, a June 30 balance sheet looks exactly the same regardless of the time period cov statements. 205

206

Chapter 5

Ethics, Fraud & Corporate Governance Sony Sony

Sony

Sony Sony Sony Corporation Sony Sony Sony

Sony Sony Sony

Sony

Concluding Remarks e have now completed the entire accounting cycle, 1. Journalize (record) transactions. vents. 2. Post to ledger accounts. Post debits and credits from the journal to the proper ledger 3. Prepare a trial balance. Prove the equality of debits and credits in the ledger. 4. Mak Mak 5. Prepare an adjusted trial balance. Prov ledger. (Note: 6. Prepar opriate disclosures.

ws the ws changes in

business at the end of the period. Financial statements should be accompanied by notes disclosing f 7. Journalize and post the closing entries. venue, expense, and dividends accounts, making them ready for recording the events of the next accounting 8. Prepare an after-closing trial balance.

207

Concluding Remarks

SUPPLEMENTAL TOPIC The Worksheet A worksheet

Learning Objective

orksheet is prepared at the end of the period, but before

LO8

ycle. Rather, it is a tool used by accountants to work out the details of the proposed end-of-period adjustments. It also provides them with a preview of ho You can see a worksheet for Ov Exhibit 5–13 on page 209.

ISN’T THIS REALLY A SPREADSHEET? Y is a holdover from the days when these schedules were prepared manually on large sheets of columnar paper. Today, most worksheets are prepared using a are or with general ledger e. Since the worksheet is simply a tool used by accountants, it often isn’ copy—it may exist only on a computer screen. But the concept remains the same; the worksheet displays in one place the unadjusted account balances, proposed adjusting entries, and y will appear if the proposed adjustments are made.

HOW IS A WORKSHEET USED? A worksheet serves sev

ws accountants to

of adjusting es

it relativ enables accountants and management to previe drafts are developed. Once the w orksheet is in the preparation of veloped at v

ments.

dev develop these interim statements without ha

during the . Yet they often need to orksheet, they can

THE MECHANICS: HOW IT’S DONE Whether done manually or on a computer, the preparation of a worksheet involv ve basic steps. We begin by describing these steps as if the worksheet were being prepared manually. ard, we explain ho cally by a computer. 1. Enter the ledger account balances in the Trial Balance columns. The worksheet begins with an unadjusted trial balance. A fe w the . In our blue. 2. Enter the adjustments in the Adjustments columns. red. ed together by the small ke

208

Chapter 5

a consists of a $600 debit to Supplies Expense and a $600 credit to Shop Supplies. Because the indi

four ledger account titles printed in red were added during the adjusting process.) 3. Prepare an adjusted trial balance. The balances in the original trial balance (blue) are r At this point, the worksheet is almost complete. We hav directly from the adjusted trial balance. Thus we have only to 4. Extend the adjusted trial balance amounts into the appr The balance sheet accounts—assets, liabilities, and owners’ equity—are extended into the (The “Balance Sheet” and “Income Statement” captions in the original trial balance xtended to only one column. Also, the account retains the same debit or credit balance as shown in the adjusted trial balance.) 5. T ecord net income or net loss. The orksheet consists of totaling the Income Statement and Balance Sheet columns and then bringing each set of columns into balance. These tasks are perorksheet. In our illustration, the amounts involved wn in black. ve not by the same amount—and that amount should be the amount of net income or net loss for the period. xplain why both sets of columns initially are out of balance by this amount. venue the net income (net loss) for the period. No wn at up-to-date amounts ance from the beginning of the period. T we must add net income and subtract any dividends. The dividends already appear in the Balance Sheet Debit column. So what’s the only thing missing? The net income (or net loss) for the period. T ne , it appears as a credit.3 After this amount is entered, each set of columns should balance.

Computers Do the Pencil-Pushing

When a worksheet is prepared by computer, one of the steps listed above—entering the adjustments. The com-

tant has entered the adjustments, it automatically computes the adjusted account balances and completes the w worksheet involv

3

T

income

Debit column. This is

venue) e income is an element of o verses.

vent of a net loss, this

209

(a) (b) (c) (d) (e)

THE WORKSHEET

200

150

750

12,200

(e) 3,000

(h)

(f ) 1,950 (g) 30

(i) 4,020

(d)

(c)

(a) 600 (b) 1,500

3,900 58,750 7,500 1,650 2,200 19,400 15,000 26,628

14,000

12,000

18,592 7,250 1,200 3,000 52,000 36,000

30 279,100

(f ) Unpaid wages owed to employees at December 31. (g) Interest payable accrued during December. (h) (i) Income taxes expense for December.

272,000

272,000

(g) 30 12,200

(f) 1,950 (a) 600 (c) 150 (d) 200

(e) 3,000

(b) 1,500 (i) 4,020

171,250

2,000 4,000 2,690 1,560 9,000 80,000 0

1,500

750

3,900 56,800 6,900 1,500 2,000 19,400 13,500 22,608

14,000

12,000

(h)

OVERNIGHT AUTO SERVICE WORKSHEET FOR THE YEAR ENDED DECEMBER 31, 2011

18,592 6,500 1,800 4,500 52,000 36,000

Depreciation on building for December. Depreciation of tools and equipment for December. Earned one-third of rent revenue collected in advance from Harbor Cab.

Shop supplies used in December.

Repair Service Revenue Advertising Expense Wages Expense Supplies Expense Depreciation Expense: Building Depreciation Expense: Tools and Equipment Utilities Expense Insurance Expense Income Taxes Expense Rent Revenue Earned Interest Expense

Cash Accounts Receivable Shop Supplies Unexpired Insurance Land Building Accumulated Depreciation: Building Tools and Equipment Accumulated Depreciation: Tools and Equipment Notes Payable Accounts Payable Income Taxes Payable Unearned Rent Revenue Capital Stock Retained Earnings Dividends Wages Payable Interest Payable

Exhibit 5–13

279,100

3,000

172,000

1,950 30

2,200 4,000 2,690 5,580 6,000 80,000 0

1,650

30

3,900 58,750 7,500 1,650 2,200 19,400 15,000 26,628 3,000

172,000

14,000

12,000

18,592 7,250 1,200 3,000 52,000 36,000

1,950 30

2,200 4,000 2,690 5,580 6,000 80,000 0

1,650

210

Chapter 5

WHAT IF: A SPECIAL APPLICATION OF WORKSHEET SOFTWARE We have discussed a relatively simple application of the worksheet concept—illustrating the effects of proposed adjusting entries on account balances. But the same concept can be applied to proposed future transactions. in the “ can prepare schedules showing how the company’ fected by such events as a merger with another company, a 15 percent increase in sales volume, or the closure of a plant. There is a tendency to view worksheets as mechanical and old-fashioned. This is not at all the case. Today, the mechanical aspects are handled entirely by computer a worksheet is to show quickly and ef v t bookkeeping—it’s planning.

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

epare an income statement, a statement of etained earnings, and a balance sheet. c

LO1

lain how the income statement and the tatement of retained earnings relate to the sheet.

LO2

inancial statement information to evaluate fitability and liquidity.

LO6

i

LO7

lain how interim financial statements are epared in a business that closes its accounts at year-end.

lain the concept of adequate disclosure. LO3

i epare a worksheet and explain its uses. LO8

lain the purposes of closing entries; prepare entries.

LO4

’

Key Terms Introduced or Emphasized in Chapter 5

epare an after-closing trial balance. LO5

r

Demonstration Problem

JAN’S DANCE STUDIO, INC. ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

Solution to the Demonstration Problem

JAN’S DANCE STUDIO, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

JAN’S DANCE STUDIO, INC. STATEMENT OF RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2011

JAN’S DANCE STUDIO, INC. BALANCE SHEET DECEMBER 31, 2011

JAN’S DANCE STUDIO, INC. GENERAL JOURNAL DECEMBER 31, 2011

JAN’S DANCE STUDIO, INC. AFTER-CLOSING TRIAL BALANCE DECEMBER 31, 2011

Self-Test Questions

Cash . . . . . . . . . . . . . . . . . . . . . . . . $14,200 Equipment rental revenue . . . . . . . .

ASSIGNMENT MATERIAL

Discussion Questions

12,100

$26,500 18,400

Brief Exercises LO1

B

LO2

B A

LO1

LO2 R

LO1

LO2

LO4

S

accounting

LO4 E

LO4

LO5 E

LO6 E

LO7

LO8

*

Exerc ses LO1

E A

LO7

accounting

LO1

LO2

TUTORS FOR RENT, INC. ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO6

LO1

LO2

LO6

E

WILDERNESS GUIDE SERVICES, INC. ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO2

E

LO4

LO5

LO2

E

LO4

C

LO5

LO3

E A

Best Buy

Best Buy Best Buy Best Buy Best Buy LO2

E C

LO4

GERDES PSYCHOLOGICAL SERVICES, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

LO2

LO4

FERRARO CONSULTING INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

LO2

E

LO4

C

LO6

E

OREGON FOODS BALANCE SHEET DECEMBER 31, 2011

LO6

E

DENVER TOURS BALANCE SHEET DECEMBER 31, 2011

LO1

E

LO2

LO7

LO1

E

LO2

LO7

LO2

LO3

E E o S

LO3

Home Depot, Inc. Home

LO6

S

Problem Set A LO1

P

LO2

LO4

LO6

PARTY WAGON, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

accounting

PARTY WAGON, INC. STATEMENT OF RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2011

PARTY WAGON, INC. BALANCE SHEET DECEMBER 31, 2011

LO1

LO2

C P

LO4 through

LO6

LAWN PRIDE, INC. ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1

P

LO4

C U

LO6

MYSTIC MASTERS, INC. ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1

LO2

P S

LO7 Commissions earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$144,000

$128,000

$90,000

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

28,000

23,000

15,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

36,000

32,000

24,000

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22,500

20,000

15,000

Depreciation expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,700

2,400

1,800

GUARDIAN INSURANCE AGENCY INCOME STATEMENT FOR THE FOLLOWING TIME PERIODS

Commissions earned . . . . . . . . . . . . . . . . . . . . . . . . . . .

LO1

P S

LO4 LO6

B C

$

$

$

SILVER LINING, INC. UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1

P S

LO4 LO6

B C

BRUSHSTROKE ART STUDIO, INC. UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO8 S

Best Buy

LO6 E

Best Buy Best Buy Best Buy

Problem Set B LO1

LO2

LO4

LO6

STRONG KNOT, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

STRONG KNOT, INC. STATEMENT OF RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2011

STRONG KNOT, INC. BALANCE SHEET DECEMBER 31, 2011

LO1

P

LO2

C P

LO4 thr

LO6

GARDEN WIZARDS ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1

P

LO4

C U

LO6

DEBIT DOCTORS, INC. ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1

P

LO2

LO7

Commissions earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$160,000 33,000 38,000 20,000 2,200

$145,000 28,000 35,000 18,000 2,100

$100,000 18,000 28,000 14,000 1,500

SILVER REAL ESTATE INCOME STATEMENT FOR THE FOLLOWING TIME PERIODS

Commissions earned . . . . . . . . . . . . . . . . . . . . . . . .

LO1

P S

LO4 LO6

B C

$

$

$

NEXT JOB, INC. UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO1

P S

LO4 LO6

B C

TOUCHTONE TALENT AGENCY UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO8 S

LO6

The Gap, Inc.

P E

The Gap The Gap The Gap, Inc.

Critical Thinking Cases LO3

C

LO1

LO3

Ford Motor Company

LO3

www.ford.com Ford

http://www.yahoo.com

Answers to Self-Test Questions

COMPREHENSIVE PROBLEM

1

Susquehanna Equipment Rentals A COMPREHENSIVE ACCOUNTING CYCLE PROBLEM

Cash Accounts Receivable Prepaid Rent Unexpired Insurance Office Supplies Rental Equipment Accumulated Depreciation: Rental Equipment Notes Payable Accounts Payable Interest Payable Salaries Payable Dividends Payable Unearned Rental Fees

Income Taxes Payable Capital Stock Retained Earnings Dividends Income Summary Rental Fees Earned Salaries Expense Maintenance Expense Utilities Expense Rent Expense Office Supplies Expense Depreciation Expense Interest Expense Income Taxes Expense

CHA P TER 6

© AP Photo/Chitose Suzuki

Merchandising Activities

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO: LO1 LO2 LO3 LO4 LO5 LO6 LO7 LO8

SAKS INC.

Saks Inc.

Saks Fifth Avenue Fifth Avenue Off 5th Street

Saks

Saks Fifth Avenue

Saks Fifth Avenue Off 5th Street

Saks Inc.

Saks

Saks

Saks Inc.

Saks ■

246

Chapter 6 Merchandising Activities

In this chapter we examine accounting issues related to merchandising businesses, such as chandising company’ ev Saks Inc.’s retail stores are good examples of merchandising outlets. Managing inventory to merchandising businesses. F e Saks v v In most merchandising companies, inv vely liquid asset—that is, it usually is sold within a few days or weeks. For this reason, inv w accounts receivable.

Merchandising Companies THE OPERATING CYCLE OF A MERCHANDISING COMPANY Learning Objective

LO1 c

usiness generates its revenue and its cash receipts from customers is called the operating cycle. The operating cycle of a merchandising company consists of the following basic transactions: (1) purchases of merchandise; (2) sales of the vable from customers. As the word cycle . Some of the ycle begins w Exhibit 6–1.

Exhibit 6–1

1. P me urch rch as an di

3. C he olle re ce

of e se

of ion bles t c a iv

2. S

al e o

f m e rc h a n d is e o n

o acc

un

t

Comparing Merchandising Activities with Manufacturing Activities Most merchandising companies purchase their inv usiness organizations in a ready-to-sell condition. Companies that manuf v General Motors, IBM, and Boeing Aircraft, are called manufacturers, rather than merchandisers. The operating cycle of a manuf y is longer and more complex than that of a merchandising company by the many activities involved in manufacturing the merchandise. Our examples and illustrations in this chapter are limited to companies that purchase their inv wever, also apply to manufacturers.

Retailers and Wholesalers Merchandising companies include both retailers and wholesalers. A retailer is a business that sells merchandise directly to the public. Retailers may be large or small; they v Saks, The Gap,

247

Merchandising Companies

and Walmart, to small neighborhood businesses, such as gas stations and convenience stores. In fact, more businesses engage in retail sales than in an usiness acti . y is the wholesaler . Wholesalers buy large v dise to many different retailers. Because wholesalers do not sell directly to the public, even the lar major type of merchandising acti . The concepts discussed in the remainder of this chapter apply equally to retailers and to wholesalers.

INCOME STATEMENT OF A MERCHANDISING COMPANY

Learning Objective

The income statement of a merchandising company differs some organization illustrated in previous chapters. Exhibit 6–2 compares the income statement y to that of a merchandising company.

SERVICE COMPANY’S INCOME STATEMENT

MERCHANDISING COMPANY’S INCOME STATEMENT

LO2

Exhibit 6–2 A COMPARISON OF INCOME STATEMENTS USED BY A SERVICE COMPANY AND A MERCHANDISING COMPANY

The income statement of Computer City is shown in Exhibit 6–3. The following discussion prepared by merchandising companies. Computer City’s $900,000 in sales represents the selling price w and major cost of doing business: the cost to acquire the inv v , their costs must be remov venue. This $540,000 cost subtracted from sales revenue in Computer City’ cost of goods sold. In essence, the cost of goods sold is an expense; however a merchandising company that it is sho xpenses in the company’s income statement.

248

Chapter 6 Merchandising Activities

Exhibit 6–3

COMPUTER CITY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

A MERCHANDISING COMPANY’S INCOME STATEMENT

s gross pr (or gross mar transactions, but it does not represent the ov usiness. A merchany has many expenses in addition to the cost of goods sold. Computer City’s $270,000 in other expenses includes wages expense, adv xpense, insurance expense, utilities e xpense, depreciation expense, and income taxes expense.1 A compan xpenses.

ACCOUNTING SYSTEM REQUIREMENTS FOR MERCHANDISING COMPANIES In previous chapters, we recorded economic events using only general ledger accounts. These control accounts, summarize usiness and the results of its operations. Although general ledger accounts provide a useful o w of a company’ vities, they do not provide the detailed information vely manage most b ers. Subsidiary ledgers y’s general ledger. Merchandising companies always maintain accounts receivable and accounts y has 500 credit customers, there are 500 indiaccounts r er that, in total, add up to the Accounts Receiv ewise, if a company has 20 creditors, there are 20 individual records in the accounts payable suber wed to each creditor. The individual balances of these accounts add up to the Accounts P general ledger. Many merchandising companies also maintain an in er by creating a separate inv y sell. The inv lar tion for oduct, showing the quantities and costs of all units purchased, sold, and

1

for companies to subdi

what condensed. F ener

xpenses into v

249

It may seem that maintaining records for thousands of separate accounts would involve an incredible amount of w ould, in a manual accounting system. However, in a computerized are posted automatically is required. Throughout the remainder of this chapter we will record various merchandise transactions directly in the general ledger control accounts. To avoid excessive detail, we will assume that

TWO APPROACHES USED IN ACCOUNTING FOR MERCHANDISE INVENTORIES Either of tw ventories: (1) a perpetual in or (2) a periodic in In the past, both systems were in widespread use. Today, however, the growing use of computerized accounting systems v usinesses with manual accounting systems. Before we e v v pr we discussed in Chapter 4 (for example, of xpired insurance policies, prepaid rent, etc.). As inv asset in the balance sheet. As it is sold to customers, this asset is conv expense, , the cost of goods sold. v w of inv the balance sheet to the income statement as illustrated in .

Exhibit 6–4 THE FLOW OF INVENTORY COSTS

As goods are purchased

As goods are sold

Perpetual Inventory Systems In a perpetual inventory system, all transactions involving costs of merchandise are recorded immediately . The system draws its name from the fact that the accounting records are k asset account entitled Inv recognize the revenue earned and the second to recognize the related cost of goods sold. This v the company’s inv . v in er. This ledger provides compan y buys and sells, including the per rently on hand.

Learning Objective

LO3

250

Chapter 6 Merchandising Activities

T

v ycle of Computer City illustration are as follows: wa

Sept. 1

Sept. 7 Oct. 1 Oct. 7

in 30 days. Sold tw ravel Agency at a retail sales price of $1,000 each, for a total of $2,000. P Paid the $6,000 account payable to Okawa Wholesale Co. v ravel Agency.

Purchases of Merchandise

v Computer City records its purchase of the 10 computer monitors on September 1 as follows:

Purchase of merchandise: the start of the cycle

subsidiary ledgent 21-Inch Monitors account in

gers. Thus, the debit to Inv the inv

. Like able is posted to the account for Okawa Wholesale Co. in Computer City’ .

ay-

Sales of Merchandise The rev

sales price v entitled Sales. Except in rare circumstances, sales revenue is considered realized when the merchandise is delivered to the customer, even if the sale is made on account. Therefore, v ravel Agency on September 7, as follows: Entries to record a sale . . .

The matching principle requires that revenue be matched (offset) with all of the costs and e venue. Therefore, a is required at the date of sale to record the cost of goods sold. and the related cost of goods sold

cost of the merchandise to Computer City, not 2

s general ledger. In addition, the $2,000 debit to Accounts Receiv 2

y’s inv

v

veral

v ent per-unit costs. This

251

ravel Agenc

vable ledger. The credit to Inv gent 21-Inch Monitors account in the inv

Payment of Accounts Payable to Suppliers

.

w

on October 1 is recorded as follows: Payment of an account payable

payable is entered in the Okaw .

s accounts payable

Collection of Accounts Receivable from Customers On October 7, collecv

ravel Agency is recorded as follows: Collection of an account receivable

vable also is posted to the RJ Travel Agency account in the accounts receivable ledger. ravel Agenc s operating cycle with respect to these two units of merchandise.

TAKING A PHYSICAL INVENTORY v continuously updated is taken, management uses the inv basis whether a physical count of the inv in the inv . Ov

v physical inven-

v wn in the inv

Inventory shrinkage v resulting from such factors as breakage, spoilage, employee theft, and shoplifting. v required to take a complete physical count of the merchandise on hand at least once a year. This procedure is called ysical inv , -end. per-unit costs in the inv inv . The Inv v then are adjusted v . To illustrate, assume that at year-end both the Inv v w an inv however, reveals that some of the merchandise listed in the accounting records is missing; the ve a total cost of $70,000. Computer City w e the following v Adjusting for inventory shrinkage

v

252

Chapter 6 Merchandising Activities

Reasonable amounts of inv and simply are debited to the Cost of Goods Sold account, as illustrated above.3

usiness

I N T E R N AT I O N A L C A S E I N P O I N T

CLOSING ENTRIES IN A PERPETUAL INVENTORY SYSTEM As e vious chapters, revenue and e at the end of each accounting period. A merchandising b system mak is a rev

closed v venue

same manner as the other expense accounts.

YOUR TURN

Periodic Inventory Systems A periodic inventory system is an alternative v inv eep up-to-date records of either the inv end of each year.

OPERATION OF A PERIODIC INVENTORY SYSTEM Learning Objective

E

LO4

A traditional periodic inv its cost is debited to an account entitled Purchases, rather than to the Inv venue, but is made to record the cost of goods sold or to reduce the balance of the Inv ven, there is no inv . v complete physical in at year v

3

If a large inv v merchandise may be debited to a special loss account, such as Fire Loss. In the income statement, a loss is v xpense.

253

Data for an Illustration To illustrate, assume that one of Computer City’s suppliers, W

v

w-

vailable: 1. The inv 2. 2011, 3. Inv

2010 cost $14,000. 2011 cost $12,000.

The inv complete physical inv -end. (Because the Inv w ws a balance of $14,000— the inv beginning .) The $130,000 cost of merchandise purchased during 2011 was recorded in the Purchases account.

Recording Purchases of Merchandise

W

y

purchases is as follows:

ledger is no in

as posted to the Purchases and Accounts Payable accounts in the general agner’s as not “double-posted,” as there er in a periodic system.

Computing the Cost of Goods Sold The year-end inv ing a complete physical count of the merchandise on hand. Once the ending inv

wn, w-

Computation of the cost of goods sold

o elements: the $130,000 cost of merchandecrease in inv ginning inv

⫺ $12,000 ending inv

Recording Inventory and the Cost of Goods Sold Wagner has now determined its inv . But neither of these amounts has yet been recorded in the company’s accounting records. In a periodic system, the ending inv the company’s year-end closing procedures closing procedures refers to the end-of-

CLOSING PROCESS IN A PERIODIC INVENTORY SYSTEM There are sev ays of recording the ending inv a periodic system, but they all produce the same results. One approach is to create a Cost of has been created, the compan v

254

Chapter 6 Merchandising Activities

Creating a Cost of Goods Sold Account w account by bringing together the costs contributing tow v v uting to the cost of goods sold include (1) be v (2) purchases made during the year. These costs are brought together by closing both the Inv w account entitled Cost of Goods Sold. This year Creating a Cost of Goods Sold account . . .

W

s Cost of Goods Sold account now includes the cost of all goods available for sale . Of course, not all of these goods were sold; the physical inv en at the end of 2011 shows that merchandise costing $12,000 is still on hand. Therefore, a second out of the Cost of Goods Sold account and into the Inv or Wagner and adjusting its balance

W o entries, W ance of $132,000 ($144,000 ⫺ v Exhibit 6–5 provides a T account presentation of these entries.

Exhibit 6–5 CREATING THE COST OF GOODS SOLD ACCOUNT 14,000

144,000

130,000

12,000

12,000

255

Completing the Closing Process Wagner may now complete its closing process v y will venue accounts, (2) e vidends account.

mak

COMPARISON OF PERPETUAL AND PERIODIC INVENTORY SYSTEMS Exhibit 6–6 provides a comparison of the way in which v

vents are recorded in per-

v v velop annual data and to minimize record-keeping requirements. A single business may use ent in to account for merchandise.

Who Uses Perpetual Systems? date information about inventory levels,

Exhibit 6–6

When management or employees need up-tov

SUMMARY OF THE JOURNAL ENTRIES MADE IN PERPETUAL AND PERIODIC INVENTORY SYSTEMS

Note: In a periodic inventory system, the Cost of Goods Sold account is both debited and credited to create its year-end balance.

256

Chapter 6 Merchandising Activities

system. Almost all manuf

usinesses need ventories of raw materials with their production schedules. Most large merchandising companies—and man ual systems. usinesses that sold many w-cost products had no choice but to use periodic inv Walmart store, for example, may sell several thousand items per hour. eepv today’s computerized terminals and bar-coded merchandise, many high-volume retailers now v act, Walmart has been a leader among retailers in develv

I N T E R N AT I O N A L C A S E I N P O I N T Walmart Sam’s Club Walmart

Walmart

v systems. Many small b However, these businesses may update their inv

usinesses with computerized inv v

v include automobiles, hea Management has a greater interest in keeping track of inv expensive. Also, sales volume usually is lo if accounting records are maintained by hand.

, most businesses use high per-unit cost. Examples . ven

Who Uses Periodic Systems? v system. In a small retail store, for example, the owner may be so f v v . Most businesses—large and small— use periodic systems for inventories that are immaterial in dollar amount, or when management has little interest in the quantities on hand. As stated previously, businesses that sell many low-cost items and have manual accounting systems sometimes have no choice but to

SELECTING AN INVENTORY SYSTEM Learning Objective

LO5

c i

Accountants—and business managers—often must select an inv actors usually considered in these decisions are listed in Exhibit 6–7.

The Trend in Today’s Business World Advances in technology are quickly e petual inventory system

v

venxtbook, you may assume that a per-

257

Transactions Relating to Purchases

Exhibit 6–7 FACTORS INFLUENCING CHOICE OF INVENTORY SYSTEM

YOUR TURN

Ace Hardware Stores

Transactions Relating to Purchases companies must account for a v

xplained in this chapter, merchandising -

Learning Objective

LO6

a perpetual inv

CREDIT TERMS AND CASH DISCOUNTS Manuf

on account. The s bill, or invoice. One common e

“net 30 days, ” meaning payment is due 10 days after the end of the month in which Manufacturers and wholesalers usually allow their customers 30 or 60 days in which to pay for credit purchases. Frequently, however encourage earlier payment. 2/10, n/30. xpression is read “2, 10, net 30, ut that the b e a 2 percent discount v . ve cash discount. Buyers, however purchase discounts, sales discounts.

258

Chapter 6 Merchandising Activities

Most well-managed companies have a policy of taking advantage of all cash discounts 4 av These companies initially record purchases of merchandise at the net cost—that is, the invoice price minus any available discount. After all, this is the amount that the company expects to pay. T vember 3 Computer City purchases 100 spreadsheet proHowever

-

ve to pay only $9,800, invoice price. Therefore, Computer City will record this purchase as follows: Purchase recorded at net cost

If the inv $9,800 account payable. v

ail to make payment within the vent, Computer City must pay PC Products the entire inv

of $10,000, after the discount period—on, say, December 3—is: Recording the loss of a cash discount

Notice that the $200 paid above the $9,800 recorded amount is debited to an account entitled expense account Computer City from this $200 expenditure was a 20-day delay Thus the lost purchase discount is basically a harge, similar to interest expense. In an xpenses. The f not taken xpense account is y should record purchases of merchandise at net cost. The y failure to take adv fered by suppliers.

Recording Purchases at Gross Invoice Price

ve to record-

invoice price. If payment is made within the discount period, these companies must record the taken. To illustrate, assume that Computer City followed a policy of recording purchases at gross inv vember 3 to record the purchase from PC Products would have been: Purchases recorded at gross price

4

is due. Sa ver only 20 days is equiv 36 percent (2% ⫻ 365/20 ⫽ . Most companies take advantage of all cash discounts, even if the

xcellent inv

259

Transactions Relating to Purchases

If payment is made within the discount period, Computer City will discharge this $10,000

Buyer records discounts taken

Purchase Discounts Taken is treated as a reduction in the cost of goods sold. 5

to the net cost method for valuing inv to discounts lost. Instead, these discounts are b

v

v tage of purchase discounts when possible. By recording inv

s attention . Mane advan-

west possible costs for purchased inv . Because of the advantage of the net cost method, it is the approach recommended by the authors of this textbook.

RETURNS OF UNSATISFACTORY MERCHANDISE On occasion, a b To illustrate, assume that on Nov ve of the spreadsheet programs purchased on November 3, because these programs were not properly amount that Computer City owes PC Products. The gross inv chandise w cost. -unit cost of $98, v

net s inv

Return is based on recorded acquisition cost

The reduction in inv

TRANSPORTATION COSTS ON PURCHASES The purchaser sometimes may pay the costs of having the purchased merchandise delivered to its premises. T acquisition of inv , or any other asset, are , these charges are part of the cost of the asset being costs should be debited directly to the Inv ve in a single shipment. In such cases, it may be impractiproduct. For this reason, many companies follow the convenient policy of debiting all transTransportation-in.

as cost of goods sold. 5

alues the ending inv v

v

ws this wever

immaterial.

260

Chapter 6 Merchandising Activities

matching prinv

ciple. e have mentioned, however are relativ

, therefore, usuvenient manner.

Transactions Relating to Sales v seller. To the extent that credit customers take adv dise for a refund, the seller’s revenue is reduced. Thus revenue sho net sales. net sales means total sales revenue minus wances and minus Exhibit 6–8 illustrates this relationship.

Exhibit 6–8

COMPUTER CITY PARTIAL INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

PARTIAL INCOME STATEMENT

The details of this computation seldom are sho practice is to begin the income statement with the amount of net sales.

SALES RETURNS AND ALLOWANCES Most merchandising companies allo y merchandise considered to be unsatisf . If the merchandise has only minor defects, customers eep the merchandise if an allowance v o entries are needed to record the sale of merchandise: one to recognize the rev chandise from the Inv versed. venue of granting either a refund or an allowance. Both refunds and allowances hav viously recorded sales and reducing v venue as the wance): A sales return reverses recorded revenue . . .

wances is a contra-revenue account—that is, it is deducted from gross sales rev wances account rather than merely debiting the venue account enables management to see both the total amount of sales and ves management an indication of customer satisfaction with the merchandise.

261

Transactions Relating to Sales

ve the cost of v

and the recorded cost of goods sold

cost sales price. keeps the merchandise.)

, not on its allowance is granted to a customer who

SALES DISCOUNTS We have e age customers to make early payments for purchases on account. Sellers and b . To the seller, the cost assolost when payments are delayed, but rather taken by customers who do pay within the discount period. Therefore, sellers design their accounting systems to measure the sales discounts taken by their customers. To achiev vable at the gross (full) invoice price. To illustrate, assume that Computer City sells merchandise to the Highlander Pub for venue is recorded at the full invoice price, as follows: Sales are recorded at the gross sales price

If the Highlander Pub mak vable. If it pays within wever, the pub will pay only $980 to settle its account. In this case, ws: Seller records discounts taken by customers

Sales Discounts is another contra-rev wances. (If the en only on the gross amount owed after v v rev

ve much in common with expense accounts; both are deducted ve debit balances. Thus contrawances and Sales Discounts) are closed to the in the same manner as expense accounts.

DELIVERY EXPENSES If the seller incurs any costs in delivering merchandise to the customer, these costs are debited to an expense account entitled Deliv v xpense is gular operating e

262

Chapter 6 Merchandising Activities

ACCOUNTING FOR SALES TAXES Sales taxes are levied by many states and cities on retail sales.6 Sales taxes actually are imposed on the consumer, not on the seller. However w v es collected. For cash sales, sales tax is collected from the customer at the time of the sales transaction. For credit sales, the sales tax is included in the amount charged to the customer’s account. v es is recorded automatically at the time the sale is made, as shown in the follo Sales tax recorded at time of sale

Modifying an Accounting System Learning Objective

LO7

a

Throughout this te tw general journal. concisely sho

ws us to of business transaction.

cient way for a b et, for example, may sell 10,000 to 15,000 items per hour. Clearly, it would not be practical to mak usinesses use special journals, routine transactions that occur frequently.

SPECIAL JOURNALS PROVIDE SPEED AND EFFICIENCY A special journal tine transaction quickly and ef

vice designed to record

ou-

. xample is the check register in your

of all cash disb But man point-of-sale (POS) terminals ets and large retail stores. These devices record sales transactions and the related cost of goods sold as quickly as the bar-coded merchandise can be passed over the scanner. Relativ wing advantages: • Transactions are recorded f • Man ge volume of transactions. • • Emplo • acti Most b

. y’s

usiness ve transactions such as sales

to suit the needs, acti accounting principles

, they are tailored usiness organization. same as those recording tech-

niques, 6

Sales taxes are applicable only when merchandise is sold to the vied when manuf

es are

263

Modifying an Accounting System

y

highly specialized can record. Thus ev v

valuating the perfory’s ov

Financial Analysis and Decision Making Gross Profit Margins

Net Sales Learning Objective

LO8

Home Depot Saks Walmart

Home Depot Saks Home Depot Saks Walmart

Walmart

264

Chapter 6 Merchandising Activities

Ethics, Fraud & Corporate Governance

PR) Pepsi Co

Pepsi-Cola Puerto Rico (Pepsi Pepsi PR Pepsi PR Pepsi PR

Coca-Cola Pepsi PR Dynergy Pepsi PR

Pepsi PR

Pepsi PR

Pepsi PR

Pepsi PR Pepsi PR

Pepsi PR

Concluding Remarks usiness. Throughout this chapter, we hav w merchandising companies measure and report the results for their operations. Man remainder of this te In Chapter 7, we examine accounts receivable and other liquid assets common to merchandisers. In Chapter 8, we focus upon issues related to merchandise inv vered in a subsequent course.

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

escribe the operating cycle of a merchandising mpany.

LO1

iscuss the factors to be considered in selecting ventory system.

LO5

s erstand the components of a merchandising ompany’s income statement.

LO2

LO6

LO3

i

LO4

I

ount for additional merchandising transactions elated to purchases and sales.

ount for purchases and sales of merchandise perpetual inventory system.

lain how a periodic inventory system operates.

efine special journals and explain their usefulness. LO7

LO8

e the performance of a merchandising s.

Key Terms Introduced or Emphasized in Chapter 6

Demonstration Problem

Solution to the Demonstration Problem

GENERAL JOURNAL

GENERAL JOURNAL

Self-Test Questions

ASSIGNMENT MATERIAL

Discussion Questions

Brief Exercises LO2 LO8

LO7

LO2 LO3

P

LO8

LO2 LO4

P S B

LO8

LO2 LO4

P S

LO8

LO2 LO4 LO8

S B

accounting

LO2

LO4

S

LO6

LO6

LO7

LO8

Exercises LO1 Y

LO6

LO1 E

accounting

LO2

PC Connection U

LO5 LO8

PC Connection PC Connection LO3 LO8

S

LO6 LO8

E P Walmart

Target

LO3 T

LO4 P

LO4

LO5 LO8

Publix Super Markets, Inc. S S

Safeway, Inc.

LO6

LO8

Walgreen Company

LO3

LO5

LO4 LO5

T S

Rite Aid Corporation

Sears LO8

LO8

E

Home Depot, Inc. Home Depot,

Inc.

Home Depot, Inc.

Problem Set A LO1

P E

LO3 LO8

accounting

LO1 P

LO3

a

HENDRY’S BOUTIQUE ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO6

LO8

LO8 T

LO3 LO6

LO3 LO6

T

LO2 LO3

o T

LO6

LO1 A

LO3 LO6

V

LO1 A

LO8

Problem Set B LO1 LO3 LO8

accounting

LO1 P

LO3

a S

LO6 LO8

HARRY’S HABERDASHERY ADJUSTED TRIAL BALANCE DECEMBER 31, 2011

LO8 T

LO3

LO6

LO3 LO6

T

LO2 LO3 T

LO6

LO1 A

LO3 LO6

V

LO1 A

LO8

Critical Thinking Cases LO5 S

LO4

LO8

A A

LO3 E

LO5

LO7

LO8

LO8

The Gap, Inc. Gap, Inc.

www.gapinc.com

http://www.yahoo.com

Answers to Self-Test Questions

CHA P TER 7

© Keizo Moi/UPI Photo/Newscom

Financial Assets

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO:

LO1

LO2

LO3

LO4

LO5

LO6

LO7

MICROSOFT CORPORATION

Microsoft Corporation

Microsoft

Microsoft Microsoft

Microsoft

■

288

Chapter 7 Financial Assets

y’s most liquid (or cashlik y v , pay taxes, and cov the availability of these highly liquid assets. In this chapter, we will examine how compacurrent values w effective companies quickly conv

HOW MUCH CASH SHOULD A BUSINESS HAVE?

Learning Objective

LO1

e t

In response to this question, most businesspeople would say, “ .” In a well-managed company principal source of these daily receipts is the collection of accounts receivable. If the daily receipts exceed routine cash outlays, the company can meet its obligations while maintaining relatively lo vested in highly liquid, v ve than cash because the vvidends. If the b in its bank accounts, it can easily conv vestments back into cash. assets ut also those assets easily and directly convertible into known amounts of cash. vestments (also called marketable securities), and receivables. W cial assets in a single chapter because they are so closely related. All of these assets represent w quickly among these asset categories. , businesses “store” mone vestments, and receiv in Exhibit 7–1.

Exhibit 7–1 MONEY FLOWS AMONG THE FINANCIAL ASSETS

Collections from customers

cash is invested temporarily

Cash payments

are sold as cash is needed

THE VALUATION OF FINANCIAL ASSETS wn at their current values, meaning the amounts of cash that these assets represent. Interestingly alue of cash is simply its f f market values. cost principle.)

alue of marketable

v aluation of these investments represents an exception to the

289

Cash

Accounts receivable, like cash, have stated face amounts. But large companies usually do not expect to collect ev vable. Some customers simply will be unable to mak vables appear in the balance sheet at the estimated collectible amount—called net realizable value. Exhibit 7–2.

Exhibit 7–2 METHODS OF MEASURING THE CURRENT VALUE OF FINANCIAL ASSETS

Cash Accountants cash as mone for deposit. These items include not only coins and paper money, but also checks, money velers’ checks. Banks also accept drafts signed by customers using bank credit cards, such as Visa and MasterCard. ered cash sales, es the sale. Most companies maintain several bank accounts as well as keep a small amount of cash control account. A cash supply of cash on hand within the organization.

REPORTING CASH IN THE BALANCE SHEET of balance sheet presentation, the balance in the Cash control account is combined with that cash equivalents.

Cash Equivalents

vestments are so liquid that the cash equivalents. Examples include money market funds, U.S. T mercial paper (v tions). These assets are considered so similar to cash that they are combined with the amount Cash and Cash Equivalents. To qualify as a cash equivalent, an inv v est quality stocks and bonds of lar v as Mark

ve a v et vestments in even the highnot vie valents are listed in the balance sheet

Restricted Cash Some bank accounts are restricted as to their use, so they are not av

entitled “Investments and Restricted Funds.”

y. For example, a bank account , such as a

290

Chapter 7 Financial Assets

wer to maintain a compensating balance (minimum av v wer from using the cash, but it does mean the compan are included in the amount of cash listed in the balance sheet, but these balances should be disclosed in the notes accompan

Lines of Credit Many b

lines of credit credit means that the bank has agreed in advance to lend the compan y w this money at any time simply by drawing credit line is used. The unused the w money quickly and easily. Although an unused line of credit does not appear as an asset or a liability in the balance sheet, it increases the company’s liquidity. Thus unused lines of credit usually are disclosed in notes accompan For example, Wet Seal, Inc., recently included the follo accompan We maintain a $35 million line of credit that can be increased up to $50 million in absence of any defaults. To date, $7.4 million of this amount has been used for the purchase of inv .

CASH MANAGEMENT Learning Objective

LO2

The term cash management refers to planning, controlling, and accounting for cash transactions and cash balances. Because cash moves so readily between bank accounts and

o

resources. Ef survival—of ev follows:

ven to the usiness organization. The basic objectives of cash management are as

• Provide accurate accounting for cash receipts, cash disbursements, and cash balances. • Prevent or minimize losses from theft or fraud. • wing and assure the availability of adequate amounts of cash for conducting business operations. • Prev no revenue.

INTERNAL CONTROL OVER CASH ver cash is sometimes regarded merely as a means of preventing fraud and wever, will also aid in achieving the other objectiv wing, and the maintenance of adequate but not excessive cash balances. The major steps in achie include the following:

v

• Emplo should not have access to the accounting records, and accounting personnel should not have access to cash. • cash budgets balances, scheduled month-by-month for the coming year. • a control listing of cash receipts at the time and place the money is received.

291

Cash

• Require that all cash receipts be deposited daily in the bank. • e all payments by check. The only exception should be for small payments to be made in cash from a .) • Require that ev xpenditure be v before ving expenditures from the function of signing checks. • reconciles the bank statements should not have an cash. (Bank statement reconciliations are discussed later in this chapter.)

Cash Over and Short In the handling of daily cash transactions, a fe inevitably will occur verage at the end of the day when the cash is counted and compared with the reading on the cash registers. For e However, the cash receipts in the register drawers total only $4,485. The follo w

verages. If the account has a debit balance, it appears in the income statement as a miscellaneous expense; if it has a credit balance, it is sho venue.

BANK STATEMENTS vides the depositor with a statement of the depositor’s account.1 As Exhibit 7–3 month, the deposits, the checks paid, an and the new balance at the end of the month. (To k

ve sho usiness day in the month.)

RECONCILING THE BANK STATEMENT A bank reconciliation is a schedule

ences between the balance sho wn in the depositor’

Learning Objective

LO3

ance of the bank account. Each month, the depositor should prepare a bank reconciliation to v s accounting the depositor’ deposit.

Normal D erences between Bank Records and Accounting Records The balance shown in a monthly bank statement seldom equals the balance appearing in the depositor’ ve xamples are: 1

Large businesses may receiv

292

Chapter 7 Financial Assets

Exhibit 7–3 A BANK STATEMENT

• Outstanding checks. Checks issued and recorded by the company but not yet presented to the bank for payment. • Deposits in transit. Cash receipts recorded by the depositor that reached the bank too late ve been recorded by the depositor. For example: • Service charges. ge a fee for handling small accounts. The amount of this charge usually depends on both the average balance of the account and the number of • Charges for depositing NSF checks. NSF stands for “Not Suf ” When checks v occasion, one of these checks may prove to be uncollectible, because the customer who wrote the check did not hav will reduce the depositor’

293

Cash

the check to the depositor marked “NSF.” The depositor should view an NSF check as an v , not as cash. • Credits for interest earned. The checking accounts of unincorporated b

• Miscellaneous bank charges and credits. Banks char checks, handling collections of notes receivable, and processing NSF checks. The bank deducts these char including a debit memorandum in the monthly bank statement. If the bank collects a note receivable on behalf of the depositor, it credits the depositor’s account and issues a credit memorandum.2 In a bank reconciliation, the balances sho records are both adjusted for any unrecorded transactions. Additional adjustments may be vered in the bank statement or in the accounting records.

Steps in Preparing a Bank Reconciliation bank reconciliation are as follows: 1.

wn in the accounting records. Any deposits not yet recorded by the bank are deposits in transit and should be added to the balance shown in the bank statement.

2. Any checks issued b 3. Add to the balance per the depositor’ y credit memoranda issued by the bank that have not been recorded by the depositor. 4. Deduct from the balance per the depositor’s records any debit memoranda issued by the bank that have not been recorded by the depositor. 5. depositor’s accounting records. 6. in the depositor’s records. 7. y items in the bank reconciliation listed as adjustments to the balance per the depositor’s records.

Illustration of a Bank Reconciliation to Parkview Company w on deposit at July 31 of $5,000.17. balance of $4,262.83. The emplo following reconciling items:

Exhibit 7–3. This statement shows a balance of cash arkview’s ledger sho

1. statement. 2. Four checks issued in July have not yet cleared the bank. These checks are:

2

w each depositor’s account as a this liability , as results, for e

. .

294

Chapter 7 Financial Assets

3. Tw

4. Three debit memoranda accompanied the bank statement:

5. Check no. 893 was issued to the telephone company in the amount of $85 but was telephone expense, w ment. In Parkview’s ledger, the Cash account is overstated ($85 $58 $27). arkview Company is shown in Exhibit

. (The num-

reconciling items just listed.)

Exhibit 7–4 THE BANK RECONCILIATION

PARKVIEW COMPANY BANK RECONCILIATION JULY 31, 2011

1 2

Adjusted cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,693.32

3

6 4 5

Adjusted cash balance (as above) . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,693.32

295

Short-Term Investments

Updating the Accounting Records

The last step in reconciling a bank statement is to update the depositor’s accounting records for any unrecorded cash transactions v balance per depositor’s records is a cash receipt or a cash payment that has not been recorded in the depositor’s accounts. Therefore, each of these items should be recorded. w a policy of making one jourves would be to mak or to mak to update the accounting records of Parkview Company are:

y

Per bank credit memoranda

Per bank debit memoranda (and correction of an error)

Short-Term Investments

Learning Objective

Companies with large amounts of liquid resources often hold most of these resources in the vestments in bonds and in the capital stocks of publicly o and sold) daily on organized securities exchanges, such as the New York Stock Exchange, the Tokyo Stock Exchange, and Mexico’s Bolsa. A etable securities is that they are readily —meaning that they can be purchased or sold quickly and easily at quoted market prices. Investments in marketable securities earn a return for the investor in the vidends, and—if all goes well—an increase in market value. Meanwhile, these investments are almost as liquid as cash itself. They can be sold immediately over the telephone, simply by placing a “sell order” with a brok Merrill Lynch or Morgan Stanley, E*TRADE Financial. , investments in mark available for sale securities.3 © Digital Vision/Getty Images/DAL 3

Other inv

trading

LO4

296

Chapter 7 Financial Assets

CASE IN POINT

Best Buy Dell Computer Corporation Ford Motor Company Pfizer, Inc. Microsoft Corporation

Accounting for Marketable Securities of inv

vents relating to inv etable securities: (1) the purchase vidends or interest revenue, (3) the sale of investments, and

PURCHASE OF MARKETABLE SECURITIES Investments in mark kerage commissions. T inv per share, plus a brok shares is:

y broThe Coca-Cola Company on December 1. Foster paid $48.98

Coca-Cola

Mark all of a company’ ments. If F v one shown above; however, it will also create a mark

vester to

Notice that the $49 cost per share computed in the explanation of the abov erage commission. The $49 per share cost basis will be used in computing any gains or losses when F

RECOGNITION OF INVESTMENT REVENUE Entries to recognize interest and dividend rev to either Interest Revenue or Dividend Revenue. T

volve a debit to Cash and a credit

297

Accounting for Marketable Securities

F

ves a $0.30 per share dividend on its 4,000 shares of Coca-Cola. The

Coca-Cola

Dividend and interest rev

y’s vestment rev

SALE OF INVESTMENTS vestment is sold, a gain or a loss often results. If an inv than its cost basis a gain is recorded, whereas selling an investment for an amount less than its cost basis results in a loss. These items appear in the “Other Income/Expense” section of the income statement.

Investments Sold at a Gain T shares of its Coca-Cola stock on December 18 for $50.04 per share, less a $20 brokerage commission. Recall that Foster’s cost basis, as computed on December 1, is $49 per share. ws:

Coca-Cola

This transaction results in a gain because F above their cost basis. The gain on the sale increases the company’s net income for the period and is reported in the income statement in similar fashion to interest and dividend revenue. At the end of the period, the credit balance in the Gain on Sale of Investments account is venue accounts.

Investments Sold at a Loss

Assume that F 2,500 shares of its Coca-Cola stock on December 27 for $48.01 per share, less a $25 brokerage commission. The entry to record the sale and the $2,500 loss is recorded as follows:

Coca-Cola

298

Chapter 7 Financial Assets

This loss reduces F income statement. The debit balance in the Loss on Sale of Investments account is closed to other expense accounts.

ADJUSTING MARKETABLE SECURITIES TO MARKET VALUE vailable for sale are presented in the balance sheet at their current market value as of the balance sheet date. Hence, this valuation principle is often called fair value accounting. et value requires the use of an account entitled Unrealized Holding Gain (or Loss) on Investments. 4

T Coca-Cola capital stock hav et value of $47,000 on December 31 (1,000 shares at a market price of $47 per share). Prior to an y’s Mark account has a balance of $49,000 (1,000 shares at $49 per share). Thus, F must make the following fair value adjustment on December 31:

Exhibit 7–5 aluation adjustment.

Exhibit 7–5

s condensed balance sheet following its marketable

FOSTER CORPORATION BALANCE SHEET AS OF DECEMBER 31 OF THE CURRENT YEAR

PRESENTATION OF MARKETABLE SECURITIES IN THE BALANCE SHEET

Marketable securities (cost, $49,000; market value, $47,000). . . . . . . . . . . . . . . . . . . .

47,000

Unrealized holding loss on investments . . . . . . . . . .

(2,000)

Although the $49,000 cost of F s mark disclosed in the balance sheet, the $47,000 market value is used in the computation of total assets. The et value also appears as an element of stockholders’ 4

ve Income. Comprehensive income is discussed in Chapter 12.

299

Accounts Receivable

, v et value of investment falls below cost, as in the case just presented, this special equity account is a subtraction , representing a holding loss. But if the market value is above cost, this addition , representing a holding gain. Thus, if Foster’s 1,000 shares of Coca-Cola had a market value on December 31 of $51 per share, the inv ould have section of the balance sheet would have included the addition of a $2,000 unrealized holding gain on investments. not subject to income taxes. Income taxes are levied only upon realized vestments are sold. Nonetheless, xpected future yond the scope of our anced accounting courses. In the assignment material at the end of this chapter, unrealized holding gains and losses simply represent the dif et value of the securities owned.

I N T E R N AT I O N A L C A S E I N P O I N T

Accounts Receivable One of the key factors underlying the gro

ward v

of many merchandising companies. Accounts receivable are relatively liquid assets, usually conv vable from customers usually appear in the v etable securities. In Chapter 5, we explained that assets capable of being conv y’s operating cycle, whichever is longer. The operating cycle was v v , invenv vable back into cash. Some companies sell vable be outstanding for 12, 24, or even 48 months before being collected. These receiv y’s ycle. Therefore, all v vity v xtend beyond one year.

UNCOLLECTIBLE ACCOUNTS We hav

vable are shown in the balance sheet at the estimated colnet realizable value. No business wants to sell merchandise on account to customers who will be unable to pay. Nonetheless, if a company makes credit sales

A limited amount of uncollectible accounts is not only expected—it is evidence of a sound credit policy verly cautious, the business may lose many sales ve been considered acceptable credit risks.

Learning Objective

LO5

300

Chapter 7 Financial Assets

Reflecting Uncollectible Accounts in the Financial Statements

An account receiv of this asset represents an expense, In measuring business income, one of the most fundamental principles of accounting is that revenue should be matched venue. Uncollectible accounts expense is caused by selling goods on credit to customers who fail to pay their bills. Therefore, this expense is estimated and recorded in the time period in which the related sales are made, ev vable may not be vable resents an expense in J . Exhibit 7–6 illustrates ho matched to revenue in the period in which the credit sale is made.

Exhibit 7–6 MATCHING UNCOLLECTIBLE ACCOUNTS EXPENSE TO THE PERIOD IN WHICH THE CREDIT SALE IS MADE

February

March

April

xpense is

May

June

A credit sale is made.

The account receivable is determined to be uncollectible.

T

orld Famous Toy Co. begins business on vable vie vable and estimates that approximately $10,000 of these accounts will prove to be uncollectible. The follo Provision for uncollectible accounts

y other expense account. as credited in the abov ace amount of the accounts receivable. It reduces the accounts receivable to their net realizable value in the balance sheet, as sho 7–7. The Allow

Exhibit 7–7 REPORTING ACCOUNTS RECEIVABLE AT ESTIMATED NET

WORLD FAMOUS TOY CO. PARTIAL BALANCE SHEET JANUARY 31, 2011

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$250,000

Less: Allowance for doubtful accounts . . . . . . . . . . . . . . . . . . . . . . .

10,000

240,000

301

Accounts Receivable

THE ALLOWANCE FOR DOUBTFUL ACCOUNTS There is no way of telling in advance which accounts receivable will prove to be uncolestimate of probable uncollectible accounts. A practical solution, therefore, is to credit a separate account called Allowance for Doubtful Accounts with the amount estimated to The Allowance for Doubtful Accounts often is described as a contra-asset account or a valuation account. The Allowance for Doubtful Accounts has a credit balance which offsets the Accounts Receiv company’s liquidity. Because the Allow not a precise calculation, professional judgment size of this v

Monthly Adjustments of the Allowance Account made by World Famous Toy Co. at January 31, the amount of the adjustment ($10,000) w January w as the company’ on two factors: (1) the estimate of uncollectible accounts and (2) the current balance in the Allowance for Doubtful Accounts. Before we illustrate the adjusting entry for a future month, let us see why the balance in the allow accounting period.

WRITING OFF AN UNCOLLECTIBLE ACCOUNT RECEIVABLE ver an account receiv o

an account receivable is

to reduce the balance of the customer’ v the customer’ wance for Doubtful Accounts. T , World Famous To Stores has gone out of business and that the $4,000 account receivable from this customer is now w vable is:

able “against the allowance”

wance for Doubtful Accounts and not e v w

xpense but merely vious estimate of the expense. f an uncollectible account receivable reduces both the

does not change the net realizable v vable in the balance sheet. The net realizable value of World Famous Toy Co.’s accounts receivable before and vable from Discount Stores is:

302

Chapter 7 Financial Assets

What happens to net realizable value?

Net realizable value . . . . . . . . .

$240,000

Net realizable value . . . . . . . . .

$240,000

Let us repeat the point that underlies the allow an expense in the period in which the sale occurs, mined to be uncollectible. The reasoning for this position is based on the matching principle.

Write-o s Seldom Agree with Previous Estimates The total amount of v viously credited to the Allow

ver, be exactly equal to the estimated

the Allowance for Doubtful Accounts will continue to show a credit balance. If the amounts f as uncollectible are greater than the estimated amount, the Allowance for Doubtful Accounts will acquire a tempor , which will be eliminated by the adjustment at the end of the period.

MONTHLY ESTIMATES OF CREDIT LOSSES lectible accounts and adjust the Allowance for Doubtful Accounts to this new estimate. T orld Famous To v $11,000 of these accounts will prov , the Allow credit balance of only $6,000, ws: Current balance in the allowance account

To increase the balance in the allow w Increasing the allowance

In the World Famous Toy illustration, estimates of the required allowance for doubtful v o general approaches to estimating credit losses: (1) a balance sheet approach, and (2) an income statement approach.

Estimating Credit Losses—The Balance Sheet Approach

The most

aging the accounts receivable. This method is sometimes called the balance sheet approach because the method emphasizes the proper balance sheet valuation of accounts receivable. “Aging” accounts receiv vable according to its age. An aging schedule for the accounts receivable of Valley Ranch Supply is illustrated in Exhibit 7–8.

303

Accounts Receivable

VALLEY RANCH SUPPLY ANALYSIS OF ACCOUNTS RECEIVABLE BY AGE DECEMBER 31, 2011

Exhibit 7–8 ACCOUNTS RECEIVABLE AGING SCHEDULE

An aging schedule is useful to management in reviewing the status of individual accounts receiv valuating the overall effectiveness of credit and collection policies. In addition, the schedule is used as the basis for estimating the amount of uncollectible accounts. elihood that it will not be collected xperience, the credit manager estimates the percentage of credit losses likely to occur in each age group of accounts receivable. This percentage, when applied to the total dollar amount in the age group, giv required balance in the Allow Exhibit 7–9 provides a schedule listing the group totals from the aging schedule and shows how the estimated total amount

VALLEY RANCH SUPPLY ESTIMATED UNCOLLECTIBLE ACCOUNTS RECEIVABLE DECEMBER 31, 2011

*These percentages are estimated each month by the credit manager, based on recent experience and current economic conditions.

At December 31, Valley Ranch Supply has total accounts receivable of $100,000, of which Allow amount of $1,680, 5

If accounts receiv

vel to $5,680. If the allow $4,000, ws:5

exceed the Allow w debit balance. allowance is adjusted each month b -end. If Valley Ranch Supply mak wance account might have a debit balance of $10,000. In this case, the year $15,680 wance up to the required credit balance of $5,680. Regardless of ho wance account of Valley Ranch Supply should be $5,680 at year-end.

Exhibit 7–9 ESTIMATED DOLLAR AMOUNT OF UNCOLLECTIBLE ACCOUNTS

304

Chapter 7 Financial Assets

Determine the difference between the current balance and the required balance

Thus, the follo

the current balance and the required balance is the Uncollectible to the period

Estimating Credit Losses—The Income Statement Approach An ve method of estimating and recording credit losses is called the income statement approach. This method focuses on estimating the uncollectible accounts expense accounts e made in the full amount of the estimated expense, without re Allowance for Doubtful Accounts. T y’s past experience indicates that about 2 percent of its credit sales will prove to be uncollectible. If credit sales for September amount to $150,000, xpense is: The income statement approach

This approach is fast and simple—no aging schedule is required and no consideration is given to the existing balance in the Allow receivable, however, pro the consideration giv vable at the balance sheet date. In past years, man ments. Most businesses today have computer software that quickly and easily prepares vable. Thus most businesses now use the balance sheet approach

RECOVERY OF AN ACCOUNT RECEIVABLE PREVIOUSLY WRITTEN OFF Occasionally a receiv recoveries of bad debts. Collection of vable pre receivable should therefore be reinstated as an asset. Let us assume, for example, that a compan W

Wilson account considered uncollectible

vable from Brad as recorded as follows:

305

Accounts Receivable

If the customer, Brad W the pre

verse ws: Wilson account reinstated

Notice that this

is exactly the opposite

Wilson and to remove his reinstated account from the system. Wilson account previously reinstated is finally collected

DIRECT WRITE-OFF METHOD Some companies do not use any valuation allowance for accounts receivable. Instead of making end-of-period adjusting entries to record uncollectible accounts expense on the basis of ves no attempt to match revenue with the expense of uncollectible accounts. directly to Uncollectible Accounts Expense, as follows:

direct write-off method is used, the accounts receivable will be listed in the balance sheet at their gross amount, and no valuation allowance will be used. The receivables, therefore, are not stated at estimated net realizable value. The allow wance method does a better job of matching revenues and expenses. In some situations, however, use y makes most of its sales for cash, vable will be small in relation to other assets. The expense acceptable because its use does not have a material gulations require taxpayers to use the direct write-of xpense used in computing taxable income. , the allowance method is better because it enables expenses to be matched with the related revenue and thus provides a more logical measurement of net income. Therefore, most companies use the allowance method in 6

FACTORING ACCOUNTS RECEIVABLE factoring factor ving to w 6

e than 500 of these companies use the allow however

usiness sells its accounts receivable to usiness to obtain vables can be collected. ws more

306

Chapter 7 Financial Assets

Factoring accounts receivable is a popular practice among small business organizations that do not have well-established credit. Large and liquid or w mone

YOUR TURN

CREDIT CARD SALES By making sales through credit card companies, merchants receiv credit sales and avoid uncollectible accounts expense. They also avoid the expenses of invesv , and making collections from customers.

Bank Credit Cards

Visa and MasterCard) are issued by banks. When the credit card company is a bank, the retailing business may deposit the signed credit card drafts directly in its bank account. Because banks accept these credit card drafts for immediate deposit, sales to customers using bank credit cards are recorded as cash sales. In e ge ge is deducted from the merchant’s bank account and appears with other bank service charges in the merchant’s monthly bank statement.

Other Credit Cards

American Express), the retailing b account. Instead of debiting Cash, the merchant records an account receivable from the credit card company , the credit card company reimburses the merchant. Businesses, however, are not reimb vable. The agreement between the credit card company and merchants usually allows the credit card company to discount the amount reimbursed by 3½ percent to 5 percent. T w Camera Shop sells a camera for $1,200 to a customer who uses a Quick Char ould be:

307

Notes Receivable and Interest Revenue

This receivable is from the credit card company

At the end of the week, Bradsha Charge Company, which redeems the draft after deducting a 5 percent discount. When payment is received by Bradshaw

The e in the income statement of Bradshaw Camera Shop.

xpenses

Notes Receivable and Interest Revenue v

ged, creditors usu-

Learning Objective

y. maker of the note. payee of the note. In Exhibit 7–10,

LO6

P

Exhibit 7–10

From the viewpoint of the maker, P recorded by crediting the Notes Payable account. However, from the vie First National Bank, this same note is an asset and is recorded by debiting the Notes Receiver of a note expects to pay cash at the (or due date); the payee expects to receive cash at that date.

NATURE OF INTEREST Interest is a charge made for the use of money wer incurs interest expense. A lender venue. When you see notes payable in a company’

308

Chapter 7 Financial Assets

w that the compan wed money, so you should e xpense in its income statement. If you see notes receiv w that the company has loaned money, so you should e venue.

Computing Interest interest: Interest

Principal

Rate of Interest

Time

xpressed as I P R T.) Interest rates usually are stated on an annual basis. For example, the total interest charge on a $200,000, one-year, 6 percent note receivable is computed as follows: P

R

T

$200,000

.06

1

$12,000

four months instead of one year, the total interest revenue ould be $4,000, computed as follows: P

R

T

$200,000

.06

4⁄12

$4,000

simple interest, meaning no interest e will introduce compound interest in Chapter 10.

ACCOUNTING FOR NOTES RECEIVABLE usiness, notes receiv

y occur

tions, for example, notes receiv y’s largest asset cate generate most of the company’s revenue. Some retailers that sell on installment plans, such as Sears Roebuck & Co., also o ge amounts of notes receivable from customers. All notes receiv . The amount debited to Notes Receivable is always the face amount of the note, regardless of received may be larger than the f an Interest Rev Receivable account.

ace amount of the note is credited to the Notes

Illustrative Entries Assume that on December 1, a 3-month, 6 percent note receivable is acquired from a customer

vable of ws:

Note received to replace account receivable

At December 31, the end of the company’ receiv

ws:

Adjusting entry for interest revenue earned in December

T year-end.

y mak

only at v

.

309

Notes Receivable and Interest Revenue

collection of the note will be: Collection of principal and interest

venue of .

If the Maker of a Note Defaults A note receiv ve been defaulted by the maker v T note used in the preceding e

ault of a note, vable

. aulted on the ould have been:

Learning Objective

v

er. The interest receivable on a defaulted note is just as

LO7

v

Financial Analysis and Decision Making

Allete, Inc. 3M (Minnesota Mining and Manufacturing Company)

Exhibit 7–11

Allete 3M Allete

YOUR TURN

310

Allete, Inc.

3M

3M

311

Concluding Remarks

Ethics, Fraud & Corporate Governance COSO IIA IMA FEI AAA

Concluding Remarks xplore the issues involved in accounting for assets. The central theme in these chapters is the valuation of assets. In Exhibit 7–2 (page 289), we hav w a company’ We hav v chapter. In addition to addressing balance sheet valuation issues, we hav ws. In the next two chapters, we explore the valuation of inventories and of plant assets. For each of these assets, you will see that several alternative valuation methods are acceptable. wever, may produce ent results. An understandv

AICPA

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

efine financial assets and explain their valuation LO1

i

LO2

escribe the objectives of cash management and i ternal controls over cash.

ount for uncollectible receivables using the wance and direct write-off methods.

LO5

a

LO3

LO4

epare a bank reconciliation and explain its .

escribe how short-term investments are eported in the balance sheet and account for t tions involving marketable securities.

LO6

lain, compute, and account eceivable and interest revenue.

for notes

LO7

aluate the liquidity of a company’s accounts eceivable.

Key Terms Introduced or Emphasized in Chapter 7

Demonstration Problem

Solution to the Demonstration Problem

GENERAL JOURNAL

GENERAL JOURNAL

Self-Test Questions

Visa

ASSIGNMENT MATERIAL

Discussion Questions

MasterCard American Express

Brief Exercises

accounting

Westinghouse Electric

LO1

LO2

LO2

LO3

LO1

LO4

LO1

LO4

a

Weis Markets

Weis

LO1

LO5

A A

LO1

LO5 A

LO1 E LO5

R

LO7 Molson Coors Brewing Co. Anheuser-Busch Companies, Inc.

LO6

LO5

Weis Sprint Nextel Corporation

Markets LO7

I a

Weis

Sprint

Sprint

Weis Markets

LO7

Exercises

accounting

LO3 Y

LO1

LO2

Apple Computer, Inc.

Apple Computer Apple Computer Apple Computer Apple Computer LO2

E

White Electric Supply

White Electric Supply

LO2

E E

LO3

E B

LO1

LO2

E

Nexity Bank Bank of America Discover Bank Commerce Bank

LO1

Microsoft Corporation LO4

Microsoft Corporation Microsoft Corporation

Microsoft Corporation LO1

LO5

A

LO7

E

Goodyear Tire & Rubber PPL Energy Co. Goodyear

Goodyear PPL LO1 A

LO5

LO1

E

PPL

LO1

E

LO5

LO7

LO1

LO4

LO6 N

Home Depot, Inc.

LO1 Home

LO4

LO5

LO7

Problem Set A LO1

LO3

P

accounting

L02

LO3

LO1

P

LO5

LO1

LO5

U A

LO1

LO4

Footlocker, Inc. The Gap, Inc.

Footlocker, Inc. The Gap, Inc. Footlocker, Inc. The Gap, Inc.

LO6

LO1

LO3

LO7

P

LO1

LO3

LO7

P P

Problem Set B LO1

P

LO3

LO2

LO3

P

LO1

LO5

LO1

P

LO5

LO1

LO4

P

LO6

P N

LO1

LO3

LO7

P

LO1

LO3

LO7

Critical Thinking Cases LO1

LO5

LO6

LO2

LO5

LO7

B

LO1 “I

LO5 LO7

LO1

LO2

R fr E

Bankrate.com www.bankrate.com

http://www.yahoo.com

Answers to Self-Test Questions

CHA P TER 8

© AP Photo/David Kohl

Inventories and the Cost of Goods Sold

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO:

LO1 LO2

LO3 LO4

LO5 LO6 LO7

KROGER CO.

Kroger Co.

Kroger

Kroger

Kroger

■

340

Chapter 8 Inventories and the Cost of Goods Sold

v that sell products. These companies must maintain not only a record of inv sale b ov v included in the income statement when inv account for inv .

xpense w to

INVENTORY DEFINED In a merchandising company, inv wned and held for sale to customers. Inv xpected to be conv y’s operating cycle.1 In the balance sheet, inv vable, because it is just one step f ved from conversion into cash than customer receivables.

The Flow of Inventory Costs wn in the balance sheet at its cost.2 As

Inv items are sold from inv

, their costs are remov venue in the income statement. This

w of costs is illustrated in

Exhibit 8–1

Purchase cost (or manufacturing costs)

.

THE FLOW OF COSTS THROUGH FINANCIAL STATEMENTS

as incurred

as goods are sold

v w of costs. When merchandise is purchased, its cost (net of allowable cash discounts) is added to the asset account Inv . As the merchandise is sold, its cost is removed from the Inv The valuation of inv and to e y cases, inv y’s largest asset, and the cost of goods sold is its largest expense. These two accounts hav valuating the liquidity and profusiness. Sev v ferent methods may 1

As explained in Chapter 6, the oper to conv v v expected to be conv

2

v

v

vable into cash. Assets ycle, whichever is longer garded as orldwide mark

et prices. Exam-

alue their inventories at mark v cost.

alued at

341

y’ v different inv

aluation methods.

WHICH UNIT DID WE SELL? v aluwhich costs should be removed from the Inv W wever, we made a simplifying assumption: All of the units in inv inv costs may v

ven product that were acquired at different costs. Acquisition

When identical units of inv these costs

v

which of

DATA FOR AN ILLUSTRATION T

later

v y sells electrical equipment and supplies. Included in the company’s invenve Elco AC-40 generators. These generators are identical; however o were pur-unit cost of $1,000, $1,200. These s inv Exhibit 8–2.

Elco AC-40

Exhibit 8–2

Elco Manufacturing

Portable generator Daily St. warehouse

Jan. 5

2

$1,000

$2,000

Feb. 5

3

1,200

3,600

Vegas Wholesale Co. 2

{

5

2

$1,000

2

1,000

3

1,200

}

$2,000 5,600

w cost layer is created whenev -unit cost. (As all units comprising a cost v . Therefore, a b ely to hav v y given time.) Now assume that, on March 1, Mead sells one of these Elco generators to Boulder Cony for $1,800 cash. What cost should be remov v

342

Chapter 8 Inventories and the Cost of Goods Sold

tion, or they may adopt a cost w assumption. Either of these approaches is acceptable. Once an approach has been selected, however, it should be applied consistently in accounting for all sales of this particular type of merchandise.

SPECIFIC IDENTIFICATION Learning Objective

I

LO1 c

generators in Mead’s inv appear on the purchase invoices. W

v

vidual units or example, each of the , and these numbers may , Mead’

The actual cost

COST FLOW ASSUMPTIONS If the items in inv homogeneous ferences), it is the seller may follow the more convenient practice of using a

, Using a

where the company has a large number of identical inv dif w assumption is in use, the seller makes an assumption as to the sequence wn from inv . For e oldest merchandise alw to be sold. w assumptions are in widespread use: 1. Average cost. This assumption values all merchandise—units sold and units remaining in inv average per verage-cost method assumes that wn from the inv .) 2. Fir st-out (FIFO). As the name implies, FIFO involv sold are the rst units that were purchased—that is, the oldest goods on hand. Thus the remaining inv 3. Under LIFO, the units sold are assumed to be those most recently acquired. The remaining inv , therefore, is assumed to consist of the earliest purchases. w assumption selected by a company need not cal movement of the company’ nearly identical), it does not matter v usiness that sells units of identical w of costs w of the merchandise. eliminates the need for separ h unit sold and looking up its actual cost. Experience has sho w assumptions provide useful and reliable measurements of the cost of goods sold, as long as they are applied

AVERAGE-COST METHOD When the average-cost method is in use, the average cost of all units in inv puted after ev verage cost is computed by dividing the total cost of goods av v . Because the average cost may change following each purchase, this method also is called the moving average method when a perpetual inv o Elco generators in its inv , each acquired at a v

343

ve Elco generators in inventory, acquired at a total cost of $5,600 (2 units @ $1,000, plus 3 units @ $1,200 $5,600). Therefore, the average per-unit cost now is $1,120 ($5,600 5 units $1,120). y venue from this sale, and the second recognizes the cost of the goods sold. These entries follow, with the cost of goods sold measured by the average-cost method:

venue is the same, regardless of the inv w assumptions.) verage-cost method is in use, the inv Exhibit 8–2. Following the sale on March 1, Mead’ ledger for Elco generators w w the av

.

Exhibit 8–3

Jan. 5

2

$1,000

$2,000

2

$1,000*

$2,000

Feb. 5

3

1,200

3,600

5

$1,120**

5,600

4

$1,120

4,480

Mar. 1

**$5,600 total cost

1

5 units

$1,120

$1,120

$1,120.

$1,200. The Unit Cost columns relating to sales and to the remaining inv , however, show the average unit cost ($5,600 total 5 units $1,120). Under the av v same per-unit cost (the average cost). Hence, it does not matter which units are sold; the cost of goods sold alw v sold would have been $3,360 (3 units

$1,120 per unit).

FIRST-IN, FIRST-OUT METHOD The merchandise purc

method,

FIFO, is based on the assumption that the st st merchandise sold. Thus, the accountant for Mead Electric

344

Chapter 8 Inventories and the Cost of Goods Sold

w

as one of those purchased on J ould be:

Following this sale, Mead’s inv

ould appear as shown in Exhibit 8–4.

Exhibit 8–4 INVENTORY SUBSIDIARY LEDGER—FIFO BASIS

Jan. 5

2

$1,000

$2,000

Feb. 5

3

1,200

3,600

Mar. 1

2

1

v layers. The cost of goods sold for a giv cost layers. T

$1,000

$1,000

{ {

$1,000

} }

2

1,000

3

1,200

1

1,000

3

1,200

$2,000 5,600 4,600

verage cost. Thus, if merchandise v cost volve sev

v four

ould include items at

ent unit costs, as sho

As the cost of goods sold always is recorded at the oldest available purchase costs, the v alued at the more recent acquisition costs.

LAST-IN, FIRST-OUT METHOD The last-in,

method,

LIFO, is among the most widely used aluing inv . As the name suggests,

the most recently using the LIFO method, it would assume that the generator sold on March 1 was one of those acquired on F venould be $1,200. wn below. The inv wn in Exhibit 8–5.

345

Exhibit 8–5

Jan. 5

2

$1,000

$2,000

Feb. 5

3

1,200

3,600

Mar. 1

2

1

$1,200

$1,200

{ {

$1,000

} }

2

1,000

3

1,200

2

1,000

2

1,200

$2,000 5,600 4,400

Lik verage cost. Thus, the inv ve several different cost layers. If a sale includes more units than are included in the most recent cost layer next most recent layer. For e ould be $4,600:

remaining in inv

alued at the oldest acquisition costs.

EVALUATION OF THE METHODS ve e v is applied should be homogeneous

v w assumption is that the units to which the assumption . If each

method can properly match sales revenue with the cost of goods sold. Each inv analysis, the selection of inv wever, the ways should be disclosed in notes accompanying the statements.

Specific Identification

venw-volume items. This is the only method that exactly parallels the w of the merchandise. If each item in the inv valuable paintings, custom je logical choice. ve appeal, because it assigns actual purv . However in inv misleading results not exist. There is also the potential to manipulate the company’ numbers

346

Chapter 8 Inventories and the Cost of Goods Sold

As an example, assume that a coal dealer has purchased 100 tons of coal at a cost of $90 per , the compan same grade of coal— b o purchases are in separate piles; thus it would be possible for the compan ved? The answer is no; et conditions, the coal in each pile is equally valuable. T other is an argument of questionable logic.

Average Cost

Identical items will have the same accounting values only under the average-cost method. Assume, for example, that a hardware store sells a given size nail for 65 cents per pound. The hardware store buys the nails in 100-pound quantities at different times at prices ranging from 40 to 50 cents per pound. Several hundred pounds of nails are always on hand, stored in a large bin. The average-cost method properly recognizes that when a customer b w exactly which nails the customer selected from the bin in order to measure the cost of goods sold. Therefore, the average-cost method av necessary to k v . Also, it is vered to customers. v inv veraged with older costs. Thus neither the valuation of ending inv

First-In, First-Out remain in inv . Over the past 50 years, we have liv prices rise ov

, which means that most lower (older)

inv . By assigning lower costs to the cost of goods sold, FIFO usually causes a b higher pr than w v aluation methods. Some companies fav wever . Some accountants and decision makers believe that FIFO tends to overstate a company’s v et conditions. By offsetting this revenue with a cost of goods sold based on older (and lower) prices, gross profits may be overstated consistently. antage of the FIFO method is that in the balance sheet inv alued

Last-In, First-Out The LIFO method is one of the most interesting and controverw assumptions. The basic assumption in the LIFO method is that the most recently v . This assumption is not w of merchandise in most businesses. Yet there are strong logical ar F more the measurement of income should be based on current market conditions. Therefore, current sales revenue should be offset by the current cost of the merchandise sold. By the LIFO method, the costs assigned to the cost of goods sold are relativ the most recent purchases.

347

aluation of the asset inveny has been

y’s oldest inv in business for man cost of the inv . Thus, when an inv

alued by the LIFO method, the company v

statements. During periods of rising inv west valuation of inv garded as the most of the inv ative method.3 Income tax considerations are the principal strategic reason for the popularity of the LIFO method. Remember that the LIFO method assigns the most recent inv venaluation methods, the LIFO method usually results in lower taxable income. inv It may seem reasonable that a company w vestors and creditors. However, income tax regulations only if the company also uses LIFO vide the ov tegic reason for selecting the LIFO method. allo

DO INVENTORY METHODS REALLY AFFECT PERFORMANCE? es, the answer to this question is no. y might report instead of LIFO. But the company would not really be an v v allocation of costs between the Inv incurred or manufacturing inv . Except for the amount of income tax v xist only on paper. The inv does es owed. To the extent that an inv es, it does . In Exhibit 8–6 we summarize characteristics of the basic inv aluation methods.

THE PRINCIPLE OF CONSISTENCY consistency method, it must follow that method consistently, the next. Thus, once a compan

v

The principle of consistency does not prohibit a compan ever changing its accounting methods. If a change is made, however, the reasons for the change must be explained, and y’

JUST-IN-TIME (JIT) INVENTORY SYSTEMS v uf ve just in time for use in the manuf

w materials w

completing the manuf 3

declining inv ativ

verses: FIFO becomes the ative.

348

Exhibit 8–6

Chapter 8 Inventories and the Cost of Goods Sold

SUMMARY OF INVENTORY VALUATION METHODS

them entirely sho v

almost $1.2 billion (Dell

y’ v Dell Computer Corporation, for example, v CASE IN POINT

Dell Computer Corporation

Dell

Dell

349

The concept of minimizing inv retailers. Ideally, manufacturers have buyers lined up for their merchandise even before the goods are produced. Many retailers, in contrast, w ge selection of in-stock merchandise—which means a big inv . volves much more than minimizing the size of inventories. It has been described as the philosophy of constantly w y vide manage-

Taking a Physical Inventory In Chapter 6 we explained the need for businesses to make a complete physical count of the merchandise on hand at least once a year inv v shrinkage losses, such as theft, spoilage, or breakage. The physical inventory usually is taken at (or near) the end of the company’ .4 vity. For example, many lar

Learning Objective

LO2

RECORDING SHRINKAGE LOSSES In most cases, the year-end physical count of the inv v aged merchandise. The costs of missing or damaged units are removed from the inv

Learning Objective

LO3

T

y’s inv v

ws the following 158 -end:

A year-end physical count, however, discloses that only 148 hand. On the basis of this physical count, the company should adjust its inv The inv same w

y uses FIFO, for example, the missing wn in the inv ve cost $100 per unit and the other 2, $115 per unit. Under $1,030 (8 units @ $100 2 units @ $115). But if this v $1,150 (10 units @ $115). v v ged (debited)

company uses LIFO,

v v

xpense account.

LCM AND OTHER WRITE-DOWNS OF INVENTORY alue of inv has become obsolete or is unsalable for other reasons. If inv written down 4

f

v w

-end is to ensure that an y’ v

ver inv

350

Chapter 8 Inventories and the Cost of Goods Sold

to zero (or to its “scrap value,” if any). A write-down of inv amount of the inv wn is relativ do material in amount, however, it is charged to a special loss account, perhaps entitled Loss from Write-Down of Inv .

The Lower-of-Cost-or-Market (LCM) Rule An asset is an economic resource. It may be ar ould cost to replace that resource in the open market. For this reason, accountants traditionally have valued inv in the balance sheet at the lower of its (1) cost or (2) market value. In this context, “market value” usually means current replacement cost. Thus the inv alued at the lower of its v lower-of-cost-or-market (LCM) rule. applied on the basis of individual inv inv . To illustrate, assume that Joel’ store sells v

v w assumption. The et values shown in Exhibit 8–7.

Exhibit 8–7 APPLYING THE LCM RULE BY INDIVIDUAL ITEM, BY CATEGORY, AND BY TOTAL INVENTORY

Measured at its FIFO cost, the inv in the general ledger individual items, the inv wn to its market value of $26,500. This is accomplished by crediting the Merchandise Inv − debit is char v in gory, it w wn the $29,000 FIFO cost by $1,500 ($29,000 − $27,500). Like on the basis of total in , a write-down of only $500 is required ($29,000 − $28,500). v alued at the lower-of-cost-or-mark , however, the lower of these two amounts is usually cost, especially for companies using LIFO.5

THE YEAR-END CUTOFF OF TRANSACTIONS Making a proper -end are recorded in the correct accounting period. 5 A notable e v hundred million dollars in a single year.

, in which the replacement cost of inv veral

351

One aspect of a proper cutof end of the period are recorded in the inv merchandise on hand at year chandise sold through the end of the period has been remov v and charged to the Cost of Goods Sold. This merchandise should not be included in the yearIf some sales transactions have not been recorded as of year-end, the quantities of merchandise shown in the inv results of the physical count are compared with the inv en for inv chandise is being counted. For this reason, many businesses count their physical inv during nonb ven if they must shut down their sales operations for a day.

Matching Revenue and the Cost of Goods Sold that both the sales rev near year-end are recorded in the same

venues and expenses y’s income statements.

Goods in Transit A sale should be recorded when title to the merchandise passes to the buyer. In making a year sit between the seller and the buyer as to which company owns the merchandise. The answer F.O.B. shipping point, uyer F.O.B. title does not pass until Man

ve within o. In such cases, the amount of merchandise in transit usually is not material in y may follow the most convenient usually is most conv ve and all sales when the merchandise is shipped to the customer. wever example, often have millions of dollars of inv ers. purchases and sales.

YOUR TURN

PERIODIC INVENTORY SYSTEMS In our preceding discussions, we hav v inv ept continuously up-to-date. With the extensive use of technology, today most large business or v Some small businesses, however, use periodic inv v Purchases account,

Learning Objective

LO4

352

Chapter 8 Inventories and the Cost of Goods Sold

rather than to the Inv made recognizing the sales revenue, b v to recognize the cost of goods sold. The inv year-end. At the end of the year, all goods on hand are counted and priced at cost. The cost assigned to this ending inv

The only item in this computation that is kept continuously up-to-date in the accounting v ation. -end inv volves two distinct steps: counting the merchandise and pricing the inv hand. Together, these procedures determine the proper valuation of inv of goods sold.

Applying Flow Assumptions in a Periodic System In our discussion of perpetual inv v v to the cost of goods sold as the sales occur to in at the end of the period. T , a retail store, uses a periodic inv -end physical inv sor are on hand. Purchases of these food processors during the year are listed in .

Exhibit 8–8 SUMMARY OF INVENTORY PURCHASES

In year

, note that of the 30 food processors av 6

We will now

-end inv v

Specific Identification

y must identify

invoices. Assume that these 12 units have an actual total cost of $1,240. The cost of goods 6

v age losses are included automatically in the cost of goods sold.

353

v for sale as sho

Average Cost The av cost is $100 ($3,000

vailable

w:

30 $100

($3,000 cost of goods av

vailable vailable for sale. Thus the average per-unit verage-cost method, the ending inv ould ould be $1,800 v

FIFO The ending inv , therefore, is assumed to consist of the most recently acquired goods. (Remember, we are now talking about the goods remaining in in , not the goods sold.) Thus the inv ould be valued at the following costs: The cost of goods sold would be $1,550 ($3,000 − $1,450).

Notice that the FIFO method results in an inv alued at relatively recent purchase costs. The cost of goods sold, however, is based on the older acquisition costs.

LIFO Therefore, the ending inv earliest purchases. The 12 food processors in inv ould be valued as: The cost of goods sold under the LIFO method is $2,020 ($3,000 − $980).

higher method ($2,020 under LIFO, as compared with $1,550 under FIFO). LIFO always results in a higher cost of goods sold when purchase costs are rising. Thus LIFO tends to minimize periodic systems. Notice also that the LIFO method may result in an ending inv below v and $90 per unit, but the most recent purchase price is $130 per unit. I N T E R N AT I O N A L C A S E I N P O I N T

well

354

Chapter 8 Inventories and the Cost of Goods Sold

Receiving the Maximum Tax Benefit from the LIFO Method Many comv restate costs indicated by the periodic accomplished by either debiting or crediting the Inv

-end inv ve. This restatement is

Often, restating ending inv lower) unit costs than those sho v v , it follows that more of these costs will be assigned to the wer taxable income. ould applying LIFO on a periodic basis at year-end result in a lower valuation of inv e ve food processors was made on December 1, at the relatively high unit cost of $130. Assuming that no additional units were sold in December, they would be included in the year-end inv v ven if these records v ” however, a last-minute purchase is not included in inv ,b Both the LIFO and average-cost methods produce different valuations of inv wever, usually

valuation of inv

.

Pricing the Year-End Inventory by Computer If purchase records are maintained by computer, as is now the case for most companies, the value of the ending inv ve been discussed. Only the number of units must be entered at year ending inv for inv

ge number of low-cost items.

INTERNATIONAL FINANCIAL REPORTING STANDARDS T v v the movement of that cost to the income statement as cost of goods sold. The general prin-

wever, in how those principles are applied. v

verage ference because w requires a company that uses LIFO for tax ay to bring U.S. generally accepted accounting principles

as “convergence” of the two. The f LIFO, and LIFO is the most popular inv to change U.S. standards to preclude the use of LIFO or to include LIFO as an acceptable ely. The most logical approach appears to wing companies accounting by U.S. cial statements. LIFO w and any change in it w process that would be required for such a change is unlik

y’s y years w. The political , but may

355

ev Reporting Standards. There are other areas where accounting for inv

International Financial wer-of-cost-or-market. Under U.S. wn to a lower market

generally accepted accounting standards, once an inv value, recov alue before the inv standards, however, the subsequent recov et value is treated as a reduction in cost v .

IMPORTANCE OF AN ACCURATE VALUATION OF INVENTORY receivable, and inv

. Of these assets, inv gest. It also is the only one ve valuation methods are acceptable. Because of the relatively large size of inv , and because man v Ev aluation of inv v Therefore, care must be taken in counting and pricing the inv -end. aluation of inv v including assets and total owners’ equity e income statement, ending inv v v valuation will ver wing year.

ects of an Error in Valuing Ending Inventory To illustrate, assume that some items of merchandise in a company’s inv , the ending inv

verlook -end understated. The costs of v

included in the cost of goods sold. This ov 7

Invent

ect Two Years

aluation of ending inv ut also the income statement for

the following year. v understated by $10,000. As we hav above, the cost of goods sold in 2011 is ov net income are understated. The ending inv wever, becomes the beginning in in 2012. An v sold and, therefore, an overstatement xactly the on the net incomes of the two successive years. Net income was understated overstated by the same amount in 2012. For this reason, inv balancing” ver a two-year period. The f o successive years does v aluation. Rather, it aggerates the mistrends in the company’ xt.

ects of Errors in Inventory Valuation: A Summary In aluation of ending inv

8–9 we ver two successive

years. In this e surements using the code letters U (understated), O (overstated), and NE aluation of inv gardless of whether the company v NE for o -end in the Following Y . 7

xactly the same in inv

Learning Objective

LO5

356

Chapter 8 Inventories and the Cost of Goods Sold

Exhibit 8–9 EFFECTS OF INVENTORY ERRORS

U U

O O

TECHNIQUES FOR ESTIMATING THE COST OF GOODS SOLD AND THE ENDING INVENTORY Taking a physical inv v if a business using a periodic inv ments, it may estimate

ould be expensive and time-consuming. Therefore, v

xcept at the end of

THE GROSS PROFIT METHOD Learning Objective

gross pr

method v v

LO6

w the rate

e vie is 40 percent of net sales, the cost of goods sold must be 60 percent. The cost of goods sold percentage (or cost ratio wn, the ending inv wing procedures: 1. the cost of goods available for sale ginning inv 2. Estimate the cost of goods sold by multiplying the net sales by the cost ratio. 3. Deduct the estimated cost of goods sold cost of goods available for sale the estimated ending inv . T v that the company’ 60 percent. of the following page.

acts, the inv v or e v

A conv

v v

y must

v -end after the taking of a physical inv v

357

Cost ratio (100%

40%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

When gross profit rate is known:

60%

60%

wever, a satisf ventory.

THE RETAIL METHOD The retail method of estimating inv mine the value of ending inv retail prices. The retail value of ending inv conv T usiness must k vailable for sale at both cost and at retail prices. T alley has merchandise available for sale costing $450,000 for the year customers at retail prices totaling $1,000,000. Thus Ski Valley’s cost ratio for the year is 45 percent ($450,000 alley can use this ratio to conv alue of its ending merchandise inv cost. Assume that Ski Valley’s emplo v year has a total retail value of $300,000. This amount is conv cost using the 45 percent cost ratio as follows:

This application of the retail method approximates a valuation of ending inv verage cost. A widely used variation of this method enables management to estimate a LIFO valuation of ending inv .

“TEXTBOOK” INVENTORY SYSTEMS CAN BE MODIFIED . . . AND THEY OFTEN ARE In this chapter we hav tems. In practice, b businesses also use W

v ent in

ent purposes. v

v

of merchandise bought

y still pro inv v v products on a daily or weekly basis. In effect, the v , real-world inv But the underlying principles remain the same.

xtbook.

Step 1 Determine cost of goods available for sale (COGAS); Step 2 Estimate the cost of goods sold (COGS) (multiply net sales by cost ratio); and Step 3 Deduct estimated COGS from the COGAS to find estimated .

358

Chapter 8 Inventories and the Cost of Goods Sold

Financial Analysis and Decision Making

Target Target

Inventory Turnover

Learning Objective

LO7

C tu

Receivables Turnover

Target

Target Target

YOUR TURN GE Capital

Target

Target

Target

Ethics, Fraud & Corporate Governance

MiniScribe

MiniScribe Corporation

MiniScribe MiniScribe Maxtor Corporation MiniScribe

Concluding Remarks v

v ws and does not necessarily parallel the physical movement of merchandise. Moreover, the choice of valuation by management can hav y’ In the following chapter tive methods used to account for plant and equipment.

359

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

IIn a perpetual inventory system, determine the ost of goods sold using (a) specific identification, ( verage cost, (c) FIFO, and (d) LIFO. Discuss the advantages and shortcomings of each method. LO1

I

LO4

a periodic inventory system, determine the ventory and the cost of goods sold using (a) specific identification, (b) average ost, (c) FIFO, and (d) LIFO.

lain the effects on the income statement of ventory valuation.

LO5

e

LO6

LO2

lain the need for taking a physical inventory.

timate the cost of goods sold and ending i ventory by the gross profit method and by the etail method.

a t

ecord shrinkage losses and other year-end djustments to inventory.

LO3

r ompute the inventory turnover and explain its LO7

Key Terms Introduced or Emphasized in Chapter 8

Demonstration Problem

Solution to the Demonstration Problem

Self-Test Questions

ASSIGNMENT MATERIAL

Discussion Questions

Brief Exercises LO1

LO4

LO1

LO4

LO4 E

LO4 E

LO4 E

accounting

LO3

LO5

LO5

LO7

LO7

Exercises LO1

E A

LO7

accounting

LO1

E

LO4

E

LO4

E E

LO2

E T

LO3

E

LO4

E

LO5

E E

LO6

E E

LO6

E E

LO1

E

General Motors Corporation

LO7

LO1

E F

LO7

Ford Motor Company

Ford Motor Company

Ford

Ford Ford Motor Company

LO7

E

Kraft Foods, Inc.

I

Kraft Kraft Kraft Kraft

LO7

E

Walmart

I

Walmart Walmart Walmart

LO7

E

Home Depot, Inc. Home

Depot, Inc.

Problem Set A LO1

P

LO1

P A

accounting

LO4

P A

LO1

LO3

P

L

LO4

P P

LO5

P

LO2

P

LO3

LO6

LO1

Wal-Mart

LO7

Walmart

Problem Set B L01

P

LO1

P A

LO4

P A

LO1

LO3

P

S

LO4

P P

LO5

P

LO2

P

LO3

LO6

LO1

JC Penney Company

LO7

JC Penney

Critical Thinking Cases LO5

C It

LO4

C L

LO3

LO7

www.sec.gov Safeway, Inc.

Staples, Inc. Safeway

Staples http://www.yahoo.com

Answers to Self-Test Questions

COMPREHENSIVE PROBLEM Guitar Universe, Inc.

GUITAR UNIVERSE, INC. TRIAL BALANCE DECEMBER 31, 2011

2

CHA P TER 9

United Parcel Service of America, Inc.

Plant and Intangible Assets

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO: LO1

LO2

LO3

LO4

LO5

LO6

LO7

LO8

UNITED PARCEL SERVICE

United Parcel Service UPS UPS

UPS

UPS

Intel

Kimberly-Clark Carnival Corporation

United Parcel Service

■

386

Chapter 9 Plant and Intangible Assets

In earlier chapters, we introduced the idea of plant assets and depreciation and stressed the importance of such assets to the successful functioning of businesses. In this chapter, we explore in greater depth the accounting issues surrounding plant assets and discuss intangible assets. Together, plant and intangible assets mak balance sheets because they represent major investments of resources. The future of many b vestment in plant and intangible assets.

PLANT ASSETS AS A “STREAM OF FUTURE SERVICES” Plant assets represent a bundle of future services and, thus, can be thought of as longxpenses. Ownership of a deliv xample, may provide about in essence represents the advance purchase of these transportation services. Similarly, a building represents the advance purchase of man go by, these services are utilized by the business, and the cost of the plant asset gradually is transferred to depreciation e revenue.

MAJOR CATEGORIES OF PLANT ASSETS wing groups: 1. Tangible plant assets. tangible refers to an asset’ ex uilding, or a machine. This cate tw a. Pr eciation. Included are plant assets of limited useful life such as b b. Land. The only plant asset not subject to depreciation is land, which has an unlimited xistence and whose usefulness does not decline over time. 2. Intangible assets. intangible assets is used to describe assets that are used in the operation of the business but hav include patents, cop accounts receiv ven though they also are lacking in physical substance. 3. Natural resources. xtracting or removing some valunatural resource, not as v in as the natural resource is extracted from the site.

ACCOUNTABLE EVENTS IN THE LIVES OF PLANT ASSETS For all cate (1) acquisition, (2) allocation of the acquisition cost to expense over the asset’s useful life (depreciation), and (3) sale or disposal.

Acquisitions of Plant Assets Learning Objective

LO1

a

The cost of a plant asset includes all expenditures that are reasonable and necessary for getting the asset to the desired location and ready for use. Thus many incidental costs may be xample, sales taxes on the purchase price, deliv xample, that a age should be recognized as an e that’s what brought about the need for the repairs.

not added to the cost of the

387

Acquisitions of Plant Assets

Interest charges after the asset is ready for use are recorded as interest e of the cost of the asset. But if a compan wn use, the interest charges during the construction period are vie s cost.

DETERMINING COST: AN EXAMPLE The concept of including in the cost of a plant asset all of the incidental char put the asset in use is illustrated by the following example. A f machine from a Colorado tool manuf ayment will be made in 48 monthly installments of $250, which include $2,000 in interest charges. Sales taxes of ges of $1,350. Installation and other set-up costs puted as follows:

All reasonable and necessary costs are capitalized

*The $2,000 in interest charges on the installment purchase will be recognized as interest expense over the next 48 months. (Accounting for installment notes payable is discussed in the next chapter.)

SOME SPECIAL CONSIDERATIONS Land ers, es paid by the pur. All these expendi-

escrow fees, legal fees for e chaser e

Sometimes land purchased as a building site has on it an old building that is not suitable for the buyer’ ged to the Land account, as well as the costs of tearing down and removing the unusable building.

Land Improvements Improvements to real estate such as driveways, fences, parkve a limited life and are therefore subject to depreciation. For this reason, the Improvements.

Buildings Buildings are sometimes purchased with the intention of remodeling them ged to the uilding has been placed in use, however considered to be maintenance e

Equipment When equipment is purchased, all of the sales taxes, deliv Once the equipment has been placed in operation, maintenance costs (including interest, es) are treated as e

Allocation of a Lump-Sum Purchase Sev be purchased at one time. Separate control accounts are maintained for each type of plant asset, such as land, buildings, and equipment.1 1

depreciation, and book v

388

Chapter 9 Plant and Intangible Assets

uildings (and perhaps other assets) are purchased for a lump sum, the purchase price must be allocated among the types of assets acquired. An appraisal may be xample, that Exercise-for ercise-for-Health purchases the entire facility at a bargain price of $800,000. The allocation of this cost on the basis of an appraisal is illustrated as follows:

Total cost is allocated in proportion to appraised values

Assuming that Exercise-for-Health purchased this f record this acquisition would be:

the total cost

YOUR TURN

Learning Objective

LO2

e e

CAPITAL EXPENDITURES AND REVENUE EXPENDITURES Expenditures for the purchase or expansion of plant assets are called capital expenditures and are recorded in asset accounts. Accountants often use the verb to mean charging an e

389

Depreciation

plant and equipment are called revenue expenditures and are recorded in expense accounts. The charge to an e xpenrev e xpensing” the item. A business may purchase man but that have a relatively lo k related depreciation e extra work involved in dev

ging an expenditure directly to an veral accounting periods astebasut if they are

e have previously mentioned the idea that the v

,e xpenses of the

that are not material

In brief, any material e veral accounting periods is considered a capital expenditure. Any e material in amount is treated as a revenue expenditure. v venue e ward consistent accounting practice from year to year. These polic set a minimum dollar amount (such as $500) for e

Depreciation W to address such topics as residual v

w we expand that discussion ve depreciation methods.

ALLOCATING THE COST OF PLANT AND EQUIPMENT OVER THE YEARS OF USE Tangible plant assets, with the exception of land, are of use to a company for only a limited Depreciation, allocation of the cost e received from the asset. fset the revenue of an accounting period with venue. (See Exhibit 9–1.) Earlier in this chapter, we described a deliv to be received ov v

ved, however, the cost of ved from the balance sheet and becomes an expense, through the

process of depreciation.

Exhibit 9–1

Purchase cost

THE DEPRECIATION PROCESS

as assets purchased

as the services are received

Depreciation: a process of allocating the cost of an asset to expense over the asset’s useful life

390

Chapter 9 Plant and Intangible Assets

xpense consists of a debit to Depreciation ves s cost estimated to hav xpired cost to expense. Separate Depreciation Expense and Accumulated Depreciation accounts are maintained uildings, deliv of different business activities, such as manuf

Depreciation Is Not a Process of Valuation Depreciation is a process of cost allocation, not a process of asset v w et values of plant assets. The market value of a building, for example, may uilding’ of depreciation expense continues, however, without re in market value. Accountants recognize that the b uilding should be systematically allocated to expense at or near the time the expense is recorded. For this reason, depreciation often is called a “noncash” expense. Bear in mind, however, that large cash payments usually are required at the time depreciable assets are purchased.

Book Value Plant assets are shown in the balance sheet at their book values (or values). The book value of a plant asset is its cost minus the related accumulated depreciation asset’s cost that has already been allocated to expense. Thus, book v of the asset’s cost that remains to be allocated to e

CAUSES OF DEPRECIATION The need to systematically allocate plant asset costs ov o major causes: (1) physical deterioration and (2) obsolescence.

Physical Deterioration

Physical deterioration of a plant asset results from use, as well as from exposure to sun, wind, and other climatic factors. When a plant asset has been carefully maintained, it is not uncommon for the owner to claim that the asset is as “good as new. y may lengthen the useful life of a machine, ev ventually reaches the point at which it must be discarded. Making repairs does not eliminate the need for recognition of depreciation.

Obsolescence

obsolescence means the process of becoming out of date because improved, more ef v xample, may become obsolete even though it is in excellent physical condition; it becomes obsolete because vailable.

METHODS OF COMPUTING DEPRECIATION Learning Objective

LO3 d

In Chapter 4, we computed depreciation only by the straight-line depreciation method. veral depreciation methods. Generally accepted accounting principles require only that a depreciation method result in a rational and systematic allocation of cost over the asset’s useful life. The straight-line method is by f The straight-line method allocates an equal portion of depreciation expense to each s useful life. Most of the other depreciation methods are v

391

Depreciation

accelerated depreciation means that larger amounts of depreciation are recognized in the early years of the asset’s life, and smaller amounts are recognized in the later years. Over the entire life of the asset, however, both the straight-line total amount of depreciation. in

. STRAIGHT-LINE METHOD

AN ACCELERATED METHOD

Annual

Annual

expense

expense

Exhibit 9–2 DEPRECIATION METHODS

Years

Years

Both methods recognize the same total depreciation

There are several accelerated methods, each producing slightly dif should be disclosed in notes accompan In this section, we illustrate and explain straight-line depreciation and one v centage-of-declining-balance, or simply the declining-balance follows.

Data for Our Illustrations Our illustrations of depreciation methods are based on the follo acquires a new deliv xpense are:

THE STRAIGHT-LINE METHOD equal portion of the asset’s cost is recognized as depreciation expense in each period of the asset’ xpense is computed by deducting the estimated residual value (or salvage value viding the remaining depreciable cost by the years of estimated useful life. Using the data in our e ws: Cost Residual Value Years of Useful Life

$17,000 $2,000 5 years

$3,000 per year

In Exhibit 9–3, the schedule summarizes the effects of straight-line depreciation over the entire life of the asset.

Computing depreciation by the straight-line method

392

Chapter 9 Plant and Intangible Assets

Exhibit 9–3 DEPRECIATION SCHEDULE

Constant annual depreciation expense

1⁄5

$ 3,000

1⁄5

3,000

1⁄5

3,000

1⁄5

3,000

1⁄5

3,000 $15,000

(We present several depreciation schedules in this chapter. In each schedule we highlight in red those features that we want to emphasize.) alue” in Exhibit 9–3 is the amount of the depreciable cost of the asset that has not yet been recognized as depreciation expense at a point in time. For example, book v $8,000, computed as follows:

Notice that the depreciation expense ov $15,000—the cost of minus the estimated residual value. The residual value is not up” in business operations. Instead, the residual value is expected to be recovered in cash upon disposal of the asset. In practice, residual v y are not expected to be material in considered to hav alues. Assets such as v tion equipment, in contrast, often do have residual values that are material in amount. It often is conv of depreciation rate. tion is in use, the depreciation rate is simply 1 divided by the life (in years) of the asset. The deliv xpense each year is 1⁄5, or 20 percent, of the depreciable amount. Similarly, an asset with a 10-year life has a depreciation rate of 1⁄10, or 10 percent; and an asset with an 8-year life, a depreciation rate of 1⁄8, or 12 1⁄2 percent.

Depreciation for Fractional Periods xpense to the nearest day or week. In fact, such a computation would giv y years, the depreciation applicable to any one year is only an approximation. tion to the nearest whole month. In our example, S&G acquired the deliv s depreciation for the year of acquisition. Assume, however October 1. would have been in use for only 3 months (or 3⁄12 . In this case, depreciation e ould be only $750, or 3⁄12 of a full year’s depreciation ($3,000 3⁄12 $750).

393

Depreciation

half-year convention, is to record one-half year’s depreciation on all assets acquired during the year. This approach is based on the verage out to approximately midyear. The half-year conv . To complete the depreciation process for an asset by the half-year convention, a s depreciation is also taken in the last year of the asset’s life. convention. In the 5-year life.

v

Exhibit 9–4 DEPRECIATION SCHEDULE

First . . . . . . . . . . . . . . . . .

$15,000

1⁄ 5

1⁄2

$ 1,500

Sixth . . . . . . . . . . . . . . . .

15,000

1⁄ 5

1⁄2

1,500

vention is in use, we ignore the date on which the asset was actuone-half year’s depreciation w includes depreciation expense in the sixth year. T year always extends the recognition of depreciation into one additional year. The half-year conv ing the year as a single group. For example, assume that an insurance company purchases ally purchased. W

compan no residual value. Using the half-year convention, the depreciation expense on all of the comws: $600,000 5 years 6⁄12 $60,000. If we did not use the half-year convention, depreciation would have to be computed

THE DECLINING-BALANCE METHOD The most widely used accelerated depreciation method is called centage-ofdeclining-balance depreciation. However 2 returns, Under the declining-balance method, an accelerated depreciation rate is computed as a xpense then is computed by applying this accelerated depreciation rate to the undepreciated cost (book v ws: Depreciation Expense 2

Remaining Book Value

Accelerated Depreciation Rate

ated Cost Reco but most prefer to use MACRS because of its favorable income tax consequences. MACRS is the only

394

Chapter 9 Plant and Intangible Assets

The accelerated depreciation rate remains constant throughout the life of the asset. Hence, the The book value (cost minus accumulated depreciation) decreases e the “declining-balance.” Thus far, we hav

and represents

the accelerated rate is e method of depreciation often is called double-declining-balance (or 200 percent decliningbalance). T wever lower percentage, such as 150 percent of the straight-line rate. This version of the declining-balance method may be described as “150 percent declining-balance.”3

Double-Declining-Balance To illustrate the double-declining-balance method, consider our example of the $17,000 deliv 5 years). Doubling this straight-line rate indicates an accelerated depreciation rate of 40 percent. Each year, we will recognize as depreciation e s book value, as we show in 9–5.

Exhibit 9–5 200% DECLININGBALANCE DEPRECIATION SCHEDULE

$17,000 $17,000

10,200

10,200

6,120

6,120

3,672

3,672 2,203

2,203 203

15,000

2,000

, the asset’s book value is computed s cost. For e , the book value of the asset at the end of the third year is computed as follows:

Recall that book value at the end of the third year by the straight-line method was $8,000. The dif ve is due to the more rapid method. Notice that the estimated residual value of the deliv does not enter into the computation of depreciation expense until the end. This is because the declining-balance method provides an “automatic” residual value. As long as each year’s depreciation expense is equal

3

v

vel. For federal ws do

395

Depreciation

will never be entirely written . However alue, depreciation should stop at this point. v alue of $2,000, the depreciation e limited to $203, rather than the $881 indicated by taking 40 percent of the remaining book value (40% $2,203 $881). With the last year’s depreciation e , the book v to its $2,000 estimated residual value. In Exhibit 9–5 we computed a full year’ w vention were in use, depreciation in the ould be reduced by half, to $3,400. The depreciation in the second year would be ($17,000 $3,400) 40%, or $5,440.

150 Percent Declining-Balance

Now assume that we wanted to depreciate this

30 percent, instead of 40 percent (a 20% straight-line rate tion schedule is in Exhibit 9–6.

150%

30%). This deprecia-

Exhibit 9–6 $17,000 $17,000

30%

11,900

11,900

8,330

8,330

5,831

(5,831

2,000)

3,915

2,000

2

1,916* 1,915*

3,915 15,000

2,000

*Switched to the straight-line method for Years 4 and 5.

Notice that we switched to straight-line depreciation in the last tw ear 3 was $5,831. T residual value of $2,000 at the end of Year 5, $3,831 in depreciation expense must be recognized over the next two years. At this point, larger depreciation charges we simply allocate this $3,831 by the straight-line method, rather than continuing to compute 30 percent of the remaining book value. (In our table, we round the allocation of this amount to the nearest dollar.) Allocating the remaining book value ov does not represent a change in depreciation methods. Rather, a switch to straight-line when this will result in larger depreciation is part of the declining-balance method. This is the way ve at the desired residual value.

WHICH DEPRECIATION METHODS DO MOST BUSINESSES USE? Many b to understand. Accelerated depreciation methods result in higher charges to depreciation expense early in the asset’s life and, therefore, lo publicly o wned companies use straight-line

150% DECLININGBALANCE DEPRECIATION SCHEDULE

396

Chapter 9 Plant and Intangible Assets

F . Management w lowest possible taxable income in the company’ can substantially reduce both taxable income and tax payments for a period of years.4 Accounting principles and income tax la ent depreciation methods y (v

The D erences in Depreciation Methods: Are They “Real”? Using the straight-line depreciation method will cause a company to report

ould be s life. But is the compan no! Depreciation— no matter how it is computed—is only an estimate. on usiness. Thus, a business that uses an accelerated depreciamor than a business that uses straight-line. However are taxes owed. Lower income tax v s life. In the preceding chapter, we made the point that if a company wants to use LIFO in its must No similar requirement exists for depreciation methods. A compan

FINANCIAL STATEMENT DISCLOSURES A company must disclose

that accelerated depreciation methods transfer the costs of plant assets to expense more quickly than the straight-line method. Thus, accelerated methods result in more (lower) asset’

ventually reverse as assets more later into their life cycle.

Estimates of Useful Life and Residual Value

ves and residual values of plant assets is the r gement. These estimates usually are based on the company’s past experience with similar assets, but the y’s ves of similar assets may v y to another. The estimated liv to depreciation expense and the lar however, that all lar

audited

s ves of plant assets are reasonable under the circumstances. Automobiles typically are depreciated over relativ ves—say ver a period of 5 to 15 years. Buildings are depreciated over much longer lives—perhaps 30 to 50 years for a new building and 15 years or more for a building acquired used.

The Principle of Consistency

The consistent application of accounting methods ith respect to depreciation methods, this means that a company does not change from year to year the method used in computing the depreciation expense for a given plant asset. However, 4 For a growing b e year of its recov

usiness may always have more assets in the early years

397

Other Depreciation Methods

management may as we hav

ferent assets. Also, , a company may—and often must

Revision of Estimated Useful Lives

w years of

period than w

revised estimate xpense decreased or increased accordingly. The procedure for changing the depreciation schedule is to spread the remaining undepreciated cost of the asset over the years of remaining useful life. amount of depreciation e not re lives of depreciable assets. T y acquires a $10,000 asset estimated to have a 5-year useful life and no residual v expense is $2,000. At the end of the third year, accumulated depreciation is $6,000, and the alue) of $4,000. At the be , management decides that the asset will last for 5 more years. The re e computed as follows:

remaining years

5 years ($4,000

5)

THE IMPAIRMENT OF PLANT ASSETS Sometimes, it becomes apparent that a company cannot reasonably expect to recover the caror example, a computer manuf v If new technology renders the equipment obsolete, however, it may become apparent that it is w v should be written down to its fair v impairment loss account. CASE IN POINT JCPenney

Other Depreciation Methods Learning Objective

wever, any rational and systematic method is acceptable, as long as costs are allocated to expense in a reasonable manner. Several such methods are discussed here.

LO4

398

Chapter 9 Plant and Intangible Assets

THE UNITS-OF-OUTPUT METHOD Under the units-of-output method, depreciation is based on some measure of output rather than vily used. To illustrate this method, consider S&G’s deliv estimated salvage v driven 100,000 miles. The depreciation rate per mile of operation is 15 cents, computed as follows: Cost

Residual Value $17,000 $2,000 100,000 miles

Cost per Unit of Output (Mile) $0.15 Depreciation per Mile

At the end of each year ven during the year. is stopped. This method provides an excellent matching of expense with revenue. However, the able accuracy. Also, this method is used only for assets such as v . Assets such as b

v

In many cases, units-of-output is an accelerated method. Often assets are used more extensively in the earlier years of their useful lives than in the later years.

MACRS Most businesses use a depreciation method called MACRS Recov usinesses also use this y do not have to compute depreciation in several different ways. MACRS is based on the declining-balance method, but should be considered designated “reco and the assumption of no salvage value are reasonable. For publicly traded companies, the use of MACRS

SUM-OF-THE-YEARS’ DIGITS Sum-of-the-years’ digits, or SYD, duces results that lie between the double-declining-balance and 150 percent-decliningbalance methods. y accounting textbooks. But it is the most comple volved. SYD is rarely used in today’s business world. Because of its complexity, it is even less frequently used in small b ws usuw or these reasons, we defer coverage of the mechanics of this method to later accounting courses.

DECELERATED DEPRECIATION METHODS Depreciation methods e less depreciation expense in the early years of an asset’s useful life and more in the later years. Such methods may achieve a reasonable matching of depreciation expense and revenue when the plant asset is expected to become increasingly productive over time. Utility companies, for example, may use these methods for new po These depreciation methods are rarely used; thus we defer coverage to later accounting courses.

399

Disposal of Plant and Equipment

DEPRECIATION METHODS IN USE: A SURVEY Ev vey of 600 publicly o

A) conducts a sur-

xceeds 600 because some companies use dif For many consecutive years, the straight-line method has consistently been by far the most act, in most years the straightline method accounts for approximately 90 percent of the depreciation methods used by these 600 companies. Other methods cov methods—are used relatively infrequently. e

Straight-line is clearly the method most widely used in financial statements

MACRS.

Disposal of Plant and Equipment When depreciable assets are disposed of at any date other than the end of the year should be made to record depreciation for the fraction of the year ending with the date of vention is in use, six months’ depreciation should be recorded on . In the following illustrations of the disposal of items of plant and equipment, it is assumed that an tion already have been recorded. As units of plant and equipment wear out or become obsolete, they must be scrapped, sold, or traded in on new equipment. Upon the disposal or retirement of a depreciable asset, the v remov xample, that of

LO5

ws: Scrapping a fully depreciated asset

Once an asset has been fully depreciated, no more depreciation should be recorded on it, ev ve of depreciation is to spread the cost of an asset over the periods of its usefulness; in no case can depreciation e in use be asset is retired.

GAINS AND LOSSES ON THE DISPOSAL OF PLANT AND EQUIPMENT Since the residual values and useful lives of plant assets are only estimates, it is not uncommon for a plant asset to be disposed of at an amount that differs from its book value at the date of disposal. When plant assets are sold, any gain or loss on the disposal is computed by comparing the book value with the amount received from the sale. A sales price in excess of the book value produces a gain; a sales price below the book value produces a loss. These gains or losses, if material in amount, should be shown separately in the income statement following the computation of income from operations, usually in a section titled “other income.”

400

Chapter 9 Plant and Intangible Assets

Disposal at a Price above Book Value

Assume that a machine costing $10,000 had accumulated depreciation of $8,000 and a book value of $2,000 at the time it was sold for ws:

Gain on disposal of plant asset Gain on Disposal of Plant Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,000

In this situation, the gain on the disposal is calculated as follows:

Disposal at a Price below Book Value

Now assume instead that the same ould be as follows:

Loss on disposal of plant asset Loss on Disposal of Plant Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,500

In this situation, the loss on the disposal is calculated as follows:

The disposal of a depreciable asset at a price equal to book value results in neither a gain ved, account for the original cost.

TRADING IN USED ASSETS FOR NEW ONES for ne wed as both a sale of the old asset and a purchase of a new one. Transactions of this type are usually considered to have “commercial substance,” and give rise to the recognition of a gain or loss. To illustrate, assume that Rancho Landscape has an old pickup truck that originally cost $10,000 but that now has a book value (and tax basis) of $2,000. Rancho trades in this old truck for a new one with a fair market v Rancho a trade-in allow $21,500 cost of the ne as follows:

401

Intangible Assets

trade-in

Notice that Rancho treats the $3,500 trade-in allowance granted by the dealership as the sales price $1,500 gain of this asset ($3,500 trade-in allowance $2,000 book value $1,500 gain). F the accounting records whenev volv not or losses on e xample is not regarded as taxable income.5

INTERNATIONAL FINANCIAL REPORTING STANDARDS v that depreciation is a process of allocating or spreading that cost ov asset. Under U.S. generally accepted accounting principles, this emphasis on cost and deprethe plant assets which contrib accumulated depreciation is the amount sho

y’s income. Cost reduced by

alue is recorded as described earlier. ve an option to follow a revaluas useful life. This rev ve requires that an asset’s fair value can be reliably measured and it must be applied to an entire class of plant assets. Revaluation is not required ev (i.e., its rev it w air v If an asset’ recorded in other comprehensiv greater depth in Chapter 12 of this textbook.

valuation, the increase is . This subject is covered in

Intangible Assets CHARACTERISTICS As the word intangible

ve no physical characteristics.

the balance sheet as a subgroup of plant assets. However, not all assets that lack physical substance are regarded as intangible assets. An account receivable, for example, has no physical attributes b intangible assets are assets that are used in the operation of the business but that have no physical substance and are noncurrent. The basis of valuation for intangible assets is cost. In some companies, however ut may have been acquired their cost, re treated as revenue e 5

w

alue to the company velopment. If these costs are xpenses).

they are

ould not be deductible in the

Learning Objective

LO6

402

Chapter 9 Plant and Intangible Assets

OPERATING EXPENSES VERSUS INTANGIBLE ASSETS For an expenditure to qualify as an intangible asset, there must be reasonable evidence of ye years, but the e treat these e xpenses. Examples are the e xpense of training employees to work with new types of machinbe versal practice to treat e

AMORTIZATION xpense of the cost of an intan-

amortization gible asset ov

asset account, b

cost of the intangible asset should, therefore, be deducted from revenue during the years in which it may be expected to aid in producing rev

GOODWILL The intangible asset goodwill a variety of meanings in our general vocab

ord has

favorable intangible attrib y. For example, assume a company purchases another company that has a favorable reputation for high-quality customer service. The purchasing company might be willing to pay a price to acquire this fav ute because of the positiv xpected to have . Even though an intangible asset such as a favorable reputation for cusy. av y to operate at a greater

v

utes expected .

Positive attrib • • • • • •

Favorable reputation. Positive market share. Positive adv image. Reputation for high quality and loyal employees. management. Manuf and other operating y.

utes can be expected to contribute to positiv ing company. The present value investor would pay today for the right to receiv

ws of the acquirwledgeable ws. (The present value

ve an abo return y’ explain the phrase normal r refers to assets minus liabilities, or owners’ equity wever, and the e ve-average net assets, is used to mean all assets except goodwill, minus liabilities.

403

Intangible Assets

A normal return

vestors demand in uying a business at the fair v assets. A business has goodwill when investors will pay a higher price because the business more Assume that tw fair market v . The relativ wer of the tw ve years is as follows:

more?

Earnings in excess of normal . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

–0–

$

50,000

An investor presumably would be willing to pay $1,000,000 to b air market value assets, an investor should be willing to pay more for Golden Dragon than for Mandarin Coast, extra amount that a buyer pays alue of this business’s goodwill.

Estimating Goodwill How much will an investor pay for goodwill? Above-average ve purchasers only if they believe that will continue after they acquire the business. Investors’ appraisals of goodwill, therefore, will v future earning power of the business. Few businesses, however, are able to maintain above-av . Consequently, the purchaser of a business will usually limit any amount paid for goodwill to not more than four v Estimating an amount for goodwill in the purchase of a b tive process. In attempting to mak usiness will add so much value usiness that you are willing to pay a price greater than the value of the idenusiness you are acquiring. For example, in the previous example, how much more than $1,000,000 w w ut whether that e future requires considerable judgment. Several methods e alue on the amount of goodwill in the purchase of a business. A widely used method that is consistent with the description of goodwill is to value the b or e 6 This suggests that Golden Dragon is w $1,300,000, which is the company’s $200,000 average net income times 6.5. Because the company’ ve a fair value of only $1,000,000, a reasonable estimate of the positive attributes of Golden Dragon, such as positive reputation or market share, is $300,000, as follows:

6

vestments in small businesses involv panies. F of publicly o

v usinesses tend to be substantially lower than those

404

Chapter 9 Plant and Intangible Assets

If a b usiness, $300,000 of goodwill would be recorded. On the other hand, if the b for less than $1,300,000, say, $1,250,000, only $250,000 of goodwill would be recorded ($1,250,000 $1,000,000 $250,000), even though the estimated value of goodwill is more

Recording Goodwill in the Accounts Because of the dif

vely estimating the v is purchased when one company buys another has purchased at their fair values and then establishes any additional amount paid to an asset account entitled Goodwill. Many businesses never purchase goodwill but dev utes like good customer relations, superior management, or other factors that result in above-av Because there is no objective w usinot recorded in the accounting records. The does not indicate a company’ et value. For man ver a period not exceeding 40 years. Goodwill is no longer required to be ut is no alue, similar to that for plant assets as explained earlier in this chapter recov a loss in the income statement of the same accounting period.

I N T E R N AT I O N A L C A S E I N P O I N T

PATENTS A patent is an exclusiv

vernment for manufacture, use, and xclusive grant is to encourage the invention of new products and processes. When a company acquires a patent by purchase from the inventor or other holder, the purchase price is recorded in an intangible asset account Patents. P xceed that wever, if the patent is lik the inv ve years of the legal life have expired. The remaining legal life is, therefore, 15 years. But if the estimated useful xpense would be:

405

Intangible Assets

patent

TRADEMARKS AND TRADE NAMES Coca-Cola’s famous name, usually printed in a distinctive typeface, is a classic example of a xclusive right to use a trademark, brand name, or commercial symbol may be obtained by re v The costs of dev paigns, which should be treated as e purchased, however, the cost may be substantial. Such cost should be capitalized and amortized to expense ov xpected to be used. If y .

FRANCHISES y or a gov xample of a franchise is the right to operate a McDonald’s geographic re to e

v

ve years. When the cost

wever, should not exceed the xpected to generate revenue.

COPYRIGHTS A cop

xclusive right granted by the federal gov

plus 70 years. The cost of obtaining a cop geable to expense when paid. Only when a cop purchased from an existing o xpenditure be material enough to w capitalized and spread over the useful life. The revenue from copyrights is usually limited to only a fe over the years in which the revenue is expected.

OTHER INTANGIBLES AND DEFERRED CHARGES ge

© The McGraw-Hill Companies, Inc./John Flournoy, photographer/DAL

ges, meaning expenditures that will pro f to expense ov ves. It is also common practice to combine these items under the heading of Other Assets, which is listed at the bottom of the asset section of the balance sheet.

RESEARCH AND DEVELOPMENT (R&D) COSTS Billions of dollars are spent each year on research and development of new products. In fact, e development e xpenses.

406

Chapter 9 Plant and Intangible Assets

In the past, some companies treated all research and development costs as expenses in the v

v

v

velopment e expense when incurred. This action by the F v

Financial Analysis and Decision Making

Exhibit 9–7 DuPont Dow Chemical Sun Microsystems Silicon Graphics Eli Lilly & Co. Pfizer Oracle Microsoft

YOUR TURN

ged to fect of reducing the -

407

Natural Resources

Natural Resources ACCOUNTING FOR NATURAL RESOURCES resources. The distinguishing characteristic of these assets is that they are physically removed v v . Theoretically, a coal mine might be regarded as an under v wever, such an inv -

Learning Objective

LO7

, plant, and equipment. Once the coal is removed from the ground, however, this coal does represent inv . We have explained that plant assets such as buildings and equipment depreciate because of e does not depreciate for these reasons, but it is gradually depleted v all of the coal has been remov and will be abandoned or sold for its residual value. To illustrate the depletion $45 million to acquire the Red Valley Mine, which is believ The residual v ved is estimated to be $5 million. The depletion that will occur ov alue, or $40 million. This depletion will occur at the rate of $4 per ton ($40 million 10 million tons) as the coal is remov ould be as follows: Recording depletion

Once removed from the mine, coal becomes available for sale. Therefore, the estimated cost of this coal is added to the Inv from the Inv contra-asset account similar to the Accumulated DepreciaRainbow Minerals’s balance sheet, the Red Valley Mine now appears as follows: The mine gradually is turned into inventory

Depreciation of Buildings and Equipment Closely Related to Natural Resources , such assets should be depreciated over their ves or ov whichever is shorter. ciation on such assets is computed using the units-of-output method, which was discussed earlier in the chapter ved.

DEPRECIATION, AMORTIZATION, AND DEPLETION— A COMMON GOAL ve a common goal. That goal is to over the years in which the asset contributes to revenue. Allocating the acquisition cost of long-lived assets ov

408

Chapter 9 Plant and Intangible Assets

application of the matching principle. enue with the e

vvenue.

Plant Transactions and the Statement of Cash Flows Learning Objective

LO8

purchased— or, more precisely (These receipts are equal to the total proceeds receiv an ws relating to acquisitions and disposals of plant assets appear in the stateinvesting activities. xpense both reduce net income, but they have As a result, both tend to make net income less ws from operating activities. Like wn of impaired assets is another example of a noncash charge or expense against income having no immediate ef ws.

t a

Noncash Investing Activities or example, a company

Ethics, Fraud & Corporate Governance

WorldCom WorldCom WorldCom WorldCom Inc. WorldCom

WorldCom WorldCom Enron WorldCom Enron WorldCom WorldCom WorldCom WorldCom

WorldCom WorldCom WorldCom WorldCom

409

Concluding Remarks

in exchange for notes receivable. The noncash aspects of inv

vities are ws. This schedule

xplained in Chapter 13.

Concluding Remarks review, we hav ace value, marketable securities at their market value, accounts receivable at their net realizable value (i.e., net amount of cash expected to be collected), inventories at the lower-of-cost-or-market, and plant assets at cost less accumulated depreciation. Two ideas that hav aluation bases are the y xpense into the income statement. Closely related to this is the objective of not ov and future expectations of a company’ vities by overstating assets and underxpenses. In the next chapter, we turn our attention to the measurement and presentation of liabilities.

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

etermine the cost of plant assets. LO1

lain the nature of intangible assets, including LO2

istinguish between capital expenditures and evenue expenditures. a

LO3

ompute depreciation by the straight-line and eclining-balance methods.

LO6

a ount for the depletion of natural resources. LO7

ount for depreciation using methods other traight-line or declining-balance.

LO4

c LO8

Account for the disposal of plant assets. LO5

r

Key Terms Introduced or Emphasized in Chapter 9

lain the cash effects of transactions involving lant assets.

Demonstration Problem

Solution to the Demonstration Problem

Self-Test Questions

ASSIGNMENT MATERIAL Coca-Cola

Discussion Questions

Brief Exercises LO1 LO2

LO3 E

LO3

LO3 E

accounting

LO3

LO4

U

LO3 LO5

P

LO3

LO5

P

LO6

LO7

LO4

Exercise LO2 LO3

accounting

LO1

LO2

E

LO3

LO3

H. J. Heinz Company

LO3 E

LO3

LO5 A

LO6 E

LO5

Food Lion, Inc. T

LO8

Food Lion

LO1 LO6

LO7

LO6 LO8

LO4

LO4

Home Depot

LO1 Home

LO3

F t

Home Depot Home Depot Home Depot

Problem Set A LO1

LO3

accounting

LO3 LO5

LO1

LO3 LO5

S A

LO5

LO6 A

LO6 A

LO4 A

LO2 D

LO3 LO5

Problem Set B LO1

P D

LO3

LO3

P C

LO5

A

accounting

LO1

LO3

LO5

LO5

P D

LO6 A

LO6

LO4 A

LO2

P

LO3

I

LO5

Critical Thinking Cases LO3

LO1

LO3

C D

LO4

LO2 C

International Paper Company

LO2

Yahoo, Google

http://www.yahoo.com

Answers to Self-Test Questions

CHA P TER 10

Liabilities A F TE R ST U DY IN G THI S CH AP TE R , YO U S HO U LD B E A BL E TO :

LO1

LO2

LO3

LO4

LO5

LO6

LO7

LO8

LO9

LO10

Learning Objectives © ThinkStock/PunchStock/DAL

DUPONT

DuPont

DuPont

DuPont

■

430

Chapter 10 Liabilities

Creditors and investors ev w to usinesses. This chapter provides a basic understanding of concepts related to liabilities and describes ho ments. In addition, the impact of debt on v

THE NATURE OF LIABILITIES debts or obligations arising from past transactions or events v .

Learning Objective

LO1 c li

however

Distinction between Debt and Equity

Businesses have two basic sources of wners’ equity in several wners’ equity is that all liabilities ev mature—that is, they come due. Owners’ equity does not mature. The date on which a liability comes due is called the maturity date.1 Although all liabilities ev . Some liabilities are so wners’ equity

ey liabilities may be a critical factor in the solvency of a business. The pro wed capital are creditors of the business, not owners. As creditors, they hav usiness but usually do not hav b wners, managers, and creditors may be modiwever, in an indenture contract. Creditors sometimes insist on being granted some control over b usiness management salaries and on dividends, and may require the creditor’s approval for additional wing or for large capital e The claims of creditors have le over the claims of o usiness ceases operations and liquidates, creditors must be paid in full before an utions are made to the owners. The relativ wever, can v collateral for a loan. If the wer defaults on a secured loan, the creditor may foreclose on the pledged assets. Assets that hav ying the wer’ general credit obligations. The

Many Liabilities Bear Interest wer’ in future shown as an e

Man as of the balance sheet date wer’s obligation to pay interest ut it is not

.

Estimated Liabilities xpenses, such as interest payable and salaries payable. In some cases, however, the dollar amount of a liability must be estimated at the balance sheet date.

1

Some liabilities are due on demand, Liabilities due on demand may come due at an

s request.

431

Current Liabilities

Estimated liabilities have two basic characteristics: The liability is xist, but the or instance, the automobiles sold by most automakers are accompanied by a w er to replace defectiv veral years. As each car is sold, the automaker incurs a liabily work that may be required under the w . The dollar amount of this liability, however, can only be estimated.

Current Liabilities cycle, whichever is longer e

-

liabilities. assets. The amount of ratio

able, income tax

current aluable indicators of a company’s abil-

venue.

ACCOUNTS PAYABLE vided into the categories of trade accounts payable. T chases of merchandise. Other accounts payable include liabilities for an

other -

Technically, the date at which a trade account payable comes into existence depends on whether goods are purchased F .O.B. destination. Under F chandise is shipped by the supplier. Under F title of o received by the buyer. However, unless material .O.B. shipping point, most companies follow the convenient practice of recording trade accounts payable when merchandise is received.

NOTES PAYABLE Notes payable are issued whenev

ve

Learning Objective

LO2

wer to pay an interest char , the interest principal amount of the note.2 T v for a period of six months at an annual interest rate of 12 percent. Six months later on May 1, y will hav est ($10,000 .12 6⁄12). As e y to issue a note payable similar to the one in Exhibit 10–1.

2

ve is to include the interest charges in the f , lar

ws.

432

Chapter 10 Liabilities

Exhibit 10–1 A NOTE PAYABLE

y’s accounting records for this Nov

wing is:

the face amount of the note

Notice that no liability is recorded for the interest charges when the note is issued. At the date that mone only for the principal amount of the loan; ver the life of the loan. At December 31, two months’ interest e wing year

accrues day by day

For simplicity year-end.

y mak

only at

Payment of principal and interest

y paid this note prior to May 1, interest charges usually would be computed only through the date of early payment.3

THE CURRENT PORTION OF LONG-TERM DEBT terly installments. In these cases, the principal amount due within one year (or the operating 3

wever, some v

is made early

433

Current Liabilities

cycle) is re liability. v 4

the balance sheet date are r

Changing the wn in

ACCRUED LIABILITIES arise from the recognition of expenses for which payment will be made accrued expenses. Examples of es payable, and a number of liabilities xpenses, the matching

Accrued

principle gov wever, these liabilities are paid at als. Therefore, the accounts payable.

PAYROLL LIABILITIES yond the scope of this text. But we believe that ev ve some understanding of the various costs associated with payrolls. Emplo addition to the w wed to employees. In fact, the total wages and salaries e To illustrate, assume that Fulbright Medical Lab emplo yees. If monthly wages for this w total by this employer w , as shown in Exhibit 10–2.

Learning Objective

LO3

Exhibit 10–2 7,650 6,200 4,000 6,000 9,500

The amounts in Exhibit 10–2 sho red are payroll taxes and insurance premiums required by law. Costs shown in green w but often are included in the total compensation package provided to employees at the discretion of the employer. In our e xceed wages expense by more than 30 percent. This relationship will vary from one employer to another, but our illustration is typical of many payrolls.

Payroll Taxes and Mandated Costs All emplo Medicare taxes on the w

yee. The percentages of the employee’s . Federal unemployment taxes apply only to es

es v the rst may v 4

r

(that is, extended or rene , even though it will

THE COMPUTATION OF TOTAL PAYROLL COSTS

434

Chapter 10 Liabilities

vides insurance to employ-

Workers’ compensation . Lik

paid in advance orkers’ Compensation Insurance, and by crediting Cash. The premiums v xample, roofers), workers’ compensation premiums may exceed 50 percent of the employees’ wages.

Other Payroll-Related Costs

Many employers pay some or all of the costs of health and life insurance for their employees and their family members, as well as make contributions to emplo utions to employee pension plans, if any, v yers.

Amounts Withheld from Employees’ Pay

Thus far es and other mandated costs levied on the employer. Employees, too, incur tax es, employees share in es.5 Emplo 6 their emplo (The net ve been made is yees’ take-home pay.) In our illustration, Fulbright Medical Lab’s 20 emplo ages of $100,000 in January. Their tak as shown in Exhibit 10–3, using assumed numbers for state and federal income tax withholdings.

Exhibit 10–3 COMPUTATION OF EMPLOYEE TAKE-HOME PAY

Employers act as tax collectors by withholding taxes from their employees

yees’ pay do not represent taxes on the employer. ages and salaries expense that must be sent directly to the tax authorities, rather than paid to the employees. In essence, the employer is required by law to act as the tax collector. In the employer’s balance arded to the proper ut the es of the employer.

Recording Payroll Activities vities. In Exhibit 10–2, the lab’s total sented gross w yees, $17,850 represented emplo es and other mandated costs (shown in red), and $15,500 represented other emplo for by the employer (shown in green). The accounting for these three amounts by Fulbright Medical Lab is summarized in Exhibit 10–4.

5

es are levied on employees at the same percentage rate as levied upon

employers. yee’ no cap on employee w 6 In many companies, employers mak

es. There is es. yees share in paying for the

435

Long-Term Liabilities

Exhibit 10–4 PAYROLL ACTIVITIES RECORDED BY THE EMPLOYER

red

7,650 6,200 4,000

green 6,000 9,500

UNEARNED REVENUE venue arises when a customer pays in advance. Upon receipt of an , the compan venue or Customers’ Deposits. As the services are rendered to the customer venue account. Notice v tor, rather than by making cash payments. v vities involved v usiness’ ycle. adv

Long-Term Liabilities assets, the purchase of another company v

vely few in

number but often involve lar from routine operating transactions. Many businesses re often are r

ve to owners’ equity as a v y —that is, the maturing obligation simply is replaced with a new long-

business.

MATURING OBLIGATIONS INTENDED TO BE REFINANCED but that is e

or example, a company may

436

Chapter 10 Liabilities

have a bank loan that comes due each year but is routinely extended for the following year. Both the compan basis. If management has both the intent and the the accountant looks to the economic substance ard economic substance. “Substance takes precedence over form.” Today’s business world is characterized by transactions of ever-increasing comple . Recognizing those

I N T E R N AT I O N A L C A S E I N P O I N T

INSTALLMENT NOTES PAYABLE ) may be due monthly tizing.

, semiannually, or at an

al. If these wever, installment notes contain a due date at which the remaining unpaid ges wever

eater than

. As the amount o successive payment representing interest expense decreases, repayment of principal increases.

Allocating Installment Payments between Interest and Principal

Learning Objective

LO4

t b p

ward In

ment that represents interest e . This distinction is made in advance by preparing an amortization table. T ear 1, King’ cost of $16,398. In payment, the compan plus interest at 12 percent per annum (or 1 percent per month). This note will be paid in 18 monthly installments of $1,000 each, beginning on Nov this installment note payable is shown in Exhibit 10–5 (amounts of interest expense are rounded to the nearest dollar).

Preparing an Amortization Table Let us explore the content of Exhibit 10–5. First, notice that the payments are made on a monthly basis. Therefore, the amounts of the (column C) are all monthly amounts.

437

Long-Term Liabilities

AMORTIZATION TABLE (12% NOTE PAYABLE FOR $16,398; PAYABLE IN 18 MONTHLY INSTALLMENTS OF $1,000)

*In the last period, interest expense is equal to the amount of the final payment minus the remaining unpaid balance. This

period of time —in this case, one month. Thus, if payments are made monthly, column B must be based on the monthly , this column w gins with the original amount of the liability ($16,398) listed at wn in xpense, shown in balance at the beginning of that month. Finally Rather than continuing to make monthly payments, King’ wn as the unpaid balance. Notice that the amount of interest e because the unpaid balance is continually decreasing.7 volves making the same computations, based on a ne y length can be easily an

7

note would increase ne

xpense, the unpaid balance of the

less ould cause the interest e

Exhibit 10–5 FOR A NOTE PAYABLE

438

Chapter 10 Liabilities

and quickly prepared by computer software. (Most “mone

are includes

, (2) the amount of periodic payments,

Using an Amortization Table or e

vember 15, Year 1) is:

Payment is allocated principal

Similarly

second payment, made on December 15, Year 1, is:

Notice that interest expense is less in December

At December 31, Y

s

balance sho

Year-end adjusting entry

The Current Portion of Long-Term Debt

Notice that as of December 31, Year 1, the unpaid balance of this note is $14,718. As of December 31, Year 2, however, the unpaid $10,814 ear 2 ($14,718 $3,904 Y months curr . .

BONDS PAYABLE Learning Objective

LO5

b t f

ge project, such as dev pany y single lender can supply tion needs to raise lar (or more)—it generally sells additional shares of capital stock or issues bonds payable.

WHAT ARE BONDS? able units, called bonds. Each bond represents a long-term, interest-bearing note payable, usually in the f alue) of $1,000 or some multiple of $1,000. The bonds are sold v v

439

Long-Term Liabilities

Bonds usually are v transferable, however, so individual bondholders may sell their bonds to other investors at any contract rate throughout the life of the bond. Thus investors ed income” inv An e ½ percent bonds of Pacific Bell (a P Telesis company, known as PacBell), due August 15, 2031. Interest on these bonds is payith this bond issue, PacBell wed $225 million by issuing 225,000 bonds of $1,000 each. PacBell holder is issued a single indicating the number of bonds purchased. Each ace amount of $25,000 and, therefore, represents ownership of 25 bonds. Inv uy thousands of bonds at one time.

The Issuance of Bonds Payable v

underwriter.

by selling the bonds to the inv ance of the bonds at the net amount receiv amount of the proceeds will be av

Transferability of Bonds e capital stocks, are traded daily on organized securities exchanges, such as the New York Bond Exchange. The holders of a 25-year bond issue need not wait 25 years to conv vestments into cash. By placing a telephone call to a broker, an investor may sell bonds within a matter of minutes at the going mark This is one of the most attractiv v rate bonds. Quoted Market Prices Bond prices are quoted as a percentage of their face value or v alue is the amount the issuing company must pay to redeem the bond at the date it © Digital Vision/Getty Images/DAL matures (becomes due). A $1,000 bond quoted at 102 would therefore have a market price of $1,020 (102 percent of $1,000). Bond prices are quoted at the nearest oneeighth of a percentage point. The following line for a hypothetical compan v vious day’s trading in bonds.

Alvaro’s 81⁄2 percent, $1,000 $975 for a bond of $1,000 face value. The lowest price was 95½, or $955 for a $1,000 bond. The closing price (last sale of the day) was 97, or $970. This was one point above the closing vious day, an increase of $10 in the price of a $1,000 bond.

Types of Bonds mortgage bonds. An unsecured bond is called a debenture bond; its value rests on the general credit ve a higher inv

440

Chapter 10 Liabilities

months’ interest on the bonds he or she owns.8 Many bonds are callable, which means that in advance of the maturity date by paying a call price. To compensate bondholders for being forced to give up their inv what higher than the face value of the bonds. Traditionally, bonds hav ative inv v o make a bond issue more attractive to these inv fund, designated for repaying the bonds . At re vailable for the payment of wn in the balance sheet under the caption “Long-T Inv ” which appears belo v version privilege in the bond indenture. A convertible bond is one that may be exchanged at the option et value of a conv et value of an equivalent number of shares of capital stock.

Junk Bonds

ve issued securities that have come to volves a substantially greater

wn as junk bonds.

o v higher rate of interest than do “investment quality” bonds.

TAX ADVANTAGE OF BOND FINANCING antage of raising money by issuing bonds instead of stock is that interest payments are deductible es. Dividends wever, are not deductible in computing taxable income. T es at a rate of 30 percent on its taxinterest expense of $1 million per year. This interest expense, however, will reduce taxable es by $300,000. As a result, the after-tax wing the $10 million is only $700,000:

v

wing to 7 percent ($700,000/$10,000,000). wing is simply multiplying the interest expense by 1 minus the company’ ate, as follows: $1,000,000 (1 .30) $700,000.

ACCOUNTING FOR BONDS PAYABLE able events for a bond issue usually are (1) issuance of the bonds, (2) semiannual interest 8

to the registered o

ve issued only registered coupon bonds or bearer bonds,

vestors—if the vestor lost the coupon, or forgot about an interest date, he or she received no interest. In many states, issuing coupon bonds now is illegal.

441

Long-Term Liabilities

.9 To illustrate these events, assume that on March 1, 2011, W lion of 12 percent, 20-year bonds payable.10 These bonds are dated March 1, 2011, and interest , each September 1 ace value), the issuance of the bonds on March 1 will be recorded by the follo

Entry at the issuance date

Ev .12

½

will be recorded as shown below:

Entry to record semiannual interest

Ev

year-end

w months and, there. Two months later

interest payments ev

Interest payment following the year-end adjusting entry

9

T only at year-end.

made on a monthly basis. 10

for many millions of dollars.

xplained earlier, actual bond issues are

442

Chapter 10 Liabilities

record the re

Redeeming the bonds at the

Bonds Issued between Interest Dates wever, investor is then required to in addition v xt interest payment date. To illustrate, let us modify our illustration to assume that W lion of 12 percent bonds at par value on May 1—two months after the March interest date ved from the bond purchasers now will include two ws:

interest dates

F months’ interest ($60 per $1,000 bond) will be paid to all bondholders, regardless of when chased their bonds. w: Notice only part of the interest payment is charged to expense

Now consider these interest transactions from the standpoint of the investors. They paid for ved checks for y have, therefore, been reimbursed properly for the use of their money for four months. vestor to another, they sell at the quoted market price plus accrued interest since the last interest payment date. This practice enables the vestor o ould have to mak ev v vestors will pay for bonds is the present value y will receive. The concept of present v A more in-depth coverage of present value appears in Appendix B at the end of this textbook. tw

BONDS ISSUED AT A DISCOUNT OR A PREMIUM vestors either at face value or at a price v

Learning Objective

close to face v LO6

a

w face value. The discount generally is quite small—perhaps 1 percent or 2 percent of the face amount of the bonds.

443

Long-Term Liabilities

wer records a liability equal to the amount received. smaller than the face value of the bond issue. At the maturity date, of course, the issuing ace value. Thus, ov issue, the borrower’s liability gradually increases from the original issue price to the maturity value.

ACCOUNTING FOR A BOND DISCOUNT: AN ILLUSTRATION To illustrate, assume that on March 1, 2011, W 97 (meaning that the bonds were sold ace value). On March 1, 2011, W receiv net liability of this amount. When wever, Wells will o full $1 million face value of the bond issue. Thus, the company’s liability must somehow be increased by $30,000 over the 20 years that the bonds are outstanding. The gradual gro y’s liability is illustrated in Exhibit 10–6. Notice that the verage rate of $1,500 per year ($30,000 total increase 20-year life of the bond issue).

Exhibit 10–6

The discount: It gets smaller as time passes Maturity value: $1 million

Issue price: $970,000

date

date

Bond Discount: Part of the Cost of Borrowing

When bonds are issued wed. Thus any discount in the issuance price becomes an additional cost of the ov wing transaction. matching principle ver the life of the bond issue.11

wer to recognize this

Discount on Bonds Payable. Thus, W follows:

11

nience. In this te tiv textbooks.

ged directly to expense as a matter of convevered in more adv

THE CARRYING VALUE OF A BOND DISCOUNT

444

Chapter 10 Liabilities

W follows:

s liability at the date of issuance appears in the balance sheet as

The Discount on Bonds Payable account has a debit balance and is treated as a contr account. wn in the balance sheet as a reduction in the face or par value alue of the bonds payable on the date of issuance is equal to the amount borrowed.

Amortization of the Discount On March 1, 2011, W

ved

company must pay its bondholders the full $1 million face value of the bond issue. This additional $30,000 represents interest expense ver the 20-year life of the bond. in the Discount on Bonds Payable account into interest expense. Thus, over time, the discount alue of the bonds—the face amount less the remaining discount balance—rises tow alue of the bond issue. Each September 1, the company records the following interest expense of $60,750:

Notice that the amortization of the discount increases W est expense by $750. It does not, however, require any immediate cash outlay. The $30,000 interest expense represented by the entire Ev months’ interest e ws:

445

Long-Term Liabilities

as follows:

Two months later, on ev full pany’ nized. The $20,250 interest expense recorded on this date is computed as:

issue is:

record the re bonds. At this date, the original $30,000 discount will be fully amortized on Bonds Payable account will hav alue of the bond issue

It is important to realize that over the life of this bond issue, W total interest e

ACCOUNTING FOR A BOND PREMIUM: AN ILLUSTRATION As noted previously wever premium to the issuer—that is, a price above par. T 103 (meaning that the bonds were sold ace v

446

Chapter 10 Liabilities

receiv wever, Wells will o lion face value y’ w be reduced by $30,000 over the 20 years that the bonds are outstanding. The gradual decrease in the company’ Exhibit 10–7. Notice that verage rate of $1,500 per year ($30,000 total increase 20-year life of the bond issue).

Exhibit 10–7

Issue price: $1,030,000

THE CARRYING VALUE OF A BOND PREMIUM

The premium: It gets smaller as time passes

Maturity value: $1 million

date

date

Bond Premium: A Reduction in the Cost of Borrowing ved at the date of issuance. Thus, any premium actually represents a reduction in the ov wing. Unlike bonds issued at a discount, the interest expense associated with bonds issued at a premium will be less y premium is credited to an account entitled Premium on Bonds Payable. Thus, W follows:

W lows:

s liability at the date of issuance will appear in the balance sheet as fol-

Note that, because the Premium on Bonds Payable account has a credit balance, it is shown in the balance sheet as an increase in the face or par value of bonds payable.

Amortization of the Premium On March 1, 2011, W

ved

447

Long-Term Liabilities

the company must pay back its bondholders only the $1 million face value of the bond issue. This $30,000 reduction in the amount owed represents interest savings ver v alue of the bonds—the face amount plus the remaining premium balance—also declines toward the alue of the bond issue. Each September 1, the company records interest expense of $59,250, computed as:

xpense on September 1 throughout the life of the bond issue is:

Notice that the $60,000 semiannual interest payment is the same regardless of whether the bonds are issued at face v mium does, however y over the life of the bond issue. Ev months’ interest e puted as follows:

Thus, the follo bond issue:

Two months later, on ev full semiannual interest payment is made to the company’ The $19,750 interest expense recorded on this date is computed as:

448

Chapter 10 Liabilities

issue is:

the re Payable account will hav

fully amortized (that is, the Premium on Bonds alue of the bond issue will be ws:

vious illustration involving a bond discount, W est expense of $2,430,000 over the life of the bonds. Had these same bonds been issued at a wever y would hav xpense of

BOND DISCOUNT AND PREMIUM IN PERSPECTIVE w, investors might pay a premium price to purchase bonds that pay an above-market rate of interest. If the bonds pay a below-market rate, investors will buy them only at a discount. issued at the mark often are issued at a small discount, b margin, not investors’ response to a below-market interest rate.12 over the entire life of the bond issue—usually 20 years or more. , bond discounts and premiums

-

on a company’s

this topic to more advanced accounting courses.13

THE CONCEPT OF PRESENT VALUE Learning Objective

E

LO7 t

The concept of present value is based on the time value of money—the idea that receiving money today is preferable to receiving mone xample, that an inv v time. Investors w , because they would receive no v ver the ne v wever, at which investors would be interested. For example, if the inv $600, the investor could e v v 12

ver 95 percent were issued at par or at a discount of less than 2 percent of face value. 13 Some companies issue zero-coupon no interest b is material and may comprise much of the company’ e

449

Long-Term Liabilities

The present value pay today

wledgeable investor will xact amount of the present value

v

be receiv vestor. However, the present value will always be less than the future amount. This is because money received today can be invested w to a lar The rate of interest that will cause a given present value to grow to a giv is called the discount rate or ate. ve interest rate required by investors at any given time is regarded as the going market rate of interest. (The procedures for computing the present v xtbook. The concept of present value is v airs. We suggest that you read Appendix B—even if it has not been assigned.)

The Present Value Concept and Bond Prices The price at which bonds sell is the present value to inv face value, the market rate is equal to the contract interest rate higher ve interest rate that investors require, the less the v For example, if inv y will pay less than $1,000 for a 9 percent, $1,000 bond. Thus, if investors require an effective interest rate greater than the discount their face value). On the other hand, if mark ve interest rate of less than the contract rate, the bonds will sell at a premium (a price above their face value). Since mark , it must be expected that the contract rate of interest may v what from the market rate at the date the bonds are issued.

BOND PRICES AFTER ISSUANCE As stated earlier, man ganized securities exchanges at quoted market prices. After bonds are issued, their mark inversely with changes in mark vestors will be willing to pay less money to own a bond that pays a given contract rate of interest. Conversely, as interest rates decline, the market prices of bonds rise. CASE IN POINT IBM

IBM

vel of interest rates are not the only f

et

v v

ace v

Volatility of Short-Term and Long-Term Bond Prices the mark

ar greater e o illustrate, assume that market

Bond prices move inversely with market interest rates

450

Chapter 10 Liabilities

interest rates suddenly soar from 9 percent to 12 percent. A 9 percent bond scheduled to w days will still have a market v to be collected in a fe wever, the market price of a . Investors who must accept these below-market interest payments for many years will b ve a f et prices of Remember that, after bonds have been issued, the issuing corporation. Therefore, changes in the mark ance do not and these changes are not recorded in the company’

, not to the

YOUR TURN

EARLY RETIREMENT OF BONDS PAYABLE early is to reliev w at an interest rate below that and issuing new bonds at a lower interest rate. Most bond issues contain a call pro w points above face value. Even without a call provimark value, a gain is realized on the retirement of the debt. If the bonds are reacquired by the issualue, a loss For e bond issue, callable on an , however, market interest rates have declined to less than 10 percent, and the mark s bonds has increased to 106.14 Re y exercises this call provision for 10 percent of the bonds ($1,000,000 face v

14

F

vide the issuwer rate of

y with an incentiv e as an approximate “ceiling” on mark

451

Estimated Liabilities, Loss Contingencies, and Commitments

called these bonds, rather than repurchasing them at mark of the bonds been below purchasing them in the open market.)

et price ve been able to retire the bonds at less cost by

Estimated Liabilities, Loss Contingencies, and Commitments ESTIMATED LIABILITIES refers to mated dollar amounts. Let us consider the example of the automaker’s liability to honor its new

Learning Objective

LO8

W that the e sold, extend sev

matching principle requires v xpense) must be garding when w v

. . However, (1) the liabilities are known to e not so great as to prevent the company from making a reasonable estimate and recording the liability. volve some de

LOSS CONTINGENCIES Loss contingencies are similar to estimated liabilities but may involve ev . A loss contingency is a possible loss (or e past events, that is expected to be resolv y is the element of whether or not any loss actually has been incurred. xample of a loss contingency is a lawsuit pending against a company. The lawsuit is based on past events, b xists as to the amount (if any) of the company’s liability. o ways. First, a loss contingency may involve a greater de . xtends to whether any loss or e xpense relating to an estimated liability is xist. Second, the concept of a loss contingency extends not only to possible liabilities but also to possible impairments of assets. ge loans to a w experiencing political instability xists as to the amount of loss, if any, associated with this loan. From the bank’s point of view, this loan is an asset that .

Loss Contingencies in Financial Statements degr volved. Loss contingencies are recorded in the accounting records only when both of the following probable be reasonably estimated. xample of a loss contingenc y has for product w not met, loss contingencies are disclosed statements if there is a r lawsuits, for example, usually are disclosed in notes accompan but the loss, if any wsuit is settled. Comving remote. Notice the judgmental nature of the criteria used in accounting for loss contingencies. These criteria involve assessments as to whether the risk of material loss is “probable,”

452

Chapter 10 Liabilities

“reasonably possible,” or “remote.” Thus the collective professional judgment of the company’s management, accountants, legal counsel, and auditors is the deciding factor in accounting for loss contingencies. Loss contingencies relate only to possible losses from past events. The risk that losses may result from future events is not a loss contingency.

be made. The follo pending litigation: Note 8: Contingencies In October of 2010, the Company was named as defendant in a $400 million patent infringement lawsuit. The Company denies all charges and is preparing its defense against them. It

Note disclosure of a loss contingency

arise as a result of this litigation.

Sometimes a portion of a loss contingenc xample, that a company is required by the Superfund Act to clean up an en v company cannot predict the total cost of the project but considers it probable that it will lose at least $1 million. The company should recognize a $1 million expected loss and record it as a liability cost ultimately may exceed the recorded amount.

COMMITMENTS commitments. They are not liabilities, but, if or example, a professional , $5 milgation to mak v past transactions, this commitment has not yet created a liability. Other e yment contract with a ke w plant, and a contract to buy or sell inv into transactions in the future.

Evaluating the Safety of Creditors’ Claims Learning Objective

LO9

E c

ant to be sure that their claims are safe—that is, that they will be paid associated with a business—management, o yees— y’s ability to pay its debts. If a business becomes illiquid (unable to pay its obligations), it may be forced into .15 Not only does management want the business to remain liquid, but it also wants the company to maintain a high credit rating with agencies such as Moody’s and Standard & Poor’s. A high credit rating helps a company borrow money more easily and at lower interest rates. In evaluating debt-paying ability y’s immediate liquidity. y’s ability to meet its interest ,

15

y is a le

y’s f y y is reorganized and allowed to continue its operations. In other cases, the busiy’s creditors and owners incur le

453

Evaluating the Safety of Creditors’ Claims

obligations over a period of years, as they come due. In pre

ge obligations v —along with the interest cover-

age ratio, which is discussed below.

METHODS OF DETERMINING CREDITWORTHINESS Interest Coverage Ratio Creditors, inv able when a company has enough income to cover its interest payments by a wide margin. xpense is the interest coverage ratio. The interest coverage ratio is computed by dividing operating income by the annual interest expense. From a creditor’s point of view, the higher this ratio, the better. In past years, most companies with good credit ratings had interest coverage ratios of, perhaps, 4 to 1 or more. Less Formal Means of Determining Creditworthiness Not all decisions to extend credit involv

wer’ xample, will sell on account to almost any long-established business— unless the w the customer is in sev . If the customer is not a wellestablished business, these suppliers may investigate the customer’ ing a credit-rating agency. In lending to small businesses or ey stockholders to personally guarantee repayment of the loan.

HOW MUCH DEBT SHOULD A BUSINESS HAVE? All b e

usiness operations. These include, for y businesses aggressively use longxpansion. Is this Can the borrowed funds be invested to earn a return higher than the rate of interest paid to creditors? wed mone usiness operations is called applying leverage. Extensive use of lev cally. But if things don’t w wer. wed money can be inv higher than the interest rates increase.16 For e w money at an interest rate of 9 percent and inv ” But leverage is a double-edged sw avorable or unfavorable. If the wed money falls below the rate of interest being paid, the wed money reduces . Companies with large amounts of debt sometimes become victims of their o verage may be summarized as follows:

The more leverage a compan on equity. Using more leverage simply means having more debt. Therefore, the debt ratio is a basic measure of the amount of leverage being applied. 16

of av

v vided by average total assets.

wed as the overall return on assets—that is, is net income e v

454

Chapter 10 Liabilities

Financial Analysis and Decision Making

Exhibit 10–8

YOUR TURN Dell Inc. Dell

Dell

Dell Dell

455

Special Types of Liabilities

Ethics, Fraud & Corporate Governance

Enron Enron Enron

Enron Enron Enron

Moody’s Enron

Standard & Poor’s Arthur Andersen Enron Enron

Enron Enron Enron Enron

Enron Enron

Enron Enron

Enron Enron Arthur Andersen Enron

Enron Enron Enron

Enron

Enron

Special Types of Liabilities v obligations encountered by most organizations. Here we e ilities most common to large or es.

LEASE PAYMENT OBLIGATIONS A compan usiness operations or ve, it may lease them. A lease is a contract in which the lessor gives the lessee the right to use an xchange for periodic rental payments. The lessor is the o lessee is a tenant or renter. Examples of assets frequently acquired by lease include automobiles, building space, computers, and equipment.

Learning Objective

L10

456

Chapter 10 Liabilities

OPERATING LEASES v but retains the usual risks and rewards of ownership, the contract is known as an operating lease. An e uilding. If the building increases in value, the lessor can receiv either selling the b xpired. Likewise, if the building declines in value, the lessor bears the loss. In accounting for an operating lease, the lessor vie ved as rental revenue, and the lessee regards these payments as rental expense. No asset or liabilthe lessee’ off-balance sheet and disclosure is required of the amounts due in each of the ne ve years, plus .

CAPITAL LEASES Some lease contracts are intended to pro

v ver most of its useful life.

capital leases wards of o to the lessee. wpoint, capital leases are regarded as equivalent to a sale of the v lessor as a sale lessee as a purchase. debits an asset account, Leased Equipment, and cr Lease Payment Obligation, for the present v Interest Expense and a reduction in the liability Lease P the lease payment obligation that will be repaid within the ne No rent expense is recorded by the lessee in a capital lease. The asset account Leased Equipment is usually depreciated by the lessee over the life of the equipment rather than the xtbook.

Distinguishing between Capital Leases and Operating Leases The Financial Accounting Standards Board (F lease as a capital lease. For example, if the lease transfers o , the lease is a capital lease. Leases that do not meet an leases.

LIABILITIES FOR PENSIONS AND OTHER POSTRETIREMENT BENEFITS Many employers agree to pay their emplo life, beginning at retirement. Pensions are not an expense of the years in which cash payments are made to retired workers. Emplo ve the pension are working for their employer. Therefore, the employer’ accrues over the years that each employee is on the payroll. s work y retire . Among other things, these amounts depend on how long retired

457

Special Types of Liabilities

employees live. Therefore, the employer’ must be estimated. Employers do not usually pay retirement pensions directly to retired employees. Most emplo pension fund (or orker’s emplo managed by a trustee (usually a bank or an insurance company). As the employer mak invests the money in securities such as stocks and bonds. Ov investment income and normally accumulates to a balance far in excess of the employer’s deposits. The pension fund—not the employer—disb retired workers. If the employer meets all of its estimated pension obligations by promptly paying cash in fully funded. yer’s balance sheet. The employer’s obligation is discharged in the current period through the payments made to the pension yer records each payment to this fund by debiting Pension Expense and crediting Cash.

Determining Pension Expense expense of a giv is complex and involves man accountants, but rather by an

w, the pension present value of the future pension rights granted to employxpense xpense is computed not by , who considers these factors:

• Average age, retirement age, and life expectancy of employees. • Employee ver rates. • Compensation levels and estimated rate of pay increases. • For e for Cramer Cable Compan ent v the year. T y’s pension plan. The follo

xpense . This amount represents the press employees for the work the

xpense for the year:

Postretirement Benefits Other than Pensions In addition to pension plans, many companies have promised their emplo postretirement such as continuing health insurance. In most respects, these nonpension postretirement however recognition of the annual e the cost. Continuing with our illustration of Cramer Cable Company, assume that Gibson & Holt computes for the compan xpense for the . Unlike its pension expense, however, Cramer does not fully fund its nonpension obligations.

458

Chapter 10 Liabilities

Only $140,000 of the total amount w for the year is:

An

xpense

y intends to fund during the next year .

curr

Unfunded Postretirement Costs Are Noncash Expenses costs are recognized as expenses as work costs are fully funded, the company mak

v not

yees retire. xpense. That is, the expense is char v

xpense e

$140,000

.

Unfunded Liabilities for Postretirement Costs: Are They Significant Amounts? Man s lar ve obligations ge relative to their total assets and other liabilities. Let us suggest several things to consider in evaluating a company’ present value xpected to be substantially more than the amount shown in the balance sheet. Next, this liability may continue to grow, especially if the company has more employees today than in the past. On the other hand, this not have to be paid all at once. It will be paid over a great many years—the life span of today’s workforce. In evaluating a company’ ing to the in addition to the balance sheet and income statement. In the vities. Thus, if a compan w from operating activities, it is in a stronger position to handle retirement costs as the w from operating acti y may have no choice but to reduce the vides to retired emplo not reduced at management’s discretion.

DEFERRED INCOME TAXES We hav types of revenue or e

xist between the w ay these same or example, most companies use the straightut use an accelerated method in their

income appearing in the income statement today may not be subject to income taxes until wever, the matching principle requires that the income shown in an income es expense, regardless of when these taxes will s income tax expense might appear as follows:

459

Concluding Remarks

Payment of income taxes e deferred

Income Tax P expense that must be paid when the compan es e liability account entitled Deferred Income Taxes.

es .

Deferred Income Taxes in Financial Statements Ho

es

caused may require that the es involves a number of complex issues that are addressed in more advanced accounting courses.

Concluding Remarks ve tw wners’’ equity. Throughout this chapter, we hav mated liabilities common to most large businesses. We hav fer from owners’ equity in several respects. The feature that most clearly distinguishes the claims of creditors from those of o ventually mature and become due. We hav ve legal priority over the claims of owners. In the next tw wners’ equity. We will examine many vidends, stock dividends, stock splits, and the dif

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

efine liabilities and distinguish between current erm liabilities.

LO1

LO6

ount for bonds issued at a discount or emium.

LO7

lain the concept of present value as it relates o bond prices.

ount for notes payable and interest expense. LO2

I

escribe the costs and the basic accounting tivities relating to payrolls.

LO3

t

epare an amortization table allocating payments een interest and principal.

LO4

t

LO8

escribe corporate bonds and explain the tax dvantage of debt financing.

LO5

t

lain how estimated liabilities, loss contingenommitments are disclosed in financial tatements.

aluate the safety of creditors’ claims. LO9

t

escribe reporting issues related to leases, postetirement benefits, and deferred taxes.

LO10

t

Key Terms Introduced or Emphasized in Chapter 10

Demonstration roblem

Solution to the Demonstration Problem

G & H PUMP MFG. CO. PARTIAL BALANCE SHEET DECEMBER 31, 2011

Self-Test Questions

ASSIGNMENT MATERIAL

Discussion Questions

Br e Exerc ses LO2

LO5

LO6

accounting

LO6 E

LO6 E

LO6 E

LO9 E

LO6 E

LO10 E

LO10 E

Exercises LO4

E Y

LO1

E E E

LO6

accounting

LO1 E

LO2

V

LO4

LO6

LO8

LO3 E

LO3

E A

LO4

E

LO5

E A

LO5

E B

DuPont

LO5

LO6 P

LO5

LO6

LO9 S

LO10 A

LO10 E P

LO10 E D

LO9

E E Depot

Home Depot, Inc. Home

Home Depot Home Depot Home Depot

Problem Set A LO1

LO6 LO8

P

Fi

accounting

LO1 LO2 LO4

LO8

P

LO2

P

LO4

P P

AMORTIZATION TABLE (12%, 30-YEAR MORTGAGE NOTE PAYABLE FOR $1,080,000; PAYABLE IN 360 MONTHLY INSTALLMENTS OF $11,110)

LO5

LO5 A

LO6

LO1

LO5

LO6

LO10

a

LO1

P

LO5

P L

LO6

LO8

LO10

Problem Set B LO1

E T F

LO6 LO8

LO1

LO2

LO4

LO8

L

LO2

P

LO4

P P

AMORTIZATION TABLE (12%, 4-YEAR NOTE PAYABLE FOR $100,000; PAYABLE IN 48 MONTHLY INSTALLMENTS OF $2,633)

LO5

LO5 A

LO6 P

LO1

LO5

LO6

LO10

P R a

LO1

LO5

L

LO6

LO8

LO10

Critical Thinking Cases LO1

LO10

T L

Wells Fargo & Company The New York Times Company The Hollywood Park Companies American Greetings Wausau Paper Mills Company Club Med., Inc. Apple Computer, Inc.

LO5

LO7

Abbott Labs

LO8 L

Airlines AMR (American Airlines)

LO1

LO10

F

American

American Airlines

American Airlines American Airlines

LO5

BondsOnline LO6 LO9

C

www.BondsOnline.com

http://www.yahoo.com

Answers to Self-Test Questions

CHA P TER 11

© AP Photo/Pat Sullivan

Stockholders’ Equity: Paid-In Capital

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO: LO1 LO2 LO3 LO4 LO5 LO6 LO7 LO8 LO9

TARGET CORPORATION

Target Corporation

Target

Target

■

Target

484

Chapter 11 Stockholders’ Equity: Paid-In Capital

In this chapter we e e also discuss why b and describe the f

et.

Corporations ganization of choice for many businesses—large and small. The stockholders. In man IBM and AT&T, there are literally

o

A corporation separate le ,

usiness organization that is recognized under the law as a apart from those of its owners. The assets itself, gal

responsible for its o entity sued as if it were a person. The major advantages and disadv or .

usiness

Exhibit 11–1 ADVANTAGES AND DISADVANTAGES OF THE

Learning Objective

LO1

a o a

, basically, is wn companies such as ExxonMobil, General Motors, and Procter & Gamble. Indeed, almost all large businesses are or wnership, professional management, and continuity of existence mak of organization for pooling the resources of a great man v however ge and publicly owned. Many small businesses are or

WHY BUSINESSES INCORPORATE y reasons, but the tw wnership. We have previously discussed the concept of limited personal

v

. This simply

485

Corporations

wnership

ansfer is represented by shares of capital stock business, this pro v b xt. F a

or a small, f ge company, it makes o xchanges.1

YOUR TURN

PUBLICLY OWNED CORPORATIONS The capital stock of many lar lar

ganized vailable for purchase by the general public, these publicly owned.

Far more people hav one might e with a direct ownership interest—that is, you . But mutual funds and pension funds invest heavily in the stocks of many publicly o vest in vered by a pension plan, you have an indirect the stocks of many publicly o not traded on any organized stock exchanges are said to be closely held. Because there is no organized market for buying and selling their shares, these ve relatively fe owned by one individual or by the members of one family.

Publicly Owned Corporations Face D erent Rules The gov to protect the interests of the public. Therefore, publicly o more re or example, publicly o are required by law to: • accepted accounting principles. (These statements are public information.) • Hav accountants. • Comply with federal securities laws, which include both criminal penalties and civil liability for deliberately or carelessly distrib • for review. 1

xchanges include, among others, the New York Stock Exchange, the National Association ASDAQ), the T s Bolsa. Collectively, stock e the stock market.

LO2

486

Chapter 11 Stockholders’ Equity: Paid-In Capital

x publicly owned companies.

Formation of a Corporation xistence under the la state of incorporation. usiness. Rather, a state often is selected because of the leniency of its laws re vities. Indeed, man usiness activities outside the state in which the corporate charter from the state of , the or called the articles of incorporation. w board of directors and to pass bylaws that will gov s acti

Organization Costs F xistence. Conceptually, organization costs are an intangible asset ver its entire life. As a practical matter, however xpense those costs immediately, even though they are often spread ov v Thus you will seldom see organization costs in the balance sheet of a publicly o poration. They have long since been recognized as an expense. Learning Objective

LO3

E s d

Rights of Stockholders

v

so o these shares, you own 10 percent , you will own 15 percent. s brok v stock indicating the number of shares he or she owns. The o 1. To vote for directors and on certain other k share o bylaws. An the capital stock has the po

shares that he or she wn 1,000 of

wing basic rights:

ote for each s wns more than 50 percent of

2. To participate in any dividends declared by the board of directors. poration may not make withdrawals of company assets, as may the o rated businesses. However dividends. Dividends y hav declared (authorized) by the board of directors. Di owned. 3. To shar ution of assets if the corporation is liquidated. ends its e ve a residual interest, and any remaining assets are di wned. Stockholders’ meetings usually are held once each year may ask questions of management and v meetings usually are attended by relatively few people—often less than 1 percent of the comy’ wever, the management group requests that

487

Formation of a Corporation

proxy statements, granting management the voting rights associated with their shares.

Functions of the Board of Directors

board of

directors ing dividends, and revie The board of a lar

ways includes several members of top management. In

outside directors refers to individuals who are not therefore, bring an independent perspective to the board.

Functions of the Corporate O icers appointed (hired) by the board of directors. These individuals are called the corpor cers. Individual stockholders do not hav usiness have been properly appointed to a managerial position. The top level of management usually includes a chief executiv , a treasurer . In addition, a vice president usually ov

specialized activities as b under the CFO’

The secr

easurer has custody of the company’ y’ y’ gal matters and mainvestor relations .

The or

Exhibit 11–2

Exhibit 11–2 indicates lines of authority e

488

Chapter 11 Stockholders’ Equity: Paid-In Capital

STOCKHOLDER RECORDS IN A CORPORATION Man

w York Stock Exchange have millions of

sell their shares; the buyers of these shares become new members of the company’s family of stockholders. v v

Stockholders Subsidiary Ledger . Instead, a single controlling account entitled Capital Stock appears in the general ledger, and a stockholders subsidiary ledger vidual stockholder number of shares, in dollars. Thus each stockholder’s account shows the number of shares o dividend check, ev

v

Stock Transfer Agent and Stock Registrar Many large, publicly owned corporations use an independent stock transfer agent and a stock registrar to maintain their ver the issuance of stock cerwner to another transfer agent, who cancels them, mak ledger, and prepares a ne w owner of the shares. This ne then must be registered with the stock registrar before it represents valid and transferable o gistrars . To prevent the accidental or fraudulent issuance of an excessive number of o

Paid-In Capital of a Corporation Learning Objective

LO4

a s

ow utions by investors in exchange for capital stock—called paid-in capital or contributed capital v retained earnings. As pre

AUTHORIZATION AND ISSUANCE OF CAPITAL STOCK authorized public must be approv y initially plan to issue. This way, if more capital is needed later to issue additional shares. Shares that have been issued ing shares. At an inv inv

outstand-

underwriter.

489

Paid-In Capital of a Corporation

the inv at the net amount receiv be raised will be av (1) e (3) the current state of the investment mark

w issue of stock is based on such factors as y, and uyers willing to purchase the shares.

State La Equity

ect the Balance Sheet Presentation of Stockholders’ gely by state laws. We have seen that coruted capital, or v

not the case. veral gal concept called par value also affects the balance sheet presentation of paid-in capital.

Par Value Par value (or stated value) represents the legal capital per share—the amount belo xcept by losses from business operations (or by special legal action). Par value, therefore, may be re of equity capital existing for the protection of creditors. Because of the legal restrictions associated with par value, state la to sho alue of shares issued. This special balance sheet presentation has led some people to believe that par v wever, the par value of the . alue of its stock at $1 per share, $5 per share, or any other amount that it chooses. Most lar alue of the stock is not an indication of its market value; the par v to be entered in the Capital Stock account. The stock of Ford has a par value of $.01 and Microsoft’s stock has a par value of only one-tenth of a cent. The market value of each of these ar abov alue. Issuance of Par Value Stock into existence, nor does it giv

When par value stock is issued, the Capital Stock account is credited with the par value of the shares issued, re . Assuming that 50,000 shares of $2 par value stock hav alue, the Capital Stock account is credited with the par v Additional Paid-in Capital, is credited for the excess of selling price over par. If, for example, our 10,000 shares were issued ould be: Stockholders’ investment in excess of par value

490

Chapter 11 Stockholders’ Equity: Paid-In Capital

invested capital, and it is added to the capital stock in the balance sheet to show the total paidws. (The $150,000 in ve a complete illustration.)

$2 par value; 10,000 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 20,000

less than par

y states. In some cases, stock is issued in e appropriate asset account is debited (for example, Inv are credited as if the stock had been sold for cash. Establishing a value for recording a transaction of this type is sometimes dif ut should be based on either the fair value of the assets received or the stock issued, whichever can be more objectiv

No-Par Stock Some states allo or stated v Capital Stock account and is viewed as le

entire issue price is credited to the wal.

COMMON STOCK AND PREFERRED STOCK of stock. In order to appeal to as many investors as possible, however sev viding inv Learning Objective

The basic type of capital stock issued by ev

common stock. wnership—v

LO5

c o

dividends, and a residual claim to assets in the ev preferred stock of capital stock. A fe class having distinctiv The follo

vestor.

is assumed so we can provide a complete example. Balance sheet presentation of common stock and preferred stock

9% cumulative preferred stock, $100 par value, authorized 100,000 shares, issued and outstanding 50,000 shares . . . . . . . . . . . . . . . . .

$ 5,000,000

Common stock, $5 par value, authorized 3 million shares, issued and outstanding 2 million shares . . . . . . . . . . . . . . . . . . . . . .

10,000,000

Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

500,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20,000,000

491

Paid-In Capital of a Corporation

CHARACTERISTICS OF PREFERRED STOCK ve the following distinctive features: 1. 2. 3. 4. 5.

Preference ov Cumulative dividend rights. Preference ov

vidends. vent of the liquidation of the company.

No voting power.

the conversion stocks v

vile valuation of any

I N T E R N AT I O N A L C A S E I N P O I N T

Stock Preferred as to Dividends 2

ments, called dividends,

Di

volv

ution of cash

tion’ ve di

vestors are y di vidend may be stated as a dollar amount, such as $5 per share. wever vidend as a percentage of par value. For e alue of $100 and a dividend preference of 9 percent must provide a $9 dividend ($100 before any di ve no guarantee that they will always receive the indicated di is available and the board of directors declares a dividend. Dividends must be paid on preentitled to receiv inv

prospering, it may decide not to pay any dividends at all. F vailable.

vidends,

Cumulative Preferred Stock The di stocks is cumulative. If all or an gular di in a given year, the amount omitted is said to be in arrears and must be paid in a subsequent year before any dividend can be paid on the common stock. noncumulative, 2

u, dividends may be vie

ution to

492

Chapter 11 Stockholders’ Equity: Paid-In Capital

the $8 per share di ard if it is not paid each year. On the other hand, if the preferred stock is cumulative, the $8 per share di ard to future years if it is not paid and the accumulated amount must be paid before any dividend can be paid on common stock. Assume that the $8 preferred dividend is paid in 2009, a vidend is paid in 2011. Follo vidend at the end of 2011.

v vidend does not ard fect on the company’ vidends on common stock v wever, any unpaid dividend on ard and must be paid before di vidend of $60,000 would have to have been paid before any dividend could have been paid on common stock. At the end of 2011, this amount has gro ard from 2010, plus the $80,000 that was not paid in 2011). Before a dividend could have been paid on common stock in 2011, the $60,000 vidend in arrears vidend of $80,000 for 2011 would have to have been paid. Di xists until a dividend is declared by the board of directors. The amount of any diviactor to investors, however, and should always be disclosed. This disclosure is usually made by a note accompanying the balance sheet such as the following: Footnote disclosure of dividends in arrears

Note 6: Dividends in arrears As of December 31, 2011, di the e

In 2012, we shall assume that the compan wished to pay di

v

vailable cash, and vidend v

stock plus the re would, therefore, receive a total of $220,000 in dividends in 2012 ($22 per share); the board vidends on the common stock.

Other Features of Preferred Stock T

v fer a conversion privilege that entitles the xchange their shares for common stock at a stipulated ratio. If the et v vidends on the common stock will probably increase. The investor who buys a conv stock as an inv

the conversion privilege, the inv y substantial increase in value of the company’ The three primary elements of stockholders’ equity for most companies are common about later in this chapter

493

Paid-In Capital of a Corporation

Exhibit 11–3.

Exhibit 11–3 PRIMARY SOURCES OF

BOOK VALUE PER SHARE OF COMMON STOCK he or she o

alue per Book value per share is the amount of net assets represented by each net assets means total assets minus total liabilities; in other words, net assets are equal to total stockholder . mon stock only, the book value per share is computed by di by the number of shares outstanding. For e ws:

The book value per share is $30; it is computed by di $120,000 by the 4,000 shares of outstanding stock.

Book Value When a Company Has Both Preferred and Common Stock Book value is usually computed only for common stock. If a compan mon stock outstanding, the computation of book value per share of common stock requires y dividends in arrears are equity is di owners

alue per residual .

How much is book value per share?

494

Chapter 11 Stockholders’ Equity: Paid-In Capital

T y at December 31 is as follows: Two classes of stock

year. As of December 31, di

y has paid no di v $80,000. xcept the $1,000,000 applicable to

of book value per share of common stock is as follows:

Thus, the issuance of capital stock for cash represents a receipt vities. Distrib cash dividends—represent a cash outlay, vities. Transactions with owners do not always hav ws. Consider an e s capital stock for a noncash asset, such as land. Cash is not increased or decreased by this ev ws.

Market Value After shares of stock have been issued, they may be sold by one investor to another market price of the stock. This market alue, the original issue price, and the alue. Which is the most relevant amount? That depends on your point of view. After shares are issued, the Thus, changes in the market price of these shares directly af stockholder, but not that of the issuing company. This concept explains why the issuing compan

Accounting by the Issuer From the viewpoint of the issuing company, outstanding stock represents an amount invested in the company by its o the market v v they originally invested in the company does not change. ved

(for e

495

Market Value

Accounting by the Investor From the investor’s point of view, shares o publicly owned company are an asset, usually called Marketable Securities. To the investor et value of securities owned is more relev inal issue price—or than the securities’ par values or book values. The market value indicates . Changes in market v vestor’s or these reasons, investors show investments in marketable et value in their balance sheets. CASE IN POINT IBM

t IBM IBM IBM IBM

Because mark

v

ac-

MARKET PRICE OF PREFERRED STOCK Investors b di

ve the dividends that these shares pay. Thus,

actor is risk. dividends. If there is a distinct possibility that the company will not di A third f value of $100, if gov say, 15 percent or 16 percent? If inv vailable, inv provides a dividend of only $8 per year. Thus the mark

LO6

vel of interest rates.

vel all et price, the stock

dividend yield) to an inv However, if the prev range, the mark , the mark

Learning Objective

alue. varies inversely with interest rates. As inter-

MARKET PRICE OF COMMON STOCK Prevailing interest rates also affect the mark wever, dividends ed in amount. Both the amount of the dividend and the mark successful.

496

Chapter 11 Stockholders’ Equity: Paid-In Capital

vely, if the compan recover their original inv investors’ expectations the risk that this lev

ven actors in the market price usiness and ved.

BOOK VALUE AND MARKET PRICE

Learning Objective

LO7

o v

To some extent, book value is used in evaluating the reasonableness of the mark stock. However, it must be used with caution; the fact that a stock is selling at less than book v gain. Book v v above book value, investors believ usiness w On the other hand, if the mark less than book value, investors believe that the company’s resources are w management. Thus the relationship between book value and market price is one measure of investors’ s management.

STOCK SPLITS Learning Objective

LO8

e

Over time, the mark s common stock may increase in value so much that it becomes too expensive for many inv split stock split is to reduce substantially the mark y’s common stock, with the vestors. For e value common stock. The mark o make the stock more lion to 2 million. This action is called a 2-for-1 stock split. A stockholder who owned 100 shares of the stock before the split will o of outstanding shares has doubled without an equity, the market price of the stock should drop from $90 to approximately $45 per share. to the size of the split. As this was a 2-for-1 split, the company must reduce the par value of -1 split, the par value would have been ould have declined to approxiA stock split does not change the balance of any accounts in the balance sheet; consequently, the transaction is recorded merely by a memor .F ws: Sept. 30

record a stock split

Memorandum: Issued additional 1 million shares of common stock in a 2-for-1 stock split. Par value reduced from $10 per share to $5 per share. wer par

v vidend. While stock dividends are similar to stock splits in some respects, they are much smaller in size and have y’s dividend policy, we defer the detailed coverage of stock dividends to Chapter 12.

Treasury Stock Learning Objective

LO9

Treasury stock s own capital stock that have been issued and later reacquired by the issuing company but that hav retired. T y time. Shares of ve dividends, to vote, or to share in assets upon dissolution of the company.

497

yee compensation for many companies. The yees to purchase stock in the company are a means of creating employee loyalty to the company. T means by which the company can have available the shares of stock needed to satisfy the requirement of stock option plans to issue shares of stock to employees. Rather than increasing the total number of outstanding shares, thereby reducing or diluting the ownership of each share, the compan wners and then sells the same yees.

RECORDING PURCHASES OF TREASURY STOCK the cost of the stock. For example, if Rile

wn $5 ws:

Note that the T par value. T

cost of the shares purchased, not their contr

garded as a reduction of stockholders’ , not as the acquisition of an asset. For this reason, the T authorized and issued, but while they are held by the issuing company, they are not outstanding. s balance sheet appears as follows,

REISSUANCE OF TREASURY STOCK shares reissued and Additional P credited for any ence the

w reissued at a ve cost is: Treasury stock reissued at a price above cost

498

Chapter 11 Stockholders’ Equity: Paid-In Capital

y’s treay’s balance sheet. It

w cost, additional paid-in capital from previous xcess of cost ov o

Reissued at a price below cost

If there is no additional paid-in capital from pre e ver the reissue price is recorded as a debit to the Additional P Notice that no gain or loss is recognized on tr shares are reissued at a price above or belo v holder an amount of paid-in capital that is lar

k transactions, even when the

ves from the new stockversely

are reissued at a price belo

STOCK BUYBACK PROGRAMS Historically the topic w

volved relatively small dollar amounts. Hence, v ve b

the balance sheets of man T ws as

y repurchase large amounts of their own

499

receiv

ws. ve rise to gains or losses, they hav

s net income. Any dif stock and the cash receiv s paid-in capital.

Financial Analysis and Decision Making

Verizon Communications

Verizon

YOUR TURN

Verizon

500

Chapter 11 Stockholders’ Equity: Paid-In Capital

Ethics, Fraud & Corporate Governance

2DoTrade

2DoTrade, Inc. 2DoTrade

2DoTrade

Concluding Remarks In this chapter, we cov

ari-

of capital stock. We e vious years usiness objectiv

that hav is the subject of Chapter 12, which follo , the

. For that reason, in this chapter

v of Chapters 11 and 12, you will have a good w ho

y’s balance sheet.

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

LO1

iscuss the advantages and disadvantages of s as a corporation.

LO2

istinguish between publicly owned and closely corporations. c LO6

iscuss the factors affecting the market price of eferred stock and common stock.

LO7

lain the significance of book value and market alue of capital stock.

lain the rights of stockholders and the roles f corporate directors and officers.

LO3

a s

ount for paid-in capital and prepare the equity tion of a corporate balance sheet.

LO4

s

lain the purpose and effects of a stock split.

LO8

a

ontrast the features of common stock with f preferred stock.

LO5

t

ount for treasury stock transactions.

LO9

e

Key Terms Introduced or Emphasized in Chapter 11

Demonstration Problem

Solution to the Demonstration Problem

Self-Test Questions

ASSIGNMENT MATERIAL

Discussion Questions

IBM

IBM

Brief Exercises LO4

LO4

LO5

LO5

LO5

accountin

LO7

LO7

LO8

LO4 LO9

T

LO4 LO9

T

Exercise LO1 F

LO3

LO1 T

LO9

accounting

LO4 LO5

S S S

LO4 LO5

a

LO4 S

LO7

LO5 LO6

P A

LO4 LO7

LO4

LO7

R o

LO9 R

LO8 E

LO9 T

LO4

Carnival Corporation A

Carnival Corporation

LO4 A

LO9

LO8 LO9

T a

LO4

Home Depot, Inc. U

LO7

Home

S

Home Depot

Problem Set A LO4

P S

LO6

LO4

P S

LO6

LO4 S

LO6

accounting

LO4

LO5

S E P

LO4

LO5

A S S

LO1 A

LO7

LO4 LO7

P V

LO4 LO5

R S

LO7 LO9

LO4 LO5

R S

LO7

LO9

Problem Set B LO4 S

LO6

LO4 S S

LO6

LO4 S

LO6

LO4 S

LO5 P

LO4 LO5

A S S

LO1 A

LO7

LO4

P P

LO7

LO4

P

LO5

S

LO7 LO9

LO4

P

LO5

R S

LO7

LO9

Critical Thinking Cases LO5

LO7 C

LO7 F

McDonnell Douglas, Inc. Boeing

McDonnell Douglas

Citicorp

Ventitex, Inc.

LO1 S B

LO3

LO1

C S

LO3

LO4

I

Staples, Inc. www.staples.com

LO5 LO7 LO9

http://www.yahoo.com

Answers to Self-Test Questions

COMPREHENSIVE PROBLEM McMinn Retail, Inc.

3

CHA P TER 12

© Shannon Stapleton/Corbis

Income and Changes in Retained Earnings

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO:

LO1

LO2

LO3

LO4

LO5

LO6 LO7

LO8

LO9

PROCTER & GAMBLE COMPANY

Procter & Gamble Company P&G

P&G

P&G

■

522

Chapter 12 Income and Changes in Retained Earnings

For inv ke ery attractive. In this chapter, we look more closely at the income statement and learn about the useful information availvestment and credit decisions. In w an income statement is prepared, you will learn about vidends, and other key f a company.

Reporting the Results of Operations w of many investors, is vidends

periodic income. Both the mark

DEVELOPING PREDICTIVE INFORMATION Revenue is a measure of the v ve been sold to customers. Revenue represents the increases in the company’ directed activities. Generally, revenue increases cash either at the time it is included in the income statement or at an earlier or later date. Expenses are measures of the cost of producing and distributing the products and services that are sold to customers. They represent decreases in the company’ vities. Expenses decrease cash at the time the ment presents a company’s revenue and expenses for a stated period of time, such as a quarter or year. venue and e vides vestors and creditors as they attempt to mak v F

vestors,

likely to recur should be presented separately from the results of the company’ vities. Two cate vents that require special treatment are (1) the results of discontinued operations and (2) the impact of extraor . One of the challenges that has f vided by different companies and by the same company over time.

REPORTING IRREGULAR ITEMS: AN ILLUSTRATION T

gular items in an income statement, assume that F o motels. Near the end of the , the company sells both motels to a national hotel chain. In addition, F o “e vents appears in Exhibit 12–1.

CONTINUING OPERATIONS continuing business activities—that is, the retail stores. Notice that the income tax expense shown in this section ($300,000) relates only to continuing operations. The income taxes gular items are shown separately in the income statement as adjustments to the amounts of these items.

Income from Continuing Operations The subtotal income from continuing operations y’

or example, if we predict no

523

FARMER CORPORATION INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

Exhibit 12–1 INCOME STATEMENT WITH NONRECURRING ITEMS

Notice the order in which the irregular items are reported

ould expect F xt year.

DISCONTINUED OPERATIONS segment of the business, the results of that segment’s operations are shown separately in the income statement. Excludy’s operations enables v y’s ongoing (continuing) operations. Two items are included in the discontinued operations section of the income statement: (1) the income or loss from operating the segment prior to its disposal and (2) the gain or loss on disposal of the segment. The income taxes relating to the discontinued operations are shown separately xpense relating to continuing business operations.

EXTRAORDINARY ITEMS The second cate gular ev income statement is e item is a gain or loss that is (1) unusual in nature and (2) not expected to recur in the foreseeable future. An example of an e y’ . discontinued operations (if any), following the subtotal income before extraor w investors what the net income would have been if the e had not occurred. y related income tax effects.

Learning Objective

LO1

524

Chapter 12 Income and Changes in Retained Earnings

Ov . As a result, today few e statements of publicly held companies.

Other Unusual Gains and Losses operations b items. Among such ev es and the gains or losses resulting from sales of plant assets. Such items, if material, should be individually listed as items of revenue or expense, rather than being combined with other items in broad categories such as sales revenue or general and administrative expenses. In the income statement of F Exhibit 12–1), the $80,000 loss resulting from the settlement of a lawsuit is listed separately in the income statement but is not shown as an e the income statement by presenting it as a separate item, b

Restructuring Charges ve challenges of a global economy, the orkforces, and consolidate operating facilities. Restructuring charges consist of items such as losses from write-do assets, sev orkers, and expenses related to the relocation of operay are presented in the company’s income statement as a single item lik wsuit in the F Exhibit 12–1 volves discontinuing a segment of the business, the e ing are presented as discontinued operations.

Distinguishing between the Unusual and the Extraordinary y to classify many losses as e while classifying many gains

YOUR TURN

In the ,

525

xtraordinary items, b as o counter this potentially misleading practice, the accounting profession no comprehensive list of e matter of judgment.

vent is a

EARNINGS PER SHARE (EPS) One of the most widely used accounting statistics is earnings per share on common stock. Investors who b Stock market prices are quoted on a per vesting in a company’s stock at a price of $50 per share, you need to kno annual dividend per share to decide whether this price is reasonable. T y’s net income is divided by the av applies only to common stock; v yond the vidends. . In this case, vided by the number of shares outstanding. In many companies, the number of shares of stock outstanding changes during the year. weighted-average number of shares outstanding.1 The weighted-av remained unchanged. For e last three months. The increase in shares outstanding resulted from the sale of 60,000 shares for cash. The weighted-average number of shares outstanding during 2011 is 95,000, determined as follows:

By using the weighted-av ved from the sale of the 60,000 additional shares was available to .

Preferred Dividends and Earnings per Share xtent vidends. To determine the earnings applicable to the common stock, vidends. The annual dividend on cumulative always deducted, even if not declared by

1

verage number of shares outstanding should be adjusted retroactively rather than weighted for the period the ne

es

Learning Objective

LO2

526

Chapter 12 Income and Changes in Retained Earnings

only the current year’s cumulativ share computation. Noncumulativ declared. T

vidends are deducted only if they have been

v

. Net ould be computed

as follows:

Earnings per share figures are required in the income statements of publicly owned companies

Presentation of Earnings per Share in the Income Statement All publicly o required ments.2 income before e net income. These additional per T -share computations, we will e tion example to include income from continuing operations and income before e items. We should point out, however income statement. The condensed income statement shown in Exhibit 12–2 is intended to vide a review of the calculations.

Exhibit 12–2

PERRY CORPORATION CONDENSED INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

EARNINGS PER SHARE PRESENTATION

Income from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 805,000

Income before extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 715,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 595,000

Earnings from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$3.67a

Earnings before extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$3.22b

Net earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$2.62c

a

($805,000 ⫺ $72,000 preferred dividends) ⫼ 200,000 shares ($715,000 ⫺ $72,000) ⫼ 200,000 shares c ($595,000 ⫺ $72,000) ⫼ 200,000 shares b

2

ASB has ex .

527

Financial Analysis and Decision Making

I N T E R N AT I O N A L C A S E I N P O I N T

YOUR TURN

Basic and Diluted Earnings per Share

Learning Objective

LO3

a s

T usiness acti results. Net earnings per share, on the other hand, shows the overall operating results of the , including any discontinued operations and e

Other Transactions Affecting Retained Earnings CASH DIVIDENDS Learning Objective

LO4

528

a e t

Investors b ment is a combination of tw and (2) cash dividends.

xpectation of getting their original investment v vestalue of the stock (stock appreciation)

vidends. Generally early stage of dev e cash for the purchase of plant and equipment or for other needs of the company. These so-called gro y must rely on their

529

Other Transactions Affecting Retained Earnings

board of directors decide that paying cash dividends is appropriate. The preceding discussion suggests three requirements for the payment of a cash dividend. These are: 1. Retained earnings. Since di uted net income of the company tical matter, man usiness if the compan w and keep pace with its competitors. 2. The fact that the compan ve been vested in ne v acquire a lar v xpression of “paying 3. Dividend action by the board of directors. Even though a company’s net income is sub, di .A vidend.

DIVIDEND DATES F

volv

ution of a dividend. These are:

1. Date of declaration. On the day on which the dividend is declared by the board of directors, a liability to make the payment comes into existence. 2. Ex-dividend date. ex-dividend date v xchanges. T of record (see following discussion). A person who buys the stock before the ex-dividend date is entitled to receiv vidend that has already been declared; conversely who sells shares before the ex-di ve the dividend. A stock is said to x-di loses the right to receive the latest declared dividend. 3. Date of record. The date of record follo weeks, and is always stated in the dividend declaration. To be eligible to receive the dividend, s records as the o 4. Date of payment. The declaration of a dividend alw o to four

vidend. These entries are illustrated below:

Entries made on declaration date and . . .

on payment date

530

Chapter 12 Income and Changes in Retained Earnings

No entries are made on either the ex-dividend date or the date of record. These dates are of to whom the di ers’ point of view, it is the ves the dividend. The gistrar. ance of the Di v of using a Di account ultimately is reduced by all di

w vidend is declared instead

LIQUIDATING DIVIDENDS A liquidating dividend the Retained Earnings account. Thus the di paid-in capital investment. Liquidating di going out of e holders may assume that a di

vidend that

vested capital.

STOCK DIVIDENDS Stock dividend ution of additional shares of stock to a company’ ords, the dividend is payable in additional shares of stock rather than in cash. Most stock dividends consist of additional shares of common stock distributed to holders of common stock. Therefore, our discussion focuses on this type of stock dividend. xists between a cash dividend and a stock dividend. A cash dividend vidend reduces . In a stock dividend, however, no assets are distributed. Thus a stock dividend causes no change . Each stockholder receives additional shares, but his or her percentage o ration is no larger than before, and the company receives no assets in the transaction. T wned equally by James Davis and Susan Miller, each o tion declares a stock di utes 200 additional shares (10 percent vis and Miller now hold 1,100 shares apiece, but each still owns one-half of the business. xactly the same as before the dividend. No vidend on the of the company’s stock. Assume that, before the stock dividend, the outstanding 2,000 shares in our example had a mark et value for the shares ⫻ $110 per share). Because the stock dividend does , the total market v should remain $220,000 after the stock dividend. As 2,200 shares are now outstanding, the mark should fall to $100 ($220,000 ⫼ 2,200 shares). In other words, the market value of the stock should fall in proportion to the number of new shares issued. will f outstanding shares is another matter.

Entries to Record a Stock Dividend In accounting for relatively small stock dividends (say, less than 20 percent), the capitalizing

v

of the ne vidend had been paid vested the cash in the business in exchange w shares of

531

Other Transactions Affecting Retained Earnings

T $5 par v declares a 10 percent stock di

et value of $25 per share. On this date, the company declaration of this dividend is: Stock dividend declared; use market price of stock

The Stock Dividend to Be Distrib not a liability because there is no obligaute cash or an declaration of a stock dividend and the date of distribution of the shares, this account, as well as the Additional Paid-in Capital: Stock Di holders’ equity section of the balance sheet. as reduced by the market value of the shares to be issued (10,000 shares ⫻ $25 per share ⫽ $250,000). Notice also that no change occurs . The amount remov account w distribution of the dividend shares is: Stock dividend distributed

Reasons for Stock Dividends Although stock dividends cause no change in total , they are popular both with management and with vidends appealing because they allow manageute something of perceived v e expanding f w product lines. e stock dividends because they receiv does not f , and the dividend is not subject to income taxes (until the shares received are sold). Also, large stock dividends tend to keep the stock price do range that appeals to most investors.

CASE IN POINT Home Depot, Inc.

Home Depot

Home Depot

532

Chapter 12 Income and Changes in Retained Earnings

Distinction between Stock Splits and Stock Dividends ence between a stock dividend and a stock split (discussed in Chapter 11)? In some respects o are similar. Both involv y’s own stock to its y. Both stock dividends and stock splits increase the number of outstanding shares of stock in the company’s stockholders’ equity vidend and a stock split lies in the ution. A stock dividend usually is intended to substitute for a cash dividend and is small enough that the mark relatively unaffected. Stock di of the stock to bring it do larger increases in the number of outstanding shares, such as 100 percent (2:1 split) or 200 percent (3:1 split). The pre vidends and stock splits. Accounting for the two also varies. Stock dividends do not result in a change in the par v et value of alue and additional paid-in capital accounts. Stock splits, on the other hand, result in a pro rata reduction in the par value Both stock dividends and stock splits are inte the company’s o agement intent.

gy with regard to

STATEMENT OF RETAINED EARNINGS Learning Objective

LO5

s e

retained earnings

v

later in this chapter ws, some statement of retained earnings, as in Exhibit 12–3.

Exhibit 12–3 STATEMENT OF RETAINED EARNINGS FOR SALT

SALT LAKE CORPORATION STATEMENT OF RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2011

Notice that the 2011 net income is added to the be Earlier in this text when we studied the accounting cycle, we learned that, as part of the venue and expense accounts are brought to a zero balance, and the net amount of these items .F

533

also, that in the statement of retained earnings the balance is reduced by the amounts of cash dividends declared during the year, as well as the amount of the stock dividend that was declared.

PRIOR PERIOD ADJUSTMENTS On occasion, a company may discover that a material error was made in the measurement of net income in a prior year

Learning Objective

LO6

ings sho

vered, they should prior period adjustment, is sho statement of retained earnings ginning of the current year. The amount of the adjustment is shown net of any related income tax To illustrate, assume that late in 2011 Salt Lak , the compan the be 2010) also is overstated by $35,000. a correction Exhibit 12–4.)

vers that it failed to as overstated by $35,000. Thus, 2011 must include . (See the illustration in

Exhibit 12–4

SALT LAKE CORPORATION STATEMENT OF RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2011 As originally reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

STATEMENT OF RETAINED EARNINGS WITH PRIOR PERIOD ADJUSTMENT $750,000

Less: Prior period adjustment for error in recording 2010 depreciation expense (net of $15,000 income taxes) . . . . . . . . . .

35,000

As restated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$715,000 Adjust beginning retained earnings for correction

ge, publicly o ely annual basis.

Restrictions of Retained Earnings prevents a compan below a designated lev accompan of $10 million might include the follo

vidend that w or example, a compan

all

534

Chapter 12 Income and Changes in Retained Earnings

Note disclosure of restrictions placed on

Note 7: Restriction of retained earnings of cash dividends that w

w $5,200,000.

COMPREHENSIVE INCOME Learning Objective

LO7

The Financial Accounting Standards Board (F position that should be recorded b One way to describe these events is that they are recognized ut not realized the company’s net income). We have studied one of these items earlier in this text—the change in market value of available-for vestments. ay changes in value for v vestments are recorded. Those inv vailable for sale are rev ket v alue does not enter into the ould had investments been sold. The change in market value of available-for-sale inv alue has alue has gone do other comprehensive income. Comprehensive income elements of other comprehensive income. Comprehensive income may be displayed to users y of the following ways: • As a second income statement. One income statement displays the components of net income and the other displays the components of comprehensive income, one element of which is net income. • As a single income statement that includes both the components of net income and the components of other comprehensive income. • As an element in the changes in stockholder displayed as a column in the statement of stockholders’ equity (discussed later in this chapter). In addition to the presentation of each year’s changes in the elements of other comprehensiv equity section of the balance sheet. The components of comprehensive income are presented net of income tax, much like an e Home Depot, Inc., included in Appendix A of this text, follo ves and presents comprehensiv Comprehensive Income. F Comprehensiv y’ pany’ y’s ov , b publicly held companies present the elements of other comprehensiv similar to Home Depot, Inc.

STATEMENT OF STOCKHOLDERS’ EQUITY Learning Objective

LO8 e e

Man w the changes during the year in all xpanded statement, called a statement of stockholders’ equity, is illustrated in for Salt Lak The top line of the statement includes the beginning balance of each major cate stockholders’ equity as presented

535

Other Transactions Affecting Retained Earnings

in

. We have added several other stock transactions to illustrate the full range of

• Issuance of common stock for $260,000 (resulting in an increase in both common stock and additional paid-in capital). • Conv decrease in 5 percent conv additional paid-in capital. •

STOCKHOLDERS’ EQUITY SECTION OF THE BALANCE SHEET s balance sheet for the year ended en directly from Exhibit 12–5. You should red as a

December 31, 2011, is shown in be able to e result of ha

.

ariations occur in the selection of titles, in the sequence of items, and in the extent of detailed void excessive detail in the balance sheet, combine several related ledger accounts into a single balance sheet item.

Exhibit 12–5

STATEMENT OF STOCKHOLDERS’ EQUITY

SALT LAKE CORPORATION STATEMENT OF STOCKHOLDERS’ EQUITY FOR THE YEAR ENDED DECEMBER 31, 2011

Note: The numbers that are not bracketed represent positive stockholders’ equity amounts. The bracketed numbers represent negative stockholders’ equity amounts.

536

Chapter 12 Income and Changes in Retained Earnings

Exhibit 12–6 SECTION OF BALANCE SHEET

From stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

112,000

692,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

780,400

Ethics, Fraud & Corporate Governance

Just for Feet, Inc. Learning Objective

I

LO9

Just for Feet Just for Feet Just for Feet Just for Feet Just for Feet Just for Feet Just for Feet Just for Feet Adidas Fila Nike Just for Feet

Just for Feet

Just for Feet

537

Concluding Remarks

Concluding Remarks e discussed v coverage of assets, liabilities, and stockholders’ equity, which began in Chapter 7 and included v . While these chapters generally follow a balance sheet organization, in Chapter 12 we also cov gular income items and In the next chapter

ws. Recall that

ws. We delayed the detailed coverage of the statews to this point in this textbook because of the importance of the material we have now covered, particularly in Chapters 7 to 12, for a full understanding of that statement.

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

LO1

escribe how irregular income items, such as ontinued operations and extraordinary items, e presented in the income statement.

LO7

efine comprehensive income, and explain how it fers from net income.

LO8

escribe and prepare a statement of stockholders’ quity and the stockholders’ equity section of the sheet.

ompute earnings per share. LO2

LO3

LO4

istinguish between basic and diluted earnings share.

ount for cash dividends and stock dividends, lain the effects of these transactions on ompany’s financial statements.

LO9

I i

trate steps management might take to ve the appearance of the company’s net ome.

Just for Feet

escribe and prepare a statement of retained LO5

LO6

efine prior period adjustments, and explain how e presented in financial statements.

Key Terms Introduced or Emphasized in Chapter 12

Demonstration roblem

Solution to the Demonstration Problem

GENERAL JOURNAL

Page 1

EMBASSY CORPORATION PARTIAL INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

EMBASSY CORPORATION STATEMENT OF RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2011

Self-Test Questions

ASSIGNMENT MATERIAL

Discussion Questions

Brief Exercises LO1

LO1

LO1

LO4

LO5

LO5 LO6

LO4

S

accounting

LO4 E

LO4

LO8

S S

LO7 E

Exercises LO4

E S

LO1

E A

LO4

LO6

LO7

accounting

LO1

LO2

LO1

LO2

LO2

LO2

LO4

S

LO4

E

LO4

E E

LO8

E R

LO2

LO4

E E T E

LO1

LO5

LO8

LO7

LO4

LO3

Home Depot, Inc. E Home Depot,

LO5 S

Home Depot Home Depot

LO1

LO8

E

Home Depot, Inc. Home Depot, Inc.

H F

Home Depot

Problem Set A LO1

LO2

P R E P

LO1

P

LO2

F S S E

LO5

LO6

accounting

LO1

LO2

LO5

LO6

A

PHOENIX, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

LO4

P E

LO4

LO8

P

E

LO4

LO8

T T

LO8 E

LO4

LO8

LO1

P

E A

P F

LO2

Problem Set B LO1

LO2

P

LO1 F

LO2

LO5 LO6

S

LO1

P R

LO2

A P

LO5

LO6

LO4

P E

DEXTER, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

LO4

LO8

E

LO4

LO8

T T

LO8

P E

LO4

P

LO8

P S S

LO1

LO2

F S

Critical Thinking Cases LO1

Atlantic Richfield Company (ARCO) ARCO American Airlines

Union Carbide Corp. Georgia-Pacific Corporation

LO1

C I

JACKSON PUBLISHING, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

LO1

C U

LO3

LO8

C

LO1

LO2

C

t I

LO8

LO9

C

LO2

Martin Marietta Materials, Inc.

http://www.yahoo.com

Answers to Self-Test Questions

CHA P TER 13

Statement of Cash Flows

Learning Objectives

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO: LO1

LO2

LO3

LO4

LO5

LO6

LO7

LO8

LO9

LOWE’S

Lowe’s Lowe’s

Lowe’s

■

564

Chapter 13 Statement of Cash Flows

y is helpful to investors and creditors in judging ws. If the company itself does not hav w, it is unlikely that the company will be in a cash position to pro ws to its investors and creditors. W ws, and in Chapter 13 we go into greater depth re ws shows how the company’ xplains how the compan v activities.

Statement of Cash Flows PURPOSES OF THE STATEMENT Learning Objective

The objectiv cash payments of a b

ws is to pro

cash receipts cash ws

LO1

y’s operating activities, ws assists investors,

investing acti creditors, and others in assessing such factors as: • The company’ v • The company’ • The company’s need for e • from operating activities. • Both the cash and noncash aspects of the company’s inv for the period. • and the end of the accounting period. Stated simply pany’

vidends. ws

valents between the be

v v

valuate a comor this y’s

v and prospective competitors.

EXAMPLE OF A STATEMENT OF CASH FLOWS ws appears in Exhibit 13–1

ws are shown

in parentheses.1

CLASSIFICATION OF CASH FLOWS Learning Objective

LO2

ws sho activities, (2) investing activities, and (3) the w

gories: (1) operating activities.2 We will no gories.

i

Operating Activities The operating activities section shows the cash effects of revenue and e

ay, the operating activities section of the ws includes the cash ef ing operations section of the income statement. To illustrate this concept, consider the effects

1

direct method. ve approach, called the indirect method, is illustrated later in this chapter. 2 To reconcile to the ending cash balance, “effects of changes in exchange rates on cash” is used in the complexities, is discussed in more advanced accounting courses.

565

Statement of Cash Flows

ALLISON CORPORATION STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2011

occur credit sales, cash will be receiv

recognition of an e

or many vents occur wever, the income statement and the operating activities fer xist between the , for example, the expense xpense is s

employees have retired. ws from operating activities include:

v

Exhibit 13–1 STATEMENT OF CASH FLOWS

566

Chapter 13 Statement of Cash Flows

Notice that receipts of interest and dividends ing activities, not as inv vities.

interest

Investing Activities

ws relating to investing activities present the cash effects volving plant assets, intangible assets, and investments. They include:

Financing Activities

vities include the follow-

loans, not to payments made on venues and expenses ws from operating activities. Also, remember that all interest vities.

Why Are Receipts and Payments of Interest Classified as Operating Activities? A case can be made that interest and dividend receipts are related to investing acti vities. The Financial Accounting Standards Board (FASB) considered this point of view but decided instead to require companies to present interest and dividend receipts and interest payments as operating activities. The F vities venue and expense transactions entering into the determination of net income. Because dividend and interest revenue and interest expense enter into ws should be presented as operating acti ws. Payments of dividends, however, do not vities.

I N T E R N AT I O N A L C A S E I N P O I N T

567

Preparing a Statement of Cash Flows

Cash and Cash Equivalents F

ws, both cash and cash equivalents. Cash equivalents highly liquid inv y market funds, commercial paper, and T that will mature within 90 days from the acquisition date. v ws are presented in the investing acti ws. The amount sho cash and cash equivalents in the balance sheet must be the same as the amount shown on the statement ws. T y between a company’ valents are not viewed as cash receipts or cash payments. Money is considered cash regardless y valents. Interest received from holding cash equivalents is included in cash receipts from operating activities. Mark vestments in the stocks and bonds of other companies, . Therefore, purchases and sales of marketable securities do ws as investing activities. y must hav gy that generates positiv ws from its operating activities if it is to be successful. A business with negativ ws from . In f of a b vities is highly dependent on its ability to to invest in a compan

vities to ensure vidends.

Similarly v vided by investing activities. At some point, plant assets, investments, and other assets available for sale will be depleted.

Cash versus Accrual Information The items in an income statement and a balwever, that ws do not cash transactions general ledger, however, is maintained on the accrual basis of accounting, not the cash basis. Thus an amount such as “Cash receiv . . $870,000” does not appear as the ved from one or more such accounts. In a small b ws directly or most businesses, however ws by examining the income statement and the changes during the period in all of the balance sheet accounts except for Cash. y transaction affecting cash must also affect some other asset, liability, or owners’ equity account.3 The change in these other accounts determines the nature of the cash transaction, as we see in the example that follows.

Preparing a Statement of Cash Flows e will now show how this statement was dev y’ Basically income statement and comparative balance sheets at the be , however, to hav

changes is Allison’s income statement,

v

Additional Information An analysis of changes in the balance sheet accounts of Allison vides the follo 3

o

Revenue, expenses, and dividends represent changes in o

y’s acti garded as

568

Chapter 13 Statement of Cash Flows

Exhibit 13–2

ALLISON CORPORATION INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

INCOME STATEMENT

year. T into the cate

ws, we hav vities, investing acti

vities.

OPERATING ACTIVITIES 1. vable increased by $30,000 during the year. 2. Dividend revenue is recognized on the cash basis, but interest revenue is recognized on the v . 3. Inv . 4. During the year xpenses payable (other than for interest or income taxes) decreased by $6,000. Depreciation for the 5. 6.

. es payable decreased by $2,000 during the year.

INVESTING ACTIVITIES 7. Analysis of the Mark ing the cost of securities purchased, and credit entries of $44,000, representing the cost of valents.) 8. Analysis of the Notes Receivable account shows $17,000 in debit entries, representing wers during the year, and $12,000 in credit vable. (Collections of interest were recorded in the Interest Rev vities.) 9. Allison’ . An analysis of the underlying transactions indicates the following:

569

Preparing a Statement of Cash Flows

Exhibit 13–3

ALLISON CORPORATION COMPARATIVE BALANCE SHEETS DECEMBER 31, 2011 AND 2010

BALANCE SHEETS

FINANCING ACTIVITIES 10. During the year y repaid $55,000 in principal amounts due on these vities.) 11. The company issued bonds payable for $100,000 cash. 12. The company issued 1,000 shares of $10 par value capital stock for cash at a price of $50 per share. 13. Cash di .

CASH AND CASH EQUIVALENTS 14. Cash and cash equivalents as sho to $20,000 at the beginning of the year and $55,000 at year-end—a net increase of $35,000. tion’

vesting and

570

Chapter 13 Statement of Cash Flows

tion by citing the paragraph numbers sho ws is fundamentally o assist in o colors in our illustrated computations. We show in blue s income statement and the preceding numwn in red.

CASH FLOWS FROM OPERATING ACTIVITIES LO3 a

As sho acti

ws in Exhibit 13–1

ws are cash receiv vidends received; the ws are cash paid to suppliers and employees, interest paid, and income taxes paid. such as net sales, cost of goods sold, or interest expense. As you study each computation, be sure that you understand why the income statement amount must be increased or decreased to ws. Y will do more than show you ho standing of the income statement and the balance sheet.

Cash Received from Customers To the extent that sales are made for cash, there ved from customers in the statement of cash ws and the amount recorded as sales rev however vable increase during the year, credit sales will have e vable. Therefore, we deduct the increase in accounts receiv receiv vable decrease, collections of these accounts will have exceeded credit sales. Therefore, we add the decrease in accounts receivable to net sales ved during the year receiv w: Cash Received Net ⴙ Decrease in Accounts Receivable ⴝ s or from Customers Sales ⴚ Increase in Accounts Receivable s

Learning Objective

xample, paragraph 1 that accounts receivable increased by $30,000 during the year. The income statement shows v computed as follows: Net sales (accrual basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$900,000

Less: Increase in accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30,000

Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$870,000

Interest and Dividends Received Our ne cash receiv e 2 cash basis. Therefore, the $3,000 sho of cash received as dividends. Interest rev sho w to conv v basis. We use the same approach to conv basis. v est revenue to the cash basis as follows:

y’s investments. As vidend revenue is recorded on the

e have already v v

cash -

571

Preparing a Statement of Cash Flows

s

Interest Interest ⴝ Received Revenue

ⴙ Decrease in Interest Receivable s or ⴚ Increase in Interest Receivable

ws interest revenue of $6,000, and para2 vable decreased by $1,000 during the year. Thus the amount of cash received as interest is computed as follows: Interest revenue (accrual basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$6,000

Add: Decrease in accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,000

Interest received (cash basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$7,000

The amounts of interest and dividends received in cash are combined for presentation in ws: Interest received (cash basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 7,000

Dividends received (cash basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,000

Interest and dividends received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$10,000

CASH PAYMENTS FOR MERCHANDISE AND FOR EXPENSES The ne

ws, “Cash paid to suppliers and employees,” includes xpenses (excluding interest and income taxes). Payments of interest and income taxes are listed as separate items in the statement. The amounts of cash paid for purchases of merchandise and for operating expenses are computed separately.

Cash Paid for Purchases of Merchandise cost of goods sold during the year, regardless of whether the merchandise was cash paid for merchandise during the year, even if the merchandise was acquired in a previrelated balance sheet accounts: inv relationship may be stated as follows: Increase in Inventory Cash Payments Cost of ⴝ or u and for Purchases Goods Sold Decrease in ⴚ Inventory ⴙ

Decrease in Accounts Payable u or Increase in ⴚ Accounts Payable ⴙ

u

u

3, the cash ws: Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$500,000

Add: Increase in inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10,000

Net purchases (accrual basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$510,000

Less: Increase in accounts payable to suppliers . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15,000

Cash payments for purchases of merchandise . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$495,000

Here is the logic behind this computation: If a company is increasing its inv , it is buying more merchandise than it sells y is increasing its not paying cash for all of these purchases in

Chapter 13 Statement of Cash Flows

Cash Payments for Expenses Expenses, as sho wever, the amounts sho as e , for example, depreciation expense. Recording depreciation expense requires no cash payment, but it does increase total e v expenses to the cash basis, we deduct depreciation expense and any other noncash expenses xpenses. Other noncash expenses—expenses not requiring

timing differences tion of e wever, the cash payments for these expenses

1. If payment is made in adv

xpense, or, ” Thus, to the extent that prepaid expenses increase over the year, cash payments exceed the amount recognized as expense. 2. xpense. 3. xpense payable. Thus, to the e xpenses payable decrease over the year, cash payments e xpense. The relationship between cash payments for e w:

Depreciation and Other t and ⴚ Noncash Expenses

w

t

Cash Payments ⴝ Expenses for Expenses

Increase in ⴙ Related Prepayments or w and Decrease in ⴚ Related Prepayments

xpenses is sum-

w

572

Decrease in ⴙ Related Accrued Liabilities w or Increase in ⴚ Related Accrued Liabilities es are sho

poration’s income statement and from paragraph 4, we may compute the company’s cash payments for operating expenses as follows: Operating expenses (including depreciation) . . . . . . . . . . . . . . . . . . . . . .

$300,000

Less: Noncash expenses (depreciation) . . . . . . . . . . . . . . . . . . . . . . . . . .

40,000

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$260,000

Add: Increase in short-term prepayments . . . . . . . . . . . . . . . . . . . . . . . .

$3,000

Decrease in accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6,000

Cash payments for operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . .

9,000 $269,000

Cash Paid to Suppliers and Employees w statement, “Cash paid to suppliers and employees,” includes cash payments for both purchases of merchandise and for operating e w may now be computed by combining the two previous calculations: Cash payments for purchases of merchandise . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$495,000

Cash payments for operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

269,000

Cash payments to suppliers and employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$764,000

573

Preparing a Statement of Cash Flows

Cash Payments for Interest and Taxes Interest expense and income taxes expense may be conv ating e and paragraph 5 year. The f of the inter T

v s income statement shows interest expense of $35,000, increased over the year means that not all . subtract xpense the

computation is as follows: Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$35,000

Less: Increase in related accrued liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7,000

Interest paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$28,000

amounts to $36,000. However 6 states that the compan income taxes payable by $2,000 over the year over the year e

xpense increases the tax decreased must have been greater than the income tax ws:

Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$36,000

Add: Decrease in related accrued liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,000

Income tax paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$38,000

A Quick Review We have now sho

w relating to s operating activities. In Exhibit 13–1 we illustrated a complete statement ws for the company. For your convenience, we again show the operating activities v

Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 870,000

Interest and dividends received . . . . . . . . . . . . . . . . . . . . . . . . . .

10,000

Cash provided by operating activities . . . . . . . . . . . . . . . . . . . .

$ 880,000

Cash paid to suppliers and employees . . . . . . . . . . . . . . . . . . . .

$(764,000)

Interest paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(28,000)

Income taxes paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(38,000)

Cash disbursed for operating activities . . . . . . . . . . . . . . . . . . . Net cash flows from operating activities . . . . . . . . . . . . . . . . . . . . .

(830,000) $ 50,000

CASH FLOWS FROM INVESTING ACTIVITIES Paragraphs 7 through 9 pro ties. In the follo

xample ws from investing activiws and explain

vesting activities can be obtained simply by looking at the changes in the related asset accounts during the year cash receipts. However, credit entries in asset accounts represent the cost (or book value) of the assets sold. T

Learning Objective

LO4

574

Chapter 13 Statement of Cash Flows

Purchases and Sales of Securities T

7, which sum-

in this chapter cost of mark However, the income statement sho $4,000 loss. Thus the cash proceeds from these sales amounted to only $40,000 ($44,000 cost, minus $4,000 loss ws, these investing acti ws: Purchases of marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$(65,000)

Proceeds from sales of marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40,000

Loans Made and Collected P

8 pro ws from making and collecting loans:

Loans made to borrowers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$(17,000)

Collections on loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12,000

v account represent new loans made during the year; credit entries indicate collections of the principal ved is credited to the Interest Revenue account and is included among the cash receipts from operating activities.)

YOUR TURN

Cash Paid to Acquire Plant Assets P

9 purchased plant assets during the year for $200,000, paying $160,000 in cash and issuing a only the $160,000 cash payment ws. However, one objectiv to show all of the company’s in during the year. Therefore, the noncash aspects ws:

Purchases of plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$200,000

Less: Portion financed through issuance of long-term debt . . . . . . . . . . . . . . . . . . .

40,000

Cash paid to acquire plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$160,000

ws.

575

Preparing a Statement of Cash Flows

Proceeds from Sales of Plant Assets Assume that an analysis of the plant asset ws net credit entries totaling $44,000 in the year book value of plant assets sold during the year. However, the income statement shows that these assets were sold at a gain of $31,000. Therefore, the cash proceeds ws:

Book value of plant assets sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$44,000

Add: Gain on sales of plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31,000

Proceeds from sales of plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$75,000

ws.

A Quick Review We have now sho

w related to s investing activities. In Exhibit 13–1 we illustrated a complete statement ws for the company. For your convenience, we again show the investing activities veloped in the preceding paragraphs.

Purchases of marketable securities . . . . . . . . . . . . . . . . . . . . . . .

$ (65,000)

Proceeds from sales of marketable securities . . . . . . . . . . . . . . .

40,000

Loans made to borrowers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(17,000)

Collections on loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12,000

Purchases of plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(160,000)

Proceeds from sales of plant assets . . . . . . . . . . . . . . . . . . . . . .

75,000

Net cash flows from investing activities . . . . . . . . . . . . . . . . . . . . . .

$(115,000)

vesting acti ws is that increases and decreases in cash from similar transactions are presented separately rather than . For e gative etable securities ($65,000) is shown separately from the positiv w from the sales of mark o to a single negativ ⫺ $40,000).

CASH FLOWS FROM FINANCING ACTIVITIES ws vesting activities, vities seldom involve gains or losses.4 Thus the debit or credit changes in ws.

Short-Term Borrowing Transactions T pro

4

10, which ws:

Proceeds from short-term borrowing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$45,000

Payments to settle short-term debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(55,000)

576

Chapter 13 Statement of Cash Flows

wing of $45,000 (a positiv w) and the gativ w) are presented in the ws. Presenting both directions of the changes in cash, rather than combining the two and presenting a net amount of $10,000 ($55,000 ⫺ ws. Presenting both positive and negativ ws is gross ws rather than presenting net ws. vie sum of the credit entries Notes Payable sum of the debit entries in this account.

P

Proceeds from Issuing Bonds Payable and Capital Stock Paragraph 11 ved cash of $100,000 by issuing bonds payable. This Bonds P Paragraph 12 the Capital Stock and Additional Paid-in Capital accounts ($10,000 ⫹ $40,000).

Cash Dividends Paid to Stockholders ration declared and paid cash di

Paragraph 13

. If dividends are both , the cash payments are equal to the related debit vidends payable, the amounts debited to

vidends declared amount of dividends paid. T dends declared by adding an account over the period.

vidends paid, we adjust the amount of diviy increase) in the Dividends Payable

A Quick Review We have now sho

w related to Allivities. In Exhibit 13–1 we illustrated a complete statement of ws for the company. For your convenience, we again sho vities veloped in the preceding paragraphs.

Proceeds from short-term borrowing . . . . . . . . . . . . . . . . . . . . . . . .

$ 45,000

Payments to settle short-term debts . . . . . . . . . . . . . . . . . . . . . . . .

(55,000)

Proceeds from issuing bonds payable . . . . . . . . . . . . . . . . . . . . . . .

100,000

Proceeds from issuing capital stock . . . . . . . . . . . . . . . . . . . . . . . .

50,000

Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(40,000)

Net cash flows from financing activities . . . . . . . . . . . . . . . . . . . . . . . .

$100,000

RELATIONSHIP BETWEEN THE STATEMENT OF CASH FLOWS AND THE BALANCE SHEET ne

valents. The statement of ws explains in some detail the change in this asset from one balance sheet date to the ws illustrate this relationship, as shown in xample:

Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . .

$35,000

Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20,000

Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$55,000

577

Preparing a Statement of Cash Flows

CASE IN POINT

Microsoft Corporation

REPORTING OPERATING CASH FLOWS BY THE INDIRECT METHOD ws from operating acti

ve folo this point in our study of the ws, we have emphasized the direct method because we consider it to be

lo v mended by the F

ing net cash provided by operating acti is the same as discussed earlier in this chapter. The two methods are more similar than it and the s case, $50,000. Both methods conv prepared on the cash basis. In Exhibit 13–4 blue ws are sho red. T ws sho begins with an income statement amount and then adds or subtracts the change during the period in related balance sheet accounts. Now look at our illustration of the indirect method in in balance sheet accounts. The difference between the two methods lies only in approach. However approaches pro

in contrast, explains why

o

vities of the business. The indirect method, ws from operating acti

578

Chapter 13 Statement of Cash Flows

Exhibit 13–4 COMPARISON OF DIRECT AND INDIRECT METHODS

Cash flows from operating activities: Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and dividends received . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . Cash paid to suppliers and employees . . . . . . . . . . . . . . . . . . . . . Interest paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash disbursed for operating activities . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . .

$ 870,000 10,000 $880,000 $(764,000) (28,000) (38,000) (830,000) $ 50,000

Learning Objective

LO5

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Add: Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued interest receivable . . . . . . . . . . . . . . . . . . Increase in accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in accrued interest liabilities. . . . . . . . . . . . . . . . . . . . . Nonoperating loss on sales of marketable securities . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Increase in accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . Increase in inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued operating expenses payable . . . . . . . . . . Decrease in accrued income taxes payable . . . . . . . . . . . . . . . Nonoperating gain on sales of plant assets . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . .

d o fl

$ 65,000 40,000 1,000 15,000 7,000 4,000 $132,000 $30,000 10,000 3,000 6,000 2,000 31,000

82,000 $ 50,000

RECONCILING NET INCOME WITH NET CASH FLOWS Learning Objective

LO6

d

T ws from operating activities. The nature and orksheet or a computer program; they are not entered in the company’ 1. Adjusting for Noncash Expenses Depreciation is an example of a noncash expense—that is, depreciation expense reduces net income but does not require an w related to depreciation resulted when the asset w as presented as an investing acti y depreciation was ever recognized.) Depreciation causes e ws. T ws, we add y other noncash expenses. (Other noncash expenses included unfunded pension e 2. Adjusting for Timing Differences Timing dif ws arise whenever revenue or expenses are recognized by debiting or crediting an account other than Cash. Changes over the period in the balances of these asset and liability accounts represent difvenue or e ws from operating activities. The balance sheet v vable, Inventoayable. 3. Adjusting for Nonoperating Gains and Losses Nonoperating gains and losses include gains and losses from sales of inv assets, and discontinued operations (which relate to investing activities); and gains and vities).

579

Preparing a Statement of Cash Flows

vities, investing activioperating activities. However fore, in conv ws from operating activities, we add back any nonoperating losses and deduct any nonoperating gains of the transaction is then presented as an investing acti xample, sale of a building) ws.

THE INDIRECT METHOD: A SUMMARY ws: Net income Depreciation Decrease in accounts receivable Decrease in inventories Decrease in prepaid expenses Increase in accounts payable Increase in accrued expenses payable Increase in deferred income taxes payable Nonoperating losses deducted in computing net income Increase in accounts receivable Increase in inventories Increase in prepaid expenses Decrease in accounts payable Decrease in accrued expenses payable Decrease in deferred income taxes payable Nonoperating gains added in computing net income Net cash provided by (used in) operating activities

LO7

INDIRECT METHOD MAY BE REQUIRED IN A SUPPLEMENTARY SCHEDULE The F direct method acti wever, elect to use the indirect method. One reason is that the FASB requires companies opting for the direct method to meet an additional Companies using the direct method are required to provide a hedule sho vities by the indirect method. However presented in the body of the statement.

THE STATEMENT OF CASH FLOWS: A SECOND LOOK We have no We hav

ws. o

of individual operating, inv ws from operating activities, we began by using the direct method, in which major categories of both positive and negativ W ws. Rather than adjusting each indi w cate Exhibit 13–5 vities and includes tw schedules. hedule A in Exhibit 13–5 from operating activities by the indirect method.

ws hedule B in Exhibit 13–5

580

Chapter 13 Statement of Cash Flows

Exhibit 13–5

ALLISON CORPORATION STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2011

(EXPANDED) STATEMENT OF CASH FLOWS

Net cash provided by operating activities (see Supplementary Schedule A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of marketable securities . . . . . . . . . . . . . . . . . . . . . . $ (65,000) Proceeds from sales of marketable securities . . . . . . . . . . . . . . 40,000 Loans made to borrowers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,000) Collections on loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 Cash paid to acquire plant assets (see Supplementary Schedule B) . . . . . . . . . . . . . . . . . . . . . . . . . . (160,000) Proceeds from sales of plant assets . . . . . . . . . . . . . . . . . . . . . . 75,000 Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from short-term borrowing . . . . . . . . . . . . . . . . . . . . . $ 45,000 Payments to settle short-term debts . . . . . . . . . . . . . . . . . . . . . . (55,000) Proceeds from issuing bonds payable . . . . . . . . . . . . . . . . . . . . 100,000 Proceeds from issuing capital stock . . . . . . . . . . . . . . . . . . . . . . 50,000 Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (40,000) Net cash provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net increase (decrease) in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, Jan. 1, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, Dec. 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Notice this supplementary schedule illustrates the indirect method of determining cash flows from operations

$ 50,000

(115,000)

100,000 $ 35,000 20,000 $ 55,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Add: Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nonoperating loss on sales of marketable securities . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Increase in accounts receivable . . . . . . . . . . . . . . . . . . . . . . $ 30,000 Increase in inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Increase in prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Decrease in accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Nonoperating gain on sales of plant assets . . . . . . . . . . . . . . 31,000 Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 65,000 40,000 1,000 15,000 7,000 4,000 $ 132,000

Purchases of plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Portion financed through issuance of long-term debt . . . . . . . . . . . . . . . . . Cash paid to acquire plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 200,000 40,000 $ 160,000

82,000 $ 50,000

discloses any noncash aspects of the company’s inv vities. This type ver some aspects of the company’s investing and How w

ws in

differ if the indirect method were ould be moved up into the ould no longer

be required as a supplemental disclosure. In f indirect method. Because the indirect method calculation is required to be disclosed if the direct method is used, many companies simply prefer to include the reconciliation of net ws and av

581

Preparing a Statement of Cash Flows

Financial Analysis and Decision Making

Net cash flows from operating activities . . . . . . . . . . . . . . . . . . . . . . . .

$ 50,000

Less: Net cash used for acquiring plant assets ($160,000 ⫺ $75,000 proceeds) . . . . . . . . . . . . . . . . . . . . . . . .

$85,000

Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40,000

Free cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

125,000 $(75,000)

YOUR TURN

Home Depot Intel Coca-Cola

Amazon

Home Depot Intel Coca-Cola Amazon

Managing Cash Flows ws. No b obligations. Even being a fe sev

act, it has a ault on its s most basic respony come due.

BUDGETING: THE PRIMARY CASH MANAGEMENT TOOL ws is a cash budget. A cash budget is a forecast of future cash receipts and payments. This budget is not uted to people outside of the organization. To managers, however In many ways, a cash b ws. However, the budget shows the results expected in future periods, rather than those achieved in the past. Also, the cash budget is more detailed, usually showing e ws month-by-month and separately for ev ganization. 582

583

Managing Cash Flows

Cash b

e man

• Encouraging managers to plan and coordinate the acti ance. • Providing managers with advance notice of the resources at their disposal and the results they are expected to achieve. • Providing tar v • Providing advance w

WHAT PRIORITY SHOULD MANAGERS GIVE TO INCREASING NET CASH FLOWS? Creditors and investors look to a company’ ws to protect their investment and prorends in ke w) y’ v or these reasons, management is under constant pressure to improve the key measures of cash w con-

Short-Term Results versus Long-Term Growth ved at the e for developing ne ov

or e

gy may lessen the company’s competitiv

.

One-Time Boosts to Cash Flows Some strate

ws ut without having muc ws. Such strategies include collecting receivables more quickly and reducing the size of inv . xample, that a compan collected in April. Notice that in each month, the company is collecting about one month’s amount of credit sales. Now assume that on March 1 the company changes its policies to allow only 30-day credit y will collect and those made in March (under the ne v ws for the months ahead. In May, the company will collect one month’s vided only a one-time boost in cash receipts. A similar one-time boost may be achieved by reducing the size of inv . This reduces but only while in e falling. Once the company stabilizes the size of its inv w and lower level, its monthly purchases

SOME STRATEGIES FOR PERMANENT IMPROVEMENTS IN CASH FLOW Several strategies may improv

ws in both , and developing an

Deferring Income Taxes

deferoduct mix.

Deferring income tax xample is

using an accelerated depreciation method wing business e gy.6 6

v

es

. Thus, it is an effective and

CRS) is an accelerated method widely used for income wing business can is that each year it defers a eater amount

Learning Objective

LO8

584

Chapter 13 Statement of Cash Flows

Peak Pricing Some businesses have more customers than they can handle—at least at Peak pricing is a strate

. Examples of such businesses include popular restaurants, . venue and to ration xceeds supply (or capacity). A higher price is charged

o related goals. First, it increases the seller’s revenue greatest demand. Second, it shifts when the b Peak pricing may make goods and services available to customers who ford them. Also, peak pricing may prevent systems, such as cellular telephones, from becoming so overloaded that they simply cannot function. Peak pricing is not always appropriate. For example, we would not expect hospitals or physicians to raise their prices during epidemve to peak pricing is a single price all the time.

Dev

ective Product Mix

ing rev ve product mix are to (1) increase total sales and gins (that is, the e ver the cost of the product). Some products complement one another uys one product often may purchase the other xamples of complementary products include french fries at a hamburger restaurant, snacks at a movie theater

Ethics, Fraud & Corporate Governance Dynergy

Dynergy Dynergy

ABG Supply ABG Supply Dynergy

Dynergy

Dynergy ABG Supply

Dynergy, Inc.

Dynergy

Dynergy

Dynergy Dynergy Dynergy

Dynergy

Some complementary products are essential to satisfying the customer. (Would you be happ t sell food?) Others increase sales by attracting customers who also purchase other types of merchandise. y’s main product lines. But, in reality, these incidental items may be the company’

A Worksheet for Preparing a Statement of Cash Flows ws is developed by systematically analyzing all changes in the noncash balance sheet accounts. This process can be formalized and documented through the preparation of a specially designed worksheet. The worksheet also provides the accountant with visual assurance that the changes in balance sheet accounts have been fully explained.

Learning Objective

LO9

DATA FOR AN ILLUSTRATION W Sho

Supply Co.7 Exhibit 13–6 are the balances in Auto’s balance sheet accounts at the be

Exhibit 13–6

AUTO SUPPLY CO. COMPARATIVE BALANCE SHEETS

AUTO SUPPLY CO. BALANCE SHEETS

Changes in the noncash

7

poration w ws.

v

v

orksheet for Allison Cor-

585

586

Chapter 13 Statement of Cash Flows

appear in the right-hand

orksheet.)

Additional Information The follo the w

blue,

ws in red.)

1. Net income for the year amounted to $250,000. Cash dividends of $140,000 were declared and paid. 2. Auto’s only noncash expense was depreciation, which totaled $60,000. 3. Marketable securities costing $15,000 were sold for $35,000 cash, resulting in a $20,000 nonoperating gain. 4. The company purchased plant assets for $100,000, making a $30,000 cash down payment and issuing a $70,000

THE WORKSHEET ws from operating activities by the indirect method.8 A ws appears in . To set up the worksheet, the company’ of the worksheet, with the be -end balances in ve shown these accounts and account balances in black.) The tw ov w each change affected cash. w

Entries in the Two Middle Columns

top portion of the workver the year. (Because these entries y are sho blue.) F orksheet, we make an of bottom portion of the worksheet indicating the of v vities and are e ve caption. (Entries representing the cash effects of transactions and the related descriptive captions appear in red.) o middle columns may be made in any sequence, b following approach: sheet

1. 2. xpense (and any other noncash expenses). 3. vities. 4. Explain any remaining changes in balance sheet accounts other than Cash. (Hint: Changes in asset accounts represent investing acti vities.) 5. Compute and record the net increase or decrease in cash. Using this approach, we next e

orksheet.

ENTRY 1. Auto’s net income explains a $250,000 credit orking paper Sources vity.9 2. Cash dividends of $140,000 caused a debit alls into the Uses column; payments of dividends are classivity.

Step 1: Explain the changes in retained earnings

8

If the w vities section. Such w 9 When the indirect method operating acti

anced accounting courses. es as the starting point

587

A Worksheet for Preparing a Statement of Cash Flows

AUTO SUPPLY CO. WORKSHEET FOR A STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2011

(x)

5,000

(8)

15,000

(5)

5,000

Exhibit 13–7 WORKSHEET FOR A STATEMENT OF CASH FLOWS

Up here we summarize the changes in each noncash account

(4) 10,000

(9) 100,000

(3) 60,000

(6) 10,000 (7) 15,000 (9) 70,000 (10) 150,000 (2) 140,000

(1) 250,000

415,000

415,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(1) 250,000

Depreciation expense . . . . . . . . . . . . . . . . . . . .

(3) 60,000

Increase in accounts receivable . . . . . . . . . . . .

c effects of these changes (4) 10,000

Decrease in inventory . . . . . . . . . . . . . . . . . . . .

(5)

5,000

Increase in accounts payable . . . . . . . . . . . . . .

(6)

10,000

Cash provided by operations— $280,000

Decrease in accrued expenses payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(7) 15,000

Gain on sales of marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . .

(8) 20,000

Proceeds from sales of marketable securities . . . . . . . . . . . . . . . . . .

(8) 35,000

Cash paid to acquire plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(9) 30,000

Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . .

(2) 140,000

Payments to retire bonds payable . . . . . . . . . .

(10) 150,000

Subtotals . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net decrease in cash . . . . . . . . . . . . . . . . . . . . Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

W

360,000 (x) 5,000 365,000

365,000

Cash provided by investing activities— $5,000

Cash used in financing activities— $290,000

365,000

ve explained how Auto’

3. Auto’s only noncash expense w orksheet, depreciation explains a $60,000 credit (decrease) in Plant and Equipment

Step 2: Account for noncash expenses

588

Chapter 13 Statement of Cash Flows

Step 3: Account for timing

bottom of the w e have explained that depreciation is not really a source of cash, but that it is added back to net income as a step in ws from operating activities. 4–7. ences ws from operating acti w y show ho ws from operating activities. 8. In 2011, Auto sold mark

y remaining changes in noncash accounts

explains the $15,000 credit change in the Mark erating gain, which is removed from the Operating Activities section of the worksheet etable vesting Activities cate . 9. note payable. These events explain a $100,000 debit in Plant and Equipment and ayable; they involved a cash outlay of vesting activity of a note payable is a noncash inv vity.)

Exhibit 13–8 AUTO SUPPLY CO. STATEMENT OF CASH FLOWS

Compare the content of this statement with the

AUTO SUPPLY CO. STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2011 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 250,000

Add: Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60,000

Decrease in inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,000

Increase in accounts payable. . . . . . . . . . . . . . . . . . . . . . .

10,000

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 325,000

Less: Increase in accounts receivable . . . . . . . . . . . . . . . . . . . .

$

10,000

Decrease in accrued expenses payable . . . . . . . . . . . . . .

15,000

Gain on sales of marketable securities . . . . . . . . . . . . . . .

20,000

Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . Proceeds from sales of marketable securities. . . . . . . . . . . . . . . Cash paid to acquire plant assets (see supplementary schedule below) . . . . . . . . . . . . . . . . . . . . . . .

45,000 $ 280,000

$

35,000 (30,000)

Net cash provided by investing activities . . . . . . . . . . . . . . . . . . . .

5,000

Dividends paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ (140,000)

Payments to retire bonds payable . . . . . . . . . . . . . . . . . . . . . . .

(150,000)

Net cash used for financing activities . . . . . . . . . . . . . . . . . . . . . . . Net decrease in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(290,000) $

(5,000)

Cash and cash equivalents, Jan. 1, 2011 . . . . . . . . . . . . . . . . . . . .

50,000

Cash and cash equivalents, Dec. 31, 2011 . . . . . . . . . . . . . . . . . .

$ 45,000

Purchases of plant assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 100,000

Less: Portion financed through issuance of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

70,000

Cash paid to acquire plant assets. . . . . . . . . . . . . . . . . . . . . . . . . .

$ 30,000

589

Concluding Remarks

10. The $150,000 debit change in Auto’s Bonds P of the liability has been repaid—that is, $150,000 in bonds has been retired. This is vities cate . fully explain orksheet explains the changes in ev ws for the year. (x) We no Step 5: Compute and record the net change in cash

orksheet. The difference between these column subtotals represents the net increase or decrease in cash. In our example, the Sources col$5,000 decrease in cash ov xactly the amount by which Cash decreased during 2011: $50,000 ⫺ $45,000 ⫽ , labeled (x), explains the credit change in the Cash account at the top of the worksheet and brings the bottom of the worksheet into balance. ws from operating activities by orksheet. In wn in blue; cash

13–8 ws appear in red.

Concluding Remarks estors and ws.

creditors and ho We delayed in-depth cov

As stated earlier, companies hav mation by either the direct or the indirect method. Although we have presented both in this chapter act that most companies emplo e have done this for two reasons. First, we believe the direct method is more readily understood by students and others who are vestors appear to generally favor the direct method, as evidenced by the follo I’ve heard many investors express a strong preference for use of the direct method of preparws. It’s widely understood and believed by many to be a more ve presentation. W ut it is an action you could con10 sider to promote transparency giv v

In the next chapter, we tak

w

y’ vestors alike must look be ws from one period to the next. They must consider factors that cause these changes and how the tions. Throughout this text, we hav useful in analyzing a company. In Chapter 14, we bring those techniques together into a comprehensiv mak y’s business acti of business gies.

10

Donald T

A National velopments,” December 11, 2003.

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

LO1

lain the purposes and uses of a statement of flows.

LO2

escribe how cash transactions are classified in a tatement of cash flows.

LO6

y net income differs from net cash lows from operating activities.

LO7

ompute net cash flows from operating activities using the indirect method.

LO8

iscuss the likely effects of various business trategies on cash flows.

LO9

lain how a worksheet may be helpful in eparing a statement of cash flows.

(

ompute the major cash flows relating to operating tivities.

LO3

r

LO4

ompute the cash flows relating to investing and inancing activities.

c

LO5

istinguish between the direct and indirect methods of reporting operating cash flows.

Key Terms Introduced or Emphasized in Chapter 13

Demonstration Problem

ELECTRO PRODUCTS, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

Solution to the Demonstration Problem ELECTRO PRODUCTS, INC. STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2011

ELECTRO PRODUCTS, INC. (continued) STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2011

Self-Test Questions

ASSIGNMENT MATERIAL

iscussion Questions

Brief Exercises LO3 E

LO7 E

LO3 E

LO7 E

LO4 E

LO4 E

LO3 E

accounting

LO2

LO6

LO2

Exercise LO1 LO2

LO1 LO2

LO6

o

accounting

LO4

LO3

E

LO6

LO3

E

LO3

E R

LO6

R

LO2 F

LO8

LO6 LO7

A P t

LO7

E

LO2

E

LO2

LO4

LO4

LO1

E

Home Depot, Inc.

H

LO2

o

LO4

Home Depot Home Depot

Problem Set A P

LO2

F o

LO4

LO4

P

accounting

LO4

LO3

P

LO8

TREECE, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

LO6 LO7

LO2

LO4

LO6 LO8

21st CENTURY TECHNOLOGIES INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

LO1 P

LO9

SATELLITE 2010 COMPARATIVE BALANCE SHEETS

LO1

LO9

MIRACLE TOOL, INC. COMPARATIVE INCOME STATEMENT FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2011

MIRACLE TOOL, INC. COMPARATIVE BALANCE SHEETS

Problem Set B LO2

LO4

LO4

LO4

P

LO3 LO8

ROYCE INTERIORS, INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

LO6 LO7

LO2

P

LO4 LO6 LO8

FOXBORO TECHNOLOGIES INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

LO1

LO9

a F

LGIN COMPARATIVE BALANCE SHEETS

LO1 a

LO9

EXTRA-ORDINAIRE, INC. COMPARATIVE INCOME STATEMENT FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2011

EXTRA-ORDINAIRE, INC. COMPARATIVE BALANCE SHEETS

Critical Thinking Cases LO1 A

LO1 LO8

Y

LO1 LO4 LO8

LO8 P

LO3

www.sec.gov

LO2

LO4 C

Coca-Cola

Amazon.com

www.coke.com

www.amazon.com

http://www.yahoo.com

Answers to Self-Test Questions

CHA P TER 14

© BananaStock/PictureQuest/DAL

Financial Statement Analysis

AF T ER ST UDYI N G T HI S C HA PT E R , YO U S HO U L D B E A B L E TO:

LO1

Learning Objective

LO2

LO3

LO4

LO5

LO6

LO7

LO8

JOHNSON & JOHNSON

Johnson & Johnson

Johnson & Johnson

Johnson & Johnson

Johnson & Johnson

Johnson & Johnson

■

622

Chapter 14 Financial Statement Analysis

Financial measures are used often to ev

means of protecting the interests of investors and creditors. This chapter e statement analysis in depth, b preceding chapters.

relev

wed by . Third, we present and discuss a comprehensive illustration in which we analyze a company’ v , we dra

as covered in earlier chapters and we

use ne

FINANCIAL STATEMENTS ARE DESIGNED FOR ANALYSIS In today’s global economy, investment capital is always on the mov ganized capital markets such as the New York Stock Exchange, investors each day shift billions of investment dollars among dif ws to those areas in which investors e w do investors y in the conte vide economic decision makers with useful e publicly o word consolidated should hav Most business organizations prepare

v

statements, meaning that items

develop useful subtotals that will assist users of the statements in can business, a practice that assists decision mak gories. In comparative statements, for al time periods appear side by side in v vestors in identifying and ev Most lar y conduct some of their business acti wns other businesses is the parent company, and the o visions or subsidiaries. For example, PepsiCo, which makes Pepsi-Cola, also o operates the companies that make Frito-Lay, Quaker Foods, Gatorade, and Tropicana ganization wn as PepsiCo. Consolidated statements present the y and its subsidas if they were a single business organization.

© AP Photo/Steven Senne

For Example . . . At this point, tak ments of Home Depot, Inc., which appear in Appendix A at the end of the te y v y describe a consolidated business entity ve been audited by KPMG LLP,

623

Tools of Analysis

Tools of Analysis o or more years are placed side by side in adjacent columns. Such a statement is called a compar the left-hand mone ords that describe the item. The balance sheet, ve ve income statement cov wn in Exhibit 14–1.

BENSON CORPORATION COMPARATIVE INCOME STATEMENT FOR THE YEARS ENDED DECEMBER 31, 2011, 2010, 2009 (IN THOUSANDS OF DOLLARS)

Exhibit 14–1 STATEMENT

Comparativ for gaining better understanding. For e of $600,000 in 2011 after years in which sales were $500,000 (2010) and $400,000 (2009) is helpful in understanding Benson’s sales trend. Fe es. It is their Analysis is lar

DOLLAR AND PERCENTAGE CHANGES the f

xpressing the change in ve. For example, if sales this year have increased by $100,000, ver last year’s sales of $1 million puts it in a ve than if it represented a 1 percent increase over sales of $10 million for

Learning Objective

LO1

the prior year. comparison year and the amount for a base year. The percentage change is computed by dividing the amount of the dollar change between years by the amount for the base year. This is illuswing tab ve income statement shown in Exhibit 14–1.

Dollar and percentage changes

624

Chapter 14 Financial Statement Analysis

Although net sales increased $100,000 in both 2010 and 2011, the percentage change differs because of the change in the base from 2009 to 2010. These calculations present no probv gative amount or a zero , however from 2010 to 2011 could not have been calculated.

Evaluating Percentage Changes in Sales and Earnings

Computing the xt gives insight into a company’s rate of gro y is e wth in its economic acti more than the r Assume, for example, that a company’s sales increase by 6 percent while the general price level rises by 10 percent. The entire increase in the dollar amount of sales may be e rather than by an increase in sales volume (the number of units sold). In fact, the company may well have sold goods than in the preceding year. In measuring the dollar or percentage change in quarterly same quarter in the preceding year. vents our analysis usiness activity.

Percentages Become Misleading When the Base Is Small Percentage changes may create a misleading impression when the dollar amount used as a base is unusually small. Occasionally we hear a television newscaster say that a company’ ve increased by a v ge percentage, such as 900 percent. The initial impression created by such a statement is that the company’ w be excessively large. But assume, for example, that a compan , that in the second year level. In this third year, net income has increased by $90,000, representing a 900 percent increase ov ws a v second year and .

TREND PERCENTAGES wing years are often expressed as trend percentages to show the extent and direction of change. Two steps are ven a weight of 100 percent. The second step is to e wing years as a percentage of its baseyear amount. This computation consists of dividing an item such as sales in the years after the base year by the amount of sales in the base year. For example, assume that 2006 is selected as the base year and that sales in the base year amounted to $300,000, as sho computed by di wing year by $300,000. Also shown in are computed by dividing the net income amount for each following year by the base-year amount of $15,000.

625

Tools of Analysis

wth in sales in the early years and accelerated growth in 2010 and 2011. Net income also shows an increasing growth trend with the exception of the year 2010, when net income declined despite a solid increase in sales. The problem was ov erall the trend percentages giv

COMPONENT PERCENTAGES Component percentages indicate the relative size of each item included in a total. For example, each item in a balance sheet could be expressed as a percentage of total assets. This shows quickly the relativ v ing component percentages for several successive balance sheets, we can see which items are Another application of component percentages is to express all items in an income statement as a percentage of net sales. Such a statement is called a common size income statement. Exhibit 14–2.

Exhibit 14–2 COMPONENT PERCENTAGES

Are the year-to-date changes favorable?

Looking only at the component percentages, we see that the increase in cost of goods sold (60 percent to 70 percent) w xpenses as a percent-

RATIOS A ratio is a simple mathematical expression of the relationship of one item to another. Ev percentage may be vie Ratios may be stated in several ways. T expresses the relationship between a company’

.

cial statement. For example, we might compare net income (taken from the income statement) with total assets (taken from the balance sheet) to see how effectively management is using av or a ratio to be useful, however, the two amounts being compared must be logically related. In subsequent sections of this chapter, we will make extensive vities.

STANDARDS OF COMPARISON whether the relationships they hav

avorable or unfavorable. Two such standards

626

Chapter 14 Financial Statement Analysis

.F expected or budgeted numbers.

Past Performance of the Company

-

the condition of the business is improving or worsening. This comparison of data over time is sometimes called horizontal analysis, to express the idea of reviewing data for a number of consecutive periods. It is distinguished from vertical, or static, analysis, which refers to the revie ving or becoming worse, horizonverse their direction at an wever ways involv ford any basis for ev act that net income was 2 percent of sales last year and is 3 percent of sales this year indicates improvement, but if there is evidence that net income should be 7 percent of sales, the record for both years is unfavorable.

Industry Standards The limitations of horizontal analysis may be overcome to some e

y’s

companies and the av xample, that the rev v Alpha’ assume that Ome

.1

v v wed as a favorable

, ould be sub-

y, but it w ven compan verages, our conclusions are valid only if the companies in question are comparable. Because of the large v industry ven companies that f in many respects. For example, one company may engage only in the marketing of oil products; another may be a fully inte .

QUALITY OF EARNINGS usiness entity

Learning Objective

LO2

c a

v

usiness, consume o , and leave the company at the mercy of creditors. In assessing the prospects of a company, we are interested not only in the total amount ut also in the rate of earnings on sales, on total assets, and on owners’ equity. In addition, we must look at the and source ver a period of years, for example, is less desirable than a steady lev A breakdo

major product lines y. Publicly o

valuating

compan 1

v Annual Statement Studies, sev

or e

K

y size. for more than 800 lines of business.

627

Measures of Liquidity and Credit Risk

Financial analysts often e

y are of higher

arises because each company’s management can choose from a variety of accounting principles and methods, all of which are considered generally acceptable. A company’s manageprojections, and accounting policies may be tailored toward these objectives. We have already methods of inv

aluation and the choice of depreciation policies. In judging the quality ativ

QUALITY OF ASSETS AND THE RELATIVE AMOUNT OF DEBT Although a satisf v y’ ability to pay its debts and dividends, we must also look at the composition of assets, their condition and liquidity outstanding. A compan , but plant and equipment may be deteriorating because of poor maintenance policies; valuable patents may be expiring; substantial losses may be imminent due to slow-moving inventories and past-due receivables. Companies with lar ws.

Measures of Liquidity and Credit Risk refers to a company’s ability to meet its continuing obligations as the or example, a compan wed money must mak v credit may be required to pay the seller within 30 days of the purchase date. Transactions like these require a company to maintain a close w . We emphasize throughout this text the importance to investors, creditors, and other users -

ays to assess liquidity

A CLASSIFIED BALANCE SHEET Learning Objective

o categories: LO3

Exhibit 14–3. current assets and current liabilities a company’

valuating

.

Current Assets Current assets represent relatively liquid resources. This cate includes cash, investments in mark vables, inventories, and prepaid expenses. T being converted into cash or used up within a relativ usiness operations. s operating cycle. Most companies have several operating cycles within a year. This means that they take cash and purchase inv , sell the inv , and collect the receivable in cash several times within a year. For these companies, , so any asset that is expected to be

628

Chapter 14 Financial Statement Analysis

Exhibit 14–3

COMPUTER CITY BALANCE SHEET DECEMBER 31, 2011

CLASSIFIED BALANCE SHEET

Learning Objective

LO4

s a

conv pan

s balance wever, have relatively long operating cycles. For example, a comge items (for e ve a production xtends well beyond one year. In these cases, the length of the company’s operat-

ing c are expected to be conv up or consumed during the year or operating cycle, if longer. For example, prepaid expenses ving been paid in adv es ould hav

629

Measures of Liquidity and Credit Risk

xpected to be conv into cash or used up within the next year or operating cycle, whichever is longer. . (The closer an asset is to becoming cash, the greater its liquidity.) Thus cash alw assets, usually followed by inv etable securities, receivables, inv prepaid expenses, in that order.

Current Liabilities

Current liabilities are existing obligations that are expected to

v expenses, such as income taxes payable, salaries payable, or interest payable. In the balance rent liabilities may be listed in any sequence. The relationship dollar amount in either cate cash to pay these liabilities is e ers ev v valuation of long-term total assets to total liabilities. We will now use Computer City’ xamine some widely applied

WORKING CAPITAL W W liabilities. Computer City’s w

xpress the relationship between curcapital is the excess v $80,000, computed as follows: Working capital varies by y size

Working capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 80,000

xpected to conv tiv working capital measures a company’s potential excess sources of cash over its upcoming uses of cash. y come due v ganization and the nature of its business activities. An analyst familiar with the nature of a company’ working capital whether the compan cial

CURRENT RATIO current ratio. This ratio is computed by dividing 1.8 to 1, computed as follows: A widely used measure Current ratio ($180,000 ⫼ $100,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

y’

1.8 to 1

ge as its

630

Chapter 14 Financial Statement Analysis

The higher

y appears to be. Historically, some ve believed that a company should hav wever, because many successful businesses hav vables and inv v v Like usinesses to hav slo ver in receivables and inv . In other words, care must be tak

ay to help ensure a v

QUICK RATIO Inv xpenses are the least liquid usiness with a long operating cycle, it may take several months to conv v quick ratio (sometimes called the acid-test ratio) to the . The quick ratio compares only the most liquid quick assets—with v rent assets that can be conv 1.06 to 1, computed as follows:

Quick ratio ($106,000 ⫼ $100,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A more demanding

1.06 to 1

v ve inventories of slow-moving merchandise (such as real estate) or inventories that have become excessive in size.

DEBT RATIO If a business fails and must be liquidated, the claims of creditors tak ver those of the owners. But if the business has a great deal of debt, there may not be enough assets even to mak debt which states total liabilities as a percentage y’s debt ratio is computed by dividing total liabilities by total assets, as sho

Debt ratio ($210,000 ⫼ $630,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

331⁄3%

. Rather, it is a measure of creditors’ long-term usiness may become unable to pay its debts. From the creditors’ point of view, the lower the debt ratio, the safer their position. Man ve maintained debt ratios tics. Banks, for example, may have v

ver 90 percent.

EVALUATING FINANCIAL RATIOS W against such as a current ratio should be at least 2 to 1, a quick ratio should be at least 1 to 1, or a debt ratio should be under 50 percent. T , the decision maker

631

Measures of Liquidity and Credit Risk

Retailers, for example, tend to hav acusinesses—which have no inv ve lower acturing companies. Large businesses with good credit ratings and reliable sources of cash receipts are able to operate with lo w of cash may be less predictable. , an e high ratio—say, 4 or 5 to 1—may indicate that too much of the company’s resources are tied y may be using were invested in a more productive way.

Standards for Comparison Financial analysts generally use tw

valuattrend in the ratio over a period y’s perfor-

of years. By revie

company’ similar companies and with These comparisons assist analysts in ev usiness environment.

Annual Reports Publicly o

ages. y’s

annual reports that provide a y. For example, annual reports include compara-

tiv v They also include 5- or 10-year summaries of ke management’s discussion and analysis of the company’s operating results, liquidity av avorable trends and events that y are also av

Industry Information

e industries is av

Dun & Bradstreet, Inc. Media General Financial Services vidual compan

ws inv y operates.

Usefulness and Limitations of Financial Ratios

xpresses the relationship of one amount to another ratios assist them in quickly ev pects of a business. A comparison of key ratios for several successive years usually indicates whether the business is becoming stronger or weaker. Ratios also provide a way to compare wever, that ratios have several limitations. For example, management may enter into year-end transactions that temporarily improve key ratios—a process called window dressing.

I N T E R N AT I O N A L C A S E I N P O I N T

632

Chapter 14 Financial Statement Analysis

T

Exhibit 14–3)

ratio of 1.8 to 1 -end, management used $20,000 of the company’ transaction w ⫺ ities to $80,000 ($100,000 ⫺ impressive 2 to 1 ($160,000 ⫼ $80,000). Is the compan ving simply paid $20,000 of liabilities a few days early? The answer is probably no, although before. Such steps to improve the company’ statements needs to be aware of this, however, and should look for instances where there is evidence that steps have been tak ve a company’s appearance. Usually

Financial statement ratios contain the same limitations as do the dollar amounts used in or e rent market v xpress only relationships. They give no indication of a company’s progress in achie ving customer satisfaction or worker productivity. A thorough analysis of inv nities involv

LIQUIDITY, CREDIT RISK, AND THE LAW Accountants view a b vities of its o ers, regardless of how the business is organized. The law, however corporations and unincorporated business or statements should understand this legal distinction, as it may affect both creditors and o Under the law, the o ships) are personally liable for an usiness organization. Therefore, credof the owners, usiness entity.2 If a business is or wever, the o not personally responsible for the liabilities of the business. Creditors may look only to the busiin seeking payment of their claims. Therefore, the liquidity of the business entity usiness is or

Small Corporations and Loan Guarantees hav may require that one or more of the company’

y need. In such cases, creditors vidails to make

do payment.

Measures of Profitability y’s pr are of interest to equity investors and management and are dra ter include percentage changes in ke equity.

2

In a limited Ev

general partners are personally responsible for the debts of the b v

633

Public opinion polls show that many people believe that most b equal to 30 percent or more of the sales price of their merchandise. Actually, this is far from cases, 15 percent of sales revenue.

CLASSIFICATIONS IN THE INCOME STATEMENT An income statement may be prepared in either the multiple-step or the single-step it pro statement for Computer City is shown in Exhibit 14–4.

Exhibit 14–4

COMPUTER CITY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

COMPUTER CITY INCOME STATEMENT (MULTIPLE-STEP)

v should be; however actually are. Moreover, you are aw reviewed in detail by gov (SEC). Consequently, you hav y hav accepted accounting principles and v

w what

634

Chapter 14 Financial Statement Analysis

YOUR TURN

Enron WorldCom

MULTIPLE-STEP INCOME STATEMENTS series of steps in which costs and

Learning Objective

e LO5

a

v

mine the subtotal gross pr . As a second step, operating expenses are deducted to obtain a subtotal called operating income expense and other nonoperating items are tak ve at net income. Notice that the income statement is divided into four major sections: (1) revenue, (2) cost of goods sold, (3) operating expenses, and (4) nonoperating items. Multiple-step income statements are noted for their numerous sections and the dev

The Revenue Section In a merchandising company, the revenue section of the income statement usually contains only one line, entitled net sales venue, if any Inv trend in net sales. As one means of evaluating this trend, the . As discussed earlier in this chapter, a percentage change is the dollar amount of the change xpressed as a percentage. It is computed by dividing the dollar amount of increase or decrease by the dollar amount of the measurement before the change cannot be e gative amount to a positive amount.) v v is called the r y’ v ny’s physical sales v wf If a company’s sales grow faster than the age, the company increases its market shar Publicly o available through several online databases.

The Cost of Goods Sold Section The second section of a merchandising company’s income statement shows cost of goods sold for the period. Cost of goods sold usually appears as a single dollar amount, which includes such incidental items as freight costs and Gross Profit: A Key Subtotal appears as a subtotal. This makes it easy for users of the income statement to compute the company’s gross pr ate gin).

635

v

In ev

xpressed as a percentage of net sales. In 2011, 40 percent, computed as follows:

y, the analyst should consider other companies

.F and 50 percent, depending on the types of products they sell. These rates usually are lowest on fast-mo velty products. y’ reasonably stable from one period to the ne vide investors with y’s products.

The Operating Expenses Section Operating e pose of producing revenue. These expenses often are subdi selling expenses and general and administrative expenses. Subdividing operating expenses ev y’s operations. For example, selling e rise and f ve expenses, on the other hand, usually remain more constant from one period to the next.

Operating Income: Another Key Subtotal Some of the rev of a b mon e Operating income

leav

xpenses vities other than the company’s basic business operations. Comvestments and income tax expense. ws the relationship between revenue v y’s basic or core business operations and venue and expenses.

Nonoperating Items

Revenue and expenses that are not directly related to the company’ usiness acti wing operating income. Tw xpense and income tax expense. Interest e not the manner in which these assets are used in business operations. Income tax expense is not included among the operating expenses because paying income taxes does not directly contribute to the production of revenue. Nonoperating rev vestments, also are listed in this section of the income statement.

Net Income Many equity investors consider net income (or net loss) to be the most y’ overall increase (or decrease) in o

vities

Financial analysts often compute net income as a percentage of net sales (net income divided by net sales). This measurement pro s control expenses v

. In 2011, Computer City’s net income amounts to 8 percent of net sales. Learning Objective

LO6 Net income as a percentage of net sales ($72,000 ⫼ $900,000) . . . . . . . . . . . . . . .

8%

636

Chapter 14 Financial Statement Analysis

EARNINGS PER SHARE videnced by shares s capital stock? To assist indi s net income to their ownership shares, public companies compute earnings per share and show these amounts at the bottom of their income statements.3 xpressed on a per-share basis. For example, the balance sheet in Exhibit 14–3 indicates that Computer City has 15,000 shares of capital stock outstanding.4 Assuming these shares had been outstanding all year $4.80:

Earnings per share ($72,000 ⫼ 15,000 shares) . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4.80

trend in major factors market value of a company’s shares.

PRICE-EARNINGS RATIO Learning Objective

LO7

u a

Financial analysts express the relationship between the market price of a company’s stock price-earnings (p/e) ratio. This ratio is computed by di et price per share of the company’ y incurs a net loss.) T s capital stock is trading among investors at a market price of $96 per share. The p/e ratio of the company’s stock is computed as follows:

Price-earnings ratio ($96 ⫼ $4.80) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

Technically, this ratio is 20 to 1. But it is common practice to omit the “to 1” and merely . The p/e ratios of many publicly o y newspapers. investor y’s futur . The more optimistic these expectations, the higher the p/e ratio is likely to be. vestors e decline vel. It could also mean, however, that the stock is . Likewise, a stock with a p/e ratio of 30 or more usually means that investors e increase vel. However, it may also signal that the stock is overvalued. One w does not follo ay down. Therefore, a company with very low earnings may have a high p/e ratio even if inv discussion, it should be ob

3

4

required Assume that all 15,000 shares hav

-share basis. For small b

637

SINGLE-STEP INCOME STATEMENTS y publicly o or this reason, the single-step income statement is widely used in Exhibit 14–5 has been re

Exhibit 14–5

COMPUTER CITY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011

COMPUTER CITY INCOME STATEMENT (SINGLE-STEP)

es its name from the fact that all costs and venue in a single step. No subtotals are shown for gross vides investors with enough information to compute these subtotals on their o e

EVALUATING THE ADEQUACY OF NET INCOME How much net income must a b viously, the dollar amount of net income that investors consider adequate depends on the size of the business. An annual net income of $1 million might seem impressive for an automobile dealership but w for a company the size of Ford, Procter & Gamble, or Home Depot. Inv o factors in evaluating a company’

Some investors regard the trend y’ investment manyfold. In ev investment analysis.

v

v

vesears

y investors use return on

RETURN ON INVESTMENT (ROI) We have emphasized throughout this te sion mak invest their money vestors w v

w how ef yed

638

Chapter 14 Financial Statement Analysis

return on investment, or ROI, Mathematically v generated by the investment is stated as a percentage of the average amount invested throughout the year Return on Investment (ROI)

ROI general formula

Return Average Amount Invested

a percentage of the average amount inv vestment at year-end. The av vested usually is computed by adding the amounts invested as of the be , and dividing this total by 2. If the inv tively stable over time, the year-end balance may be used instead of an average. The concept of ROI is applied in man v ability of a b v . As a result, a number of variations in the basic ROI ratio have been dev verage amount inv e will discuss two common applications of the ROI concept: return on assets and r .

RETURN ON ASSETS (ROA) This ratio is used in ev operating income, since interest expense and income tax which assets are used. The return on assets is computed as follows: Return on Assets (ROA)

is operating income

Operating Income Average Total Assets

Let us no Exhibit balance sheet in Exhibit ny’s average

s assets at the be sho 20 percent, Operating Income Average Total Assets

Most successful b

, amounts to $120,000.

-end. Therefore, the compa$600,000 [($570,000 ⫹ $630,000) ⫼ 2]. ws: $120,000 $600,000

20%

verage total assets of, perhaps, 15 percent or

w money. However, interest rates are at historic lows in the United States and are likely y’

wing.

RETURN ON EQUITY (ROE) ve measures the ef y with which management has utilized the assets under its control, re return on vestment—that is, on owner . net income, ws: Retur income

OE)

Net Income Average Total Stockholders’ Equity

T . The com$72,000. The year-end balance sheet (Exhibit ) shows total pan stockholders’ equity of $420,000. To enable us to complete our computation, we will assume

639

beginning of the year amounted to $380,000. Therefore, the $400,000 [($380,000 ⫹ $420,000) ⫼ 2]. 18 percent, computed as follows:

average

$72,000 $400,000

Net Income Average T Traditionally

ve e

18%

v

v wing companies with ne wer than the ov how the compan expenses. A company that suffers a net loss pro on .

venue and negative

Comprehensive Illustration: Seacliff Company Now that we have presented sev analysis of a company

w the comprehensive ws from material presented in this xt. We take a

comprehensiv tiv

year comparativ 14–6 14–10 have been compiled. For conv amounts hav

Exhibit 14–6

y sho

oExhibits

vely small dollar © Digital Vision/Getty Images/DAL

SEACLIFF INCOME STATEMENTS

SEACLIFF COMPANY COMPARATIVE INCOME STATEMENT FOR THE YEARS ENDED DECEMBER 31, 2011, AND DECEMBER 31, 2010

640

Exhibit 14–7

Chapter 14 Financial Statement Analysis

SEACLIFF STATEMENTS OF RETAINED EARNINGS

SEACLIFF COMPANY STATEMENT OF RETAINED EARNINGS FOR THE YEARS ENDED DECEMBER 31, 2011, AND DECEMBER 31, 2010

Exhibit 14–8

SEACLIFF BALANCE SHEETS

SEACLIFF COMPANY CONDENSED COMPARATIVE BALANCE SHEET* DECEMBER 31, 2011, AND DECEMBER 31, 2010

*In order to focus attention on important subtotals, this statement is highly condensed and does not show individual asset and introduced as needed in the text discussion. For example, a list of Seacliff Company’s current assets and current liabilities appears in Exhibit 14–18.

641

Exhibit 14–9

SEACLIFF STATEMENT OF CASH FLOWS

SEACLIFF COMPANY CONDENSED COMPARATIVE STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2011, AND DECEMBER 31, 2010

*N/A indicates that computation of the percentage change is not appropriate. Percentage changes cannot be determined if the base year is zero or if a negative amount

SEACLIFF COMPANY NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2011, AND DECEMBER 31, 2010

Exhibit 14–10 SEACLIFF NOTES TO FINANCIAL STATEMENTS

642

Chapter 14 Financial Statement Analysis

ANALYSIS BY COMMON STOCKHOLDERS v y’s vestment is in shares of stock, so earnings per share and dividends

Learning Objective

LO8

f

per share

c

Earnings per Share of Common Stock stock by the weighted-average number of shares of common stock outstanding during the year y in Exhibit

Exhibit 14–11 EARNINGS PER SHARE OF COMMON STOCK

Earnings related to number of common shares outstanding

ve decreased by $7.05 in 2011, representing a decline of vel in 2010 ($7.05 ⫼ $20.25 ⫽ avorable dev y and creates y’ wth. W xpect to see a decline in the market v ’ we assume the common stock had a market value of $160 at December 31, 2010, and of $132 171⁄2 percent decline in the market value of ev s investment ($28 decline ⫼ $160 ⫽ 17.5%).] nearly 35 percent

Price-Earnings Ratio

, the relationship

between the mark expressed as a ratio, called the price-earnings ratio (or p/e ratio by dividing the mark y’s p/e ratio. Companies with track records of rapid growth may sell at p/e ratios of perhaps 30 to 1, or even higher w 10 to 1. ’s p/e ratio was approximately 8 to 1 ($160 ⫼ $20.25 ⫽ 7.9), suggesting that investors were expecting as 10 to 1 ($132 ⫼ $13.20 ⫽ 10.0). A p/e ratio in this range suggests that investors e vel.

Dividend Yield Di

ut a secondv ve re others invest in stocks principally with the expectation of rising mark xpansion of the business, the expanded operations should produce an increase in the net income of the compan e each share of stock more valuable. ve inv ings and dividends per share to the market value vidends per share divided by mark yield rate of a company’s stock. Di vestors whose objective is to maximize the dividend rev v vidend yield on its common stock was 3.1 percent in 2010 ($5 ⫼ $150) and 3.6 percent in 2011 ($4.80 ⫼ $132).

643

Summary of Earnings and Dividend Data for S ’s per Exhibit 14–12.

The relationships

vidends to its year

Exhibit 14–12 EARNINGS AND DIVIDENDS PER SHARE OF COMMON STOCK

et v and dividends per share. Investors appraising this stock at December 31, 2011, should consider vidend yield of 3.6 percent meet their expectations ve inv vestors will also place considerable weight on estimates of the company’s prospectiv

Earnings and dividends related to market price of common stock

Revenue and Expense Analysis

f Company is unfav ant to know the reasons for the decline in net income. The comparative income statements in 14–6 show that despite a 20 percent increase in net sales, net income fell from $90,000 in 2010 to $75,000 in 2011, a decline of 16.7 percent.

ve expenses (32.6 percent), and the cost of goods sold (26.2 percent), all of which exceeded the 20 percent increase in net sales. vestigation reveals Seacliff Company decided in 2011 to olume. This would explain the

increase volume would hav ing expenses. However, operating expenses rose by $73,000, resulting in a $33,000 decrease in operating income. The ne xpenses increased and why vestor may be limited here, because detailed operating expenses are not usually sho Some conclusions, however v available in the comparativ y sho Exhibit . The substantial increase in selling e 2011 in an attempt to improve sales v wever, the fact that selling expenses increased en more bothersome is the increase in genve e ve expenses might be expected to accompany increased sales volume, but because some of the e generally should be less than proportional to any increase in sales. The increase in general ve e vestors. ver operating expenses than over rev oper atio ing expenses. We sho av y in Exhibit .

Exhibit 14–13

If management were able to increase the sales v

Does a higher operating expense ratio indicate higher net income?

644

Chapter 14 Financial Statement Analysis

or e

y can increase its sales by

and reduce the operating e ⫺ $560,000 ⫺ $240,000), an increase of over 57 percent.

RETURN ON INVESTMENT (ROI) v y in using available resources. Regardless of the size of the organization, capital is a scarce resource and must be used ef compan ve

Return on Assets As noted previously income, since interest expense and income tax related to the average inv

operating

. In Exhibit 14–14, the computation

Exhibit 14–14 PERCENTAGE RETURN ON ASSETS Earnings related to

This ratio sho drawing conclusions as to the effectiv

y’s assets fell in 2011. Before ’s management, however, we should

Return on Common Stockholders’ Equity W was simply net income divided by av and

y’s common less an

. vidends.

the beginning of 2010 was $355,000, is computed in Exhibit 14–15.

Exhibit 14–15 RETURN ON COMMON

Does the use of leverage benefit common stockholders?

as achiev

as higher than the vidend rate paid to avorable use of leverage.

645

Comprehensive Illustration: Seacliff Company

LEVERAGE Applying lev

wed mone

greater than the cost of . In other

w w mone by doing so. However, leverage can act as a double-edged sw avorable av all below the av wed capital, leverage will reduce . In this situation, payould appear to be a logical move. However, many companies do not hav ed in to the unfav verage. w much lev the of the company’ av wed capital. If a business incurs so much debt that it becomes unable reorganization of the business.

Debt Ratio One indicator of the amount of leverage used by a business is the debt ratio. viding total liabilities by total assets. A high debt ratio indicates an extensive use of leverage, that is, a lar vided by creditors. A low debt ratio, on the other hand, indicates that the b verage. The debt ratio at year wn in Exhibit 14–16.

Exhibit 14–16 Proportion of assets financed by creditors

y has a lower debt ratio in 2011 than in 2010. Is this favorable or unfavorable? From the vie paid to creditors. However, a high debt ratio can be unfavorable alls below f Compan vely low 14 percent in 2011, the ould not w avorable effects of lev to decline. CASE IN POINT Dell Inc. Dell Dell Dell Dell Dell Dell Dell

646

Chapter 14 Financial Statement Analysis

ANALYSIS BY LONG-TERM CREDITORS actors: (1) the s ability to meet its interest requirements, and alls due.

v

Yield Rate on Bonds be computed in the same manner as the yield rate on shares of stock, because bonds, unlike stocks, hav wnership of a 12 percent, 10-year, v receive $1,000 at the end of 10 years. If the market price of this bond is $950, the yield rate on an inv e the present value of these two contractual rights equal to the $950 market price. alue, the yield rate is equal to the bond interest rate. The yield rate varies inversely with chang . If interest rates rise, the market price of existing bonds will f v alue, the yield rate is less than the bond interest rate; if the price of a bond is below maturity value, the yield rate is higher than the bond interest rate.

Interest Coverage Ratio Bondholders feel that their investments are relatively safe if the issuing compan gin.

ver its annual interest obligations by a com-

vailable for the payment of interest to the annual interest expense, called the interest coverage ratio or times interest earned y in Exhibit 14–17.

Exhibit 14–17

Long-term creditors watch this ratio

v

ver-

age ratio above 2.0 is considered strong.

Debt Ratio as computed in . From a creditor’s viewpoint, the lower the debt ratio, the better, since this means that stockholders have contributed a higher percentage of the funds to the business, and therefore the mar As shown in 14–16 ould generally be conavorable change because the debt burden, including required interest payments, is less in 2011 than in 2010, thereby making the claim of each creditor more secure.

Secured Claims uildings o wer value of the collateral in assessing the safety of their claims.

hav

ANALYSIS BY SHORT-TERM CREDITORS Bank wever, is in the

647

Comprehensive Illustration: Seacliff Company

orking capital) to cial statements by a bank vestigating the credit status of a customer, is likely to center on the working capital position of the prospective debtor.

Amount of Working Capital Working capital is the e

ver -cash assets that provide a “cushion” of

liquidity over the amount e tions. The details of the working capital of Seacliff Company are sho

Exhibit 14–18

Exhibit 14–18.

SEACLIFF SCHEDULE OF WORKING CAPITAL

SEACLIFF COMPANY COMPARATIVE SCHEDULE OF WORKING CAPITAL AS OF DECEMBER 31, 2011, AND DECEMBER 31, 2010

*Amounts adjusted so that totals equal 100.0.

This schedule sho by only $18,000. As a result, w

Quality of Working Capital

In ev

usiness, orking capital as well as the total dollar

actors af v The schedule in Exhibit 14–18 shows an unfav Company’s w v v liquid resource than cash. Therefore, the quality of working capital is not as liquid as in 2010. Turnover rates (or ratios vables and inv

Accounts Receivable Turnover Rate As explained in Chapter 7, the accounts receiv

ver rate indicates how quickly a company conv v ver rate

vable viding net sales by the

648

Chapter 14 Financial Statement Analysis

av vable.5 The number of days required (on average) to collect accounts receiv viding the number of days in a year (365) ver rate. The computations in Exhibit use the data in our Seacliff example, vable at the beginning of 2010 were $80,000.

Exhibit 14–19 ACCOUNTS RECEIVABLE TURNOVER

Are customers paying promptly?

There has been no change in the average time required to collect receivables. The interpretation of the average age of receivables depends upon the company’ seasonal acti -end. For example, if the company grants 30-day 14–19 indicates that accounts receivable wever, collections are being made ahead of schedule.

Inventory Turnover Rate

The inv ver rate indicates how many times y is able to sell a quantity of goods equal to its average inven. Mechanically viding the cost of goods sold for the year by the average amount of inv . The number of days required to sell this amount of inv ver rate. These computations were explained in Chapter 8 and are demonstrated in Exhibit 14–20 y, assuming inv ginning of 2010 was $100,000. The trend indicated by this analysis is unfavorable, since the length of time ver (sell) its inv

Exhibit 14–20 INVENTORY TURNOVER

Companies that have lo . This is another w high v wer inv

v

ver rates in w, a

ver rates.

Operating Cycle The inv

ver rate indicates how quickly inv sells, but not how quickly this asset conv cash. y’s ability to generate cash. The period of time required for a merchandising company to conv v cash is called the operating cycle. The illustration appeared in Chapter 6 and is repeated in for your convenience. 5 Ideally, the accounts receiv receiv

ver is computed by dividing net credit sales by the monthly average of wever, generally is not pro

649

Comprehensive Illustration: Seacliff Company

Exhibit 14–21

1. P me urch rch as an di

3. C he olle re ce

of e se

of ion bles t c a iv

2. S

ale o

f m e rc h a n d is e o n

o acc

un

The operating cycle

t

Seacliff’s operating cycle in 2011 was approximately 145 days, computed by adding the ver inv verage 41 days required to collect receivables. This compares with an operating cycle of only 137 days in 2010, computed as 96 days to dispose of the inv vables. From the viewshorter the operating cycle, the of the borrower’s w ould re Company’s operating cycle as an unfav

Current Ratio vides considerable evidence that a company will Company is computed in Exhibit 14–22.

Exhibit 14–22 CURRENT RATIO Does this indicate satisf

Quick Ratio

Because inv

v quick ratio is sometimes computed as a sup-

v mark k

v

f Company has no marExhibit 14–23.

Exhibit 14–23 QUICK RATIO

Here again the analysis reveals a fav e ter is considered satisf .

Unused Lines of Credit From the vie

, a company’s

ance to lend the company an limit. As long as this line of credit remains av w that the business can borrow cash quickly and easily for an

650

Chapter 14 Financial Statement Analysis

Existing unused lines of credit are disclosed in notes accompan Exhibit vie ’s $35,000 line of credit as enhancing the company’s liquidity.

ould

CASH FLOW ANALYSIS W

v

y’

ws of $95,000 from its operating activities—a relativ was $90,000. This $95,000 remained after payment of interest to creditors and amounted to more than three times the di ws from operating activities appeared quite suf obligations and also pay dividends. In 2011, however far below the company’s $75,000 net income and only approximately 58 percent of the amount of di ould view this dramatic decline in ws as a negative and potentially dangerous development. A reconciliation of Seacliff’ activities is shown in 14–24. F institution. Therefore, the increase in notes payable is treated in the same way as the increase acti

wing activities, the change would be clas-

from operating activities.

Exhibit 14–24 SEACLIFF RECONCILIATION OF NET INCOME TO NET ACTIVITIES

As explained in Chapter 13, the FASB requires companies to provide this reconciliation either ws or in a supplemental schedule. ’s lo vable and inv v receivable is to be expected. The lar vent xt year. The large increase in inv , however, may have ’ . ’ , would appear considerinventory turnover rate, ger inv .

Cash Flows from Operations to Current Liabilities provides evidence of the company’

v

651

14–25.

Exhibit 14–25 CASH FLOWS FROM CURRENT LIABILITIES

as much stronger in 2010 than in 2011. In 2010, -end, indicating an abilxistwever, operations provided only 17 percent as much cash as vily on e

v

USEFULNESS OF NOTES TO FINANCIAL STATEMENTS veral notes, interpreting the statements. Users should view these notes as an integral part of In preceding chapters we hav n

y items that are disclosed in notes accompawing:

• Accounting policies and methods • Unused lines of credit • • statements) • Dividends in • •

alues shown in the

In the notes accompan ’ is, the Note 2 would be of interest to anyone evaluating the company’

.

YOUR TURN

INTERNATIONAL FINANCIAL REPORTING STANDARDS As you hav xpected to require sev xist man local standards, as in the United States, and there are emer are rapidly being accepted in v

652

Chapter 14 Financial Statement Analysis

Tw ments and se

v verlapping o

between or among tw entities, although legally they may be recognized as separate entities. At the present time, prepared. This mak vided when compared with presenting infor. Se

usiness, usue

v vestors and creditors of the e

u-

tion a company’ the world among indi

presented when disclosure is required. Policies re of the man

o w ver time, we will

move tow ven greater reliance than today on the comparability of orldwide.

SUMMARY OF ANALYTICAL MEASUREMENTS xtbook thus far, including .

Exhibit 14–26

(continued on next page)

653

Exhibit 14–26

continued

654

Chapter 14 Financial Statement Analysis

Ethics, Fraud & Corporate Governance ISS ISS

The Corporate Library (TCL) ISS TCL

Risk Metrics Group

ISS Governance Services The Corporate Library

(TCL) ISS Governance Services

TCL ISS TCL

ISS

Concluding Remarks xternal users who do not have access to the company’s accounting records. Investors and creditors must rely to a considerable e wned cor(SEC) and is available to the public in hard copy act, the astest growing source of free information available to decision makers in this information age. Man v licly o v or e ge companies are av Standard & Poor’s, Moody’s Investors Service, and The Value Line Investment Survey. Anyone may subscribe to these inv Bank

Concluding Remarks

y business from credit-rating agencies, such as Dun & Bradstreet. e p/e ratios, are a measure of investors’ expectations. A company may be wing fast. But if investors had expected ev market price of its stock may decline. Similarly, if a troubled company’s losses are smaller than e v compan fundamental analysis. This approach to investing works better in the fected by many f vents, political events, fads, and alue.

655

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

LO1

lain the uses of dollar and percentage changes, end percentages, component percentages, and tios.

LO2

iscuss the quality of a company’s earnings, sets, and working capital.

LO3

i

lain the nature and purpose of classifications financial statements.

epare a classified balance sheet and compute ely used measures of liquidity and credit risk.

LO4

LO6

ompany’s net income into perspective by elating it to sales, assets, and stockholders’ quity.

LO7

ompute the ratios widely used in financial tatement analysis and explain the significance f each.

I

LO5

epare a multiple-step and a single-step income tatement and compute widely used measures of fitability.

LO8

Analyze financial statements from the viewpoints f common stockholders, creditors, and others.

Key Terms Introduced or Emphasized In Chapter 14

Demonstration Problem Walgreen Drug Stores

Walgreen

Solution to the Demonstration Problem

Self-Test Questions

ASSIGNMENT MATERIAL

D scuss on Questions

Merck Bristol-Myers Squibb

Brief Exercises LO1

LO1

LO1

LO4

LO4

accounting

LO4 E

LO6 E

LO6 E

LO7 E

LO7 E

Exercises LO1

E P

LO1

E T

LO1

E C

accounting

LO3

LO4

LO5

LINK, INC. STATEMENT OF EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2011

LO6

Kimberly-Clark Corporation

E

Kimberly-Clark Kimberly-Clark Kimberly-Clark LO1 LO6

E

o

LO6

E

LO3

E

Home Depot, Inc.

LO4 A

LO6

Home Depot, Inc.

LO4

LO6

LO7

LO7

LO6

E

LO7

LO7

E

Johnson & Johnson

LO6 LO7

Pro lem Set A LO1

LO5

P

accounting

LO3

P A

LO5

LO3

LO4

P

LO3 Kroger

The Kroger Company Kroger

LO4

LO7

Kroger

Kroger

Kroger

LO3

LO4

LO7

a

LO4

P

LO5

F A

LO7

LO4

Medtronics

LO5

LO7

Medtronic

LO5

LO7

LO5

P

LO7 LO8

Problem Set B LO1

LO5

P

P I

LO3

LO5

LO3

LO4

LO3

P L

LO4 LO7

LO3 LO4 LO7

P

a

LO4

LO5

LO7

LO4

LO5

LO7

A

LO5

P

LO7

LO5

P

LO7

R T

LO8

Critical Thinking Cases LO1 S

LO3

LO5

C

A

TEXAS STEAK RANCH BALANCE SHEET DECEMBER 31, 2011

THE STOCKYARDS BALANCE SHEET DECEMBER 31, 2011

LO5 S

California Public Employees Retirement System

LO5 E

(CALPERS) CALPERS

LO7

General Motors Johnson & Johnson Coca-Cola LO8

E a

http://www.yahoo.com

Answers to Self-Test Questions

COMPREHENSIVE PROBLEM Home Depot, Inc. ANALYSIS OF THE FINANCIAL STATEMENTS OF A PUBLICLY OWNED CORPORATION Home Depot, Inc.

Home Depot, Inc.

Home Depot, Inc.

Home Depot

4

Home Depot

Home Depot, Inc.

Home Depot

CHA P TER 15

Global Business and Accounting A F TE R ST U DY IN G THI S CH AP TE R , YO U S HO U LD B E A BL E TO :

LO1

LO2

LO3

LO4

LO5

LO6

LO7 LO8

Learning Objectives

INTERNATIONAL ACCOUNTING STANDARDS BOARD

■

684

Chapter 15 Global Business and Accounting

gan a mission in 1993 to dev vide you with a foundation for understanding the richness and comple y chosen country developed differently from those in the United States and those in other countries. Countries such as y establish their o set of accounting standards that will be acceptable to all gov securities markets. This is a v standards are affected by the political, legal, economic, and cultural systems in which they are embedded. Thus, the v ve a sig-

w investors, creditors, and managers understand and use accounting information. The objective of this chapter is to introduce you to the comple usiness and to explore some of the accounting issues associated with global business. This is only a brief introduction. As your business education progresses, additional details will be added to the

Globalization Globalization occurs as managers become aware of and engage in cross-border trade and operations. Think of globalization as a continuous process where at the most basic level a y’s managers become aware that changes in foreign exchange rates,

Exhibit 15–1

Country/Block

LOCATION OF THE WORLD’S LARGEST MULTINATIONALS IN 2009

European Union United States Japan China Switzerland Canada South Korea Central/South America Australia Russia India Others Source: and Japan (80).

Number of Companies

Percentage

163

33%

140

28%

68

14%

37

7%

15

3%

14

3%

14

3%

11

2%

9

2%

8

1%

7

1%

14

3% .

685

Globalization

versity s ability to compete. An example of a higher gins with raw material extraction Exhibit 15–1 we show the location of the world’s top multinational companies. The top 10 companies include seven oil companies, one automobile company (Toyota), one retailer (W nomic issues will hav lev

Learning Objective

ing, joint v the simplest lev ver product creation, licensing giv national licensing

Exporting is, at exporting maintains Interw, or antage. Most major multinational food manufacturing companies are involv international joint venture is a company owned by tw wholly owned international subsidiary is created when a company uses its o . Finally, global sourcing is the close coordination of R&D, manufacturing, and mark includes e entures, and wholly owned subsidiaries in cross-border operations. As sho Exhibit 15–2 ard gro wing stages: (1) e en-

LO1

In practice, there are many subcategories that are not shown in the exhibit, and companies .

Exhibit 15–2 PROCESSES FOR INCREASING GLOBALIZATION

o

y exchange rates crew to globalize clearly impact a

686

Chapter 15 Global Business and Accounting

Environmental Forces Shaping Globalization Learning Objective

I

LO2 ( s

To help you understand ho ma ries: (1) political and leg

vironmental forces affect the accounting inforvironmental forces in four catego-

These cate ence on its political and le illustrated in Exhibit 15–3

s economy and culture hav

POLITICAL AND LEGAL SYSTEMS Learning Objective

LO2a

political risks. Political risk occurs because gov v wnership from the company to the gov y may be asked to relinquish control over operations due to gov ention. For example, when Iran nationalized y companies lost o invested in oil exploration, drilling, and oil deliv

I a a

La

v

v

vities. Tax . La gov

or example, gov

ve o

ention include content or value-added requirements and sourcing requirements. T w materials or labor content to allo the regions covered by the agreement. For e AFT v Another example of political intervention is the foreign trade zone within the United y leave the zone. Companies that import ra actories in these trade zones. These compave an impact on revenue recognition ges the company’s working capital as discussed in Chapter 14. As countries change and grow, governments try to manage that growth through political and legal means. For example, governments use tax incentives that encourage or discourage

Exhibit 15–3 ENVIRONMENTAL FORCES IMPACTING GLOBALIZATION

687

Environmental Forces Shaping Globalization

ownership of stocks. Policies also affect the level of individual savings, which impacts the availability of capital. Educational policies impact the literacy rate, the extent of formal education and training, and the number of accounting professionals. The political and le vide the framew

ECONOMIC SYSTEMS vailor example, in a planned economy the gov among v v wned and controlled.

economy

Learning Objective

LO2b

viet Union and So xtensively vely, in market economies, ownership of land and the means of production are private, and markets dictate the allocation of resources and the output among se . Compaattempting to operate in a market economy. The rev In some countries, b es into industrial organizations as one method of raising capital. In South Korea and Japan, companies group themselves into conglomerates representing different industries. South Korean conglomerates, called chaebol, and Japanese conglomerates, called etsu, tomers and suppliers, and they usually contain a bank. W pliers receive loans, inv customers higher up on the pyramid. Suppliers integrate their operations with other suppliers and with their customers. T ws preclude the ganized b orea.

I N T E R N AT I O N A L C A S E I N P O I N T Samsung Hyundai LG

CULTURE ay individuals in a society act and perceive each others’ actions.2 v ay foreign companies conduct business in the United States. Like usiness, and hierarchical or common practices in the United States, w where. Ignoring usiness problems. v locations. • Individualism versus collectivism. The de among indi

2

F e of the Mind

vism. Citizens of Asian vism than those in the United States.

Cultures and Organi w-Hill, 1991), or www.geert-hofstede.com.

Learning Objective

LO2c

688

Chapter 15 Global Business and Accounting

•

. The e

voidance. • Short-term versus long-term orientation. W , and lasting relationships are highly v

v

. • e versus small power distance. Large power distance cultures accept unequally uted po ganizations. The idea that ev created equal or should hav oice is more highly valued in small po societies. Exhibit

pro

v

Exhibit 15–4

H ⫽ High, M ⫽ Medium, L ⫽ Low. *Not available.

We can use Exhibit

to understand ho

ve shown that in South Korea and Japan, where collectivism is high, less emphasis is placed on vestors. The needs of creditors are given preference over the needs of inv from a bank in the k ept within the collecti v w to develop. The relativ of independent accountants is small, but increasing in many Asian countries.

TECHNOLOGY AND INFRASTRUCTURE Learning Objective

LO2d

I a a

Other cross-border differences create global business challenges because of variations in v and among various geographic locations and peoples can be dif that create joint v w emplo vailable in the U.S. workforce. I N T E R N AT I O N A L C A S E I N P O I N T

689

Dif are dif-

v Infrastructure impediments also pose problems for globalization. Poor xample, telephones, faxes, and comacilities (for example, specialized labora-

b acturing plants in many dev are not heated or cooled, which can create adverse operating en

© AP Photo/Manish Swarup

w venxpected costs into their computations to properly compute the cost of globally sourced products.

Harmonization of Financial Reporting Standards Learning Objective

or e LO3

price lev hand, have e

xico, on the other

company to be v wn borders, dif y are if business acti xtends across borders. For example, cross-border , in which a company sells its securities in the capital mark , has become increasingly popular. Business acti harmonization of accounting standards, ods and principles throughout the world. The International Accounting Standards Board ged with the responsibility of ver 150 professional or and over 2 million accounting professionals w v ve well-developed capital markets, the IASB standards pro v

INTERNATIONAL FINANCIAL REPORTING STANDARDS: ADOPTION OR CONVERGENCE ve taken tw accounting standards to achiev

ve chosen to adopt xactly as written and promulgated by the IASB.

Adoption ing them with IFRS. The adoption approach was agreed to by the European Union in 2005 ets were required to adopt 15–5 shows that Chile, Mexico, and Canada have chosen to adopt IFRS.

690

Chapter 15 Global Business and Accounting

vely,

15–5 sho Convergence so that they will produce IFRS “equiv as an ongoing process because, as IFRS changes, conver v

ve chosen to converge ver ve ver

Exhibit 15–5

Europe: adoption in 2005

Canada: adoption in 2011

IFRS GLOBAL ADOPTION AND CONVERGENCE

Arctic North North Atlantic America Caribbean

USA: convergence by 2014–2016

EQUATOR Mexico: adoption in 2012

Russia: IFRS adoption delayed China: convergence in 2007 Asia

Europe Middle East Africa

Central America

Oceania

Indian

South America

South Pacific

Japan: adoption by 2016

Nor Pacific

Australia Australia: convergence in 2007

South Atlantic

Chile: adoption in 2009

Antarctica Brazil: convergence in 2010

India: convergence in 2012–2014

w eral years. However

best approach to mo Exhibit 15–6 pro

ver

vve called

v

ws that the number of available auditors in an . This variation is a direct result of the environmental v . The United States and the United Kingdom have the most highly developed capital markets in the w e o sho ed asset revaluations are only allowed under IFRS and U.K. GAAP. V v 15–6 v wer levels of se v

Exhibit 15–6

691

Foreign Currencies and Exchange Rates

wers. Thus, demand for se

Foreign Currencies and Exchange Rates In addition to the en tional b

v

, for example, a Japanese company that y will want to be y—yen—but the U.S. company’ y must be converted into another. y exchange that enables them to b vailing exchange rate. tion can pay a liability to a Japanese compan system. The U.S. compan y e v y’s bank.3

EXCHANGE RATES y exchange rate y

y uy-

xchange rate may be vie y

, based on the worldwide © Royalty-Free/Corbis/DAL

or example, a few of the e

.

eet Journal

Exhibit 15–7 U.S. DOLLAR EQUIVALENTS FOR FIVE FOREIGN CURRENCIES

*Many European countries, such as Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the

y is equivalent to a giv y. Assume that a U.S. company owes a Japanese company 1 million yen (expressed ¥1,000,000). How many dollars are needed to settle this obligation, xchange rate is $0.00764 per yen? To restate an amount of forvalent amount of U.S. dollars, we multiply the foreign y amount by the exchange rate, as follows:4

3

Amount Stated in Foreign Currency

Exchange Rate (in dollars)

Equivalent Number of U.S. Dollars

¥1,000,000

$0.00764 per yen

$7,640

vely

v v To conv v y, we would divide the dollar amount by the exchange rate. For example, $7,640 ⫼ $0.00764 per yen ⫽ ¥1,000,000.

4

Learning Objective

LO4

692

Chapter 15 Global Business and Accounting

vely, consider that a Japanese company agrees to pay a U.S. company $10,000 for v y needs to w the number of yen per dollar. The yen per dollar can be computed by dividing one dol⫼ $.00764/yen ⫽ ¥130.9/dollar. Using the yen per dollar e v ws: Amount Stated in U.S. Dollars $10,000

Exchange Rate (in yen)

Amount Stated in Foreign Currency (yen)

¥130.9 per dollar

¥1,309,000 v

of dollars or restating a dollar amount into an equiv translating y.

y is called

Exchange Rate Jargon or “weak, . For example, an evening newscaster might say, “ ening British pound, b the Japanese yen and the Swiss franc. xchange rates? T , we must remember that an e y stated in terms of another currency. U.S. dollars. wever, the y y. To illustrate, consider the table from The Wall Street Journal shown in Exhibit 15–7. The exchange rate for the Japanese yen is $0.00764. At this exchange rate, $1 is equivalent to ¥130.9 (as shown above). Thus, while we would say that the exchange rate for the Japanese yen is $0.00764, the Japanese would say that the exchange rate for the U.S. dollar is ¥130.9. Now let us assume that the exchange rate for the yen (stated in dollars) rises to $0.0109. At this exchange rate, $1 is equivalent to only ¥92 ($1 ⫼ $.0109 ⫽ ¥92). In the United States, we would say that the exchange rate for the yen has risen from $0.00764 to $0.0109. In Japan, however, they would say that the exchange rate for the dollar has fallen from ¥130.9 to ¥92. dollar has fallen against the yen. o statements mean the same thing—that the yen has become more valuable relative to the dollar. No ening ut fell slightly against the Japanese yen and the Swiss franc. xchange xchange rate) ,b slightly y is described as “strong” when its exchange rate is rising relative to most xchange rate is f because of changes in the environmental forces discussed earlier in this chapter.

ACCOUNTING FOR TRANSACTIONS WITH FOREIGN COMPANIES Learning Objective

LO5 t c

yb

y, the y. If the price is stated in dollars, the U.S. company encounters no special accounting problems. suppliers or customers. foreign currency, the company encounters two accounting problems. First, as the U.S. company’s accounting records are maintained in dollars, the transaction price must be translated into dollars before the transaction can be recorded. The second problem arises when (1) the purchase or sale is made on account and (2) the exchange rate changes xchange rate will cause the U.S. company to experience either a gain or a loss in the settlement of the transaction.

693

Foreign Currencies and Exchange Rates

Credit Purchases with Prices Stated in a Foreign Currency Assume that y buys merchandise from a British compan $1.63 v

ould be: The amount of a foreign currency credit purchase is determined by using the exchange rate on the date it is journalized

Let us now assume that by September 30, when the £10,000 account payable must be paid, the exchange rate has fallen to $1.61 per British pound. If the U.S. company had paid for the merchandise on August 1, the cost would have been $16,300. On September 30, however, only $16,100 is needed to pay the £10,000 liability (£10,000 ⫻ $1.61 ⫽ $16,100). Thus, the decline in the exchange rate has saved the company $200. This savings is recorded in Gain on Fluctuations in Foreign Exchange Rates. September 30 to record payment of the liability and recognition of this gain would be: The foreign exchange rate gain for the credit purchase is determined by using the exchange rate on the payment date

Now let us assume that instead of declining, the exchange rate had increased $1.63 on August 1 to $1.66 y would have to pay $16,600 y would be paying $300 more than if the liability had been paid on August 1. This additional $300 cost was caused by the increase in the e on September 30 would be: A foreign exchange rate xchange the purchase date and the collection date

, ha y results in a gain for the debtor if the e of payment. The gain results because fewer dollars will be needed to repay the debt than had originally been owed. An increase in the exchange rate, on the other hand, causes the debtor to incur a loss. In this case, the debtor will hav o y needed to pay the debt.

Credit Sales with Prices Stated in a Foreign Currency es credit sales

y that y also will experience gains or losses

694

Chapter 15 Global Business and Accounting

xchange rate. T y sells of £10,000. We shall again assume that the e

xample to y at a price ould be:

In 60 days (September 30), the U.S. compan y the U.S. dollar equivalent of £10,000. If the exchange rate on September 30 has fallen to $1.61 per pound, the U.S. company will collect only $16,100 (£ 10,000 ⫻ $1.61 ⫽ $16,100) in full vable. Since the receivable had originally been equivalent to $16,300, the decline in the exchange rate has caused a loss of $200 to the U.S. company. The ould be: A foreign exchange rate loss occurs when the exchange rate decreases the collection date

No

ve case, in which the e y’

into $16,600, creating a gain for the U.S. company

v ould then be:

Adjustment of Foreign Receivables and Payables at the Balance Sheet Date We hav xchange rates may cause gains or losses for comv or convenience, however, the company usually w xception to this conv is made to recognize any gains or losses that hav y foreign payables or receiv T Exhibit 15–8 occurs on November 10 when a U.S. company b y at a price of 10 million yen wing year. If the exchange rate is $0.0100 per yen on Nov y to record the purchase would be:

695

Foreign Currencies and Exchange Rates

account must be recorded in dollars using the exchange rate on the date of purchase

Exhibit 15–8 FOREIGN EXCHANGE COMPANY BUYS EQUIPMENT FROM A JAPANESE COMPANY

Now assume that on December 31, the exchange rate has fallen to $0.0097 per yen. At this exchange rate, the U.S. company’s account payable is equiv ⫻ xchange rates are recognized in the period in which the change occurs. y should mak -equivalent and to recognize any related gain or loss. , dated December 31, would be: The foreign exchange rate gain on accounts payable is included in year-end statements

Similar adjustments should be made for an y. If the e

vable at year-end

696

Chapter 15 Global Business and Accounting

for e 15–8, the U.S. company must now spend $99,000 to buy the ¥10,000,000 needed to pay its y y a $2,000 loss since year

Notice the over

as a $1,000 xchange rate for the yen between November 10 and the date

exchange rate from Nov

as xchange rate

v y times the change in exchange rates between the transaction date and the payment date (¥10,000,000 ⫻ [$0.0100 ⫺ $0.0099] ⫽ $1,000 gain). The $3,000 gain recorded at the balance sheet date and the $2,000 loss recorded at the date of v w effects. y should be included in the income statement. They typically are presented in a e interest expense and gains and losses on the sale of plant assets.

CURRENCY FLUCTUATIONS—WHO WINS AND WHO LOSES? xchange rates are sustained by companies (or individuals) that have either payables or receivables that are eign currency. ve large foreign liabilities. Companies that e ely to have large receivables As foreign exchange rates (stated in dollars) fall, e xchange rate f y becomes less expensive. ve to spend fewer dollars to pay their foreign liabilive to w vables become w fewer and fewer dollars. xchange rates rise, this situation rev receivables become equivalent to an increasing number of dollars.

Strategies to Avoid Losses from Rate Fluctuations

o basic approaches to av insist that receiv y. The other approach is called hedging and can be accomplished in a number of ways. T y makes large credit sales to companies in Mexico, but anticipates that the exchange rate for the Me ally decline. The U.S. company can avoid losses by setting its sales prices in dollars. Then, if the exchange rate does decline, the Mexican companies will have to spend more pesos to pay ut the U.S. company will not receive fewer dollars. On the other hand, the U.S. compan purchases from Mexican companies at prices stated in pesos, because a decline in the exchange rate will reduce the number of dollars

697

Foreign Currencies and Exchange Rates

The interests of the Mexican companies, however, are exactly the opposite of those of the U.S. company. If the Mexican companies anticipate an increase in the exchange rate for the U.S. dollar, they will want to b Ultimately company is in the better bargaining position.

Hedging Hedging refers to the strate of taking of thoughts about the bet, and you w

. To illuse a large bet on a football game. Later you have second ou could ay, you will lose

one bet, b A company that has similar amounts of accounts receivable and accounts payable in the same xchange rate will cause losses on the foreign receiv xchange v not have similar amounts of receivables and payables in the y. However, they may create this situation by buying or selling foreign y future contracts. These contracts, commonly called futures, are the right to receive y are accounts receivable y. Thus, for example, a compan tracts. Then, if the e gain in the v

Exchange Rates and Competitive Prices Up to this point, we have discussed ve receivables or payables stated in y. However xchange rates change the relative prices of goods produced in dif s products more or less competitiv world. Even a small store with no foreign accounts receiv usixchange rates. Consider, for example, a small store in Kansas that sells a U.S.-made brand of television sets. If foreign exchange rates f made television sets will decline. Thus, the store selling U.S.-made television sets may have vision sets at lo makes U.S. goods more expensive to customers in for Thus, a U.S. television manuf The situation rev relatively high. A weak dollar mak xpensive to U.S. consumers. Also, a weak dollar makes U.S. products less expensiv

YOUR TURN

, we may say that a strong U.S. dollar helps companies that sell foreign-made goods in the U.S. market. A weak dollar, on the other hand, gives a competitive advantage to companies that sell U.S. products both at home and abroad.

Learning Objective

LO6

698

Chapter 15 Global Business and Accounting

CONSOLIDATED FINANCIAL STATEMENTS THAT INCLUDE FOREIGN SUBSIDIARIES In Chapter 14, we discussed the concept of consolidated ments view the operations of the parent compan panies were a single b . Sev accounting records of the foreign subsidiaries must be translated into U.S. dollars. Second, generally accepted accounting principles. These problems pose interesting challenges to professional accountants and will be porations, however, should kno panies are e

Global Sourcing Learning Objective

LO7

Los Angeles Times illustrated the additional problems associated v Exhibit 15–9

s c

Exhibit 15–9 GLOBAL SOURCING FOR MATTEL INC.’S BARBIETM DOLL

699

Global Sourcing TM

doll from its raw materials source in a Saudi Araaiwan uses the ethylene to produce vinyl pellets that are shipped to Dongguan in China’s Guangdong province. At the Chinese joint-v , 5,500 workers, paid between $30 and $40 per month, make the plastic doll and her clothes. However and Japan. The molds themselv Barbie’s nylon hair. Hong K

utes

v Finally y thousands of U.S. workers result in a $10.00 BarbieTM Mattel Inc. has indicated TM is about $1.00. Exhibit 15–10 illustrates the costs and exchange rate issues involved in the production of a BarbieTM doll. Panel A pro y exchange rates for the countries involved in global sourcing for the BarbieTM doll. Panel B includes estimated product export costs for the Mattel Inc. BarbieTM made at the Meitai factory in Dongguan, China. The estimated costs in the exhibit are based on a single day’ xchange rates. Companies must choose a representative exchange rate to compute the cost buildup in y.

Exhibit 15–10 AND ESTIMATED PRODUCT COST FOR BARBIETM DOLLS

*Estimates based on information provided in R. Tempest, “Barbie and the World Economy,” Los Angeles Times, September 22, 1999, p. 1. †

Based on exchange rates from www.xe.com/ucc.

xhibit does not pro e usiness in a global environment. Many companies underestimate the cost of globalizing their business operations because they are not familiar with the en the be lenge for companies wishing to become more global.

700

Chapter 15 Global Business and Accounting

FOREIGN CORRUPT PRACTICES ACT In many countries, product costs also include e work. Kenyan business executives refer to go (“something small”), the Chinese pay huilu, Russians shell out around the w usiness. In man wed as wrong or unethical. However, U.S.-based businesses are Foreign Corrupt Practices Act (FCPA), passed in

advantage e

or over 20 years, U.S. companies have complained about the A. v , the 1997–1998 Asian crisis was

ciated with doing b v

vestment. orld Bank instituted policies in the late 1990s

Kenya were suspended until policies and procedures to prev Man A. The scope of the FCPA is v gal for all U.S. companies and foreign companies operating in the United States, their af v pany and $100,000 for executives involv

ve years.

YOUR TURN

Learning Objective

LO8

The FCP

o

y’s assets, allowing only authorized personnel to have , to

701

Concluding Remarks

Ethics, Fraud & Corporate Governance InVision InVision InVision InVision Technologies, InVision

Inc. InVision InVision

InVision InVision InVision InVision InVision

motivate the awarding of business that w payments, to motiv Af v

ve been awarded, and facilitating e actions more rapidly than the

globalization must ensure that their cross-border employees comply with the FCPA.

Concluding Remarks w ou have learned how global environmental differences create demand for dif wever, other global forces, particularly global securities markets and lar velopment of w? We believ ward wever expect wide variation in disclosure lev veral years to come.

END-OF-CHAPTER REVIEW SUMMARY OF LEARNING OBJECTIVES

LO1

fine four mechanisms companies use to business activities.

LO5

ompute gains or losses on receivables or yables that are stated in a foreign currency change rates fluctuate.

LO6

escribe techniques for “hedging” against losses rom fluctuations in exchange rates.

LO7

s how global sourcing increases product ost complexity.

entify how global environmental forces— l and legal systems, (b) economic s tems, (c) culture, and (d) technology and in rastructure—affect accounting practices. LO2

LO3

LO4

lain why there is demand for harmonization of inancial reporting standards.

emonstrate how to convert an amount of money rom one currency to another. c

Key Terms Introduced or Emphasized in Chapter 15

f the Foreign Corrupt

LO8

tices Act. t

Demonstration Problem

Solution to the Demonstration Problem

GENERAL JOURNAL

GENERAL JOURNAL

Self-Test Questions

ASSIGNMENT MATERIAL

Discussion Questions

Brief Exercises LO4

LO4

LO5

F

LO4

LO5

LO5

LO6

LO4

CompuTech

CompuTech

LO2

accounting

http://www.geert-hofstede.com

LO5

LO6

LO8

Lockheed

LO4

Exercises LO1 through

LO8

LO1

LO2

accounting

LO4

www.xe.com/ucc

LO2

www.state.gov

L

LO7 LO8

LO2 LO5

Boeing Nikon Citroën

Peugot Caterpillar

LO4 F

LO5

www.iasplus.com/country/useias.htm

LO3

LO4

LO5

Home Depot

LO1

Home Depot

Home Depot

Home Depot

LO2

LO5

LO6

Home Depot

LO4 LO7

Mattel Inc.

LO2 LO3

Honda Motor Company

LO3 Honda Motor Company

Honda Motor Company

LO2

Problem Set A LO4 LO5

LO7

a

accounting

LO1

LO4

LO6

LO4

LO7

WALLERTON, INC. BUDGETED INCOME STATEMENT FOR THE PERIOD ENDING DECEMBER 31, 2011

LO4 LO7

www.ustr.

LO2

gov LO7

LO4

LO6

LO8 F

Home Depot, Inc. Home Depot

LO1

LO2

Home Depot Home Depot

LO6 LO7

Home Depot

Home Depot, Inc.

Problem Set B LO4

P E

LO5 LO7

LO1

LO4

R

LO6

LO4

LO7

JELTON, INC. BUDGETED INCOME STATEMENT FOR THE PERIOD ENDING DECEMBER 31, 2011

LO4

LO7

LO2

www.ustr.gov LO7

LO4

LO6

LO8 F

Critical Thinking Cases LO1 LO2

LO2 LO3 LO5

LO1 LO2

www.naftz.org LO7

LO2 LO3

www.oecd.org

http://www.yahoo.com

Answers to Self-Test Questions

AP P ENDIX A

Home Depot 2009 Financial Statements

A-1

Appendix A Home Depot 2009 Financial Statements

Item 8.

Financial Statements and Supplementary Data.

Management’s Responsibility for Financial Statements The financial statements presented in this Annual Report have been prepared with integrity and objectivity and are the responsibility of the management of The Home Depot, Inc. These financial statements have been prepared in conformity with U.S. generally accepted accounting principles and properly reflect certain estimates and judgments based upon the best available information. The financial statements of the Company have been audited by KPMG LLP, an independent registered public accounting firm. Their accompanying report is based upon an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Audit Committee of the Board of Directors, consisting solely of independent directors, meets five times a year with the independent registered public accounting firm, the internal auditors and representatives of management to discuss auditing and financial reporting matters. In addition, a telephonic meeting is held prior to each quarterly earnings release. The Audit Committee retains the independent registered public accounting firm and regularly reviews the internal accounting controls, the activities of the independent registered public accounting firm and internal auditors and the financial condition of the Company. Both the Company’s independent registered public accounting firm and the internal auditors have free access to the Audit Committee. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f ) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of January 31, 2010 based on the framework in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation, our management concluded that our internal control over financial reporting was effective as of January 31, 2010 in providing reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. The effectiveness of our internal control over financial reporting as of January 31, 2010 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included on page 30 in this Form 10-K.

/s/ FRANCIS S. BLAKE Francis S. Blake Chairman & Chief Executive Officer

/s/ CAROL B. TOMÉ Carol B. Tomé Chief Financial Officer & Executive Vice President – Corporate Services

A-2

Appendix A Home Depot 2009 Financial Statements

Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders The Home Depot, Inc.: We have audited the accompanying Consolidated Balance Sheets of The Home Depot, Inc. and subsidiaries as of January 31, 2010 and February 1, 2009, and the related Consolidated Statements of Earnings, Stockholders’ Equity and Comprehensive Income, and Cash Flows for each of the fiscal years in the three-year period ended January 31, 2010. These Consolidated Financial Statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these Consolidated Financial Statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the Consolidated Financial Statements referred to above present fairly, in all material respects, the financial position of The Home Depot, Inc. and subsidiaries as of January 31, 2010 and February 1, 2009, and the results of their operations and their cash flows for each of the fiscal years in the three-year period ended January 31, 2010, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), The Home Depot, Inc.’s internal control over financial reporting as of January 31, 2010, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 25, 2010 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. /s/ KPMG LLP Atlanta, Georgia March 25, 2010

A-3

Appendix A Home Depot 2009 Financial Statements

THE HOME DEPOT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS

amounts in millions, except per share data

NET SALES Cost of Sales GROSS PROFIT Operating Expenses: Selling, General and Administrative Depreciation and Amortization Total Operating Expenses OPERATING INCOME Interest and Other (Income) Expense: Interest and Investment Income Interest Expense Other Interest and Other, net EARNINGS FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES Provision for Income Taxes EARNINGS FROM CONTINUING OPERATIONS EARNINGS (LOSS) FROM DISCONTINUED OPERATIONS, NET OF TAX NET EARNINGS Weighted Average Common Shares BASIC EARNINGS PER SHARE FROM CONTINUING OPERATIONS BASIC EARNINGS (LOSS) PER SHARE FROM DISCONTINUED OPERATIONS BASIC EARNINGS PER SHARE Diluted Weighted Average Common Shares DILUTED EARNINGS PER SHARE FROM CONTINUING OPERATIONS DILUTED EARNINGS (LOSS) PER SHARE FROM DISCONTINUED OPERATIONS DILUTED EARNINGS PER SHARE

January 31, 2010

Fiscal Year Ended(1) February 1, February 3, 2009 2008

$ 66,176 43,764 22,412

$ 71,288 47,298 23,990

$ 77,349 51,352 25,997

15,902 1,707 17,609 4,803

17,846 1,785 19,631 4,359

17,053 1,702 18755 7,242

(18) 676 163 821

(18) 624 163 769

3,982 1,362 2,620 41 $ 2,661

3,590 1,278 2,312 (52) $ 2,260

1,683

6,620 2,410 4,210 185 $ 4,395

1,682

1,849

$

1.56

$

1.37

$

2.28

$ $

0.02 1.58

$ $

(0.03) 1.34

$ $

0.10 2.38

1,692

1,686

1,856

$

1.55

$

1.37

$

2.27

$ $

0.02 1.57

$ $

(0.03) 1.34

$ $

0.10 2.37

(1) Fiscal years ended January 31, 2010 and February 1, 2009 include 52 weeks. Fiscal year ended February 3, 2008 includes 53 weeks. See accompanying Notes to Consolidated Financial Statements.

(74) 696 — 622

A-4

Appendix A Home Depot 2009 Financial Statements

THE HOME DEPOT, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS

amounts in millions, except share and per share data

ASSETS Current Assets: Cash and Cash Equivalents Short-Term Investments Receivables, net Merchandise Inventories Other Current Assets Total Current Assets Property and Equipment, at cost: Land Buildings Furniture, Fixtures and Equipment Leasehold Improvements Construction in Progress Capital Leases Less Accumulated Depreciation and Amortization Net Property and Equipment Notes Receivable Goodwill Other Assets Total Assets LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities: Accounts Payable Accrued Salaries and Related Expenses Sales Taxes Payable Deferred Revenue Income Taxes Payable Current Installments of Long-Term Debt Other Accrued Expenses Total Current Liabilities Long-Term Debt, excluding current installments Other Long-Term Liabilities Deferred Income Taxes Total Liabilities STOCKHOLDERS’ EQUITY Common Stock, par value $0.05; authorized: 10 billion shares; issued: 1.716 billion shares at January 31, 2010 and 1.707 billion shares at February 1, 2009; outstanding: 1.698 billion shares at January 31, 2010 and 1.696 billion shares at February 1, 2009 Paid-In Capital Retained Earnings Accumulated Other Comprehensive Income (Loss) Treasury Stock, at cost, 18 million shares at January 31, 2010 and 11 million shares at February 1, 2009 Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity See accompanying Notes to Consolidated Financial Statements.

January 31, 2010

February 1, 2009

$

$

1,421 6 964 10,188 1,321 13,900

519 6 972 10,673 1,192 13,362

8,451 17,391 9,091 1,383 525 504

8,301 16,961 8,741 1,359 625 490

37,345 11,795 25,550 33 1,171 223 $ 40,877

36,477 10,243 26,234 36 1,134 398 $ 41,164

$

$

4,863 1,263 362 1,158 108 1,020 1,589 10,363 8,662 2,140 319 21,484

86 6,304 13,226 362 (585) 19,393 $ 40,877

4,822 1,129 337 1,165 289 1,767 1,644 11,153 9,667 2,198 369 23,387

85 6,048 12,093 (77) (372) 17,777 $ 41,164

A-5

Appendix A Home Depot 2009 Financial Statements

THE HOME CONSOLIDATED STATEMENTS OF EQUITY AND COMPREHENSI

Common Stock cept per share data Shares Amount

amounts in million

Paid-In Capital

Retained Earnings

NCOME

Accumulated Other Comprehensive Income (Loss)

Treasu Stock Shares Amount

Stockholders’ Equity $

Cumulative Effect of the Adoption of 48 Shares Issued Under Employee Stock Plans

slation Adj Stoc

nts

tions, Awards an of Re ted Stock

—

—

—

12

1

239

—

—

—

—

—

206

(111)

—

455

Total Comprehensive Income

25,030 (111) 4,395 $

—

240

—

4 455 (10)

4,395

455 (10)

ation —

206 (10,815)

Retirement of Treas

Stock

(735)

(37)

—

—

(2,608)

(24,239)

735

26,884 (1,709)

Other

1,698 Shares Issued Under Employee Stock Plans

Translation Adjustments Stock Options, Aw of Re ted Stock

$

29

85

$ 5,800

9

—

68

—

—

—

—

—

176

—

—

—

—

$ 11,388

$

755

(831)

(8) $

29

(314) $

17,714 2,260

—

68

—

7 (831) (1)

—

176

$

4,840

$

2,260

(831) (1)

ation (70)

Cash Dividends ($0.90 per s

e)

(1,521)

—

(1,521) (25)

Comprehensive Income $ Net E

ings

—

—

—

2,661

—

17,777 2,661

$

1,428

$

2,661

58 Tax Effect of Sale Employees

tion Shares by

Cash Flow Hedges, net of tax

—

—

(2)

—

—

—

— 11

(2) 426 11

—

426 11

201 Re

hase of C

on Stock

Other Comprehensive Income BALANCE, JANUARY 31, 2010

—

—

—

—

—

(7)

—

(3)

2

(213)

(213) (1,525) (1)

—

2 $

1,716

$

86

$ 6,304

$ 13,226

See accompanying Notes to Consolidated Financial Statements.

$

362

(18) $

(585) $

19,393

3,100

A-6

Appendix A Home Depot 2009 Financial Statements

THE HOME DEPOT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS

amounts in millions

CASH FLOWS FROM OPERATING ACTIVITIES: Net Earnings Reconciliation of Net Earnings to Net Cash Provided by Operating Activities: Depreciation and Amortization Impairment Related to Rationalization Charges Impairment of Investment Stock-Based Compensation Expense Changes in Assets and Liabilities, net of the effects of acquisitions and disposition: (Increase) Decrease in Receivables, net Decrease (Increase) in Merchandise Inventories Decrease (Increase) in Other Current Assets Increase (Decrease) in Accounts Payable and Accrued Expenses Decrease in Deferred Revenue (Decrease) Increase in Income Taxes Payable Decrease in Deferred Income Taxes (Decrease) Increase in Other Long-Term Liabilities Other Net Cash Provided by Operating Activities CASH FLOWS FROM INVESTING ACTIVITIES: Capital Expenditures, net of $10, $37 and $19 of non-cash capital expenditures in fiscal 2009, 2008 and 2007, respectively Proceeds from Sale of Business, net Payments for Businesses Acquired, net Proceeds from Sales of Property and Equipment Purchases of Investments Proceeds from Sales and Maturities of Investments Net Cash (Used in) Provided by Investing Activities CASH FLOWS FROM FINANCING ACTIVITIES: (Repayments of) Proceeds from Short-Term Borrowings, net Repayments of Long-Term Debt Repurchases of Common Stock Proceeds from Sales of Common Stock Cash Dividends Paid to Stockholders Other Financing Activities Net Cash Used in Financing Activities Increase (Decrease) in Cash and Cash Equivalents Effect of Exchange Rate Changes on Cash and Cash Equivalents Cash and Cash Equivalents at Beginning of Year Cash and Cash Equivalents at End of Year SUPPLEMENTAL DISCLOSURE OF CASH PAYMENTS MADE FOR: Interest, net of interest capitalized Income Taxes

January 31, 2010

$

2,661

Fiscal Year Ended(1) February 1, 2009

$

2,260

February 3, 2008

$

4,395

163 201

1,902 580 163 176

(23) 625 4 59 (21) (174) (227) (19) 70 5,125

121 743 (7) (646) (292) 262 (282) 306 242 5,528

(966)

(1,847)

178 33 (755)

147 (168) 139 (1,729)

(3,558) 8,337 (13) 318 (11,225) 10,899 4,758

(1,774) (213) 73 (1,525) (64) (3,503) 867 35 519 $ 1,421

(1,732) (313) (70) 84 (1,521) (128) (3,680) 119 (45) 445 $ 519

1,734 (20) (10,815) 276 (1,709) (105) (10,639) (154) (1) 600 $ 445

$ $

$ $

$ $

1,806

664 2,082

622 1,265

1,906

207

116 (491) 109 (465) (159) (348) 186 271 5,727

(1) Fiscal years ended January 31, 2010 and February 1, 2009 include 52 weeks. Fiscal year ended February 3, 2008 includes 53 weeks. See accompanying Notes to Consolidated Financial Statements.

672 2,524

Appendix A Home Depot 2009 Financial Statements

A-7

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Business, Consolidation and Presentation The Home Depot, Inc. and its subsidiaries (the “Company”) operate The Home Depot stores, which are full-service, warehouse-style stores averaging approximately 105,000 square feet in size. The stores stock approximately 30,000 to 40,000 different kinds of building materials, home improvement supplies and lawn and garden products that are sold to doit-yourself customers, do-it-for-me customers and professional customers. At the end of fiscal 2009, the Company was operating 2,244 stores, which included 1,976 The Home Depot stores in the United States, including the Commonwealth of Puerto Rico and the territories of the U.S. Virgin Islands and Guam (“U.S.”), 179 The Home Depot stores in Canada, 79 The Home Depot stores in Mexico and 10 The Home Depot stores in China. The Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation. Fiscal Year The Company’s fiscal year is a 52- or 53-week period ending on the Sunday nearest to January 31. Fiscal years ended January 31, 2010 (“fiscal 2009”) and February 1, 2009 (“fiscal 2008”) include 52 weeks. The fiscal year ended February 3, 2008 (“fiscal 2007”) includes 53 weeks. Use of Estimates Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities, the disclosure of contingent assets and liabilities, and reported amounts of revenues and expenses in preparing these financial statements in conformity with U.S. generally accepted accounting principles. Actual results could differ from these estimates. Fair Value of Financial Instruments The carrying amounts of Cash and Cash Equivalents, Receivables and Accounts Payable approximate fair value due to the short-term maturities of these financial instruments. The fair value of the Company’s investments is discussed under the caption “Short-Term Investments” in this Note 1. The fair value of the Company’s Long-Term Debt is discussed in Note 11. Cash Equivalents The Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. The Company’s Cash Equivalents are carried at fair market value and consist primarily of high-grade commercial paper, money market funds and U.S. government agency securities. Short-Term Investments Short-Term Investments are recorded at fair value based on current market rates and are classified as available-for-sale. Accounts Receivable The Company has an agreement with a third-party service provider who directly extends credit to customers, manages the Company’s private label credit card program and owns the related receivables. We evaluated the third-party entities holding the receivables under the program and concluded that they should not be consolidated by the Company. The agreement with the third-party service provider expires in 2018, with the Company having the option, but no obligation, to purchase the receivables at the end of the agreement. The deferred interest charges incurred by the Company for its deferred financing programs offered to its customers are included in Cost of Sales. The interchange fees charged to the Company for the customers’ use of the cards and the profit sharing with the third-party administrator are included in Selling, General and Administrative expenses (“SG&A”). The sum of the three is referred to by the Company as “the cost of credit” of the private label credit card program. In addition, certain subsidiaries of the Company extend credit directly to customers in the ordinary course of business. The receivables due from customers were $38 million and $37 million as of January 31, 2010 and February 1, 2009, respectively. The Company’s valuation reserve related to accounts receivable was not material to the Consolidated Financial Statements of the Company as of the end of fiscal 2009 or 2008.

A-8

Appendix A Home Depot 2009 Financial Statements

Merchandise Inventories The majority of the Company’s Merchandise Inventories are stated at the lower of cost (first-in, first-out) or market, as determined by the retail inventory method. As the inventory retail value is adjusted regularly to reflect market conditions, the inventory valued using the retail method approximates the lower of cost or market. Certain subsidiaries, including retail operations in Canada, Mexico and China, and distribution centers, record Merchandise Inventories at the lower of cost or market, as determined by a cost method. These Merchandise Inventories represent approximately 18% of the total Merchandise Inventories balance. The Company evaluates the inventory valued using a cost method at the end of each quarter to ensure that it is carried at the lower of cost or market. The valuation allowance for Merchandise Inventories valued under a cost method was not material to the Consolidated Financial Statements of the Company as of the end of fiscal 2009 or 2008. Independent physical inventory counts or cycle counts are taken on a regular basis in each store and distribution center to ensure that amounts reflected in the accompanying Consolidated Financial Statements for Merchandise Inventories are properly stated. During the period between physical inventory counts in stores, the Company accrues for estimated losses related to shrink on a store-by-store basis based on historical shrink results and current trends in the business. Shrink (or in the case of excess inventory, “swell”) is the difference between the recorded amount of inventory and the physical inventory. Shrink may occur due to theft, loss, inaccurate records for the receipt of inventory or deterioration of goods, among other things. Income Taxes The Company provides for federal, state and foreign income taxes currently payable, as well as for those deferred due to timing differences between reporting income and expenses for financial statement purposes versus tax purposes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in income tax rates is recognized as income or expense in the period that includes the enactment date. The Company and its eligible subsidiaries file a consolidated U.S. federal income tax return. Non-U.S. subsidiaries and certain U.S. subsidiaries, which are consolidated for financial reporting purposes, are not eligible to be included in the Company’s consolidated U.S. federal income tax return. Separate provisions for income taxes have been determined for these entities. The Company intends to reinvest substantially all of the unremitted earnings of its non-U.S. subsidiaries and postpone their remittance indefinitely. Accordingly, no provision for U.S. income taxes for these non-U.S. subsidiaries was recorded in the accompanying Consolidated Statements of Earnings. Depreciation and Amortization The Company’s Buildings, Furniture, Fixtures and Equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets. Leasehold Improvements are amortized using the straight-line method over the original term of the lease or the useful life of the improvement, whichever is shorter. The Company’s Property and Equipment is depreciated using the following estimated useful lives:

Life

Buildings Furniture, Fixtures and Equipment Leasehold Improvements

5–45 years 3–20 years 5–45 years

Capitalized Software Costs The Company capitalizes certain costs related to the acquisition and development of software and amortizes these costs using the straight-line method over the estimated useful life of the software, which is three to six years. These costs are included in Furniture, Fixtures and Equipment in the accompanying Consolidated Balance Sheets. Certain development costs not meeting the criteria for capitalization are expensed as incurred.

Appendix A Home Depot 2009 Financial Statements

A-9

Revenues The Company recognizes revenue, net of estimated returns and sales tax, at the time the customer takes possession of merchandise or receives services. The liability for sales returns is estimated based on historical return levels. When the Company receives payment from customers before the customer has taken possession of the merchandise or the service has been performed, the amount received is recorded as Deferred Revenue in the accompanying Consolidated Balance Sheets until the sale or service is complete. The Company also records Deferred Revenue for the sale of gift cards and recognizes this revenue upon the redemption of gift cards in Net Sales. Gift card breakage income is recognized based upon historical redemption patterns and represents the balance of gift cards for which the Company believes the likelihood of redemption by the customer is remote. During fiscal 2009, 2008 and 2007, the Company recognized $40 million, $37 million and $36 million, respectively, of gift card breakage income. This income is recorded as other income and is included in the accompanying Consolidated Statements of Earnings as a reduction in SG&A. Services Revenue Net Sales include services revenue generated through a variety of installation, home maintenance and professional service programs. In these programs, the customer selects and purchases material for a project and the Company provides or arranges professional installation. These programs are offered through the Company’s stores. Under certain programs, when the Company provides or arranges the installation of a project and the subcontractor provides material as part of the installation, both the material and labor are included in services revenue. The Company recognizes this revenue when the service for the customer is complete. All payments received prior to the completion of services are recorded in Deferred Revenue in the accompanying Consolidated Balance Sheets. Services revenue was $2.6 billion, $3.1 billion and $3.5 billion for fiscal 2009, 2008 and 2007, respectively. Self-Insurance The Company is self-insured for certain losses related to general liability, product liability, automobile, workers’ compensation and medical claims. The expected ultimate cost for claims incurred as of the balance sheet date is not discounted and is recognized as a liability. The expected ultimate cost of claims is estimated based upon analysis of historical data and actuarial estimates. Prepaid Advertising Television and radio advertising production costs, along with media placement costs, are expensed when the advertisement first appears. Amounts included in Other Current Assets in the accompanying Consolidated Balance Sheets relating to prepayments of production costs for print and broadcast advertising as well as sponsorship promotions were not material at the end of fiscal 2009 and 2008. Vendor Allowances Vendor allowances primarily consist of volume rebates that are earned as a result of attaining certain purchase levels and advertising co-op allowances for the promotion of vendors’ products that are typically based on guaranteed minimum amounts with additional amounts being earned for attaining certain purchase levels. These vendor allowances are accrued as earned, with those allowances received as a result of attaining certain purchase levels accrued over the incentive period based on estimates of purchases. Volume rebates and certain advertising co-op allowances earned are initially recorded as a reduction in Merchandise Inventories and a subsequent reduction in Cost of Sales when the related product is sold. Certain advertising co-op allowances that are reimbursements of specific, incremental and identifiable costs incurred to promote vendors’ products are recorded as an offset against advertising expense. In fiscal 2009, 2008 and 2007, gross advertising expense was $897 million, $1.0 billion and $1.2 billion, respectively, and is included in SG&A. Specific, incremental and identifiable advertising co-op allowances were $105 million, $107 million and $120 million for fiscal 2009, 2008 and 2007, respectively, and were recorded as an offset to advertising expense in SG&A. Cost of Sales Cost of Sales includes the actual cost of merchandise sold and services performed, the cost of transportation of merchandise from vendors to the Company’s stores, locations or customers, the operating cost of the Company’s sourcing and distribution network and the cost of deferred interest programs offered through the Company’s private label credit card program.

A-10

Appendix A Home Depot 2009 Financial Statements

The cost of handling and shipping merchandise from the Company’s stores, locations or distribution centers to the customer is classified as SG&A. The cost of shipping and handling, including internal costs and payments to third parties, classified as SG&A was $426 million, $501 million and $571 million in fiscal 2009, 2008 and 2007, respectively. Impairment of Long-Lived Assets The Company evaluates its long-lived assets each quarter for indicators of potential impairment. Indicators of impairment include current period losses combined with a history of losses, management’s decision to relocate or close a store or other location before the end of its previously estimated useful life, or when changes in other circumstances indicate the carrying amount of an asset may not be recoverable. The evaluation for long-lived assets is performed at the lowest level of identifiable cash flows, which is generally the individual store level. The assets of a store with indicators of impairment are evaluated by comparing its undiscounted cash flows with its carrying value. The estimate of cash flows includes management’s assumptions of cash inflows and outflows directly resulting from the use of those assets in operations, including gross margin on Net Sales, payroll and related items, occupancy costs, insurance allocations and other costs to operate a store. If the carrying value is greater than the undiscounted cash flows, an impairment loss is recognized for the difference between the carrying value and the estimated fair market value. Impairment losses are recorded as a component of SG&A in the accompanying Consolidated Statements of Earnings. When a leased location closes, the Company also recognizes in SG&A the net present value of future lease obligations less estimated sublease income. As part of its Rationalization Charges, the Company recorded no asset impairment and $84 million of lease obligation costs in fiscal 2009 compared to $580 million of asset impairments and $252 million of lease obligation costs in fiscal 2008. See Note 2 for more details on the Rationalization Charges. The Company also recorded impairments on other closings and relocations in the ordinary course of business, which were not material to the Consolidated Financial Statements in fiscal 2009, 2008 and 2007. Goodwill and Other Intangible Assets Goodwill represents the excess of purchase price over the fair value of net assets acquired. The Company does not amortize goodwill, but does assess the recoverability of goodwill in the third quarter of each fiscal year, or more often if indicators warrant, by determining whether the fair value of each reporting unit supports its carrying value. The fair values of the Company’s identified reporting units were estimated using the present value of expected future discounted cash flows. The Company amortizes the cost of other intangible assets over their estimated useful lives, which range from 1 to 20 years, unless such lives are deemed indefinite. Intangible assets with indefinite lives are tested in the third quarter of each fiscal year for impairment, or more often if indicators warrant. The Company recorded no impairment charges for goodwill or other intangible assets for fiscal 2009, 2008 or 2007. Stock-Based Compensation The per share weighted average fair value of stock options granted during fiscal 2009, 2008 and 2007 was $6.61, $6.46 and $9.45, respectively. The fair value of these options was determined at the date of grant using the Black-Scholes optionpricing model with the following assumptions:

January 31, 2010

Risk-free interest rate Assumed volatility Assumed dividend yield Assumed lives of option

2.3% 41.5% 3.9% 6 years

Fiscal Year Ended February 1, 2009

2.9% 33.8% 3.5% 6 years

February 3, 2008

4.4% 25.5% 2.4% 6 years

Derivatives The Company uses derivative financial instruments from time to time in the management of its interest rate exposure on long-term debt and its exposure on foreign currency fluctuations. The Company accounts for its derivative financial instruments in accordance with the Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) 815-10. The fair value of the Company’s derivative financial instruments is discussed in Note 5.

Appendix A Home Depot 2009 Financial Statements

A-11

Comprehensive Income Comprehensive Income includes Net Earnings adjusted for certain revenues, expenses, gains and losses that are excluded from Net Earnings under U.S. generally accepted accounting principles. Adjustments to Net Earnings and Accumulated Other Comprehensive Income consist primarily of foreign currency translation adjustments. Foreign Currency Translation Assets and Liabilities denominated in a foreign currency are translated into U.S. dollars at the current rate of exchange on the last day of the reporting period. Revenues and expenses are generally translated using average exchange rates for the period and equity transactions are translated using the actual rate on the day of the transaction. Segment Information The Company operates within a single reportable segment primarily within North America. Net Sales for the Company outside of the U.S. were $7.0 billion for fiscal 2009 and were $7.4 billion for fiscal 2008 and 2007. Long-lived assets outside of the U.S. totaled $3.0 billion and $2.8 billion as of January 31, 2010 and February 1, 2009, respectively.

A-12

Appendix A Home Depot 2009 Financial Statements

10-Year Summary of Financial and Operating Results The Home Depot, Inc. and Subsidiaries amounts in millions, except where noted

Net sales

10-Year Compound Annual Growth Rate

5.6%

ngs before provision for income taxes

2009

$

66,176

$

71,288

0.5

3,982

3,590

—

13.3

(45.1)

—

13.1

(39.6)

Gross margin – % of sales

—

33.9

33.7

Interest and other, net – % of sales

—

1.2

1.1

N

—

4.0

3.2

N

ncrease (decrease) (%) per share increase (decrease) (%)

– % of sales

Total assets

9.1%

Merchandise inventories

6.4

10,188

10,673

27.7

8,662

9,667

Book value per share ($)

7.9

11.42

10.48

Total debt-to-equity (%)

—

49.9

64.3

Invent

—

4.1x

4.0x

Capital expenditures

(9.5)

966

1,847

Cash dividends per share ($) STORE DATA Number of stores Square footage at fiscal year-end (Decrease) increase in square footage (%) Average square footage per store (in thousands) STORE SALES AND OTHER DATA Comparable store sales increase (decrease) (%)(4)(5) Weighted average weekly sales per operating store (in thousands) Weighted average sales per square foot ($) Number of customer transactions Average ticket ($) Number of associates at fiscal year-end(3)

23.3

0.900

9.2% 8.9 — (0.3)

2,244 235 (1.3) 105

debt

ove

)

$

40,877

2007(1)

2008

$

41,164

$

77,349 (2.1) 6,620 4,210 (20.1) 2.27 (11.0) 1,856 33.6 24.3 0.8 8.6 5.4

$

44,324 1,968 11,731 27,476 11,383 17,714 10.48 64.3 75.8 1.15:1 4.2x 13.9

$

0.900

1,906 3,558 13 0.900

2,274 238 1.3 105

2,234 235 4.9 105

STATEMENT OF CASH FLOWS DATA

— (4.3)% (4.1) 4.8 0.8 4.6

(8.7)

(6.6) $

563 279 1,274 51.76 317,000

$

601 298 1,272 55.61 322,000

(6.7) $

658 332 1,336 57.48 331,000

(1) Fiscal years 2007 and 2001 include 53 weeks; all other fiscal years reported include 52 weeks. (2) Fiscal years 2003 through 2009 include Continuing Operations only. The discontinued operations in fiscal years prior to 2003 were not material. See Note 4 to the Consolidated Financial Statements included in Item 8, “Financial Statements and Supplementary Data.” (3) Amounts for fiscal years 2009, 2008 and 2007 include Continuing Operations only. All amounts in other fiscal years reported include discontinued operations. See Note 4 to the Consolidated Financial Statements included in Item 8, “Financial Statements and Supplementary Data.”

A-13

Appendix A Home Depot 2009 Financial Statements

amounts in million

cept where noted

2006

Net sales

ncrease (decrease) (%) per share increase (decrease) (%)

Gross margin – % of sales Interest and other, net – % of sales N

2004

2003

2002

2001(1)

2000

$ 79,022 $ 77,019 $ 71,100 $ 63,660 $ 58,247 $ 53,553 $ 45,738 2.6 8.3 11.7 9.3 8.8 17.1 19.0 8,502 8,967 7,790 6,762 5,872 4,957 4,217 5,266 5,641 4,922 4,253 3,664 3,044 2,581 (6.6) 14.6 15.7 16.1 20.4 17.9 11.3 2.55 2.63 2.22 1.86 1.56 1.29 1.10 (3.0) 18.5 19.4 19.2 20.9 17.3 10.0 2,062 2,147 2,216 2,289 2,344 2,353 2,352 33.6 33.7 33.4 31.7 31.1 30.2 29.9 22.4 21.9 22.4 21.1 21.1 20.9 20.7 — (0.1) — 0.5 0.1 10.8 11.6 11.0 10.6 10.1 9.3 9.2 6.7 7.3 6.9 6.7 6.3 5.7 5.6

ngs before provision for income taxes N

2005

– % of sales (3)

Total assets

$ 52,263 $ 44,405 $ 39,020 $ 34,437 $ 30,011 $ 26,394 $ 21,385 5,069 2,563 3,818 3,774 3,882 3,860 3,392 12,822 11,401 10,076 9,076 8,338 6,725 6,556 26,605 24,901 22,726 20,063 17,168 15,375 13,068 11,643 2,672 2,148 856 1,321 1,250 1,545 25,030 26,909 24,158 22,407 19,802 18,082 15,004 12.71 12.67 11.06 9.93 8.38 7.71 6.46 46.5 9.9 8.9 3.8 6.7 6.9 10.3 46.6 15.2 8.9 6.1 6.7 6.9 10.3 1.39:1 1.20:1 1.37:1 1.40:1 1.48:1 1.59:1 1.77:1 4.5x 4.7x 4.9x 5.0x 5.3x 5.4x 5.1x 16.8 20.4 19.9 19.2 18.8 18.3 19.6

Merchandise inve debt Book value per share ($) Total debt-to-equity (%) Invent

ove

)

STATEMENT OF CASH FLOWS DATA $ 1,886 $ 1,579 $ 1,319 $ 1,076 $ 903 $ 764 $ 601 3,542 3,881 3,948 3,508 2,749 3,393 3,574 4,268 2,546 727 215 235 190 26 0.675 0.400 0.325 0.26 0.21 0.17 0.16

Cash dividends per share ($) Number of stores

2,147 224 4.2 105

(Decrease) increase in square footage (%) ST

2,042 215 7.0 105

1,890 201 9.8 106

1,707 183 10.2 107

3.1

5.1

3.7

1,532 166 14.1 108

1,333 146 18.5 109

1,134 123 22.6 108

—

4

LES AND OTHER DATA (2.8)

Weighted average weekly sales per operating store (in thousands) Number of customer transactions Number of ass

l year-end(3)

(0.5)

$

723 $ 763 $ 766 $ 763 $ 772 $ 812 $ 864 358 377 375 371 370 394 415 1,330 1,330 1,295 1,246 1,161 1,091 937 58.90 57.98 54.89 51.15 49.43 48.64 48.65 364,400 344,800 323,100 298,800 280,900 256,300 227,300

(4) Includes Net Sales at locations open greater than 12 months, including relocated and remodeled stores. Stores become comparable on the Monday following their 365th day of operation. Comparable store sales is intended only as supplemental information and is not a substitute for Net Sales or Net Earnings presented in accordance with generally accepted accounting principles. (5) Comparable store sales in fiscal years prior to 2002 were reported to the nearest percent.

APPENDIX B

The Time Value of Money Future Amounts and Present Values

Learning Objectives

A FT E R ST UDYI NG T H I S AP PE N D I X , YOU S H OU L D B E A B L E TO :

LO1 LO2 LO3

LO4

LO5 LO6

B-1

The Concept

The Concept vesting is the time value of money. This concept is based on the idea that an amount of money av vested to accumulate to a lar y available today is considered to be equivalent in value to a larger sum av In our discussion, we will refer to an amount of money available today as a present value. In contrast, an amount receivable or payable at a future date will be described as a future amount. T of 8 percent per year. The balance of your account at the end of each of the next four years is Exhibit B–1.

Learning Objective

LO1

Learning Objective

LO2

Exhibit B–1 THE VALUES OF MONEY OVER TIME $680 ($630 3 1.08)

Future values are bigger, This is the real issue.

Balance ($)

$630 ($583 3 1.08) $583 ($540 3 1.08) $540 ($500 3 1.08) $500

alues of your $500 inv open the account, your investment has a present value of only $500. As time passes, the value vestment increases to the future amounts appendix, present values will be illustrated in red, blue.)

RELATIONSHIPS BETWEEN PRESENT VALUES AND FUTURE AMOUNTS alue and an in the future amount. We hav

interest that is included v

s: (1) the rate of interest at which the present value increases and (2) the length of time over which interest accumulates. (Notice in our graph, the f w ger the future amount.)

Present Values Change over Time increases tow amount becomes the present value of the inv

The present value of an inv arrives, what once w or e

,

The Basic Concept (Stated Several D erent Ways) Notice that the present v

always less than its future amounts. This is the basic idea

B-2

Appendix B The Time Value of Money: Future Amounts and Present Values

underlying the time value of money. But this idea often is e ing the following:

ays, includ-

• A present value is always less than • ways greater than a present value. • A dollar available today is always w more than a dollar that does not become available • A dollar av

ways w

Read these statements carefully lent” of a lar money.

less than a dollar that is available today. alue is the “equivaalue of

COMPOUND INTEREST The relationships between present v on the inv reinvested, compounding the interest. vesting the interest causes the amount inv in each successive period. Over a long period of time, an investment in which interest is comge amounts.

CASE IN POINT

APPLICATIONS OF THE TIME VALUE OF MONEY CONCEPT Learning Objective

LO3

E i a

Investors, accountants, and other decision makers apply the time value of money in three basic w w, along with a typical example. 1. T If we inv 2. T Example: W 20 years. Ho assets will be inv 3. T to pay today for ne year for the next 10 years?

v

ver time. Example: w much

vested ev ver the next s ws e

Example: v xpected to reduce production costs by $20,000 per

We will now introduce a framew

Future Amounts A future amount is simply the dollar amount to which a present value will accumulate over time. As we have stated, the difference between a present v depends on (1) the interest rate and (2) the period of time over which the present value accumulates.

B-3

Future Amounts

Exhibit B–1. But there are faster and easier ways. For example, man merely enter the present v a table of future amounts, such as Table FA–1 in .

Exhibit B–2 THE FUTURE VALUE OF $1 Approach to computing future amount 1.010

1.015

1.050

1.060

1.080

1.100

1.120

1.150

1.200

1.020

1.030

1.103

1.124

1.166

1.210

1.254

1.323

1.440

1.030

1.046

1.158

1.191

1.260

1.331

1.405

1.521

1.728

1.041

1.061

1.216

1.262

1.360

1.464

1.574

1.749

2.074

1.051

1.077

1.276

1.338

1.469

1.611

1.762

2.011

2.488

1.062

1.093

1.340

1.419

1.587

1.772

1.974

2.313

2.986

1.072

1.110

1.407

1.504

1.714

1.949

2.211

2.660

3.583

1.083

1.126

1.477

1.594

1.851

2.144

2.476

3.059

4.300

1.094

1.143

1.551

1.689

1.999

2.358

2.773

3.518

5.160

1.105

1.161

1.629

1.791

2.159

2.594

3.106

4.046

6.192

1.220

1.347

2.653

3.207

4.661

6.727

9.646

16.367

38.338

1.270

1.430

3.225

4.049

6.341

9.850

15.179

28.625

79.497

1.431

1.709

5.792

8.147

15.968

30.913

59.136

153.152

708.802

THE TABLES APPROACH $1 will accumulate over a given v y of the illustrated interest wn in the body of this table as factors, rather than as

Learning Objective

rates. W dollar amounts. T alue greater than $1, simply multiply the present value by the factor obtained from the table. The formula for using the table in this manner is:

LO4

Future Amount ⴝ Present Value ⴛ Factor (from Table FA–1) vings account, illustrated in Exhibit B–1 alue of $500, inv rate of 8 percent. Thus, the future values of the account in each of the next four years can be computed as follo

Table FA–1 $540

$500 ⫻ 1.080 ⫽ $540

$583

$500 ⫻ 1.166 ⫽ $583

$630

$500 ⫻ 1.260 ⫽ $630

$680

$500 ⫻ 1.360 ⫽ $680

vely easy. The more interesting question is: How much must we invest today

compute the amounts in our graph

B-4

Appendix B The Time Value of Money: Future Amounts and Present Values

Computing the Required Investment At the be

ear 1, Metro Recyyees by the end of Year 5. It w much must Metro invest in this plan today to accumulate the promised $5 million by the end of Year 5, assuming that payments to the fund will be inv Table FA–1: Our original formula . . .

Future Amount ⴝ Present Value ⴛ Factor (from Table FA–1) In this situation, we know e are looking for the present value which, when invested at an interest rate of 8 percent, will accumulate to $5 million ve years. T present value, wn above may be restated as follows: Future Amount Present Value ⴝ _______________________ Factor (from Table FA–1)

restated to find the present value

Table FA–1, we get a factor of 1.469 v ear 1 is 8 percent interest. Thus, the amount of the required inv $3,403,676 ($5 million ⫼ 1.469). Invested at 8 percent, this amount will accumulate to the v Exhibit B–3.

Exhibit B–3 THE FUTURE AMOUNT OF A SINGLE INVESTMENT

Year 2

Year 3

Year 4

Year 5

Present value $3,403,676

THE FUTURE AMOUNT OF AN ANNUITY In many situations, an investor will make a series of investment payments rather than a single payment. As an example, assume that you plan to deposit $500 into your savings ve years. If the account pays annual interest of 8 percent, what will be the balance in your sa Tables, such as Table FA–2 in Exhibit B–4, may be used to answer this question. Table FA–2 or which is a series of payments of $1 made at the end T ply multiply the amount of the periodic payment by the factor appearing in the table, as shown here: Approach to computing the future amount of an annuity

Future Amount ⴝ Periodic Payment ⴛ Factor (from Table FA–2) of an Annuity In our example, a factor of 5.867 and 8 percent interest. If this f that your sa

ve periods ⫻ 5.867) at the end of

B-5

Future Amounts

Exhibit B–4 FUTURE VALUE OF AN ORDINARY ANNUITY

1.000

1.000

1.000

1.000

1.000

1.000

1.000

1.000

1.000

2.010

2.015

2.050

2.060

2.080

2.100

2.120

2.150

2.200

3.030

3.045

3.153

3.184

3.246

3.310

3.374

3.473

3.640

4.060

4.091

4.310

4.375

4.506

4.641

4.779

4.993

5.368

5.101

5.152

5.526

5.637

5.867

6.105

6.353

6.742

7.442

6.152

6.230

6.802

6.975

7.336

7.716

8.115

8.754

9.930

7.214

7.323

8.142

8.394

8.923

9.487

10.089

11.067

12.916

8.286

8.433

9.549

9.897

10.637

11.436

12.300

13.727

16.499

9.369

9.559 11.027

11.491

12.488

13.579

14.776

16.786

20.799

10.462 10.703 12.578

13.181

14.487

15.937

17.549

20.304

25.959

22.019 23.124 33.066

36.786

45.762

57.275

72.052

102.444

186.688

26.974 28.634 44.502

50.816

66.765

88.497 118.155

184.168

392.484

43.077 47.276 95.836 119.121 187.102 299.127 484.463 1014.346 3539.009

ve years. Therefore, if you invest $500 at the end of each of the ne ve years in the savings ve-year period. While computing the future amount of an inv , many busiamount of the periodic payments

Computing the Required Periodic Payments

ech Company is required to accumulate $10 million in a to retire bonds payable ve years from now. The bond indenture requires Ultra Tech to make equal payments to the at the end of each of the ne v o answer this annuity: Future Amount ⴝ Periodic Payment ⴛ Factor (from Table FA–2) of an Annuity In our e million. However

Our original formula . . .

w that Ultra T vested o make this calculation, ws: Future Amount of an Annuity Periodic Payment ⴝ __________________________ Factor (from Table FA–2)

payments of $1,638,000 are made at the end of each of the ne

⫼ 6.105). If ve years to a bond sinking wn

in Exhibit B–5.

INTEREST PERIODS OF LESS THAN ONE YEAR In our computations of future amounts, we have assumed that interest is paid (compounded) . Therefore, in using the tables, we used annual an annual interest rate. Inv

restated to find the amount of the periodic payments

B-6

Appendix B The Time Value of Money: Future Amounts and Present Values

Exhibit B–5

FUTURE AMOUNT OF A SERIES OF INVESTMENTS

ear 1

Sinking f payment 1 $1,638,000

r2

r3

Sinking f payment 2 $1,638,000

r4

Sinking f payment 3 $1,638,000

r5

Sinking f payment 4 $1,638,000

Sinking f payment 5 $1,638,000

, quarterly . Tables FA–1 and FA–2 may be used with any of these payment periods, but the rate of interest must represent the interest rate for that period. As an example, assume that 24 monthly payments are to be made to an investment fund that pays a 12 percent annual interest rate. T vestment, we w actor from Table FA–2 for 24 periods, using a monthly interest rate of 1 percent—the 12 percent annual rate divided by 12 months.

Present Values Learning Objective

LO5

o

As indicated previously, the present value is today’s value of funds to be received in the alue has many applications in business and accounting, it is most easily explained in the context of evaluating inv xt, the present v wledgeable investor would pay today ve an e alue is always less because the investor will e v xceeds its present value represents the investor’ v o factors: (1) the rate of discount rate) required by the investor and (2) the length of time until the v receipt is called discounting To illustrate the computation of present value, assume that an investment is expected to result in a $1,000 cash receipt at the end of one year and that an investor requires a 10 vestment. We know from our discussion of present and future values that the difference between a present v on the investment. In our example, the future amount would be equal to 110 percent of the original investment, because the investor expects 100 percent of the investment back plus a 10 percent return on the investment. Thus, the investor would be willing to pay $909 ($1,000 ⫼ 1.10) for this investment. This computation may be v ws (amounts rounded to the nearest dollar):

Amount to be invested (present value) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 909

Required return on investment ($909 ⫻ 10%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

91

Amount to be received in one year (future value) . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,000

B-7

Present Values

Exhibit B–6, if the $1,000 is to be received s investor would pay only $826 for the inv ⫼ 1.10) ⫼ 1.10]. This computation may be v Amount to be invested (present value) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 826

Required return on investment in first year ($826 ⫻ 10%) . . . . . . . . . . . . . . . . . . . . . .

83

Amount invested after one year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 909

Required return on investment in second year ($909 ⫻ 10%) . . . . . . . . . . . . . . . . . . .

91

Amount to be received in two years (future value) . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,000

The amount that our investor would pay today, $826, is the present value of $1,000 to be received tw w ference venue) vestor over the two-year period.

Exhibit B–6 PRESENT VALUE OF $1,000 TO BE RECEIVED IN A SINGLE SUM IN TWO YEARS

Year 2

Present value $826

USING PRESENT VALUE TABLES Although we can compute the present v visions, tables are available that simplify the calculations. We can use a table of present v present v amount as illustrated in the follo Present Value ⴝ Future Amount ⴛ Factor (from Table PV–1) Table PV–1 in

B–7

actor of .826 at the intersection of two actor by the e $1,000, we get a present value of $826 ($1,000 ⫻ .826), the same amount computed previously.

WHAT IS THE APPROPRIATE DISCOUNT RATE? As explained earlier, the discount rate may be viewed as the investor’ All inv volve some de be less than expected. Inv today’s market conditions, inv on low-risk investments, such as gov or relatively high-risk inv w product line, investors may expect the present value of the inv increases, its value to investors decreases.

wer. In other words, as the risk of an inv

Formula for finding present value

B-8

Appendix B The Time Value of Money: Future Amounts and Present Values

Exhibit B–7 PRESENT VALUE OF $1

.990

.985

.952

.943

.926

.909

.893

.870

.833

.980

.971

.907

.890

.857

.826

.797

.756

.694

.971

.956

.864

.840

.794

.751

.712

.658

.579

.961

.942

.823

.792

.735

.683

.636

.572

.482

.951

.928

.784

.747

.681

.621

.567

.497

.402

.942

.915

.746

.705

.630

.564

.507

.432

.335

.933

.901

.711

.665

.583

.513

.452

.376

.279

.923

.888

.677

.627

.540

.467

.404

.327

.233

.914

.875

.645

.592

.500

.424

.361

.284

.194

.905

.862

.614

.558

.463

.386

.322

.247

.162

.820

.742

.377

.312

.215

.149

.104

.061

.026

.788

.700

.310

.247

.158

.102

.066

.035

.013

.699

.585

.173

.123

.063

.032

.017

.007

.001

THE PRESENT VALUE OF AN ANNUITY Many inv w ing an inv xpected to produce ee years.1 If Camino Company e it may compute the present v

ws for a number of y is evaluat$10,000 in each of the vestment, ws as follows:

1

$10,000

.893

$ 8,930

2

10,000

.797

7,970

3

10,000

.712

7,120 $24,020

This analysis indicates that the present value of the e

ws from the invest-

amount that Camino Company could afford to pay for this inv wn in Exhibit B–8. In the preceding analysis, we computed the present value of the investment by separately Table PV–1. Separately discounting each period’ ws v xample are uniform in amount, there are easier ways to compute the total present value. Man alue of an investment ve been entered. 1

“ . For convenience, we follo ws for each year occur at year-end. This assumption causes relativ

B-9

Present Values

Exhibit B–8 PRESENT VALUE OF THREE $10,000 CASH FLOWS DISCOUNTED AT 12%

Year 1

Year 2

Year 3

Present value $24,020

Another approach is to refer to a pr , which shows the present value of $1 to be received eac Table PV–2 appears in Exhibit B–9.2 To illustrate the use of Table PV–2, let’ xample of the investment by Camino Company. That inv as e xt three years, and the company’ as 12 percent per year. Using Table PV–2, we can compute the present value of the investment with the follo Present Value of an Annuity ⴝ Periodic Cash Flows ⴛ Factor (from Table PV–2) As illustrated in Table PV–2, the present value of $1 to be received at the end of the next 2.402. If we multiply 2.402 by the e alue of $24,020, which is .

Formula to find the present value of a series of cash flows

Exhibit B–9 PRESENT VALUE OF AN ORDINARY ANNUITY

2

period.

0.990

0.985

0.952

0.943

0.926

0.909

0.893

0.870

0.833

1.970

1.956

1.859

1.833

1.783

1.736

1.690

1.626

1.528

2.941

2.912

2.723

2.673

2.577

2.487

2.402

2.283

2.106

3.902

3.854

3.546

3.465

3.312

3.170

3.037

2.855

2.589

4.853

4.783

4.329

4.212

3.993

3.791

3.605

3.352

2.991

5.795

5.697

5.076

4.917

4.623

4.355

4.111

3.784

3.326

6.728

6.598

5.786

5.582

5.206

4.868

4.564

4.160

3.605

7.652

7.486

6.463

6.210

5.747

5.335

4.968

4.487

3.837

8.566

8.361

7.108

6.802

6.247

5.759

5.328

4.772

4.031

9.471

9.222

7.722

7.360

6.710

6.145

5.650

5.019

4.192

18.046

17.169

12.462

11.470

9.818

8.514

7.469

6.259

4.870

21.243

20.030

13.799

12.550

10.529

8.985

7.784

6.434

4.937

30.108

27.661

16.547

14.621

11.717

9.677

8.192

6.623

4.993

or

annuity

ws occur at the end of each

B-10

Appendix B The Time Value of Money: Future Amounts and Present Values

DISCOUNT PERIODS OF LESS THAN ONE YEAR al between re ing examples, we hav

ws is called the discount period. In our precedws once a year . The present value tables can be used with discount periods of an but the discount rate must be for that length of time. For example, if we use Table PV–2 quarterly cash payquarterly rate. There are many applications of the present value concept in accounting. In the next several

Valuation of Financial Instruments Learning Objective

LO6

v another business, and an

a

ities not

v

act, the only common liabiles.)

ver the present v of the e present value—not at the e Let us illustrate with a few common examples. Cash appears in the balance sheet at its face amount. This face value is a present value—that is, the value of the cash today. Marketable securities appear in the balance sheet at their current market values. These too are present v conv today. Accounts receiv amounts expected to be collected or paid in the near future. T , these are future amounts, not present values. But they usually are received or paid within 30 or 60 days. Convolv their present values simply are not material.

INTEREST-BEARING RECEIVABLES AND PAYABLES the present v does become material. Thus, interest-bearing receivables and payables initially are recorded in accounting records at the present value of the alue substantially less than the sum of the expected future amounts. Consider, for e , 9 percent bonds payable issued at par. At the ved. xpected to total $370 million, computed as follows: Future interest payments ($100 million ⫻ 9% ⫻ 30 years) . . . . . . . . . . . . . . . . . .

$ 270,000,000

Maturity value of the bonds (due in 30 years) . . . . . . . . . . . . . . . . . . . . . . . . . . .

100,000,000

Sum of the future cash payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$370,000,000

alue of $370 million in future cash payments to be made ov ent v the receivable or the liability.

aluation of

“NON-INTEREST-BEARING” NOTES On occasion, companies may issue or accept notes that make no mention of interest, or in w alue of such a note and its f material, the note initially is recorded at its present value.

B-11

Valuation of Financial Instruments

T Development Co. As full payment for this land, Elron issues a $300,000 installment note paynote makes no mention of interest charges. Clearly valent of $300,000 available today. Elron should use the present value of this note—not the f . v 10 percent per annum. The present value of Elron’ is $248,700 [$100,000, ⫻ 2.487 Table PV–2) in Exhibit B–9]. Elron should view this $248,700 as the “principal amount” of this installment note payable. The remaining $51,300 ($300,000 ⫺ $248,700) represents interest charges included in the installElron should record the purchase of the land and the issuance of this note as follows:3 248,700 248,700 $248,700

(U.S. Development Co. should mak the land and the valuation of its note receivable.) Elron also should prepare an amortization table

Exhibit B–10.

Exhibit B–10

AMORTIZATION TABLE (3-YEAR, $300,000 INSTALLMENT NOTE PAYABLE, DISCOUNTED AT 10% PER ANNUM)

Issue date

Jan. 1, 2011

AMORTIZATION TABLE FOR A DISCOUNTED NOTE PAYABLE

$248,700

1

Dec. 31, 2011

$100,000

$24,870

$75,130

173,570

2

Dec. 31, 2012

100,000

17,357

82,643

90,927

3

Dec. 31, 2013

100,000

90,927

–0–

9,073*

*In the last period, interest expense is equal to the amount of the final payment minus the remaining unpaid balance. This compensates for the use of a present value table with factors carried to only three decimal places.

ws:

3

v es use of an account entitled Discount on Notes Payable. ve approach produces the same results and will be e

B-12

Appendix B The Time Value of Money: Future Amounts and Present Values

MARKET PRICES OF BONDS The market price of bonds may be regarded as the present value principal and interest payments, discounted at the prevailing market rate of interest at the time of issuance. T , 10 percent bonds when the going market rate of interest is 12 percent. Because bond interest , we must use 20 semiannual 6 percent semiannual market rate of interest in our present value calculations. The discounted present value of the bond’ is $885,500, computed as follows: Present value of future principal payments: $1,000,000 due after 20 semiannual periods, discounted at 6%: $1,000,000 ⫻ .312 (from Table PV–1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$312,000

Present value of future interest payments: $50,000 per period ($1,000,000 ⫻ 10% ⫻ 1⁄2 ) for 20 semiannual periods, discounted at 6%: $50,000 ⫻ 11.470 (from Table PV–2) . . . . . . . . . . . . . . . . . . .

573,500

Expected issuance price of bond issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$885,500

Note that, because the market rate of interest exceeds the bond’s coupon rate, the bonds are issued at a $114,500 discount ($1,000,000 face value ⫺ $885,500 w ace value). As illustrated in Chapter 10, the entire amount of the discount is debited to an account titled Discount on Bonds P issuance of this bond is:

full $1 million face value of the bond issue, or $114,500 more than it received at the time the bonds were issued. y’s total interest expense Thus, Driscole will incur interest expense of $55,725 ev

ver the 10-year life of the bond. ws:

xpense is:

xpense by $5,725, it does not require an immediate cash outlay. The $114,500 of additional interest expense for the entire

B-13

Valuation of Financial Instruments

CAPITAL LEASES W v xplore this topic in greater detail. A capital lease is regarded as a sale of the leased asset by the lessor to the lessee. At the date of this sale, the lessor recognizes sales revenue equal to the present value lease payments receivable, discounted at a realistic rate of interest. The lessee also uses the present value of the future payments to determine the cost of the leased asset and the valuation of the related liability. T ace Tractor uses a capital lease the sale of a tractor to Kelly Grading Co. The tractor w ace Tractor’ inv elly Grading Co. to make 24 $1,000 each, be include an interest charge of 1 percent per month. At the end of the 24-month lease, title to the elly Grading Co. at no additional cost.

Accounting by the Lessor (Pace Tractor) Table PV–2 shows that the present value of $1 to be received monthly for 24 months, discounted at 1 percent per month, is 21.243. Therefore, the present v ⫻ 21.243, or $21,243. Pace T to the present v ws:

21,243 21,243

15,000 15,000

ven though the gross amount to be collected from Kelly Grading Co. amounts to $24,000 ($1,000 ⫻ 24 payments). The difference between these tw ace Tractor as interest revenue ov T v

alue of the lease payments receivable is reduced to $20,455 ($21,243 original balance, less $788). Therefore, the interest rev second $205 ($20,455 ⫻ 1%).4 4

Both Pace Tractor and Kelly Grading Co. would prepare amortization tables sho

B-14

Appendix B The Time Value of Money: Future Amounts and Present Values

Accounting by the Lessee (Kelly Grading Co.) Kelly Grading Co. also should use the present v of the related liability, as follows: 21,243 21,243

est dollar) will be:

OBLIGATIONS FOR POSTRETIREMENT BENEFITS As we explain in Chapter 10, an the balance sheet at the present value of the e The computation of this present value is so comple . But the present v ar less than the e payments, as the cash payments will take place many years in the future.

ASSIGNMENT MATERIAL

Discussion Questions

1. Explain what is meant by the phrase . 2. Explain why the present v ways less 3. Identify the two f ference between the present value and the future amount of an inv 4. vestment applications of the concept of the time value of money. 5. alue and (a w occurs, and (b alue.

Explain the valuation concept

6. statements. 7.

v

wn in the balance sheet at their present values? Explain. 8. Assuming no change in the e ws, what factors may cause the present v .

Problems LO1 U Using Future Amount T

LO2

LO4

yees.

Use Table FA–1 (in Exhibit B–2) and Table FA–2 (in Exhibit B–4 wing investments: a. $20,000 is invested for 10 years, at 6 percent interest, compounded annually. b. $100,000 is to be receiv v

accountin

B-15

Problems

c. d.

$10,000 is invested in a fund at the end of each of the next 10 years, at 8 percent interest, . $50,000 is invested initially, plus $5,000 is inv xt .

Tilman Company is required by a bond indenture to mak

LO3 Bond Sinking Fund

accumulate to a total of $500,000 at the end of the 20-year period.

LO4

Instructions a. Calculate the amount of the annual payments. b. c. Mak

ver the 20-year period. ilman’s accounting records at $500,000

d. LO1 Using Present Value

LO2

LO5

What would be the ef Explain.

Use Table PV–1 (in Exhibit B–7) and Table PV–2 (in Exhibit B–9 alws: ues of the follo a. $15,000 to be paid annually for 10 years, discounted at an annual rate of 6 percent. P . b. $9,200 to be received today, assuming that the money will be inv . c. $300 to be paid monthly for 36 months, with an additional “balloon payment” of $12,000 due . d.

LO3 Present Value and

LO5

$25,000 to be receiv xt tw

wed by $15,000 to be received ve years in which collections are received), dis-end.

, Rural Gas & Electric Co. issued $50,000,000 face value, 9 percent, 10-year bonds payable, with interest dates of December 31 and June 30. The bonds were issued at a discount, resulting in an effective semiannual interest rate of 5 percent. Instructions a. Compute the issue price for the bond that results in an effectiv 5

LO6

alue over 20 semian-

b. a. c. LO3 Valuation of a Note

LO5

LO6

On December 1, Sho paying $10,500 cash and issuing an installment note payable in the face amount of $28,800. The note is to be paid in 24 monthly installments of $1,200 each. Although the note makes no mention ge, the rate of interest usually charged to Sho is 1½ percent per month. Instructions a. Compute the present value of the note payable, using a discount rate of 1½ percent per month. b. 1. v 2. interest e ve interest method. (Round interest expense to the nearest dollar.) c. Show how the liability for this note would appear in the balance sheet at December 31. .)

B-16

Appendix B The Time Value of Money: Future Amounts and Present Values

LO3

LO5

Capital Leases: A Comprehensive P

Custom T On November 1, 2011, Custom T v mak

an Lines to ginning on November 30, 2011. The present value uilt-in interest charge of 1 percent per month, is equal to

the re transfer to Interstate Van Lines.

LO6

Instructions a. 1. Nov (Debit Lease P payments.) 2. Nov

3. b. 1. 2.

vable for the $42,150 present value of the future lease

venue and reduction of Lease Payments Receivable. The portion of each monthly payment recognized as interest revenue is equal to 1 percent of the balance of the account Lease Payments Receivable, at the be dollar.) December 31, to record receipt of the second monthly payment. an Lines on: Nov Nov the payment representing interest expense in a manner parallel to that described in part a. )

3. 4.

-end. Compute depreciation e mated salvage value of $6,150.

c. d.

LO5

LO6

P

an Lines at December 31, 2011. Compute the amount of Interstate Van Lines’s lease payment obligation at December 31, 2011.

Valuation of a Note

On December 31, Richland F opers in e est on the note is payable annually

Unrealistic Interest U R

follo

velve-year, 4 percent note receivable for $900,000. Interv w interest rate on the note and made the

B-17

Problems

Instructions a. Compute the present value of the note receivable from Skyline Developers at the date of sale, assuming that a realistic rate of interest for this transaction is 12 percent. (Hint: Consider both alue of the note.) b. . Show supc.

Explain what ef s accountant will have on (1) the net income in the year of the sale and (2) the combined net income of the ne ve years. Ignore income taxes.

Index A

I-1

Index

of, 140–141 unadjusted balance, 143 worksheets and, 207–210 year-end, 143–154 Adoption of IFRS, 18–19, 689–691 AFLAC Inc., 169 -closing trial 203 Aging receivable, 302–304 Allete, Inc., 309–310 Allow 301–302, 303n Allowances, 260–261, 264 Alvaro, 439 Amazon, 582, 618 America West 169 American Accounting Association 20, 311 American Airlines, 66, 168, 480, 557 American Cancer Society, 14–15 American Express, 306, 316 American Greetings, 479 As (AICPA), 20, 311 auditing 20 code of professional conduct, 22, 23 CPA examination, 24 ey of depreciation methods, 399 402 of bond B-12 of bond premium, of discounted note payable, B-11 goal of, negative, 437n of patents, tables for calculating, 436–438 -Busch Companies, Inc., 318 net cash ws, B-8n 192, 631 legal requirements for, Management Discussion and Analysis (MD&A), 206, 631 value of, B-4–B-5 present value of, B-8–B-9 Apple Computer, 120, 319–320, 479 Andersen, 455 of 486 39 Asset 88, 388–389 Assets, conv to expenses, 140–141, 142, cost principle and, 41 55, 196, 627–629 depreciable, 146 financial. See Financial assets going and, 41 intangible. See Intangible assets 386, 407–408 objecti 99

plant. See Plant assets prepaid expenses, 144–146 purchasing for cash, 45, 91 purchasing on 46, 92 nancing, 45, 92 of, 627 quick, 630 sale of, 46, 93 stable-dollar assumption and, 42 write-downs of, 252, 349–350, 397, 408 Atlantic Co. 557 AT&T, 484 Audits AICPA Auditing Standards Board, 20 of 19, 192 Gov Office (GAO), 24 Revenue Service (IRS), 24 lying to e auditors, 536 Available for sale 295 Average-cost method, 342 evaluation of, 346 in periodic inv systems, 353 v 342–343, 348 Average equity, 204 Avis Rent-a-Car, 188

B Balance sheet, 12, 38, equation, 50 adjusting entries, of, 156–158 assets. See Assets b 50 cash presentation, 289–290 classified, 627–629 of revenue and, inv and, 355–356 liabilities. See Liabilities marketable securities, 298–299 o , 43, 56–57 of expenses and, 48 preparing, 195–196 recording 90–93 sample, 194 separate subtotals, 196 statement of cash flows and, 576–577 , 489, 490, 535–536 uncollectible accounts, 300 sheet approach, 302–304 Bally Total 169 Bank credit cards, 306 Bank of 321 Bank reconciliation, 291–295 Bank statements, 291–295 337 y, 452

Bar-coded merchandise, 256 Basic per share, 528 Bear 3 Bearer bonds, 440n Best Buy, 191, 220, 231, 296 Board of directors, 486, 487, 529 Boeing Co., 32, 246, 517, 708 Bond 439 Bonds payable, accounting for,

444–445, B-12

442–445, 448, B-12 bonds issued at premium, dates, 442 value of, 446 conv 440 early retirement of, of, 439, 576 440 market prices of, 439, 449–450 nature of bonds, present value of, 448–449, B-12 statement of cash flows and, 576 tax advantage of bond financing, 440 of, 439 of, 440n, 448n yield rate, 646 BondsOnline, 480 Book value, 148, 390 disposal of plant/equipment and, market price and, 496 per share of stock, 653 eeping, 25 Boston Celtics, 66 Squibb, 660 Buildings, 386. See also Plant assets acquisition of, 387–388 depreciation of, 147–148, 407 Bush, George W., 9, 59 Business entity, 40 Business organization. See F business organization Bylaws, 486

C Public Employees Retirement System, 32, 678 Call price, 440 Callable bonds, 440 Capital expenditures, 388–389, 408 Capital leases, 456, B-13–B-14

I-2

Index

Capital stock, 57, 485, by investor, 495 by issuer, 91, 494 of, 576 book value of, 496 buyback stock. See Common stock dividends. See Dividends analysis, 655 market value of, 653 stock, 490 par value of, stock. See stock splits, 496, 532 stock, Capitalization, 388–389 vs. IFRS, 100 improper, 408 of retained 530–531 in 22–26 as profession, 22–23 accounting as stepping stone, 25 accounting education, 25 eeping, 25 gov accounting, 24 management accounting, 24 public 23–24 v 52, 139, 165, 168, 169, 385, 509 value. See Book value Cash, 289–295. See also w on balance sheet, 289–290 over, bank reconciliation, 291–295 cash budgets, 290, 582–583 control listing of cash receipts, 290 cash 291 management of, 290. See also Cash flow management over and 291 reductions in, 577 289–290 on statement of cash flows, 567, 569–570 valuation of, 288–289 Cash basis accounting, 100 basis vs., 567 conv from basis to, Cash budgets and budgeting, 290, 582–583 Cash discounts purchase, 257–259 sales, 261, 264 Cash dividends, 101, 486, 528–530 for, 106, 529–530 in 491–492, 493 closing dividends 201–202, 530 debit-credit for, 101 106, 529–530 dividend dates, 529–530 as financing acti , 566, 576 liquidating dividends, 530 marketable securities, 296–297

stock and, 495, 525–526 receipts of, as operating acti , 570–571 requirements for of, 529 statement of cash flows and, 576 195 stock dividends vs., 530 rights to, 486 Cash equivalents, 289, 567, 569–570 Cash w, 564. See also ws discounted, B-6–B-10 581, 653 management of. See Cash flow management negative, 39 net B-8n increasing, 583–585 from operating activities, 454, 581, 652 reconciling net income, 578–579 650–651, 652 positive, 39 Cash w analysis, Cash w management, 290–291, 582–585 cash budgets, 290, 582–583 products, income tax 583 increasing cash flows, 583–585 peak pricing, 584 product mix development, 584–585 Cash w prospects, 10 Cash management, 290. See also w management Cash over and 291 , 708 Auditor (CIA), 21–22 Management (CMA), 20, 21–22 public accountants (CPAs), 21–22, 23–24 AICPA. See CPAs (AICPA) audits by, 19, 192 CPA examination, 24 licensing of, 21 Chaebol, 687 Check registers, 262 Chief accounting (CAO), 24 Chief executive (CEO), 487 statements, 59 SEC enforcement action involvement, 26 Chief (CFO), 487 statements, 59 SEC enforcement action involvement, 26 China Airlines, 32 Cisco Systems, 37, 82 517 708

statements, 622 sheet, 627–629 income statement, 633–639 Clear Inc., 169 Closely held 485, 526n Closing entries, 198–202 cost of goods sold, 252 dividends account, 201–202, 530 expense 199–200 Income 201 periodic inv systems, 253–255 inv systems, 252, 255 revenue accounts, 199 of closing process, 202 (nominal) 198–202 Club Med., Inc., 479 Coca-Cola Co., 264, 296–299, 405, 413, 582, 618, 679 Codes of ethics, 22, 23, 408 Collateral, 430 Commerce Bank, 321 Commissions 98 Commitments, 452 Committee of Sponsoring Organizations of the Treadw 20–21, 311 Common size income statement, 625 Common stock, 490. See also Capital stock book value per share, dividends. See Dividends 525–528, 636, 642, 653 financial analysis by holders of, 642–645 market price of, stock splits, 496, 532 Communication, control and, 8–9 Comparable store sales, 263 Comparative statements, 622, 623–627 Compensating balance, 290 products, 584–585 Component percentages, 625 interest, B-2 Comprehensive income, 534 CompuTech, 706 256 atism, 99, 347 Consistency principle, 347, 396–397 Consolidated statements, 622, 652, 698 Continuing operations, 522–523 Contra-asset 148, 301 accounts, 497 Contra-revenue accounts, 260, 261 Contract (interest) rate, 439, 449 Contributed capital, 488. See also Capital stock Control accounts, 248, 289 Control activities, 8. See also Control environment, 8

I-3

Index

listing, 290 , 24, 487 Convergence with IFRS, 18–19, 689–691 Convertible bonds, 440 Convertible stock, 491, 492, 528 Copyrights, 405 bonds. See Bonds payable , 486 gov 26 adequate 206 capital vs. revenue e 408 cash flow manipulation, 584–585 cation of financial statements by senior executives, 59 codes of ethics, 22, 23, 408 debt understatement, 455 F A), 700–701 foreign officials, improper payments to, 700–701 ille 111, 264, 408 income overstatement, 159, 311, 536 inv valuation, 359 merchandising companies, 264 pump-and-dump schemes, 500 rating quality of, 654 revenue overstatement, 311 sales w 264 Sarbanes-Oxley Act (SOX). See Sarbanes-Oxley Act (SOX) SEC enforcement actions. See Securities shell companies, 500 special entities (SPEs), 455 fraud and, 26 Gov Quotient (CGQ), 654 The (TCL), 654 484–500 accounting practices, 57 advantages/disadvantages of, 484, 632 board of directors, 486, 487 characteristics of, 38, 56 closely held, 485, 526n double 484 of, income tax rate for, 153 limited personal , 484, 632 multinational. See Globalization officers, 487 organization 487 organization costs, 486 o , 57 See also Capital stock parent company, 622 publicly owned, 500 reasons for 632

small, loan guarantees for, 632 records, 488 rights, subsidiaries, 622, 685, 698 stock, Cost w assumptions, 342 average-cost method, 342–343, 348, 353 FIFO. See (FIFO) method LIFO. See Last-in, first-out (LIFO) method in system, 352 Cost layer, 341 Cost of goods sold. See also Inventory valuation defined, 247 merchandising companies, 247–255 closing 252 creating account, 254 estimating 356–357 profit method, 356–357 inv systems, 253–255 inv systems, 249–252 year-end balance, 255 on multiple-step income statement, 634 Cost 41 Cost ratio, 356–357 Coupon bonds, 440n CPW, 191 Credit balances, 87–88 Credit card sales, Credit losses, 302–304 Credit memoranda, 293n, 294 Credit ratings, 452, 455 Credit 627–632, 652–653 Credit 257–259 Creditors, 42–43, 430 evaluating claims of, financial statement use by, 652–653 Credits, 87–89 in accounting, 88–89 for, 88, 100–101 Cross-border 689 accounting practices and, Cumulative stock, 525–526 assets, 55, 196, 299 accounts receivable. See receivable cash. See Cash cash equivalents, 289, 567, 569–570 described, inv . See Inv marketable 288, 295–299, 574 notes receivable, 307–309 prepaid expenses, 144–146 liabilities, 55, 196, 431–435 accounts payable. See Accounts payable expenses, 150–152, 433

cash flo 652 assets

650–651, 629

defined, 629 fi 652–653 income tax payable, 153–154 notes payable, 42, 150–151, sales payable, 262 revenue, 149–150, 435 55, 205, 431, 454, 629–630, 649, 652

D Date of 529 Date of record, 529 Days to collect average accounts receivable, 652 Days to sell the average inv , 653 bonds, 439 Debit balances, 87–88 Debit 293n, 294 Debits, 87–89 in 88–89 for, 88, 100–101 Debt. See also Liabilities appropriate level of, 453 vs., 430 leverage, 453, 645 relative amount of, 627 of, 455 Debt ratio, 454, 630, 645, 646, 653 Debt 436 Decelerated depreciation, 398 Declining-balance depreciation, 393–395 Default, 309 of expenses, 140–141, 142, 144–148, of income taxes, 583 intangibles as, 405 of revenue, 141, 142, 149–150, 156 42 Dell Computer, 296, 348, 454, 645 Depletion, 407–408 Deposits in 292 Depreciable assets, 146, 386 Depreciation, 146–148, 389–399 of buildings, 147–148, 407 causes of, 390 computing, 390–396 accelerated methods, 391 decelerated methods, 398 declining-balance method, 393–395 double-declining balance method, 394–395 half-year convention, 393

I-4

Index

Depreciation—Cont. computing—Cont. MACRS (Modified Accelerated Cost Recov 393n, 394n, 398, 583n most-used methods, 395–396, 399 150 percent declining-balance method, 394n, 395 straight-line method, 147, 390–393, 395–396 sum-of-the-years’ digits (SYD) method, 398 method, 398 cost allocation over years of use, 389–390 defined, 389 of equipment, 148, 407 as estimate, 146–147 197, 396–397 for periods, 392–393 goal of, losses, 397 as noncash expense, 148 process of, 389 residual value, 147n, 391–392, 394–395, 396 tax considerations, 393n, 394n, 395–396, 583 life, 146–147, 396, 397 valuation vs., 390 Depreciation rate, 392 De , Inc., 169 Diluted per share, 528 Direct method, 305 58, 196–198, 206 Discontinued operations, 522, 523 period, 257 rate, 449, B-6, B-7–B-8 cash ws, B-6–B-10 Discounts on bonds payable, on purchase 257–259 on sales 261, 264 understating sales discounts, 264 Discover 321 Dividend yield, 495, 642–643, 653 Dividends, 96, 101 accounting for, 106, 529–530 cash. See Cash dividends debit-credit for, 101 dividend dates, 529 liquidating, 530 stock, 530–532 sis, 623–624 Double-declining balance depreciation, accounting, 88–89 Double taxation, 484 Dow Chemical Co., 406 Due on demand liabilities, 430n

Dun & Inc., 626n, 631, 655 DuPont, 406, 429, 468 Dynergy, 264, 584–585

E E. I. du Pont de Nemours and Co. See DuPont 525–528, 636, 653 analysis by common 642 basic, 528 diluted, 528 income statement presentation, 526–528 net, 528 dividends and, 525–526 weighted-average, 525 statement. See Income statement Economic substance, 436 Economic systems, 687 ve rate of interest, 449 Eli Lilly & Co., 406 9, 26, 111, 159, 408, 455, 634 Entity principle, 40 Equipment, 386. See also Plant assets acquisition of, 387–388 cost 387 depreciation of, 148, 407. See also Depreciation disposal of, in used for new, Estimates Allowance for Accounts, 301 cost of goods sold, 356–357 credit losses, 302–304 depreciation, 146–147 fractional periods, 392–393 useful life, 396 ending inv , 356–357 in e nancial information, 13 goodwill, income tax expense, 153–154 liabilities, 451 predictive for operations, 522 residual value, 147n, 391–392, 394–395, 396 302–304 Ethics. See also v AICPA code of professional conduct, 22, 23 codes of, 408 inte and, 21–22 E-Trade 295 Ex-dividend date, 529, 530 Exchange rates, 691–699 competitive prices and, 697 fl in, 696–697 y transactions, accounting for, 692–696 global sourcing and, 698–699 jargon, 692

Expense accounts, 258 Expenses, 49, 96, 98–101 141, 142, 150–152, 156 benefi period, 99 , 102, 105, 572–573 closing entries for expense accounts, 199–200 conv assets to, 142, 144–148, 156 , 100–101 142, 144–148, 156, defined, 522 depreciation. See Depreciation entries for 103, 106 in 643–644 insurance policies, matching and, 99 noncash, 148, 408, 578 nonoperating items, 635 of, 48 prepaid, 144–146 685 9–10, 12–13, 57–59 items, 522, 523–525 484

F Face amount, 308 Facilitating payments, 701 Factoring, 305–306 Fair value 298–299 Fannie Mae, 35 Fastow, w, 111, 455 Federal Trade Commission, 9 Fees 98 Fila, 536 Finance charges, 258 See also e

9–10, 12–13, 57–59

12–13 users of 58–59 objectives of, 10–12 Financial Accounting Standards Board (FASB), 17–18, 622 Accounting Standards Codification, 18 capital lease 456 cash flow statement cate 566 comprehensive income, 534 direct method of cash flows, 579 e items, 524 FASB/IASB convergence project, 18–19, goodwill inflation

requirements, 404 42

Index

interest payments/receipts classifications, 566 stock 491 R&D 406 SEC and, 17 Financial assets, 286–337 accounts receivable. See Accounts receivable cash. See Cash gov issues, 311 defined, 288 309–310 marketable 288, 295–299, 574 notes receivable, 307–309 inv 295–296 valuation of, 288–289, 298–299 Financial Executives (FEI), 21, 311 Financial position, 5 Financial 12–13 conceptual work for, 18, 146 , 12 fraudulent, 26. See also vobjectives of, 54 timeline for, 53 Financial statement analysis, 11–12, 55, v ver rate, 309–310, 358–359, 454, 647–648, 652 cash flow analysis, 650–651 by common 642–645 comparative financial statements, 622, 623–627 component percentages, 625 623–625, 634, 653 of assets, 627 of 626–627 ratios, 625 relative amount of debt, 627 standards for comparison, 625–626, 631 trend percentages, 624–625 comprehensive illustration, 639–651 v 654 cost ratio, by creditors, 38, 646–650, 652–653 55, 205, 431, 454, 629–630, 649, 652 debt ratio, 454, 630, 645, 646, 653 analysis, 655 gross profit margins, 263, 634–635 standards 626, 631 interest coverage ratio, 453, 454, 646, 653 inv ver rate, 358, 454, 648, 652 inv valuation, 358–359

liquidity and credit risk measures, 652–653 by creditors, 646, 653 for merchandising businesses, 263 net cash flows from operating activities, 454, 581, 652 net income percentage, 204, 653 net sales, 260, 263 past and, 626 527, 636, 642, 653 profitability measures, 203–204, 499, 632–639, 653 quick ratio, 454, 630, 649, 652 R&D to sales, 406 OA), 453n, 499, 638, 644, 653 , 499, 644, 653 OE), 204, 453n, 638–639, 653 vestment (ROI), 10, 637–638, 644 revenue and expense analysis, 643–644 by creditors, 646–650 of measures, 652–653 working capital, 205, 431, 454, 629, 647, 652 Financial statement order, 109 Financial statements, 12, 58, 196–198, 206 adjusting effects of, 156–158 of, 39, 53 audits of, 19, 192 balance sheet. See Balance sheet cation requirements, 59 classified, 622, 627–629, 633 comparative, 622, 623–627 consolidated, 622, 652, 698 cov ferent time periods, 12, 205 es in, 459, 583 defined, 38 economic substance and, 436 e 9–10, 38–39, 57–59 filing with SEC, 24 fi , 12 of business organization, 55–57 statements, A-1–A-13 income See Income statement interim, 12, 205 to, 38–39 inv cost flo 249, 340–349 inv and, 355–356 loss contingencies in, management’s interest in, 58–59, 263 notes accompanying. See Notes accompanying financial statements preparing, 192–196, 207–210

I-5

of, 622 relationships among, 52–55, 196 statement of cash flows. See Statement of cash flows 194, 195, 532–534 , 534–535 timeline for, 53 of, 12, 38–39 uncollectible accounts presentation, 300 window 59, 631–632 worksheets, 207–210, 585–589 Financing activities, 51, 494, 564 cash flows from, 566, 569, 575–576 noncash, 52 stock transactions, First-in, (FIFO) method, 348 evaluation of, 346 354 in periodic inv systems, 353 v 343–344 shrinkage and, 349 Fiscal year, 98, 192n Fixed-percentage-of-declining-balance depreciation, 393–395 F.O.B. destination, 351, 431 F.O.B. shipping point, 351, 431 Food Lion, Inc., 417 Footlocker, Inc., 327 Ford Motor Co., 240, 296, 369–370, 489, 637 F A), F

y, 691–699 consolidated financial statements, 698 exchange rates, 691–692 y 692–696 competitive prices and, 697 fluctuations in, global sourcing and, 698–699 jargon, 692 697 hedging, 697 F trade zones, 686 F of business organization, 55–57 See and, 632 o 56–57 56, 632, 632n sole proprietorships, 55–56, 632 Franchises, 405 Fraud. See gov Free cash w, 581, 653 Frito-Lay, 622 analysis, 655 Future 697 Future value, B-2–B-6. See also Present value

I-6

Index

G Gain, 297 The Gap, Inc., 239, 246, 285, 327 Gatorade, 622 GE Capital, 359 ve expenses, 635 General credit obligations, 430 General Electric, 155, 155n General 89–90, 94, 107, 157, 262 General ledger software, 207 General Motors, 98, 246, 369, 484, 679 General 632n 13 Generally accepted accounting (GAAP), 17 adequate disclosure, 58, 196–198, 206 convergence with IFRS, 18–19, 689–691 FASB and, 17–18 financial consolidated statements, 652 e costs, 100 inv valuation, 252, 354–355 reversals of inv 252 se 652, 690–691 and fair ov 196 Georgia-P 557 Getty, J. Paul, 97 Global 685, 698–699 Globalization, 682–719 environmental forces, 686–689 culture, 687–688 economic systems, 687 political/legal systems, 686–687 688–689 Foreign Corrupt Practices Act (FCPA), 700–701 xchange rates. See F y global sourcing, 685, 698–699 See standards multinational companies, locations of, 684 stages of, 685 Going assumption, 41 Goods in 351 Goodwill, Goodyear Tire & Rubber, 322 Gov Accountability Of (GAO), 24 Gov 24 method, 258–259 Gross 248, Gross margin, 263, 634–635, 653 Gross method, Gross rate. See gin Group of T (G-20), 683

Guarantees, loan, 632 Guidance for Smaller Public Companies Reporting on Internal Control over Financial Reporting, 21

H H. J. Heinz Co., 416 Half-year convention, 393 of accounting standards, 18–19, 689–691 adoption of IFRS, 18–19, 689–691 convergence with IFRS, 18–19, 354–355, 689–691 HealthSouth, 26, 59 Hedging, 697 295n Hershey’s, 189 cost, 41, 148 Hofstede, 687n, 706–707 The ood Park Companies, 479 Home Depot, Inc., 34, 68–69, 125, 171, 192, 196, 197, 224, 263, 275, 324, 370, 418, 470, 510, 531, 534, 547–548, 582, A-1–A-13 Honda Motor Co., 710 analysis, 626 687

I IBM, 246, 449, 484, 495, 505 items, 155, 256 loss, 397 Income continuing operations, 522–523 interest, 307–309, 566, 570–571 net. See Net income Income statement, 12, 38–39, 49–51, accounting

and, 97–98

100 adjusting of, 156–158 classifications in, 633 size, 625 comprehensive income and, 534 continuing operations, 522–523 discontinued operations, 522, 523 525–528, 636, 642 expenses, 96, 98–101 e items, 522, 523–525 interim, 12, 205 inv and, 355–356 limitations of, 193–195 merchandising company, 247–248 multiple-step, 633–635 predictive 522 preparing, 192–195 profi See Profitability

recording

101–107 charges, 524 revenue, 96, 98, 100–101 sample, 194 service company, 247 single-step, 633 time period 97–98 unusual gains/losses, 524 Income statement approach, 304 Income , 198–201 closing, 201 e to, 199–200 rev to, 199 Income tax expense. See also Taxes 153–154 583 estimated payments, 153 as nonoperating item, 635 in table periods, 154 unrealized gains/losses and, 299 Indenture 430 organizations, 687 analysis, 626, 631 42 peddling, 700–701 689 Group, 685 Installment notes payable, of Auditors (IIA), 20, 311 of Management Accountants (IMA), 20, 311 Intangible assets, 386, of, 402 characteristics of, 401 copyrights, 405 charges, 405 financial analysis of, 406 franchises, 405 goodwill, operating expenses vs., 402 other 405 patents, research and development (R&D) costs, 405–406 trademarks/trade names, 405 Inte , 16–22. See also vernance AICPA code of professional conduct, 22, 23 competence and, 21–22 ethical behavior and, 21–22 17–19 judgment and, 21 professional organizations and, 20–21 Intel 29, 37, 38, 385, 582 Interest, 307–308 on bank accounts, 293 compound, B-2

Index

computing, 308 on liabilities, 430 marketable 296–297 present value and, B-1–B-2 Interest coverage ratio, 453, 454, 646, 653 Interest expense, 635 151–152, on bonds payable, cash for, 573 computing interest, 308 on discounted notes payable, B-10–B-11 FASB/IASB standards for classifying, 566 on installment notes payable, 436–438 on liabilities, 430, on notes payable, 432n as operating acti , 566 plant assets 387 as tax deduction, 440 Interest income 293 computing interest, 308 F 566 on notes receivable, 307–309 as operating acti , 566, Interest rates bond prices and, 449–450 stock and, 495 present value and, B-1 Interim statements, 12, 205 control, 8–9 over cash, 290–291 y Act 21 Internal Control-Integrated Fr 8, 21 Revenue (IRS), 24 13–14, 58–59 Accounting Standards Board (IASB), 18, 683–684 cash flow statement cate 566 FASB/IASB convergence project, 18–19, goodwill requirements, 404 interest payments/receipts classifications, 566 LIFO prohibited, 353 Aerospace Machinists, 32 Financial Standards (IFRS), 18–19, 683 adoption of, 18–19, 689–691 consolidated statements, 652 convergence with, 18–19, 354–355, 689–691 financial statement analysis, 651–652 vs. See Generally accepted accounting principles (GAAP) inv valuation, 252, 354–355 plant asset revaluation, 401 se 652, 690–691

joint v 685 licensing, 685 700 Paper Co., 426 Inv . See also Inv Inv aluation accounting for, 249 246, 340 purchase-related 250, 253, 255, 257–260 sales-related transactions, 250–251, 255, 260–262 ledger, 248–249, 341, 343, 344, 345 Inv 251–252, 349, 352n Inv systems compared, 255–256, 257 just-in-time (JIT), 347–349 modification of, 357 See Periodic inv See v tems selecting, 256–257 Inv ver rate, 358, 454, 648, 652 Inv valuation, 340–359 accuracy, of, 355–356 consistency in, 347 gov issues, 359 cost flow assumptions, 342 average-cost method, 342–343, 346, 348, 353 FIFO. See (FIFO) method LIFO. See Last-in, first-out (LIFO) method in system, 352–354 in, 355–356 estimating gross profit method, 356–357 retail method, 357 evaluation of methods, 345–347 financial analysis and, 358–359 standards, 252, 354–355 losses fire/theft, 252n lower-of-cost-or-market (LCM) 350 at market 340n impacted by, 347 inv systems, 351–354 inv systems, 340–351 physical inv , 251–252, 349–350 specific identification method, 348 evaluation of, 345–346 periodic inv systems, 352–353 inv systems, 342 of methods, 348 tax considerations, 347, 354 write-do 349–350 year-end 350–351 year-end pricing by computer, 354 Invested capital, 490

I-7

Investing activities, 51, 564 cash flo 566, 568–569, 573–575 noncash, 52, Investment 10–11. See also Financial statement analysis InVision Technologies, Inc., 701 Invoices, 257 ISS Gov 654

J JCPenney, 98, 378, 397 & Co., 621, 667, 679 89–90 general, 89–90, 94, 107, 157, 262 posting entries to ledger accounts, 90–93, 101–109 recording in, 89–90 balance sheet bonds payable, 440–448 cash dividends, 529–530 closing 198–202 income statement 101–107 notes payable, 432 payroll activities, special, 262–263 JP Morgan Chase, 3 bonds, 440 Just for Feet, Inc., 536 Just-in-time (JIT) systems, 347–349

K Keiretsu, 687 Kimberly-Clark, 385, 664 Kozlowski, 26 LLP, 622 Foods, Inc., 85, 370 Co., 339, 669

L Land, 386, 387–388 Last-in, (LIFO) method, 348 evaluation of, 346–347 fi 354–355 in periodic inv systems, 353–354 in inv systems, 344–345 and, 349 tax benefits, maximizing, 354 Leases, 455–456, B-13–B-14 Ledgers, 86 ledger accounts after posting, 94–95, 107–109 , 248, 249 Legal capital, 489 Lessee, 455, B-14 Lessor, 455, B-13

I-8

Index

Leverage, 453, 645 LG, 687 Liabilities, 428–481 advance collections as, 149–150 452 conv venue, 141, 142, 149–150, 156 credit balances in liability accounts, 88 creditors’ claims, evaluating, See income taxes, 583 defined, 430 due on 430n estimated, 451 197 lease payment obligations, See loss contingencies, of, owners’ equity vs., 430 payment of, 47 pensions/postretirement benefits, 43n, 454 special entities (SPEs), 455 unfunded, 458 Limited 632n Limited personal liability, 56, 484, 632 Lines of credit, 290, 454, 649–650 , 57–58, 627 evaluating, 204–205, 452–454, 627–632 legal issues, 632 630, 646 58, 629–630, 646–650, 652–653 Loan 632 707 liabilities, 43n, bonds payable. See Bonds payable

installment notes payable, nanced, secured claims, 646 Loss, 297–298 Loss contingencies, Lower-of-cost-or-market (LCM) Lowe’s, 563 Lump-sum purchases, 387–388

M CRS, 393n, 394n, 398, 583n Maker of the note, 307 Management 6, 13–16 career 24 (CMA), 20, 21–22 characteristics, 15–16

350

13–14, 58–59 objectives of, 14–15 Management Discussion and Analysis (MD&A), 206, 631 Managerial accounting. See Management operations just-in-time (JIT) systems, 347–349 companies vs., 246 operating cycle of, 246–247 Market economies, 687 Market rate of interest, 449 Market share, 634 Market value, 653 accounting by investor, 495 accounting by issuer, 494 of assets, 148 of bonds, 439, B-12 book value and, 496 of stock, of financial 653 of marketable 288–289, 298–299 of stock, 495 etable 288, 295–299 accounting for, 296–299, 567, 574 balance sheet presentation, 298–299 di revenue recognition, 296–297 purchase of, 296 sale of, 297–298, 574 valuation of, 288–289, 298–299 Marietta Materials, Inc., 561 MasterCard, 289, 306, 316 Matching principle, 99, 154–155 accounting, 100 bond discounts, 443 depreciation, 146, estimated liabilities, 451 income taxes, and, 155 sales of 250 costs, 260 300, 302 , 155–156 adjusting and, 155 prior period adjustments, 533–534 professional judgment and, 155–156 costs, 260 Inc., 698–699, 709 dates, 307, 430 bond retirement prior to, in fi statement notes, 197 value, 439 Maxtor 359 McDonald’s, 405 McDonnell Douglas, Inc., 517 McKesson 69 General Financial 631 taxes, 433, 434, 434n, 435

Medtronics, 671 Memorandum 496 Merchandising companies, 244–285 accounting system requirements, 248–249 gov issues, 264 cost of goods sold, 247–248 closing 252 creating 254 inv systems, 253–255 inv systems, 249–252, 340–351 year-end balance, 255 financial analysis of, 263 income statement, 247–248 inv systems compared, 255–256, 257 252–257 249–252, 340–351 selecting, 256–257 manuf operations vs., 246 accounting system, 262–263 operating cycle of, 246–247, 340, 358–359, 648–649 measures, 263 purchase-related transactions, 250, 251, 253, 255, 257–260 retailers, 246–247 sales-related 250–251, 255, companies vs., 247 wholesalers, 247 Merck, 660 Lynch, 295 Mexico’s Bolsa, 295 37, 169, 287, 296, 321, 406, 489, 577 MiniScribe 359 Minuit, Peter, B-2 v tem (MACRS), 393n, 394n, 398, 583n Molson Coors Brewing Co., 318 Monitoring, 9 Moody’s Investors 452, 455, 654 Mor Stanley, 295 bonds, 439 Moving average method, 342–343 Multinational companies. See GlobalizaStandards (IFRS) Multiple-step income statement, 633–635

N NAFTA, 686 NASDAQ, 359, 408 National on Fraudulent Financial 20–21 resources, 386, 407–408 Negative 437n Negative cash ws, 39 Net assets, 493

I-9

Index

Net cash

ws B-8n increasing, 583–585 from operating activities, 454, 581, 652 reconciling with net income, 578–579 Net cost method, 258, 259, 259n Net per share, 528 Net assets, Net income, 49, 96–101, 634, 635 adequacy of, 637 percentage changes in, 624–625, 653 as percentage of net sales, 653 reconciling with net cash flows, 578–579 in, 454 Net income percentage, 204, 653 Net loss, 49, 96 Net realizable value, 41, 289, 299 Net sales, 260, 263, 634 New York Bond Exchange, 439 New Y 295, 408, 455 The New York Times Co., 149, 169, 479 Nexity 321 Nicolaisen, Donald T., 589n Nike, 536 Nikon, 708 No-par stock, 490 Nominal accounts, closing, 198–202 Noncash charge/expense, 148, 408, 458, 578 Noncash inv 52, Nonoperating items, 635 rade Agreement (NAFTA), 686 Notes accompanying statements, 196–198, 206 adequate disclosure in, 58, 196–198, 206 commitments, 452 depreciation methods, 197, 396–397 dividends in 492 loss contingencies, (MD&A), 206, 631 dates of liabilities, 197 533–534 sample, 641 usefulness of, 651 Notes payable, 42, installment notes, non-interest bearing, B-10–B-11 Notes receivable, 307–309 NSF checks, 292–293

O Objectivity principle, 99 Obsolescence, 390 Olis, Jamie, 585 150 percent declining-balance depreciation, 394n, 395

Operating activities, 51, 564–566 direct method of cash flows, 564–566, 568, 570–573 net cash flows from, 454, 581, 652 Operating cycle, 246 assets and, 627–629 operations, 246 merchandising 246–247, 340, 358–359, 648–649 454, 653 Operating expense ratio, 643–644, 653 Operating expenses, 402, 635 Operating income, 634, 635, 653 Operating leases, 456 Oracle, 406 Organization 14 Other accounts payable, 431 Outside directors, 487 Outstanding checks, 292 Outstanding shares, 488, 525 Overall gross margin, 263 Owners’ equity, 43 on balance sheet, 57 88 , decreases in, 43, 99, 100–101 increases in, net income and, 96 usiness organization, 56–57

P P Bell, 439 Paid-in capital, 488. See also Capital stock Par value, Parent company, 622 P 26 P 56 general 632n liability of 632, 632n equity, 56–57 Patents, Payables. See Accounts payable; Bonds payable; Notes payable Payee of the note, 307 P liabilities, 150–151, Payroll taxes, PC Connection, 137, 272 Peak pricing, 584 Pension 457 Pension liabilities, B-14 Pepsi-Cola Rico, 264 PepsiCo, Inc., 264, 622 Percentage changes, statement analysis, 623–625, 634, 653 Percentage of net sales, 406, 635, 653 evaluation inv method and, 347 merchandising operations, 263

inv systems, 249, 252–257 average cost method, 353 closing 253–255 cost flow 352–354 FIFO, 353 LIFO, 353–354 operation of, 252–253 v , 255–256, 257 physical inv , 252–253, 352 selecting, 256–257 losses in, 352n specific identification method, 352–353 transactions in, 253 accounts, 198 inv systems, 249–252 closing 252, 255 cost flow 342 FIFO, 343–344 LIFO, 344–345 v , 255–256, 257 physical inv , 251–252, 349–350 selecting, 256–257 specific identification method, 342 transactions in, 250–251 Personal guarantees, 632 Personal , 56, 632 Petty cash 291 Peugot, 708 , Inc., 296, 406 Physical deterioration, 390 Physical inv , 251–252 in periodic inv 252–253, 352 v 251–252, 349–350 Planned economies, 687 assets, 384–401 acquisitions of, 386–389, 574 capital e 388–389, 408 categories of, 386 gov issues, 408 cost 387 defined, 386 depreciation of. See Depreciation disposal of, 575 of, 397, 408 intangible. See Intangible assets 401 land, 386, 387–388 386, revenue e 389 statement of cash flows and, 574–575 386 tangible, 386 trading in used for new, Point-of-sale (POS) Positive cash ws, 39

262

I-10 Post-closing Posting

Index

ratio, 527, 636,

balance, 203 642, 653

OA), 453n, 499, 638, 90–93, 101–109 ledger accounts posting, 94–95 liabilities, 456–458, B-14 PPL Energy Co., 322 stock, See also Capital stock book value per share, conv 491, 492, 528 cumulative, 525–526 vidends 495, 525–526 per share and, 525–526 market of, 495 Premium, on bonds payable, 445–448 Prepaid expenses, 144–146 Present value, 402, 448–449, B-1–B-17 of annuities, B-8–B-9 bond and, 449 interest, B-2 , B-10 discount rate and, B-6, B-7–B-8 ows, B-6–B-10 aluation, B-10–B-14 capital leases, B-13–B-14 interest-bearing receivables/payables, B-10 market prices of bonds, B-12 non-interest-bearing notes, B-10–B-11 postretirement benefits obligations, B-14 amounts, B-2–B-6 457, 458 tables for calculating, B-7–B-8 time value of money concept, B-1–B-2 ratio, 527, 636, 642, 653 Principle amount, of note payable, Prior period adjustments, 533–534 Procter & Gamble, 15, 484, 521, 637 Product mix, 584–585 Professional judgment, 21 w estimates, 301 e 524–525 inflation adjustments, 42 loss contingency accounting, 451–452 , 155–156 Professional organizations, 20–21 See Income statement , 57 evaluating, 203–204, 632–639, 653 525–528, 636, 642 gross profit margin, 263, 634–635, 653 multiple-step income statement, 633–635 net income, adequacy of, 637

, 499, 644, 653 OE), vestment (ROI), 10, 637–638, 644 single-step income statements, 633, 637 of 653 gross profit, 248 income tax e table 154 Project Alpha, 584–585 notes, 307–309 Proxy statements, 487 Public accounting careers, 23–24 Public Company Accounting Oversight Board (PCAOB), 19 Public 485 Publicly owned Publix Super Markets, Inc., 273 Pump-and-dump schemes, 500 Purchase discounts, 257–259 Purchase on account, 46, 92, 257–259 cash, 45, 91, 571, 574 credit 257–259 257–259 involving foreign y, 693 lump-sum purchases, 387–388 marketable securities, 296, 574 merchandise inv , 250, 253, 255, 257–259, 571 plant assets, 574 of merchandise, 259 45, 92 costs, 259–260

Q Quaker Foods, 622 Quick assets, 630 Quick ratio, 454, 630, 649, 652 Qwest, 26

R Rate of

634 625. See also individual ratios evaluating, 630–631 liquidity, 454, 629–632, 652–653 market price of common stock, 653 profi , 653 usefulness/limitations of, 631–632 Real 198 Realization principle, 98, 154 Receivables. See vable; Notes receivable

Recoveries of bad debts, 304–305 liabilities, 433n, Registered bonds, 440n Research and development (R&D) costs, 405–406 Residual o 493 Residual value, 147n, 391–392, 394–395, 396 cash, 289–290 charges, 524 Results of operations, 5. See also Retail method, 357 Retailers, 246–247. See also Merchandising companies Retained 57, 96, 488 capitalizing, 530–531 dividend payments and, 201–202, 528–530 vidends 530 period adjustments, 533–534 of, 533–534 results of operations and, 522–528 statement of, 194, 195, 532–534 stock dividends and, 530–532 count, 201 of investment, 10 OA), 453n, 499, 638, 644, 653 , 499, 644, 653 on (ROE), 204, 453n, 638–639, 653 on inv (ROI), 10, 637–638, 644 of 259 Revenue, 49, 96, 98. See also Income statement uncollected, 141, 142, 152–153, 156 venue accounts, 199 conv liabilities to, 141, 142, 149–150, 156 , 100–101 of, 47–48 entries for 104 entries for cash, 101, 104 in 643–644 investment, 296–297 matching costs to, 154–155, 351 on multiple-step income statement, 634 nonoperating items, 635 realization principle and, 98, 154 149–150, 435 Revenue e 389 Reverse mergers, 500 Risk assessment, 8. See also Credit Risk Rite Aid

Group, 654 274 Associates, 626n balance, 94

I-11

Index

S Safeway, Inc., 273, 380 Avenue, 245 Avenue 5th 245 Saks Inc., 245, 246, 263 Salaries (wages) expense 150–151, cash payments, 572 benefits, 434n Sales, 98, 247–248. See also Sales ev 624, 653 net, 260, 263, 634 per square foot of selling space, 263 Sales allowances, 260–261, 264 Sales discounts, 257, 261, 264 Sales 260–261, 264 Sales taxes, 262, 262n Sales assets, sale of, cash, 570 credit card, 306–307 deliv expenses, 261 discounts, 261, 264 involving foreign y, 693–694 marketable securities, 297–298, 574 merchandising y, 255, plant assets, sale of, and allow 260–261, 264 year-end, 351 Salvage (residual) value, 147n, 391–392, 394–395, 396 Same-store sales, 263 Sam’s Club, 256 687 Sarbanes-Oxley Act (SOX), 9, 19, 111 CEO/CFO statements, 59 404 cation, 9 and, 9, 21 lying to e auditors, 536 passage of, 59 Public Compan ersight (PCAOB), 19 whistle-blower protection, 264 Scrap value, 350 Sears Roebuck & Co., 275, 308 , 487 Secured claims, 646 and Exchange (SEC), 17, 24, 622 enforcement actions accounts receivable manipulation, 311 capitalization, improper, 408 cash flow manipulation, 584–585 debt understatement, 455 foreign officials, improper payments to, 701 income overstatement, 159, 264, 311, 536

inv 359 MD&A, inadequate disclosure in, 206 pre-Sarbanes-Oxley Act, 111 Project Alpha, 584–585 w ment, against senior executives, 26 shell companies, 500 FASB and, 17 fi versight by, 24, 192 global accounting standards and, 18 vergence and 18 Segment of the business discontinuing or selling, 523 se 652, 690–691 Selling expenses, 635 charges/fees, bank, 292 companies, 247 Shell companies, 500 investments. See Marketable liabilities, 43n, 454 , 58, 629–630, 646–650, 652–653 losses, 251–252, 349, 352n Silicon Graphics, 406 Single-step income statements, 633, 637 433n, 440 Skilling, y, 111 Smith, Weston, 59 Social taxes, 433, 434, 434n, 435 Sole proprietorships, 55–56 liability of owner, 632 owner’s , 56 Sony 5, 206 Special 262–263 Special entities (SPEs), 455 method, 348 evaluation of, 345–346 periodic inv systems, 352–353 inv systems, 342 Nextel 319 Stable-dollar assumption, 42 Standard & Poor’s, 452, 455, 654 Standards for comparison, statement analysis, 625–626, 631 Standards for the Professional Practice of Internal Auditing, 20 Staples, Inc., 380, 518 State of 486 Stated value, 489–490 ws, 12, 39, 51–52, 562–618 gov issues, 584–585 direct method additional 567–568 valents, 567, 569–570 expenses, 571–573 classification of cash flows, 564–567

financing activities, 569, 575–576 method vs., 577–578 investing activities, 566, 568–569, 573–575 operating activities, 564–566, 568, 570–573, 650–651 , 579–580 expanded, 579–580 free cash flows, 581, 653 indirect method, 577–580 plant asset transactions and, liabilities and, 458 567–580, 585–589 of, 564 ows,

576–577 and, 494 schedule, 579–580 stock transactions and, worksheet for, 585–589 See also Balance sheet of operations. See Income statement of retained 532–534 195 prior period adjustments, 533–534 restrictions of retained 533–534 sample, 194 of , analysis, 626 Stock. See Capital stock Stock buyback Stock 486 Stock dividends, Stock market, 485n Stock option plans, 497 Stock registrar, 488 Stock splits, 496, 532 Stock agent, 488 56, 484 personal by, 632 records for, 488 of, equity, 57, 482–518 average, 204 balance sheet presentation, 489, 490, 535–536 comprehensive income and, 534 paid-in-capital, , 534–535 total, 493 stock purchase and, Unrealized Holding Gain (or Loss) on Investments, 298–299 meetings, ledger, 488

I-12

Index

depreciation, 147, 390–393 accelerated depreciation vs., 391, 395–396, 399 for 392–393 residual value, 391–392 Subsidiaries, 622 foreign, on consolidated financial statements, 698 wholly owned 685 ledgers, 248, 249 payable, 248 receivable, 248 inv , 248–249, 341, 343, 344, 345 marketable , 296 488 Sum-of-the-years’ digits (SYD) depreciation, 398 Sun Microsystems, 406 schedule, of cash ws, 579–580

T T 87–89 Take-home pay, 434 T v . See Physical v Tangible plant assets, 386. See also Plant assets Target, 272, 358–359, 483 Tax 6 Taxes bond financing adv 440 cash payments for, 573 income taxes, 153 depreciation and, 393n, 394n, 395–396 305, 305n double taxation, 484 income tax expense. See Income tax expense inv valuation and, 347, 354 es, 433, 434, 434n, 435 taxes, sales taxes, 262, 262n es, 433, 434, 434n, 435 T closing, 198–202 3M (Minnesota Mining and Manufacturing Co.), 309–310 Time period 97–98 Time value of money. See Present value T , 140, 141–142, 578 T Stock Exchange, 295 Toyota, 685 Trade accounts payable, 431 Trade names, 405

Trademarks, 405 Trading 295n T of ownership, 56, 484, 485 T 259–260 Treadway, James C., Jr., 21 Treasurer, 487 T stock, T ws from operating activities, 454, 581, 653 Trend in net income, 454 Trend percentages, Trial balance, 109–110 adjusted, 157–158, 192, 193 after-closing, 203 unadjusted, 143 uses/limitations of, 110 Tropicana, 622 T ver rates, 454 accounts receivable, 309–310, 358–359, 454, 647–648, 652 inv , 358, 454, 648, 652 Tweedie, Sir David, 683 200 percent 2DoTrade, Inc., 500 Tyco, 26

U Unadjusted balance, 143 Uncollectible 299–305 aging accounts receivable, 302–304 Allow 301–302, 303n allowance method, 301–302, 305n balance sheet approach, 302–304 direct write-off method, 305, 305n estimating credit losses, 302–304 income statement approach, 304 recov refl

statements, 300 off, 301–302, 305n 439, revenue, 141, 142, 149–150, 156, 435 postretirement costs, 458 Union Carbide 557 United Parcel (UPS), 385 U.S. Justice 500, 536 Units-of-output depreciation, 398 Unlimited personal , 56 Investments, 298–299 life, 146–147 estimating, 396 revising, 397

V Valuation accounts, 301 Value Line Investment Survey, 654 Ventitex, Inc., 517 V 499 V analysis, 626 Visa, 289, 306, 316

W Wages expense. See ages) expense Walgreen Co., 274, 658 The Wall Street Journal, 527, 691, 692 W 96, 98, 247, 256, 263, 272, 370, 374, 685 Walt Disney Company, 98 Walton, 256 Waste Management, 159 Wausau Paper Mills Co., 479 Weis Markets, 317, 319 Wells Fargo & Co., 479 Westinghouse Electric, 317 Wet Seal, Inc., 290 Whistle-blower protection, 264 White Supply, 320 Wholesalers, 247. See also Merchandising companies Wholly owned subsidiaries, 685 Window dressing, 59, 631–632 W payroll, Workers’ compensation, 434 W 205, 431, 454, 629, 647, 652 Worksheets, 207–210, 585–589 World Bank, 700 WorldCom, 9, 26, 159, 408, 634 wns 397, 408 of inv , 349–350 lower-of-cost-or-market (LCM) 350 reversals of, 252 fs against the allowance, 301–302, 305n direct, 305, 305n recov of bad debts, 304–305

Y Yield bond, 646 dividend, 495, 642–643, 653

Z Zero-coupon bonds, 448n