Financial Accounting Solutions Manual [6 ed.] 1618533118, 9781618533111

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Chapter 1 Introducing Financial Accounting Learning Objectives – coverage by question MiniExercises

Exercises

LO1 – Identify the users of accounting information and discuss the costs and benefits of disclosure.

25

28, 34

LO2 – Describe a company’s business activities and explain how these activities are represented by the accounting equation.

19, 20, 21

27, 29, 32, 33

36, 37, 38, 43

47

LO3 – Introduce the four key financial statements including the balance sheet, income statement, statement of stockholders’ equity and statement of cash flows.

22, 23, 24

30, 31

37, 38, 39, 40, 41, 42, 43, 44, 45

46, 47, 49

26

34

LO4 – Describe the institutions that regulate financial accounting and their role in establishing generally accepted accounting principles. LO5 – Compute two key ratios that are commonly used to assess profitability and risk – return on equity and the debt-to-equity ratio.

32, 33

LO6 – Appendix 1A: Explain the conceptual framework for financial reporting.

35

Solutions Manual, Chapter 4

Problems

Cases and Projects

49, 50

50

36, 43, 44, 45

46, 47, 48, 49

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QUESTIONS Q1-1.

Organizations undertake planning activities that subsequently shape three major activities: financing, investing, and operating. Financing is the means used to pay for resources. Investing refers to the buying and selling of resources necessary to carry out the organization’s plans. Operating activities are the actual carrying out of these plans. (Planning is the glue that connects these activities, including the organization’s ideas, goals and strategies.)

Q1-2.

An organization’s financing activities (liabilities and equity = sources of funds) pay for investing activities (assets = uses of funds). An organization cannot have more or less assets than its liabilities and equity combined and, similarly, it cannot have more or less liabilities and equity than its total assets. This means: assets = liabilities + equity. This relation is called the accounting equation (sometimes called the balance sheet equation, or BSE), and it applies to all organizations at all times.

Q1-3.

The four main financial statements are: income statement, balance sheet, statement of stockholders’ equity, and statement of cash flows. The income statement provides information relating to the company’s revenues, expenses and profitability over a period of time. The balance sheet lists the company’s assets (what it owns), liabilities (what it owes), and stockholders’ equity (the residual claims of its owners) as of a point in time. The statement of stockholders’ equity reports on the changes to each stockholders’ equity account during the year. Some changes to stockholders’ equity, such as those resulting from the payment of dividends and unrealized gains (losses) on marketable securities, can only be found in this statement as they are not included in the computation of net income. The statement of cash flows identifies the sources (inflows) and uses (outflows) of cash, that is, from what sources the company has derived its cash and how that cash has been used. All four statements are necessary in order to provide a complete picture of the financial condition of the company.

Q1-4.

The balance sheet provides information that helps users understand a company’s resources (assets) and claims to those resources (liabilities and stockholders’ equity) as of a given point in time. An income statement reports whether the business has earned a net income (also called profit or earnings) or a net loss. Importantly, the income statement lists the types and amounts of revenues and expenses making up net income or net loss. The income statement covers a period of time.

Q1-5.

Your authors would agree with Mr. Buffett. A recent study of top financial officers suggests they find earnings and the year-to-year changes in earnings as the most important items to report. We would add cash flows particularly from operations, and the year-to-year changes.

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Financial Accounting, 6th Edition

Q1-6.

The statement of cash flows reports on the cash inflows and outflows relating to a company’s operating, investing, and financing activities over a period of time. The sum of these three activities yields the net change in cash for the period. This statement is a useful complement to the income statement which reports on revenues and expenses, but conveys relatively little information about cash flows.

Q1-7.

Articulation refers to the updating of the balance sheet by information contained in the income statement or the statement of cash flows. For example, retained earnings is increased each period by any profit earned during the period (as reported in the income statement) and decreased each period by the payment of dividends (as reported in the statement of cash flows and the statement of stockholders’ equity). It is by the process of articulation that the financial statements are linked.

Q1-8.

Return refers to income, and risk is the uncertainty about the return we expect to earn. The lower the risk, the lower the expected return. For example, savings accounts pay a low return because of the low risk of a bank not returning the principal with interest. Higher returns are to be expected for common stocks as there is a greater uncertainty about the realized return compared with the expected return. Higher expected return offsets this higher risk.

Q1-9.

Companies often report more information than is required by GAAP because the benefits of doing so outweigh the costs. These benefits often include lower interest rates and better terms from lenders, higher stock prices and greater access to equity investors, improved relationships with suppliers and customers, and increased ability to attract the best employees. All of these benefits arise because the increased disclosure reduces uncertainty about the company’s future prospects.

Q1-10. External users and their uses of accounting information include: (a) lenders for measuring the risk and return of loans; (b) shareholders for assessing the return and risk in acquiring shares; and (c) analysts for assessing investment potential. Other users are auditors, consultants, officers, directors for overseeing management, employees for judging employment opportunities, regulators, unions, suppliers, and appraisers. Q1-11. Managers deal with a variety of information about their employers and customers that is not generally available to the public. Ethical issues arise concerning the possibility that managers might personally benefit by using confidential information. There is also the possibility that their employers and/or customers might be harmed if certain information is not kept confidential.

Solutions Manual, Chapter 4

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Q1-12. Return on equity (ROE) is computed as net income divided by average stockholders’ equity (an average of stockholders’ equity for the current and previous year is commonly used, but the ratio is sometimes computed only with beginning or ending stockholders’ equity). The return on equity is a popular measure for analysis because it compares the level of return earned with the amount of equity invested to generate the return. Furthermore, it combines both the income statement and the balance sheet and, thereby, highlights the fact that companies must manage both well to achieve high performance. Q1-13. While businesses acknowledge the increasing need for more complete disclosure of financial and nonfinancial information, they have resisted these demands to protect their competitive position. These companies must weigh the benefits they receive from the market as a result of more transparent and revealing financial reporting against the costs of divulging proprietary information. Q1-14. Generally Accepted Accounting Principles (GAAP) are the various methods, rules, practices, and other procedures that have evolved over time in response to the need to regulate the preparation of financial statements. They are primarily set by the Financial Accounting Standards Board (FASB), an entity of the private sector with representatives from companies that issue financial statements, accounting firms that audit those statements, and users of financial information. Q1-15. International Financial Reporting Standards (IFRS) are the accounting methods, rules and principles established by the International Accounting Standards Board (IASB). The need for IFRS stems from the wide variety of accounting principles adopted in various countries and the lack of comparability that this variety creates. IFRS are intended to create a common set of accounting guidelines that will make the financial statements of companies from different countries more comparable. The IASB has no enforcement authority. As a consequence, the strict enforcement of IFRS is left to the accounting profession and/or securities market regulators in each country. Many countries have reserved the right to make exceptions to IFRS by applying their own (local) accounting rules in selected areas. Some accountants and investors argue that a little diversity is a good thing – variations in accounting practice reflect differences in cultures and business practices of various countries. However, one concern is that IFRS may create the false impression that everyone is following the same rules, even though some variation will continue to permeate international financial reporting.

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Financial Accounting, 6th Edition

Q1-16. The auditor’s primary function is to express an opinion on whether the financial statements fairly present the financial condition of the company and are free from material misstatements. Auditors do not prepare the financial statements; they only audit them and issue their opinion on them. Q1-17.A The objectives of financial accounting are to provide information: • That is useful to investors, creditors, and other decision makers who possess a reasonable knowledge of business activities and accounting • To help investors and creditors assess the amount, timing and uncertainty of cash flows. This includes the information presented in the cash flow statement as well as other information that might help investors and creditors assess future dividend and debt payments • About economic resources and financial claims on those resources. This includes the information in the balance sheet and any supporting information that might help the user assess the value of the company’s assets and future obligations • About a company’s financial performance, including net income and its components (i.e., revenues and expenses) • That allows decision makers to monitor company management to evaluate their effective, efficient, and ethical stewardship of company resources Q1-18.A The four enhancing qualitative characteristics of accounting information are comparability, verifiability, timeliness, and understandability. Comparability refers to the use of similar accounting methods across companies. Comparability improves the users’ ability to interpret the information by making comparisons to other companies. Verifiability means that consensus among independent observers could be reached that reported information is a faithful representation. Verifiable financial information improves the quality of the information because auditing and interpretation of the reported data will be easier and more trusted. Timeliness means that the financial reporting information must be available to decision makers in time for the financial statement users to make decisions. Understandability means that the financial statements should be presented in such a way that users who have reasonable knowledge of business activities can understand the statements. This is difficult because organizations and transactions have become more complex over time (more global, expanding into new industries, etc.) and thus the reporting of such complexities is difficult. The more understandable the statements can be the better for users of the statements.

Solutions Manual, Chapter 4

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MINI EXERCISES M1-19. (10 minutes) LO 2 ($ millions) Assets

=

Liabilities

$19,381

+

Equity

$13,720

$5,661

Macy’s receives more of its financing from creditors ($13,720 million) versus owners ($5,661 million). Its owner financing comprises 29.2%% of its total financing ($5,661 mil / $19,381 mil.).

M1-20. (10 minutes) LO 2 ($ millions) Assets

=

Liabilities

$87,896

+

Equity

$68,919

$18,977

Coca-Cola receives more of its financing from creditors ($68,919 million) than from owners ($18,977 million). Its owner financing comprises 21.6% of its total financing ($18,977 mil./ $87,896 mil.).

M1-21. (15 minutes) LO 2 ($ millions) Assets Hewlett-Packard Enterprises Co General Mills Harley-Davidson

=

Liabilities

+

Equity

$ 55,493

$ 34,219

(a) $ 21,274

$30,624.0 (c) $ 9,972.7

(b) $24,482.9 $ 8,128.4

$6,141.1 $1,844.3

The percent of owner financing for each company follows: Hewlett-Packard Ent. Co:

38.3% ($21,274 mil./ $55,493 mil.);

General Mills:

20.1% ($6,141.1 mil./ $30,624 mil.);

Harley-Davidson:

18.5% ($1,844.3 mil./ $9,972.7 mil.). continued next page

©Cambridge Business Publishers, 2020 4-6

Financial Accounting, 6th Edition

The creditor percent of financing is computed as 100% minus the owner percent. Therefore, Hewlett Packard Enterprises Co is more owner-financed (38.3%) than the other two firms, while Harley-Davidson has the highest percentage of creditor (nonowner) financing (81.5% = 100% - 18.5%).

M1-22. (15 minutes) LO 3 For its annual report dated September 29, 2018, Apple reports the following amounts (in $ millions): Assets

=

Liabilities

+

Equity

$365,725

=

$258,578

+

$107,147

As shown, the accounting equation holds for Apple. Also, we can see that Apple’s creditor financing is 70.7% of its total financing ($258,578 mil./$365,725 mil).

M1-23. (20 minutes) LO 3 Nike, Inc. Statement of Shareholders' Equity For Year Ended May 31, 2017

Balance, May 31, 2016 Stock Issuance Net Income Dividends Other changes Balance, May 31, 2017

Contributed Capital $ 7,789 121

$

731 8,641

Retained Earnings $ 4,151

Other Stockholders' Equity $ 318

4,240 (1,159) (3,253) 3,979

(531) (213)

$

$

Total Stockholders' Equity $ 12,258 121 4,240 (1,159) (3,053) $ 12,407

Nike was more profitable in the fiscal year ending May 2017 versus in the fiscal year ending May 2018. Net income was $4,240 million in the fiscal year ending May 2017 compared to $1,933 in the fiscal year ending May 2018. Note: As reported in the text, ROE was 17.4% in the fiscal year ending May 2018 compared to 34.4% in the fiscal year ending May 2017.

Solutions Manual, Chapter 4

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M1-24. (20 minutes) LO 3 a. BS

d. BS and SE

g. SCF and SE

b. IS

e. SCF

h. SCF and SE

c. BS

f. BS and SE

i.

IS and SE

M1-25. (10 minutes) LO 1 There are many stakeholders affected by this business decision, including the following (along with a description of how): • • • •

You/Manager—your reputation, self-esteem, and potentially your livelihood can be affected. Creditors/Bondholders─ credit decisions based on inaccurate information can occur. Shareholders—buying or selling shares based on inaccurate information can occur. Management/Employees of your company—repercussions of your decision extend to them; also, your decision may suggest an environment condoning dishonesty

Indeed, our decisions can affect many more parties than we might initially realize.

M1-26. (10 minutes) LO 4 Internal controls are rules and procedures that involve monitoring an organization’s activities, transactions, and interactions with customers, employees and other stakeholders to promote efficiency and to prevent wrongful use of its resources. They help prevent fraud, ensure the validity and credibility of accounting reports, and are often crucial to effective and efficient operations. The absence or failure of internal controls can adversely affect the effectiveness of both domestic and global financial markets. Enron (along with other accounting scandals) provided a case in point. Because the failure of internal controls can have significant economic consequences, Congress is interested in making sure that publicly- traded companies have adequate internal controls and that any concerns about internal controls are properly reported.

©Cambridge Business Publishers, 2020 4-8

Financial Accounting, 6th Edition

EXERCISES E1-27. (15 minutes) LO 2 ($ millions)

Assets

=

Liabilities

+

Equity

Motorola Solutions, Inc .....

$ 8,208

$ 9,950

$ (1,742)

Kraft Heinz Company........ $ 119,992 Merck & Co Inc. ................ $87,872

$53,958

$ 66,034

$53,303

$34,569

The percent of creditor financing for each company follows: Motorola Solutions: 121.2% ($9,950 mil./ $8,208 mil.); Kraft Heinz: 45.0% ($53,958 mil./ $119,992 mil.); Merck & Co: 60.7% ($53,303 mil./ $87,872 mil.). The owner percent of financing is computed as 100% minus the owner percent. Merck is more creditor-financed than Kraft Heinz. Motorola has negative equity so their liabilities are larger than their recorded assets.

E1-28. (15 minutes) LO 1 External users and some questions they seek to answer with accounting information from financial statements include: 1. Shareholders (investors), who seek answers to questions such as: a. Are resources owned by a business adequate to carry out plans? b. Are the debts owed excessive in amount? c. What is the current level of income (and its components)? 2. Creditors, who seek answers for questions such as: a. Does the business have the ability to repay its debts? b. Can the business take on additional debt? c. Are resources sufficient to cover current amounts owed? 3. Employees (and potential employees), who seek answers to questions such as: a. Is the business financially stable? b. Can the business afford to pay higher salaries? c. What are growth prospects for the organization?

Solutions Manual, Chapter 4

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E1-29. (20 minutes) LO 2, 3 ($ millions) a. Using the accounting equation: ($ millions) Assets Intel ...................................$123,249

=

Liabilities $54,230

+

Equity $69,019

b. Starting with the accounting equation at the beginning of the year: ($ millions) Assets = Liabilities + JetBlue Airways ................. $9,323 $5,310 Using the accounting equation at the end of the year: ($ millions) Assets = Liabilities JetBlue Airways ................. $9,781 $4,947 ($9,323+$458) ($5,310$363)

Equity $4,013

+

Equity $4,834

Alternative approach to solving part (b): Assets($458) = Liabilities($-363) + Equity(?) where “” refers to “change in.” Thus:  Ending Equity = $458 + $363 = $821 and Ending equity = $4,013 + $821 = $4,834

c. Starting with the accounting equation at the end of the year: ($ millions) Assets = Liabilities Walt Disney ....................... $98,598 $44,693 ($49,637-$4,944) Using the accounting equation at the beginning of the year: ($ millions) Assets = Liabilities Walt Disney ....................... $95,789 $49,637 ($98,598-$2,809)

©Cambridge Business Publishers, 2020 4-10

+

Equity $53,905

+

Equity $46,152

Financial Accounting, 6th Edition

E1-30. (10 minutes) LO 3 Computation of dividends Retained earnings, 2016 ........................................................................ $19,922 + Net income ............................................................................................. 2,024 – Cash dividends....................................................................................... (?) = Retained earnings, 2017 ........................................................................ $20,531 Thus, dividends were $1,415 million for 2017. This dividends amount comprises 70% ($1,415/ $2,024) of its 2017 net income.

E1-31. (20 minutes) LO 3 COLGATE-PALMOLIVE COMPANY Income Statement For the year ended December 31, 2017 ($millions)

Revenues Cost of goods sold Gross profit

$15,454 6,099 9,355

Other expenses, including income taxes Net income (or loss)

7,331 $ 2,024

E1-32. (15 minutes) LO 2, 5 a. Return on equity (ROE)

= = =

Net income / Average stockholders’ equity $12,662 / [($152,502 + $139,036)/2] 8.69%

b. Debt-to-equity

= = =

Total liabilities / Stockholders’ equity $44,793* / $152,502 29.4

*$44,793 = $197,295 - $152,502

Solutions Manual, Chapter 4

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E1-33. (150 minutes) LO 2, 5 a. Return on equity (ROE)

= = =

Net income / Average stockholders’ equity €10,525 / [(€64,023 + €57,950)/2] 17.3%

b. Debt-to-equity

= = =

Total liabilities / Stockholders’ equity €191,582* / €64,023 2.99

*€191,582 = €255,605 - €64,023

E1-34. (20 minutes) LO 1, 4 a. Financial information provides users with information that is useful in assessing the financial performance of companies and, therefore, in setting securities prices. To the extent that securities prices are accurate, the costs of the funds that companies raise will accurately reflect their relative efficiency and risk of operations. Those companies that can effectively utilize capital better will be able to obtain that capital at a reasonable cost, and society’s financial resources will be effectively allocated. b. First, the preparation of financial statements involves and understanding of complex accounting rules and a significant amount of assumptions and estimation. Second, GAAP allows for differing accounting treatments for the same transaction. And third, auditors are at a relative information disadvantage vis-à-vis company accountants. As the capital markets place increasing pressures on companies to perform, accountants are often placed in a difficult ethical position to use the flexibility given to them under GAAP in order to bias the financial results. E1-35.A (15 minutes) LO 6 1.

e

6.

g

2.

f

7.

j

3.

i

8.

c

4.

a

9.

d

5.

h

10.

b

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Financial Accounting, 6th Edition

PROBLEMS P1-36. (40 minutes) LO 2, 5 a. Year

Assets

Liabilities

Equity

Net Income

2016

$127,136

$69,153

$57,983

$10,508

2017

$118,806

$64,628

$54,178

$15,326

2018

$118,310

$66,984

$51,326

$9,750

b. 2017 ROE = $15,326 / [($57,983+$54,178)/2] = 27.3% 2018 ROE = $9,750 / [($51,326+$54,178)/2] = 18.5% P&G’s ROE decreased in 2018, however, it was above the median for Fortune 500 companies in both years.

c. 2017 debt-to-equity = $64,628 / $54,178 = 1.19 2018 debt-to-equity = $66,984 / $51,326 = 1.31 P&G’s debt-to-equity ratio increased in 2018 and it is below the median for Fortune 500 companies in both years.

Solutions Manual, Chapter 4

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P1-37. (30 minutes) LO 2, 3 a. GENERAL MILLS, INC. Income Statement For Year Ended May 27,2018 ($ millions)

Sales ....................................................................... Cost of goods sold .................................................. Gross profit ............................................................. Other expenses, including income taxes ................ Net income ..............................................................

$15,740.4 10,312.9 5,427.5 3,264.5 $ 2,163

GENERAL MILLS, INC. Balance Sheet May 27, 2018 ($ millions)

Cash & cash equivalents Noncash assets Total assets

$

399 30,225 $30,624

Total liabilities Stockholders’ equity Total liabilities and equity

$24,131.6 6,492.4 $30,624

GENERAL MILLS, INC. Statement of Cash Flows For Year Ended May 27, 2018 ($ millions)

Net cash flows from operations ............................... Net cash flows from investing ................................. Net cash flows from financing ................................. Effect of exchange rates on cash ............................ Net change in cash ................................................. Cash, beginning year .............................................. Cash, ending year ...................................................

$ 2,841 (8,685.4) 5,445.5 31.8 (367.1) 766.1 $ 399

b. $6,492.4 /$30,624 = 21.2% contributed by owners

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Financial Accounting, 6th Edition

P1-38. (30 minutes) LO 2, 3 a. ABERCROMBIE & FITCH Income Statement For Year Ended February 3, 2018 ($ millions)

Sales ....................................................................... Cost of goods sold .................................................. Gross profit ............................................................. Other expenses including income taxes ........... .…. Net income ..............................................................

$ 3,492.7 1,408.8 2,083.9 2,073.4 $ 10.5

ABERCROMBIE & FITCH Balance Sheet February 3, 2018 ($ millions)

Cash asset Noncash assets Total assets

$

675.6 1,650.1 $ 2,325.7

Total liabilities Stockholders’ equity Total liabilities and equity

$ 1,073.2 1,252.5 $ 2,325.7

ABERCROMBIE & FITCH Statement of Cash Flows For Year Ended February 1, 2014 ($ millions)

Net cash flows from operations ............................... Net cash flows from investing ................................. Net cash flows from financing ................................. Effect of exchange rate changes on cash ............... Net change in cash ................................................. Cash, beginning year .............................................. Cash, ending year ...................................................

$ 285.7 (106.8) (74.8) 24.3 128.4 547.2 $ 675.6

b. $1,252.5 / $2,325.7 = 53.9% contributed by owners $1,073.2 / $2,325.7 = 46.1% contributed by creditors

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P1-39. (30 minutes) LO 3 TILLY’S, INC. Income Statements For years ended February 3, 2018 and January 28, 2017 ($ thousands)

Fiscal year ending Sales Cost of goods sold

2018 $576,899 401,529

2017 $568,952 400,493

Gross profit Other expenses, including income taxes

175,370 160,670

168,459 157,049

Net income

$ 14,700

$ 11,410

TILLY’S, INC. Balance Sheets February 3, 2018 and January 28, 2017 ($ thousands)

Cash asset Noncash assets

2018 $ 53,202 236,909

2017 $ 78,994 211,512

Total assets

$290,111

$290,506

Total liabilities Stockholders’ equity

$ 129,686 160,425

$ 101,286 189,220

Total liabilities and stockholders’ equity

$290,111

$290,506

TILLY’S, INC. Cash Flow Statements For years ended February 3, 2018 and January 28, 2017 ($ thousands)

Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities

2018 $32,708 (40,878) (17,622)

2017 $48,509 (21,658) 1,123

Change in cash Cash balance, beginning of the year

(25,792) 78,994

27,974 51,020

Cash balance, end of the year

$53,202

©Cambridge Business Publishers, 2020 4-16

$78,994

Financial Accounting, 6th Edition

P1-40. (30 minutes) LO 3 TESLA , INC. Income Statements For years ended December 31, 2017 and 2016 ($ millions)

Sales Cost of goods sold

2017 $11,758.8 9,536.3

2016 $ 7,000.1 5,400.9

2,222.5 4,183.9

1,599.2 2,274.2

Gross profit Other expenses, including income taxes Net income (loss)

$ (1,961.4)

$ (675.0)

TESLA, INC. Balance Sheets December 31, 2017 and 2016 ($ millions)

Cash asset Noncash assets

2018 $ 3,367.9 25,287.5

2017 $ 3,393.2 19,270.9

Total assets

$28,655.4

$22,664.1

Total liabilities Stockholders’ equity

$23,420.8 5,234.6

$ 17,126 5,538.1

Total liabilities and stockholders’ equity

$28,655.4

$22,664.1

TESLA, INC. Cash Flow Statements For years ended December 31, 2017 and 2016 ($ millions)

Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities Effect of exchange rate changes on cash Change in cash Cash balance, beginning of the year Cash balance, end of the year

Solutions Manual, Chapter 4

2017 $(60.7) (4,419) 4,414.9 39.5 (25.3) 3,393.2 $3,367.9

2016 $(123,8) (1,416.4) 3,744.0 (7.4) 2,196.3 1,196.9 $3,393.2

©Cambridge Business Publishers, 2020 4-17

P1-41. (15 minutes) LO 3 CROCKER CORPORATION Statement of Stockholders’ Equity For Year Ended December 31, 2019 Contributed Capital December 31, 2018 ...............................

$ 70,000

Issuance of common stock ....................

30,000

Retained Earnings $ 30,000

_______

December 31, 2019 ...............................

$100,000

$100,000 30,000

Net income ............................................ Cash dividends ......................................

Stockholders’ Equity

50,000

50,000

(25,000)

(25,000)

$ 55,000

$155,000

P1-42. (15 minutes) LO 3 DP SYSTEMS, INC. Statement of Stockholders’ Equity For Year Ended December 31, 2019 Common Stock December 31, 2018 ................................

$ 550

Net income ............................................. Cash dividends .......................................

____

December 31, 2019 ................................

$ 550

©Cambridge Business Publishers, 2020 4-18

Retained Earnings

Stockholders’ Equity

$2,437

$2,987

859

859

(281)

(281)

$3,015

$3,565

Financial Accounting, 6th Edition

P1-43. (15 minutes) LO 2, 3, 5 a. Return on equity is net income divided by average stockholders’ equity. Nokia’s ROE: €-1,458 / [(€16,218 + €20,975)/2] = -0.078 or -7.8%. b. Debt-to-equity is total liabilities divided by stockholders’ equity. Nokia’s debt-to-equity: (€41,024 − €16,218) / €16,218 = 1.53. c. Revenues less expenses equal net income. Taking the revenues and net income numbers for Nokia, yields: €23,147 million − Expenses = €-1,458 million. Therefore, expenses must equal €24,605 million.

P1-44. (20 minutes) LO 3, 5 a. BEST BUY CO., INC. Income Statement For the year ended February 3, 2018 ($ millions)

Sales revenue ………………………………… Cost of goods sold ………………………….. Gross profit …………………………………… Other expenses, including income taxes …… Net income (or loss) ………………………….

$42,151 32,275 9,876 8,876 $ 1,000

b. Best Buy’s ROE = $1,000 mil. / [($4,709 mil. + $3,612 mil.)/2] = 24.0%. c. Best Buy’s debt-to-equity = ($13,049 - $3,612) / $3,612 = 2.61

Solutions Manual, Chapter 4

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P1-45. (20 minutes) LO 3, 5 a. FACEBOOK, INC. Income Statement For the years ended December 31, 2017 and 2016 ($ millions)

Revenue Operating expenses Gross profit from operations Other expenses, including income taxes Net income b. Stockholders’ equity:

2017 $ 40,653 20,450

2016 $ 27,638 15,211

20,203

12,427

4,269

2,210

$ 15,934

$

10,217

2017 -- $84,524 mil. - $10,177 mil. = $74,347 mil. 2016 -- $64,961 mil. - $5,767 mil. = $59,194 mil.

2017 ROE = $15,934 mil. / [($74,347 mil. + $59,194 mil.)/2] = 23.9.0%. 2016 ROE = $10,217 mil. / [($59,194 mil. + $44,218 mil.)/2] = 19.8%. c. 2017 debt-to-equity = $10,177 / $74,347 = 0.14. 2016 debt-to-equity = $5,767 / $59,194 = 0.10.

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Financial Accounting, 6th Edition

CASES and PROJECTS C1-46. (40 minutes) LO 3, 5 a. STARBUCKS CORPORATION Income Statement For the years ended September 30,2018 and October 1, 2017 ($ millions)

2018 $ 24,719.5 10,174.5 14,545.0 10,027 $4,518.0

Sales revenue Cost of goods sold Gross profit on sales Other expenses, including income taxes Net income b.

2017 $ 22,386.8 9,034.3 13,352.5 10,467.6 $ 2,884.9

2018 stockholders’ equity: $24,256.4 mil. – $22,980.6 mil. = $1,275.8 mil. 2017 stockholders’ equity: $14,365.6 mil. -- $8,908.6 mil. = $5,457 mil. 2018 ROE: $4,518 / [($1,275.8 + $5,457)/2] = 134.2% 2017 ROE: $2,884.9 / [($5,457 + $5,890.7)/2] = 50.8%

c.

2018 debt-to-equity: $22,980.6 / $1,275.8 = 18.01 2017 debt-to-equity: $8,908.6 / 5,457 = 1.63

d.

2018 ROE restated: ($4,518.0 - $3,700) / [($1,275.8- $3,700 + 5,457)/2] = 53.9% The unrecorded potential litigation cost of $3,700 is subtracted from the net income number and from the 2018 stockholders’ equity amount to arrive at this number. This does not take into account the effect of income taxes.

e.

The primary cost to Starbucks of disclosing information about the pending litigation is that the disclosure may cause potential investors and creditors to hold a less favorable view of the company. A concern about the disclosure is that such disclosure may actually affect the outcome of the litigation. The primary benefit to disclosure is that by disclosing information about the lawsuit before its completion, the company cannot be accused of withholding relevant information from stakeholders. This prevents potential lawsuits from investors or creditors and contributes to the company’s reputation for reliable financial reporting.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-21

C1-47. (40 minutes) LO 2, 3, 5 a. The Gap, Inc.: Nordstrom, Inc.:

ROE = $848 / [($3,144 + $2,904)/2] = 28.00% ROE = $437 / [($977 + $870)/2] = 47.3%

Nordstrom had the higher ROE. b. The Gap, Inc.: Nordstrom, Inc.:

Debt-to-equity = ($7,989 - $3,144) / $3,144 = 1.54 Debt-to-equity = ($8,115 - $977) / $977 = 7.31

Nordstrom relies more on debt than The Gap. c. THE GAP, INC. 2018 Income Statement ($millions)

Revenues Cost of goods sold Gross profit Other expenses, including income taxes Net income (or loss)

$15,855 9,789 6,066 5,218 $ 848

NORDSTROM, INC. 2013 Income Statement ($millions)

Revenues Cost of goods sold Gross profit Other expenses, including income taxes Net income (or loss) The Gap:

$15,478 9,890 5,588 5,151 $ 437

$6,066 / $15,855 = 38.3%

Nordstrom: $5,588 / $15,478 = 36.1% d. Nordstrom earned a higher ROE than The Gap (47.3% vs. 28%). Nordstrom’s debtto-equity ratio is 7.31 vs. about 1.54 for The Gap. The Gap reported a slightly higher gross profit per dollar of sales revenue (38.3% vs. 36.1% for Nordstrom). These two percentages are very close, reflecting the similarity of their retail operations. One important difference (not provided or apparent in the information supplied) is that Nordstrom has a larger consumer credit business than The Gap.

©Cambridge Business Publishers, 2020 4-22

Financial Accounting, 6th Edition

C1-48. (30 minutes) LO 5 a. JetBlue: Southwest: b. JetBlue: Southwest: c. JetBlue: Southwest:

ROE = $1,147 / {[($9,781-$1,108) + ($9,323 - $1,444)] /2} = 13.9% ROE = $3,488 / {[($25,110-$13,973) + ($23,286-$14,845)] /2} = 35.6% Debt-to-equity = $1,108 / ($9,781 - $1,108) = 0.13 Debt-to-equity = $13,973 / ($25,110 - $13,973) = 1.25 $1,147 / $7,015 = 16.4% $3,488 / $21,171 = 16.5%

d. JetBlue’s ROE was 13.9% for the year. In comparison, Southwest earned an ROE of 35.6% in 2017. Both of these ROE numbers are at or above the average for Fortune 500 companies. Currently, Southwest uses more creditor financing. This has changed over time, JetBlue carried more debt just 5 years ago. Southwest’s debt-to-equity ratio is 1.25 compared to a debt-to-equity ratio of 0.13 for JetBlue. In terms of income per dollar of sales, both companies look very similar. JetBlue’s reported net income equaled 16.4% of revenues, while Southwest reported net income equal to 16.5% of revenues. The numbers for both airlines have improved significantly in recent years.

C1-49. (20 minutes) LO 1, 3, 5 a. $285,000 Assets - $45,000 Liabilities = $240,000 Net Assets. $72,000 Average Annual Income / $240,000 Investment = 30% return. Seale's return would be 24% ($72,000 Average Annual Income / $300,000 Investment), assuming no adjustment is made for Meg’s salary. (See part b.) b. No. Withdrawals do not affect net income, because they are not part of the firm's operating activities. However, in calculating Krey's return in part a, Seale might wish to "impute" an amount for Krey's half-time work in computing Krey's return on investment. Thus, if Seale believes that Krey's services are worth $18,000 (half of the $36,000 salary she expects to pay a full-time manager), annual income should be calculated at $54,000 instead of $72,000. If Seale hires a full-time manager at $36,000, her return will be only 12% [($72,000 - $36,000)/$300,000]. c. Yes, the difference between net income shown in the financial statements and net income shown on the tax return can be legitimate, because income tax rules for determining revenues and deductions from revenues differ from Generally Accepted Accounting Principles. Seale may obtain additional assurance about the propriety of the financial statements by engaging a licensed professional accountant to audit the financial statements and render a report on them. Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-23

C1-50. (15 minutes) LO 1, 4 a. It is important for a CPA to be independent when performing audit services because third parties will be relying on the audited financial statements in making decisions. The financial statements are the representations of the corporation's management. The audit by a CPA adds credibility to the financial statements. Only if third parties believe that the CPA is independent will a CPA be able to add credibility to financial statements. b. Jackie is not independent for two reasons: (1) her brother is president and chair of the board of directors of the company to be audited and (2) Jackie is on the board of directors of the company to be audited. The auditing profession takes the position that Jackie's other activities for the company—consulting and tax work—do not impair a CPA's independence. This last point may generate some discussion, particularly in this case when the potential auditor is the same person (Jackie) who is doing the consulting work. Usually, when the same CPA firm does both auditing and consulting work, those tasks are assigned to different persons to ensure auditor independence.

©Cambridge Business Publishers, 2020 4-24

Financial Accounting, 6th Edition

Chapter 2 Constructing Financial Statements Learning Objectives – coverage by question MiniExercises

Exercises

Problems

Cases and Projects

LO1 – Describe and construct the balance sheet and understand how it can be used for analysis.

14, 17, 19, 21 - 27, 29 - 31

34-44, 46, 47

49 - 57, 59, 60, 62, 66, 67, 69

71

LO2 – Use the financial statement effects template (FSET) to analyze transactions.

18, 29 - 31

44 - 47

57, 62, 67, 69

LO3 – Describe and construct the income statement and discuss how it can be used to evaluate management performance.

19 - 23, 28, 31

35, 37, 39 - 44, 47

49 - 51, 54, 57, 61, 62, 64 - 67, 69

71, 72

LO4 – Explain revenue recognition, accrual accounting, and their effects on retained earnings.

18 - 20, 22, 23, 25, 26, 28, 29, 31

39, 44, 47

57, 62, 67, 69

71

LO5 – Illustrate equity transactions and the statement of stockholders’ equity.

18, 21 - 24, 27, 31

35 - 37

53, 66, 67, 69

71

32, 33

45, 48

58, 63, 68, 70

34, 36, 38, 41, 42, 46

52, 55, 56, 59, 60

LO6 – Use journal entries and Taccounts to analyze and record transactions. LO7 – Compute net working capital, the current ratio, and the quick ratio, and explain how they reflect liquidity.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-25

QUESTIONS Q2-1.

An asset is something that we own that is expected to provide future benefits. A liability is a current obligation that will require a future sacrifice. Equity is the difference between assets and liabilities. It represents the claims of the company’s owners to its income and assets. The following are some examples of each: Assets

• Cash • Receivables • Inventories • Plant, property and equipment

Liabilities

• Accounts payable • Accrued liabilities • Notes payable • Long-term debt

Equity

• Contributed capital (common and preferred stock) • Additional paid-in capital • Earned capital (retained earnings) • Treasury stock

Q2-2.

The revenue recognition principle requires that revenues be recognized when earned. Revenues are earned when the product has been delivered to the buyer and is usually signified by a formal transfer of title. A good test of whether revenue has been earned is whether the rights, risks and obligations of ownership have been transferred to the buyer. If a service is involved, revenues are not earned until the service has been provided. The expense recognition principle prescribes that expenses be recognized when assets are diminished (or liabilities increased) as a result of earning revenue or carrying out the company’s operations. When these two principles are followed, income can be properly measured in a given accounting reporting period.

Q2-3.

Accrual accounting entails the recognition of revenue under the revenue recognition principle (record revenues when goods or services are transferred to the customer), and the recognition of expenses when net assets decrease from the process of earning revenue or supporting the company’s operations. The recognition of revenues or the expenses does not require that cash be received or disbursed. For example, the recognition of revenues on sale can lead to an account receivable, and wage expense can be accrued using a wages payable (accrued) liability account.

©Cambridge Business Publishers, 2020 4-26

Financial Accounting, 6th Edition

Q2-4.

The statement of stockholders’ equity provides information relating to all events that impact stockholders’ equity during the period. It contains information relating to stock sales and repurchases, net income, dividends, and the use of stock for other purposes including occasional acquisition of assets. This statement, also referred to as the statement of owners’ equity, also includes the effects of some transactions that are not captured in the determination of net income. These items are included in what is called “other comprehensive income.” One example of such an item is the loss or gain on the translation of the assets and liabilities of foreign owned subsidiaries into United States currency.

Q2-5.

An asset must be “owned” and it must provide “future benefits.” Owning means we have title to the asset (some leased assets are also recorded on the balance sheet as we will discuss in Chapter 10). Future benefits can mean the future inflows of cash. Or, it could relate to some other benefit, such as the reduction of expenditures, an increase in another asset, or the reduction of a liability.

Q2-6.

Liquidity generally refers to cash. That is, how much cash do we have, how much cash is being generated, and how much cash can we raise quickly. Liquidity is essential to the survival of the business. After all, we can only pay our loans with cash, and our employees will only accept cash for their wages. Some assets are more liquid than others in the sense that they can be converted more easily to cash. Money market accounts and accounts receivable, which can be sold, provide examples. Inventories are considered more liquid than plant assets. We will address liquidity issues more formally in Chapters 4 and 9.

Q2-7.

Current means that the asset will be liquidated (converted to cash) within the next year (or the operating cycle if longer than 1 year).

Q2-8.

Historical costs are used by accountants because they are less subjective and, therefore, more reliable than using market values. Market values can be biased for two reasons: first, we may not be able to measure them accurately (consider our inability to accurately measure the market value of a production facility, for example), and second, managers may intervene in the reporting process to intentionally bias the results in order to achieve a particular objective (i.e. enhancing the stock price). The use of historical costs in accounting records does not negate the importance of market values. For example, a firm offering to pledge land as collateral for a loan will be expected to use the market value of that land rather than its historic cost. The same would be true if a corporation were considering the sale of the land. Finally, we shall see that certain assets are reported at market value in the balance sheet; securities that are available to be sold provide an example.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-27

Q2-9.

An intangible asset is an asset that we cannot touch. To be included on the balance sheet, it has to meet the tests of an asset (e.g., we own it, and it will provide future benefits). In addition, recognized intangible assets are always acquired in a transaction with an independent party. Internally generated intangible assets, however, are not recorded on the balance sheet. Some examples are goodwill, patents and trademarks, contractual agreements like royalties, leases, and franchise agreements. All of the intangible assets, though not recorded if internally generated, are recorded if purchased, as in an acquisition of another company, for example.

Q2-10.

Both the current ratio and quick ratio are measures of a firm’s ability to pay its obligations as they come due; measures of a firm’s liquidity. The current ratio is computed by dividing the firm’s current assets by its current liabilities. Current ratios that exceed 1.0 are deemed to represent a strong current liquidity position. The quick ratio is an even more conservative measure of a firm’s liquidity as it excludes inventory from the calculation. The quick ratio is computed by dividing the firm’s sum of cash and cash equivalents, marketable securities and accounts receivable by its current liabilities.

Q2-11.

The three conditions necessary to recognize a liability are: 1. The liability reflects a probable future sacrifice on the part of the organization. 2. The amount of the obligation is known or can be reasonably estimated. 3. The transaction that caused the obligation has occurred.

Q2-12.

Net working capital = Current assets – Current liabilities. Increasing the amount of trade credit (e.g., accounts payable to suppliers) increases current liabilities and reduces net working capital. As trade credit increases, we are using someone else’s cash rather than our own. As a business grows, its net working capital grows, as the growth of inventories and receivables are generally greater than that of accounts payable and accrued liabilities. Net working capital is an asset category that must be financed just like fixed assets.

Q2-13.

$700,000 Assets - $220,000 Liabilities = $480,000 Stockholders' equity $480,000 Stockholders’ equity – $300,000 Common stock = $180,000 Retained earnings

©Cambridge Business Publishers, 2020 4-28

Financial Accounting, 6th Edition

MINI EXERCISES M2-14. (10 minutes) LO 1 Use the accounting equation. a. Cash Accounts receivable Supplies Equipment Accounts payable Common stock Retained earnings b. Retained Earnings: December 31, 2018 January 1, 2018 Increase Add: Dividends Net Income

$ 8,000 23,000 9,000 138,000 178,000 $ 11,000 110,000

121,000 $ 57,000

$ 57,000 30,000 27,000 12,000 $ 39,000

M2-15. (5 minutes) LO 1 a. $200,000 - $85,000 = $115,000 equity b. $32,000 + $28,000 = $60,000 assets c.

$93,000 - $52,000 = $41,000 liabilities

M2-16. (5 minutes) LO 1 a. $375,000 - $105,000 = $270,000 equity b. $43,000 + $11,000 = $54,000 assets c.

$878,000 - $422,000 = $456,000 liabilities

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-29

M2-17. (5 minutes) LO 1 a. $450,000 - $326,000 = $124,000 equity b. $618,000 - $165,000 = $453,000 liabilities c.

$400,000 + $200,000 + $185,000 = $785,000 assets

M2-18. (10 minutes) LO 2, 4, 5 a. no effect

e. increase

b. decrease

f.

c.

g. increase

decrease

increase

d. no effect

M2-19. (15 minutes) LO 1, 3, 4 a. Balance sheet

e. Balance sheet

i.

Income statement

b. Income statement

f.

Balance sheet

j.

Income statement

c.

Balance sheet

g. Balance sheet

k.

Balance sheet

d. Income statement

h. Balance sheet

l.

Balance sheet

M2-20. (20 minutes) LO 3, 4 a. Net income computation Service revenue (record when earned) …………… Wage expense …………………………………………. Net income ………………………………………………

$100,000 (60,000) $ 40,000

b. Yes, recognizing the wage liability would cause wage expense to increase by $10,000 and net income would decrease by the same amount (before taxes).

©Cambridge Business Publishers, 2020 4-30

Financial Accounting, 6th Edition

M2-21. (10 minutes) LO 1, 3, 5 a. Balance sheet b. Income statement, Statement of stockholders’ equity c.

Balance sheet

d. Income statement e. Statement of stockholders’ equity f.

Statement of stockholders’ equity

g. Balance sheet h. Income statement i.

Statement of stockholders’ equity, Balance sheet

M2-22. (10 minutes) LO 1, 3, 4, 5 a. Balance sheet b. Balance sheet c.

Income statement, Statement of stockholders’ equity

d. Statement of stockholders’ equity, Balance sheet e. Balance sheet f.

Income statement

g. Balance sheet h. Balance sheet

M2-23. (10 minutes) LO 1, 3, 4, 5 a. Balance sheet b. Income statement c.

Statement of stockholders’ equity, Balance sheet

d. Income statement e. Statement of stockholders’ equity f.

Balance sheet

g. Balance sheet h. Balance sheet

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-31

M2-24. (15 minutes) LO 1, 5 Ending retained earnings = Beginning retained earnings + Net income – Dividends + the effects of other adjustments. And, the ending retained earnings for one period is the beginning retained earnings for the following period.

Fiscal year ending: Beginning retained earnings (deficit) …………

Jan. 28, 2017 $

Net income (loss) …………… Dividends paid …………… Other net changes in retained earnings ……… Ending retained earnings (deficit) ……………

$

(258)

Feb. 3, 2018 $

(727)

1,158

983

(1,268)

(686)

(359)

(321)

(727)

$

(751)

M2-25. (10 minutes) LO 1, 4 a. Increase assets (Cash); Increase equity (Service Revenues) b. Increase assets (Office Supplies) Increase liabilities (Accounts Payable) c.

Increase assets (Cash) Increase equity (Contributed Capital or Common Stock)

d. Decrease liabilities (Accounts Payable) Decrease assets (Cash) e. Increase assets (Cash) Increase liabilities (Notes Payable) f.

Increase assets (Accounts Receivable) Increase equity (Service Revenues)

g. Increase assets (Office Equipment) Decrease assets (Cash) h. Decrease equity (Interest Expense) Decrease assets (Cash) i.

Decrease equity (Utilities Expense) Increase liabilities (Accounts Payable)

©Cambridge Business Publishers, 2020 4-32

Financial Accounting, 6th Edition

M2-26. (10 minutes) LO 1, 4 a. Increase assets (Office Equipment) Decrease assets (Cash) b. Increase assets (Accounts Receivable) Increase equity (Service Revenue) c.

Decrease equity (Rent Expense) Decrease assets (Cash)

d. Increase assets (Cash) Increase equity (Service Revenue) e. Increase assets (Cash) Decrease assets (Accounts Receivable) f.

Increase assets (Office Equipment) Increase liabilities (Accounts Payable)

g. Decrease equity (Salaries Expense) Decrease assets (Cash) h. Decrease liabilities (Accounts Payable) Decrease assets (Cash) i.

Decrease equity (Retained Earnings) Decrease assets (Cash)

M2-27. (10 minutes) LO 1, 5 JOHNSON & JOHNSON Statement of Retained Earnings For Year Ended December 31, 2017 Retained earnings, January 1, 2017 ........................................................................

$70,418

Add:

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

1,300

Less:

Dividends ...................................................................................................

(8,943)

Other retained earnings changes ..............................................................

(2,615)

Retained earnings, December 28, 2014 ..................................................................

Solutions Manual, Chapter 4

$60,160

©Cambridge Business Publishers, 2020 4-33

M2-28. (10 minutes) LO 3, 4

2018 $350,000 200,000 $150,000

Revenues .................................................................... Expenses ..................................................................... Net income ..................................................................

2019 $ 0 0 $ 0

Explanation: All of the revenue is reported in 2018 when services are provided—per the revenue recognition principle. Likewise, the expense is reported in 2018 when it is incurred—because a liability was incurred to generate the revenue. The timing of receipts or payments of cash does not affect the recording of revenues, expenses, and net income.

M2-29. (15 minutes) LO 1, 2, 4 Balance Sheet Transaction a. Issue stock for $20,000 cash.

Cash Asset +20,000 Cash

+

Noncash Assets

=

b. Pay $2,000 rent in advance.

-2,000 Cash

+2,000 Prepaid rent

c. Purchase computer equipment for $7,000 cash.

-7,000 Cash

+7,000 Computer Equipment

d. Purchase inventory for $13,000 on account e. Pay supplier of inventory in part d. Totals

+13,000 Inventory

-13,000 Cash

-2,000

= Liabil-ities +

22,000

Contrib. Capital + +20,000 Common Stock

Earned Capital

Revenues

-

Expenses

=

-

=

=

-

=

=

-

=

+13,000 Accts = Payable

-

=

-

=

-

=

=

+

Income Statement

=

-13,000 Accts Payable 0

©Cambridge Business Publishers, 2020 4-34

+

20,000

+

Net Income

Financial Accounting, 6th Edition

M2-30 (15 minutes) LO 1, 2 Balance Sheet Transaction

Cash Asset

a. Borrow €19,000 from local bank.

+19,000 Cash

b. Pay €3,000 insurance premium for covered for following year.

-3,000 Cash

c. Purchase vehicle for €32,000 cash.

-32,000 Cash

+

= Liabilities

=

d. Purchase and receive €2,500 of office supplies on account (pay supplier later).

-16,000

+

+

Contrib. + Capital

Earned Capital

+19,000 Note Payable

Revenues -

Expenses

=

-

=

+3,000 Prepaid insurance

=

-

=

+32,000 Vehicle

=

-

=

=

-

=

NO ENTRY =

-

=

-

=

+2,500 Supplies Inventory

e. Place order for €1,000 of additional supplies to be delivered next month. Totals

Noncash Assets

Income Statement

37,500

Solutions Manual, Chapter 4

Net Income

+2,500 Accts Payable

=

21,500

+

0

+

0

©Cambridge Business Publishers, 2020 4-35

M2-31. (15 minutes) LO 1, 2, 3, 4, 5 Balance Sheet Transaction a. Receive merchandise inventory costing $9,000, purchased with cash

Cash Asset

+

-9,000 Cash

= Liabilities +

Contrib. + Capital

Earned Capital

Revenues -

=

-

-4,500 Inventory +7,500 Accounts Receivable

c. Place order for $5,000 of additional merchandise inventory to be delivered next month.

-4,500

-4,000 Cash

e. Pay $7,000 rent for use of premises during the month.

-7,000 Cash

f. Receive full payment from customer in part b.

+7,500 Cash

=

+7,500

+7,500 Revenue

Net Income

=

=

-

=

-

+4,000 Wage Expense

-

+7,000 Rent Expense

=

-

15,500

=

-7,000 =

-4,500

-

-4,000 =

-12,500

=

+4,500 Cost of Goods Sold

NO ENTRY =

d. Pay employee $4,000 for compensation earned during the month.

Expenses

+9,000 Inventory

b. Sell half of inventory in (a) for $7,500 on credit.

Totals

Noncash Assets

Income Statement

+7,500

-4,000 =

-7,000

-7,500 Accounts Receivable

+

4,500

=

©Cambridge Business Publishers, 2020 4-36

+

+

-8,000

7,500

-8,000

Financial Accounting, 6th Edition

M2-32. (10 minutes) LO 6 a. Inventory (+A) ............................................................................................... Cash (-A) ..............................................................................................

9,000

b. Cost of goods sold expense (+E, -SE) ......................................................... Inventory (-A) ......................................................................................... Accounts receivable (+A) ............................................................................. Sales revenue (+R, +SE) .......................................................................

4,500

c.

9,000

4,500 7,500 7,500

NO ENTRY

d. Wage expense (+E, -SE) .............................................................................. Cash (-A) ...............................................................................................

4,000

e. Rent expense (+E, -SE)................................................................................ Cash (-A) ...............................................................................................

7,000

f.

Cash (+A) …………………………………………………….. Accounts receivable (-A) ………………………………..

4,000

7,000 7,500 7,500

M2-33. (10 minutes) LO 6 + (f)

Cash (A) 7,500 (a) (d) (e)

-

+ 9,000 4,000 7,000

(b)

+

(a)

Inventory (A) 9,000 (b)

Sales (R) (b)

-

4,500 +

Wage Expense (E) 4,000

-

+

Rent Expense (E) 7,000

-

+ 7,500 (e)

Solutions Manual, Chapter 4

7,500

-

(d) -

-

Cost of Goods Sold (E) 4,500

(b) +

Accounts Receivable (A) 7,500 (f)

©Cambridge Business Publishers, 2020 4-37

EXERCISES E2-34. (25 minutes) LO 1, 7 Use the accounting equation to determine Retained Earnings as of May 31, 2019. a. & b. BEAVER, INC. Balance Sheets May 31, 2019

June 1, 2019

Assets Cash

$ 12,200

$

3,200

Accounts receivable

18,300

18,300

Supplies

16,400

16,400

Equipment

55,000

70,000

$101,900

$107,900

Accounts payable

$ 5,200

$ 5,200

Notes payable

20,000

33,000

Total liabilities

25,200

38,200

Common stock

42,500

42,500

Retained earnings

34,200

27,200

76,700

69,700

$101,900

$107,900

Total assets Liabilities

Stockholders' Equity

Total stockholders' equity Total liabilities and stockholders' equity c.

Net working capital = Current assets – Current liabilities $32,700 = ($3,200 + $18,300 + $16,400) – $5,200

©Cambridge Business Publishers, 2020 4-38

Financial Accounting, 6th Edition

E2-35. (30 minutes) LO 1, 3, 5 Use the accounting equation and the information on changes in contributed capital and retained earnings. Beginning equity (= Beginning assets – Beginning liabilities) + Common Stock Issued + Net income (= Revenues – Expenses) – Dividends Ending equity (= Ending assets – Ending liabilities) a. Equity, Beginning ($28,000 - $18,600) Equity, Ending ($30,000 - $17,300) Increase Add: Net Capital Withdrawn ($5,000 - $2,000) Net Income Add: Expenses Revenues

$ 9,400 12,700 3,300 3,000 6,300 8,500 $14,800

b. Equity, Beginning ($12,000 - $5,000) Add: Net Capital Contributed ($4,500 - $1,500) Add: Net Income ($28,000 - $21,000) Equity, Ending

$ 7,000 3,000 10,000 7,000 $17,000

Assets, Ending Equity, Ending Liabilities, Ending,

$26,000 17,000 $ 9,000

Equity, Beginning ($28,000 - $19,000) Add: Net Income ($18,000 - $11,000)

$ 9,000 7,000 16,000 1,000 15,000 19,000 $ 4,000

c.

Less: Dividends Equity, Ending ($34,000 - $15,000) Common Stock Issued d. Common Stock Issued Net Income ($24,000 - $17,000) Cash Dividends Increase in Equity Equity, Ending ($40,000 - $19,000) Equity, Beginning Add: Liabilities, Beginning Total Assets, Beginning

Solutions Manual, Chapter 4

$ 3,500 7,000 10,500 6,500 4,000 21,000 17,000 9,000 $26,000

©Cambridge Business Publishers, 2020 4-39

E2-36 (30 minutes) LO 1, 5, 7 Use the accounting equation to determine stockholders’ equity balances. a. LANG SERVICES Balance Sheets December 31, 2018

2017

Assets Cash Accounts receivable Supplies Equipment Total assets

$10,000 22,800 4,700 32,000 $69,500

$ 8,000 17,500 4,200 27,000 $56,700

Liabilities Accounts payable Notes payable Total liabilities

$25,000 1,800 26,800

$25,000 1,600 26,600

Stockholders’ equity Equity Total liabilities and stockholders’ equity

42,700 $69,500

30,100 $56,700

b. Equity, December 31, 2018 Equity, December 31, 2017 Increase Add: Dividends Less: Common Stock issued Net Income for 2018 c.

$42,700 30,100 12,600 17,000 29,600 5,000 $24,600

Current ratio = ($10,000 + $22,800 + $4,700)/$25,000 = 1.50 Quick ratio = ($10,000 + $22,800)/$25,000 = 1.31

d. Lang’s liquidity position is satisfactory as its current ratio meets the industry norm, and its quick ratio is also above the industry average. The firm appears to have invested about the “right” amount in liquid assets—neither too much, nor too little.

©Cambridge Business Publishers, 2020 4-40

Financial Accounting, 6th Edition

E2-37. (30 minutes) LO 1, 3, 5 Use the accounting equation to determine Retained Earnings balances. a. LYNCH SERVICES Balance Sheets December 31, Assets Cash Accounts receivable Supplies Land Building Equipment Total assets Liabilities Accounts payable Mortgage payable Total liabilities Stockholders’ equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders’ equity

2018

2017

$ 23,000 42,000 20,000 40,000 250,000 43,000 $418,000

$ 20,000 33,000 18,000 40,000 260,000 45,000 $416,000

$

$

6,000 90,000 96,000

220,000 102,000 322,000 $418,000

9,000 100,000 109,000

220,000 87,000 307,000 $416,000

b. Retained Earnings, December 31, 2018 Retained Earnings, December 31, 2017 Increase during 2018 Add: Dividend for 2018 Net Income for 2018

Solutions Manual, Chapter 4

$102,000 87,000 15,000 10,000 $ 25,000

©Cambridge Business Publishers, 2020 4-41

E2-38. (30 minutes) LO 1, 7 Use the accounting equation to determine Retained Earnings as of September 30, 2019. The two transactions have the following effects: •

Equipment purchase increases the equipment asset by $11,000, decreases the cash asset by $3,000, and increases the notes payable liability by $8,000.

•

Dividend payment decreases the cash asset by $3,000 and decreases the retained earnings equity by $3,000.

a. & b. BROWNLEE CATERING SERVICE Balance Sheets September 30, 2019

October 1, 2019

Assets Cash Accounts receivable Supplies inventory Equipment Total assets

$10,000 17,000 9,000 34,000 $70,000

$ 4,000 17,000 9,000 45,000 $75,000

Liabilities Accounts payable Notes payable Total liabilities

$24,000 12,000 36,000

$24,000 20,000 44,000

Stockholders’ equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders’ equity

27,500 6,500 34,000 $70,000

27,500 3,500 31,000 $75,000

c. Current ratio Quick ratio

September 30 (10,000 + 17,000 + 9,000) ÷ 24,000 = 1.50

October 1 (4,000 + 17,000 + 9,000) ÷ 24,000 = 1.25

(10,000 + 17,000) ÷ 24,000 = 1.13

(4,000 + 17,000) ÷ 24,000 = 0.88

d. Quite a few possibilities exist, from increasing long-term borrowing to issuing new stock to selling unneeded equipment.

©Cambridge Business Publishers, 2020 4-42

Financial Accounting, 6th Edition

E2-39. (15 minutes) LO 1, 3, 4 Income statement

Balance sheet

Sales .......................................... $30,000

Cash ....................................................................$ 8,000

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

12,000

Accounts receivable ............................................ 30,000

Net income (loss) ....................... $18,000

Total assets .........................................................$38,000 Wages payable ....................................................$12,000 Common stock .................................................... 8,000 Retained earnings ............................................... 18,000 Total liabilities and equity ....................................$38,000

E2-40. (15 minutes) LO 1, 3 a. Procter & Gamble ($ millions)

Amount

Classification

Net sales ........................................................................................$ 65,058

I

Income tax expense.......................................................................

3,063

I

Retained earnings.......................................................................... 96,124

B

Net earnings .................................................................................. 15,411

I

Property, plant and equipment (net) .............................................. 19,893

B

Selling, general and administrative expense ................................. 18,568

I

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

4,594

B

Total liabilities ................................................................................ 64,268

B

Stockholders' equity ....................................................................... 56,138

B

Net earnings from continuing operations

I

10,194

b. Total assets = Total liabilities + Stockholders’ equity Total assets = $64,268 + $56,138 = $120,406

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-43

E2-41. (15 minutes) LO 1, 3, 7 a. Shoprite Holdings Ltd (rand millions) Sales of merchandise

Amount

Classification

R 141,000

I

Depreciation and amortization

2,176

I

Reserves (Retained earnings)

18,838

B

Property, plant and equipment

18,407

B

107,174

I

Trade and other payables

17,414

B

Total assets

55,723

B

Total equity

27,749

B

Employee benefits expense

10,498

I

Total non-current assets

24,572

B

1,492

B

Cost of goods and services

Total non-current liabilities b. Total liabilities = Total assets minus total equity Total liabilities = R 55,723 – R 27,749 = R 27,974 million.

c.

Current ratio = Current assets/Current liabilities = [R 55,723 – R 24,572] / [R 27,974 – R 1,492] = R 31,151 / R 26,482 = 1.18

©Cambridge Business Publishers, 2020 4-44

Financial Accounting, 6th Edition

E2-42. (15 minutes) LO 1, 3, 7 a. El Puerto de Liverpool (Mexican peso thousands)

Amount

Classification

$122,168,279

I

Retained earnings

82,963,786

B

Inventory

18,486,423

B

Administration expenses

33,549,108

I

168,266,121

B

33,358,545

B

7,137,563

I

Total current assets

67,351,290

B

Total stockholders’ equity

90,082,378

B

1,913,794

B

38,849,994

B

Total revenue

Total assets Long-term debt Financing costs (expenses)

Prepaid expenses Total non-current liabilities b. Total liabilities = Total assets - Stockholders’ equity Total liabilities = $168,266,121 - $90,082,378 = $78,183,743 Current liabilities = $78,183,743 - $38,849,994 = $39,333,749

c.

Quick ratio = [Cash + Marketable securities + Accts. receivable] / Current Liabilities = [Current assets – Inventory – Prepaid expenses] / Current liabilities = [$67,351,290 - $18,486,423 - $1,913,794] / $39,333,749 = 1.19

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-45

E2-43. (15 minutes) LO 1, 3 a. Kimberly-Clark ($ millions)

Amount

Classification

Net sales ........................................................................................ $18,259

I

Cost of goods sold ......................................................................... 11,706

I

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

6,730

B

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

2,319

I

Property, plant & equipment, net ...................................................

7,436

B

Marketing, research and general expenses ..................................

3,227

I

Accounts receivable, net ...............................................................

2,315

B

Total liabilities ................................................................................ 14,269

B

Total stockholders' equity ..............................................................

B

882

b. Total assets = Total liabilities + Stockholders’ equity Total assets = $14,269 + $882 = $15,151 Total revenue – Total expenses = Net income $18,259 – Total expenses = $2,319 Thus, Total expenses = $15,940 c.

Debt-to-equity ratio = Total liabilities / Stockholders’ equity = $14,269 / $882 = 16.18

©Cambridge Business Publishers, 2020 4-46

Financial Accounting, 6th Edition

E2-44. (15 minutes) LO 1, 2, 3. 4 Balance Sheet Transaction

Cash Asset

(1) Receive €50,000 in exchange for common stock.

+50,000

(2) Borrow €10,000 from bank.

+10,000

+

Noncash Assets

=

Liabilities

Income Statement +

Contrib. + Capital

Earned Capital

Revenues -

Expenses

Cash

Common Stock

=

-

=

-

=

-

=

-

=

-

=

-

=

-

=

+10,000

Cash

=

Notes Payable

+2,000

+2,000

Inventory

=

Accounts Payable

(4) Receive €15,000 cash from customers for services provided.

+15,000

(5) Pay €2,000 cash to supplier in part (3).

- 2,000

(6) Receive order for future services with €3,500 advance payment.

+3,500

(7) Pay €5,000 cash dividend to shareholders.

- 5,000

(8) Pay employees €6,000 cash for compensation earned.

- 6,000

- 6,000

+6,000

Cash

Retained Earnings

Wages Expense

Totals

Cash =

+15,000

+15,000

Retained Earnings

Revenue

+15,000

- 2,000

Cash

=

Accounts Payable +3,500

Cash =

Unearned Revenue

- 5,000

Cash

Retained Earnings

=

=

- 500

-

- 500

Cash

65,000

Net Income

+50,000

(3) Purchase €2,000 of supplies inventory on credit.

(9) Pay €500 cash for interest on loan in (2).

=

+

2,000

Solutions Manual, Chapter 4

=

13,500

+

50,000

+

3,500

- 6,000

+500

Retained Earnings

=

=

-

15,000

-

Interest Expense 6,500

=

=

- 500

8,500

©Cambridge Business Publishers, 2020 4-47

E2-45. (20 minutes) LO 2, 6 a. 1.

2.

3.

4.

5.

6.

7.

8.

9.

Cash (+A) .................................................................................................... 50,000 Common stock (+SE) ............................................................................ Receive €50,000 in exchange for common stock.

50,000

Cash (+A) .................................................................................................... 10,000 Notes payable (+L) ................................................................................ Borrow €10,000 from bank.

10,000

Inventory (+A) ............................................................................................. 2,000 Accounts payable (+L) ........................................................................... Purchase €2,000 supplies inventory on account.

2,000

Cash (+A) .................................................................................................... 15,000 Revenue (+R, +SE) ............................................................................... Recognize €15,000 revenue for services provided.

15,000

Accounts payable (-L) ................................................................................. 2,000 Cash (-A) ............................................................................................... Pay supplier €2,000 cash.

2,000

Cash (+A) .................................................................................................... 3,500 Unearned revenue (+L) ......................................................................... Receive €3,500 advance from customer.

3,500

Retained earnings (-SE) ............................................................................. 5,000 Cash (-A) ............................................................................................... Pay €5,000 cash dividend to shareholders.

5,000

Wages expense (+E, -SE) .......................................................................... 6,000 Cash (-A) ............................................................................................... Pay employees €6,000

6,000

Interest expense (+E, -SE) ......................................................................... Cash (-A) ............................................................................................... Pay €500 interest on note.

©Cambridge Business Publishers, 2020 4-48

500 500

Financial Accounting, 6th Edition

b. + (1) (2) (4) (6) Bal.

+ (3) Bal. -

+ (8) Bal. + (9) Bal.

Cash (A) 50,000 2,000 10,000 5,000 15,000 6,000 3,500 500 65,000

-

Supplies Inventory (A) 2,000 2,000

-

Revenue (R) 15,000 15,000

(5) (7) (8) (9)

-

Unearned Revenue (L)

+ (3) Bal. +

3,500 3,500 -

+

Notes Payable (L) 10,000 10,000

-

Interest Expense (E) 500 500

-

(7) Bal.

(6) Bal. + (2) Bal.

-

Common Stock (SE) 50,000 50,000

+ (1) Bal.

-

Retained Earnings (SE) 5,000 5,000

+

(4) Bal.

Wages Expense (E) 6,000 6,000

Solutions Manual, Chapter 4

Accounts Payable (L) 2,000 2,000 0

(5)

©Cambridge Business Publishers, 2020 4-49

E2-46. (20 minutes) LO 1, 7 a. & b. BETTIS CONTRACTORS Balance Sheets June 30, 2019 Assets Cash

$ 14,700

Accounts receivable

July 2, 2019 $

2,200

9,200

9,200

30,500

30,500

54,400

41,900

Land

25,000

25,000

Equipment

98,000

108,000

$177,400

$174,900

$

$

Supplies Current assets

Total assets Liabilities Accounts payable Current liabilities Notes payable Total liabilities

8,900

8,900

8,900

8,900

30,000

33,000

38,900

41,900

100,000

100,000

38,500

33,000

138,500

133,000

$177,400

$174,900

Stockholders’ equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders’ equity

c.

CR = $54,400 / $8,900 = 6.11 QR = ($14,700 +$9,200) / $8,900 = 2.69

d. Bettis’ current ratio indicates a strong liquidity position. The firm might want to consider investing some of its cash in assets that contribute to the firm’s earning power. The quick ratio is reasonable as a company does not want to tie up too much of its assets in a nonearning asset (cash). A quick glance at the data indicates that the firm's liquidity position has weakened since June.

©Cambridge Business Publishers, 2020 4-50

Financial Accounting, 6th Edition

E2-47. (15 minutes) LO 1, 2, 3, 4 Balance Sheet Transaction 1. Receive $20,000 cash in exchange for common stock.

Cash Asset

+

= Liabilities +

+20,000

Contrib. + Capital

Cash

+2,000

3. Sell inventory for $3,000 on credit. 4. Record cost of goods sold in 3.

=

Accts Payable

+3,000

+3,000

+3,000

Accounts Receivable

Retained Earnings

Sales

Inventory

+3,000

-3,000

Cash

Accounts Receivable

6. Acquire $5,000 of equipment by signing a note.

=

-5,000

9. Pay $2,000 cash dividend.

-2,000

TOTALS

15,000

=

-

=

-

=

-

=

-2,000

Net Income

-

=

COGS Expense

=

-

=

-

=

- 2,000

+5,000 Notes = Payable

-1,000

Cash

+3,000

+ 2,000

Retained Earnings

=

+5,000 Equipment

8. Pay $5,000 cash on a note payable.

Expenses

+2,000

-2,000

-1,000

Revenues -

Common Stock

=

Inventory

7. Pay wages of $1,000 in cash.

Earned Capital

+20,000

2. Purchase $2,000 of inventory on credit.

5. Collect $3,000 cash from transaction 3.

Noncash Assets

Income Statement

+ 1,000

Retained Earnings

=

-

Wages Expense

=

- 1,000

-5,000

Cash

=

Notes Payable

-

=

-

=

-2,000 =

Cash +

5,000

Solutions Manual, Chapter 4

=

Retained Earnings 2,000

+

20,000

+

-2,000

3,000

-

3,000

=

0

©Cambridge Business Publishers, 2020 4-51

E2-48. (20 minutes) LO 6 a. 1.

2.

3.

4.

5.

6.

7.

8.

9.

Cash (+A) .................................................................................................... 20,000 Common stock (+SE) .............................................................................

20,000

Inventory (+A) .............................................................................................. 2,000 Accounts payable (+L) ...........................................................................

2,000

Accounts receivable (+A) ............................................................................ 3,000 Sales (+R, +SE) .....................................................................................

3,000

Cost of goods sold (+E, -SE) ....................................................................... 2,000 Inventory (-A)..........................................................................................

2,000

Cash (+A) .................................................................................................... 3,000 Accounts receivable (-A) ........................................................................

3,000

Equipment (+A) ........................................................................................... 5,000 Notes payable (+L) .................................................................................

5,000

Wages expense (+E, -SE) ........................................................................... 1,000 Cash (-A) ................................................................................................

1,000

Notes payable (-L) ....................................................................................... 5,000 Cash (-A) ................................................................................................

5,000

Retained earnings (-SE) .............................................................................. 2,000 Cash (-A) ................................................................................................

2,000

©Cambridge Business Publishers, 2020 4-52

Financial Accounting, 6th Edition

b. +

Cash (A) 20,000 1,000 3,000 5,000 2,000

(1) (5)

-

(7) (8) (9) -

+

Inventory (A) 2,000 2,000

(2)

Accounts Receivable (A) 3,000 3,000 Equipment (A) 5,000

(6)

(8)

Accounts Payable (L) 2,000

Notes Payable (L) 5,000 5,000

Solutions Manual, Chapter 4

(3)

-

(5) -

(7)

-

+

Cost of Goods Sold (E) 2,000

+ +

Sales Revenue (R) 3,000

(1)

(4) +

+

+

-

(4) (3)

Common Stock (SE) 20,000

+

(9)

Wages Expense (E) 1,000

Retained Earnings (SE) 2,000

-

+

(2)

+ (6)

©Cambridge Business Publishers, 2020 4-53

PROBLEMS P2-49. (30 minutes) LO 1, 3 a. Comcast, Apple, Target and Harley-Davidson are financed primarily by debt (between 63% and 82% of total assets). Nike is financed more by equity (47% debt). b. The highest ratios of income to assets were Nike (18.2%), Apple (12.9%) and Comcast (12.2%). Possible reasons include the firms’ ability to command a premium price for their brands and, in the case of Nike and Apple, the ability to outsource a significant amount of their production (and avoid investments in productive capacity). c.

Apple has the highest estimated ROE at 36%. (The ROE is estimated because we have only this year’s equity.) Nike has the second highest ROE at 34%, and Comcast is at just under 33%. Both Apple and Nike are able to reduce expenses through outsourcing production to Asia.

P2-50. (30 minutes) LO 1, 3 a. While Apple is 64% debt financed, Hewlett-Packard’s liabilities exceed its total assets. (It has negative stockholders’ equity.) Hewlett-Packard is the more heavily leveraged firm. Some of the difference can be attributed to HPQ’s expensive acquisitions that resulted in subsequent write-offs. b. Hewlett-Packard's net income to asset ratio is 7.7% while Apple’s is 12.9%. The ratios are not close, which might not be expected given the similarities of their activities. More heavily leveraged firms are open to greater risk and for this reason we might expect a greater return to be earned on HewlettPackard’s assets to compensate for the higher risk. But that turns out not to be the case. Apple’s return exceeds Hewlett-Packard’s, suggesting that Apple has superior products or is more efficient in its operations. c. Hewlett-Packard’s gross profit as a percent of sales is 18.4% while Apple’s is 38.5%. The implication is that Apple does have the more efficient production operation and/or product designs that allow it to command a premium price from consumers.

©Cambridge Business Publishers, 2020 4-54

Financial Accounting, 6th Edition

P2-51. (30 minutes) LO 1, 3 a. Comcast is 63% financed with debt, while Verizon is 83% financed with debt. High debt financing is not uncommon in an industry with large investments in property, plant and equipment. Verizon’s debt percentage is particularly high as it repurchased a significant portion of its common stock that had been held by Vodafone Group, thereby reducing shareholders’ equity. b. Comcast has the slightly higher net income to total asset ratio at 12.2% compared to 11.9% for Verizon. This small difference can be explained by the larger amount of interest expense that Verizon pays on its debt financing. c.

Verizon has a slightly lower return on total assets while reporting much higher leverage (debt), so it is likely that Comcast would have better access to additional capital.

P2-52. (30 minutes) LO 1, 7 a. 3M at 69% is the more heavily debt-financed firm. Abercrombie and Fitch is the lowest debt financed at 46%. Apple is 64% financed by debt. b. Apple has the most working capital, but it is a much larger firm than 3M or Abercrombie & Fitch. A better measure of the comparative differences in working capital is the current ratio, which is the ratio of the firm’s current assets to its current liabilities. This ratio is greatest for Abercrombie & Fitch at 2.5.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-55

P2-53. (30 minutes) LO 1, 5 a.

BARTH COMPANY Balance Sheet December 31, 2018 Assets Cash Accounts receivable Equipment Land

$ 8,800 18,400 9,000 50,000

Liabilities

Total assets

$86,200

Accounts payable

$ 7,500

Equity Stockholders’ equity Total liabilities & equity

78,700 $86,200

b. Increase in Equity Add: Dividends Net Income for 2018

($78,700-$67,500)

$11,200 12,000 $23,200

c.

($78,700-$67,500)

$11,200 21,000 32,200 13,500 $18,700

Increase in Equity Add: Dividends Less: Additional Investment Net Income for 2018

P2-54. (20 minutes) LO 1, 3 a. Total assets (Total liabilities and equity) Total expenses (Sales – Net income) Total expenses as percent of sales

ANF

JWN

$2,326

$8,115

3,482

14,700

99.7% ($3,482/$3,493)

97.1% ($14,700/$15,137)

b. Return on average equity…

ANF $11 [($2,326-$1,074)+$1,252]/2

©Cambridge Business Publishers, 2020 4-56

= 0.9%

JWN $437 [($8,115-$7,138)+$870]/2

= 47.3%

Financial Accounting, 6th Edition

P2-55. (30 minutes) LO 1, 7 a. ($ millions)

Current Assets

Noncurrent Assets

Total Assets

Current Liabilities

Noncurrent Liabilities

Total Liabilities

Equity

2014 ……

$5,559

$9,967

$15,526

$6,226

$8,301

$14,527

$999

2015 ……

5,426

9,416

14,842

6,349

8,453

14,802

40

2016 ……

5,115

9,487

14,602

5,846

8,639

14,485

117

2017 ……

5,211

9,940

15,151

5,858

8,411

14,269

882

b. Kimberly Clark’s current assets most likely include cash, accounts receivable, inventories, and prepaid assets. Its long-term assets most likely include property, plant and equipment (PPE), goodwill, and other intangible assets that have arisen from acquisitions. c.

2016: Working capital = $5,115 - $5,846 = $(731) Current ratio = $5,115 / $5,846= 0.87 2017: Working capital= $5,211 - $5,858 = $(647) Current ratio $5,211 / $5,858 = 0.89

d. Kimberly Clark’s liquidity ratios have remained stable over this four year period. In 2014, the current ratio was 0.89, the same as 2017. The company has reduced investment in current assets and current liabilities proportionately over the last four years.

P2-56. (30 minutes) LO 1, 7 a. ($ millions) 2014 …… 2015 …… 2016 …… 2017 ……

Current Assets

Noncurrent Assets

$ 5,863 6,045 4,996 3,812

$ 7,322 5,292 4,366 3,450

Total Assets $13,185 11,337 9,362 7,262

Current Liabilities $ 5,595 5,438 4,681 4,915

Noncurrent Liabilities

Total Liabilities

$ 8,535 7,855 8,505 6,070

$14,130 13,293 13,186 10,985

Equity $ (945) (1,956) (3,824) (3,723)

b. We might reasonably predict inventories to comprise the bulk of its current assets. In fact, SHLD’s inventory is more than 80% of its current assets. c.

2014: $5,863 / $5,595= 1.05 2017: $3,812 / $4,915 = 0.78

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-57

d. SHLD’s deteriorating condition can been seen in the decline in current assets, non-current assets and its shareholders’ equity. In fact, beginning in 2014, SHLD’s shareholders’ equity was negative, indicating that the book value of its liabilities exceeded the book value of its assets. This situation has only become worse over the past three years as the negative balance in equity in 2017 is nearly four times as large as it was in 2014.

P2-57. (30 minutes) LO 1, 2, 3, 4 a. Balance Sheet Transaction 1. Issued common stock $7,000. 2. Paid rent $750.

Cash Asset +7,000 Cash

+

Noncash Assets

=

=

5. $1,200 cash received for services.

+1,200 Cash

=

+6,800 Accounts Receivable -2,200 Cash

8. Paid $370 cash for utilities.

Earned Capital

+500 Accounts Payable

= +750 Rent Expense +500 Advertising Expense

=

-750

=

-500

-

=

-

=

+1,200

+6,800 Retained Earnings

+6,800 Counseling Services Revenue

-

=

+6,800

-900 Cash

10. Acquired land for $13,000.

-13,000 Cash

11. Paid $100 interest in cash.

-100 Cash

-

+2,200 Salary Expense

=

-2,200

=

-370 Retained Earnings

-

+370 Utilities Expense

=

-370

=

-900 Retained Earnings

-

=

-

=

= -100 Retained Earnings

=

$19,800

Net Income

+1,200 Counseling Services Revenue

9. Paid $900 cash dividend.

+

=

+1,200 Retained Earnings

-370 Cash

$5,880

-

+15,000 Notes Payable

-2,200 Retained Earnings

Totals

-

-500 Retained Earnings

=

Expenses

-

=

+13,000 Land

Revenues -

-750 Retained Earnings

=

6. Billed clients $6,800 for services. 7. Paid $2,200 cash for salary.

Contrib. + Capital +7,000 Common Stock

=

3. Received $500 invoice for advertising expense. +15,000 Cash

+

=

-750 Cash

4. Borrowed $15,000 cash from bank.

Liabilities

Income Statement

=

©Cambridge Business Publishers, 2020 4-58

$15,500

+

$7,000

+

$3,180

$8,000

-

+100 Interest Expense

=

-100

-

$3,920

=

$4,080

Financial Accounting, 6th Edition

b.

LAMBERT SERVICES Income Statement For the Month of December 2018 Counseling services revenue

$8,000

Expenses Rent expense

$ 750

Advertising expense Salary expense

500 2,200

Utilities expense

370

Interest expense

100

Total expenses

3,920

Net income

$4,080

P2-58. (30 minutes) LO 6 a. 1.

2.

3.

4.

5.

6.

7.

8.

Cash (+A) .................................................................................................... 7,000 Common stock (+SE) .............................................................................

7,000

Rent expense (+E,-SE) ............................................................................... 750 Cash (-A) ................................................................................................

750

Advertising expense (+E, -SE) .................................................................... 500 Accounts payable (+L) ...........................................................................

500

Cash (+A) .................................................................................................... 15,000 Notes payable (+L) .................................................................................

15,000

Cash (+A) .................................................................................................... 1,200 Counseling services revenue (+R,+SE) .................................................

1,200

Accounts receivable (+A) ............................................................................ 6,800 Counseling services revenue (+R,+SE) .................................................

6,800

Salary expense (+E,-SE) ............................................................................. 2,200 Cash (-A) ................................................................................................

2,200

Utilities expense (+E,-SE) ........................................................................... 370 Cash (-A) ................................................................................................

370

continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-59

a. continued 9.

10.

11.

Retained earnings (dividend paid) (-SE) ..................................................... 900 Cash (-A) ................................................................................................

900

Land (+A) ..................................................................................................... 13,000 Cash (-A) ................................................................................................

13,000

Interest expense (+E,-SE) 100 Cash (-A) ................................................................................................

100

b. + (1) (4) (5)

Cash (A) 7,000 750 15,000 2,200 1,200 370 900 13,000 100

-

(2) (7) (8) (9) (10) (11)

-

+

Accounts Receivable (A) 6,800

(6)

-

+

Land (A) 13,000

(10)

-

(9)

+

Rent Expense (E) 750

-

+

Salary Expense (E) 2,200

-

Interest Expense (E) 100

-

(2)

(7)

+ (11)

©Cambridge Business Publishers, 2020 4-60

+ (3)

+ (8)

Accounts Payable (L) 500

+ (3)

Notes Payable (L) 15,000

+

Common Stock (SE) 7,000

+

Retained Earnings (SE) 900

+

Counseling Services Rev. (R) 1,200 6,800

Advertising Expense (E) 500

Utilities Expense (E) 370

(4)

(1)

+ (5) (6)

-

-

Financial Accounting, 6th Edition

P2-59. (30 minutes) LO 1, 7 a. ($ millions)

Current Assets

2014 …… 2015 …… 2016 …… 2017 ……

$68,531 89,378 106,869 128,645

Noncurrent Assets $ 163,308 201,101 214,817 246,674

Total Assets $231,839 290,479 321,686 375,319

Current Liabilities $63,448 80,610 79,006 100,814

Noncurrent Liabilities

Total Liabilities

Equity

$ 56,844 90,514 114,431 140,458

$120,292 171,124 193,437 241,272

$ 111,547 119,355 128,249 134,047

b.

For a computer company we might reasonably expect inventories and cash to be the predominant items in current assets. The reality is that inventory is not a large dollar amount (less than 1% of total assets) because the company’s business model depends on high inventory turnover—that is, it works diligently to minimize the quantity of inventory to avoid product obsolescence. The surprise is that 37% of Apple’s current assets are cash and short-term marketable securities. Long-term assets are primarily concentrated in financial securities, with property, plant and equipment a distant second.

c.

The percentage of Apple’s assets that is financed with liabilities has increased over this time period. AAPL has started to pay shareholder dividends and to repurchase its common stock, but it has borrowed money to do so.

d.

2017: $128,645/$100,814 = 1.28; 2014: $68,531/$63,448 = 1.08

e.

Apple’s current ratio is below the industry average. A probable cause of this decrease is the increasing size of the company. Net working capital has increased since 2014. So, even though these measures are low, Apple’s size and the monetary “cushion” of AAPL’s financial assets gives them a relatively strong liquidity position.

P2-60. (30 minutes) LO 1, 7

a. (RMB millions) 2016 … 2017 … 2018 …

Current Assets

Noncurrent Assets

20,792 26,516 40,949

Solutions Manual, Chapter 4

35,675 47,114 73,377

Total Assets 56,467 73,630 114,326

Current Liabilities 8,071 13,623 21,651

Noncurrent Liabilities

Total Liabilities

9,696 12,919 22,619

17,767 26,542 44,270

Equity 38,700 47,088 70,056

©Cambridge Business Publishers, 2020 4-61

b. Alibaba’s current assets are likely to be primarily comprised of cash, accounts receivable, inventories and prepaid expenses. Its long-term assets will likely be primarily comprised of property, plant and equipment (PPE) for its operations, financial investments, and goodwill and other intangible assets arising from acquisitions. c. Current ratio:

2016: 20,792 / 8,071 = 2.58 2018: 40,949 / 21,651 = 1.89

d. Working capital:

2016: 20,792 - 8,071 = 12,721 2018: 40,949 - 21,651 = 19,298

P2-61. (30 minutes) LO 3 a. ($ millions) 2014 …… 2015 …… 2016 …… 2017 ……

Revenues

Cost of Goods Sold

$ 27,799 30,601 32,376 34,350

$ 15,353 16,534 17,405 19,038

Gross Profit $12,446 14,067 14,971 15,312

Operating Expenses

Operating Income

$ 8,766 9,892 10,469 10,563

$ 3,680 4,175 4,502 4,749

Other Expense

Net Income

$ 987 902 742 509

$ 2,693 3,273 3,760 4,240

b. The gross profit percentage (also called gross profit margin) for each year follows: Nike, Inc. 2014 .............................. 2015 .............................. 2016 .............................. 2017 ..............................

Gross Profit Percentage 44.8% 46.0% 46.2% 44.6%

Nike’s sales, gross profit and net income have remained steady over this period, reflecting continued strength. The company's operating expenses have increased at about the same pace as sales. c.

Wages, advertising and promotion, and general and administration expenses are likely to be the major cost categories for Nike.

©Cambridge Business Publishers, 2020 4-62

Financial Accounting, 6th Edition

P2-62. (30 minutes) LO 1, 2, 3, 4 a. Balance Sheet Transaction 1. Issued common stock for cash. 2. Rent paid in cash $4,800.

Cash Asset

+

Noncash Assets

5. July insurance premium prepaid in cash: $1,800. 6. Flight services collected in cash; $22,700.

Cash

-4,800 =

Cash

Expenses

=

Net Income

-

-1,600 -

Retained Earnings

-900

-900 =

Cash -1,800

+1,800

Cash

Prepaid Insurance

=

=

+15,900

-1,500 = Accounts Payable

-

=

=

-

=

+15,900

+15,900

=

Retained Earnings

Flight Services Revenue

-16,000

-16,000 =

Cash

11. Invoice received for fuel; $3,500.

-900

-

+15,900 Accounts Receivable

10. Paid wages in cash: $16,000.

=

+22,700

Flight Services Revenue

Accounts Receivable

Advertising Expense

=

Retained Earnings

Cash

-1,600

-

=

-13,200

+1,600 Entertainment = Expense

-4,800

=

+22,700

Cash

=

-

+22,700

-1,500

Rent Expense

+900 -

Retained Earnings

+22,700 Cash

=

+4,800

Retained Earnings

+1,600 Accounts = Payable

+16,000 -

Retained Earnings +3,500

-3,500

= Accounts Payable

Wages expense

=

-16,000

=

-3,500

+3,500 -

Retained Earnings

-3,000

Fuel Expense

-3,000 =

Cash $57,900

-

-

-4,800

+13,200

TOTALS

Revenues

Common Stock

=

9. Received $13,200 on account.

12. Cash dividend paid; $3,000.

+

Earned Capital

+$50,000

7. Billed for flight services ; $15,900.

8. Paid $1,500 on accounts.

+

+$50,000

3. Invoice for entertainment expense: $1,600. 4. Cash paid for advertising: $900.

= Liabilities

Income Statement Contrib. Capital

+

$4,500

Solutions Manual, Chapter 4

=

-

Retained Earnings $3,600

+

$50,000

+

$8,800

$38,600

-

= $26,800

=

$11,800

©Cambridge Business Publishers, 2020 4-63

b.

OUTBACK FLIGHTS Income Statement For the Month of June 2019 Revenue Services fees earned Expenses Rent expense Entertainment expense Advertising expense Wages expense Fuel expense Total expenses Net income

$38,600 $ 4,800 1,600 900 16,000 3,500 26,800 $11,800

Note: The insurance premium paid is for the next month (July) and is not an expense at the end of June.

P2-63. (30 minutes) LO 6 a. 1.

2.

3.

4.

5.

6.

7.

Cash (+A) .................................................................................................... 50,000 Common stock (+SE) .............................................................................

50,000

Rent expense (+E,-SE) ............................................................................... 4,800 Cash (-A) ................................................................................................

4,800

Entertainment expense (+E,-SE) ................................................................ 1,600 Accounts payable (+L) ...........................................................................

1,600

Advertising expense (+E,-SE) ..................................................................... 900 Cash (-A) ................................................................................................

900

Prepaid insurance (+A) ................................................................................ 1,800 Cash (-A) ................................................................................................

1,800

Cash (+A) ................................................................................................... 22,700 Flight services revenue (+R,+SE) ..........................................................

22,700

Accounts receivable (+A) ............................................................................ 15,900 Flight services revenue (+R,+SE) ..........................................................

15,900

continued next page

©Cambridge Business Publishers, 2020 4-64

Financial Accounting, 6th Edition

a. continued 8.

9.

10.

11.

12.

Accounts payable (-L) ................................................................................. 1,500 Cash (-A) ................................................................................................

1,500

Cash (+A) .................................................................................................... 13,200 Accounts receivable (-A) ........................................................................

13,200

Wages expense (+E,-SE) ............................................................................ 16,000 Cash (-A) ................................................................................................

16,000

Fuel expense (+E,-SE) ................................................................................ 3,500 Accounts payable (+L) ...........................................................................

3,500

Retained earnings (dividend paid) (-SE) ..................................................... 3,000 Cash (-A) ................................................................................................

3,000

b. + (1) (6) (9)

+

Accounts Receivable (A) 15,900 (9)

+

Prepaid Insurance (A) 1,800

(7)

(5)

+ (2)

+ (4)

Cash (A) 50,000 4,800 22,700 900 13,200 1,800 1,500 16,000 3,000

Rent Expense (E) 4,800

Advertising Expense (E) 900

-

(2) (4) (5) (8) (10) (12)

13,200

Accounts Payable (L) 1,500 1,600 3,500

(8)

-

Common Stock (SE) 50,000

(12)

-

-

(1)

+

Flight Services Revenue (R) 22,700 15,900

+ (6) (7)

+

Entertainment Expense (E) 1,600

-

+

Wages Expense (E) 16,000

+

Solutions Manual, Chapter 4

+

-

(10)

(11)

(3) (11)

Retained Earnings (SE) 3,000

(3)

-

+

Fuel Expense (E) 3,500

-

-

©Cambridge Business Publishers, 2020 4-65

P2-64. (30 minutes) LO 3 a. ($ millions)

Revenues

Cost of Revenues

Gross Profit

Operating Expenses

Operating Income

Other Expense

Net Income

2014 ……

$ 16,447.8

$ 6,858.8

$9,589.0

$ 6,507.9

$ 3,081.1

$ 1,013.4

$2,067.7

2015 ……

19,162.7

7,787.5

11,375.2

7,774.2

3,601.0

841.7

2,759.3

2016 ……

21,315.9

8,511.1

12,804.8

8,632.9

4,171.9

1,353.0

2,818.9

2017 ……

22,386.8

9,038.2

13,348.6

9,213.9

4,134.7

1,249.8

2,884.9

b. The gross profit percentage (also called gross profit margin) for each year follows: Starbucks, Inc. 2014

Gross Profit Percentage 58.3%

2015

59.4%

2016

60.1%

2017

59.6%

SBUX gross profit percentage edged up in 2015 and 2016, but decreased slightly in 2017. It is still quite high. c.

Selling, general and administrative expenses are the major operating expense categories for Starbucks. Most store operating expenses (rent, utilities, coffee, etc.) are included in the Cost of Revenues category.

©Cambridge Business Publishers, 2020 4-66

Financial Accounting, 6th Edition

P2-65. (30 minutes) LO 3

a. Revenues

Cost of Goods Sold

2014 ……

€ 71,227

€ 50,869

€ 20,358

2015 ……

75,636

53,789

2016 ……

79,645

2017 ……

83,049

(€ millions)

Gross Profit

Operating Expenses

Operating Income

Other Expense

Net Income

€ 13,751

€ 6,607

€ 1,100

€ 5,507

21,847

15,805

6,042

(1,338)

7,380

55,826

23,819

16,500

7,319

1,735

5,584

58,021

25,028

17,337

7,691

1,512

6,179

b. The gross profit percentage (also called gross profit margin) for each year follows: Siemens AG

Gross Profit Percentage

2014

28.6%

2015

28.9%

2016

29.9%

2017

30.1%

Siemens’ gross profit percentage increased steadily between 2014 and 2017. The increase reflects the improved economic conditions and Siemens’ increasing sales over the period. c.

The principal items in Siemens’ operating expenses include selling and general administrative expenses and research and development expenses.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-67

P2-66. (25 minutes) LO 1, 3, 5 a. GEYER, INC. Income Statement For Year Ended December 31, 2018 Service fees .................................................................................................................... $67,600 Supplies expense ........................................................................................................... $ 9,700 Insurance expense ......................................................................................................... 1,500 Salaries expense ............................................................................................................ 30,000 Advertising expense ....................................................................................................... 1,700 Rent expense .................................................................................................................. 7,500 Miscellaneous expense .................................................................................................. 200 Total expenses ......................................................................................................... 50,600 Net income ...................................................................................................................... $17,000 b. GEYER, INC. Statement of Stockholders’ Equity For Year Ended December 31, 2018

Common Stock

Retained Earnings

Balance at December 31, 2017 ........................... $4,000

Total Stockholders’ Equity

$6,200

$10,200

(13,500)

(13,500)

Net income ........................................................ _____

17,000

17,000

Balance at December 31, 2018 ........................... $5,400

$9,700

$15,100

Stock issuance .................................................. 1,400 Dividends ..........................................................

1,400

c. GEYER, INC. Balance Sheet December 31, 2018 Cash ...............................................

$14,800

Accounts payable ............................................. $ 1,800

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

6,100

Notes payable .................................................. 4,000

Total assets ....................................

$20,900

Total liabilities ………………

5,800

Common stock ……………….

5,400

Retained earnings* ………….

9,700

Total liabilities and equities ..

$20,900

* $6,200 beginning balance + $17,000 net income - $13,500 dividend

©Cambridge Business Publishers, 2020 4-68

Financial Accounting, 6th Edition

P2-67. (45 minutes) LO 1, 2, 3, 4, 5 a & b. Balance Sheet Transaction Beg. Balances 1. Paid $600 cash toward accounts payable 2. Paid rent in cash: $3,600

Cash Asset

+

+5,000

Noncash Assets +5,200

+

+3,500

Contrib. Capital +

Earned Capital

+5,500

+1,200

Revenues

-

Expenses

=

Net Income

-

-600 = Accounts Payable

-

-3,600

-3,600 =

Cash

Accounts Receivable

= +500

5. Cash collected on account: $10,000

+10,000

-10,000

Cash

Accounts Receivable

6. Paid wages expense in cash: $2,400

-2,400

+11,500

+11,500

Retained Earnings

Services Revenue

-

=

-680

= Accounts Payable

-

-20 =

Retained Earnings

=

Retained Earnings

-900

=

+11,500

=

-500

=

Wages Expense

=

-2,400

=

-680

=

-20

+680

Retained Earnings

-20

-3,600

+2,400 -

Retained Earnings +680

Cash

Advertising Expense

-

-2,400

7. Invoiced for utility expense: $680

=

+500

Retained Earnings

=

Cash

Rent Expense

-

-500

= Accounts Payable

=

+3,600 -

Retained Earnings

+11,500

4. $500 invoice received for advertising

9. Paid $900 cash dividend

=

-600 Cash

3. Billed clients $11,500

8. Paid $20 cash for interest on note

= Liabilities

Income Statement

Utilities Expense +20

-

Interest Expense

-900

Cash

10. Paid $4,000 cash for sound equipment

-4,000

+4,000

Cash

Equipment

=

TOTALS

$3,480

$10,700

=

+

Solutions Manual, Chapter 4

$4,080

+

$5,500

+

$4,600

$11,500

-

=

-

=

-

$7,200

=

$4,300

©Cambridge Business Publishers, 2020 4-69

c. SCHRAND AEROBICS, INC. Income Statement For Month Ended January 31, 2019 Services revenue .................................................................................................................. $11,500 Expenses .............................................................................................................................. Rent expense................................................................................................................... 3,600 $3,600 Advertising expense ........................................................................................................ 500 Wages expense .................................................................................................................... 2,400 Interest expense .............................................................................................................. 20 Utilities expense............................................................................................................... 680 Total expenses .....................................................................................................................

7,200

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

$4,300

d. SCHRAND AEROBICS, INC. Statement of Stockholders’ Equity For Month Ended January 31, 2019 Common Stock Balance at January 1, 2019 ................................. $5,500

Retained Earnings $1,200

Total Stockholders’ Equity $ 6,700

Stock issuance .................................................. Dividends ..........................................................

(900)

(900)

Net income ........................................................ _____

4,300

4,300

Balance at January 31, 2019 ............................... $5,500

$4,600

$10,100

e. SCHRAND AEROBICS, INC. Balance Sheet January 31, 2019 Cash ............................................... Accounts receivable........................ Equipment ....................................... Total assets …………….

©Cambridge Business Publishers, 2020 4-70

$ 3,480 6,700 4,000 $14,180

Accounts payable ......................................... $ 1,580 Notes payable ............................................... 2,500 Total liabilities ................................................ 4,080 Common stock ............................................... 5,500 Retained earnings ........................................ 4,600 Total liabilities and equity .............................. $14,180

Financial Accounting, 6th Edition

P2-68. (30 minutes) LO 6 a. 1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

Accounts payable (-L) ................................................................................. 600 Cash (-A) ................................................................................................

600

Rent expense (+E,-SE) ............................................................................... 3,600 Cash (-A) ................................................................................................

3,600

Accounts receivable (+A) ............................................................................ 11,500 Services revenue (+R,+SE) ...................................................................

11,500

Advertising expense (+E, -SE) .................................................................... 500 Accounts payable (+L) ...........................................................................

500

Cash (+A) .................................................................................................... 10,000 Accounts receivable (-A) ........................................................................

10,000

Wages expense (+E, -SE) ........................................................................... 2,400 Cash (-A) ................................................................................................

2,400

Utilities expense (+E, -SE) .......................................................................... 680 Accounts payable (+L) ...........................................................................

680

Interest expense (+E, -SE) ..........................................................................20 Cash (-A) ................................................................................................

20

Retained earnings (-SE) .............................................................................. 900 Cash (-A) ................................................................................................

900

Equipment (+A) ........................................................................................... 4,000 Cash (-A) ................................................................................................

4,000

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-71

b. + Beg. Bal. (5)

End Bal.

Cash (A) 5,000 600 10,000 3,600 2,400 20 900 4,000 3,480

(1) (2) (6) (8) (9) (10)

+ Beg. Bal. (3) End Bal.

Accounts Receivable (A) 5,200 10,000 11,500 6,700 + Equipment (A) (10) 4,000 End Bal. 4,000 + (6) End Bal.

Wages Expense (E) 2,400 2,400 +

(2) End Bal. + (4) End Bal.

Rent Expense (E) 3,600 3,600 Advertising Expense (E) 500

(1)

-

2,500 Common Stock (SE) 5,500

(5)

(9)

-

-

-

+ (7) End Bal. -

+ (8) End Bal.

Accounts Payable (L) + 600 1,000 Beg. Bal. 500 (4) 680 (7) 1,580 End Bal. Notes Payable (L) + 2,500 Beg. Bal. End Bal. + Beg. Bal.

5,500 End Bal. Retained Earnings (SE) + 900 1,200 Beg. Bal. 300 End Bal. Services Revenue (R) 11,500 11,500

+

Utilities Expense (E) 680 680

-

Interest Expense (E) 20 20

(3) End Bal.

-

500

©Cambridge Business Publishers, 2020 4-72

Financial Accounting, 6th Edition

P2-69. (45 minutes) LO 1, 2, 3, 4, 5 a & b. Balance Sheet Transaction

Cash Asset

Beg.Balances

+6,700

1. Paid $950 cash for rent.

-950

2. Received $8,800 cash on account. 3. $500 paid on accts. payable.

+

= Liabilities +

Contrib. Capital +

Earned Capital

+14,800

=

+6,000

+12,400

Cash

Accounts Receivable

+1,600

+1,600

Retained Earnings

Services Revenue

Notes Payable

+8,100 Accounts Receivable

=

-4,000

Rent Expense

=

-$950

-

=

-

=

-

=

-

=

+8,100

+8,100

Retained Earnings

Services Revenue

-

=

+8,100

=

-4,000

=

-410

-4,000 =

Cash

8. Received invoice for utilities: $410.

=

9. Paid $6,000 dividend.

-6,000

+1,600

10. Paid $9,800 cash for vehicle.

-9,800

+9,800

Cash

Vehicles

+4,000 -

Retained Earnings +410

-410

Accts Payable

Retained Earnings

Salary Expense +410

-

Utilities Expense

-6,000 =

Cash

$800

Net Income

+5,000 =

6. Billed $8,100 for services.

TOTALS

-

Accts Payable

=

Cash

Cash

=

-500 =

Cash

11. Paid $50 cash interest on note.

Expenses

+950

=

-500 Cash

+5,000

-

=

Retained Earnings

=

-8,800

5. Borrowed $5,000 signed note.

+3,100

Revenues

-950

+8,800

+1,600

7. Paid $4,000 for cash salary.

Noncash Assets

Cash

4. Received $1,600 cash for services.

Income Statement

Retained Earnings

=

-50

-

=

-

=

-50 =

+

$23,900

Solutions Manual, Chapter 4

=

+50

Retained Earnings $8,010

+

$6,000

+

$10,690

$9,700

-

Interest Expense

=

-50

-

$5,410

=

$4,290

©Cambridge Business Publishers, 2020 4-73

c. KROSS, INC. Income Statement For Month Ended January 31, 2019 Services revenue ....................................................................................... Rent expense………………………………………………...

$9,700 $ 950

Utilities expense……………………………………………. Salary expense………………………………………….… Interest expense………………………………………….… Total expenses ........................................................................................... Net income .............................................................................................

410 4,000 50 5,410 $4,290

d. KROSS, INC. Statement of Stockholders’ Equity For Month Ended January 31, 2019 Common Retained Stock Earnings Balance at January 1, 2019 ................................. $6,000 $12,400

Total Stockholders’ Equity $18,400

Stock issuance .................................................. Dividends ..........................................................

(6,000)

(6,000)

Net income ........................................................ _____

4,290

4,290

Balance at January 31, 2019 ............................... $6,000

$10,690

$16,690

e. KROSS, INC. Balance Sheet January 31, 2019 Cash ............................................... $

800

Accounts payable ........................................... $ 510

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

14,100

Notes payable ................................................7,500

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

9,800

Total liabilities .................................................8,010

Total assets .................................... $24,700 Common stock ...............................................6,000 Retained earnings .......................................... 10,690 Total liabilities and equity ............................... $24,700

©Cambridge Business Publishers, 2020 4-74

Financial Accounting, 6th Edition

P2-70. (30 minutes) LO 6 a. 1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

Rent expense (+E,-SE) ...............................................................................950 Cash (-A) ................................................................................................

950

Cash (+A) .................................................................................................... 8,800 Accounts receivable (-A) ........................................................................

8,800

Accounts payable (-L) .................................................................................500 Cash (-A) ................................................................................................

500

Cash (+A) .................................................................................................... 1,600 Services revenue (+R,+SE) ...................................................................

1,600

Cash (+A) .................................................................................................... 5,000 Notes payable (+L) .................................................................................

5,000

Accounts receivable (+A) ............................................................................ 8,100 Services revenue (+R, +SE) ..................................................................

8,100

Salary expense (+E,-SE) ............................................................................. 4,000 Cash (-A) ................................................................................................

4,000

Utilities expense (+E,-SE) ...........................................................................410 Accounts payable (+L) ...........................................................................

410

Retained earnings (-SE) .............................................................................. 6,000 Cash (-A) ................................................................................................

6,000

Vehicles (+A) ............................................................................................... 9,800 Cash (-A) ................................................................................................

9,800

Interest expense (+E,-SE) ........................................................................... 50 Cash (-A) .................................................................................................

50

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-75

b. + Beg. Bal. (2) (4) (5)

+ Beg. Bal. (6)

+

+

+ (7)

(1) (3) (7) (9) (10) (11)

Accounts Receivable (A) 14,800 8,800 8,100

(10)

(1)

Cash (A) 6,700 950 8,800 500 1,600 4,000 5,000 6,000 9,800 50

Vehicles (A) 9,800

Rent Expense (E) 950 Salary Expense (E) 4,000

©Cambridge Business Publishers, 2020 4-76

-

+

Interest Expense (E) 50

-

-

Accounts Payable (L) + 500 600 Beg. Bal. 410 (8)

-

Notes Payable (L) + 2,500 Beg. Bal. 5,000 (5)

-

Common Stock (SE) + 6,000 Beg. Bal.

(3)

-

-

-

Retained Earnings (SE) + 6,000 12,400 Beg. Bal.

-

Services Revenue (R) + 1,600 8,100

(9) -

Utilities Expense (E) 410

(11)

(2)

+ (8)

Financial Accounting, 6th Edition

(4) (6)

CASES and PROJECTS C2-71. (30 minutes) LO 1, 3, 4, 5 WILDLIFE PICTURE GALLERY Income Statement For the month of March 2019

a. Revenues Commissions earned

$28,500

Expenses Rent expense

$ 900

Wages expense Utilities expense

4,900 350

Delivery expense Total expenses

1,700 7,850

Net income b.

$20,650 WILDLIFE PICTURE GALLERY Statement of Stockholders’ Equity For the month of March 2019

Common Stock Balance at March 1, 2019 ....................................$ 0 Stock issuance .................................................. 6,500 Dividends .......................................................... Net income ........................................................ _____ Balance at March 31, 2019 .................................. $6,500 c.

Assets Cash Advance receivable*

Total assets

Retained Earnings $ 0

20,650 $20,650

WILDLIFE PICTURE GALLERY Balance Sheet March 2019 Liabilities $51,200 Payable to artists** 500 Notes payable Accounts payable Total liabilities Stockholders’ equity Total liabilities and $51,700 stockholders’ equity

Stockholders’ Equity $ 0 6,500 20,650 $27,150

$12,500 10,000 2,050 24,550 27,150 $51,700

* It is important to recognize that the Wildlife Picture Gallery is a separate entity from its shareholder/operator, Sarah Penney. The $500 payment for airfare is not an expense of the business, but rather a payment on behalf of an employee. Sarah will have to reimburse the company or have the amount deducted in future compensation, as recognized in the advance receivable asset for Wildlife Picture Gallery. ** 70% x ($95,000) – $54,000 is owed to artists.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-77

C2-72. (30 minutes) LO 3 Andrea faces a dilemma when she prepares her expense reimbursement request. She has, in essence, been asked by her supervisor to join him in overcharging expenses to the company. Should Andrea not file a reimbursement request for the Luxury Inn lodging costs, the company should question why she and her supervisor stayed at different locations. Discussion of this case should focus on the options available to Andrea. The options include the following: 1.

File an expense reimbursement request for the Luxury Inn and, therefore, minimize the likelihood of jeopardizing her relationship with her supervisor.

2.

File an expense reimbursement request for the Spartan Inn and let future events take whatever course they follow.

3.

Report the situation to her supervisor's boss.

4.

Discuss the situation with her supervisor and indicate that she (Andrea) is not comfortable with filing the Luxury Inn receipt. Perhaps encourage the supervisor to seek a change in company policy to provide daily allowances for lodging and meal costs rather than reimbursing actual costs.

5.

Leave the employ of the company.

There is no single correct answer to the problem. The first choice is not a good solution for the long run as it starts a slippery slope for Andrea, which is likely to lead to further concessions to improper behavior and more serious problems. Additional and more serious situations increase the chances her behavior is likely to be discovered and she could be fired or even sent to jail. One would hope that sleepless nights would intervene long before this time. It is better to draw the line here. Talking to her supervisor is a good idea and perhaps instituting a policy that avoids any temptation. Leaving the company would be a fallback choice if discussion of the situation does not lead to a resolution of the situation that preserves Andrea’s ethical requirements.

©Cambridge Business Publishers, 2020 4-78

Financial Accounting, 6th Edition

Chapter 3 Adjusting Accounts for Financial Statements Learning Objectives – coverage by question MiniExercises

Exercises

21 - 23, 25, 29,

33, 35,

30

36, 38

23, - 25,

32 - 36,

29, 30

38

Problems

Cases and Projects

LO1 – Identify the major steps in the accounting cycle. LO2 – Review the process of journalizing and posting transactions.

LO3 – Describe the adjusting process and illustrate adjusting entries.

LO4 – Prepare financial statements from adjusted accounts.

40 - 42, 46, 47, 49,

55 - 58

52 - 54 40 - 43, 46 - 49,

55 - 58

52 - 54 40 - 42,

26

39

44, 47, 49, 50,

55, 58

53, 54 LO5 – Describe the process of closing temporary accounts.

LO6 – Analyzing changes in balance sheet accounts.

Solutions Manual, Chapter 4

27, 28, 30

24, 25, 29

31, 33, 37, 39

34 - 36, 38

42, 44, 45, 49 - 51

55

53, 54 40, 42, 49 52 - 54

55, 56, 58

©Cambridge Business Publishers, 2020 4-79

QUESTIONS Q3-1.

The five major steps in the accounting cycle are: 1. 2. 3. 4. 5.

Analyze business activity using transaction analysis based on the related source documents. Record results of the transaction analysis chronologically in the general journal and create a trial balance. Adjust the recorded data to update all accounts for expense and revenue recognition not previously recognized. Report the adjusted financial data in the form of financial statements. Close the books by posting the adjusting and closing entries, which “zero out” the temporary accounts.

Q3-2.

The fiscal year is the annual accounting period adopted by a firm. A firm using a fiscal year ending on December 31 is on a calendar-year basis.

Q3-3.

Examples of source documents that underlie business transactions are invoices sent to customers, invoices received from suppliers, bank checks, bank deposit slips, cash receipt forms, and written contracts.

Q3-4.

A general journal is a book of original entry that may be used for the initial recording of any type of transaction. It contains space for dates and for accounts to be debited and credited, columns for the amounts of the debits and credits, and a posting reference column for numbers of the accounts that are posted.

Q3-5.

When entries are posted, the page number and identifying initials of the appropriate journal are placed next to the amounts in the appropriate accounts. The account number is entered beside the related amount posted in the journal's posting reference column. This procedure enables interested users to trace amounts in the ledger back to the originating journal entry and permits us to know which entries have been posted.

Q3-6.

An adjusting journal entry is a journal entry made at the end of an accounting period to reflect accural accounting. It usually affects a balance sheet account and an income statement account and rarely involves cash.

Q3-7.

A chart of accounts is a list of the accounts appearing in the general ledger, with the account numbering system indicated. Normally the accounts are classified as asset, liability, owners' equity, revenue, and expense accounts, and often the numbering system identifies the account classification. For example, a coding system might assign the numbers 100–199 to assets, 200–299 to liabilities, and so on.

©Cambridge Business Publishers, 2020 4-80

Financial Accounting, 6th Edition

Q3-8.

Many of the transactions reflected in the accounting records through the first two steps of the accounting cycle affect the net income of more than one period. Therefore, adjustments to the account balances are ordinarily necessary at the end of each accounting period to record the proper amount of revenue and to match expenses with revenue properly. This process is also intended to achieve a more accurate picture of financial position by adjusting balance sheet amounts to show unexpired costs, up-to-date amounts of obligations, and so on.

Q3-9.

1.

Allocating assets to expense to reflect expenses incurred during the period. Example: Recording supplies used by debiting Supplies Expense and crediting Supplies.

2.

Allocating payments received in advance by crediting the revenue account to reflect revenues earned during the period. Example: Recording service fees earned by debiting Unearned Service Fees and crediting Service Fees Earned.

3.

Accruing expenses to reflect expenses incurred during the period that are not yet paid or recorded. Example: Recording unpaid wages by debiting Wages Expense and crediting Wages Payable.

4.

Accruing revenues to reflect revenues earned during the period that are not yet received or recorded. Example: Recording commissions earned by debiting Commissions Receivable and crediting Commissions Earned.

Q3-10.

Jan. 31

Insurance expense (+E, -SE) Prepaid insurance (-A) To record insurance expense for January ($1,872/24 = $78).

78 78

Q3-11.

A contra account is an account that is related to, and deducted from, another account when financial statements are prepared or when book values are computed. Accumulated depreciation is deducted from the cost of a depreciable asset in computing and portraying the asset's book value.

Q3-12.

The building is five years old by the end of 2015, so the accumulated depreciation of $800,000 represents five years of depreciation at an annual rate of $160,000 ($800,000/5). If the annual depreciation is $160,000, then the expected life of the building must be 25 years. At the end of 2022, the building will be twelve years old, and the accumulated depreciation will be 12×$160,000, or $1,920,000. The book value of the building (defined as original cost less accumulated depreciation) will be $2,080,000.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-81

Q3-13.

(a)

(b)

Q3-14.

Q3-15.

Jan. 1

Cash (+A) Subscriptions received in advance (+L) To record receipt of two-year subscriptions. Jan. 31

Subscriptions received in advance (-L) Subscriptions revenue (+R,+SE) To record subscription revenue earned during January ($9,720/24 = $405).

Jan. 31

Jan. 31

9,720 9,720

405 405

Wages expense (+E, -SE) Wages payable (+L) To record unpaid wages for Jan. 30–31 [($475/5)  2 = $190].

190

Interest receivable (+A) Interest income (+R,+SE) To record interest earned during January.

360

190

360

Q3-16.

The temporary accounts—sometimes called nominal accounts—are closed at year-end. They consist principally of the income statement accounts (expense and revenue accounts). (The Income Summary account and the Dividend account are also closed if they are used.)

Q3-17.

Step 1) Step 2)

Q3-18.

Close revenue accounts: Debit each revenue account for an amount equal to its balance, and credit the Retained Earnings account for the total of revenues. Close expense accounts: Credit each expense account for an amount equal to its balance, and debit the Retained Earnings account for the total of expenses.

A post-closing trial balance ensures that an equality of debits and credits has been maintained throughout the adjusting and closing procedures and that the general ledger is in balance to start the next period. Only balance sheet accounts appear in a post-closing trial balance. Depreciation Expense and Supplies Expense are temporary accounts that should have been closed and should not appear in the post-closing trial balance.

©Cambridge Business Publishers, 2020 4-82

Financial Accounting, 6th Edition

Q3-19.

The cost principle and the matching concept support Dehning's handling of its catalog costs. Prepaid Catalog Costs is an asset account that is initially recorded at the amount that the catalogs cost Dehning. This is consistent with the cost principle that states that assets are initially recorded at the amounts paid to acquire the assets. The catalogs help Dehning generate sales revenues. The matching concept states that the catalog costs should be matched as expenses with the revenues they help generate. Dehning does this by expensing the catalog costs over their estimated useful lives.

Q3-20.

(a)

Supplies Expense ($825 + $260 − $630 = $455) for the period is omitted from the income statement, overstating net income by $455 (ignoring taxes).

(b)

Both Supplies and Owners' Equity are overstated by $455 on the January 31 balance sheet (again, before considering taxes).

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-83

MINI EXERCISES M3-21. (45 minutes) LO 2 a. Balance Sheet Cash Asset

Transaction June 1.

June 2.

June 3

June 6.

Invested $12,000 cash.

Paid $950 cash for June rent.

+

=

Cash

Contrib. Capital

+ Earned Capital

+6,400 Office Equipment

-1,800

+3,800

Cash

Supplies

Accounts Receivable

-3,250

Cash

Accounts Receivable

June 19. Paid $3,000 on office equipment account.

-3,000

+950 - Rent Expense =

-950

+6,400 -

=

-

=

Service Fees Earned

=

-

=

-

=

-

=

+2,000 Accounts = Payable

+4,700 Retained Earnings

=

+4,700

=

-900

+4,700

-900 =

Retained Earnings

=

Retained Earnings

=

Retained Earnings

-350

-350

Cash

5,750

Net Income

=

-950

= Accounts Payable

Cash

TOTALS

=

-3,000

Cash

-2,500

Expenses

Retained Earnings

Accounts = Payable

+4,700

June 30. Paid $2,500 salaries.

-

-

=

+3,250

of

Revenues

Common Stock

-950 Cash

June 17. Collected $3,250 on accounts.

June 30. Paid $350 utilities.

+

+12,000

June 11. $4,700 billed for services.

June 25. Paid cash dividend $900.

= Liabilities

+12,000

Purchased $6,400 of office equipment on account. Purchased $3,800 of supplies; $1,800 cash, $2,000 on account.

Noncash Assets

Income Statement

+350 -

Utilities Expense

-

Salaries Expense

=

-

3,800

=

-2,500

Cash +

11,650

=

5,400

©Cambridge Business Publishers, 2020 4-84

+

12,000

+

0

=

+2,500

4,700

-350

-2,500

900

Financial Accounting, 6th Edition

b.

June

1

2

3

6

11

17

19

25

30

30

Cash (+A) Common stock (+SE) Owner invested cash for stock. Rent expense (+E, -SE) Cash (-A) Paid June rent.

12,000 12,000

950 950

Office equipment (+A) Accounts payable (+L) Purchased office equipment on account.

6,400

Supplies (+A) Cash (-A) Accounts payable (+L) Purchased $3,800 of supplies; paid $1,800 down with balance due in 30 days.

3,800

Accounts receivable (+A) Service fees earned (+R,+SE) Billed clients for services.

4,700

Cash (+A) Accounts receivable (-A) Collections from clients on account.

3,250

Accounts payable (-L) Cash (-A) Payment on account.

3,000

6,400

1,800 2,000

4,700

3,250

3,000

Retained earnings (-SE) Cash (-A) Issued dividends.

900

Utilities expense (+E, -SE) Cash (-A) Paid utilities bill for June.

350

Salaries expense (+E, -SE) Cash (-A) Paid salaries for June.

2,500

Solutions Manual, Chapter 4

900

350

2,500

©Cambridge Business Publishers, 2020 4-85

c.

+ June 1 17

+ June 11

Cash (A) 12,000 950 3,250 1,800 3,000 900 350 2,500

+ June 2 6 19 25 30 30

Accounts Receivable (A) 4,700 3,250 June 17

-

Common Stock (SE) + 12,000

June 1

June 6

+ June 3 June 19

Service Fees Earned (R) 4,700

+ June 11

June 30

+ June 30

©Cambridge Business Publishers, 2020 4-86

-

Office Equipment (A) 6,400

-

Accounts Payable (L) + 3,000 6,400 2,000

June 3 June 6

-

Retained Earnings (SE) 900

+

+

Rent Expense (E) 950

-

+

Utilities Expense (E) 350

-

June 25

June 2

-

Supplies (A) 3,800

Salaries Expense (E) 2,500

-

Financial Accounting, 6th Edition

M3-22. (45 minutes) LO 2 a. Balance Sheet Transaction April 1

April 2

April 3

April 3

April 4

April 7

Cash Asset

Invested $9,000 in cash.

+9,000

Paid $2,850 cash for lease.

-2,850

+

Noncash Assets

Contrib. Capital

+ Earned Capital

-

Expenses

=

Net Income

Common Stock

-

=

-

=

-

=

-

=

-

=

+2,850 Prepaid Van = Lease

Cash

+10,000

Purchased $5,500 equipment for $2,500 cash with rest on account.

-2,500

+5,500

Cash

Equipment

Paid $4,300 cash for supplies.

-4,300

+4,300

Cash

Supplies

Paid $350 cash for ad.

-350

= Note Payable

Cash

+3,000

=

Accounts Payable

= -350 =

Cash

April 21 Billed $3,500 for services

Accounts Receivable

April 23 Paid $3,000 cash on account.

-3,000

April 28 Collected $2,300 on account.

+2,300

-2,300

Cash

Accounts Receivable

April 29 Paid $1,000 cash dividend.

-1,000

April 30 Paid $1,750 cash for wages.

-1,750

+350 - Ad.

Retained Earnings

+3,500

+3,500 =

Retained Earnings

Expense

-350

=

+3,500 Cleaning Fees Earned

=

-

=

-

=

-

=

+3,500

-3,000 =

Cash

Accounts Payable

=

-1,000

Cash

=

Retained Earnings

=

Retained Earnings

=

Retained Earnings

-1,750

Cash -995

+1,750 -

Wages Expense

-

Van Fuel Expense

-

3,095

-995

Cash 4,555

Revenues

+9,000

+10,000

TOTALS

+

=

Cash

Borrowed $10,000.

April 30 Paid $995 cash for gas.

= Liabilities

Income Statement

+

13,850

Solutions Manual, Chapter 4

=

10,000

+

9,000

+

-595

=

-1,750

+995

3,500

= =

©Cambridge Business Publishers, 2020 4-87

-995

405

b.

April

1

2

Cash (+A) Common stock (+SE) Owner invested cash for stock.

9,000

Prepaid van lease (+A)

2,850

9,000

Cash (-A)

2,850

Paid six months' lease on van. 3

3

4

7

21

23

Cash (+A) Notes payable (+L) Borrowed money from bank for one year at 10% interest.

10,000 10,000

Equipment (+A) Cash (-A) Accounts payable (+L) Purchased $5,500 of equipment; paid $2,500 down with balance due in 30 days.

5,500

Supplies (+A) Cash (-A) Purchased supplies for cash.

4,300

Advertising expense (+E, -SE) Cash (-A) Paid for April advertising.

2,500 3,000

4,300 350 350

Accounts receivable (+A) Cleaning fees earned (+R, +SE) Billed customers for services.

3,500

Accounts payable (-L) Cash (-A)

3,000

3,500

3,000

Payment on account. 28

29

30

30

Cash (+A) Accounts receivable (-A) Collections from customers on account.

2,300

Retained earnings (-SE) Cash (-A) Issued cash dividends.

1,000

Wages expense (+E, -SE) Cash (-A) Paid wages for April.

1,750

Van fuel expense (+E, -SE) Cash (-A) Paid for gasoline used in April.

©Cambridge Business Publishers, 2020 4-88

2,300

1,000

1,750 995 995

Financial Accounting, 6th Edition

c. + April 1 3 28

+

Cash (A) 9,000 2,850 10,000 2,500 2,300 4,300 350 3,000 1,000 1,750 995

April 4

Supplies (A) 4,300

April 23

Accounts Payable (L) 3,000 3,000

-

Common Stock (SE) 9,000

+ April 7

Van Fuel Expense (E) 995

Solutions Manual, Chapter 4

Accounts Receivable (A) 3,500 2,300

April 21

+

Prepaid Van Lease (A) 2,850

April 2 + April 3

-

-

+ April 3

-

-

-

April 3

+

Cleaning Fees Earned (R) + 3,500 April 21

+ April 30

-

Retained Earnings (SE) 1,000

April 1

-

Equipment (A) 5,500

April 28

Notes Payable (L) + 10,000

April 29

+

Advertising Expense (E) 350

+ April 30

+ April 2 3 4 7 23 29 30 30

Wages Expense (E) 1,750

-

-

©Cambridge Business Publishers, 2020 4-89

M3-23. (20 minutes) LO 2, 3 a. Balance Sheet Cash Asset

Transaction 1. Received $20,100 in advance for contract work.

Jan. 1

+

Noncash Assets

= Liabilities

+20,100

Income Statement +

Contrib. Capital +

Earned Capital

Revenues

-

Expenses

=

Net Income

+20,100

Cash

Unearned = Service Fees

-

Cash (+A) Unearned service fees (+L) To record fee received in advance.

=

20,100 20,100

b. Balance Sheet Transaction

Cash Asset

+

Noncash Assets

2. Adjusting entry for work completed by Jan. 31.

= Liabilities

Income Statement +

Contrib. Capital +

-3,350

Earned Capital +3,350

Unearned = Service Fees

Retained Earnings

Revenues

-

Expenses

=

Net Income

+3,350 Service

Fees

Jan. 31 Unearned service fees (-L) Service fees (+R, +SE) To reflect January service fees earned on contract ($20,100/6 = $3,350).

-

=

+3,350

3,350 3,350

c. Balance Sheet Transaction 3. Adjusting entry for fees earned but not billed.

Jan. 31

Cash Asset

+

Noncash Assets

= Liabilities

Income Statement +

Contrib. Capital +

Earned Capital

+570

+570

Fees Receivable

Retained Earnings

=

Fees receivable (+A) Service fees (+R, +SE) To record unbilled service fees earned at January 31.

©Cambridge Business Publishers, 2020 4-90

Revenues

-

Expenses

=

Net Income

=

+570

+570 Service

Fees

-

570 570

Financial Accounting, 6th Edition

M3-24. (15 minutes) LO 3, 6 1. Balance Sheet Cash Asset

Transaction

+

1. Adjusting entry for prepaid insurance

Noncash Assets

= Liabilities

Income Statement +

Contrib. Capital +

-185

Earned Capital

Revenues

-

-185

Prepaid Insurance

=

Net Income

=

-185

+185

Retained Earnings

=

Expenses

-

Jan. 31 Insurance expense (+E, -SE) Prepaid insurance (-A) To record January insurance expense ($6,660/36 = $185).

Insurance Expense

185 185

2. Balance Sheet Cash Asset

Transaction

+

2. Adjusting entry for supplies used

Jan.

31

Noncash Assets

= Liabilities

Income Statement +

Contrib. Capital +

Earned Capital

Revenues

-

Expenses

-

-1,080

-1,080

+1,080

Supplies Inventory

Retained Earnings

Supplies Expense

=

Supplies expense (+E, -SE) Supplies inventory (-A) To record January supplies expense ($1,930 − $850 = $1,080).

=

Net Income

=

-1,080

1,080 1,080

3. Transaction

Cash Asset

+

Noncash Assets

3. Adjusting entry for deprecia-tion of equipment.

-

-

Balance Sheet Contra Liabil= Assets ities

Income Statement +

Contrib. Capital

+62 Accum. Deprecn.

+

Earned Capital

Revenues

-62 Retained Earnings

Jan. 31 Depreciation expense—Equipment (+E, -SE) 62 Accumulated depreciation—Equipment (+XA, -A) To record January depreciation on office equipment ($5,952/96 = $62).

-

Expenses

=

-

+62 Deprec. Expense

=

62

Continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-91

Net Income -62

4. Balance Sheet Transaction

Cash Asset

+

Noncash Assets

4. Adjusting entry for rent

= Liabilities

Income Statement Contrib. Capital +

+

Earned Capital

-875 Unearned = Rent Liability

Revenues

+875

+875

Retained Earnings

Rent Revenue

Jan. 31 Unearned rent liability (-L) Rent revenue (+R, +SE) To record portion of advance rent earned in January.

-

Expenses

-

=

Net Income

=

+875

875 875

5. Balance Sheet Transaction

Cash Asset

+

Noncash Assets

5. Adjusting entry for accrued salaries

= Liabilities

=

Income Statement Contrib. Capital +

+

Earned Capital

Revenues

-

Expenses

-

+490

-490

+490

Salaries Payable

Retained Earnings

Salaries Expense

Jan. 31 Salaries expense (+E, -SE) Salaries payable (+L) To record accrued salaries at January 31.

=

Net Income

=

-490

490 490

M3-25. (15 minutes) LO 2, 3, 6 (All amounts in thousands of Mexican pesos.) a. Balance Sheet Transaction Inventory purchases (total)

Cash Asset

+

Noncash Assets

=

+78,023,979 Inventory

Liabilities

Income Statement +

Contrib. Capital +

Revenues

-

Expenses

=

Net Income

+78,023,979 =

Accounts Payable

Inventories (+A)……………………………………. Accounts payable (+L)……………………… To record total purchases made at various dates. b.

Earned Capital

-

=

78,023,979 78,023,979

Beginning AP balance + Purchases – Payments = Ending AP balance. So, $15,210,743 + $78,023,979 - Payments = $22,535,802. Thus, Payments = $70,698,920.

©Cambridge Business Publishers, 2020 4-92

Financial Accounting, 6th Edition

c. Balance Sheet Transaction

Cash Asset

Adjusting entry for cost of goods sold for 2013.

+

Noncash Assets

= Liabilities

Income Statement +

Contrib. Capital + Earned Capital Revenues

–73,387,487 Inventory

=

-

Expenses

Net Income

=

–73,387,487

+73,387,487

Retained Earnings

- Cost of Goods = Sold

–73,387,487

* Beginning Inv balance + Purchases – Cost of goods sold = Ending Inv balance. So, $13,849,931 + $78,023,979 – COGS = $18,486,423. Thus, COGS = $73,387,487

Cost of goods sold (+E, -SE)…………………................... Inventories (-A)………………………………… To record cost of goods sold for the year ended 12/31/2017.

73,387,487 73,387,487

(Note: the COGS figure can be verified from the firm’s financial statements. Purchases cannot be so determined, but could be established by working backwards. See M3-29.)

M3-26. (15 minutes) LO 4 ARCHITECT SERVICES COMPANY Statement of Stockholders’ Equity For Year Ended December 31, 2018

Common Stock Balance at December 31, 2017 .................................... $30,000 Stock issuance ..........................................................

Retained Earnings $18,000

6,000

Dividends..................................................................

Total Stockholders’ Equity $48,000 6,000

(9,700)

(9,700)

_____

29,900

29,900

Balance at December 31, 2018 .................................... $36,000

$38,200

$74,200

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

M3-27. (5 minutes) LO 5 Ending balance = Beginning balance + Credit from closing revenue – Debit from closing expenses: $137,600 = $99,000 + $347,400 - $308,800

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-93

M3-28. (15 minutes) LO 5 a.

Date 2018 Desc ription Debit Credi t Dec.

31

31

Commissions revenue (-R) Retained earnings (+SE) To close the revenue account. Retained earnings (-SE) Wages expense (-E) Insurance expense (-E) Utilities expense (-E) Depreciation expense (-E) To close the expense accounts.

84,900 84,900 55,900 36,000 1,900 8,200 9,800

Closing the revenue and expense accounts into retained earnings has the effect of increasing the retained earnings balance by an amount equal to net income (revenue minus expenses). The balance of Smith’s Retained Earnings after closing entries are posted is: $101,100 credit ($72,100 + $84,900 - $55,900). b. + Bal. Bal. + Bal. Bal. + Bal. Bal.

Wages Expense (E) 36,000 36,000 0

-

+ (2) Dec. 31

Bal. Bal.

(2) Dec. 31

(1) Dec. 31

Depreciation Expense (E) 9,800 9,800 (2) Dec. 31 0

(2) Dec. 31

Insurance Expense (E) 1,900 1,900 0

©Cambridge Business Publishers, 2020 4-94

-

Utilities Expense (E) 8,200 8,200 0

(2) Dec. 31

- Commissions Revenue (R) + 84,900 84,900 0 - Retained Earnings (SE) + 55,900 72,100 84,900 101,100

Bal. Bal.

Bal. (1) Dec.31 Bal. Dec.31

Financial Accounting, 6th Edition

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-95

M3-29. (30 minutes) LO 2, 3, 6 (All amounts in $ millions.) a. Balance Sheet Transaction

Cash Asset

Recognize cost of goods sold

+ Noncash Assets = Liabilities

Income Statement +

Contrib. Capital + Earned Capital Revenues

-111,934 Merchandise Inventory

-

-111,934 =

=

+111,934 - Cost of Goods = Sold

Retained Earnings

Cost of goods sold (+E,-SE) ....................................................................................

Expenses

Net Income -111,934

111,934

Merchandise Inventory(-A)................................................................................

111,934

To recognize the cost of goods sold. b.

Beginning Inv balance + Purchases – Cost of goods sold = Ending Inv balance. So $11,461 + Purchases - $111,934 = $16,047. Thus purchases = $116,520 Balance Sheet

Transaction Recording inventory purchases.

Cash Asset

+ Noncash Assets = Liabilities +116,520 Merchandise Inventory

Income Statement +

Contrib. Capital + Earned Capital Revenues

-

Expenses

=

Net Income

+116,520 =

-

Account Payable

Merchandise inventory(+A)..................................................................................... Accounts payable (+L) ......................................................................................

=

116,520 116,520

To recognize the purchases on account. c.

Beginning AP balance + Purchases – Payments = Ending AP balance So, $25,309 + $116,520 - Payments = $34,616. Thus, Payments = $107,213

©Cambridge Business Publishers, 2020 4-96

Financial Accounting, 6th Edition

M3-30 (10 minutes) LO 2, 3, 5 a. Balance Sheet Transaction a.

Cash Asset

+

Dec. 31 Interest earned.

Noncash Assets

= Liabilities

Income Statement +

+600 Interest Receivable

=

Contrib. Capital + Earned Capital Revenues +600

+600

Retained Earnings

Interest Income

-

Dec.31 Interest receivable (+A) Interest income (+R, +SE) To record accrued interest income. b.

Dec. 31

Expenses

=

Net Income

=

+600

600 600

Interest income (-R) Retained earnings (+SE) To close the Interest Income account.

2,400 2,400

c. Balance Sheet Transaction

Cash Asset

c.

+900

-600

Cash

Interest Receivable

Jan. 31 Receipt of $900 interest

+

Noncash Assets

= Liabilities =

2019 Jan. 31 Cash (+A) Interest income (+R, +SE) Interest receivable (-A) 600 To record cash receipt of interest.

Solutions Manual, Chapter 4

Income Statement +

Contrib. Capital + Earned Capital Revenues +300

+300

Retained Earnings

Interest Income

-

Expenses

-

=

Net Income

=

+300

900 300

©Cambridge Business Publishers, 2020 4-97

EXERCISES E3-31. (30 minutes) LO 5 a.

Dec.

31

31

Service fees earned (-R) Retained earnings (+SE) To close the revenue account.

80,300 80,300

Retained earnings (-SE) Rent expense (-E) Salaries expense (-E) Supplies expense (-E) Depreciation expense (-E) To close the expense accounts.

82,300 20,800 45,700 5,600 10,200

b. + Bal. Bal.

Rent Expense (E) 20,800 20,800 0

+ (2)

Bal. Bal. + Bal. Bal.

+ Bal. Bal. (2)

Salaries Expense (E) 45,700 45,700 0

-

Retained Earnings (SE) 82,300 67,000 80,300 65,000

+

(2)

(1)

Supplies Expense (E) 5,600 5,600 0 Depreciation Expense (E) 10,200 10,200 0

Service Fees Earned (R) + 80,300 80,300 0

(2)

(2)

Bal. Bal.

Bal. (1) Bal.

Brooks Consulting earned a loss during the period (expenses exceeded revenues by €2,000), so the ending retained earnings is lower than the beginning retained earnings (even though no dividends were paid).

©Cambridge Business Publishers, 2020 4-98

Financial Accounting, 6th Edition

E3-32. (30 minutes) LO 3 a. Income Statement

Balance Sheet Transaction

Cash Asset

Noncash + Assets

-

1. Adjusting entry for depreciateion: equipment.

-

2. Adjusting entry for utilities expense.

-

-700

=

+

+

-

+300

-610

=

+390

-390

Utilities Payable

Retained Earnings

=

+

-400

-

Expenses

-

+610

=

=

-

-

-

+468

+468

Retained Earnings

Premium Revenue

-965 Retained Earnings

=

-

610

=

887

+

0

Depreciation expense—Equipment (+E,-SE) Accumulated depreciation—Equip (+XA, -A) To record depreciation for the period.

+

=

-610

+390

=

-390

+700

=

-700

=

+468

=

-965

=

+300

=

-1,897

Rent Expense

-468

+965

-

-

+965 Wages Expense

+300

+300

Retained Earnings

Interest Income

-1,897

768

-

-

2,665

610 610

2. Utilities expense (+E, - SE) Utilities payable (+L) To record accrued utilities expense.

390

3. Rent expense (+E,-SE) Prepaid rent (-A) To record rent expense for the month ($2,800/4 = $700).

700

4. Contract liabilities (-L) Premium revenue (+R,+SE) To record premium revenue earned [($624/12)  9 = $468].

468

390

700

468

Continued next page

Solutions Manual, Chapter 4

Net Income

Utilities Expense

Contract Liabilities

Wages Payable

=

Depreciation Expense

-700

Interest Receiv-able 0

Revenues

Retained Earnings

5. Adjusting entry for wage expense. 6. Adjusting entry for interest earned.

Earned Capital

Retained Earnings

Prepaid Rent -

1.

+610

-

4. Adjusting entry for premium revenues.

b.

= Liabilities

Contrib. Capital

Accum. Depreciation

3. Adjusting entry for rent expense.

TOTALS

Contra Assets

©Cambridge Business Publishers, 2020 4-99

b.

continued 5. Wages expense (+E,-SE) Wages payable (+L) To record accrued wages at the end of the period.

965

6. Interest receivable (+A) Interest income (+R,+SE) To accrue interest earned but not yet received.

300

965

300

E3-33. (15 minutes) LO 2, 3, 5 a. Balance Sheet Cash Asset

Transaction a.

+

Noncash Assets

Adjusting entry for salaries expense.

= Liabilities =

Income Statement +

Contrib. Capital + Earned Capital Revenues

Expenses

-

+4,700

-4,700

+4,700

Salaries Payable

Retained Earnings

Salaries Expense

2018 Dec.31 Salaries expense (+E,-SE) Salaries payable (+L) To record accrued salaries payable.

b.

-

=

Net Income -4,700

=

4,700 4,700

31 Retained earnings (-RE)

250,000

Salarie To close the Salaries Expense account. c. Balance Sheet Cash Asset

Transaction c.

Paid salaries.

Noncash Assets

= Liabilities

-12,000 Cash

2019 Jan.

+

=

+

Contrib. Capital + Earned Capital Revenues

+4,700

-7,300

Salaries Payable

Retained Earnings

7 Salaries payable (-L) Salaries expense (+E,-SE) Cash (-A) To record payment of salaries.

©Cambridge Business Publishers, 2020 4-100

Income Statement -

Expenses

-

Salaries Expense

=

+7,300

Net Income -7,300

=

4,700 7,300 12,000

Financial Accounting, 6th Edition

E3-34. (20 minutes) LO 3, 6 Balance, January 1 = $960 + $800 − $620 = $1,140.

a. b.

Amount of premium = $82  12 = $984. Therefore, five months' premium ($984 − $574 = $410) has expired by January 31. The policy term began on and has been in effect since September 1, 2018.

c.

Wages paid in January = $3,200 − $500 = $2,700.

d.

Monthly depreciation expense = $8,700/60 months = $145. Fields has owned the truck for 18 months ($2,610/$145 = 18).

E3-35. (30 minutes) LO 2, 3, 6 a. Balance Sheet Transaction 1.7/31

Cash Asset

+ Noncash Assets =

Adjusting entry for rent expense.

-475 Prepaid

2. 7/31 Adjusting entry for ad. expense.

Liabilities

Income Statement +

Contrib. Capital + Earned Capital

=

-475

Rent

-210

Revenues

=

+475

=

-475

=

-210

=

-1,900

-

=

+800

-1,900

-

=

+300

=

-1,485

-

+800

+800

Fees Receivable

Retained Earnings

Refinish. Revenue

-300

+300

+300

Performance Obligation Liability

Retained Earnings

Refinish. Revenue

-1,485

1,100

Retained Earnings

5. 7/31 Adjusting entry for fees revenue. =

-300

+

0

+

+210 Advertising Expense

+800

Solutions Manual, Chapter 4

-

Retained Earnings

4. 7/31 Adjusting entry for fees revenue.

-1,785

Net Income

-

-1,900 Supplies Inventory

+

=

Rent Expense

- 210

Prepaid Advertising

0

Expenses

Retained Earnings

3. 7/31 Adjusting entry for supplies expense.

TOTALS

-

+1,900 Supplies Expense

-

2,585

©Cambridge Business Publishers, 2020 4-101

b.

July

31

31

31

31

31

Rent expense (+E,-SE) Prepaid rent (-A) To record July rent expense ($5,700/12 = $475).

475 475

Advertising expense (+E,-SE) Prepaid advertising (-A) To record July advertising expense ($630/3 = $210).

210

Supplies expense (+E,-SE) Supplies inventory (-A) To record supplies expense for July ($3,000 − $1,100 = $1,900).

1,900

Fees receivable (+A) Refinishing fees revenue (+R,+SE) To record unbilled revenue earned during July.

800

Performance obligation liability (-L) Refinishing fees revenue (+R,+SE) To record portion of advance fees earned in July ($600/2 = $300).

300

210

1,900

800

300

c. + Prepaid Rent (A)

-

Bal.

5,700

475

Bal.

5,225

Bal. Bal.

+ Prepaid Advertising (A) 630 210 420

+ Supplies (A) (1)

(2)

Bal.

3,000

Bal.

1,100

(5)

+ Fees Receivable (A) (4)

(3)

- Performance Obligation Liability (L) + 300 600 Bal. 300 Bal. - Refinishing Fees Revenue (R) +

800

2,500 800 300 3,600 +

Supplies Expense (E)

(3)

-

Advertising Expense(E) -

(2)

210

+ (1)

Bal. (4) (5) Bal.

1,900

+

©Cambridge Business Publishers, 2020 4-102

1,900

Rent Expense (E)

-

475

Financial Accounting, 6th Edition

E3-36. (30 minutes) LO 2, 3, 6 (All amounts in $ thousands.) a. Balance Sheet Cash Asset

Transaction Recognize inventory purchases

+

Noncash Assets

= Liabilities

+1,433,446 Inventory

Income Statement +

Contrib. Capital + Earned Capital Revenues

-

Expenses

=

Net Income

+1,433,446 =

Accounts Payable

-

Inventory (+A) .........................................................................................................

=

1,433,446*

Accounts payable (+L) .......................................................................................

1,433,446

To recognize inventory purchases. * Beginning Inv balance + Purchases – Cost of goods sold = Ending Inv. So, $399,795 + Purchases $1,408,848 = $424,393. Thus, purchases = $1,433,446 b.

Beginning compensation payable + Compensation expense – Compensation paid = Ending compensation payable, so $37,235 + $650,000 – Payments = $65,045 Payments = $622,190

c.

The balances of accrued compensation on February 3, 2018 and January 28, 2017 are reported as a current liability.

E3-37. (30 minutes) LO 5 a.

Dec.

31

31

Service fees revenue (-R) Interest income (-R) Retained earnings (+SE) To close the revenue accounts.

92,500 2,200

Retained earnings (-SE) Salaries expense (-E) Advertising expense (-E) Depreciation expense (-E) Income tax expense (-E) To close the expense accounts.

64,700

Solutions Manual, Chapter 4

94,700

41,800 4,300 8,700 9,900

©Cambridge Business Publishers, 2020 4-103

b. - Retained Earnings (SE) + 64,700 42,700 94,700 72,700

(2)

Bal. (1) Bal.

- Service Fees Revenue (R) + 92,500 92,500 0 - Interest Income (R) + 2,200 2,200 0

(1)

(1)

+ Salaries Expense (E) 41,800 41,800 0 + Depreciation Expense (E) 8,700 8,700 0

Bal. Bal. Bal. Bal.

(2)

Bal. Bal.

(2)

Bal. Bal.

Bal. Bal. Bal. Bal.

+ Advertising Expense (E) 4,300 4,300 0 + Income Tax Expense (E) 9,900 9,900 0

(2)

(2)

E3-38. (15 minutes) LO 2, 3, 6 a. Balance Sheet Transaction (1) Collect deposits from customers.

Cash Asset +200,000 Cash

(2) Recognize income on completed customer orders.

+565,387 Cash

(1)

+

Noncash Assets

= =

Liabilities +200,000 Customer Deposits

=

-197,998 Customer Deposits

Income Statement +

Contrib. Capital

Cash (+A) ………………………………………………

+ Earned Capital

+763,385 Retained Earnings

Revenues

-

+763,385 Sales Revenue

-

Expenses

= =

=

200,000

Customer deposits* (+L) ………………………

200,000

To record unearned customer deposits.

(2)

Customer deposits* (-L) ..........................................................................................197,998 ** Cash (+A)…………………………………………………

565,387

Sales revenue (+R, +SE) ....................................................................................

763,385

To record sales revenue and recognized deposits earned. * Also sometimes called Unearned Customer Deposits ** $60,958 + $200,000 – Deposits earned = $62,960; Deposits earned = $197,998.

©Cambridge Business Publishers, 2020 4-104

Financial Accounting, 6th Edition

Net Income

+763,385

b. Balance Sheet Transaction

Cash Asset

Record inventory purchases

+

Noncash Assets

= Liabilities

+330,822 Inventory

Income Statement +

Contrib. Capital + Earned Capital Revenues

-

Expenses

=

Net Income

+330,822 =

Accounts Payable

-

Inventory (+A) ......................................................................................................

=

330,822

Accounts Payable (+L) ...................................................................................

330,822

To recognize inventory purchases. BI +Purchases – EI = COGS. So $162,323 + Purchases - $149,483 = $343,662. Thus: Cost of acquiring inventory =$330,822 c.

Customer Deposits are reported as a current liability.

E3-39. (40 minutes) LO 4, 5 a. SOLOMON CORPORATION Income Statement For Year Ended December 31, 2018 Service fees revenue ....................................................................................................................

$71,000

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

(18,000)

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

(37,100)

Depreciation expense……………………………….……………..

(7,000)

Net income .................................................................................................................................. SOLOMON CORPORATION Statement of Stockholders’ Equity For Year Ended December 31, 2018 Common Retained Stock Earnings Balance at December 31, 2017 .................................... $43,000 $20,600*

$ 8,900

Total Stockholders’ Equity $63,600

Stock issuance ............................................................. Dividends.....................................................................

(8,000)

(8,000)

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

_______

8,900

8,900

Balance at December 31, 2018 ....................................

$43,000

$21,500

$64,500

*12,600 + 8,000 The dividend was paid and debited to retained earnings prior to the end of the period. continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-105

a.

continued SOLOMON CORPORATION Balance Sheet December 31, 2018

Assets

Liabilities

Cash

$ 4,000

Accounts receivable Equipment Less:Accumulated depreciation

6,500

Notes payable

$10,000

Total Liabilities

10,000

$78,000 14,000

Total Assets

64,000

$74,500

Owners’ Equity Common stock

43,000

Retained earnings

21,500

Total Liabilities and Owners’ Equity

$74,500

b. 1.

2.

3.

4.

Service fees revenue (-R) ....................................................................................... 71,000 Retained earnings (+SE) ...................................................................................

71,000

Retained earnings (-SE) ......................................................................................... 18,000 Rent expense (-E) .............................................................................................

18,000

Retained earnings (-SE) ......................................................................................... 37,100 Salaries expense (-E) ........................................................................................

37,100

Retained earnings (-SE) ......................................................................................... 7,000 Depreciation expense (-E) ...............................................................................

7,000

The cash dividend has already been paid and is already reflected in the adjusted trial balance. c.

Only the T-accounts affected by closing process are shown here.

Bal. Bal

+ Depreciation Expense (E) 7,000 7,000 0

Bal. Bal.

+ Salaries Expense (E) 37,100 37,100 0

(4)

(1)

+ (3)

Bal. Bal

(2-4)

©Cambridge Business Publishers, 2020 4-106

- Service Fees Revenue (R) + 71,000 71,000 0

Bal. Bal.

Rent Expense (E) 18,000 18,000 0

- Retained Earnings (SE) + 62,100 12,600 71,000 21,500

(2)

Bal. (1)

Financial Accounting, 6th Edition

Bal.

PROBLEMS P3-40. (90 minutes) LO 2, 3, 6 a., b. &d. +

Cash (A)

Apr. 1 5 18

11,500 1,800 4,900

Bal.

+

2,880 6,100 1,000 675

Apr. 1 2 2 29

100 2,500

30 30

4,945 +

Prepaid Insurance (A) 2,880 2,880 120 2,760

Apr. 1 Unadj. bal. Adj bal. + Apr. 2 Bal.

-

+ Apr. 30 Adj. Bal. + Apr. 30 Bal.

-

Equipment (A) 3,100 3,100

5,500 4,000 4,600

Bal. +

4,900

Apr. 18

Supplies (A) 1,200 1,200 800 400

Apr. 5 Unadj. bal. Adj. bal. +

(d) Apr. 30

Apr. 2 Bal.

-

-

Apr. 12 30 Unadj. bal. (d) 30

9,950

Adj. Bal.

Advertising Expense (E) 100 100

Apr. 12 30

-

(d) Apr. 30

-

Roofing Fees Revenue (R) 5,500 4,000 9,500 450

Supplies Expense (E) (d) 800 800

Accounts Receivable (A)

+

Accounts Payable (L) 2,100 1,200 3,300 -

Apr. 30

-

-

-

Contract Liability (L) 1,800 (d) 450 1,800 1,350

-

+ Apr. 2 5 Bal. + Apr. 5 Unadj. bal Adj. Bal

Common Stock (SE) 11,500 11,500 +

Apr. 29 Bal.

Trucks (A) 6,100 6,100

Fuel Expense (E) 675 675

+ Apr. 1 Bal. -

continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-107

a.

continued +

Insurance Expense (E) (d) 120 120

Apr. 30 Adj. Bal.

-

+ Apr. 30 Bal.

Wages Expense (E) 2,500 2,500

-

+ Depreciation Expense – Equip. (E) Apr. 30 (d) 35 Adj. Bal. 35

- Accumulated Deprec. – Equip. (XA) + 35 (d) Apr. 30 35 Adj. Bal.

+ Depreciation Expense - Trucks (E) (d) 125 125

- Accumulated Deprec. – Trucks (XA) + 125 (d) Apr. 30 125 Adj. Bal

Apr. 30 Adj. Bal. b.

Balance Sheet Transaction

Cash Asset

4/1

Cash received +11,500 for stock. Cash

4/1

Purchase liability insurance.

4/2

Purchase truck for cash.

-6,100 Cash

4/2

Purchase equipment.

-1,000 Cash

4/5

Purchase supplies on account.

4/5

Cash in advance for roofing repairs.

+

=

Liabilities

+

=

-2,880 Cash

Income Statement Contrib. Capital

+ Earned Capital

+11,500 Common Stock

-

Expenses

= =

=

-

=

+ 6,100 Truck =

-

=

+3,100 Equipment

= +2,100 Accts Payable

-

=

+ 1,200 Supplies

= +1,200 Accts Payable

-

=

=

-

=

+5,500 Roofing Fees Revenue

=

-

=

+1,800 Cash

+1,800 Contract Liability

+5,500 Accts = Receivable +4,900 Cash

Revenues

-

+2,880 Prepaid Insurance

4/12 Bill customers for services. 4/18 Collected cash on account.

Noncash Assets

+5,500 Retained Earnings

-4,900 Accts = Receivable

Net Income

+5,500

4/29 Paid cash for -675 Cash fuel.

=

-675 Retained Earnings

- +675 Fuel = Expense

-675

4/30 Paid cash for -100 Cash ads.

=

-100 Retained Earnings

- +100 Ad. = Expense

-100

4/30 Paid cash wages.

=

-2,500 Retained Earnings

- +2,500 Wages = Expense

-2,500

+4,000 Accounts Receivable

=

+4,000 Retained Earnings

17,880

=

-2,500 Cash

4/30 Bill customers for services. Totals

4,945

+

5,100

+

11,500

+

6,225

+4,000 Roofing Fees Revenue 9,500

-

3,275

=

+4,000

=

6,225

continued next page

©Cambridge Business Publishers, 2020 4-108

Financial Accounting, 6th Edition

b.

continued

Date 2019 Apr. 1

Description

Debit

Credit

Cash (+A) Common stock (+SE) Owner invested cash.

11,500 11,500

1

Prepaid insurance (+A) Cash (-A) Paid two-year premium on liability insurance policy.

2,880 2,880

2

Trucks (+A) Cash (-A) Purchased used truck for $6,100 cash.

6,100

Equipment (+A) Cash (-A) Accounts payable (+L) Purchased ladders and other equipment, $1,000 down with $2,100 balance due in 30 days.

3,100

Supplies (+A) Accounts payable (+L) Purchased supplies on account.

1,200

2

5

5

12

18

29

30

30

30

Cash (+A) Contract liability (+L) Received advance payment for services.

6,100

1,000 2,100

1,200 1,800 1,800

Accounts receivable (+A) Roofing fees revenue (+R,+SE) Billed customers for services. Cash (+A) Accounts receivable (-A) Collection on account from customers. Fuel expense (+E,-SE) Cash (-A) Paid truck fuel bill for April. Advertising expense (+E,-SE) Cash (-A) Paid for April newspaper advertising.

5,500 5,500 4,900 4,900 675 675 100 100

Wages expense (+E, -SE) Cash (-A) Paid wages.

2,500

Accounts receivable (+A) Roofing fees revenue (+R, +SE) Billed customeers for services.

4,000

Solutions Manual, Chapter 4

2,500

4,000

©Cambridge Business Publishers, 2020 4-109

c. LOUGEE ROOFING SERVICE Unadjusted Trial Balance April 30, 2019 Debit $ 4,945 4,600 1,200 2,880 6,100 3,100

Cash Accounts Receivable Supplies Prepaid Insurance Trucks Equipment Accounts Payable Contract liability Common Stock Roofing Fees Revenue Fuel Expense Advertising Expense Wages Expense

Credit

$ 3,300 1,800 11,500 9,500 675 100 2,500 $26,100

$26,100

d. Balance Sheet Transaction

Cash Asset

+

1. Recognize one month of insurance expense.

Noncash Assets

-

-120

-

= Liabilities

Income Statement +

Contrib. Capital

+

=

-800

-

-

=

-

4. Recognize depreciation expense on equipment.

-

5. Recognize roofing fees earned.

-

+125

=

-

+35

-125

=

-450

+450

160

=

-450

+800

+125

-

-120

=

-800

=

-125

+35

=

-35

=

+450

=

-630

Depreciation Expense +450

-

Retained Roofing Fees Earnings Revenue +

0

+

-630

450

-

1,080

continued next page

©Cambridge Business Publishers, 2020 4-110

=

Depreciation Expense

-35

Contract liability -

-

Retained Earnings =

+120

Net = Income

Supplies Expense

Retained Earnings

Accum. Depreciation

Expenses

Insurance Expense

-800

Accum. Depreciation

-920

-

Retained Earnings

3. Recognize depreciation expense – Trucks.

+

Revenues

Retained Earnings

Supplies

0

Earned Capital -120

Prepaid Insurance

2. Recognize supplies expense.

Totals

Contra Assets

Financial Accounting, 6th Edition

d.

continued Description

Debit

Date 2019 April 30 Insurance expense (+E,-SE)

Credit

120

Prepaid insurance (-A)

120

To record April insurance expense ($2,880/24 months = $120). 30

Supplies expense (+E,-SE) Supplies (-A)

800

Depreciation expense—Trucks (+E,-SE) Accumulated depreciation—Trucks (+XA,-A)

125

800

To record April supplies expense ($1,200 − $400 = $800). 30

125

To record April depreciation on trucks. 30

Depreciation expense—Equipment (+E,-SE) Accumulated depreciation—Equipment (+XA,-A)

35 35

To record April depreciation on equipment. 30

Contract liability (-L) Roofing fees revenue (+R,+SE)

450 450

To record portion of advance payment earned in April ($1,800/4 = $450). P3-41. (40 minutes) LO 2, 3 a.

Cash Accounts Receivable Prepaid Rent Prepaid Insurance Supplies Equipment Accounts Payable Performance Obligations Common Stock Photography Fees Revenue Wages Expense Utilities Expense

Solutions Manual, Chapter 4

SNAPSHOT COMPANY Unadjusted Trial Balance December 31, 2018 Debit $2,150 3,800 12,600 2,970 4,250 22,800

Credit

$1,910 2,600 24,000 34,480 11,000 3,420 $62,990

______ $62,990

©Cambridge Business Publishers, 2020 4-111

b. Balance Sheet Transaction 1.

2.

3.

4.

5.

6.

7.

8.

Cash Asset

+

Fees earned but not received.

Noncash Assets

-

+925

-

=

Liabilities

Income Statement +

Contrib. Capital

+

=

Fees Receivable

Recognize depreciatio n expense for one year.

-

Recognize utilities expense.

-

+2,280

=

Accum. Depreciation

Recognize rent expense for year.

-6,300

=

-

-990

-2,730

+

-9,095

+925

-

Retained Earnings

Photo Fees Revenue +2,280 Depreciation Expense

-

-

+2,600 Retained Earnings

=

-

+2,600

-

2,280

©Cambridge Business Publishers, 2020 4-112

=

-375

Wages Payable

Retained Earnings

-1,825

+

0

+

-9,550

+6,300

-

-

-400

= -6,300

= +2,600

+990

=

-990

Insurance Expense

-2,730

+375

=

Photo Fees Revenue

-

Retained Earnings =

= -2,280

Rent Expense

-990

=

+400

+925

Utilities Expense

Retained Earnings -

Net = Income =

-2,280

-6,300

= -2,600 Performance Obligations

Expenses

Retained Earnings

Retained Earnings

-

0

+925

-400

Supplies

Recognize wages expense.

-

Retained Earnings

Prepaid Insurance

Recognize supplies expense.

Revenues

+400

=

-

Recognize insurance expense.

Earned Capital

Utilities Payable

Prepaid Rent

Recognize photo revenues.

Totals

Contra Assets

+2,730

= -2,730

Supplies Expense -

+375

=

-375

Wages Expense 3,525

-

13,075

= -9,550

Financial Accounting, 6th Edition

c.

Date 2018 Dec.31

Description

Debit Credit

Fees receivable (+A) Photography fees revenue (+R, +SE)

925 `

925

To record revenue earned but not billed. 31

Depreciation expense (+E,-SE) Accum. depreciation—Equipment (+XA, -A)

2,280 2,280

To record depreciation for the year ($22,800/10 years = $2,280). 31

Utilities expense (+E, -SE) Utilities payable (+L)

400 400

To record estimated December utilities expense. 31

Rent expense (+E, -SE) Prepaid rent (-A)

6,300 6,300

To record rent expense for the year ($12,600/2 years = $6,300). 31

Performance obligations (-L) Photography fees revenue (+R, +SE)

2,600 2,600

To record advance payments earned during the year. 31

Insurance expense (+E, -SE) Prepaid insurance (-A)

990 990

To record insurance expense for the year ($2,970/3 years = $990). 31

Supplies expense (+E,-SE) Supplies (-A)

2,730 2,730

To record supplies expense for the year ($4,250 − $1,520 = $2,730). 31

Wages expense (+E, -SE) Wages payable(+L)

375 375

To record unpaid wages at December 31.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-113

d. + Cash (A) Unadj. bal. 2,150 Adj. bal. 2,150 + Accounts Receivable (A) Unadj. bal.

3,800

Adj. bal.

3,800

- Accounts Payable (L) + 1,910 Unadj. bal. 1,910 Adj. bal. - Performance Obligations (L) + Dec.31

2,600

Unadj. bal.

0

Adj. bal.

(1) 925

400

(3) Dec.31

925

400

Adj. bal.

+ Fees Receivable (A) Dec. 31 Adj. bal.

- Utilities Payable (L) +

+ Prepaid Rent (A) Unadj. bal. Adj. bal.

12,600

- Wages Payable (L) +

6,300 (4) Dec.31

6,300 + Prepaid Insurance (A) -

Unadj. bal.

2,970

Adj. bal.

1,980

Unadj. bal. Adj. bal.

+ Supplies (A) 4,250 2,730 1,520

Unadj. bal. Adj. bal.

990

(6) Dec.31

(7) Dec.31

+ Equipment (A) 22,800 22,800

+ Supplies Expense (E) Adj. bal.

(7) 2,730 2,730

Adj. bal.

(6) 990 990

©Cambridge Business Publishers, 2020 4-114

(8) Dec.31

375

Adj. bal.

24,000

Unadj. bal.

24,000

Adj. bal.

- Photo Fees Revenue (R) + 34,480 Unadj. bal 925 (1) Dec.31 2,600 (5) Dec.31 38,005 Adj. bal. + Wages Expense (E) Unadj. bal. 11,000 Dec.31 (8) 375 Adj. Bal. 11,375 + Utilities Expense (E) Unadj. bal. 3,420 Dec.31 (3) 400 Adj. Bal. 3,820 + Depreciation Expense – Equip. (E) Dec.31 Adj. Bal.

+ Insurance Expense (E) Dec. 31

375 - Common Stock (SE) +

- Accum. Depreciation – Equip. (XA) + 2,280 (2) Dec.31 2,280 Adj. Bal.

Dec. 31

(5) 2,600

(2) 2,280 2,280 + Rent Expense (E) -

Dec.31 Adj. Bal.

(4) 6,300 6,300

Financial Accounting, 6th Edition

P3-42. (90 minutes) LO 2, 3, 4, 5, 6 a. Balance Sheet Transaction

Cash Asset

+

1. Recognize rent expense.

Noncash Assets -775

2. To recognize supplies expense.

-

Contra Assets

Prepaid Rent

-1,700 Supplies

-

= Liabilities

Earned Capital

Revenues

-

Expenses

Net = Income

=

-775 Retained Earnings

- +775 Rent = Expense

=

-1,700 Retained Earnings

-

=

-74 Retained Earnings

-

+74 = Depreciation Expense

-74

+1,700 Supplies Expense

=

-775

-1,700

3. To recognize depreciation expense.

-

4. To recognize wages expense.

-

= +210 Wages Payable

-210 Retained Earnings

-

+210 Wages = Expense

-210

5. To recognize utilities expense.

-

=

-300 Retained Earnings

- +300 Utilities = Expense

-300

+380 Accounts Receivable

-

=

=

+380

-2,095

-

=

-2,679

6. To recognize fees earned.

Totals

0

+

+74 Accum. Deprec.

Income Statement Contrib. + Capital +

74

+300 Utilities Payable

=

510

+

0

+

+380 Retained Earnings

+380 Service Fees Revenue

-

-2,679

380

-

3,059

b.

Date 2019 June 30

Description

Debit Credit

Rent expense (+E, -SE) Prepaid rent (-A)

775 775

To record June rent expense ($3,100/4 months = $775). 30

Supplies expense (+E, -SE) Supplies (-A)

1,700 1,700

To record June supplies expense (2,520 − $820 = $1,700). 30

Depreciation expense—Equip (+E, -SE) Accum. depreciation—Equipment (+XA, -A)

74 74

To record June depreciation ($4,440/60 months = $74). 30

Wages expense (+E, -SE) Wages payable (+L)

210 210

To record unpaid wages at June 30. 30

Utilities expense (+E, -SE) Utilities payable (+L)

300 300

To record estimated June utilities expense. 30

Accounts receivable (+A) Service fees revenue (+R, +SE)

380 380

To record fees earned but not billed in June.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-115

c. + Cash (A) Unadj. bal 1,180 Adj. bal. 1,180 + Accounts Receivable (A) Unadj. bal Jun. 30 Adj. bal.

- Accounts Payable (L) + 760 760 - Wages Payable (L) +

Unadj. bal Adj. bal.

450

210

(4) Jun.30

(6) 380

210

Adj. bal.

830 - Utilities Payable (L) +

+ Prepaid Rent (A) Unadj. bal

3,100

Adj. bal.

2,325

Adj. bal.

Unadj. bal Adj. bal.

Unadj. bal Adj. bal.

775 (1) Jun.30

Adj. bal.

5,300

Unadj. bal.

- Common Stock (SE) + 2,000

Unadj. bal

775

2,000

Adj. bal.

+ Supplies (A) 2,520 1,700 (2) Jun.30 820 + Equipment (A) 4,440 4,440

Unadj. bal Jun.30 Adj. bal. Jun.30 Adj. bal.

(2) 1,700 1,700

©Cambridge Business Publishers, 2020 4-116

- Service Fees Revenue (R) + 4,650 380 5,030 + Wages Expense (E) 1,020 (4) 210 1,230 + Utilities Expense (E) (5) 300 300

Unadj. bal (6) Jun.30 Adj. bal.

+ Depreciation Expense – Equip.(E) -

+ Supplies Expense (E) Adj. bal.

300

(1) 775

- Accum. Depreciation – Equip.(XA) + 74 (3) Jun.30 74 Adj. Bal.

Jun. 30

(5) Jun.30

- Retained Earnings (SE) +

+ Rent Expense (E) Jun.30

300

Jun.30

(3) 74

Adj. bal.

74

Financial Accounting, 6th Edition

d. MURDOCK CARPET CLEANERS Income Statement For Year Ended June 30, 2019 Revenues Service fees…………………………………….…

$5,030

Expenses Rent expense……………………………………

$ 775

Wages expense…………………………………

1,230

Supplies expense…………………………………

1,700

Utilities expense………………………………….

300

Depreciation expense……………………………

74

Total expenses……………………………………

4,079

Net income………………………………………… .......................................................................... $ 951 MURDOCK CARPET CLEANERS Balance Sheet June 30, 2019

Assets

Liabilities

Cash Accounts receivable Supplies Prepaid rent Equipment Less: Accumulated depreciation

Total Assets

Solutions Manual, Chapter 4

$ 1,180 830 820 2,325 $ 4,440 74

4,366

$9,521

Accounts payable Wages payable

$ 760 210

Utilities payable Total Liabilities

300 1,270

Owners’ Equity Common stock Retained earnings Total Liabilities and Owners’ Equity

2,000 6,251 $9,521

©Cambridge Business Publishers, 2020 4-117

e. 1.

2.

3.

4.

5.

6.

Retained earnings (-SE) ........................................................................................ Rent expense (-E) .............................................................................................

775

Retained earnings (-SE) ......................................................................................... Supplies expense (-E) .......................................................................................

1,700

Retained earnings (-SE) ......................................................................................... Wages expense (-E)..........................................................................................

1,230

Retained earnings (-SE) ......................................................................................... Utilities expense (-E ).......................................................................................

300

Retained earnings (-SE) ......................................................................................... Depreciation expense (-E) ................................................................................

74

Service fees revenue (-R) .......................................................................................

5,030

775

1,700

1,230

300

74

Retained earnings (+SE)...................................................................................

1. 2. 3. 4. 5.

- Retained Earnings (SE) + 5,300 775 1,700 1,230 300 74 5,030 6,251

Bal.

Bal.

+ Rent Expense (E) 775 775 0

1.

Bal.

+ Supplies Expense (E) 1,700 1,700 0

2.

6. Bal.

+ Wages Expense(E) Bal.

Bal.

1,230 0

1,230

+ Depreciation Expense (E) 74 74 0

©Cambridge Business Publishers, 2020 4-118

5,030

+ Utilities Expense (E) 3.

Bal.

5.

6.

300 0

300

4.

- Service Fees Revenue (R) + 5,030 5,030 Bal. 0

Financial Accounting, 6th Edition

P 3-43. (30 minutes) LO 3 a. Balance Sheet Transaction

Cash Asset

+

Noncash Assets

-

Contra Assets

= Liabilities

Income Statement +

Contrib. Capital

+

Earned Capital

Revenues

-

Expenses

= Net Income

1. Accrue salary expense.

-

=

+720 Salaries Payable

-720 Retained Earnings

-

+720 Salaries Expense

=

-720

2. Accrue interest expense.

-

=

+200 Interest Payable

-200 Retained Earnings

-

+200 Interest Expense

=

-200

-

=

+900 Retained Earnings

=

+900

-

=

-400 Retained Earnings

-

+400 Maint. Expense

=

-400

-

=

-300

-

+300 Ad. Expense

=

-300

-

+160 Rent Expense

=

-160

=

+38

3. Accrue fees receivable.

+900 Fees Receivable

4. Accrue maintenance expense.

-400 Prepaid Maintenance

5. Accrue ad. Expense.

-300 Prepaid Advertising

6. Accrue rent expanse. 7. Accrue interest revenue.

+38

Totals

0

+

+238

Solutions Manual, Chapter 4

-

Retained Earnings -

= +160 Rent Payable

-160 Retained Earnings

-

=

+38 Retained Earnings

-

+2,175 = Accum. Depreciation

-2,175 Retained Earnings

Interest Receivable

8. Accrued depreciation expense.

+900 Printing Revenue

-

2,175

=

1,080

+

0

+

-3,017

+38 Interest Revenue

938

-

-

+2,175 Depreciation Expense

=

-2,175

-

3,955

=

-3,017

©Cambridge Business Publishers, 2020 4-119

b.

Date Dec

31

31

31

31

31

31

31

31

Description

Debit

Credit

Salaries expense (+E, -SE) Salaries payable (+L) To accrue salaries at December 31 ($1,800  2/5 = $720).

720

Interest expense (+E, -SE) Interest payable (+L) To accrue interest expense at December 31.

200

Fees receivable (+A) Printing revenue (+R, +SE) To record revenue earned but not yet billed.

900

Maintenance expense (+E ,-SE) Prepaid maintenance (-A) To record December maintenance expense. ($2,400 / 6 = $400).

400

Advertising expense (+E, -SE) Prepaid advertising (-A) To record December advertising expense ($900  1/3 = $300).

300

Rent expense (+E, -SE) Rent payable (+L) To accrue one-half month's rent expense [(400  $0.80)/2 = $160].

160

Interest receivable (+A) Interest income (+R, +SE) To accrue interest earned in December.

38

Depreciation expense—Equipment (+E, -SE) Accum. depreciation—Equipment (+XA) To record annual depreciation on equipment.

©Cambridge Business Publishers, 2020 4-120

720

200

900

400

300

160

38

2,175 2,175

Financial Accounting, 6th Edition

P3-44. (40 minutes) LO 4, 5 a.

TRUEMAN CONSULTING INC. Income Statement For the Year Ended December 31, 2018 Revenue Service fees Expenses Rent expense Salaries expense Supplies expense Insurance expense Depreciation expense—Equipment Interest expense Total Expenses Net Income

$58,400 $12,000 33,400 4,700 3,250 720 630 54,700 $ 3,700

TRUEMAN CONSULTING INC. Statement of Stockholders’ Equity For the Year Ended December 31, 2018 Common Stock Balance at December 31, 2017 .................................... $1,000

Retained Earnings $3,305

Total Stockholders’ Equity $4,305

Stock issuance ............................................................. Dividends .................................................................... Net income ..................................................................

_____

3,700

3,700

Balance at December 31, 2018 ....................................

$1,000

$7,005

$8,005

TRUEMAN CONSULTING Balance Sheet December 31, 2018

Assets

Liabilities

Cash Accounts receivable Supplies Prepaid insurance Equipment Less: Accumulated depreciation

$ 2,700 Accounts payable 3,270 Long-term notes payable 3,060 Total Liabilities 1,500 $ 6,400 1,080

Total Assets

Solutions Manual, Chapter 4

$ 845 7,000 7,845

Owners’ Equity 5,320 Common stock

$15,850

Retained earnings Total Liabilities and Owners’ Equity

1,000 7,005 $15,850

©Cambridge Business Publishers, 2020 4-121

b.

Date 2018 Dec.

31

31

Description

Debit

Credit

Service fees revenue (-R) Retained earnings (+SE) To close the revenue account.

58,400 58,400

Retained earnings (-SE) Rent expense (-E) Salaries expense(-E) Supplies expense (-E) Insurance expense (-E) Depreciation expense—Equip (-E) Interest expense (-E) To close the expense accounts.

54,700 12,000 33,400 4,700 3,250 720 630

P3-45. (30 minutes) LO 5 a.

Date 2018

Description

Dec.31 Service fees revenue (-R) Miscellaneous income (-R) Retained earnings (+SE) To close the revenue accounts. 31

Retained earnings (-SE) Salaries expense (-E) Rent expense (-E) Insurance expense (-E) Depreciation expense (-E) Income tax expense (-E) To close the expense accounts.

Debit

Credit 97,200 4,200 101,400

74,800 42,800 13,400 1,800 8,000 8,800

b. After the closing entries are posted, Retained Earnings has a $45,700 credit balance ($19,100 + $26,600 net income).

©Cambridge Business Publishers, 2020 4-122

Financial Accounting, 6th Edition

c. Wilson Company Post-Closing Trial Balance December 31, 2018 Debit Cash Accounts Receivable Prepaid Insurance Equipment Accumulated Depreciation Accounts Payable Income Tax Payable Common Stock Retained Earnings

Credit

$8,500 8,000 3,600 72,000 $12,000 600 8,800 25,000 45,700 $92,100

______ $92,100

P3-46. (30 minutes) LO 2, 3 a. Balance Sheet Transaction

Cash Asset

+

1. Recognize Advertising expense.

Noncash Assets

=

-400

=

+

Contrib. Capital +

-1,140

+1,300

-1,300

Wages Payable*

Retained Earnings

=

+1,000

+

-540

=

Net Income

-

+400

=

-400

=

-1,300

=

-1,140

-

=

+2,400

-

=

+1,000

=

560

-

-

+1,140 Insurance Expense

-2,400

+2,400

+2,400

Retained Earnings

Service Fee Revenue

+1,000

+1,000

=

+1,300 Wages Expense

Performance Obligations

Rent Receivable

0

Expenses

Retained Earnings =

5. Recognize rent revenue.

-

Advertising Expense

-1,140

Prepaid Insurance

4. Recognize service fees earned.

Revenues

Retained Earnings =

3. Recognize insurance expense.

Earned Capital -400

Prepaid Advertising

2. Accrue wage expense.

Totals

Liabilities

Income Statement

Retained Rental Income Earnings =

-1,100

+

0

+

560

3,400

-

2,840

*Assumes wages earned had not been accrued or recognized yet as an expense. continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-123

a.

continued

Date 2018 Dec. 31

Description

Debit Credit

Advertising expense (+E, -SE) Prepaid advertising (-A)

400 400

To record advertising expense ($1,200 − $800 = $400). 31

Wages expense (+E, -SE) Wages payable (+L)

1,300 1,300

To record accrued wages. 31

Insurance expense (+E, -SE) Prepaid insurance (-A)

1,140

Performance obligations (-L) Service fee revenue (+R, +SE)

2,400

1,140

To record insurance expense ($3,420 − $2,280 = $1,140). 31

2,400

To recognize unearned fees as earned ($5,400 − $3,000 = $2,400). 31

Rent receivable (+A) Rental income (R, +SE)

1,000 1,000

To record rent earned but not yet recorded. b. Balance Sheet Transaction

Cash Asset

+

Noncash Assets

1. Pay wages of $2,400.

-2,400

2. Receipt of $1,000 rent revenue.

+1,000

-1,000

Cash

Rent Receivable

Date 2019

Jan. 4

= Liabilities + =

Cash

Income Statement Contrib. Capital +

Earned Capital

-1,300

-1,100

Wages Payable

Retained Earnings

=

Revenues

-

Expenses

-

+1,100

= Net Income =

-1,100

Wages Expense -

=

Description Debit Credit Wages payable (-L) Wages expense (+E, -SE) Cash (-A)

1,300 1,100 2,400

To record payment of wages. 4

Cash (+A) Rent receivable (-A)

1,000 1,000

To record collection of rent.

©Cambridge Business Publishers, 2020 4-124

Financial Accounting, 6th Edition

P3-47. (90 minutes) LO 2, 3 For part d, the adjusting entries are indicated by the numbers 1-5. The unadjusted trial balance required in part c is calculated before the adjusting entries are made. a., b. & d.

6/1 6/2 6/30

6/10 6/28

6/2

6/1

6/1

+ Cash (A) 24,000 4,400 6,400 875 7,800 930 3,600 1,240 520 3,600 1,500 21,535 + Accounts Receivable (A) 5,800 7,800 5,200 3,200 + Prepaid Advertising (A) 930 310 620 + Office Supplies (A) 2,840 1,310 1,530

+ Advertising Expense (E) 310 + Salaries Expense (E) -

6/12 6/26 2.

6/18

- Accounts Payable (L) + 9,480

6/1

- Salaries Payable (L) + 725

2.

- Contract Liabilities (L) + 3,200 6,400 3,200

5.

6/30

- Common Stock (SE) + 24,000

4.

6/30

- Retained Earnings(SE) + 1,500

1.

1.

+ Supplies Expense (E) 1,310

+ Office Equipment (A) 11,040

- Acc. Depreciation – Off. Equip (XA) + 115

4.

6/1 6/2 6/2 6/12 6/15 6/18 6/26 6/30

6/15

3.

6/1

+ Travel Expense (E) 1,240

3.

+ Depreciation Expense(E) 115

6/2

+ Rent Expense (E) 875 - Service Fees Revenue (R) +

3,600 3,600 725

5,800 5,200 3,200

7,925

14,200

+ Postage Expense (E) 520

Solutions Manual, Chapter 4

6/2

©Cambridge Business Publishers, 2020 4-125

6/10 6/28 5.

b. Balance Sheet Transaction

Cash Asset

+

Noncash Assets

=

6/1. Investment for common stock.

+24,000 Cash

6/1. Purchase of assets for cash & on account.

-4,400 Cash

6/2. Pay rent $875.

-875 Cash

=

6/2. Purchase $930 of advertising in advance.

-930 Cash

+930 Prepaid = Advertising

6/2

Signed research contract.

=

+ 11,040 Office Equipment +2,840 Supplies

+6,400 Cash

6/10. Bill customers for services.

Liabilities

=

=

+5,800 Accounts Receivable

Income Statement +

Contrib. Capital

+

Earned Capital

Revenues -

+24,000 Common Stock +9,480 Accounts Payable

-875 Retained Earnings

=

+5,800 Retained Earnings

+5,800 Service Fees Revenue

=

-

=

-

=

-

+6,400 Contract Liabilities

Expenses

+875 Rent Expense

Net Income

=

-875

-

=

-

=

-

=

+5,800

6/12. Paid salaries.

-3,600 Cash

=

-3,600 Retained Earnings

-

+3,600 Salaries Expense

=

-3,600

6/15. Paid travel expenses.

-1,240 Cash

=

-1,240 Retained Earnings

-

+1,240 Travel Expense

=

-1,240

6/18. Paid postage.

-520 Cash

=

-520 Retained Earnings

-

+520 Postage Expense

=

-520

6/26. Paid salaries.

-3,600 Cash

=

-3,600 Retained Earnings

-

+3,600 Salaries Expense

=

-3,600

+5,200 Accounts Receivable

=

+5,200 Retained Earnings

-

=

+5,200

-7,800 Accounts Receivable

=

-

=

6/28. Bill customers for services. 6/30. Collect service fees.

+7,800 Cash

6/30. Cash dividend paid.

-1,500 Cash

-1,500 Retained Earnings

+5,200 Service Fees Revenue

-

continued next page

©Cambridge Business Publishers, 2020 4-126

Financial Accounting, 6th Edition

P3-47. b. continued

Date 2019 June

1

Description

Debit

Credit

Cash (+A) Common stock (+SE)

24,000 24,000

Owner invested cash for common stock. 1

Office equipment (+A) Office supplies (+A) Cash (-A) Accounts payable (+L)

11,040 2,840 4,400 9,480

Purchased equipment and supplies; $4,400 cash paid with the remainder due in 60 days. 2

Rent expense (+E, -SE) Cash (-A)

875 875

Paid June rent. 2

Prepaid advertising (+A) Cash (-A)

930 930

Paid three months' advertising in advance. 2

Cash (+A) Contract liabilities (+L)

6,400 6,400

Received two months' fees in advance on six-month contract. 10

Accounts receivable (+A) Service fee revenue (+R, +SE)

5,800 5,800

Billed customers for services. 12

Salaries expense (+E, -SE) Cash (-A)

3,600 3,600

Paid two weeks' salaries to employees. 15

Travel expense (+E, -SE) Cash (-A)

1,240 1,240

Paid business travel expenses. 18

Postage expense (+E, -SE) Cash (-A)

520 520

Paid postage for questionnaire mailing. 26

Salaries expense (+E, -SE) Cash (-A)

3,600 3,600

Paid two weeks' salaries to employees. continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-127

P3-47. b. continued

Date 2019 June

28

Description

Debit

Credit

Accounts receivable (+A) Service fees revenue (+R, +SE)

5,200 5,200

Billed customers for services. 30

Cash (+A) Accounts receivable (-A)

7,800 7,800

Collections from customers on account. 30

Retained earnings (-SE) Cash (-A)

1,500 1,500

Declared and paid dividends. c. MARKET-PROBE Unadjusted Trial Balance June 30, 2019 Debit Cash Accounts Receivable Office Supplies Prepaid Advertising Office Equipment Accounts Payable Contract Liabilities Common Stock Retained Earnings* Service Fees Revenue Salaries Expense Rent Expense Travel Expense Postage Expense

Credit

$21,535 3,200 2,840 930 11,040 $9,480 6,400 24,000 1,500 11,000 7,200 875 1,240 520 $50,880

______ $50,880

* The negative (debit) balance in Retained Earnings reflects the dividend paid.

©Cambridge Business Publishers, 2020 4-128

Financial Accounting, 6th Edition

P3-47. d. Balance Sheet Cash Asset

Transaction a.

Recognize supplies expense.

+

Noncash Assets

-

-1,310

-

c.

-

Accrue depreciation expense. -310

30

30

=

+115

-

+725

-725

Salaries Payable

Retained Earnings

=

Expenses

-

+1,310

-

=

=

-1,310

=

-725

+115 = Depreciation Expense

-115

+725 Salaries Expense

-115

=

Net = Income

Supplies Expense

-

Retained Earnings -310

-

+310

=

-3,200

+3,200

+3,200

Retained Earnings

Service Fees Revenue

-

= +3,200

Debit Credit

Supplies expense (+E, -SE) Office supplies (-A) To record supplies used during June ($2,840 − $1,530 = $1,310). Salaries expense (+E, -SE) Salaries payable (+L) To record unpaid salaries at June 30.

1,310 1,310

725 725

Depreciation expense—Office equipment (+E, -SE) Accum. deprec. Off. equipment (+XA, -A) To record June depreciation ($11,040/96 mo. = $115). Advertising expense (+E, -SE) Prepaid advertising (-A) To record one month's advertising expense.

115 115

310 310

Contract liabilities (-L) Service fee revenue (+R, +SE) To record one month's fees earned, received in advance.

-310

Advertising Expense

Contract Liabilities

Description

Solutions Manual, Chapter 4

-

Retained Earnings -

Date 2019

Revenues

-1,310

Prepaid Advertising

Recognize earned service fees.

30

=

Accum. Depreciation

d. Recognize advertising expense.

30

= Liabilities

Earned Capital

Retained Earnings -

June 30

Income Statement Contrib. + Capital +

Office Supplies

b. Recognize salaries expense.

e.

Contra Assets

3,200 3,200

©Cambridge Business Publishers, 2020 4-129

P3-48. (40 minutes) LO 3 a. DELIVERALL Unadjusted Trial Balance December 31, 2018 Debit $ 2,300 5,120 1,680 6,270 42,240

Cash Accounts Receivable Prepaid Advertising Supplies Equipment Notes Payable Accounts Payable Common Stock Mailing Fee Revenue Wages Expense Rent Expense Utilities Expense

Credit

$7,500 2,700 9,530 86,000 38,800 6,300 3,020 $105,730

________ $105,730

b Balance Sheet Transaction 1. Recognize advertising expense.

Cash Asset

+

Noncash Assets

-

Contra Assets

-1,540 Prepaid Advertis- ing

+

+

Earned Capital

Revenues

-

Expenses

Net = Income

=

-1,540 Retained Earnings

-

+1,540 Advertising Expense

=

-1,540

=

-5,280 Retained Earnings

-

+5,280 = Depreciation Expense

-5,280

2. Recognize depreciation expense.

-

3. Recognize utilities expense.

-

= +325 Accts Payable

-325 Retained Earnings

- +325 Utilities = Expense

4. Accrue wages expense.

-

=

-1,200 Retained Earnings

-

+1,200 Wages Expense

=

-1,200

-

=

-4,750 Retained Earnings

-

+4,750 Supplies Expense

=

-4,750

6. Accrue interest expense.

-

=

-450 Retained Earnings

- +450 Interest = Expense

-450

7. Recognize rent expense*.

-

= +430 Accts Payable

-430 Retained Earnings

- +430 Rent = Expense

-430

5. Recognize supplies expense.

-4,750 Supplies

+5,280 Accum. Deprec.

= Liabilities

Income Statement Contrib. Capital

+1,200 Wages Payable

+450 Interest Payable

*(1/2%  $86,000 = $430). The rent for the year ($6,300 = $525 x 12) has already been recognized in the accounts. See the beginning balances given in the problem statement.

continued next page

©Cambridge Business Publishers, 2020 4-130

Financial Accounting, 6th Edition

-325

P3-48. b.

continued

Date 2018 Dec. 31

Description

Debit

Credit

Advertising expense (+E, -SE) Prepaid advertising (-A)

1,540 1,540

To record 11 months' advertising expense ($1,680  11/12 = $1,540). 31

Depreciation expense (+E, -SE) Accumulated depreciation (+XA, -A)

5,280 5,280

To record depreciation for the year ($42,240/8 years = $5,280). . 31

Utilities expense (+E, -SE) Accounts payable (+L)

325 325

To record estimated December utilities expense. 31

Wages expense (+E, -SE) Wages payable (+L)

1,200 1,200

To record unpaid wages at December 31. 31

Supplies expense (+E, -SE) Supplies (-A)

4,750 4,750

To record supplies expense for the year ($6,270 − $1,520 = $4,750). 31

Interest expense (+E, -SE) Interest payable (+L)

450 450

To record accrual of interest expense at Dec. 31. 31

Rent expense (+E, -SE) Accounts payable (+L)

430 430

To record additional rent owed under lease (1/2%  $86,000 = $430).

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-131

P3-48. c.

Only the T-accounts needed to enter the adjustments are provided. - Accounts Payable (L) + 2,700 325 430

2.

Bal. 3. 7.

Bal.

+ Prepaid Advertising (A) 1,680 1,540

1.

Bal.

+ Supplies (A) 6,270 4,750

5.

- Accumulated Depreciation–Equip (XA) + 5,280

2.

1.

- Interest Payable (L) + 450

6.

Bal. 7.

+ Rent Expense (E) 6,300 430

- Wages Payable (L) + 1,200

4.

Bal. 4.

+ Wages Expense (E) 38,800 1,200

Bal. 3.

+ Utilities Expense (E) 3,020 325

+ Depreciation Expense (E) 5,280

+ Interest Expense (E) 6.

450

©Cambridge Business Publishers, 2020 4-132

+Advertising Expense (E) 1,540

+ Supplies Expense (E) 5.

4,750

Financial Accounting, 6th Edition

P3-49 (60 minutes) LO 2, 3, 4, 5, 6 a. Balance Sheet

Transaction 1. Recognize rent expense.

2. Recognize supplies expense.

Cash Asset

+

Noncash Assets

-

-795

-

Contra Assets

=

Liabilities

+

Contrib. Capital

+

=

-1,980

Earned Capital

Revenues

-795

Prepaid Rent

-

Expenses

=

Net Income

-

+795

=

-795

=

-1,980

=

-335

=

-560

=

-390

=

+500

Retained Earnings -

=

Rent Expense

-1,980

Supplies

-

+1,980

Retained Earnings

3. Accrue depreciation expense.

-

4. Accrue wages payable.

-

5. Recognize utilities expense.

-

6. Recognize service revenue.

-

+335

=

Supplies Expense

-335

Accum. Depreciation

-

Retained Earnings =

=

=

+335 Depreciatio n Expense

+560

-560

Wages Payable

Retained Earnings

+390

-390

Accounts Payable

Retained Earnings

-500

+500

+500

Service Contract Liability

Retained Earnings

Service Revenue

Date 2019 Description Mar. 31

Income Statement

-

+560 Wages Expense

-

+390 Utilities Expense

-

Debit Credit

Rent expense (+E, -SE) Prepaid rent (-A)

795 795

To record March rent expense ($4,770/6 months = $795).

31

Supplies expense (+E, -SE) Supplies (-A)

1,980 1,980

To record March supplies expense ($3,700−$1,720 = $1,980).

31

Depreciation expense—Equipment (+E, -SE) Accumulated depreciation—Equipment (+XA, -A)

335 335

To record March depreciation ($36,180/108 months = $335).

31

Wages expense (+E, -SE) Wages payable (+L)

560 560

To record unpaid wages at March 31.

31

Utilities expense (+E, -SE) Accounts payable (+L)

390 390

To record estimated March utilities expense.

31

Service contract liability (-L) Service revenue (+R, +SE)

500 500

To record revenue received in advance that was earned in March.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-133

P3-49. b.

Not all the T-accounts given are needed to enter the adjustments required. Also, the closing entries required in part d are referenced by 1c, 2c etc. - Accounts Payable (L) + 2,510 390 2,900

Bal. 5. Bal.

Bal. Bal.

Bal. Bal. - Acc Depreciation - Equipment (XA) + 335

3.

6.

-Service Revenue(R) + 6c.

12,860

12,360 500

+ Prepaid Rent (A) 4,770 795 3,975 + Supplies (A) 3,700 1,980 1,720 - Service Contract Liability (L) + 500 1,000

1.

2.

Bal.

500

Bal.

795

1c.

+ Rent Expense (E) Bal. 6.

1.

795

+ Supplies Expense (E) 2.

3.

5.

1c. 2c. 3c. 4c. 5c.

+Depreciation Expense (E) 335 335

+ Utilities Expense (E) 390 390 - Retained Earnings (SE) + 795 1,980 335 4,460 390 12,860 4,900

©Cambridge Business Publishers, 2020 4-134

3c.

5c.

Bal. 4.

1,980

1,980

2c.

+Wages Expense (E) 3,900 560 4,460

4c.

- Wages Payable (L) + 560

4.

6c.

Financial Accounting, 6th Edition

P3-49. c.

WHEEL PLACE COMPANY Income Statement For Month Ended March 31, 2019 Service revenue…………………………………….……...

$12,860

Expenses: Utilities expense…………….…………………..…………

$390

Supplies expense…………..………………………………

1,980

Wages expense……………..…………………………..…

4,460

Depreciation expense………………………………….…

335

Rent expense……………………………………………...

795

Net income ………………………………………………...

7,960 $4,900

WHEEL PLACE COMPANY Balance Sheet March 31, 2019

Assets

Liabilities

Cash

$ 1,900 Accounts payable

$ 2,900

Accounts receivable

3,820 Wages payable

560

Supplies

1,720 Service contract liability

500

Prepaid rent

3,975

Equipment Less:Accumulated depreciation

Total Liabilities

$ 36,180 335

35,845 Owners’ Equity Common stock Retained earnings

Total Assets

Solutions Manual, Chapter 4

3,960

$47,260 Total Liabilities and Owners’ Equity

38,400 4,900 $47,260

©Cambridge Business Publishers, 2020 4-135

P3-49.

d. 1c.

2c. 3c. 4c.

5c. 6c.

Retained earnings (-SE)................................................................. Rent expense (-E)......................................................................

795

Retained earnings (-SE)................................................................. Supplies expense (-E) ...............................................................

1,980

Retained earnings (-SE)................................................................. Depreciation expense (-E) ........................................................

335

Retained earnings (-SE)................................................................. Wages expense (-E) ..................................................................

4,460

Retained earnings (-SE)................................................................. Utilities expense (-E) ................................................................

390

795

1,980 335 4,460

390

Service revenue (-R) ..................................................................... 12,860 Retained earnings (+SE) ...........................................................

12,860

The closing journal entries are shown in the T-accounts in part b. P3-50. (30 minutes) LO 4, 5 a. TRAILS, INC. Income Statement For the Year Ended December 31, 2018 Revenues Subscription revenue Advertising revenue Total revenues Expenses Salaries expense Printing and mailing expense Rent expense Supplies expense Insurance expense Depreciation expense Income tax expense Total expenses Net income

$ 168,300 49,700 $218,000 100,230 85,600 8,800 6,100 1,860 5,500 1,600 209,690 $8,310 Continued next page

©Cambridge Business Publishers, 2020 4-136

Financial Accounting, 6th Edition

P3-50. a.

continued TRAILS, INC. Statement of Stockholders’ Equity For Year Ended December 31, 2018

$25,000

$23,220

Total Stockholders’ Equity $48,220

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

_____

8,310

8,310

Balance at December 31, 2018 ....................................

$25,000

$31,530

$56,530

Common Stock Balance at December 31, 2017 ....................................

Retained Earnings

Stock issuance .......................................................... Dividends .................................................................

TRAILS, INC. Balance Sheet December 31, 2018 Assets

Liabilities

Cash

$3,400

Accounts payable

Accounts receivable

8,600

Subscription liabilities

Supplies

4,200

Salaries payable

Prepaid insurance Office equipment Less: Accum. depreciation

930

3,500 15,600

$66,000 Stockholders' equity 11,000

55,000 Retained earnings Total stockholders' equity _______

Solutions Manual, Chapter 4

10,000

Total liabilities

Common stock

Total assets

$ 2, 100

$72,130

$25,000 31,530 56,530

Total liabilities and stockholders' equity

$72,130

©Cambridge Business Publishers, 2020 4-137

b.

Date 2018 Dec.

31

Description

Debit

Credit

Subscription revenue (-R) Advertising revenue (-R) Retained earnings (+SE)

168,300 49,700 218,000

To close the revenue accounts. 31

Retained earnings (-SE) Salaries expense (-E) Printing and mailing expense (-E) Rent expense (-E) Supplies expense (-E) Insurance expense (-E) Depreciation expense (-E) Income tax expense (-E)

209,690 100,230 85,600 8,800 6,100 1,860 5,500 1,600

To close the expense accounts.

P3-51. (30 minutes) LO 5 a.

Date 2018 Dec.

31

Description

Debit

Service fee revenue (-R) Retained earnings (+SE)

Credit 72,500 72,500

To close the revenue account. 31

Retained earnings (-SE) Wages expense (-E) Rent expense (-E) Insurance expense (-E) Supplies expense (-E) Advertising expense(-E) Depreciation expense—Trucks(-E) Depreciation expense—Equipment (-E)

58,800 29,800 10,200 2,900 5,100 6,000 4,000 800

To close the expense accounts.

b. The balance in Retained Earnings after closing entries are posted is $29,250 credit ($15,550 + $13,700).

©Cambridge Business Publishers, 2020 4-138

Financial Accounting, 6th Edition

c. MAYFLOWER MOVING SERVICE Post-Closing Trial Balance December 31, 2018 Debit $ 3,800 5,250 2,300 3,000 28,300

Cash Accounts Receivable Supplies Prepaid Advertising Trucks Accumulated Depreciation—Trucks Equipment Accumulated Depreciation—Equipment Accounts Payable Service contract liabilities Common Stock Retained Earnings

Credit

$10,000 7,600 2,100 1,200 2,700 5,000 29,250 $50,250

______ $50,250

P3-52. (20 minutes) LO 2, 3, 6 a. Balance Sheet Transaction 1. Recognize maintenance expense. 2. Recognize supplies expense.

Cash Asset

+ Noncash Assets = -1,800

=

-5,200

=

Revenues

Expenses

=

Net Income

+1,800

=

-1,800

=

-5,200

-

=

+4,500

-

=

+2,800

=

-913

-

Maintenance Expense -

Retained Earnings -4,500

+4,500

+4,500

Retained Earnings

Commission Revenue

+2,800

+2,800

Retained Earnings

Commission Revenue

=

=

+913 Rent

Payable

-913 Retained Earnings

+5,200 Supplies Expense

Performance Obligations

Commis- sions Receivable

Solutions Manual, Chapter 4

Earned Capital

-5,200

=

5. Rent expense.

Contrib. Capital +

Retained Earnings

Supplies

+2,800

+

-1,800

Prepaid Maintenance

3. Accrue earned commissions.

4. Earned but unbilled commission fees.

Liabilities

Income Statement

-

+913 Rent

Expense

©Cambridge Business Publishers, 2020 4-139

b. Balance Sheet Cash Asset

Transaction 1. Recognize maintenance expense.

+

Noncash Assets

=

Liabilities

Income Statement +

Contrib. Capital +

-2,800 = Commis-sions Receivable

Earned Capital

Revenues

-

=

Net Income

+1,800 Retained Earnings

+1,800 Commission Revenue

-

=

+1,800

-

=

Expenses

+4,600 Accounts Receivable

2. Recognize rent -913 Cash expense.

= -913 Rent Payable

c.

Date 2018 Dec. 31

Description

Debit Credit

Maintenance expense (+E, -SE) Prepaid maintenance (-A)

1,800 1,800

To record four months' maintenance expense [($2,700/6)  4 = $1,800]. 31

Supplies expense (+E, -SE) Supplies (-A)

5,200

Performance obligations (-L) Commission revenue (+R, +SE)

4,500

5,200

To record supplies expense ($8,400 − $3,200 = $5,200). 31

4,500

To transfer fees earned from unearned fees ($8,500 − $4,000 = $4,500). 31

Commissions receivable (+A) Commission revenue (+R, +SE)

2,800 2,800

To record fees earned but not yet billed. 31

Rent expense (+E, -SE) Rent payable (+L)

913 913

To record additional 2018 rent [1%  ($84,000 + $4,500 + $2,800) = $913]. 2019 Jan. 10

Accounts receivable (+A) Commisions receivable (-A) Commision revenue (+R, +SE)

4,600 2,800 1,800

To record billings on Jan. 10, 2016. 10

Rent payable (-L) Cash (-A)

913 913

To record payment of contingent rent from 2018.

©Cambridge Business Publishers, 2020 4-140

Financial Accounting, 6th Edition

P3-53. (60 minutes) LO 3, 4, 5, 6 a. Balance Sheet Transaction 1. Cash sales.

Cash Asset

Noncash Assets

+145,850 Cash

-

Contra Assets

= Liabilities

+

Contrib. Capital +

Earned Capital

Revenues

-

Expenses

Net Income

=

-

=

+76,200 Accounts Payable

3. Recognize -77,300 Cash recent payments on A/P.

-

=

-77,300 Accounts Payable

4. Recognize -24,000 Cash rent paid and rent expense.

+200 Prepaid Rent

=

-23,800 Retained Earnings

-

+23,800 Rent Expense

=

-23,800

5. Recognize -12,500 Cash wage expense and wages paid.

-

= +250 Wages Payable

-12,750 Retained Earnings

-

+12,750 Wages Expense

=

-12,750

6. Recognize depreciation expense.

-

=

-1,700 Retained Earnings

-

+1,700 Deprec. Expense

b. 1.

+2,500 Inventories

+1,700 Accum. Deprec.

+145,850 +145,850 Retained Sales Revenue Earnings

=

-

2. Record inventory purchased and used.

2.

+

Income Statement

-73,700 Retained Earnings

= +145,850

-

+73,700 = Cost of Goods Sold

-

=

Cash (+A) ................................................................................................................................... 145,850 Sales revenue (+R,+SE) ............................................................................................................ 145,850 Inventories (+A) ........................................................................................................................ 2,500 Cost of goods sold (+E, -SE) .................................................................................................... 73,700* Accounts payable (+L) .............................................................................................................. 76,200 Or, make two separate entries with the same net effect: Inventory (+A) ........................................................................................................................... 76,200 Accounts payable (+L) .............................................................................................................. 76,200 Cost of goods sold (+E, -SE) .................................................................................................... 73,700* Inventory (-A) ............................................................................................................................ 73,700 *73,700 = 12,000 +76,200 – 14,500.

continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-141

=

-73,700

-1,700

P3-53. b.

continued

3.

Accounts payable (-L) ............................................................................................................... 77,300* Cash (-A) .................................................................................................................................... 77,300 *77,300 = 5,200 +76,200 – 4,100. 4. Prepaid rent (+A) ....................................................................................................................... 200* Rent expense (+E, -SE) ............................................................................................................. 23,800* Cash (-A) ................................................................................................................................... 24,000 * $23,800 = $3,800 + ($24,000 ÷12) x (10) and 200 = $24,000 – $3,800 – ($24,000 ÷12) x (10). The rent expense for the first two months of the year is $3,800. But the rate for March 1, 2019 through February 29, 2020 is $2,000 per month. So, for the last ten months of 2019, the rent expense is $20,000, making the total rent expense $23,800 for 2019. 5.

6.

Wages expense (+E,-SE) .......................................................................................................... 12,750* Cash (-A) ....................................................................................................................................12,500 Wages payable (+L) .................................................................................................................. 250 * 12,750 = 12,500 + (350 – 100). Depreciation expense (+E,-SE) ................................................................................................ 1,700 Acc. depreciation – Equipment (+XA, -A) .............................................................................. 1,700

c. & e. The closing entries required in part e are also included here and indicated by the letter e before the relevent entry.

Bal. 1.

Bal.

Bal. Bal.

+ Cash (A) 8,500 145,850 77,300 24,000 12,500 40,550 + Equipment (A) 7,500 7,500 - Accumulated Depreciation Equip.(XA) + 3,000 1,700 4,700

3.

3. 4. 5.

-Accounts Payable (L)+ 5,200 77,300 76,200 4,100

Bal. 2. Bal.

+ Inventories (A) 12,000 2,500 14,500

Bal. 4. Bal.

+ Prepaid Rent (A) 3,800 200 4,000

Bal. 6. Bal.

- Wages Payable (L) + 100 250 350

Bal. 2. Bal.

-Owners’ Equity (SE)+ 23,500 33,900 57,400

Bal. 5. Bal.

continued next page

©Cambridge Business Publishers, 2020 4-142

Financial Accounting, 6th Edition

Bal. e. Bal.

P3-53. c. & e. continued -Sales Revenue (R)+ 145,850 145,850 0

e.

4. Bal.

5. Bal.

+Rent Expense (E)23,800 23,800 0 +Wages Expense (E)12,750 12,750 0

1. Bal.

2. Bal.

6. e. Bal.

+Cost of Goods Sold (E)73,700 73,700 0 +Depreciation Expense(E)1,700 1,700 0

e.

d. & e. Part d is easier to complete if the closing entries required in part e are journalized and entered in the T-accounts. The appropriate T-account entries for part e have been made earlier and indicated by the letter e. Sales revenue (-R) ..................................................................................................................... 145,850 Cost of goods sold (-E) ............................................................................................................. Rent expense (-E) ...................................................................................................................... Wages expense (-E) .................................................................................................................. Depreciation expense (-E) ........................................................................................................ Owners’ equity ........................................................................................................................... To close temporary revenue and expense accounts.

73,700 23,800 12,750 1,700 33,900

FISCHER CARD SHOP Income Statement For the Year ended December 31, 2019 Sales revenue Cost of goods sold Gross profit Other expenses: Rent expense Wages expense Depreciation expense Total other expenses Net income

$145,850 73,700 72,150 $23,800 12,750 1,700 38,250 $33,900 continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-143

e.

e.

P3-53. d. & e. continued FISCHER CARD SHOP Balance Sheets As of December 31,

2018

2019

$ 8,500

$ 40,550

Inventories

12,000

14,500

Prepaid rent

3,800

4,000

24,300

59,050

Equipment

7,500

7,500

Accumulated depreciation

(3,000)

(4,700)

Equipment, net

4,500

2,800

$ 28,800

$ 61,850

$ 5,200

$ 4,100

Wages payable

100

350

Total liabilities

5,300

4,450

Owners’ equity

23,500

57,400

$ 28,800

$ 61,850

Assets: Cash

Total current assets

Total assets Liabilities and owners’ equity: Accounts payable

Total liabilities and owners’ equity

©Cambridge Business Publishers, 2020 4-144

Financial Accounting, 6th Edition

P3-54. (120 minutes) LO 2, 3, 4, 5, 6 a. & b. The T-accounts follow the journal entries and the FSET. Balance Sheet Transaction 12/1 Investment for common stock. 12/2. Rent paid in cash. 12/2

Purchase supplies on account.

12/3

Office equipment bought for 4,700 cash and rest on account.

12/8. Paid for supplies.

Cash Asset +20,000 Cash

+

Noncash Assets

= =

-1,200 Cash

Liabilities

Income Statement +

Contrib. Capital +20,000 Common Stock

=

+1,080 Supplies

+

Earned Capital

-1,200 Retained Earnings

= =

- +1,200 Rent = Expense -

=

-4,700 Cash

+9,500 Office = Equipment

+4,800 Accounts Payable

-

=

-1,080 Cash

=

-1,080 Accounts Payable

-

=

-900 Retained Earnings

12/20 Received cash for consulting services.

+3,000 Cash

=

+3,000 Retained Earnings

12/28 Paid wages in cash.

-900 Cash

=

-900 Retained Earnings

=

+7,200 Retained Earnings

=

-1,800 Retained Earnings

12/30 Bill clients for consulting.

1. Record supplies expense.

Expenses

+1,080 Accounts Payable

=

Adjusting Entries

-

=

12/14 Paid wages in -900 Cash cash.

12/30 Paid cash dividends.

Revenues

+7,200 Fees Receivable -1,800 Cash

Cash Asset

+

Noncash Assets

-

Balance Sheet Contra LiabiAssets = lities

-370 Supplies -

=

2. Accrue wages expense.

-

=

3. Record depreciation expense. 4. Recognize accrued consulting fees.

-

+120 = Accum. Deprec. =

+2,250 Fees Receivable

Solutions Manual, Chapter 4

+270 Wages Payable

Net Income

-1,200

- +900 Wages = Expense +3,000 Consulting Revenue

-

=

-900

+3,000

- +900 Wages = Expense +7,200 Consulting Revenue

-

=

-

=

-900

+7,200

Income Statement Contrib. + Capital +

Earned Capital

Revenues

Net = Income

-

Expenses

-370 Retained Earnings

-

+370 Supplies Expense

=

-370

-270 Retained Earnings

- +270 Wages = Expense

-270

-120 Retained Earnings +2,250 Retained Earnings

-

+2,250 Consulting Revenue

+120 = -120 Depreciation Expense = +2,250

©Cambridge Business Publishers, 2020 4-145

P3-54. c.

Transactions: Dec.

1

Cash (+A) Common stock (+SE)

20,000 20,000

Invested $20,000 cash in the business. 2

Rent expense (+E, -SE) Cash (-A)

1,200 1,200

Paid rent for December. 2

Supplies (+A) Accounts payable (+L)

1,080 1,080

Purchased various supplies on account. Dec.

3

Office equipment (+A) Cash (-A) Accounts payable (+L)

9,500 4,700 4,800

Purchased $9,500 of office equipment, $4,700 cash down payment and balance due in 30 days. 8

Accounts payable (-L) Cash (-A)

1,080 1,080

Payment on account. 14

Wages expense (+E, -SE) Cash (-A)

900 900

Paid assistant's wages. 20

Cash (+A) Consulting revenue (+R, +SE)

3,000 3,000

Cash received for services. 28 Wages expense (+E, -SE) Cash (-A)

900 900

Paid assistant's wages. 30

31

Fees receivable (+A) Consulting revenue (+R, +SE) Billed customers for services.

7,200

Retained earnings (-SE) Cash (-A)

1,800

7,200

1,800

Issued and paid $1,800 in dividends.

©Cambridge Business Publishers, 2020 4-146

Financial Accounting, 6th Edition

P3-54. b, c, and g. The adjusting entries requested are included and are denoted by the letter a followed by a number 1 through 5. The closing entries requested in part g are indicated by the letter g. + 12/1 12/20

Cash (A) 20,000 3,000

Bal.

12,420

1,200 4,700 1,080 900 900 1,800

12/2 12/3 12/8 12/14 12/28 12/31

12/2 Bal.

+Supplies(A)1,080 370 710

12/3

+Office Equipment (A) 9,500

1a

-Wages Payable(L) + 2a.

270

-Accumulated Depreciation+ Office Equipment (XA) 120

12/8

12/31 g.

- Accounts Payable (L) + 1,080 1,080 4,800 4,800

3a. Bal.

3a.

-Consulting Revenue(R)+ 3,000 7,200 12,450 2,250 Bal. +Depreciation Expense(E)120 120 0

Solutions Manual, Chapter 4

20,000

12/2 Bal.

+Rent Expense (E) 1,200 1,200 0

g.

12/14 12/28 2a. Bal.

+ Wages Expense (E) 900 2,070 900 270 0

12/20 12/30 4a. 0

12/30 4a. Bal.

+Fees Receivable (A)7,200 2,250 9,450

12/2 12/3 Bal.

- Retained Earnings (SE)+ 1,800 12,450 3,760 6,890

g.

-Common Stock(SE)+

Bal.

g.

1a. Bal.

12/1

+ Supplies Expense (E) 370 370 0

©Cambridge Business Publishers, 2020 4-147

g.

g.

g.

P3-54. d.

Cash Fees Receivable Supplies Office Equipment Accounts Payable Common Stock Retained Earnings (Dividend) Consulting Revenue Wages Expense Rent Expense

e.

RHOADES TAX SERVICES Unadjusted Trial Balance December 31, 2018 Debit $12,420 7,200 1,080 9,500

Credit

$4,800 20,000 1,800 10,200 1,800 1,200 $35,000

______ $35,000

Adjusting Entries:

Date 2018 Dec.

31

Description

Debit

Supplies expense (+E, -SE) Supplies (-A)

370

Wages expense (+E, -SE) Wages payable (+L)

270

370

To record December supplies expense ($1,080 − $710). 31

Credit

270

To reflect unpaid wages at December 31. 31

Depreciation expense (+E, -SE) Accumulated depreciation (+XA, -A)

120 120

To record December depreciation. 31

Fees receivable (+A) Consulting revenue (+R, +SE)

To record unbilled service revenue (30  $75).

2,250 2,250

Continued next page

©Cambridge Business Publishers, 2020 4-148

Financial Accounting, 6th Edition

P3-54. e.

continued

Cash Fees Receivable Supplies Office Equipment Accumulated Depreciation Accounts Payable Wages Payable Common Stock Retained Earnings Consulting Revenue Supplies Expense Wages Expense Rent Expense Depreciation Expense

RHOADES TAX SERVICES Adjusted Trial Balance December 31, 2018 Debit $12,420 9,450 710 9,500

Credit

$120 4,800 270 20,000 1,800 12,450 370 2,070 1,200 120 $37,640

______ $37,640

f. RHOADES TAX SERVICES Income Statement For the Month of December 2018 Revenue Consulting revenue Expenses Wages expense Rent expense Supplies expense Depreciation expense Total expenses Net income

$12,450 $ 2,070 1,200 370 120 3,760 $ 8,690

Continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-149

P3-54. f.

continued RHOADES TAX SERVICES Statement of Stockholders’ Equity For the Month of December 2018 Common Stock Balance at December 1, 2018 ......................................

$0

Stock issuance ..........................................................

20,000

Retained Earnings $0

Total Stockholders’ Equity $0 20,000

Dividends .................................................................

(1,800)

(1,800)

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

______

8,690

8,690

Balance at December 31, 2018 ....................................

$20,000

$6,890

$26,890

RHOADES TAX SERVICES Balance Sheet December 31, 2018

Assets Cash Fees receivable Supplies Total current assets Office equipment Less: Accum. depreciation

$ 9,500 120

Total assets

©Cambridge Business Publishers, 2020 4-150

Liabilities and Equity $12,420 Accounts payable 9,450 Wages payable 710 Total liabilities 22,580 Stockholders’ equity 9,380 Common stock Retained earnings Total liabilities and stockholders’ $31,960 equity

$ 4,800 270 5,070

20,000 6,890 $31,960

Financial Accounting, 6th Edition

P3-54. g.

Date 2018 Dec.31

Description

Debit

Consulting revenue (-R) Retained earnings (+SE)

Credit

12,450 12,450

To close the revenue account. 31

Retained earnings (-SE) Wages expense (-E) Rent expense (-E) Supplies expense (-E) Depreciation expense (-E)

3,760 2,070 1,200 370 120

To close the expense accounts. h.

Cash Fees Receivable Supplies Office Equipment Accumulated Depreciation Accounts Payable Wages Payable Retained Earnings Common Stock

RHOADES TAX SERVICES Post-Closing Trial Balance December 31,2018 Debit Credit $12,420 9,450 710 9,500

$32,080

Solutions Manual, Chapter 4

$ 120 4,800 270 6,890 20,000 $32,080

©Cambridge Business Publishers, 2020 4-151

CASES and PROJECTS C3-55. (90 minutes) LO 2, 3, 4, 5, 6 a.

1.

Entries in the FSET are first shown for the initial deposits and checks. These are entries 1- 8. Entries a - f are the adjusting entries that would be made at the end of the three months. The expenditures for rent and salaries are assumed to have been initially debited to expense accounts. Balance Sheet

Transaction

Cash Asset

+

Noncash Assets

-

Contra Assets

=

Liabilities

Income Statement +

Contrib. Capital

+ Earned Capital

-

Expenses

+50,000 Cash

-

=

2. Collections from customers.

+81,000 Cash

-

=

3. Bank borrowing.

+10,000 Cash

-

= +10,000 Loans Payable

4. Rent expense.

-24,000 Cash

-

=

5. Purchased equipment.

-25,000 Cash

+25,000 Equipment

-

=

-

=

6. Purchased inventory.

-62,000 Cash

+62,000 Inventory

-

=

-

=

-6,000 Cash

-

=

-6,000 Retained Earnings

-

+6,000 Salaries Expense

=

-6,000

-13,000 Cash

-

=

-13,000 Retained Earnings

-

+13,000 Misc. Expenses

=

-13,000

-

=

+9,000 Retained Earnings

+9,000 Sales Revenue

=

+9,000

+12,000 Prepaid Rent

=

+12,000 Retained Earnings

- -12,000 Rent = Expense

+12,000

8. Paid other expenses. a. Recognize credit sales. b. Adjust rent expense.

+9,000

d. Recognize cost of goods sold.

+81,000 Retained Earnings

-41,000 Inventory

-

= +3,000 Salaries Payable

-

=

-41,000 Retained Earnings

=

e. Accrue depreciation expense.

-

f. Accrue interest expense*.

-

+1,250 Accumulated Depreciation

=

+81,000 Sales Revenue

= +81,000

-

-24,000 Retained Earnings

A/R

c. Accrue salaries expense.

-

Net = Income

1. Investment for common stock.

7. Paid salaries.

+50,000 Investment

Revenues

-3,000 Retained Earnings

=

- +24,000 Rent = -24,000 Expense

-

+3,000 Salaries Expense

=

-3,000

- +41,000 Cost = of Goods Sold

-41,000

-1,250 Retained Earnings

-

-1,250

-300 Retained Earnings

- +300 Interest = Expense

+1,250 Deprec. Expense

=

+300 Interest Payable

*($10,000 x 1% x 3 mos.) continued next page

©Cambridge Business Publishers, 2020 4-152

=

Financial Accounting, 6th Edition

-300

a.

2.

Journal entries are shown only for the adjustments a-f.

a.

Accounts receivable (+A) Sales revenue (+R, +SE) To recognize sales on account.

b.

c.

d.

e.

f.

Prepaid rent (+A) Rent expense (-E, +SE) To recognize remaining prepaid rent and correct rent expense. Salaries expense (+E, -SE) Salaries payable (+L) To recognize unpaid salaries earned during September. Cost of goods sold (+E, -SE) Merchandise inventory (-A) To recognize cost of sales; ($62,000 - $21,000). Depreciation expense (+E, -SE) Accumulated depreciation (+XA, -A) To accrue depreciation on the fixtures and equipment ($25,000/60) x (3). Interest expense (+E, -SE) Interest payable (+L) To accrue interest on bank loan assumed taken out 7/1/2019. ($10,000) x (0.12) x (1/4).

Solutions Manual, Chapter 4

9,000 9,000

12,000 12,000

3,000 3,000

41,000 41,000

1,250 1,250

300 300

©Cambridge Business Publishers, 2020 4-153

C3-55. b.

T-accounts: The opening balances shown are the amounts in the accounts prior to the entry of the adjustments described in items a through f. The cash balance represents the deposits made, $141,000, less the checks drawn, $130,000. + Cash (A) 11,000

Bal.

Bal.

+ Merchandise Inventory (A) 62,000 41,000 + Prepaid Rent (A) 12,000

b. + Equipment (A) 25,000

Bal.

- Accumulated Deprec.-Equip. (XA) + 1,250

a.

Bal.

+ Rent Expense (E) 24,000 12,000

Bal.

+ Other Expense (E) 13,000

+ Bal. c. +

c.

- Owners’ Equity (SE) + 50,000

Bal.

Bal. a.

b.

d.

+ Cost of Goods Sold (E) 41,000

e.

+ Depreciation Expense (E) 1,250

- Bank Loan Payable (L) + 10,000

Salaries Expense (E) 6,000 3,000

-

Interest Expense (E) 300

-

©Cambridge Business Publishers, 2020 4-154

- Salaries Payable (L) + 3,000

e.

+ Accounts Receivable (A) 9,000

- Sales Revenue (R) + 81,000 9,000

f.

d.

-

Interest Payable (L) + 300

Financial Accounting, 6th Edition

Bal.

f.

C3-55. c. SEASIDE SURF SHOP Income Statement July 1, 2019 to September 30 ,2019 Sales revenue Cost of goods sold Gross margin Expenses: Rent expense Salaries expense Depreciation expense Interest expense Misc. expenses Net income

$90,000 41,000 49,000 $12,000 9,000 1,250 300 13,000

35,550 $13,450

SEASIDE SURF SHOP Balance Sheet September 30, 2019 Assets Current assets Cash Accounts receivable

$11,000 9,000

Inventory

21,000

Prepaid rent

12,000

Total current assets

53,000

Fixtures and equipment, net Total assets

23,750 $76,750

Liabilities and owners’ equity Current liabilities Salaries payable

$3,000

Bank loan payable

10,000

Interest payable Total current liabilities Owners’ equity* Total liabilities and owners’ equity

300 13,300 63,450 $76,750

*$50,000 + $13,450

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-155

C3-55. d.

Chapter 1 introduced the return on equity ratio as a simple performance measure that can be used to evaluate how well this new business is doing. The return on equity is calculated as the ratio of net income to average total equity. In this case, the return on equity for the three-month period was 23.7% = $13,450 / [($50,000+ $63,450)/2]. This is a very good return for a three-month period and equates to 95% annualized. However, the favorable performance evaluation should be tempered by a few caveats: (1) Because this business appears to be a sole proprietorship, any “salary” paid to the owner is not deducted from net income. Instead, cash payments to the owner are treated as dividends (or withdrawals). As a consequence, any services provided by the owner to the business would not be reflected among the expenses reported in the income statement, and net income would be overstated. (2) No expense is reported in the income statement for income taxes. This is consistent with the business being a sole proprietorship, in which income taxes are levied against the owner as an individual taxpayer. Again, this makes “net” income appear to be larger than it otherwise might be. (3) Retail businesses are notoriously seasonal. That is, sales (and profits) fluctuate from season to season. A business such as this one would likely have its highest sales in the second and third quarters. This seasonality must be considered when we try to annualize quarterly results like these. Once the business has operated for a year or two, the owner would likely have a better idea about how seasonal fluctuations affect sales and returns and would be better able to interpret quarterly performance measures. (4) Finally, Seaside’s cash position is precarious. The firm has burned through most of the $60 thousand cash raised to begin the business and is likely to have trouble replacing its inventory as well as paying its bills. Perhaps they can convince lenders to come to its rescue. If not, the firm will not last another three months.

©Cambridge Business Publishers, 2020 4-156

Financial Accounting, 6th Edition

C3-56. (15 minutes) LO 2, 3, 6 a.

The following analysis shows how the relevant information affects total assets, liabilities, and owners’ equity of the firm: Assets $88,500

Per original balance sheet Percentage of debt equity 1. Recognition of insurance expense ($4,500  1/2 = $2,250) 2. Depreciation correction $68,500 = $3,425) 3. (No adjustment required) 4. Unbilled services performed

Liabilities $45,900 51.9%

Owners Equity $42,600 48.1%

(2,250)

(2,250)

3,425

3,425

6,000

6,000

(5% 

5. Advance consulting fee earned ($11,300  1/2 = $5,650) 6. Recognition of supplies expense ($13,200 − $4,800 = $8,400) Revised totals Percentage of debt and equity

(5,650) (8,400) $87,275

______ $40,250 46.1%

5,650 (8,400) $47,025 53.9%

Revised debt-to-equity ratio: $40,250/$47,025 = 0.86 Original debt-to-equity ratio: $45,900/$42,600 = 1.08 b.

Apparently, the loan agreement has not been violated.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-157

C3-57. (30 minutes) LO 2, 3 a.

b.

Discussion of this case may consider the following ethical considerations facing Javetz: 1.

Balancing the long-run interests of the firm (securing the international contract) against the short-run requirement to present accurately the financial data of the company for the current year (recording $150,000 adjusting entry).

2.

Compromising the confidentiality of the contract negotiations (by disclosing the contract negotiations to additional persons) versus compromising her professional responsibilities (by omitting a significant year-end adjusting entry).

3.

Jeopardizing her position with the firm (by revealing information the president wants kept secret) versus risking possible future legal action by parties relying on the firm's financial statements (by not revealing a significant accrued expense and accrued liability in the financial statements).

Discussion of this case should also note that outside auditors frequently access confidential data and disclosing the contract negotiations to the auditor should not represent a significant breach of confidentiality. Perhaps Javetz can achieve a reasonable solution to her dilemma by suggesting that an adjusting entry be recorded and described in very general terms (for example, labeling the liability Payable to Consultants and indicating it is for marketing research and development). Such an adjustment would permit the disclosure of the significant liability without revealing important details to anyone else within or outside the company.

©Cambridge Business Publishers, 2020 4-158

Financial Accounting, 6th Edition

C3-58. (30 minutes) LO 2, 3, 4, 6 a. - d. FSET: Balance Sheet Transaction a1. Recognize prepaid catalog costs.

Cash Asset

Noncash Assets

=

-62,550

+62,550

=

Cash

Prepaid Catalog Costs

a2. Advertising credits received.

+ 849

-62,138

+

=

-336

+849

=

+849

-

Expenses

= Net Income

-

=

-

=

+849

=

-62,138

=

-336

-

Retained Earnings

=

=

+62,138 Catalog Expenses

-336

-

Retained Earnings

Cash

d2. Recognize sales using gift certificates.

Revenues

-62,138

Advertising Credits Receivable

+19,175

+

Earned Capital

Retained Advertising Earnings Credits Revenue

Prepaid Catalog Costs

Recognize expiration of advertising credits.

d1. Sales of gift certificates.

Liabilities

Advertising Credits Receivable

b. Recognize advertising expense.

c.

+

Income Statement Contrib. Capital

+336 Expense: Expiration of Advertising Credits

+19,175

-

=

-

=

Gift Certificate Liability

=

- 18,230 Gift Certificate Liability

+18,230

+18,230

Retained Gift Certificate Earnings Revenues

Continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-159

+18,230

a. – d.

continued

Journal Entries: a1.

a2.

b.

c.

Prepaid catalog costs (+A) Cash (-A) To record catalog printing costs.

62,550 62,550

Advertising credits receivable (+A) Advertising credits revenue (+R, +SE) To recognize advertising credits earned.

849 849

Catalog expense (+E, -SE) Prepaid catalog costs (-A) To regognize catalog expense ($3,894 + $62,550 - $4,306).

62,138 62,138

Advertising credit expiration expense (+E, -SE) Advertising credits receivable (-A) To record the expiration of advertising credits ($21 + $849 - $534).

336 336

Advertising credits expire either because they were used to advertise or, if there was a time limitation to their use, the time limit expired. d1.

d2.

Cash (+A) Customer deposits (+L) To recognize gift certificates sold but not yet redeemed.

19,175

Gift certificate liability (-L) Gift certificate revenues (+R, +SE) To recognize revenues based on redeemed gift certificates ($6,108 +$19,175 - $7,053).

18,230

©Cambridge Business Publishers, 2020 4-160

19,175

18,230

Financial Accounting, 6th Edition

2

Chapter 4 Reporting and Analyzing Cash Flows Learning Objectives – coverage by question MiniExercises

Exercises

Problems

Cases and Projects

LO1 – Explain the purpose of the statement of cash flows and classify cash transactions by type of business activity: operating, investing and financing

21 - 24, 29

LO2 – Construct the operating activities section of the statement of cash flows using the direct method.

25, 27, 30, 31

34, 38, 41, 43, 44

47, 49, 51, 53

59

LO3 – Reconcile cash flows from operations to net income and use the indirect method to compute operating cash flows.

21, 23, 25 - 29

35, 42, 44

45, 46, 48, 50 - 56

57, 58, 59

LO4 – Construct the investing and financing activities sections of the statement of cash flows.

21, 24

36 - 40, 42

46, 48, 50 - 56

57, 58, 59

32, 33, 35, 43

46, 48, 50, 52, 55, 56

59

LO5 – Compute and interpret ratios that reflect a company’s liquidity and solvency using information reported in the statement of cash flows. LO6 – Appendix 4A: Use a spreadsheet to construct the statement of cash flows.

Solutions Manual, Chapter 4

58, 59

55

©Cambridge Business Publishers, 2020 4-161

QUESTIONS Q4-1.

Cash equivalents are short-term, highly liquid investments that firms acquire with temporarily idle cash to earn interest on these excess funds. To qualify as a cash equivalent, an investment must (1) be easily convertible into a known cash amount and (2) be close enough to maturity so that its market value is not sensitive to interest rate changes (generally, investments with initial maturities of three months or less). Three examples of cash equivalents are treasury bills, commercial paper, and money market funds.

Q4-2.

Cash equivalents are included with cash in a statement of cash flows because the purchase and sale of such investments are considered to be part of a firm's overall management of cash rather than a source or use of cash. Similarly, as statement users evaluate cash flows, it may matter very little to them whether the cash is on hand, deposited in a bank account, or invested in cash equivalents.

Q4-3.

Operating activities Inflow: Cash received from customers Outflow: Cash paid to suppliers Investing activities Inflow: Sale of equipment Outflow: Purchase of stocks and bonds Financing activities Inflow: Issuance of common stock Outflow: Payment of dividends

Q4-4.

a. b. c. d. e. f. g. h.

Investing; outflow. Investing; inflow. Financing; outflow. Operating (direct method, not shown separately under indirect method); inflow. Financing; inflow. Operating (direct method, not shown separately under indirect method); inflow. Operating (direct method, not shown separately under indirect method); outflow. Operating (direct method, not shown separately under indirect method); inflow.

©Cambridge Business Publishers, 2020 4-162

Financial Accounting, 6th Edition

Q4-5.

This is a noncash investing and financing event. It must be reported in a supplementary schedule to the statement of cash flows.

Q4-6.

Noncash investing and financing transactions are disclosed as supplemental information to a statement of cash flows because a secondary objective of cash flow reporting is to present information about investing and financing activities. Noncash investing and financing transactions, generally, affect future cash flows. Issuing bonds payable to acquire equipment, for example, requires future cash payments for interest and principal on the bonds. On the other hand, converting bonds payable into common stock eliminates future cash payments related to the bonds. Knowledge of these types of events, therefore, should be helpful to users of cash flow data who wish to assess a firm's future cash flows.

Q4-7.

A statement of cash flows helps external users assess the amount, timing, and uncertainty of future cash flows to the enterprise. These assessments help users evaluate their own future cash receipts from their investments in, or loans to, the firm. A statement of cash flows shows the periodic cash effects of a firm's operating, investing, and financing activities. Distinguishing among these different categories of cash flows helps users compare, evaluate, and predict cash flows. With cash flow information, creditors and investors are better able to assess a firm's ability to settle its liabilities and pay its dividends. Over time, the statement of cash flows permits users to observe and analyze management's investing and financing policies. A statement of cash flows also provides information useful in evaluating a firm's financial flexibility (which is its ability to generate cash to respond to unanticipated needs and opportunities).

Q4-8.

The direct method presents the net cash flow from operating activities by showing the major categories of operating cash receipts and cash payments (such as cash received from customers, cash paid to employees and suppliers, cash paid for interest, and cash paid for income taxes). The indirect (or reconciliation) method, in contrast, presents the net cash flow from operating activities by applying a series of adjustments to the accrual net income to convert it to a cash basis.

Q4-9.

Under the indirect method, depreciation is added to net income because, as a noncash expense, it was deducted in computing net income. Adding depreciation to net income, therefore, eliminates it from the cash-basis income amount. Amortization and depletion expenses are handled the same way.

Q4-10.

Under the indirect method, the $98,000 cash received from the sale of the land will appear in the cash flows from investing activities section of the statement of cash flows. In addition, the $28,000 gain from the sale will be deducted from net income as one of the adjustments made to determine the net cash flow from operating activities.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-163

Q4-11.

Net income Add (deduct) items to convert net income to cash basis Depreciation expense Subtract change in accounts receivable Subtract change in inventory Add change in accounts payable Add change in income tax payable Net cash provided by operating activities

$ 88,000 6,000 13,000 (9,000) (3,500) 1,500 $ 96,000

Q4-12.

The separate disclosures required for a company using the indirect method in the statement of cash flows are (1) cash paid during the year for interest (net of amount capitalized) and for income taxes, (2) all noncash investing and financing transactions, and (3) the policy for determining which highly liquid, short-term investments are treated as cash equivalents.

Q4-13.

The statement of cash flows will show a positive net cash flow from operating activities if operating cash receipts exceed operating cash payments. This could happen, for example, if noncash expenses (such as depreciation and amortization) exceed the net loss. It would also happen if operating cash receipts exceed sales by more than the loss or if operating cash payments are less than accrual expenses by more than the loss (or some combination of these events).

Q4-14.

Sales + Accounts receivable decrease = Cash received from customers

$925,000 14,000 $939,000

Q4-15.

Wages expense + Wages payable decrease = Cash paid to employees

$ 86,000 1,100 $ 87,100

Q4-16. + =

Advertising expense Prepaid advertising increase Cash paid for advertising

$ 43,000 1,600 $ 44,600

Q4-17.

Under the direct method, the $5,100 cash received from the sale of equipment will appear in the cash flows from investing activities section of the statement of cash flows.

Q4-18.

The separate disclosures required for a company using the direct method in the statement of cash flows are (1) a reconciliation of net income to net cash flow from operating activities, (2) all noncash investing and financing transactions, and (3) the policy for determining which highly liquid, short-term investments are treated as cash equivalents.

©Cambridge Business Publishers, 2020 4-164

Financial Accounting, 6th Edition

Q4-19.

The operating cash flow to current liabilities ratio is calculated by dividing net cash flow from operating activities by average current liabilities. This ratio is a measure of a firm's ability to liquidate its current liabilities.

Q4-20.

The operating cash flow to capital expenditures ratio is calculated by dividing a firm's cash flow from operating activities by its annual capital expenditures. A ratio below 1.00 means that the firm's current operating activities are not providing enough cash to cover the capital expenditures. A ratio above 1.0 is normally considered a sign of financial strength.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-165

MINI EXERCISES M4-21. (5 minutes) LO 1, 3, 4 a. b. c. d. e.

Positive adjustment Negative adjustment Positive adjustment Positive adjustment Negative adjustment

M4-22. (10 minutes) LO 1 a. b. c. d. e. f. g.

Cash flow from an operating activity. Cash flow from an investing activity. Cash flow from an investing activity. Cash flow from an operating activity. Cash flow from a financing activity. Cash flow from a financing activity. Cash flow from an investing activity.

M4-23. (15 minutes) LO 1, 3

1 2 3 4 5 6 7 8 9 10 11

GENERAL MILLS, INC. Selected Items from the Cash Flow Statement Long-term debt repayments Change in receivables Depreciation and amortization Change in prepaid expenses Dividends paid Stock-based compensation Cash received from sales of assets and businesses Net earnings Change in accounts payable Proceeds from common stock issued Purchases of land, buildings and equipment

©Cambridge Business Publishers, 2020 4-166

Financing Operating Operating Operating Financing Operating Investing Operating Operating Financing Investing

Financial Accounting, 6th Edition

M4-24. (10 minutes) LO 1, 4 a.

(3) Cash flow from a financing activity.

b.

(1) Cash flow from an operating activity.

c.

(4) Noncash investing and financing activity.

d.

(1) Cash flow from an operating activity.

e.

(1) Cash flow from an operating activity.

f.

(5) None of the above (a change in the composition of cash and cash equivalents).

M4-25. (30 minutes) LO 2, 3 a. Income Statement

Balance Sheet

+

Accts. Receivable

(1)

+

+507,400 +

(2)

+91,500 +

+

(3)

Transaction

+

Contrib. Capital +

=

+

+

+507,400

+507,400 -

=

+507,400

=

+

+

+91,500

+91,500 -

=

+91,500

+

+ –320,100 =

+

+

–320,100

-

+320,100 =

–320,100

(4)

+

+ –63,400 =

+

+

–63,400

-

+63,400 =

–63,400

(5)

+

+ +351,600 =

+351,600 +

+

-

=

(6)

-47,700 +

+ +47,700 =

+

+

-

=

(7)

+483,400 +

–483,400 +

=

+

+

-

=

(8)

–340,200 +

+

=

–340,200 +

+

-

=

(9)

-172,300 +

+

=

+

+

-172,300

-

+172,300 =

-172,300

Total

+14,700 +

+24,000 + +15,800 =

+11,400 +

+

+43,100

-

+555,800 =

+43,100

+

Inventories

=

Accts. Payable

Earned Capital

Revenue

+598,900

-

Expenses

= Net Income

Net income was €43,100 (from the net income column), and cash flow from operating activities was €14,700 (from the cash column).

b.

c.

Cash Asset

1. 2. 3.

Accounts receivable increased by €24,000, Inventories increased by €15,800, and Accounts payable increased by €11,400.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-167

d.

The accounting equation is kept with every entry, so it is kept for the totals over the period. Cash flow + change in accounts receivable + change in inventory = Change in accounts payable + net income. This relationship can be presented in the following indirect method cash flow from operating activities. Net income € 43,100 - Change in accounts receivable –24,000 - Change in inventories –15,800 + Change in accounts payable +11,400 Cash flow from operating activities € 14,700

M4-26. (15 minutes –INDIRECT METHOD) LO 3 Net income Add (deduct) items to convert net income to cash basis Add back depreciation Subtract gain on sale of investments Subtract change in operating assets: Accounts receivable Inventory Prepaid rent Add change in operating liabilities: Accounts payable Income tax payable Net cash provided by operating activities

©Cambridge Business Publishers, 2020 4-168

$ 45,000 8,000 (9,000) (9,000) (6,000) 2,000 4,000 (2,000) $ 33,000

Financial Accounting, 6th Edition

M4-27. (30 minutes) LO 2, 3 a. Balance Sheet Transaction

Cash Asset

(1) (2)

+46,200

(3)

+

Accts. Receivable

+

+

+769,200

+

-

+

+

+

+

+

Contr. + Capital

=

+

+

+769,200

+769,200 -

=

+769,200

-

=

+

+

+46,200

+46,200 -

=

+46,200

-

=

+

+

–526,700

-

+526,700 =

–526,700

-

=

+

+

-

=

-

=

+

+

-

=

-

=

+

+

-

+117,900 =

+

-

=

+

+

-

=

=

+

+

–122,800

-

+122,800 =

–122,800

+

+

-23,000

-

+23,000 =

-23,000

+

+

+25,000

+815,400 -

+790,400 =

+25,000

(4)

–149,100

+

+

(5)

–521,600

+

+

+

+

(6)

–724,100

Prepaid Rent

+149,100

–117,900

-

Accum. Deprec.

=

(7)

+724,100

+

(8)

–122,800

+

+

-

+

+

-

+23,000

=

-

+23,000

=

(9) Total

–23,200

+

+45,100

Income Statement

+

+31,200

Wages Payable

+526,700

–521,600

+5,100

Earned Capital

Revenue

–117,900

-

Expenses

= Net Income

b.

Net income was $25,000 (from the net income column), and cash flow from operating activities was –$23,200 (from the cash column).

c.

1. 2. 3. 4.

d.

The accounting equation is kept with every entry, so it is kept for the totals over the period.

Accounts receivable increased by $45,100, Prepaid rent increased by $31,200, Accumulated depreciation (a contra-asset) increased by $23,000 due to depreciation expense and Wages payable increased by $5,100.

Cash flow + change in accounts receivable + change in prepaid rent – change in accumulated depreciation = Change in wages payable + net income. This relationship can be presented in the following indirect method cash flow from operating activities. Net income $ 25,000 + Depreciation expense 23,000 – Change in accounts receivable –45,100 – Change in prepaid rent –31,200 + Change in wages payable +5,100 Cash flow from (used in) operating activities ($ 23,200)

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-169

–117,900

M4-28. (15 minutes—INDIRECT METHOD) LO 3 Net loss Add (deduct) items to convert net loss to cash basis Add back depreciation Subtract change in operating assets: Accounts receivable Inventory Prepaid expenses Add change in operating liabilities: Accounts payable Accrued liabilities Net cash provided by operating activities

$(21,000) 8,600 (9,000) (3,000) (3,000) 4,000 (2,600) $ 4,000

Weber Company's 2018 operating activities provided $4,000 cash. The dividend paid to shareholders affects cash flows from financing activities.

M4-29. (20 minutes) LO 1, 3 A “+” indicates that the amount is added and a “-“ indicates that it is subtracted when preparing the cash flow statement using the indirect method. NORDSTROM, INC. Consolidated Statement of Cash Flows – Selected Items 1

Decrease in accounts receivable

Operating

+-

2

Capital expenditures

Investing

-

3

Proceeds from long-term borrowings

Financing

+

4

Increase in deferred income tax net liability

Operating

+

5

Principal payments on long-term borrowings

Financing

-

6

Increase in merchandise inventories

Operating

-

7

Increase in prepaid expenses and other assets

Operating

-

8

Proceeds from issuances under stock compensation plans

Financing

+

9

Increase in accounts payable

Operating

+

10

Net earnings

Operating

+

11

Payments for repurchase of common stock

Financing

-

12

Increase in accrued salaries, wages and related benefits

Operating

+

13

Cash dividends paid

Financing

-

14

Depreciation and amortization expenses

Operating

+

©Cambridge Business Publishers, 2020 4-170

Financial Accounting, 6th Edition

M4-30. (15 minutes—DIRECT METHOD) LO 2 a. – =

Rent expense Prepaid rent decrease Cash paid for rent

$ 60,000 (2,000) $ 58,000 Balance Sheet

Transaction

Cash

Begin Balance Make rent payment

+ +

-X

+

Record rent expense

+

End Balance

+

Noncash Assets

10,000 Prepaid Rent +X Prepaid Rent -60,000 Prepaid Rent 8,000

Income Statement

= Liabilities

+

Contr. + Capital

Earned Surplus

=

+

+

-

=

=

+

+

-

=

=

+

+

=

+

+

Revenue

-

-60,000 Retained Earnings

-

Expenses

+60,000 Rent Expense

-

=

=

Net Income

-60,000

=

X must equal $58,000 to make the FSET balance. b. – =

Interest income Interest receivable increase Cash received as interest

$ 16,000 (700) $ 15,300 Balance Sheet

Transaction

Cash

Begin Balance Record interest income Receive interest payment End Balance

+ +

+

+X

Noncash Assets

3,000 Interest Receivable +16,000 Interest Receivable

Income Statement

= Liabilities

+

Contr. + Capital

=

+

+

=

+

+

Earned Surplus

+16,000 Retained Earnings

Revenue

-

Expenses

=

-

=

+16,000 Interest income

=

+

-X

=

+

+

-

=

+

3,700

=

+

+

-

=

Net Income

+16,000

X must equal $15,300 to make the FSET balance.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-171

c. Cost of goods sold + Inventory increase + Accounts payable decrease = Cash paid for merchandise purchased

$ 98,000 3,000 4,000 $105,000

Balance Sheet

Income Statement

+

Noncash Assets

=

Liabilities

+

Contr. + Capital

Begin Balance

+

19,000 Inventory

=

11,000 Accounts Payable

+

+

-

=

Purchase inventory

+

+X

=

+X

+

+

-

=

=

-Y Accounts Payable

+

+

-

=

Transaction

Pay supplier Recognize Cost of Goods Sold End Balance

Cash

-Y

+

+

-98,000 Inventory

=

+

22,000

=

7,000

+

+

+

+

Earned Surplus

-98,000 Retained Earnings

Revenue

-

-

Expenses

98,000 Cost of Goods Sold

-

=

=

Net Income

-98,000

=

To make the inventory account work properly, X (purchases) must equal $101,000. If purchases were $101,000, then Y (payments to suppliers) must equal $105,000.

M4-31. (15 minutes—DIRECT METHOD) LO 2 Operating cash flow + change in operating assets = net income + change in operating liabilities or Net income - change in operating assets + change in operating liabilities = operating cash flow – =

Effect of sales on net income Change in accounts receivable Effect of customers on cash

+ =

Effect of cost of goods sold on net income Change in inventory Change in accounts payable Effect of merchandise purchases on cash

$825,000 (11,000) $814,000 ($550,000) (13,000) (6,000) ($569,000)

Chakravarthy Company received $814,000 in cash from its customers and paid $569,000 in cash to its suppliers.

©Cambridge Business Publishers, 2020 4-172

Financial Accounting, 6th Edition

EXERCISES E4-32. (20 minutes) LO 5 (All dollar amounts in millions) a. Merck: $6,447/$17,909 = 0.360 Pfizer: $16,470/$30,771 = 0.535 Abbott Labs: $5,570/$7,786 = 0.715 Johnson & Johnson: $21,056/$28,412 = 0.741 b.

Merck: $6,447 – $1,888 = $4,559 Pfizer: $16,470 – $1,956 = $14,514 Abbott Labs: $5,570 – $1,135 = $4,435 Johnson & Johnson: $21,056 – $3,279 = $17,777

c.

None of the firms has sufficient cash flow to cover their current liabilities although none of the ratios is alarmingly low. The industry ratios shown in Chapter 5, show that only Merck is below median. Pfizer and Johnson & Johnson are the larger of these companies and have relatively more cash left over after capital expenditures to consider using on other activities that could strengthen the firm’s operating or financial position. But all four have significant free cash flow that could be invested or returned to shareholders in the form of dividends or stock repurchases. Given that these firms are of different sizes and have different research program success, it is difficult to generalize further.

E4-33. (20 minutes) LO 5 (All dollar amounts in millions) a. Wal-Mart: $28,337/$72,725 = 0.390 Coca-Cola: $6,995/$26,863 = 0.260 ExxonMobil: $30,066/$52,705 = 0.570 b.

Wal-Mart: $28,337 – ($10,051 – $378) = $18,664 Coca-Cola: $6,995 – ($1,675 – $104) = $5,424 ExxonMobil: $30,066 – ($15,402 – $3,103) = $17,767

c.

All three companies are producing much more cash than needed for capital expenditures. All of them are returning substantial amounts of cash to shareholders through dividends and share repurchases. ExxonMobil appears to be in the best position with respect to OCFCL, but it is lower than the industry average reported in Chapter 5. Wal-Mart and Coca-Cola have lower ratios, and are also below the average ratio for their industries.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-173

E4-34. (30 minutes—INDIRECT METHOD) LO 2 MASON CORPORATION Statement of Cash Flows For Year Ended December 31, 2018 Cash flows from operating activities Cash received from customers Cash received as interest Cash paid to employees and suppliers Cash paid as income taxes Net cash provided by operating activities Cash flows from investing activities Sale of land Purchase of equipment Net cash used by investing activities Cash flows from financing activities Issuance of bonds payable Acquisition of treasury stock Payment of dividends Net cash provided by financing activities Net decrease in cash Cash at beginning of year Cash at end of year

$194,000 6,000 (148,000) (11,000) $ 41,000 40,000 (89,000) (49,000) 30,000 (10,000) (16,000) 4,000 (4,000) 16,000 $ 12,000

E4-35. (15 minutes—INDIRECT METHOD) LO 3, 5 a.

Net income

$113,000

Add (deduct) items to convert net income to cash basis Accounts receivable increase Inventory decrease Prepaid insurance increase Accounts payable increase Wages payable decrease Net cash provided by operating activities b.

(5,000) 6,000 (1,000) 4,000 (2,000) $115,000

$115,000/[($31,000 + $29,000)/2] =3.83

©Cambridge Business Publishers, 2020 4-174

Financial Accounting, 6th Edition

E4-36. (15 minutes–INVESTING ACTIVITIES) LO 4 The basic approach here is to use the beginning and ending balances and the additional information to reconstruct what must have happened during 2018. Begin by setting up the T-accounts for property, plant and equipment with the beginning and ending balances. + Beg. balance

Ending balance

Property, plant and equipment at cost (A) 1,000

-

-

Accumulated depreciation (XA)

1,200

+ 350

Beg. balance

390

Ending balance

At this point in the book, we know four entries that can affect these two accounts – (1) acquisitions using cash, (2) acquisitions without cash (other financing), (3) disposals, and (4) depreciation expense. The journal entries for these entries are given below, with amounts given in the problem filled in. (1)

(2)

(3)

(4)

Property, plant and equipment at cost (+A) Cash (-A) To record purchase of property, plant and equipment with cash.

300

Property, plant and equipment at cost (+A) Mortgage payable (+L) To record purchase of property, plant and equipment with financing.

100

Cash (+A) Accumulated depreciation (-XA, +A) Property, plant and equipment at cost (-A) Gain on equipment disposal (+R, +SE) To record sale of used equipment.

100 Y

Depreciation expense (+E, -SE) Accumulated depreciation (+XA, -A) To record depreciation expense.

300

100

X 20

Z Z

continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-175

The three unknowns in the journal entries correspond to the three questions in the problem. We begin by putting the journal entry amounts into the T-accounts. + Beg. balance (1) (2) (3) Ending balance

Property, plant and equipment at cost (A) 1,000 300 100

-

X 1,200

-

Accumulated depreciation (XA)

+ 350

Beg. balance

Z 390

(3) (4) Ending balance

Y

a.

The PPE at cost account will only balance if the value X equals 200. So, the original cost of the used equipment that was sold is €200. We can put that amount in the T-account (so it balances) and also in Journal entry (3).

b.

Now, looking at journal entry (3), we see that there is only one unknown left – the depreciation that had accumulated on the used equipment. In order for the entry to balance (with debits equal to credits), the accumulated depreciation must have been 120 (= Y). Cost of 200 and accumulated depreciation of 120 would produce a net book value of 80, so when Meubles Fischer sold it for 100, they recorded a gain of 20 on the disposal.

c.

Back at the Accumulated depreciation T-account, we can fill in the entry for (3), leaving only the depreciation expense to determine for entry (4). Knowing that the disposal reduced the contra-asset by 120, and that the contra-asset increased by 40 over the year, we can infer than the depreciation expense must have been €160 (= Z).

©Cambridge Business Publishers, 2020 4-176

Financial Accounting, 6th Edition

E4-37. (15 minutes—INVESTING ACTIVITIES) LO 4 The basic approach here is to use the beginning and ending balances and the additional information to reconstruct what must have happened during 2018. Begin by setting up the T-accounts for property, plant and equipment with the beginning and ending balances. + Beg. balance

Ending balance

Property, plant and equipment at cost (A) 175

-

-

Accumulated depreciation (XA) 78

Beg. balance

83

Ending balance

183

+

At this point in the course, we know four entries that can affect these two accounts – (1) acquisitions using cash, (2) acquisitions without cash (other financing), (3) disposals, and (4) depreciation expense. The journal entries for these entries are given below, with amounts given in the problem filled in. (1)

(2)

(3)

(4)

Property, plant and equipment at cost (+A) Cash (-A) To record purchase of property, plant and equipment with cash.

28 28

Property, plant and equipment at cost (+A) Mortgage payable (+L) To record purchase of property, plant and equipment with financing.

0

Cash (+A) Accumulated depreciation (-XA, +A) Loss on equipment disposal (+E, -SE) Property, plant and equipment at cost (-A) To record sale of used equipment.

Z Y 5

Depreciation expense (+E, -SE) Accumulated depreciation (+XA, -A) To record depreciation expense.

17

0

X

17

continued next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-177

The three unknowns in the journal entries correspond to the three questions in the problem. We begin by putting the journal entry amounts into the T-accounts. + Beg. balance (1) (2) (3) Ending balance

Property, plant and equipment at cost (A) 175 28 0

-

X 183

-

Accumulated depreciation (XA) 78

Y 17 83

+ Beg. balance

(3) (4) Ending balance

a.

The PPE at cost account will only balance if the value X equals 20. So, the original cost of the used equipment that was sold is £20. We can put that amount in the T-account (so it balances) and also in Journal entry (3).

b.

The accumulated depreciation account will only balance if the value Y equals 12. So, the accumulated depreciation on the used equipment sold must be £12, and that amount can be entered into transaction (3) above.

c.

Now, looking at journal entry (3), we see that there is only one unknown left – the amount of cash received from disposal of the used equipment. In order for the entry to balance (with debits equal to credits), the cash amount must have been £3 million (= Z). Cost of 20 and accumulated depreciation of 12 would produce a net book value of 8, so when Kasznik Ltd. sold it for 3, they recorded a loss of 5 on the disposal.

©Cambridge Business Publishers, 2020 4-178

Financial Accounting, 6th Edition

E4-38. (30 minutes) LO 2, 4 a.

The analysis from the chapter shows that Cash flow (payments)

+

Change in inventory

=

Change in accounts payable

+

Net income (COGS expense)

X

+

-57 (=8,899-8,956)

=

+1,484 (=12,484-11,000)

+

-89,052

The solution to this is that X = -$89,052 + 57 + 1,484 = -$87,511. So, the payments to suppliers reduced cash by $87,511 million in fiscal year 2017. b.

The net property and equipment account decreased by $693 million (=$13,642 – $14,335). Depreciation expense would have decreased this balance by $1,545 million in fiscal year 2017, so the net investment must have been $852 million (=-$693 + $1,545) to result in the ending balance of $13,642 million.

c.

With the beginning balance of $27,684 million in retained earnings, net earnings of $4,078 would have increased retained earnings to $31,762 million. But the ending balance in retained earnings is $30,137 million, so Walgreens Boots must have paid $1,625 million in dividends (=$31,762 - $30,137).

E4-39. (15 minutes) LO 4 a.

Cash flows from investing activities will show: Purchase of stock investments

Sale of stock investments b.

Cash flows from financing activities will show: Issuance of bonds Retirement of bonds

Solutions Manual, Chapter 4

$ (80,000)

59,000 $130,000 (131,000)

©Cambridge Business Publishers, 2020 4-179

E4-40. (20 minutes) LO 4 a.

The net increase in property and equipment, cost was $821,989 (= $98,190,992 - $97,369,003). Expenditures should have increased this by $1,182,854, and the non-cash transaction another $239,382. Therefore, the original cost of the property and equipment sold must have been $600,247 (= $1,182,854 + $239,382 - $821,989). Depreciation expense should have increased the accumulated depreciation account by $3,876,111, but the account increased by only $3,275,864. The accumulated depreciation on the property and equipment sold must account for the difference, making it $600,247 (=$3,876,111 - $3,275,864).

b.

The book value of the property and equipment sold was zero (=$600,247 – $600,247), and the reported gain on sale of the property and equipment was $56,446. Therefore, the cash proceeds on the sale of these fully-depreciated assets must have been $56,446!

c. Cash (+A) Accumulated depreciation (-XA, +A) Property and equipment, cost (-A) Gain on sale of property and equipment (+R, +SE) d.

$ 56,446 600,247 $ 600,247 56,446

Retained earnings increased by $1,688,643 (= $20,738,143 – 19,049,500), and net income was $3,184,803, which would increase retained earnings. The difference would be accounted for by cash dividends paid to shareholders, and the amount is $1,496,160 ($3,184,803 - $1,688,643). The dividends paid are approximately equal to previous years even though earnings are considerably higher, demonstrating that companies are reluctant to change dividends as earnings fluctuate up and down..

E4-41. (20 minutes—DIRECT METHOD) LO 2 a. + =

Advertising expense Prepaid advertising increase Cash paid for advertising

$ 62,000 4,000 $ 66,000

+ =

Income tax expense Income tax payable decrease Cash paid for income taxes

$ 29,000 2,200 $ 31,200

– – =

Cost of goods sold Inventory decrease Accounts payable increase Cash paid for merchandise purchased

$180,000 (5,000) (2,000) $173,000

b.

c.

©Cambridge Business Publishers, 2020 4-180

Financial Accounting, 6th Edition

E4-42. LO 3, 4 HOSKINS CORPORATION Statement of Cash Flows Year ended December 31, 2018 Cash Flows from Operations: Net income Adjustments: Add back Depreciation – Change in Accounts Receivable – Change in Inventory – Change in Prepaid Expenses + Change in Accounts Payable + Change in Income Taxes Payable Cash Flows from Operating Activities Cash Flows from Investing: Purchases of Equipment Proceeds from Disposal of Equipment

$ 700 350 (900) (100) 250 400 (100) $ 600

(1,200) 600

Cash Flows from Investing Activities Cash Flows from Financing: Dividends Paid Increase in Short-term Debt Decrease in Long-term Debt Cash Flows from Financing Activities Net Change in Cash Beginning Cash Balance Ending Cash Balance

Solutions Manual, Chapter 4

(600)

(250) 1,500 (1,000) 250 250 300 $ 550

©Cambridge Business Publishers, 2020 4-181

E4-43. (30 minutes—DIRECT METHOD) LO 2, 5 a. – =

Sales Accounts Receivable Increase Cash Received from Customers

$750,000 (5,000) $745,000

– – =

Inventory Decrease Accounts Payable Increase Cash Paid for Merchandise Purchased

(6,000) (4,000) $460,000

+ =

Wages Expense Wages Payable Decrease Cash Paid to Employees

$110,000 2,000 $112,000

+ =

Insurance Expense Prepaid Insurance Increase Cash Paid for Insurance

$ 15,000 1,000 $ 16,000

Cost of Goods Sold

Cash Flows from Operating Activities Cash Received from Customers Cash Paid for Merchandise Purchased Cash Paid to Employees Cash Paid for Rent Cash Paid for Insurance Net Cash Provided by Operating Activities b.

$470,000

$745,000 $460,000 112,000 42,000 16,000

630,000 $115,000

$115,000/[($31,000 + $29,000)/2] =3.83

E4-44. (15 minutes) LO 2, 3 1.

True

---

2.

False

$25

3.

False

$10

4.

False

$0

©Cambridge Business Publishers, 2020 4-182

Changing financial reporting depreciation will change net income, but not cash flows. Changing tax depreciation will change cash flows, but not net income. This issue is examined later in Chapter 10.

Financial Accounting, 6th Edition

PROBLEMS P4-45. (20 minutes) LO 3 Cash flows from operating activities Net income ...............................................................................................................................

$135,000

Adjustments to reconcile net income to operating cash flows Add back depreciation expense ......................................................................................... $25,000 Gain on sale of assets

(5,000)

Subtract changes in: Accounts receivable ..........................................................................................................(10,000) Prepaid expenses ............................................................................................................... 3,000 Add changes in: Accounts payable .............................................................................................................. 6,000 Wages payable................................................................................................................... (4,000)

Net cash provided from operating activities .............................................................................

Solutions Manual, Chapter 4

15,000

$150,000

©Cambridge Business Publishers, 2020 4-183

P4-46. (45 minutes—INDIRECT METHOD) LO 3, 4, 5 a.

Cash, December 31, 2018 .......................................................................................... $11,000 Cash, December 31, 2017 .......................................................................................... 5,000 Cash increase during 2018 ......................................................................................... $ 6,000

b.

STATEMENT OF CASH FLOWS (INDIRECT METHOD) WOLFF COMPANY Statement of Cash Flows For Year Ended December 31, 2018 Net Cash Flow from Operating Activities Net Income Add (Deduct) Items to Convert Net Income to Cash Basis

Depreciation Accounts Receivable Increase Inventory Increase Prepaid Insurance Decrease Accounts Payable Decrease Wages Payable Increase Income Tax Payable Decrease Net Cash Provided by Operating Activities Cash Flows from Investing Activities Purchase of Plant Assets Cash Flows from Financing Activities Issuance of Bonds Payable Payment of Dividends Net Cash Provided by Financing Activities Net Increase in Cash Cash at Beginning of Year Cash at End of Year

c.

$56,000

17,000 (9,000) (30,000) 2,000 (3,000) 3,000 (1,000) $35,000 (55,000) 55,000 (29,000) 26,000 6,000 5,000 $11,000

(1) $35,000/(($23,000 + $24,000)/2) = 1.49 (2) $35,000/$55,000 = 0.64 Wolff’s cash flow ratios indicate that, while the company has sufficient cash flow to cover its current obligations, it must rely on external financing to pay for capital expenditures.

©Cambridge Business Publishers, 2020 4-184

Financial Accounting, 6th Edition

P4-47. (30 minutes) LO 2 a. Adjustments to Convert Income Statement Items to Operating Activity Cash Flows Net income

=

$ 56,000

Sales revenue

–Cost of goods sold

–Wage expenses

–Insurance expense

–Depreciation expense

–Interest expense

+Gains

–Losses

–Income tax expense

$635,000

–430,000

–86,000

–8,000

–17,000

–9,000

+0

–0

–29,000

Adjustments: +Depreciation expense

Add back depreciation expense

+17,000 –Gains 0

Subtract (add) non-operating gains (losses)

+Losses 0

Subtract the change in operating assets (operating investments)

–Change in accounts receivable

– Change in inventory

–Change in prepaid insurance

-9,000

-30,000

-(-2,000)

Add the change in operating liabilities (operating financing) Cash from operations $ 35,000

=

Receipts from customers $626,000

b.

+Change in accounts payable

+Change in wages payable

+Change in income tax payable

+(-3,000)

+3,000

+(-1,000)

–Payments for merchandise

–Payments for Wages

–Payments for insurance

(zero)

–Payments for interest

(zero)

(zero)

–Payments for income tax

-83,000

-6,000

0

-9,000

+0

–0

–30,000

-463,000

Computing cash flows from operating activities using the direct method provides additional detail about the specific cash flows that occurred during the period. For example, the indirect method does not reveal that Wolff paid $463,000 for merchandise during 2018, or $83,000 for wages. Because this detail is missing, the FASB requires supplemental disclosure of two specific (and important) cash payments – interest and taxes – if the indirect method is used.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-185

P4-48. (45 minutes—INDIRECT METHOD) LO 3, 4, 5 a.

Cash, December 31, 2018 Cash, December 31, 2017 Cash increase during 2018

$49,000 28,000 $21,000

b.

Statement of Cash Flows (Indirect Method) ARCTIC COMPANY Statement of Cash Flows For Year Ended December 31, 2018

Net Cash Flow from Operating Activities Net Loss

$ (42,000)

Add (Deduct) Items to Convert Net Loss to Cash Basis Depreciation Gain on Sale of Land Accounts Receivable Decrease Inventory Decrease Prepaid Advertising Decrease Accounts Payable Decrease Interest Payable Increase Net Cash Used by Operating Activities Cash Flows from Investing Activities Sale of Land Purchase of Equipment Net Cash Used by Investing Activities Cash Flows from Financing Activities Issuance of Bonds Payable Purchase of Treasury Stock Net Cash Provided by Financing Activities Net Increase in Cash Cash at Beginning of Year Cash at End of Year

22,000 (25,000) 8,000 6,000 3,000 (14,000) 6,000 $ (36,000) 70,000 (183,000)* (113,000) 200,000 (30,000) 170,000 21,000 28,000 $ 49,000

* The sum of the increase in PPE assets account ($138,000) and the book value of the land sold ($45,000).

c.

- $36,000/(($23,000 + $31,000)/2) = -1.33 - $36,000/$183,000 = -0.20 Arctic’s operating cash flows are negative, primarily because the firm reported a net loss for the year. As a consequence, its cash flow ratios indicate insufficient cash flows to fund operations and capital expenditures.

©Cambridge Business Publishers, 2020 4-186

Financial Accounting, 6th Edition

P4-49. (30 minutes) LO 2 a. Adjustments to Convert Income Statement Items to Operating Activity Cash Flows Net income (loss) –$ 42,000

=

Sales revenue $728,000

–Cost of goods sold –534,000

–Wage expenses –190,000

–Advertising expense –31,000

–Depreciation expense –22,000

–Interest expense –18,000

+Gains

–Losses

+25,000

–0

Income tax expense –0

Adjustments:

Add back depreciation expense

+Depreciation expense +22,000 –Gains –25,000

Subtract (add) non-operating gains (losses)

+Losses 0

Subtract the change in operating assets (operating investments)

–Change in accounts receivable -(-8,000)

Add the change in operating liabilities (operating financing) Cash from operations –$ 36,000

=

b.

Receipts from customers $736,000

–Change in prepaid advertising -(-3,000)

–Change in inventory -(-6,000)

+Change in accounts payable +(-14,000)

+change in wages payable +0

–Payments for merchandise –542,000

–Payments for Wages –190,000

+Change in interest payable +6,000 –Payments for advertising –28,000

(zero)

0

–Payments for interest –12,000

+Change in income tax payable +0

(zero)

(zero)

+0

–0

–Payments for income tax –0

Computing cash flows from operating activities using the direct method provides additional detail about the specific cash flows that occurred during the period. For example, the indirect method does not reveal that Arctic paid $542,000 for merchandise during 2018, or $28,000 for advertising. Because this detail is missing, the FASB requires supplemental disclosure of two specific (and important) cash payments – interest and taxes – if the indirect method is used.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-187

P4-50. (50 minutes—INDIRECT METHOD) LO 3, 4, 5 a.

Cash, December 31, 2018 ............................................................................... Cash, December 31, 2017 ............................................................................... Cash increase during 2018 ..............................................................................

b.

STATEMENT OF CASH FLOWS (INDIRECT METHOD)

$27,000 18,000 $ 9,000

DAIR COMPANY Statement of Cash Flows For Year Ended December 31, 2017 Net Cash Flow from Operating Activities Net Income Add (deduct) items to convert net income to cash basis Depreciation Amortization of intangible assets Loss on bond retirement Accounts receivable increase Inventory decrease Prepaid expenses increase Accounts payable increase Interest payable decrease Income tax payable decrease Net cash provided by operating activities Cash flows from investing activities Sale of equipment Cash flows from financing activities Retirement of bonds payable Issuance of common stock Payment of dividends Net cash used by financing activities Net increase in cash Cash at beginning of year Cash at end of year

©Cambridge Business Publishers, 2020 4-188

$ 85,000

22,000 7,000 5,000 (5,000) 6,000 (2,000) 6,000 (3,000) (2,000) $119,000 17,000 (125,000) 24,000 (26,000) (127,000) 9,000 18,000 $ 27,000

Financial Accounting, 6th Edition

c.

(1) Supplemental cash flow disclosures Cash paid for interest ................................................................................................................... Cash paid for income taxes .......................................................................................................... *

Interest expense + Interest payable decrease Cash paid for interest

$10,000 3,000 $13,000

†

Income tax expense + Income tax payable decrease Cash paid for income taxes

$36,000 2,000 $38,000

(2) Schedule of noncash investing and financing activities Issuance of bonds payable to acquire equipment ........................................................................ d.

(1) (2) (3)

$ 13,000* $ 38,000†

$ 60,000

$119,000/[($42,000 + $41,000)/2] = 2.87. The firm did not spend any cash on capital investments. The firm did issue debt for equipment, but this is not a capital expenditure. $119,000 + $17,000 = $136,000

P4-51. (45 minutes) LO 2, 3, 4 a.

Cash received from customers was $176,594. They report an increase in accounts receivable, net of $941. So, based on the information in the statement of cash flows, total revenues would be $176,594 + $941 = $177,535

b.

Add net income and subtract dividends as follows: $38,983 + $6,623 - $2,049 = $43,557.

c.

Stock-based compensation is deducted as an expense when computing net income. However, it is compensation paid in the form of common stock, not cash. Since it doesn’t decrease cash, it is added back to net income when reconciling net income to cash flow from operations.

d.

Some of CVS’ operations occur in Canada and some of its cash transactions are transacted in Canadian dollars. When the financial statements are prepared, the Canadian dollars must be translated into U.S. dollars so that the statements are presented in a common unit of currency. The amount listed in the cash flow statement reflects the small effect that this conversion had on the cash flows and cash balances of CVS.

e.

CVS used its cash flow from operating activities as follows: • It invested over $2.9 billion, mostly in new property, plant and equipment and acquisitions; • It spent over 6.7 billion on financing transactions, mostly to repurchase stock and pay dividends, net of amounts borrowed; • It decreased its cash balance by almost 1.7 billion.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-189

P4-52. (50 minutes—INDIRECT METHOD) LO 3, 4, 5 a.

Cash and cash equivalents, December 31, 2018 .................................................................. Cash and cash equivalents, December 31, 2017 .................................................................. Cash and cash equivalents decrease during 2018 ................................................................

$19,000 25,000 $ 6,000

b. RAINBOW COMPANY Statement of Cash Flows For Year Ended December 31, 2018 Cash flow from operating activities Net income Add (deduct) items to convert net income to cash basis Depreciation Patent amortization Loss on sale of equipment Gain on sale of investments Accounts receivable increase Inventory increase Prepaid expenses increase Accounts payable increase Interest payable increase Income tax payable decrease Net cash provided by operating activities ……… Cash flows from investing activities Sale of investments Purchase of land Improvements to building Sale of equipment Net cash used by investing activities Cash flows from financing activities Issuance of bonds payable Issuance of common stock Payment of dividends Net cash provided by financing activities ……… Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of year …. Cash and cash equivalents at end of year

©Cambridge Business Publishers, 2020 4-190

$ 90,000 39,000 7,000 5,000 (3,000) (10,000) (26,000) (4,000) 4,000 1,000 (2,000) $101,000 60,000 (90,000) (95,000) 14,000 (111,000) 30,000 24,000 (50,000) 4,000 (6,000) 25,000 $ 19,000

Financial Accounting, 6th Edition

c.

(1)

(2)

d.

(1) (2) (3):

Supplemental Cash Flow Disclosures Cash paid for interest Cash paid for income taxes

$ 12,000* $ 46,000†

* Interest expense - Interest payable increase Cash paid for interest

$13,000 (1,000) $12,000

† Income tax expense + Income tax payable decrease Cash paid for income taxes

$44,000 2,000 $46,000

Schedule of noncash investing and financing activities Issuance of preferred stock to acquire patent

$ 25,000

$101,000/[($34,000 + $31,000)/2] = 3.11. $101,000/$185,000 = 0.55. $101,000 – ($90,000 + $95,000 - $14,000) = -$70,000

P4-53. (35 minutes) LO 2, 3, 4 a.

Cash and cash equivalents, December 31, 2018 ……….. Cash and cash equivalents, December 31, 2017 ……….. Cash and cash equivalents decrease during 2018 ……..

$19,000 25,000 $ 6,000

b. RAINBOW COMPANY Statement of Cash Flows (Direct Method) For Year Ended December 31, 2018 Cash flows from operating activities Cash received from customers ………………………… Cash received as dividends …………………………….. Cash paid for merchandise purchased ……………….. Cash paid for wages and other operating expenses … Cash paid for interest …………………………………….. Cash paid for income taxes ……………………………… Net cash provided by operating activities ……………..

$740,000 15,000 462,000 134,000 12,000 46,000

Cash flows from investing activities Sale of investments ……………………………………….. Purchase of land …………………………………………… Improvements to building ………………………………… Sale of equipment ………………………………………….. Net cash used by investing activities …………………...

$755,000

(654,000) 101,000

60,000 (90,000) (95,000) 14,000 (111,000)

Table continued on next page

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-191

b. Table continued RAINBOW COMPANY Statement of Cash Flows (Direct Method) For Year Ended December 31, 2018 Cash flows from financing activities Issuance of bonds payable ………………………………. Issuance of common stock ………………………………. Payment of dividends ……………………………………… Net cash provided by financing activities ………………

30,000 24,000 (50,000) 4,000

Net decrease in cash and cash equivalents ……………….. Cash and cash equivalents at beginning of year …………. Cash and cash equivalents at end of year …………………. c.

(1)

(2)

(6,000) 25,000 $ 19,000

Reconciliation of net income to net cash flow from operating activities Net income Add (deduct) items to convert net income to cash basis Depreciation Patent amortization Loss on sale of equipment Gain on sale of investments Accounts receivable increase Inventory increase Prepaid expenses increase Accounts payable increase Interest payable increase Income tax payable decrease Net cash provided by operating activities

39,000 7,000 5,000 (3,000) (10,000) (26,000) (4,000) 4,000 1,000 (2,000) $101,000

Schedule of noncash investing and financing activities Issuance of preferred stock to acquire patent

$ 25,000

©Cambridge Business Publishers, 2020 4-192

$ 90,000

Financial Accounting, 6th Edition

P4-54. (30 minutes) LO 3, 4 Operating cash flow + change in operating assets = net income + change in operating liabilities, or Net income - change in operating assets + change in operating liabilities = operating cash flow a.

Apple’s adjustment for accounts receivable is ($2,093) million. This adjustment represents minus the change in receivables, so Apple’s operations would have caused accounts receivable to go up by $2,093 million. ($ millions) Net sales ………………………………………………………………… - Change in accounts receivable ……………………………………

-2,093

+ Change in deferred revenue

-626

Cash collected from customers …………………………………….. b.

c.

$226,515

($ millions) - Cost of goods sold ……………………………………………………. - Change in inventories …………………………………………….. + Change in accounts payable ………………………………………

($141,048) -2,723 +9,618

- Cash paid for purchases of inventories ……………………………

($134,153)

($ billions) Property, plant and equipment, ending balance …………………

$33.8

- Purchases of property, plant and equipment …………………

(12.5)

+ Book value of PPE assets sold …………………………………...

none

+ Depreciation of property, plant and equipment ………………

8.2

Property, plant and equipment, beginning balance …………… d.

$229,234

$29.5

Stock-based compensation expense is deducted when calculating net income similar to cash compensation. The only difference is that the compensation is paid in shares of stock (or stock options) instead of cash. Because stockbased compensation does not require the payment of cash, it is treated as a noncash expense, much like depreciation, and added back to net income when the indirect method is used in the cash flow statement. Generally speaking, compensation cost is classified as part of operating activities whether or not the compensation is paid in cash.

Solutions Manual, Chapter 4

©Cambridge Business Publishers, 2020 4-193

P4-55.A (75 minutes) LO 3, 4, 5, 6 a. A

B

C

D

E

F

G

1

Effect of change on cash flow

2 3

H

2016

2015

Change

Operating

Investing

Financing

I

J

No effect

Total

on cash

(F+G+H+I)

Assets

4

Cash and cash equivalents

1,993,854

1,159,449

834,405

5

Receivables, net

O

10,666,986

11,085,689

(418,703)

418,703

418,703

6

Inventories

O

5,735,110

5,242,197

492,913

(492,913)

(492,913)

7

Prepaid expenses

O

1,275,918

1,350,201

(74,283)

74,283

74,283

8

Income tax receivable

O

22,473

476,154

(453,681)

453,681

453,681

O,I

22,034,603

24,488,478

(2,453,875)

9

Property, plant and equipment, net

10

Depreciation expense

11

PPE purchased

12

PPE sold

13

3,876,111 (1,182,854) (56,446)

2,453,875

56,446

PPE acuired w/o cash

(239,382)

14

Cash surrender value of life insurance

O

15

Other

O

438,429

630,259

(191,830)

191,830

191,830

917,533

973,195

(55,662)

55,662

55,662

1,068,745

(1,068,745)

16 17

LIABILITIES

18

Checks outstanding in excess of bank balances

O

19

Accounts payable

O

4,235,488

20

Current portion of long-term debt

F

837,225

21

Line of credit outstanding

F

22

Other accrued expenses

O

5,158,236

5,021,286

136,950

136,950

136,950

23

Salary continuation plan

O

114,958

106,148

8,810

8,810

8,810

-

-

4,049,333 799,204 2,823,477

186,155

(1,068,745)

(1,068,745)

186,155

38,021

186,155 38,021

(2,823,477)

(2,823,477)

38,021 (2,823,477)

Table continued next page

©Cambridge Business Publishers, 2020 4-194

Financial Accounting, 6th Edition

a.

Table continued A

B

C

D

E

24

Note payable to bank, non-current

F

5,351,057

25

Capital lease obligation

F

208,412

-

26

6,213,513

F

G

H

(862,456)

I

J

(862,456)

208,412

(862,456) 239,382

Repayment of lease principal

208,412

(30,970)

27

Salary continuation plan

O

920,440

921,882

(1,442)

(1,442)

(1,442)

28

Deferred income taxes, net

O

2,632,762

2,717,360

(84,598)

(84,598)

(84,598)

29 30

STOCKHOLDERS’ EQUITY

31

Common stock at par value

F

9,219,195

9,219,195

32

Additional paid-in capital

F

6,805,984

6,552,973

33 34 35

253,011

Stock-based compensation Retained earnings

O, F

20,738,143

19,049,500

253,011

253,011

3,184,803

3,184,803

1,688,643

Net income

-

Dividends Treasury shares – at cost (2,537,036 shares in 2016 and 2015)

(1,496,160) F

(13,136,994)

(13,136,994)

7,135,855

Solutions Manual, Chapter 4

(1,496,160)

(1,126,408)

(5,175,042)

-

834,405

©Cambridge Business Publishers, 2020 4-195

b.

The following statement of cash flows from operations combines the effects of the income tax asset and liability and combines the effects of the deferred tax asset and liability. In addition, the effects of changes in current and noncurrent salary continuation plan liabilities have been combined in the operating cash flow. GOLDEN ENTERPRISES, INC. Consolidated Statement of Cash Flows Year ended June 3, 2016 CASH FLOWS FROM OPERATING ACTIVITIES: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Deferred income taxes Stock based compensation Gain on sale of property and equipment - Change in receivables, net - Change in inventories - Change in prepaid expenses - Change in cash surrender value of insurance - Change in other assets + Change in accounts payable + Change in checks outstanding in excess of bank balances + Change in accrued expenses + Change in salary continuation plan(both current and noncurrent) + Change in accrued income taxes Net cash provided by operating activities

3,876,111 (84,598) 253,011 (56,446) 418,703 (492,913) 74,283 191,830 55,662 186,155 (1,068,745) 136,950 7,368 453,681 7,135,855

CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property, plant and equipment Proceeds from sale of property, plant and equipment Net cash used in investing activities

(1,182,854) 56,446 (1,126,408)

CASH FLOWS FROM FINANCING ACTIVITIES: Debt repayments (line of credit and long-term debt) Principal payments under capital lease obligations Cash dividends paid Net cash used by financing activities

(3,647,912) (30,970) (1,496,160) (5,175,042)

NET INCREASE IN CASH AND CASH EQUIVALENTS CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR CASH AND CASH EQUIVALENTS AT END OF YEAR c.

$ 3,184,803

834,405 1,159,449 $ 1,993,854

OCFCL = $7,135,855 ÷ [(10,345,907 + 13,868,193) ÷ 2] = 0.589 OCFCX = $7,135,855 ÷ 1,182,854 = 6.03

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

1-1

P4-56. (30 minutes) LO 3, 4, 5 The problem demonstrates the effect of payment terms on cash flows. A young, growing organization is particularly susceptible to cash shortages, even when reporting profits. Many of the decisions that might foster growth also use cash. In this simple case, Amazin, Inc. could eliminate the dividend for the present time. Sometimes a company’s business model will facilitate the generation of cash flows. For example, at the time it went public, Groupon was collecting cash as customers bought coupons, but then they didn’t pay the vendors until a few weeks went by. With that arrangement, faster growth meant that Groupon generated more cash, not less. a. Base case

Beginning

Quarter 1

Amazin, Inc

Balance sheets

Cash Accts receivable PPE, net Accts payable Shareholders’ equity

Income statement

Statement of cash flows

Revenue COGS Depreciation SG&A Net income Net income + Depreciation - Δ Accts receivable + Δ Accts payable Cash from opns Capital expenditures Dividends Change in cash

400.0 600.0

-95.0 1000.0 675

1,000.0

400.0 1,180 1,000.0 400.0 75.0 300.0 225.0 225.0 75.0 -1,000.0 +400.0 -300.0 -150.0 -45.0 -495.0

©Cambridge Business Publishers, 2020 1-2

Financial Accounting, 6th Edition

b. Aggressive growth

Beginning

Quarter 1

Amazin, Inc

Balance sheets

Cash Accts receivable PPE, net Accts payable Shareholders’ equity

Income statement

Statement of cash flows

Revenue COGS Depreciation SG&A Net income Net income + Depreciation - Δ Accts receivable + Δ Accts payable Cash from opns

400.0 600.0

-195.8 1,200 675

1,000.0

480 1,199.2 1,200.0 480.0 75.0 396.0 249.0 249.0 75.0 -1,200.0 480.0 -396.0

Capital expenditures

-150

Dividends

-49.8

Change in cash

-595.8

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

1-3

c. Happy suppliers Amazin, Inc

Balance sheets

Beginning Cash Accts receivable PPE, net Accts payable Shareholders’ equity

Income statement

Statement of cash flows

Quarter 1 400.0 600.0

-463.0 1,000.0 675.0

1,000.0

̶ 1,212.0

Revenue COGS Depreciation SG&A Net income

1000.0 360.0 75.0 300.0 265.0

Net income + Depreciation - Δ Accts receivable + Δ Accts payable Cash from opns

265.0 75.0 -1000 ̶ -660.0

Capital expenditures

-150.0

Dividends Change in cash

-53.0 -863.0

©Cambridge Business Publishers, 2020 1-4

Financial Accounting, 6th Edition

CASES AND PROJECTS C4-57. (30 minutes) LO 3, 4 The required debt to equity ratio allows for total liabilities to be up to $477 million. That is $477 / ($125+$148) =1.747 < 1.75. This implies total short-term borrowing of $107 million and an ending cash balance of $70 million. LAMBERT CO. Statement of Cash Flows (projected)

Cash from operations Net income …………………………………………………… Depreciation expense ……………………………………… Increase in accounts receivable …………………………. Decrease in inventory ……………………………………… Increase accounts payable ……………………………….. Decrease in income taxes payable ………………………. Cash provided by (used in) operations ……………….. Cash from investing Acquisitions of property, plant and equipment ………… Disposal proceeds ………………………………………….. Cash provided by (used in) investing …………………. Cash from financing Issue long-term debt ……………………………………….. Repay long-term debt ……………………………………….. Common stock issue ……………………………………….. Shareholder dividends ……………………………………… Increase (decrease) in short-term borrowing …………… Cash provided by (used in) financing ………………….. Net change in cash …………………………………………….. Beginning cash balance ………………………………………. Ending cash balance …………………………………………..

$

18 120 (40) 20 30 (10) $ 138 (225) 75 (150) 80 (100) 25 (30) 57

$

32 20 50 70

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

1-5

C4-58. (45 minutes) LO 1, 3, 4 a.

see following page

b. 1 2 3 4 5 6 7 8 9 10 11

12 13

Accounts receivable (+A) …………………………… Sales revenue (+R,+SE)…………………………

3,800

Cash (+A) ……………………………………………… Accounts receivable (-A) ………………………

3,500

Cost of goods sold (+E,-SE) ………………………… Inventory (-A) …………………………………….

1,800

Inventory (+A) ………………………………………… Accounts payable (+L) …………..……………..

1,200

Accounts payable (-L) …..…………………………… Cash (-A) …….…………………………………..

1,100

3,800 3,500 1,800 1,200 1,100

Salaries and wages expense (+E,-SE) ……………. Salaries and wages payable (+L) …………….

700

Salaries and wages payable (-L) …………………… Cash (-A) ……..…………………………………..

730

Rent expense (+E,-SE)……………………….……… Prepaid rent (-A) ………………………………..

200

Prepaid rent (+A) ……………………..……………… Cash (-A) …….…………………………………..

600

Depreciation expense (+E,-SE) ……………………. Accumulated depreciation (+XA,-A) ………….

150

Cash (+A) ………………………………………………. Accumulated depreciation (-XA,+A) ………………… Fixtures and equipment (-A) ……………………

700 730 200 600 150 10 70 80

Fixtures and equipment (+A) ……………………….. Cash (-A) …………………………………………..

800

Interest expense (+E,-SE) …..……………………….. Cash (-A) …………………………………………..

16

800 16

continued next page

©Cambridge Business Publishers, 2020 1-6

Financial Accounting, 6th Edition

b.

continued 14 15

16

Bank loan payable (-L) ……….……………………….. Cash (-A) …………………………………………..

1,600

Cash (+A) ……………………………………………….. Long-term loan payable (+L) ……………………

2,000

Income tax expense (+E,-SE) …………………………. Taxes payable (+L) ………………………………..

374

1,600 2,000

374

Retained earnings (-SE) ………………………………. Cash (-A) ……………………………………………

17

80 80

Revenue (-R) ……………………………………………. Cost of goods sold (-E) …………………………. Salaries and wages expense (-E) ……………… Rent expense (-E) ………………………………… Depreciation expense (-E) ……………………… Interest expense (-E) …………………………….. Income tax expense (-E) ………………………… Retained earnings (+SE) …………………………

18

3,800 1,800 700 200 150 16 374 560

Entry 18 closes revenue and expense accounts to retained earnings. a. & c. + 2

11

15 Bal

Cash (A) 600 3,500 1,100 730 600 10 800 16 1,600 2,000 80 1,184

5 7 9 12 13 14

- Accounts Payable (L) + 3,000 5 1,100 1,200 4 3,100 Bal

- Salaries and Wages + Payable (L) 100 7 730 700 6 70 Bal

- Retained Earnings (SE)+ 1,300 17 80 560 18 1,780 Bal

17

-

+ Accounts Rec. (A) 6,500 1 3,800 3,500 Bal 6,800

- Common Stock (SE) + 4,600 4,600 Bal

2

Taxes Payable (L) + 0 374 16 374 Bal

- Bank Loan Payable (L) + 1,600 14 1,600 0 Bal

18

Revenue (R) + 3,800 3,800 0

1 Bal

+ Cost of Goods Sold (E) 3 1,800 1,800 18 Bal 0

continued next page

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

1-7

a. & c.

continued + 4 Bal

Inventory (A) 2,400 1,200 1,800 1,800

+ Prepaid Rent (A) 0 9 600 200 Bal 400

+

12 Bal

Fixtures and Equipment (A) 1,900 800 80 2,620

3

- Long-term Loan (L) + 0 2,000 15 2,000 Bal

+ Salaries & Wages (E) 6 700 700 18 Bal 0

+ Rent Expense (E) 200 200 18 Bal 0 8

8

+ Depreciation Exp. (E) 10 150 150 18 Bal 0

11

- Accum. Deprec. (XA) + 800 11 70 150 10 880 Bal

+ Interest Expense (E) 13 16 16 18 Bal 0 + Income Tax Exp (E) 16 374 374 18 Bal 0

©Cambridge Business Publishers, 2020 1-8

Financial Accounting, 6th Edition

C4-59. (30 minutes) LO 1, 2, 3, 4, 5 a.

Depreciation and amortization are noncash expenses that are deducted in the computation of net income. The depreciation and amortization add-back effectively zeros these expenses out of the income statement to focus on operating cash flow. The positive amount for depreciation and amortization does not mean that the company is generating cash from depreciation and amortization, a common misconception. It is merely an adjustment to remove these expenses from net income to convert profit to cash flow.

b.

Gains and losses on disposals of asset are the result of investing activity, not operating activity, but they are recognized in net income. When we start with net income in an indirect method cash from operations, subtracting the gain removes this investing item from the determination of cash from operations. Daimler reports cash proceeds from disposals of PPE and intangible assets of €812 million. If the recognized gain is €453 million, then the book value of the assets disposed would be €359 million (= €812 million - €453 million).

c.

It does not. The adjustments can only be interpreted relative to the amounts that are included in net income. The negative €1,455 million inventory adjustment means that Daimler’s cost to acquire inventory for the year exceeded its cost of goods sold for the year by €1,455 million.

d.

Free cash flow (€ millions): ̶€1,652 – €(6,744 + 3,414 - 812) = -€10,998. Daimler’s operating cash flow is slightly negative, but its free cash flow is significantly negative due to the large investment in PPE and intangible assets. Daimler financed its investing activities and dividends by €16 billion in net additions to long-term financing.

e.

The primary sources of difference between net income and cash from operating activities are a net increase in operating assets, income taxes, and large increases in financial receivables and vehicles on operating leases. These last two items are related to their customer finance operation. In its financial statements, Daimler reports that “Customized financing and leasing products accelerate our automotive business.” One of the most important factors behind our success is our attractive and innovative range of services around vehicle financing and insurance. Daimler Financial Services has posted record figures for many years. We aim to systematically pursue our strategy of profitable growth at high speed in the future. Daimler Financial Services finances or leases half of all the new vehicles sold worldwide by the Daimler Group.

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f.

Daimler is a global corporation and transacts business in many different currencies. When the financial statements are prepared, these various currencies must be translated into one common currency (Euros in this case) for reporting purposes. Because exchange rates fluctuate, this translation process results in some changes in the cash value of some transactions and cash balances. The -€868 million listed in the cash flow statement reflects the net impact on Euros of the translation of foreign currencies.

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Financial Accounting, 6th Edition

Chapter 5 Analyzing and Interpreting Financial Statements Learning Objectives – coverage by question MiniExercises

Exercises

LO1 – Prepare and analyze common-size financial statements.

15, 16, 19, 20

35

LO2 – Compute and interpret measures of return on investment, including return on equity (ROE), return on assets (ROA), and return on financial leverage (ROFL).

14, 17, 21, 22

LO3 – Disaggregate ROA into profitability (profit margin) and efficiency (asset turnover) components. LO4 – Compute and interpret measures of liquidity and solvency.

Problems

Cases and Projects

25 - 31, 34

36, 38, 41

49

14, 17, 21, 22, 24

25, 27 - 31, 34

36, 38, 41, 45, 46

47 - 49

18, 23

32, 33

37, 39, 42

49

LO5 – Appendix 5A: Measure and analyze the effect of operating activities on ROE. LO6 – Appendix 5B: Prepare financial statement forecasts.

40, 43

35

44

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QUESTIONS Q5-1.

Return on investment measures profitability in relation to the amount of investment that has been made in the business. A company can always increase dollar profit by increasing the amount of investment (assuming it is a profitable investment). So, dollar profits are not necessarily a meaningful way to look at financial performance. Using return on investment in our analysis, whether as investors or business managers, requires us to focus not only on the income statement, but also on the balance sheet.

Q5-2.

ROE is the sum of return on assets (ROA) and the return that results from the effective use of financial leverage (ROFL). Increasing leverage increases ROE as long as ROA exceeds the after-tax interest rate. Financial leverage is also related to risk: the risk of potential bankruptcy and the risk of increased variability of profits. Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt.

Q5-3.

Gross profit margins can decline because 1) the industry has become more competitive, and/or the firm’s products have lost their competitive advantage so that the company has had to reduce prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from higher-margin/slowly-turning products to lower-margin/higher-turning products. Declining gross profit margins are usually viewed negatively. On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed negatively.

Q5-4.

Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D are more asset-like and create long-term economic benefits even though they are not reported as assets on the balance sheet.

Q5-5.

Asset turnover measures the amount of revenue volume compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower. Turnover measures productivity, and an important company objective is to make assets as productive as possible. Since turnover is one of the components of ROE (via ROA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver.

Q5-6.

ROE>ROA implies a positive return on financial leverage. This results from borrowed funds being invested in operating assets whose return (ROA) exceeds the cost of borrowing. In this case, borrowing money increases ROE.

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Financial Accounting, 6th Edition

Q5-7.

Common-size financial statements express balance sheet and income statement items in ratio form. Common-size balance sheets express each asset, liability and equity item as a percentage of total assets and common-size income statements express each line item as a percentage of sales. The ratio form facilitates comparison among firms of different sizes as well as across time for the same firm.

Q5-8.

The asset turnover ratio (AT) is the ratio of sales revenue to average total assets. The ratio is increased by increasing sales while holding assets constant, or by reducing assets without reducing sales. The most effective means of improving the ratio is to increase the efficient utilization of operating assets. This is done by improving inventory management practices, improving accounts receivable collection, and improving the efficient use of PP&E.

Q5-9.

The “net” in net operating assets, means operating assets “net” of operating liabilities. This netting recognizes that a portion of the costs of operating assets is financed by parties other than the company. For example, payables and accrued expenses help fund inventories, wages, utilities, and other operating costs. Similarly, long-term operating liabilities also help finance the cost of long-term operating assets. Thus, these long-term operating liabilities are deducted from long-term operating assets.

Q5-10.

Companies must manage both the income statement and the balance sheet in order to maximize ROA. This is important, as many managers look only to the income statement and do not fully appreciate the value added by effective balance sheet management. The disaggregation of ROA into its profit margin and turnover components facilitates analysis of these two areas of focus.

Q5-11.

There are an infinite number of possible combinations of margin and turnover that will yield a given level of ROA. The relative weighting of profit margin and asset turnover is driven in large part by the company’s business model. As a result, since companies in an industry tend to adopt similar business models, industries will generally trend toward points along the margin/turnover continuum.

Q5-12.

Liquidity refers to how much cash a company has, how much cash is coming in, and how much cash can be raised quickly. Companies must generate cash in order to pay their debts, pay their employees and provide their shareholders a return on investment. Cash is, therefore, critical to a company’s survival.

Q5-13.

Ratio analysis relies on the data presented in the financial statements and is, therefore, dependent on the quality of those statements. Differences in the application of GAAP across companies or within the same company across time can affect the reliability of the analysis. Limitations of GAAP itself and differences in the make-up of the company (e.g., types of products or industries in which the company competes) can also affect the usefulness of ratio analysis.

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MINI EXERCISES M5-14. (15 minutes) LO 2, 3 a. ROE = $5,000/$500,000 = 1% ROA = $20,000/$1,000,000 = 2% ROFL = 1% - 2% = -1% b. Net profit margin = $5,000/$1,000,000 = 0.5% Asset turnover = $1,000,000/$1,000,000 = 1.0 Financial leverage = $1,000,000/$500,000 = 2.0 c.

ROFL is negative for Sunder Company, indicating that financial leverage is hurting this company. The return on assets is insufficient to cover the interest cost of the debt. DuPont analysis masks this problem. The financial leverage ratio of 2.0 suggests (incorrectly) that leverage doubled the return.

M5-15. (20 minutes) LO 1 TARGET CORPORATION Common-size Balance Sheets Cash and cash equivalents……………………………………. Inventory…………………………………………………………. Other current assets……………………………………………. Total current assets…………………………………………….. Property and equipment, net………………………………….. Other noncurrent assets……………………………………….. Total assets………………………………………………………

2018 6.8% 22.2% 3.2% 32.2% 64.2% 3.6% 100.0%

2017 6.7% 22.2% 3.1% 32.0% 65.9% 2.1% 100.0%

Accounts payable………………………………………………. Accrued and other current liabilities………………………….. Current portion of long-term debt and other borrowings....... Total current liabilities…………………………………………. Long-term debt and other borrowings……………………….. Deferred income taxes…………………………………………. Other noncurrent liabilities……………………………………. Total shareholders' investment………………………………. Total liabilities and shareholders' investment………………..

22.2% 10.9% 0.7% 33.8% 29.0% 1.8% 5.3% 30.0% 100.0%

19.4% 10.0% 4.6% 33.9% 29.5% 2.3% 5.0% 29.3% 100.0%

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Financial Accounting, 6th Edition

M5-16 (20 minutes) LO 1 TARGET CORPORATION Common-size Income Statement Year ended: Sales revenue………………..………………………………………………. Cost of sales…………………………………………………………………. Selling, general and administrative expenses……………………………. Depreciation and amortization……………………………………………… Earnings from continuing operations before interest and income taxes Net interest expense………………………………………………………… Earnings from continuing operations before income taxes……………… Provision for income taxes…………………………………………………. Net earnings from continuing operations ………………………………… Discontinued operations, net of tax ……………………………………….. Net earnings (loss) …………………………………………………………..

February 3, 2018 100.0% 71.1% 19.8% 3.1% 6.0% 0.9% 5.1% 1.0% 4.1% 0.0% 4.1%

M5-17. (15 minutes) LO 2, 3 ($ millions) a. EWI = $2,928 + $666 x (1 - 0.25) = $3,427.5 (using net earnings from continuing operations) Average total assets = ($38,999 + $37,431)/2 = $38,215 ROA = $3,427.5/$38,215 = 8.97% (using net earnings from continuing operations) Using net earnings, ROA = ($2,934 + (1 - 0.25) × 666)/(($38,999 + $37,431)/2) = 8.98% b. Using earnings from continuing operations: PM = $3,427.5/$71,879 = 4.77% AT = $71,879 /$38,215= 1.88 4.77% X 1.88 = 8.97%

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M5-18. (20 minutes) LO 4 a. 2018 Current ratio = $12,564 / $13,201 = 0.95 2017 Current ratio = $11,990 / $12,707 = 0.94 2018 Quick ratio = $2,643 / $13,201 = 0.20 2017 Quick ratio = $2,512 / $12,707 = 0.20 Both of these ratios held steady over the year. Target’s current assets increased modestly, as did its current liabilities. The make-up of the current liabilities changes somewhat over the year, with operating liabilities increasing and current debt repayments decreasing. Both of these ratios are lower than the retail industry medians, though Target’s scale of operation seems to reassure its creditors. b. 2018 Times interest earned = $4,312 / $666 = 6.47 2018 Debt-to-equity = ($38,999 - $11,709) / $11,709= 2.33 2017 Debt-to-equity = ($37,431 - $10,953) / $10,953 = 2.42 Target’s debt-to-equity decreased slightly and is lower than the retail industry median. The timesinterest-earned ratio is calculated without including the income from discontinued operations. c.

Target is liquid and not excessively financially leveraged. Its times interest earned ratio indicates that earnings before interest and taxes is just about 6.5 times interest expense. Because the company generates significant operating profits and operating cash flow ($6.8 billion), we have no solvency concerns about Target.

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Financial Accounting, 6th Edition

M5-19. (20 minutes) LO 1 3M COMPANY Common-size Balance Sheets Assets Current assets Cash, cash equivalents and marketable securities Accounts receivable - net of allowances of $103 and $88 Total inventories Prepaids Other current assets Total current assets Property, plant and equipment - net Goodwill Intangible assets - net Other assets Total assets Liabilities and Shareholders’ Equity Current liabilities Short-term borrowings and current portion of long-term debt Accounts payable Accrued payroll Accrued income taxes Other current liabilities Total current liabilities Long-term debt Pension and postretirement benefits Other liabilities Total liabilities Total equity Total liabilities and equity

2017

2016

10.9% 12.9% 10.6% 2.5% 0.7% 37.6%

8.1% 13.3% 10.3% 2.5% 1.4% 35.6%

23.3% 27.7% 7.7% 3.7% 100.0%

25.9% 27.9% 7.1% 3.6% 100.0%

4.9% 5.1% 2.3% 0.8% 7.1% 20.2%

3.0% 5.5% 2.1% 0.9% 7.5% 18.9%

31.8% 9.5% 7.8% 69.4% 30.6% 100.0%

32.5% 12.2% 5.0% 68.6% 31.4% 100.0%

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M5-20. (15 minutes) LO 1 3M COMPANY Common-size Income Statements Net sales Operating expenses Cost of sales Selling, general and administrative expenses Research, development and related expenses Gain on sale of businesses Total operating expenses Operating income Interest expense Interest income Income before income taxes Provision for income taxes Net income including noncontrolling interest

2017

2016

100.0%

100.0%

50.5% 20.8% 5.8% -1.9% 75.3% 24.7% 1.0% -0.2%

50.0% 20.7% 5.8% -0.4% 76.0% 24.0% 0.7% -0.1%

23.8% 8.5% 15.4%

23.4% 6.6% 16.8%

M5-21. (20 minutes) LO 2, 3 ($ millions) a. 2017 EWI = $4,869 + $322 x (1 - 0.35) = $5,078.3 2017 Average total assets = ($37,987 + $32,906)/2 = $35,446.5 ROA = $5,078.3/$35,446.5 = 14.33% b. PM = $5,078.3/$31,657 = 16.04% AT = $31,657/$35,446.5 = 0.893 16.04% X 0.893 = 14.32% (0.01 difference due to rounding)

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Financial Accounting, 6th Edition

M5-22. (15 minutes) LO 2, 3 ($ millions) a. URBN:

TJX:

b. URBN:

TJX:

c.

Average total assets = ($1,953 + $1,903)/2 = $1,928 ROA = $108 / $1,928 = 5.60% Average total assets = ($14,058 + $12,884)/2 = $13,471 ROA = $2,653 / $13,471 = 19.69% PM = $108 / $3.616 = 2.99% AT = $3,616 / $1,928 = 1.88 2.99% X 1.88 = 5.62% (0.02 difference due to rounding) PM = $2,653 / $35,865 = 7.40% AT = $35,865 / $13,471 = 2.66 7.40% X 2.66 = 19.68% (0.01 difference due to rounding)

URBN’s ROA is quite a bit lower than TJX’s. TJX has a higher PM and AT. As is typical of valuepriced retailers, TJX’s asset turnover is high – its AT is 41% higher than that of URBN. On balance, TJX’s business model appears to be more successful in 2017 as it is able to maintain both a high AT and a high PM, resulting in higher ROA.

M5-23. (20 minutes) LO 4 ($ millions) a. Verizon’s current ratio for the two years presented is as follows: 2017 current ratio: $29,913 / $33,037 = 0.91 2016 current ratio: $26,395 / $30,340 = 0.87 In 2017, Verizon’s current ratio was below 1.0 which is below the industry median current ratio of 1.19. We might want to know, however, whether Verizon’s current assets are concentrated in cash or relatively illiquid inventories, as well as the maturity schedule of its current liabilities. Its CR in 2016 is in the same range as 2017. From 2016 to 2017, Verizon reports a significant increase in accounts receivable and a significant increase in debt due within the next year.

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b. Verizon’s times interest earned ratio for the two years is as follows: 2017 times interest earned = $25,327 / $4,733 = 5.35 2016 times interest earned = $25,362 / $4,376 = 5.80 Verizon’s times interest earned ratio has decreased, but remains higher than the industry median (2.57). 2017 debt-to-equity = $212,456 / $43,096 = 4.93 2016 debt-to-equity = $220,148 / $22,524 = 9.77 Verizon’s 2016 debt-to-equity ratio is significantly above the 1.83 median for companies in the telecommunications industry. The ratio decreased dramatically to 4.93 in 2017 due to increased shareholders’ equity. Verizon’s operating cash flow to current liabilities ratio is as follows: 2017 OCFCL = $25,305 / [($33,037 + $30,340)/2] = 0.80 2016 OCFCL = $22,810 / [($30,340 + $35,052)/2] = 0.70 c.

Verizon is carrying a significant amount of debt. Although its profitability and operating cash flow are fairly strong, neither is particularly high in relation to the company’s liabilities and interest costs. Verizon’s liquidity appears below that of others in its industry, and its debt-to-equity is now very high. Given its significant capital expenditure requirements and its current debt load, Verizon may have to fund future capital expenditures with higher-cost equity. And, to the extent that its competitors are not as highly leveraged, this may negatively impact Verizon’s competitive position.

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Financial Accounting, 6th Edition

M5-24. (30 minutes) LO 3 a. $ millions Procter & Gamble ........................................... CVS................................................................. Valero Energy .................................................

Asset Turnover $66,832/$66,119 = 1.01 $184,765/$94,797 = 1.95 $88,407/ $48,166 = 1.84

b. $ millions

ART

Procter & Gamble ........................................... $66,832/$4,640 = 14.40 CVS................................................................. $184,765/$12,673 = 14.58 Valero Energy ................................................. $88,407/ $6,296 = 14.04 $ millions

INVT

Procter & Gamble ........................................... $33,449/$4,681 = 7.15 CVS................................................................. $156,208/$15,028 = 10.39 Valero Energy ................................................. $81,926/ $6,047 = 13.55 $ millions

PPET

Procter & Gamble ........................................... $66,832/$20,247 = 3.30 CVS................................................................. $184,765/$10,234 = 18.05 Valero Energy ................................................. $88,407/ $26,976 = 3.28 c.

For all three companies, these ratios reflect differences in their businesses, and the overall AT ratio is related to the three individual ratios as seen in Exhibit 5.8 in the chapter. The three companies collect from their customers relative quickly, as seen in the similar values of ART. Valero carries the smallest amount of inventory relative to its cost of goods sold. Procter & Gamble’s ratios are influenced by the relative strength of its largest customer (Walmart), resulting in higher inventory levels and slower collections. In addition, P&G has a large level of intangible assets, as we will see in Chapter 8, so its PPET is relatively high, but its AT is the lowest of the three. CVS’s inventory turnover is higher than P&G. CVS leases most of its store space, so PP&E is low relative to sales (though that practice will change in the near future as we will see in Chapter 10).

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EXERCISES E5-25. (30 minutes) LO 2, 3 a. ($ millions) McDonald’s

[$5,192 + $921 x (1 - 0.35)] / $32,414 = 17.9%

Yum! Brands

[($1,340 + $440 x (1 - 0.35)] / $5,382 = 30.2%

($ millions)

PM = EWI / Sales

AT = Sales / Avg. Assets

McDonald’s

[$5,192 + $921 x (1 - 0.35)] / $22,820 = 25.4%

$22,820 / $32,414 = 0.70

Yum! Brands

[($1,340 + $440 x (1 - 0.35)] / $5,878 = 27.7%

$5,878 / $5,382 = 1.09

b.

c.

McDonald’s ROA is lower than Yum! Brands’ in fiscal 2017. The companies’ profit margins (PM) are similar, but Yum! Brands has a significantly higher asset turnover (AT). For both firms, asset turnover is influenced by franchising and leasing of retail stores.

E5-26. (20 minutes) LO 2 a. Case Assets Non-interest-bearing liabilities Interest-bearing liabilities Shareholders’ equity Earnings before interest and taxes Interest expense Earnings before taxes Tax expense (40%) Net income ROE ROA ROFL

A 1,000 0 0 1,000

B 1,000 0 250 750

C 1,000 0 500 500

D 1,000 0 500 500

E 1,000 200 0 800

F 1,000 200 300 500

120 0 120 48 72

120 25 95 38 57

120 50 70 28 42

80 50 30 12 18

100 0 100 40 60

80 30 50 20 30

7.2% 7.2% 0.0%

7.6% 7.2% 0.4%

8.4% 7.2% 1.2%

3.6% 4.8% -1.2%

7.5% 6.0% 1.5%

6.0% 4.8% 1.2%

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Financial Accounting, 6th Edition

b. These three cases differ only in the amount of interest-bearing liabilities used to finance the firm. As leverage increases, the return to shareholders’ equity (ROE) increases. However, the return on assets (ROA) does not change, because the ROA is independent of the way that the business was financed. c.

However, financial leverage (the use of liabilities to finance the firm) does not always work in favor of shareholders. The liability holders require a fixed return (6% after-tax = 10% x (1 – 40%)), and in order for leverage to work in favor of shareholders, the overall return on assets must exceed this fixed return. In case C, the return on assets is 7.2% > 6%, so ROFL is positive. In case D, the return on assets is 4.8% < 6%, so ROFL is negative. In case E, the return on assets equals the after-tax return required on interest-bearing liabilities, but the company has only non-interest-bearing liabilities. The ROA is greater than zero, so ROFL is positive. In essence, the rate required on liabilities is the “break-even” ROA in order for ROFL to be positive.

d. In case F, there is a mixture of liability types. Even though ROA is less than the amount needed for interest-bearing liabilities, ROFL is positive because some of Company F’s liabilities require no interest. The general relationship among these variables is the following: ROE = ROA + ROA*(NL/SE) + [ROA – (1 – t)*i]*(IL/SE) where

A = Assets, NL = non-interest-bearing liabilities, IL = interest-bearing liabilities, SE = shareholders’ equity, t = tax rate, i = pre-tax interest rate on interest-bearing liabilities, ROE = return on shareholders’ equity, and ROA = return on assets.

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E5-27. (20 minutes) LO 2, 3 ($ millions)

CVS

Walgreens

a.

EWI Avg. Assets ROA

$6,623 + $1,062 x (1 - 0.35) = $7,313.3 ($95,131 + $94,462)/2 = $94,796.5 $7,313.3/ $94,796.5 = 7.71%

$4,101 + $728 x (1 - 0.35) = $4,574.2 ($66,009 + $72,688) /2 = $69,348.5 $4,574.2/ $69,348.5 = 6.60%

b.

PM AT

$7,3313.3/$184,765 = 3.96% $184,765 /$94,796.5 = 1.95

$4,574.2/$118,214 = 3.87% $118,214/$69,348.5 = 1.70

c.

Avg. Equity ROE ROFL

($37,695 + $36,834)/2 = $37,264.5 $6,623 / $37,264.5 = 17.77% 17.77% - 7.71% = 10.06%

($28,274 + $30,281)/2 = $29,277.5 $4,101 / $29,277.5 = 14.01% 14.01% - 6.60% = 7.41%

d. Walgreen’s ROE and ROA are lower than CVS’s. CVS’s PM is slightly higher than Walgreen’s, but its AT is considerably higher than Walgreen’s. The low PMs for both companies reflect the highly competitive retail pharmaceutical industry. Both companies are using financial leverage, but to a larger degree for CVS. Asset turnover and ROA differences would have to be examined further, because both companies use operating leases that do not show up on the balance sheet. (Though, that is scheduled to change in the near future. Chapter 10 looks at this important topic.)

E5-28. (30 minutes) LO 2, 3 ($ millions) a. ROE

2017: $9,601 / [($69,019 + $66,226) / 2] = 14.20% 2016: $10,316 / [($66,226 + $61,085) / 2] = 16.21%

b. ROA

2017: [$9,601 + $637x(1 - 0.35)] / [($123,249 + $113,327) / 2] = 8.47% 2016: [$10,316 + $725x(1 - 0.35)] / [($113,327 + $101,459) / 2] = 10.04%

ROFL

2017: 14.20% - 8.47% = 5.73% 2016: 16.21% - 10.04% = 6.17%

ROFL is positive, so leverage is working in favor of Intel’s shareholders.

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Financial Accounting, 6th Edition

c.

Net Profit Margin

2017: $9,601 / $62,761 = 15.30% 2016: $10,316 / $59,387 = 17.37%

Asset Turnover

2017: $62,791 / [($123,249 + $113,327) / 2] = 0.531 2016: $59,387 / [($113,327 + $101,459) / 2] = 0.553

Financial Leverage

2017: [($123,249 + $113,327) / 2] / [($69,019 + $66,226) / 2] = 1.749 2016: [($113,327 + $101,459) / 2] / [($66,226 + $61,085) / 2] = 1.687

Intel’s financial leverage increased slightly from 2016 to 2017. Both ROA and ROE decreased. Based on ROFL, leverage increased ROE by about 70% over ROA each year. These increases correspond to the DuPont financial leverage measure in this case because Intel’s borrowing costs are so low. In general, there is a bias in DuPont analysis in that it tends to overstate the benefits of financial leverage. Offsetting this bias, DuPont analysis calculates the net profit margin, which is lower than PM because the numerator is net of interest costs. For comparison purposes, Intel’s PM ratios are presented below. PM ratio

2017: [$9,601 + $637 x (1 - 0.35)] / $62,761 = 15.96% 2016: [$10,316 + $725 x (1 - 0.35)] / $59,387 = 18.16%

E5-29. (30 minutes) LO 2, 3 ($ millions) a.

ROE

2019: 2018: 2017:

€850 / [(€138+€1,477) / 2] = 105.26% €805 / [(€1,477+€2,184) / 2] = 43.98% €448 / [(€2,184+$€1,875) / 2] = 22.07%

b.

ROA

2019: 2018: 2017:

[€850+€246x(1 - 0.25)] / [(€6,108+€6,451) / 2] = 16.47% [€805+€208x(1 - 0.25)] / [(€6,451+€7,173) / 2] = 14.11% [€448+€237x(1 - 0.25)] / [(€7,173+€6,972) / 2] = 8.85%

ROFL

2019: 2018: 2017:

105.26% - 16.47% = 88.79% 43.98% - 14.11% = 29.87% 22.07% - 8.85% = 13.22%

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c.

Net Profit Margin

2019: 2018: 2017:

€850 / €10,364 = 8.20% €805 / €9,613 = 8.37% €448 / €8,632 = 5.19%

Asset Turnover

2019: 2018: 2017:

€10,364 / [(€6,108+€6,451) / 2] = 1.650 €9,613 / [(€6,451+€7,173) / 2] = 1.411 €8,632 / [(€7,173+€6,972) / 2] = 1.221

Financial Leverage

2019: 2018: 2017:

[(€6,108+€6,451) / 2] / [(€138+€1,477) / 2] = 7.776 [(€6,451+€7,173) / 2] / [(€1,477+€2,184) / 2] = 3.721 [(€7,173+€6,972) / 2] / [(€2,184+€1,875) / 2] = 3.485

HD Rinker’s ROA increased slightly from 2018 to 2019 (mostly due to better asset turnover), but its ROE skyrocketed! During both 2018 and 2019, Rinker increased its liabilities, and significantly reduced its equity. Its debt-to-equity ratio is 43.3 at the end of fiscal year 2019, so the ROE is greater than 100%. This level of returns is exceptional for shareholders, but the company’s condition could be precarious if its performance were to deteriorate. The DuPont analysis shows that the net profit margin decreased from 2018 to 2019, but the asset turnover improved significantly. Based on ROFL, leverage increased ROA by 2.5 times in 2017 (22.07%/8.85%) while in 2019, leverage increased ROA by a factor of 6.4 (105.26%/16.47%). DuPont analysis suggests that leverage had a slightly larger impact (3.485 in 2017 and 7.776 in 2019) but the trend is the same. This is consistent with the bias in DuPont analysis in that it tends to overstate the effects of financial leverage. Offsetting this bias, DuPont analysis calculates the net profit margin, which is lower than PM because the numerator is net of interest costs. For comparison purposes, HD Rinker’s PM ratios are presented below: PM ratio

2019: 2018: 2017:

[€850+€246x (1-.25)] / €10,364 = 9.98% [€805+€208x (1-.25)] / €9,613 = 10.00% [€448+€237x(1-.25)] / €8,632 = 7.25%

©Cambridge Business Publishers, 2020 1-26

Financial Accounting, 6th Edition

E5-30. (20 minutes) LO 2, 3 ($ millions) a. EWI

$181 + $62 x (1 - 0.35) = $221.3

Avg. Equity

($2,120 + $1,852)/2 = $1,986.0

Avg. Assets

($6,323 + $5,540)/2 = $5,931.5

ROE

$181 / $1,986.0 = 9.11%

ROA

$221.3 / $5,931.5 = 3.73%

ROFL

9.11% - 3.73% = 5.38%

b. PM

$221.3 / $10,240 = 2.16%

AT

$10,240 / $5,931.5 = 1.73

c.

Office Depot has a very low profit margin and an asset turnover that is a little less than 2.0. This ratio combination is consistent with a low-price, high-volume business model. However, compared to the retail industry, Office Depot is doing poorly. Both its AT and its PM are below the median. As a result, its ROA and ROE are well below the industry medians.

E5-31. (20 minutes) LO 2, 3 ($ millions) a.

b.

c.

EWI

$1,211 + $20 x (1-.35) = $1,224.0

Avg. Equity

($2,354 + $1,354) / 2 = $1,854.0

Avg. Assets

($5,178 + $4,068) / 2 = $4,623.0

ROE

$1,211 / $1,854.0 = 65.32%

ROA

$1,224.0 / $4,623.0 = 26.48%

ROFL

65.32% - 26.48% = 38.84%

PM

$1,224.0 / $5,964 = 20.52%

AT

$5,964 / $4,623.0 = 1.29

Intuit has a relatively high PM ratio and a low AT ratio. These numbers are consistent with the business model employed in the software industry. Contrast these numbers with those of Office Depot (E5-30). Intuit uses financial leverage effectively; leverage increased its ROA by a factor of almost 2.5 (65.32%/26.48%).

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E5-32. (30 minutes) LO 4 a. 2017

2016

$6,570,520/$7,674,670 = 0.86

$6,259,796/$5,827,005 = 1.07

($3,367,914+$155,323+$515,381) /$7,674,670 = 0.53

($3,393,216+$105,519+$499,142)/$5,827,005 = 0.69

2017

2016

Debt-toequity ratio

$23,022,980/$5,632,392 = 4.09

$16,750,167/$5,913,909 = 2.83

Timesinterestearned ratio

(-2,209,032 + $471,259)/$471,259 = -3.69

Current ratio Quick ratio b.

c.

Cash burn rate = (-60,654 - $3,414,814)/365 days = -$9,522 thousand per day. Tesla’s financial condition has been a topic of considerable discussion in the recent past. Its current and quick ratios have dropped from 2016 to 2017, and they are among the lowest in Exhibit 5.13. (The restricted cash should not be considered an available resource for paying obligations, but the amount is not very significant.) The same is true of its debt-to-equity ratio. The times-interest-earned ratio doesn’t tell us much because it’s negative. Tesla is not earning income from which interest cash be paid; rather it is earning losses that are increased by interest expense. As of 2017, Tesla is using up cash for operations and capital expenditures at the rate of about $10 million per day. With $3.3 billion in cash as of the end of 2017, that means that if Tesla continues to spend at the same rate, it will run out of cash in late 2018. But that’s a very big “if,” and it is the source of disagreement among investors. Almost every new company starts its life with negative free cash flow. But every successful new company must reach a point where it stops consuming cash and begins to generate cash. The 2018 quarterly reports for Tesla appear to show that point may have been reached.

©Cambridge Business Publishers, 2020 1-28

Financial Accounting, 6th Edition

E5-33. (30 minutes) LO 4 a.

($ millions)

Current Ratio

OCFCL

2015

€51,442 / €39,562 = 1.30

€6,612 / [(€36,598 + €39,562) / 2] = 0.174

2016

€55,329 / €42,916 = 1.29

€7,611 / [(€39,562 + €42,916) / 2] = 0.185

2017

€58,429 / €43,394 = 1.35

€7,176 / [(€42,916 + €43,394) / 2] = 0.166

Siemens has a current ratio that is above 1.0 and has been steady around 1.3 over these years. Moreover, its OCFCL ratio stayed in the same range around 0.175. While the current ratio provides a useful point estimate of liquidity, the OCFCL ratio suggests that operations are not generating sufficient net cash flow to cover short-term obligations, but it would be useful to also get a sense of the volume of resource flows relative to the current liabilities. Siemens’ revenues for 2017 exceeded €83 billion. b.

($ millions)

Times interest earned

Debt-to-equity

2015

€(7,218 + 818) / €818 = 9.82

€85,293 / €34,474 = 2.47

2016

€(7,404 + 989) / €989 = 8.49

€90,901 / €34,211 = 2.66

2017

€(8,306 + 1,051) / €1,051 = 8.90

€89,277 / €43,089 = 2.07

The times interest earned ratio decreased in 2016 but rebounded in 2017. Siemens’ debt-to-equity ratio has been quite high around 2.50, but decreased in 2017. c.

It’s always a good idea to look into the numbers that make up the ratios before coming to conclusions. For instance, Siemens’ current liabilities include about €10.3 billion in unearned revenue, representing more than a quarter of its current liabilities. In the normal course of business, deferred performance liabilities like these aren’t paid off with cash – rather Siemens must provide the agreed-upon services and products to the customers. It’s not easy to place Siemens into one of the industry groups in Exhibit 5.13, but its DE ratio appears to be higher than any industry median except utilities. However, its TIE appears to be in a satisfactory range. And, the company’s size and diversified businesses give it a stability that can reassure lenders.

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E5-34. (30 minutes) LO 2, 3 ($ millions) a.

b.

c.

EWI

$848 + $74 x (1 - 0.35) = $896.1

Avg. Equity

($3,144 + $2,904) / 2 = $3,024.0

Avg. Assets

($7,989 + $7,610) / 2 = $7,799.5

ROE

$848 / $3,024.0 = 28.04%

ROA

$896.10 / $7,799.5 = 11.49%

ROFL

28.04% - 11.49% = 16.55%

PM

$896.10 / $15,855 = 5.65%

AT

$15,855 / $7,799.5 = 2.033

GPM

$6,066 / $15,855 = 38.26%

INVT

$9,789 / [($1,997 + $1,830) / 2] = 5.116

d. The Gap showed strong performance in the year ended February 3, 2018 (hereafter, 2017), with modest improvements over 2016. Its ROA was 11.5%, which is high for the retail industry. ROE was almost 30% indicating the effective use of financial leverage. Interest costs were low, suggesting that most of The Gap’s debt is from operating liabilities (accounts payable and accrued expenses). Its profit margin and asset turnover ratios place The Gap in a strong position for this industry. The GPM and INVT ratios are two important performance measures for retail companies such as The Gap. GPM measures the ability of the firm to sell its merchandise at reasonable margins while INVT provides evidence on inventory management and the popularity of its product line. Both measures are near the median for retailers in 2017.

©Cambridge Business Publishers, 2020 1-30

Financial Accounting, 6th Edition

E5-35.B (20 minutes) LO 1, 6 a. & b. THE GAP, INC. Common-size and Income Statement Forecasts

Net sales Cost of goods sold and occupancy expenses Gross profit Operating expenses Operating income Interest expense Interest income Income before income taxes Income taxes Net income c.

100.0%

100.0%

$15,800

$16,300

$16,800

63.7% 36.3% 28.7% 7.7% 0.5% -0.1% 7.2% 2.9% 4.4%

61.7% 38.3% 28.9% 9.3% 0.5% -0.1% 9.0% 3.6% 5.3%

9,796 6,004 4,582 1,422 74 (19) 1,367 342 $ 1,025

10,106 6,194 4,727 1,467 74 (19) 1,412 353 $ 1,059

10,416 6,384 4,872 1,512 74 (19) 1,457 364 $ 1,093

Note: 2016 and 2017 common size statements are reversed (2016 on the left). Forecasted statements are presented for three different sales levels. The Gap’s statement forecasts are based on (1) projected sales and (2) a set of assumptions that determine the relationship between various expense items and sales revenue. The accuracy of the projection depends on the reliability of these estimates, which depends on management’s ability to maintain a stable GPM ratio, maintain INVT ratio, and control operating expense ETS ratios. It also depends on which costs are variable and which are fixed. If SG&A expenses were fixed at the 2017 level regardless of 2018 sales, then the forecasted statements would show a greater variation in profits as sales change.

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PROBLEMS P5-36. (45 minutes) LO 2, 3 ($ millions) Nike a.

Adidas

EWI

$1,933 + $54 x (1 - 0.25) = $1,973.5

€1,100 + €93 x (1 - 0.30) = €1,165.10

Avg. Equity

($9,812 + $12,407) / 2 = $11,109.5

(€6,435 + €6,455) / 2 = €6,445

Avg. Assets

($22,536 + $23,259) / 2 = $22,897.5

(€14,522 + €15,176) / 2 = €14,849

ROE

$1,933 / $11,109.5 = 17.40%

€1,100 / €6,445 = 17.07%

ROA

$1,973.5 / $22,897.5 = 8.62%

€1,165.1 / €14,849 = 7.85%

ROFL

17.40% - 8.62% = 8.78%

17.07% - 7.85% = 9.22%

Nike’s performance on both measures of profitability exceeded that of Adidas, though not by a wide margin. We can examine possible reasons for that difference by looking at the ratios below.

b.

PM AT

$1,973.5 / $36,397 = 5.42% $36,397 / $22,897.5 = 1.59

€1,165.1 / €21,218 = 5.49% €21,218 / €14,849 = 1.43

Nike’s PM ratio is very slightly lower than Adidas’s, but its AT ratio is 11% higher. So, Nike’s higher ROA appears to be driven by more efficient use of assets.

c.

GPM Operating ETS

$15,956 / $36,397 = 43.8% $11,511 / $36,397 = 31.6%

€10,703 / €21,218 = 50.4% €8,634 / €21,218 = 40.7%

Adidas reports a higher GPM ratio than Nike by about 7%. However, that is more than offset by much higher operating expenses as a percentage of sales.

d.

ART INVT PPET

$36,397 / $[(3,498 + 3,677) / 2] = 10.15 $20,441 / $[(5,261 + 5,055) / 2] = 3.96 $36,397 / $[(4,454 + 3,989) / 2] = 8.62

€21,218 / €[(2,315 + 2,200) / 2] = 9.40 €10,514 / €[(3,693 + 3,764) / 2] = 2.82 €21,218 / €[(2,000 + 1,915) / 2] = 10.84

Nike’s INVT is significantly higher than Adidas’s, suggesting that Nike may be managing inventory more efficiently. Both companies’ PPET ratios are high. These are consistent with a business model that outsources most of the production.

©Cambridge Business Publishers, 2020 1-32

Financial Accounting, 6th Edition

e. The two companies’ fiscal years overlap by seven months. Nike’s income statement includes January through May 2018 while Adidas’ statements cover January through May 2017. (Both cover June through December 2017.) Economic conditions were not materially different in 2018 than 2017, so the comparisons involving income statement accounts shouldn’t be affected too much. However, companies that experience seasonality will have balance sheets that look different at different points in time. For instance, a company might have lower inventory levels just after a busy season, and choosing that point for the end of its fiscal year would produce a higher value for ROA or INVT than a fiscal year just prior to its busy season. f.

Normally, we would want to identify any major differences in the valuation of assets and the measurement of income between these two companies. For example, some assets are more likely to be valued at current value (rather than historical cost) under IFRS reporting. Such a difference would affect ratios such as ROA, AT, INVT and PPET.

P5-37. (20 minutes) LO 4 ($ millions) a.

Current Ratio

Quick Ratio

Nike

Adidas

2017: $15,134 / $6,040 = 2.51

€8,645 / €6,291 = 1.37

2016: $16,061 / $5,474 = 2.93

€8,886 / €6,765 = 1.31

2017: $(4,249+996+3,498) / $6,040 = 1.45

€(1,598+398+2,315) / €6,291 = 0.69

2016: $(3,808+2,371+3,677) / $5,474 = 1.80

€(1,510+734+2,200) / €6,765 = 0.66

Nike is more liquid than Adidas. Its current ratio is around 2.5 and its quick ratio is near 1.5 – both values close to the medians for the apparel industry. In fact, Nike’s quick ratio is higher than Adidas’s current ratio.

b.

TIE

Debt-to-Equity

2017: ($4,325 + $54) / $54 = 81.09

(€2,022 + €93) / €93 = 22.74

2016: ($4,886 + $59) / $59 = 83.81

(€1,536 + €74) / €74 = 21.76

2017: $12,724 / $9,812 = 1.30

€8,087 / €6,435 = 1.26

2016: $10,852 / $12,407 = 0.87

€8,721 / €6,455 = 1.35

Nike’s debt-to-equity ratio is very low with values close to the apparel industry average. But the ratio increased significantly in 2017 when liabilities increased by $1.9 billion and equity decreased by about $2.6 billion. Adidas’s debt-to-equity ratio is higher, and also went up in 2017. Nike’s TIE ratio decreased while Adidas’ ratio increased slightly.

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c.

Historically, Adidas relies on greater amounts of debt financing than does Nike, but their DE ratios are essentially equivalent in this latest year. The TIE ratio for Nike is much higher than for Adidas. Although Adidas’s TIE ratio is not too low, Nike’s small amount of interest expense produces a very high TIE. Neither company should have difficulty meeting its debt obligations, but Adidas may not be able to borrow as much in the future (if needed).

P5-38. (45 minutes) LO 2, 3 ($ millions) a.

Home Depot

Lowe’s

EWI

$8,630 + $1,057 x (1 - 0.35) = $9,317.05

$3,447 + $649 x (1 - 0.35) = $3,868.85

Avg. Equity

($1,454 + $4,333) / 2 = $2,893.5

($5,873 + $6,434) / 2 = $6,153.5

Avg. Assets

($44,529 + $42,966) / 2 = $43,747.5

($35,291 + $34,408) / 2 = $34,849.5

ROE

$8,630 / $2,893.50 = 298.3%

$3,447 / $6,153.5 = 56.0%

ROA

$9,317.05 / $43,747.5 = 21.3%

$3,868.85 / $34,849.5 = 11.1%

ROFL

298.3% - 21.3% = 277.0%

56.0% - 11.1% = 44.9%

In 2017, Home Depot’s profitability exceeded that of Lowe’s, both in return to shareholders and in return on assets. Home Depot also had a much larger proportional effect from the use of leverage. It has shareholders’ equity that is only 17% of its current earnings – the result of large dividends and share buybacks.

b.

PM

$9,317.05 / $100,904 = 9.2%

$3,868.85 / $68,619 = 5.6%

AT

$100,904 / $43,747.5 = 2.31

$68,619 / $34,849.5 = 1.97

Home Depot has a higher PM ratio, so it makes more money for every dollar of sales, and it also generates more sales for every dollar of resources, suggesting that it is managing assets more efficiently.

c.

GPM

$34,356 / $100,904 = 34.0%

$23,409 / $68,619 = 34.1%

Operating ETS

($17,864 + $1,811) / $100,904 = 19.5%

($15,376 + $1,447) / $68,619 = 24.5%

These two companies have identical gross profit margins, but The Home Depot’s operating ETS ratio is lower by a significant amount (5% of sales, or $5 billion). Overall, Home Depot performed slightly better with respect to these two profitability measures.

©Cambridge Business Publishers, 2020 1-34

Financial Accounting, 6th Edition

d.

($ millions)

Lowe’s

Home Depot

ART

$100,904 / $[(1,952 + 2,029)/2] = 50.69

$68,619 / 0 = N/A

INVT

$66,548 / $[(12,748 + 12,549)/2] = 5.26

$45,210 / $[(11,393 + 10,458)/2] = 4.14

PPET

$100,904 / $[(22,075 + 21,914)/2] = 4.59

$68,619 / $[(19,721 + 19,949)/2] = 3.46

Lowe’s reports no accounts receivable and Home Depot reports very small amounts of receivables. Neither company relies on customer credit to generate sales, so the ART ratio is not very informative. More important is the INVT ratio. Home Depot’s INVT is higher than Lowe’s ratio. The same is true for the PPET ratio. These differences are consistent with the difference in the AT ratios noted earlier. Overall, the numbers suggest that Home Depot is managing inventories and PPE assets more efficiently. e. Overall, It appears that Home Depot performed better than Lowe’s in 2017. Its ratio values are either equal to or better than Lowe’s in almost every category.

P5-39. (30 minutes) LO 4 ($ millions) a.

Home Depot

Lowe’s

Current Ratio

2017: 2016:

$18,933 / $16,194 = 1.17 $17,724 / $14,133 = 1.25

$12,772 / $12,096 = 1.06 $12,000 / $11,974 = 1.00

Quick Ratio

2017: 2016:

($3,595 + $1,952) / $16,194 = 0.343 ($2,538 + $2,029) / $14,133 = 0.323

($588 + $102) / $12,096 = 0.057 ($558 + $100) / $11,974 = 0.055

Both companies’ current ratios are above one, though Home Depot’s is a bit higher. Quick ratios are very low due to the lack of receivables and low cash balances. Both companies rely on operating cash flow to cover liquidity needs. Given the lack of receivables, the INVT ratio becomes doubly important (see P5-38). Failure to turn inventories quickly would result in lower operating cash flow and liquidity problems. Hence, both companies emphasize inventory management.

b.

TIE Debt-to-Equity

2017: 2016:

($13,698 + $1,057)/$1,057 = 13.96 ($12,491 + $972)/$972 = 13.85

($5,489 + $649)/$649 = 9.46 ($5,201 + $657)/$657 = 8.92

2017: 2016:

$43,075 / $1,454 = 29.63 $38,633 / $4,333 = 8.92

$29,418 / $5,873 = 5.01 $27,974 / $6,434 = 4.35

For both companies, the debt-to-equity ratio increased from 2016 to 2017 indicating more reliance on debt financing. In fact, The Home Depot had free cash flow over $10 billion in 2017, and it returned $12.2 billion to shareholders in dividends and repurchases of common stock. Both companies’ DEs are higher than the median for the retail industry. Despite this trend, both companies’ TIE ratios increased.

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c.

The Home Depot utilizes more debt financing than does Lowe’s though both are higher than the median retail firm. This results in a higher ROFL (see P5-38), as well as higher debt-to-equity. Both firms have TIE ratios that are above the median for the retail industry.

P5-40.A (30 minutes) LO 5 ($millions)

Home Depot

Lowe’s

NOPAT

$8,630 – [($74 - $1,057) x (1 - 0.35)] = $9,268.95

$3,447 – [($16 - $649) x (1 - 0.35)] = $3,858.45

NOA 2017:

$44,529 - $(43,075 – 2,761 – 24,267) = $28,482

$(35,291 - 102 - 408) - $(29,418 – 1,431 – 15,564) = $22,358

NOA 2016:

$42,966 - $(38,633 - 1,252– 22,349) = $27,934

$(34,408 - 100 - 366) - $(27,974 – 1,305 – 14,394) = $21,667

Avg. NOA

($28,482 + $27,934) / 2 = $28,208

($22,358 + $21,667) / 2 = $22,012.5

b.

RNOA

$9,268.95 / $28,208 = 32.9%

$3,858.45 / $22,012.5 = 17.5%

c.

NOPM

$9,268.95 / $100,904 = 9.19%

$3,858.45 / $68,619 = 5.62%

NOAT

$100,904 / $28,208 = 3.58

$68,619 / $22,012.5 = 3.12

a.

d. The Home Depot reports a higher RNOA than does Lowe’s, and the pattern in the operating results parallels that in the total-firm results in P5-38. This is consistent with the ROA numbers computed in P5-38 (ROA=21.3% for Home Depot and 11.1% for Lowe’s). Overall, we would expect operating companies to have higher RNOA than ROA, because their core business is the operations of the company, not investing in financial assets. And, if management seeks to earn a favorable return for shareholders, they must expect a higher return on their operations than they have to pay for borrowed funds.

©Cambridge Business Publishers, 2020 1-36

Financial Accounting, 6th Edition

P5-41. (30 minutes) LO 2, 3 ($ millions) a.

2017

2016

EWI

$4,910 + $453 x (1 - 0.35) = $5,204.45

$3,431 + $381 x (1 - 0.35) = $3,678.65

Avg. Assets

($45,403 + $40,377) / 2 = $42,890.0

($40,377 + $38,311) / 2 = $39,344.0

ROA

$5,204.45/ $42,890.0= 12.1%

$3,678.65/ $39,344.0= 9.3%

PM

$5,204.45/ $65,872 = 7.9%

$3,678.65/ $60,906 = 6.0%

AT

$65,872 / $42,890.0 = 1.54

$60,906 / $39,344.0= 1.55

UPS’ ROA appears healthy in both years. Although AT decreased slightly in 2017, PM increased, which caused a corresponding increase in ROA. b.

Compensation ETS

$34,588 / $65,872 = 52.5%

$34,770 / $60,906 = 57.1%

The largest single expense on UPS’s income statement is compensation. ratio from 57.1% to 52.5% of sales explains the rise in PM in 2017. c.

d.

The decrease in this ETS

Avg. Equity

($1,030 + $429) / 2 = $729.5

($429 + $2,491) / 2 = $1,460.0

ROE

$4,910 / $729.5 = 673.1%

$3,431 / $1,460 = 235.0%

ROFL

673.1% - 12.1% = 661.0%

235.0% - 9.3% = 225.7%

UPS relies very heavily on debt financing. In 2017 and 2016, when ROA was at an acceptable level, ROFL produced an ROE 25 to 55 times as large as ROA.

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P5-42. (30 minutes) LO 4 ($ millions) a.

2017

2016

Current Ratio

$15,548 / $12,708 = 1.22

$13,849 / $11,730 = 1.18

Quick Ratio

$(3,320 + 749 + 8,773) / $12,708 = 1.01

$(3,476 + 1,091 + 7,695) / $11,730 = 1.05

UPS current and quick ratios changed little in 2017. The quick ratio is only slightly lower than the current ratio because UPS does not carry inventory balances. b.

TIE

($7,148 + $453) / $453 = 16.78

($5,136 + $381) / $381 = 14.48

Debt-to-Equity

$44,373 / $1,030 = 43.08

$39,948 / $429 = 93.12

The debt-to-equity ratio decreased dramatically in 2017 due to percentage change in shareholders’ equity exceeding that of liabilities. Nevertheless, a debt-to-equity ratio in the 40s is extremely high. At the same time, the TIE ratio increased due to an increase in pre-tax earnings. c.

UPS relies heavily on liability financing. The company’s current ratio and quick ratio are quite a bit lower than the medians of the Business Services industry. Being a capital-intensive business, their debt-to-equity ratio is significantly higher than the median. Although the company appears liquid, its ability to meet its obligations depends heavily on operating cash flow. The high debt-to-equity ratio suggests that UPS may have difficulty borrowing additional funds if needed.

P5-43.A (30 minutes) LO 5 ($ millions) a. NOPAT

United Parcel Service (UPS) $4,910 – [($72 – $453) x (1 – 0.35)] = $5,157.65

NOA

2017: $(45,403 – 749 - 483) - $(44,373 – 4,011 – 20,278) = $24,087 2016: $(40,377 – 1,091 - 476) - $(39,948 – 3,681 – 12,394) = $14,937

Avg. NOA

($24,087 + $14,937) / 2 = $19,512

b. RNOA

$5,157.65 / $19,512 = 26.4%

©Cambridge Business Publishers, 2020 1-38

Financial Accounting, 6th Edition

c.

NOPM

$5,157.65 / $65,872 = 7.8%

NOAT

$65,872 / $19,512.0 = 3.38

d. UPS invests only small amounts in non-operating assets (less than 3% of total assets). So, when UPS invests borrowed funds in its operations, it earns a return above 20%, at least in 2017. Because its borrowing costs are significantly less than 20%, the financial leverage works in favor of the shareholders. P5-44.B (45 minutes) LO 6 a. UNITED PARCEL SERVICE, INC. Income Statements ($ millions)

2017 Actual

2018 Forecast

Revenue………………………………………………

$65,872

$70,000

Compensation and benefits………………………..

34,588

36,756

Other…………………………………………………..

23,755

25,244

Operating profit………………………………………

7,529

8,000

Investment income…………………………………..

72

72

Interest expense………………………………………

453

453

Income before income taxes………………………..

7,148

7,619

Income taxes…………………………………………..

2,238

1,905

Net income……………………………………………..

$ 4,910

$ 5,714

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b. UNITED PARCEL SERVICE, INC. Balance Sheets 2017 Actual

($ millions)

2018 Forecast

Cash and equivalents………………………………….

$ 3,320

$ 3,844

Marketable securities…………………………………..

749

749

Accounts receivable, net………………………………

8,773

9,323

Other current assets…………………………………..

2,706

2,876

Total current assets……………………………………

15,548

16,792

Property, plant and equipment……………………….

22,118

23,504

Goodwill ………………………………………………

3,872

4,115

Intangible assets, net ………………………………

1,964

2,087

Non-current investments and restricted cash ………

483

483

Deferred income tax assets…………………………

265

282

Other assets…………………………….………………

1,153

1,225

Total assets……………………….…………………….

$45,403

$48,488

Current maturities of long-term debt…………………

$

4,011

$

4,011

Accounts payable……………………………………….

3,872

4,115

Accrued wages and withholdings…………………….

2,521

2,679

17

18

Self-insurance reserves, current portion…………….. Accrued group welfare and retirement plan contributions ……………………………………….

705

749

677

719

Other current liabilities…………………………………

905

962

Total current liabilities…………………………………

12,708

13,253

Long-term debt………………………….………………

20,278

20,278

Pension and postretirement obligation………………

7,061

7,503

Deferred taxes liabilities………………………………..

757

804

Self-insurance reserves ……………………………….

1,765

1,876

Other noncurrent liabilities……………………………..

1,804

1,917

Total liabilities…………………………………………...

44,373

45,631

Shareowners' equity……………………………………

1,030

2,857

Total liabilities and shareowners' equity……………..

$45,403

$48,488

Hedge margin liabilities

Students’ forecast calculations may vary. An unrounded forecast factor was used in the calculations presented in the solution.

©Cambridge Business Publishers, 2020 1-40

Financial Accounting, 6th Edition

P5-45. (45 minutes) LO 3 a. A summary of the ratios for these five companies appears in the following table. Calculations are provided below for each company. ABT PM GPM

BMY

JNJ

GSK

PFE

3.89%

5.72%

2.49%

9.15%

42.21%

54.96%

68.50%

66.84%

65.74%

78.61%

b. A summary of the ratios for these five companies appears in the following table. Calculations are provided below for each company. ABT R&D ETS SG&A ETS c.

BMY

JNJ

GSK

PFE

8.16%

33.29%

13.81%

14.83%

14.57%

33.29%

24.34%

28.02%

32.04%

28.14%

What is perhaps most remarkable is how similar these five companies are. For example, the SG&A ETS ratio ranges between 24% and 34%, with three of the five between 28% and just over 32%. GPM ranges from a low of 55% (ABT) to 79% (PFE), but the other three firms are between 65% and 69%. This suggests that the business models employed by these companies are very similar. The PM ratio shows a fairly wide variation, ranging from a low of 2.5% (JNJ) to 42.2% (PFE). Interestingly, ABT appears to be one of the least profitable, with a 3.9% PM and a 55.0% GPM, yet it spends the least on R&D. That pattern could be caused by the fact that ABT spun off its researchoriented pharmaceuticals into a separate company (AbbVie). As an example, calculations of ratios for Abbott Laboratories follow: ($ millions)

Abbott Laboratories (ABT)

PM

$477 + $904 x (1 - 0.35) / $27,390 = 3.89%

GPM

($27,390 - $12,337) / $27,390 = 54.96%

R&D ETS

$2,235 / $27,390 = 8.16%

SG&A ETS

$9,117 / $27,390 = 33.29%

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P5-46. (45 minutes) LO 3 a. Best Buy

Kroger

Nordstrom

Office Depot

Walgreens Boots

Return on assets (ROA)

7.85%

6.35%

3.52%

3.84%

8.20%

Profit margin (PM)

2.51%

1.91%

3.64%

2.22%

4.18%

Asset turnover (AT)

3.13

3.33

0.97

1.73

1.96

b.

AR turnover (ART) Inventory turnover (INVT) PP&E turnover (PPET)

Best Buy

Kroger

Nordstrom

Office Depot

Walgreens Boots

35.18

74.66

89.99

12.66

20.08

6.41

14.61

5.04

6.56

10.91

17.88

5.83

3.95

15.44

9.55

c.

Gross profit margin (GPM)

Best Buy

Kroger

Nordstrom

Office Depot

Walgreens Boots

23.4%

22.0%

36.1%

24.0%

23.4%

Nordstrom has the highest GPM (36.1%), but WBA has the highest ROA (8.20%) and PM (4.18%). Nordstrom has the lowest AT (0.97), reflecting its “higher margin, lower volume” position. On the other end of the spectrum, Kroger has the lowest PM (1.91%) and the highest AT and INVT, Inventory management is critical for a grocery chain. All of these companies have high ART, reflecting the fact that most of their customers pay at the time of purchase. Retail companies have the choice to report inventory and cost of sales using last-in, first-out (LIFO) or first-in, first-out (FIFO), which can affect margins and turnover ratios. We will look into this more closely in Chapter 7. In addition, retail companies lease much of their store space. As a result, the PPET ratio depends on how these store leases are reported in the balance sheet. Lease accounting is discussed in Chapter 10. continued next page

©Cambridge Business Publishers, 2020 1-42

Financial Accounting, 6th Edition

c.

continued Calculations follow for Best Buy as an example ($ millions): Best Buy (BBY) EWI

$1,000 + $75 x (1-.25) = $1,056.25

ROA

$1,056.25 / $13,452.5 = 7.85%

PM

$1,056.25 / $42,151 = 2.51%

AT

$42,151 / $13,452.5 = 3.13

ART

$42,151 / $1,198 = 35.18

INVT

$32,275 / $5,036.5 = 6.41

PPET

$42,151 / $2,357 = 17.88

GPM

($42,151 - $32,275) / $42,151 = 23.4%

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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CASES and PROJECTS C5-47. (30 minutes) LO 3 a. Raising prices and/or reducing manufacturing costs are not necessarily independent solutions and are likely related to other factors. The effect of a price increase on gross profit is a function of the demand curve for the company’s product. If the demand curve is relatively elastic, a price increase will likely significantly reduce demand, thereby decreasing, rather than increasing, gross profit (an example is a 10% increase in price and a 20% decrease in demand). A price increase will have a more desired effect if the demand curve is relatively inelastic (a 10% price increase with a 3% decrease in demand). Cutting manufacturing costs will positively affect gross profit (via reduction of COGS) if the more inexpensively made product is not perceived to be of lesser quality, thereby reducing demand. b. Raising prices is difficult in competitive markets. As the number of product substitutes increases, companies are less able to raise prices. Rather, they must be able to effectively differentiate their products in some manner in order to reduce consumers’ substitution. This can be accomplished, for example, by product design and/or advertising. These efforts, however, likely entail additional cost, and, while gross profit might be increased as a result, SG&A expense may also increase with little effect on the bottom line. Manufacturing costs consist of raw materials, labor and overhead. Each can be targeted for cost reduction. A reduction of raw materials costs generally implies some reduction in product quality, but not necessarily. It might be the case that the product contains features that are not in demand by consumers. Eliminating those features will reduce product costs with little effect on selling price. Similarly, companies can utilize less expensive sources of labor (off-shore production, for example), that can significantly reduce product costs and increase gross profit provided that product quality is maintained. Finally, manufacturing overhead can be reduced by more efficient production. Wages and depreciation expense are two significant components of manufacturing overhead. These are largely fixed costs, and the per-unit product cost can often be reduced by increasing capacity utilization of manufacturing facilities (provided, of course, that the increased inventory produced can be sold). The bottom line is that increasing gross profit is a difficult process than can only be accomplished by effective management and innovation.

©Cambridge Business Publishers, 2020 1-44

Financial Accounting, 6th Edition

C5-48. (30 minutes) LO 3 a. Working capital management is an important component of the management of a company. By reducing the level of working capital, companies reduce the costs of carrying excess assets. This can have a significantly positive effect on financial performance. Some common approaches to reducing working capital via reductions in receivables and inventories, and increases in payables, include the following: •

Reduce receivables o Constricting the payment terms on product sales o Better credit policies that limit credit to high-risk customers o Better reporting to identify delinquencies o Automated notices to delinquent accounts o Increased collection efforts o Prepayment of orders or billing as milestones are reached o Use of electronic (ACH) payment o Use of third-party guarantors, including bank letters of credit

•

Reduce inventories o Reduce inventory costs via less costly components (of equal quality), produce with lower wage rates, eliminate product features (costs) not valued by customers o Outsource production to reduce product cost and/or inventories the company must carry on its balance sheet o Reduce raw materials inventories via just-in-time deliveries o Eliminate bottlenecks in manufacturing to reduce work-in-process inventories o Reduce finished goods inventories by producing to order rather than producing to estimated demand

•

Increase payables o Extend the time for payment of low or no-cost payables—so long as the relationship with suppliers is not harmed.

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b. The terms of payment that a company offers to its customers is a marketing tool, similar to product price and advertising programs. Many companies promote payment terms separately from other promotions (no payment for six months or interest-free financing, for example). As companies restrict credit terms, the level of receivables will likely decrease, thereby reducing working capital. The restriction of credit terms may also have the undesirable effect of reducing demand for the company’s products. The cost of credit terms must be weighed against the benefits, and credit terms must be managed with care so as to optimize costs rather than minimize them. Credit policy is as much art as it is science. Likewise, the depth and breadth of the inventories that companies carry impact customer perception. At the extreme, inventory stock-outs result in not only the loss of current sales, but also the potential loss of future sales as customers are introduced to competitors and may develop an impression of the company as “thinly stocked.” Inventories are costly to maintain, as they must be financed, insured, stocked, moved, and so forth. Reduction in inventory levels can reduce these costs. On the other hand, the amount and type of inventories carried is a marketing decision and must be managed with care so as to optimize the level inventories, not necessarily to minimize them. One company’s account payable is another’s account receivable. So, just as one company seeks to extend the time of payment, so as to reduce its working capital, so does the other company seek to reduce the average collection period so as to accomplish the same objective. Capable, dependable suppliers are a valuable resource for the company, and the supplier relation must be handled with care. All companies take as long to pay their accounts payable as the supplier allows in its credit terms. Extending the payment terms beyond that point begins to negatively impact the supplier relation, ultimately resulting in the loss of the supplier. The supplier relation must be managed with care so as to optimize the terms of payment, rather than necessarily to minimize them.

©Cambridge Business Publishers, 2020 1-46

Financial Accounting, 6th Edition

C5-49. (30 minutes) LO 2, 3 a. The list of parties that are affected by schemes to manage earnings is often much broader than first thought. It includes the following affected parties: 1. employees above and below the level at which the scheme is implemented 2. stockholders and elected members of the board of directors 3. creditors of the company (suppliers and lenders) and their employees, stockholders, and boards of directors 4. competitors of the company 5. the company’s independent auditors 6. regulators and taxing authorities b. Managers often believe that earnings management activities will be short-lived, and will be curtailed once its operations “turn around.” Often, this does not prove to be the case. Interviews with managers and employees who have engaged in these activities often reveal that they started rather innocuously (just managing earnings to “make the numbers” in one quarter), but, quickly, earnings management became a slippery slope. Ultimately, the parties the company was trying to protect (shareholders, for example) are hurt more than they would have been had the company reported its results correctly, exposing problems early so that corrective action could be taken (possibly by removing managers) to protect the broader stakeholders in the company. c.

Company managers are just ordinary people. They desire to improve their compensation, which is often linked to financial performance. Managers may act to maximize their current compensation at the expense of long-term growth in shareholder value. The reduction in the average employment period at all levels of the company has exacerbated the problem.

d. Unfortunately, the separation of ownership and control often leads to less informed shareholders who are unable to effectively monitor the actions of the managers they have hired. To the extent that compensation programs are linked to financial measures, managers can use the flexibility given to them under GAAP to their benefit, even without violating GAAP per se. These actions can only be uncovered by effective auditing and enforced by an effective audit committee of the board. Corporate governance has grown considerably in importance following the accounting scandals of the early 2000s. The Sarbanes-Oxley Act mandates new levels of corporate governance. The stock market and the courts are helping to enforce this mandate.

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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Chapter 6 Reporting and Analyzing Revenues, Receivables, and Operating Income Learning Objectives – coverage by question MiniExercises

Exercises

LO1 – Describe and apply the criteria for determining when revenue is recognized.

14, 15, 17

27, 28, 33, 40

LO2 – Illustrate revenue and expense recognition when the transaction involves future deliverables and/or multiple elements.

17, 24, 25

27, 28, 31, 40, 41

47

LO3 – Illustrate revenue and expense recognition for long-term projects.

13, 16

27 - 30

43

18 - 21, 23

34 - 38

45, 46

50

LO5 – Calculate return on net operating assets, net operating profit after taxes, net operating profit margin, accounts receivable turnover, and average collection period.

20, 22

32, 35, 39

42, 45

50

LO6 –Discuss earnings management and explain how it affects analysis and interpretation of financial statements.

26

33

44

48, 49

39

42

51

LO4 – Estimate and account for uncollectible accounts receivable.

LO7 Appendix 6A – Describe and illustrate the reporting for nonrecurring items.

Problems

Cases and Projects

48, 49

48 - 50

©Cambridge Business Publishers, 2020 1-48

Financial Accounting, 6th Edition

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

1-49

QUESTIONS Q6-1.

Revenue should be the amount of consideration that a firm expects to receive for the performance obligations to the customer that it fulfilled during the period. The revenue rules describe a five-step process. First, the contract (i.e., agreement) with the customer myst be identified. Then the firm’s distinct performance obligations under the contract must be determined. Next, the amount of consideration the the firm expects to receive must be estimated. If there are multiple performance obligations, then the consideration must be allocated to them based on their stand-alone selling prices. These steps are completed at the commencement of the contract with the customer. Then, as the firm fulfills a performance obligation, it should recognize as revenue the amount that was allocated to the performance obligation.. For retailers, like Abercrombie & Fitch, revenue is generally earned when title to the merchandise passes to the buyer (e.g., when the buyer takes possession of the merchandise), because returns can be estimated. For companies operating under long-term contracts, the performance obligation (e.g., to construct an office building) is usually fulfilled over the period of construction. Many such companies use the amount of cost incurred as a measure of the fulfillment of the performance obligation. See the examples of The Gap and Fluor in the chapter.

Q6-2.

Financial statement analysis is usually conducted for purposes of forecasting future financial performance of the company. Discontinued operations are, by definition, not expected to continue to affect the profits and cash flows of the company. Accordingly, the financial statements separately report discontinued operations from continuing operations to provide more useful measures of financial performance and financial income. For example, yielding an income measure that is more likely to persist into the future, and a net assets measure absent discontinued items.

Q6-3.

Restructuring costs typically consist of two general categories: asset writedowns and accruals of liabilities. Asset write-downs reduce assets and are recognized in the income statement as an expense that reduces income and, thus, equity. Liability accruals create a liability, such as for anticipated severance costs and exit costs, and yield a corresponding expense that reduces income and equity.

Q6-4.

Big bath refers to an event in which a company records a nonrecurring loss in a period of already depressed income. By deliberately reducing current period earnings, the company removes future costs from the balance sheet or creates ‘reserves’ that can be used to increase future period earnings.

©Cambridge Business Publishers, 2020 1-50

Financial Accounting, 6th Edition

Q6-5.

Earnings management may be motivated by a desire to reach or exceed previously stated earnings targets, to meet analysts’ expectations, or to maintain steady growth in earnings from year to year. This desire to achieve income goals may be motivated by the need to avoid violating covenants in loan indentures or to maximize incentive-based compensation. The tactics used to manage income involve transaction timing (recognizing a gain or loss) and estimations that increase (or decrease) income to achieve a target.

Q6-6.

Non-GAAP or Pro forma income adjusts GAAP income to eliminate (and sometimes add) various items that the company believes do not (or do) reflect its core operations. The SEC requires that GAAP income be reported together with pro forma income. Yet, companies often report their GAAP income at the very end of the earnings or press release, thus obfuscating their comparison and focusing attention on the pro forma income. It is because of this potential to confuse the reader about the true financial performance of the company that the SEC has become concerned. Also, pro forma numbers are not subject to accepted standards (and, thus, we observe differing definitions over time and across companies), are not subject to usual audit tests, and are subject to management latitude in what is and is not included and how items are measured.

Q6-7.

Estimates are necessary in order to accurately measure and report income on a timely basis. For example, in order to record periodic depreciation of longlived assets, one must estimate the useful life of the asset. Estimates allow accountants to match revenues and expenses incurred in different periods. For example, accountants estimate warranty costs so that the warranty expense is matched against the corresponding sales revenue. If the accounting process waited until no estimates were necessary, there would be a significant delay in the reporting of financial results.

Q6-8.

When analysts publish earnings forecasts, these forecasts become a benchmark against which some investors evaluate the company’s performance. A company that fails to meet analysts’ forecasts may suffer a stock price decline, even though earnings are higher than previous years’ earnings and overall performance is good. Consequently, management may feel pressure to meet or slightly exceed analysts’ forecasts of earnings.

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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Q6-9.

Bad debts expense is recorded in the income statement when the allowance for uncollectible accounts is increased. If a company overestimates the allowance account, net income will be understated on the income statement and accounts receivable (net of the allowance account) will be underestimated on the balance sheet. In future periods, such a company will not need to add as much to its allowance account since it is already overestimated from that prior period (or, it can reverse the existing excess allowance balance). As a result, future net income will be higher. On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense.

Q6-10. There are several possible explanations for a decrease in the allowance account. First, after an aging of accounts receivable, Wallace Company may have determined that a smaller percentage of its receivables are past due. Wallace Company may have changed its credit policy such that it is attracting lower-risk customers than in the past. Second, experience may have indicated that the percentages used to estimate uncollectibles was too high in previous years. By correcting the estimated percentage of defaults, the estimated uncollectibles would end up lower than in past years. Third, Wallace Company may be managing earnings. By lowering estimated uncollectibles, the company can increase current earnings, but may end up reporting a loss in a future year when write-offs exceed the balance in the allowance account. Q6-11. Minimizing uncollectible accounts is not necessarily the best objective for managing accounts receivable. That objective could be accomplished by not offering to sell to customers on credit. The purpose of offering credit to customers is to increase sales and profits. Losses from uncollectible accounts are a cost of doing business. As long as the benefit (greater contribution to profits due to increased sales) exceeds the cost (increased losses due to uncollectibles) then a higher-risk credit policy which increases the amount of uncollectible accounts would be a more profitable policy. Q6-12. The number of defaults tends to rise and fall with the economy. For example, in a recession, customers are more likely to default and companies take longer, on average, to pay their bills than during a healthy economy. This would result in higher estimated uncollectibles if the estimates are based on an aging of accounts receivable. For many companies, sales revenue also tends to decline during a recession. If estimated uncollectibles are estimated as a percentage of sales, then the estimate would tend to fall in a recession. This is contrary to the increase in the number of defaults that occurs during a recession. Therefore, the percentage of sales approach is not as sensitive to changing economic conditions as is accounts receivable aging.

©Cambridge Business Publishers, 2020 1-52

Financial Accounting, 6th Edition

MINI EXERCISES M6-13. (15 minutes) LO 3

Year 2019 2020 2021 Total a b c

Costs Incurred $ 400,000 1,000,000 500,000 $1,900,000

Performance Obligation Fulfilled Over Time Revenue Recognized Percent of Total (percentage of costs Income Expected costs incurred  total (revenue – (rounded)

21%a 53%b 26%c

contract amount)

$ 525,000 1,325,000 650,000 $2,500,000

costs incurred)

$125,000 325,000 150,000 $600,000

$400,000 / $1,900,000 $1,000,000/ $1,900,000 $500,000 / $1,900,000

M6-14. (20 minutes) LO 1 Company GAP

Revenue recognition When merchandise is given to the customer and returns can be estimated (or the right of return period has expired).

Merck

When merchandise is transferred to the customer and returns can be estimated (or the right of return period has expired). The company will also establish a reserve and recognize expense relating to uncollectible accounts receivable at the time the sale is recorded. When merchandise is transferred to the customer and the right of return period, if any, has expired. The company will also establish a reserve and recognize expense for uncollectible accounts receivable and anticipated warranty costs at the time the sale is recorded. Interest is earned by the passage of time. Each period, Bank of America accrues income on each of its loans and establishes a receivable on its balance sheet.

Deere

Bank of America

Johnson Controls

Revenue is recognized under long-term contracts under the cost-to-cost method as a measure of the fulfillment of performance obligation over time. ©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 1

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©Cambridge Business Publishers, 2020 1-54

Financial Accounting, 6th Edition

M6-15. (15 minutes) LO 1 The Unlimited can only recognize revenues once they have transferred the products to the customer and the amount of returns can be estimated with sufficient accuracy. Assuming that happens at the time of sale, it must estimate the proportion of product that is likely to be returned and deduct that amount from gross sales for the period. In this case, it would report $4.9 million in net revenue (98% of $5 million) for the period. If The Unlimited does not have sufficient experience to estimate returns, then one would question whether there is a substantive contract with the customer, and it should wait to recognize revenue until the right of return period has elapsed.

M6-16. (20 minutes) LO 3 a. Performance Obligation Fulfilled Over Time: Year Percent completed Revenue Expense: Construction costs Gross profit

2019

2020

2021

Total

30% $12,000,000

50% $20,000,000

20% $8,000,000

$40,000,000

9,000,000 $3,000,000

15,000,000 $5,000,000

6,000,000 $2,000,000

30,000,000 $10,000,000

2021 $40,000,000

Total $40,000,000

30,000,000 $10,000,000

30,000,000 $10,000,000

b. Performance Obligation Fulfilled At Delivery: Year Revenue Expense: Construction costs Gross profit

2019

2020

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

1-55

M6-17. (20 minutes) LO 1, 2 a. A.J. Smith should recognize the warranty revenue as it is earned. Since the warranties provide coverage for three years beginning in 2020, one-third of the revenue should be recognized in 2020, one-third in 2021, and the remaining third in 2022. b. Year Revenue Warranty expenses Gross profit

2020 $566,666 166,666 $400,000

2021 $566,667 166,667 $400,000

2022 $566,667 166,667 $400,000

Total $1,700,000 500,000 $1,200,000

c. Total revenue from sales of the camera packages is $79,800 ($399 x 200). The revenue is allocated among the three elements of the sale (camera, printer and warranty) as follows: Element Camera Printer Warranty Total

Retail Price $300 125 75 $500

Proportion of Total 60% ($300/$500) 25% ($125/$500) 15% ($75/$500) 100%

Using these proportions, the revenue is allocated among the three elements and recognized for each element as it is earned. In this case, the portion of the revenue allocated to the camera and printer are recognized immediately, while the revenue allocated to the warranty is deferred and recognized over the three-year warranty coverage period. Year 2020 2021 2022 2023 Total

Revenue $67,830 3,990 3,990 3,990 $79,800

($79,800 x 0.6) + ($79,800 x 0.25) ($79,800 x 0.15) / 3

©Cambridge Business Publishers, 2020 1-56

Financial Accounting, 6th Edition

M6-18. (15 minutes) LO 4 a. To bring the allowance to the desired balance of $2,100, the company will need to increase the allowance account by $1,600, resulting in bad debts expense of that same amount. b. The net amount of Accounts Receivable is calculated as follows: $98,000 − $2,100 = $95,900. c. - Allowance for Doubtful Accounts (XA) + 500 Balance 1,600 (a) 2,100 Balance

(a)

+ Bad Debts Expense (E) 1,600

Balance

1,600

M6-19. (15 minutes) LO 4 a. Credit losses are incurred in the process of generating sales revenue. Specific losses may not be known until many months after the sale. A company sets up an allowance for uncollectible accounts to place the expense of uncollectible accounts in the same accounting period as the sale and to report accounts receivable at its estimated realizable value at the end of the accounting period. b. The balance sheet presentation shows the gross amount of accounts receivable, the allowance amount, and the difference between the two, the estimated net realizable value. The balance sheet, thus, reports the net amount that we expect to collect. That is the amount that is the most relevant to financial statement users. c. The rule for expense recognition is that expenses are recognized when assets are diminished (or liabilities increased) as a result of earning revenue or supporting operations, even if there is no immediate decrease in cash. This dictates the use of the allowance method. Recognition of expense only upon the write-off of the account would delay the reporting of our knowledge that losses are likely and, thereby, reduce the informativeness of the income statement. Accountants believe that providing more timely information justifies the use of estimates that may not be as precise as we would like.

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M6-20. (20 minutes) LO 4, 5 a. ($ millions)

2018

2017

Accounts receivable (net) .............................................$421.4

$450.2

Allowance for returns and uncollectible 222.2 accounts ....................................................................

214.4

Gross accounts receivable ...........................................$643.6

$664.6

Percentage of uncollectible accounts to gross accounts receivable ................................................... 3.1% ($19.7/$643.6 )

1.7% ($11.6/$664.6)

b. In general, an increase in the allowance for uncollectible accounts as a percentage of gross accounts receivable may indicate that the quality of the accounts receivable has declined, perhaps because the economy has declined, the company is selling to a less creditworthy class of customers, or the company’s management of accounts receivable is less effective. Ralph Lauren’s three biggest wholesale customers accounted for 19% of sales in 2018 and 29% of receivables at the end of March 2018. The declining fortunes of traditional retailers may account for the increase in the allowance for uncollectibles. It may also indicate, however, that the receivables were under-reserved (e.g., allowance account was too low in 2017). This would result in lower reported profits in 2018 because past profits were too high. It is also possible that credit quality has not changed and that the amount recorded in prior years is correct, but that management has incentives to record less income in 2018. c. $6,182.3/[($421.4+$450.2)/2] = 14.19 times 365/14.19 = 25.73 days

M6-21. (10 minutes) LO 4 Bad debts expense of $2,400 ($120,000 × 0.02) would cause the allowance for uncollectibles to increase by the same amount. If the allowance increased by only $2,100 for the period, Sloan Company must have written off accounts totaling $300. In computing accounts receivable, sales revenue increased the account by $120,000, and the write-offs would decrease it by $300. If there was a net increase of $15,000 for the period, Sloan Company must have collected $104,700 in cash. ($104,700 = $120,000 $300 - $15,000.)

©Cambridge Business Publishers, 2020 1-58

Financial Accounting, 6th Edition

M6-22. (20 minutes) LO 5 a. Accounts Receivable Turnover

Average Collection Period

Procter & Gamble

$66,832/ [($4,686 +$4,594)/2]

365 / 14.4 = 25.3 days

ColgatePalmolive

$15,454 / [($1,480+$1,411)/2]

= 14.4 times 365 / 10.7 = 34.1 days

= 10.7 times

b. P&G turns its accounts receivable faster than Colgate-Palmolive. Receivable turns typically evolve to an equilibrium level for each industry that arises from the general business models used by industry competitors. Differences can arise due to variations in the product mix of competitors, the types of customers they sell to, their willingness to offer discounts for early payment, and their relative strength vis-à-vis the companies or individuals owing them money. Also, the size of the firm may affect the ability of a company to exert bargaining power over major suppliers or customers. For instance, both of these companies sell a significant amount of their product to Walmart. P&G is a sizable company, and may have greater bargaining power over Walmart than does the smaller ColgatePalmolive. One other possibility is that the difference is due to the companies’ differing fiscal year-ends. If the receivable balance is not constant during the year due to some seasonality, then the receivable turnover ratio will depend on the choice of fiscal year.

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M6-23. (20 minutes) LO 4 a. i.

ii.

Accounts receivable (+A) ……………………………………… Sales revenue (+R, +SE) …………………………..…… Bad debts expense (+E, -SE)

3,200,000 3,200,000 42,000

…………………………………

Allowance for uncollectible accounts (+XA, -A)……. iii.

iv.

v.

42,000

Allowance for uncollectible accounts (-XA, +A) ………. Accounts receivable (-A) …………………………………..

39,000

Accounts receivable (+A) ……………………………………… Allowance for uncollectible accounts (+XA, -A)

12,000

Cash (+A) …..……………………………………………………… Accounts receivable (-A) …………………………………

12,000

39,000

12,000

12,000

The recovered receivable is reinstated, so that its payment may be properly recorded.

b. Besides the $12,000 in recovery, the collections from customers can be summarized in the following entry: vi.

Cash (+A) Accounts receivable (-A)

2,926,000 2,926,000

(This amount includes payment of the recovered receivable for $12,000. The allowance increases by $15,000 over the period, so the fact that net receivables increased by $220,000 means that gross receivables must have increased by $235,000. That fact allows us to “back out” the cash received.)

©Cambridge Business Publishers, 2020 1-60

Financial Accounting, 6th Edition

c. +

(v) (vi)

(i) (iv)

(iii)

Cash (A) 12,000 2,926,000 2,938,000 + Accounts Receivable (A) 3,200,000 12,000 39,000 12,000 2,926,000 235,000 Allowance for Uncollectibles (XA) 42,000 39,000 12,000 15,000

-

+ (ii)

Sales Revenue (R) + 3,200,000

Bad Debts Expense (E) 42,000

(i)

-

(iii) (v) (vi) + (ii) (iv)

d. Balance Sheet Transaction

Cash Asset

i. Sales on account.

+

Noncash Assets

+3,200,000 Accounts Receivable

ii. Bad debts expense.

-

-39,000

-

Accounts Receivable

iv. Reinstate account previously written off.

vi. Collect cash on sales.

+42,000

= =

=

Allowance for Uncollectible Accounts

iii. Write-off of uncollectibl e accounts.

v. Collect reinstated account.

Contra Assets

+12,000

+2,926,000 Cash

-12,000

+

Contrib. Capital

+

Earned Capital +3,200,000 Retained Earnings -42,000

Revenues

- Expenses =

+3,200,000

-

-

Retained Earnings =

-

+12,000

= +3,200,000

+42,000

=

Bad Debts Expense -

=

-

=

-

=

-

=

Allowance for Uncollectible Accounts -

Accounts Receivable -2,926,000 -

=

Accounts Receivable

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

Net Income

Sales Revenue

Allowance for Uncollectible Accounts

Accounts Receivable +12,000 Cash

-39,000

Liabilities

Income Statement

1-61

-42,000

M6-24. (20 minutes) LO 2 a. Fiscal Year 2018 2019 2020 2021

Revenue $48,000 55,000 62,000 62,000

Revenue Growth 14.6% 12.7% 0.0%

b. Fiscal Year Revenue 2018 $48,000 2019 55,000 2020 62,000 2021 62,000

(end of year)

Customer Purchases = Revenue + Change in Unearned Revenue Liability

Growth in Customer Purchases

$20,000 24,000 26,000 25,000

55,000 + 4,000 = 59,000 62,000 + 2,000 = 64,000 62,000 - 1,000 = 61,000

8.5% -4.7%

Unearned Revenue Liability

c. In both fiscal year 2020 and 2021, the growth in customer purchases is lower than the growth in reported revenues. The practice of deferring revenue recognition implies that reported revenues in a given period are the result of customer purchases over many periods, resulting in a smoothing of revenues. In the case of Finn Publishing, revenues in any given year are the result of newsstand and bookstore purchases during that year, plus part of the subscriptions from that year, plus part of the subscriptions from the previous year. That means that growth in annual revenues is a composite of growth in customer purchases over an even longer period of time. For 2020 and 2021, Finn’s growth in revenues exceeds the growth in customer purchases because the revenues are still reflecting growth from prior periods. Purchases are a “leading indicator” of revenues, and thus, calculating customer purchase behavior can be useful in forecasting future revenue and identifying changes in customers’ attitudes about a company’s current offerings.

©Cambridge Business Publishers, 2020 1-62

Financial Accounting, 6th Edition

M6-25. (15 minutes) LO 2 This question is based on an actual situation, in which the accounting rules were influencing the product decisions. The rules for revenue deferral when there are multiple deliverables (i.e., multiple performance obligations) deterred the company from providing enhancements and upgrades that were available. If Commtech’s customers (the wireless companies) had been willing to pay for the upgrades to their customers’ phones, that would have been allowed. (It’s not clear what the wireless companies’ incentives would be, because they may want to encourage users to purchase new phones – with a new service contract – rather than improving their existing phones.) The question can generate a discussion about whether accounting should drive decisions. Whether it should or not, it does, so the question should evolve into what top management should do about this type of situation. Does the situation described in the problem require some managerial action, or not. Is the company foregoing sales because of its accounting? Within Commtech, the finance staff was skeptical of marketing’s predictions that the upgrades and enhancements would increase the sales of existing phone models. If the upgrades and enhancements are delivered, Commtech will have to change its accounting for revenue, with a resulting decrease in near-term profitability. How might the company communicate that change in a way that the investing public will understand as a net benefit to the company?

M6-26 (20 minutes) LO 6 a. Verdi Co. would report stable sales because extending sales to lower credit quality customers broadens the customer pool and thus Verdi Co. can sell the same number of computers year over year. b. Verdi Co. should have disclosed that is was selling to higher credit risk customers. At a minimum, Verdi Co. should have estimated a larger expected bad debts expense related to these customers. (If the credit quality was so poor, Verdi Co. may even consider not reporting the revenue on the grounds that the agreement with the customer lacked commercial substance). c. In future periods when it is revealed that customers cannot pay for the computers, Verdi Co. will have to write off the related accounts receivable. If these bad debts were not reserved for early via the bad debts expense and allowance for doubtful accounts, then Verdi Co. will have to record bad debts expense when the debt goes bad. This will result in an expense in a year different than the reported revenue and will supress future earnings, potentially significantly.

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EXERCISES E6-27. (20 minutes) LO 1, 2, 3 Company

Revenue Recognition

a. L Brands

When merchandise is given to the customer and returns can be estimated (or the right of return period has expired).

b. Boeing Corporation

Revenue is recognized under long-term government contracts under the cost-to-cost (percentage-of-completion) method.

c. SUPERVALU

When merchandise is given to the customer and cash is received.

d. Real estate developer

When title to a house is transferred to the buyers.

e. Wells Fargo

Interest is earned by the passage of time. Each period, Wells Fargo accrues income on each of its loans and establishes an account receivable on its balance sheet.

f. Harley-Davidson When title to the motorcycles is transferred to the buyer. Harley will also set up a reserve for anticipated warranty costs and recognize the expected warranty cost expense when it recognizes the sales revenue. g. Gannett Co.

When the publications are sent to subscribers.

©Cambridge Business Publishers, 2020 1-64

Financial Accounting, 6th Edition

E6-28. (15 minutes) LO 1, 2, 3 April 6

May 31

June 15

July 15

July 31

DR Cash (+A) CR Contract liability (+L)

$40,000

DR Contract liability (-L) DR Accounts receivable (+A) DR Contract asset (+A) CR Revenue (+R, +SE)

$40,000 $50,000 $30,000

DR Cash (+A) CR Accounts receivable (-A)

$50,000

$40,000

$120,000

$50,000

DR Accounts receivable (+A) CR Contract asset (-A) CR Revenue (+R, +SE)

$110,000

DR Cash (+A) CR Accounts receivable (-A)

$110,000

$30,000 $80,000

$110,000

On May 31, Haskins is entitled to payment of $50,000, but it has earned revenue of $120,000. That is, it expects to receive consideration of $120,000 for the 120 units that it has delivered to Skaife. The contract asset represents consideration that Haskins has earned, but which is contingent on future events (i.e., delivery of the remaining 80 units).

E6-29. (20 minutes) LO 3 ($ millions)

a. Performance obligation fulfilled over time

b. Performance obligation

with cost-to-cost method Revenue recognized (percentage of costs incurred  total contract amount)

fulfilled at a point in time.

Year

Costs incurred

Percent of total expected costs

Income (revenue – costs incurred)

2019

$100

25%

$125

$ 25

2020

300

75%

375

75

500

100

$400

100%

$500

$100

$500

$100

Revenue recognized $

0

Income $

c. Any ratios involving revenues (Profit margin or Accounts receivable turnover would be affected. Ratios based on any measure of profit would show more variation in the method in part (b), The cumulative effect on net income would cause retained earnings to be higher (or at least never lower) under the method in part (a), affecting the debt-to-equity ratio and the return on shareholders’ equity. ©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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0

©Cambridge Business Publishers, 2020 1-66

Financial Accounting, 6th Edition

E6-30. (30 minutes) LO 3 a. Design/Engineering

Year Cost incurred % Completed Revenue Margin 1 7.00 70.0% 10.50 3.50 2 2.00 20.0% 3.00 1.00 3 1.00 10.0% 1.50 0.50 10.00 100.0% 15.00 5.00

Margin % 33.3% 33.3% 33.3%

Construction

Year Cost incurred % Completed Revenue Margin 1 0.00 0.0% 0.00 0.00 2 15.00 60.0% 18.00 3.00 3 10.00 40.0% 12.00 2.00 25.00 100.0% 30.00 5.00

Margin % NA 16.7% 16.7%

Sum

Year 1 2 3

b. Combined

Year 1 2 3 Total

7.00 17.00 11.00 35.00

7.00 17.00 11.00 35.00

20.0% 48.6% 31.4% 100.0%

10.50 21.00 13.50 45.00

3.50 4.00 2.50 10.00

33.3% 19.0% 18.5%

9.00 21.87 14.13 45.00

2.00 4.87 3.13 10.00

22.2% 22.3% 22.2%

c. Treating the two activities as distinct performance obligations causes the design/engineering activities to report a margin of 33.3%, while the construction activities have a margin of 16.7%. When the design/engineering activities are greater than the construction activities, the margin will be higher. When the activities are viewed as a single performance obligation, the margins are “homogenized” into a combined rate of 22.2%. Treating the two activities as separate performance obligations results in more variation in the margin reported. In addition, it would lower the debt-to-equity ratio. Earlier recognition of revenue and profit would cause shareholders’ equity to be higher earlier in the contract, with no impact on the liabilities, resulting in lower debtto-equity.

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E6-31. (15 minutes) LO 2 a. Multiple element arrangements are sales transactions in which two or more performance obligations (deliverables) are “bundled” together and sold for one price. The revenue should be recognized on each performance obligation as it is fulfilled. This involves first assigning a portion of the sales revenue to each performance obligation and then recognizing each portion of the revenue only when that obligation has been fulfilled. i.e., delivered to the customer. b. The total revenue for the “bundle” is $200. However the Fire, if sold alone sells for $110 and the Amazon Prime membership sells for $120, which brings the total “value” to $230. Thus, the Fire tablet represents 47.83% of the total value of the bundle ($110/$230). Amazon should recognize $95.65 at the time of the sale (47.83% of the $200 sale price) and defer the remaining $104.35. Over the remainder of the quarter, Amazon would recognize one-fourth of this amount as revenue from the Amazon Prime membership. c. Cash Asset

Transaction To record bundled sale transaction on July 1

+200

Balance Sheet Noncash Contrib. + = Liabilities + + Assets Capital +

To recognize Prime revenue at end of quarter

=

+104.35 Unearned revenue

+95.62

Retained earnings

Sales revenue

-$26.09

+$26.09

+$26.09

Unearned revenue

Retained earnings

Sales revenue

Unearned revenue (-L) Sales revenue (+R, +SE)

+

Revenues - Expenses =

+95.65

Cash (+A) Sales revenue (+R, +SE) Unearned revenue (+L)

+

Income Statement Earned Capital

-

Net Income

=

+95.65

+$26.09

200.00 95.65 104.35 26.09 26.09

©Cambridge Business Publishers, 2020 1-68

Financial Accounting, 6th Edition

E6-32. (15 minutes) LO 5 a. 2016: €4,363 – [€0 – €432 x (1- 0.30)] = $4,665.40 2017: €5,616 – [€0 – €179 x (1- 0.30)] = $5,741.30 b. 2016: €4,665.40/€37,600 = .1241 or 12.41% 2017: €5,741.30/€42,636 = .1347 or 13.47% c. €5,741.30/ [(€67,246 - €26,714 + €58,504 - €24,340) / 2] = .1537 or 15.37%

E6-33. (15 minutes) LO 1, 6 a. There is not yet a contract with the customer that meets the company’s normal business practice,” so revenue would not be recognized. b. The performance obligation – to deliver customized units to the customer – has not yet been fulfilled. The product has been shipped, but not to the customer and not with the specified customizations that are required by the customer. c. The company could recognize revenue using the expected amount of “consideration” that it will receive from the customer. (Prior to ASC 606, the revenue could not be recognized because the price is not yet fixed or determinable.) d. The distributor does not have the means to pay for the items delivered, so collectability cannot be reasonably assured (until the distributor sells the product to an end customer). Again, there would be a question as to whether a contract exists with the distributor.

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E6-34. (20 minutes) LO 4 a. Prior to the aging of accounts, the balance in the Allowance for Uncollectible Accounts would be a credit of $520 (the opening balance of $4,350 less the amounts written off of $3,830). 2019 bad debts expense computation $250,000  0.5% $ 90,000  1% 20,000  2% 11,000  5% 6,000  10% 4,000  25%

Less: Unused balance before adjustment Bad debts expense for 2019

= = = = = =

$1,250 900 400 550 600 1,000 4,700 520 $4,180

b. Accounts receivable, net = $381,000 - $4,700 = $376,300 Reported in the balance sheet as follows: Accounts receivable, net of $4,700 in allowances ...................................

$376,300

c. + (a)

Bad Debts Expense (E) 4,180

-

- Allowance for Uncollectible Accounts (XA) + 4,350 Balance Write-offs 3,830 4,180 (a) 4,700

Balance

d. If the write-offs had been $1000 higher, so too would be the bad debt expense. And, if the write-offs had been $1000 lower, the bad debt expense would have been $1000 lower. The aging of accounts determines the end-of-period balance sheet value, which is combined with the beginning-of-period value and the write-offs during the period to determine the bad debt expense. Any difference between the bad debt expectations and the actual bad debt experience is corrected in this process.

©Cambridge Business Publishers, 2020 1-70

Financial Accounting, 6th Edition

E6-35. (25 minutes) LO 4, 5 a. Allowance for doubtful accounts (-XA) Accounts receivable (-A)

2.6 2.6

Provision for doubtful accounts (+E,-SE) Allowance for doubtful accounts (+XA)

2.5 2.5

The provision for doubtful accounts (bad debts expense) has the effect of decreasing Steelcase’s reported income by $2.5 million for the year. The write-off of $2.6 million of uncollectible accounts has no direct effect on income. b. Accounts receivable, net Allowance for doubtful accounts

2018 300.3 11.1

2017 307.6 11.2

Gross receivables (net plus allowance)

$311.4

$318.8

Allowance as a % of gross receivables

3.56%

3.51%

c. $3,055.5 / [($300.3 + $307.6) / 2] = 10.1 times. d. $3,055.5 + ($28.2 - $15.9) – ($300.3 - $307.6) – $2.5 = $3,072.6.

E6-36. (15 minutes) LO 4 Accounts receivable Less Allowance for uncollectible accounts

$138,100 10,384

$127,716

Computations Accounts Receivable Beginning balance Sales Collections Write-offs ($3,600 + $2,400 +$900) Provision for uncollectibles ($1,173,000  0.8%)

$

122,000 1,173,000 (1,150,000) (6,900) _________ $ 138,100

Allowance for Uncollectible Accounts $ 7,900

(6,900) 9,384 $ 10,384

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E6-37. (20 minutes) LO 4 a. Aging schedule at December 31, 2016 Current $304,000  1% = $ 3,040 0–60 days past due 44,000  5% = 2,200 61–180 days past due 18,000  15% = 2,700 Over 180 days past due 9,000  40% = 3,600 Amount required 11,540 Balance of allowance 4,200 Provision $ 7,340 = 2019 bad debts expense b. Current Assets Accounts receivable Less: Allowance for uncollectible accounts

$375,000 11,540 $363,460

c. + (a)

Bad Debts Expense (E) 7,340

-

- Allowance for Uncollectible Accounts (XA) + 4,200 Balance 7,340 (a) 11,540

Balance

E6-38. (30 minutes) LO 4 a. Year 2018 2019 2020 Total

Sales $ 751,000 876,000 972,000 $2,599,000

Collections $ 733,000 864,000 938,000 $2,535,000

Accounts Written Off $ 5,300 5,800 6,500 $17,600

Accounts Receivable at the end of 2020 is $46,400, computed as: ($2,599,000 - $2,535,000 - $17,600). Bad Debts Expense is: 2018 2019 2020 208-2020

$ 7,510 8,760 9,720 $25,990

computed as 1%  $751,000 computed as 1%  $876,000 computed as 1%  $972,000 computed as 1%  $2,599,000

Allowance for Uncollectible Accounts is $8,390 computed as: $25,990 total bad debts expense less $17,600 in total write-offs. ©Cambridge Business Publishers, 2020 1-72

Financial Accounting, 6th Edition

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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b. Beg Bal Sales 2018 Bal Sales 2019 Bal Sales 2020 Bal

Accounts Receivable (A) 0 751,000 5,300 Write offs 733,000 Collections 12,700 876,000 5,800 Write offs 864,000 Collections 18,900 972,000 6,500 Write offs 938,000 Collections 46,400

Allowance for Uncollectibles (XA) 0 Beg Bal Write offs 5,300 7,510 Bad debts exp.

Write offs

5,800

2,210 8,760

2018 Bal Bad debts exp.

Write offs

6,500

5,170 9,720

2019 Bal Bad debts exp.

8,390

2020 Bal

There isn’t any indication that the 1% rate is incorrect. If the rate is too high, we would expect the allowance to grow at a faster rate than receivables. If the rate is too low, the opposite would occur. In this case, the allowance percentage of receivables is 17%, 27% and 18% at the end of 2018, 2019 and 2020, respectively. So, there is no clear direction that would indicate an inappropriate estimate.

E6-39. (20 minutes) LO 5, 7 a.

Personal Systems Printing

Earnings from Operations $1,213 3,161

Corporate Investments

(87)

End. Assets $12,156 10,548

3

Beg. Avg. Assets Assets $ 10,686 $11,421.0 9,959 10,253.5

1

2

Return on Capital Employed 10.6% 30.8%

(4,350.0)%

b. The most profitable group is Printing, which represents HP’s traditional strength. However, it is not growing (based on a small sales percentage increase in 2017). The Personal Systems (commercial and personal PCs, workstations, calculators, etc.) also has a good return on capital employed. Corporate Investments is described by the company as including HP Labs and cloud-related business incubation projects. The negative return makes sense as this sounds like new businesses and R&D within HP. c. The activities in Corporate Investments are reducing profits in the present, but they are vital to the long-run competitive health of the company. An operating manager might have a short-term horizon and be tempted to reduce the resources devoted to these activities. Keeping it separate allows top management (which should have the longestrun horizon) to keep a close eye on it. ©Cambridge Business Publishers, 2020 1-74

Financial Accounting, 6th Edition

E6-40. (20 minutes) LO 1, 2 a. Just like for-profit organizations, not-for-profit organizations cannot recognize revenue until it has been earned. In the case of The Metropolitan Opera, it cannot recognize the ticket revenue until the performances occur. (The Metropolitan Opera does not issue quarterly reports, so we cannot observe how much of the revenue has been earned part way through its fiscal year.) b. This entry is simplified by the fact the fiscal year-end is after the end of the current season and by assuming that all of The Metropolitan Opera’s deferred revenue relates to the following season (and none to any years after the following season). To record revenue for the fiscal year 2017 season: Deferred revenue (-L) Cash or Accounts receivable (+A) Revenues (+R, +NA)

46,609 41,905 88,514

(As a not-for-profit, The Metropolitan Opera does not have shareholders’ equity, but rather “net assets.” Therefore, the recognition of revenue increases net assets (NA) on the balance sheet.) To record advance purchases for the fiscal year 2018 season: Cash or Accounts receivable (+A) 42,649 Deferred revenue (+L) 42,649 c. The Metropolitan Opera usually operates close to seating capacity. And, in a typical year, more than one-half of its seats are sold before the season. The quantity of unsold seats will affect The Metropolitan Opera’s marketing efforts for subscribers who have not yet renewed, outreach to new potential subscribers and promotions for individual tickets which go on sale shortly before the season. Those efforts can be scaled up or down depending on the experience with advance sales.

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E6-41. (20 minutes) LO 2 a. Membership fees are initially recorded as a liability (deferred revenue) and recognized on a straight-line basis over the membership term (12 months). BJ’s obligation is to provide access to its clubs, its website, and its gas stations over the membership period, so the value transferred to the member is provided on a straight-line basis. b. Cash (+A) Deferred membership fees (+L)

142.1

Deferred membership fees (-L) Membership fee revenue (+R, +SE)

138.4

142.1

138.4

The latter entry can be inferred from the information on membership fee revenue in the income statement. The former entry can be inferred by noting that the Deferred membership fee liability increased by $3.7 million over the period. Therefore, the sales of memberships exceeded the revenue from memberships by $3.7 million. c. When a customer spends $100 in the rewards program, they are entitled to $2 in cash back. This reduces the value of the consideration that BJ’s receives from the customer’s purchase from $100 to $98. The $2 would be provided to the member in electronic awards in $20 increments. So, the entry would be the following: Cash

100 Revenue Payable to member

98 2

Once the member reaches the $20 mark, the payable would be debited and cash would be credited.

©Cambridge Business Publishers, 2020 1-76

Financial Accounting, 6th Edition

PROBLEMS P6-42.A (20 minutes) LO 5, 7 a. The following items might be considered to be operating: 1. Net Sales, cost of sales, R&D expenses, and SG&A expenses are typically designated as operating. 2. Amortization of intangible assets, integration and separation costs, and restructuring charges would usually be considered to be operating under the assumptions that the acquisition that gave rise to the intangible assets is included as part of operations, and that the restructuring did not involve discontinuation of distinct parts of the business. 3. The asbestos-related charge, restructuring charges and goodwill impairment losses would be considered to be operating since they are related to DowDuPont’s operating activities. (These items are both operating and nonrecurring – see b.) 4. Equity in earnings of nonconsolidated affiliates would be considered operating under the assumption that the affiliates are related to DowDuPont’s core operations, which is typically the case. 5. Sundry income would generally be considered nonoperating in the absence of a footnote clearly indicating its connection to the operating activities of the company. 6. Interest expense and amortization of debt discount is nonoperating. b. The following items might be identified as nonrecurring items: 1. Asbestos-related charges – this is an accrual of an expense due to increased asbestos-related liability related to Union Carbide Corporation, a wholly-owned subsidiary of the company. More specifically, it is primarily due to higher mesothelioma claim activity relative to forecasts of such activity. GAAP requires such an accrual if the loss is probable and can be reasonably estimated. Since it is a one-time occurrence, it can be considered to be a transitory item. 2. Goodwill and other asset impairment losses – this loss results from changes in expectations of the performance of past acquisitions. It would be considered operating, but transitory. 3. Restructuring charges (credits) – The $3,280 million resturcturing charge for 2017 reflects the actions following the Dow/DuPont merger, a goodwill impairment charge of $1,491 million and $939 million impairment relating to a facility in Brazil. Restructuring costs are considered “special items,” meaning that individually they are transitory, but as a category, they happen frequently.

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c. 2017 NOPAT: $1,592 – [($966 - $1,082) x (1-0.25)] = $1,679.00 NOPM: $1,679.00 / $62,484 = 2.69% 2016 NOPAT: $4,404 – [($1,452 - $858) x (1-0.25)] = $3,958.50 NOPM: $3,958.50 / $48,158 = 8.22%

P6-43. (20 minutes) LO 3 a. 1. Performance obligation fulfilled based on number of employees trained Year Number of employees trained Revenues (# trained x $1,200) Expenses (# trained x $437.50)* Gross Profit

2019 125 $150,000.00 54,687.50 $95,312.50

2020 200 $240,000.00 87,500.00 $152,500.00

2021 75 $90,000.00 32,812.50 $57,187.50

Total 400 $480,000.00 175,000.00 $305,000.00

2021 $30,000.00 17.14% $82,285.71 30,000.00 $52,285.71

Total $175,000.00 100.00%* $480,000.00* 175,000.00 $305,000.00

* $437.50 = $175,000 / 400

2. Performance obligation fulfilled based on costs incurred Year Cost incurred Percentage completed Revenues (% x $480,000) Expenses Gross profit

2019 $65,000.00 37.14% $178,285.71 65,000.00 $113,285.71

2020 $80,000.00 45.71% $219,428.57 80,000.00 $139,428.57

* Answers may vary due to rounding of percentage completed.

b. The question depends on what measure best reflects the value delivered to the customer as the contract progresses. Using the number of employees trained would reflect Elliot Company’s value from a more effective salesforce. The cost of developing the materials is spread across the 400 employees as they are trained. But the cost incurred to develop the materials also creates value for the customer. The accounting standard says “An output method would not provide a faithful depiction of the entity’s performance if the output selected would fail to measure some of the goods or services for which control has transferred to the customer. For example, output methods based on units produced or units delivered would not faithfully depict an entity’s performance in satisfying a performance obligation if, at the end of the reporting period, the entity’s performance has produced work in process or finished goods controlled by the customer that are not included in the measurement of the output.” (ASC 606-10-55-17)

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Financial Accounting, 6th Edition

P6-44. (15 minutes) LO 6 a. Management would have an incentive to shift $1 million of income from the current period into next. This might be accomplished by delaying revenue recognition or accelerating expenses. This would increase their bonus by $100,000 next year without decreasing the current bonus. b. Management would have an incentive to shift $3 million of income from next year into income reported this year. This would increase the current year bonus by $300,000 without reducing next year’s bonus. c. Management would have an incentive to shift income from the current year into next year. Even though this would reduce earnings this year, earnings are already so low that management does not expect to receive a bonus. Shifting earnings into a future period increases the bonus in that period. d. These incentives for earnings management would be mitigated if the “kinks” in the bonus formula were removed. Alternatively, some companies pay bonuses based on a three-year moving average of earnings to minimize the impact of earnings management. This problem can provide an opportunity to discuss the “slippery slope” of earnings management. For example, management’s optimism about next year in part b may not turn out to be warranted. Suppose next year’s “natural” earnings turns out to be $20 million instead of $24 million. Management’s action in the first year will have reduced next year’s $20 million to $17 million, and earnings management would again be required to meet the target. And, if meeting the target in one year causes the next year’s target to increase, things can get out of control very quickly.

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P6-45. (40 minutes) LO 4, 5 ($ millions)

a. Net receivables as of January 31, 2017 were $1,128,610 thousand. b. ($ thousands) Bad debts expense (+E, -SE) Allowance for doubtful accounts (+XA) Allowance for doubtful accounts (-XA) Accounts receivable (-A) +

Bad Debts Expense (E) 17,568

17,568 17,568 13,566 13,566

-

- Allowance for Doubtful Accounts (XA) + 21,376 Balance 13,566 17,568 25,378

Balance

Balance

+ Accounts Receivable (A) 1,136,593 13,566

The $350 thousand recovery of a written-off account would be accounted for in the following way: Accounts receivable (+A) Allowance for doubtful accounts (+XA)

350

Cash (+A) Accounts receivable (-A)

350

350

350

The first entry reestablishes the customer’s account, and the second entry recognizes the cash payment that discharges that account. c. Allowance for doubtful accounts to gross accounts receivables are: 2.2% ($25,378/$1,153,988) in fiscal 2017 1.9% ($21,376/$1,136,593) in fiscal 2016

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d. The 2017 receivables turnover rate is $4,881,951 / [($1,128,610 + $1,115,217)/2] = 4.35. In 2016, the ART was $5,456,650/[($1,115,217 + $1,145,099)/2] = 4.83. The Average Collection Period (ACP) is 365/4.35 = 83.9 days in 2017 and 365/4.83 = 75.6 days in 2016. e. The increase in the allowance as a percentage of receivables and the slowdown in collections both indicate that Mattel is having a little more trouble in collecting from its customers. It’s possible that this change is due to the retail sector’s financial difficulties (e.g., the bankruptcy of Toys R Us). Or, Mattel’s decline in sales may mean that its products are less important to its distribution channel, and therefore less of a priority for payment. More generally, it’s also possible that the changes reflect a general decline in economic conditions or a relaxing of Mattel’s credit policies, including collection practices.

P6-46. (25 minutes) LO 4 a. The gross margin for the first quarter is 37.7% = $1,427/$3,783. The items sold in the first quarter, but expected to be returned in the second quarter, had a gross margin of 59.1% = $93 - $38)/$93. The Gap expects that the returns will be those items that have a higher-than-average margin. b. Sale and expected returns: (1) Record revenue. Cash (+A) Revenue (+R,+SE) (2) Record COGS. Cost of goods sold (+E,-SE) Inventory (-A) (3) Recognize Revenue contra, returns (+XR, -SE) expected returns. Sales returns allowance liability (+L) Right-of-return asset (+A) Cost of goods sold (-E, +SE)

5,000 5,000 3,000 3,000 500 500

300 300

continued next page

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b. continued Returns: (4) Process return transactions.

Inventory (+A)

300

Right-of-return asset (-A) Sales return allowance liability (-L) Cash (-A)

300 500 500

At the conclusion of this transaction, the customers have their cash, the inventory costs have been adjusted to include the returned items, and the sales returns allowance liability has a balance of zero because the actual returns coincided with the expected returns

P6-47. (25 minutes) LO 2 a. The deferred net revenue liability goes up when customers purchase game software from TTWO, and it goes down when TTWO recognized revenue for the post-sale service. So, TTWO must have recognized more in revenue than it sold during the quarter. This phenomenon could be due to a seasonality effect. For example, TTWO’s revenues are greatest in the last calendar quarter. b. Purchases equal revenues plus the change in the deferred net revenue liability. Therefore, the first quarter purchases were $387,982 thousand + ($466,429 thousand - $566,141 = $288,270 thousand. Purchases were less than revenue recognized in the income statement. Changes in the deferred net revenue liability provide a leading indicator of the company’s revenues. One must be careful, though, to account for seasonality in purchases.

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CASES and PROJECTS C6-48. (40 minutes) LO 1, 2, 6 a. Cash or Accounts receivable (+A) Sales revenue (+R, +SE)

80

Cost of sales (+E, -SE) Inventory (-A)

40

Cash or Accounts receivable (+A) Sales revenue (+R, +SE) Payable to restaurant merchant (+L)

80

80

40

b. 40 40

The revenue recognized differs between parts a and b because in part a, Groupon is acting as a principal in the transaction. In part b, Groupon is acting as an agent for the restaurant, and its revenue is limited to its commission. c. In this case, Groupon must account for “variable consideration.” There is a 90% chance that Groupon will earn $40 in revenue and a 10% chance that it will earn $80 in revenue. Therefore, its expected revenue is $44 = 0.9*40 + 0.1*80. The payable to the merchant is $36 = 0.9*40 + 0.1*0. Cash or Accounts receivable (+A) Sales revenue (+R, +SE) Payable to restaurant merchant (+L)

80 44 36

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C6-49. (30 minutes) LO 1, 2, 6 a. When Dell sells other companies’ software products, it is often as part of a multipleelement sales agreement. For example, the customer may purchase hardware, software, and customer support for one price. This is an example of a bundled sale. Dell must allocate the sales price based on the relative fair market value of each element. Revenue is recognized for each specific element when it is clear that the element has been delivered and the revenue is earned. There are at least two possibilities for earnings management here. First, Dell could misallocate the sales price. By allocating more of the price to hardware and less to software, Dell may be able to manage when earnings are reported. Second, Dell may be aggressive in applying the “earned and realizable” criteria to each element, thereby prematurely recognizing revenue. From the information provided, it appears that Dell was recognizing revenue on software “resales” at the time of sale. However, most software is not truly sold. Instead, the customer purchases a license to use the software. As a result, Dell should have deferred part of the revenue and recognized it ratably over the license period. b. Extended warranties are typically sold separately from other products. Therefore, the revenue should be deferred and recognized ratably over the warranty contract period. Dell employees were apparently recording revenue at the time of sale, or were recognizing the revenue over a shorter time period than the contract period. As a result, revenues and income were overstated. c. It is common for managers to have performance targets based on revenues and earnings. This provides an incentive for these employees to take actions to accelerate revenue recognition when it appears that targets may not be met. On the other hand, in periods when revenues and earnings exceed the targets, managers may delay revenue recognition until a future period. In this way, they can “store up” revenues and earnings to meet future targets. The key to preventing this type of abuse is the periodic audit of divisional revenues and earnings. In addition, businesses spend a large amount of resources trying to design incentive compensation plans that do not encourage this type of abuse. Note: Dell Inc. was publicly traded under the ticker symbol DELL until it was taken private in October of 2013 by Michael Dell, the company’s founder, and Silver Lake Partners.

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C6-50. (45 minutes) LO 2, 4, 5 a. 2017: i. Bad debts expense (+E, -SE) Allowance for doubtful accounts (+XA, -A) ii.

2,913 2,913

Allowance for doubtful accounts (-XA, +A) Accounts receivable (-A)

2,981 2,981

2018: iii. Bad debts expense (+E, -SE) Allowance for doubtful accounts (+XA, -A)

5,439

iv.

2,518

5,439

Allowance for doubtful accounts (-XA, +A) Accounts receivable (-A)

2,518

- Allowance for Doubtful Accounts (XA) ($000) + Balance 7,254 2016 Balance 2,913 (i) (ii) 2,981 Balance 7,186 2017 Balance 5,439 (iii) (iv) 2,518 10,107 2018 Balance

b. 2017: $7,186 / ($188,679 + $7,186 + $24,300) = 3.3% 2018: $10,107 / ($212,377 + $10,107 + $18,628) = 4.2% The increase in allowance relative to receivables could be due to the difficult environment that many retail companies (Wiley’s customers) are experiencing. c. If sales returns are material in amount and can be estimated with a reasonable degree of accuracy, they should be estimated just as bad debts are estimated. Sales revenue is debited for the estimated returns in the amount of the revenue while an allowance for returns is credited an equal amount. In addition, the Cost of goods sold is credited for the cost of the expected returns, and a right-of-return asset is debited. One important difference is that with sales returns (unlike bad debts) the customer returns the product to the company and it is often returned to inventory. Hence, the amount of allowance for returns is a net amount equal to the estimated gross profit on expected returns. d. Accounts receivable turnover: $1,796,103 / [($212,377 + $188,679)/2] = 8.96 times. Average collection period: 365 / 8.96 = 40.74 days.

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C6-51 (20 minutes) LO 7 a. Restructuring charges are reported as part of operating income though 3M has allocated the restructuring costs to various operating categories in the income statement rather than reporting a single line item for restructuring. A liability is recorded on the balance sheet for the restructuring costs (e.g., severance) that have not been paid. Reporting the gain on sale of businesses as part of operating income implies that these were peripheral transactions and did not qualify as discontinued operations. b. A financial analyst generally should treat these costs as nonrecurring in nature. Thus, when forecasting future earnings the analyst would generally not expect another restructuring. c. Management may have incentives to overstate restructuring charges in some cases. If the charges are overstated, the manager will expense more as restructuring costs (and record a larger liability) than they really expect. If the company does not actually have cash outlays in future periods equivalent to the accrued liability related to the restructuring charge, the liability that was recorded will need to be reversed. In the period in which that occurs, recorded income will be higher than it otherwise would be, perhaps helping managers meet an earnings target. On the other hand, management may have incentives to understate restructuring charges in some cases. If they do not want the current period earnings to be too low (relative to some target, or if the managers are nearing the end of their working horizon) then they may record too low a cost for restructuring. However, this will make it harder to reach future targets because if the actual cash outlays turn out to be higher than the costs they accrue, additional expenses will need to be recorded in future years.

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Chapter 7 Reporting and Analyzing Inventory Learning Objectives – coverage by question MiniExercises

Exercises

Problems

Cases and Projects

33, 34, 36

37, 38

LO1 – Interpret disclosures of information concerning operating expenses, including manufacturing and retail inventory costs.

13 - 15, 17

LO2 – Account for inventory and cost of goods sold using different costing methods.

18 - 21, 23

26, 27, 29 - 31

LO3 – Apply the lower of cost or net realizable value rule to value inventory.

24

28

LO4 – Evaluate how inventory costing affects management decisions and outsiders’ interpretations of financial statements.

18

26, 29 - 31

33, 34, 36

37, 38

16, 22

25, 31, 32

33 - 35

37

26, 29, 30

36

37

LO5 – Define and interpret gross profit margin and inventory turnover ratios. Use inventory footnote information to make appropriate adjustments to ratios. LO6 – Appendix 7A: Analyze LIFO liquidations and the impact they have on the financial statements.

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QUESTIONS Q7-1.

When company A purchases inventory from company B, the buyer and seller must agree on which firm is responsible for the transportation costs. The terminology “freight on board shipping point” or FOB is used to indicate the buyer assumes responsibility for the transportation cost once notice of delivery to the shipper is received. In addition, the buyer assumes responsibility for any delay or damage during transit. When goods are shipped FOB, the seller normally can recognize revenue unless the seller has not fulfilled all requirements of the purchase agreement. An example is when an equipment installation and/or up-and-running properly is part of that agreement.

Q7-2.

If stable purchase prices prevail, the dollar amount of inventories (beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding (inflationary) profit in inventory.

Q7-3.

FIFO holding gains occur when the costs of earlier inventory acquisitions are matched against current selling prices. Holding gains on inventories increase with an increase in the inflation rate and a decrease in the inventory turnover rate. Conversely, if the inflation rate is low or inventories turn quickly, there will be less holding (inflationary) profit in inventory.

Q7-4.

(a) Last-in, first-out, (b) Last-in, first-out, (c) First-in, first-out, (d) First-in, first-out, (e) Last-in, first-out.

Q7-5.

A significant tax benefit results from using LIFO when costs are consistently rising. LIFO results in lower pretax income and, therefore, lower taxes payable, than other inventory costing methods.

Q7-6.

Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule. When the replacement cost for inventory falls below its (FIFO or LIFO) historical cost, the inventory must be written down to the lower replacement costs (market value).

Q7-7.

The various inventory costing methods would produce the same results (inventory values and cost of goods sold) if prices were stable. The inventory costing methods produce differing results when prices are changing.

Q7-8.

Inventory “shrink” refers to the loss of inventory due to theft, spoilage, damage, etc. Shrink costs are part of cost of goods sold but do not represent goods that were actually sold.

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Financial Accounting, 6th Edition

Q7-9.

The “LIFO reserve” is the difference between the cost of inventory determined using the last-in, first-out (LIFO) method and the cost determined using another method (either FIFO or average cost). Companies that report inventory cost using the LIFO method must also report the LIFO reserve. This allows the financial statement reader to convert from LIFO to another method for comparison purposes. The LIFO reserve represents the difference between the historical, LIFO cost of inventory and its current cost. This disparity between the book value and the current value represents a gain from holding the inventory that has not yet been recognized in income or in equity ̶ an unrealized holding gain.

Q7-10. Because LIFO assigns the last units purchased during the year to cost of goods sold (COGS), changing prices can make it difficult to forecast earnings. Companies have discretion as to when and how much inventory they purchase during an accounting period. LIFO is always applied on a periodic, annual basis, so a purchase made during the final days of the year will end up in COGS and affect current earnings. However, if that purchase is delayed until the first week of the next year, it could be several years before those units are transferred to COGS. Unlike other inventory methods, LIFO requires that the quantity and price of inventory purchases be predicted to make accurate earnings forecasts. Q7-11A. LIFO liquidation is involuntary when it is caused by events that are beyond management’s control. Examples of such events include labor strikes, natural disasters, or wars which could interrupt the delivery of inventory by suppliers or shut down production facilities. Q7-12A. In periods of rising prices, LIFO liquidation results in older, lower-cost goods being expensed as cost of goods sold, yielding higher profits. This may be the result of a management decision to reduce inventory levels for efficiency purposes. However, it may also be an earnings management tactic. Management may be trying to avoid violating bond covenants, or it may be trying to manipulate management compensation. In any case, this practice is costly, in that the additional profits lead to higher income taxes.

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MINI EXERCISES M7-13. (15 minutes) LO 1 The cost to be assigned to the inventory is $535 ($500 + $30 + $5). + (a) (b) (d) -

Inventory (A) 500 30 5

-

Notes Payable (L) 500

-

+ (a)

(c)

Accounts Payable (L) 30 10 5

+

+ Interest Expense, Discounts Lost (E) 10

(b) (c) (d) -

M7-14. (15 minutes) LO 1 The only cost that should be included in inventory is the cost of merchandise to be sold.

M7-15. (20 minutes) LO 1 RAW MATERIALS INVENTORY Beginning inventory Purchases Materials used Ending inventory WORK IN PROCESS INVENTORY Beginning inventory Materials used Labor costs Overhead costs Cost of goods produced Ending inventory FINISHED GOODS INVENTORY Beginning inventory Cost of goods produced Cost of goods sold Ending inventory

$ + -

0 84,000 63,000 $ 21,000

+ + + -

$

0 63,000 58,000 28,000 130,000 $ 19,000

+ -

$ 0 130,000 95,000 $ 35,000

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M7-16. (10 minutes) LO 5 2017:

$76,450 - 25,354 $76,450

= 0.668

2016:

$71,890 - 21,685 $71,890

= 0.698

2015:

$70,074 - 21,536 $70,074

= 0.693

M7-17. (15 minutes) LO 1 a. Purchases are understated. If ending inventory is correctly valued, cost of goods sold will also be understated and current income will be overstated. There would be no effect in the following year. If, however, ending inventory is understated (due to the mistakenly recorded purchase) then there is no effect on income in either period. b. Purchases are overstated. The effect on income, assuming normal inventory levels, depends on the inventory costing system being used by the company. Assuming rising prices, income would be reduced in the current year under LIFO or average costing but unaffected under FIFO costing. Income in the following year would not be affected. (The solution assumes the error is not discovered and corrected in the current year.) c. Shrink (part of cost of goods sold) is overstated and ending inventory is understated. Consequently, current period income is understated. If the inventory is counted correctly the following year, the error will reverse itself and income will be overstated. This is an example of a “self-correcting” inventory error.

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M7-18. (20 minutes) LO 2, 4 a. Balance Sheet, December 2019 Assets Cash Inventory

$12,000 50,000

Shareholders’ equity Contributed capital

$62,000

b. All monetary amounts in $ thousands. Year Income statement: Revenue COGS-FIFO Earnings before tax Tax expense Net income Cash flows: Receipts Inventory purchases Tax payments Cash from operations

2020

2021

2022

75 50 25 10 15

85 60 25 10 15

95 70 25 10 15

75 -60 -10 5

85 -70 -10 5

95 -80 -10 5

Dividends Cash from financing Net change in cash

-9 -9 -4

-9 -9 -4

-9 -9 -4

Balance sheet: Assets Cash Inventory Total

8 60 68

4 70 74

0 80 80

Shareholders’ equity Contributed capital Retained earnings Total

62 6 68

62 12 74

62 18 80

Clearly there is a problem with this business model. The company is showing profits, and assets and retained earnings are increasing. However, there is a cash flow problem. The net change in cash every year is -$4 thousand and, by the end of 2022, the company would have a cash balance of zero. In 2023, it would not be possible to replenish the inventory and to pay the dividend. ©Cambridge Business Publishers, 2020 1-92

Financial Accounting, 6th Edition

c. All monetary amounts in $ thousands. Year Income statement: Revenue COGS-LIFO Earnings before tax Tax expense Net income

2020

2021

2022

75 60 15 6 9

85 70 15 6 9

95 80 15 6 9

75 -60 -6 9

85 -70 -6 9

95 -80 -6 9

-9 -9 0

-9 -9 0

-9 -9 0

Balance sheet: Assets Cash Inventory Total

12 50 62

12 50 62

12 50 62

Shareholders’ equity Contributed capital Retained earnings Total

62 0 62

62 0 62

62 0 62

Cash flows: Receipts Inventory purchases Tax payments Cash from operations Dividends Cash from financing Net change in cash

Interestingly, the use of LIFO reduces profits, and the company’s reported assets (and net assets) are not growing like the FIFO case above. However, the cash flow situation is improved. The company can pay the desired dividends and continue to replace its inventory at the end of every year. The difference between LIFO and FIFO is that FIFO profits include a gain from holding inventory while prices are rising. When the company is taxed on that gain, it has less cash available to maintain its physical assets (inventory). In essence, paying taxes based on FIFO (when inventory costs are increasing) can cause a firm’s ability to stay in business to be taxed away. LIFO profits exclude holding gains, so the company could continue to stay in business. (The tax authorities will “catch up” when the business decides to stop investing in inventory, and the LIFO liquidation profits get taxed.)

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M7-19. (20 minutes) LO 2 a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000 FIFO ending inventories = $400,000 - $205,000 = $195,000

b. LIFO cost of goods sold = 1,700 @ $150 = $255,000 LIFO ending inventories = $400,000 - $255,000 = $145,000

c. AC cost of goods sold = 1,700 @ $400,000/3,000 = $226,667 AC ending inventories = $400,000 – $226,667 = $173,333

M7-20. (15 minutes) LO 2 a. $1,320,000 + purchases - $6,980,000 = $1,460,000; purchases = $7,120,000. b. 1.

2.

Inventory (+A) Cash or Accounts payable (-A or +L)

7,120,000

Cost of goods sold (+E, -SE) Inventory (-A)

6,980,000

7,120,000

6,980,000

c. +

+ Balance (1) Balance

Cash (A) 7,120,000

Inventory (A) 1,320,000 7,120,000 6,980,000 1,460,000

+ (1)

(2)

Cost of Goods Sold (E) 6,980,000

-

(2)

d. Transaction a. Purchase inventory. c. Cost of inventory sold.

Cash Asset -7,120,000 Cash

Balance Sheet Noncash LiabiContrib. + = + + Assets lities Capital +7,120,000 Inventory

=

-6,980,000 Inventory

=

Income Statement Earned Capital

Revenues - Expenses = -

-6,980,000 Retained Earnings

-

Net Income

= +6,980,000 Cost of Goods Sold

-6,980,000 =

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M7-21. (10 minutes) LO 2 a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400 FIFO ending inventories = $12,400 - $6,400 = $6,000

b. LIFO cost of goods sold = 600 @ $12 = $7,200 LIFO ending inventories = $12,400 - $7,200 = $5,200

c. AC cost of goods sold = 600 @ $12,400/1,100 = $6,764 AC ending inventories = $12,400 – $6,764 = $5,636

M7-22. (20 minutes) LO 5 a. Wal-Mart Target

Inventory Turnover-2017 373/[(43.8+43.0)/2] = 8.59 51.1/[(8.66+8.31)/2] = 6.07

Inventory Turnover-2016 361/[(43.0+44.5)/2] = 8.25 49.1/[(8.31+8.60)/2] = 5.81

b. Wal-Mart’s inventory turnover rate is higher than Target’s. There can be several reasons for this. Wal-Mart’s product lines may be oriented toward lowermargin/higher-turnover goods (Wal-Mart does report a lower gross profit margin than Target). Both companies had slight increases in turnover rates from 2016 to 2017. At the end of 2017, both companies hold roughly the same, or slightly more, inventory than in the prior year, possibly in anticipation of increased sales in 2018 (or the addition of new products). c. Inventory turns improve as the dollar volume of goods sold increases relative to the dollar volume of goods on hand. Inventory reductions can be realized by reducing the depth and breadth of product lines carried (e.g., not every style, size and color), eliminating slow-moving product lines, working with suppliers to arrange for delivery when needed rather than inventorying for a longer holding period, and marking down goods for sale at the end of product seasons. Retailers must balance the cost savings from inventory reductions against the marketing implications of lower inventory levels on hand. It would be possible to stock only those items that turn over very quickly, but those items may have low margins. Or, there may be items that turn over slowly, but have sufficient margins to make offering them attractive, even though it reduces inventory turnover. Whenever ratios are used as incentive measures, it is important to recognize that they may cause “cherry-picking” of only those activities that provide the highest ratio outcome. ©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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M7-23. (15 minutes) LO 2 a. Cost of goods sold (+E, -SE) Inventory (-A)

142,790,000 142,790,000

b. Balance (c) Balance

c.

+ Inventory 25,790,000 142,790,000 140,560,000 23,560,000

+ (a)

Cost of Goods Sold 142,790,000

-

(a)

Inventory (+A) Cash or Accounts payable (-A or +L)

140,560,000 140,560,000

d. ($000) Transaction

Cash Asset

c. Purchase inventory

-140,560 Cash

a. Cost of inventory sold

Balance Sheet Noncash LiabilContrib. + = + + Assets ities Capital +140,560 Inventory -142,790 Inventory

Income Statement Earned Capital

Revenues - Expenses =

=

=

-142,790 Retained Earnings

-

Net Income

= +142,790 Cost of Goods Sold

-142,790 =

M7-24. (10 minutes) LO 3 a. (60 x $45) + (210 x $34) + (300 x $20) + (100 x $27) = $18,540 b. Cost: (60 x $45) + (210 x $38) + (300 x $22) + (100 x $27) = $19,980 Market: (60 x $48) + (210 x $34) + (300 x $20) + (100 x $32) = $19,220 Therefore, the ending inventory balance should be $19,220.

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EXERCISES E7-25. (45 minutes) LO 5 a. Fiscal year 2015: Gross profit margin = ($705 – $503) ÷ $705 = 28.7% Inventory turnover ratio = $503 ÷ [($214 + $223) ÷ 2] = 2.30 times Fiscal year 2016: Gross profit margin = ($703 – $497) ÷ $703 = 29.3% Inventory turnover ratio = $497 ÷ [($223 + $212) ÷ 2] = 2.29 times b. Fiscal Year 2015

2016

Quarter 1 2 3 4 1 2 3 4

Gross Profit $ 27 91 56 28 32 90 55 29

Gross Profit Margin 21.3% 36.0% 28.9% 21.5% 24.6% 35.7% 28.7% 22.3%

The gross profit and gross profit margin numbers show that West Marine is significantly more profitable in the second and third quarters. The revenues from these quarters are 50% - 100% higher than the other quarters and the gross profit from quarters two and three is sometimes more than three times that of quarters one and four. Unlike many retailers, who make most of their sales and profits in the fourth calendar quarter, West Marine must discount its prices and run promotions in order to generate sales in the first and fourth quarters.

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c. Inventory is lowest at the end of the fiscal year. At the end of the first quarter (end of March), inventory has increased in anticipation of the busy second quarter, and inventory stays high through the second quarter (end of June). By the end of September (third quarter), inventory has declined, and it continues to decline through the fourth quarter. It is common for seasonal businesses to choose fiscal year-ends when inventories (and other balances like receivables) are lower. But it can mean that annual ratios (like those calculated in part a) do not reflect the inventory investment that was necessary to generate the sales reported for the year. Understanding these seasonal effects can be important for cash management over the year. d. One approach to calculating an inventory turnover ratio is to use an “average of averages” approach. For the first quarter of 2015, the average inventory was ($214 + $257) / 2 = $235.5. Follow the same process to determine the average inventory for quarters two, three and four. Then average the averages. The effect of this process is the following: 2015: Weighted average inventory = [214 + 2x(257 + 258 + 237) + 223)] / 8 = $242.6 2016: Weighted average inventory = [223 + 2x(269 + 254 + 232) + 212)] / 8 = $243.1 The weighted average inventory levels are greater than the simple annual averages for both years because the fiscal year-end is set when inventory is predictably low. When these inventory values are divided into annual cost of goods sold, the inventory turnover ratios are lower than those calculated in part a. Weighted average inventory turnover ratio: 2015: $503 / $242.6 = 2.07 times 2016: $497 / $243.1 = 2.04 times

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E7-26.A (30 minutes) LO 2, 4 6 Units 1,000 1,800 800 1,200 4,800

Beginning Inventory Purchases: #1 #2 #3 Goods available for sale

Cost $ 20,000 39,600 20,800 34,800 $115,200

Units in ending inventory = 4,800 – 2,800 = 2,000

a. First-in, first-out

Ending Inventory

Units 1,200 800 2,000

@ @

Cost of goods available for sale Less: Ending inventory Cost of goods sold

Cost $29 = $26 =

Total $34,800 20,800 $55,600

$115,200 55,600 $ 59,600

b. Last-in, first-out

Ending inventory

Units 1,000 @ 1,000 @ 2,000

Cost of goods available for sale Less: Ending inventory Cost of goods sold

Cost $20 $22

Total = $20,000 = 22,000 $42,000

$115,200 42,000 $ 73,200

c. Average cost $115,200/4,800 = $24 average unit cost 2,000 x $24 = $48,000 ending inventory $115,200 - $48,000 = $67,200 cost of goods sold (or 2,800x$24)

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d. 1. The first-in, first-out method in most circumstances represents physical flow. This inventory system applies to perishables or to situations in which the earliest items acquired are moved out first because of risk of deterioration or obsolescence. 2. Last-in, first-out results in the lowest inventory amount during periods of rising unit costs, which in turn results in the lowest net income and the lowest income tax. 3. The first-in, first-out results in the lowest cost of goods sold in periods of rising prices. This is the inventory method Chen should use to report the largest amount of income. Of course, this assumes that prices will continue to rise. Companies cannot change inventory costing methods without justification, and the change may be prohibited by tax laws as well.

E7-27. (25 minutes) LO 2

Beginning inventory Purchases: Purchase #1 Purchase #2 Purchase #3 Cost of goods available for sale

Units 100 650 550 200 1,500

@ @ @ @

Cost $46 42 38 36

@ @

Cost $36 38

= = = =

Total $ 4,600 27,300 20,900 7,200 $60,000

= =

Total $ 7,200 5,700 $12,900

a. First-in, first-out

Ending inventory .................................

Units 200 150 350

Cost of goods available for sale.......... Less: Ending inventory ....................... Cost of goods sold ..............................

$60,000 12,900 $47,100

b. Average cost Cost of Goods Available for Sale/Total Units Available for Sale = $60,000/1,500 = $40 Average Unit Cost Ending Inventory = 350 units x $40 =

$14,000

Cost of goods available for sale Less: Ending inventory Cost of goods sold

$60,000 14,000 $46,000

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c. Last-in, first-out

Ending inventory

Units 100 @ 250 @ 350

Cost $46 42

Cost of goods available for sale Less: Ending inventory Cost of goods sold

= =

Total $ 4,600 10,500 $15,100 $60,000 15,100 $44,900

E7-28. (20 minutes) LO 3 a. 1. (70 x $190) + (45 x $268) + (20 x $350) + (120 x $60) + (80 x $88) + (50 x $126) = $52,900. 2. Desks: (70 x $190) + (45 x $280) + (20 x $350) = $32,900 (70 x $210) + (45 x $268) + (20 x $360) = $33,960 Chairs: (120 x $60) + (80 x $95) + (50 x $130) = $21,300 (120 x $64) + (80 x $88) + (50 x $126) = $21,020 Therefore, inventory would be reported at $32,900 + $21,020 = $53,920. 3. (70 x $190) + (45 x $280) + (20 x $350) + (120 x $60) + (80 x $95) + (50 x $130) = $54,200 (70 x $210) + (45 x $268) + (20 x $360) + (120 x $64) + (80 x $88) + (50 x $126) = $54,980 Therefore, inventory would be reported at $54,200. b. Applying the lower of cost or net realizable value (NRV) rule to individual items in inventory results in the lowest inventory amount, the highest cost of goods sold and the lowest net income. Under either of the other two methods, the inventory may be valued at the higher of cost or NRV for some items in inventory.

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E7-29.A (20 minutes) LO 2, 4, 6 a. $13,042 million b. $14,275 million c. Pretax income has been reduced by $1,233 million cumulatively since GM adopted LIFO inventory costing. This is because it has matched current inventory costs against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used. If LIFO has put $1,233 million less into ending inventory than FIFO, it must have put $1,233 more into cost of goods sold than FIFO. d. Pretax income has been reduced by $1,233 million (see part c). Assuming a 35% tax rate, taxes have been reduced by $1,233 x 0.35 = $431.6 million. Cumulative taxes were decreased by the use of LIFO inventory costing. e. During this period GM was experiencing declining earnings while inventory costs were not keeping pace. Under these conditions, FIFO reporting mitigates the effect on income. E7-30.A (25 minutes) LO 2, 4, 6 a. $6,149 million b. $7,786 million. The FIFO inventory carrying amount is greater than the LIFO carrying amount, which is common. It implies Deere’s current inventory costs are rising. We cannot blindly assume that inventory costs always rise, however. When costs decline as is true in the computer chip industry (generally not on LIFO) or in the past year in the oil and gas industry (generally on LIFO), a lower FIFO carrying amount can occur. However, if prices fall for so long and to such an extent that the FIFO carrying amount is lower than the LIFO carrying amount the company would have to consider switching off of LIFO onto FIFO. c. Pretax income has been decreased by $1,637 million cumulatively since Deere adopted LIFO inventory costing. This result occurs because higher current inventory costs are matched against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used. d. Pretax income has been decreased by $1,637 million (see part c). Assuming a 25% tax rate, taxes have been decreased by $1,637 x 0.25 = $409.25 million. Cumulative taxes have been decreased by use of LIFO inventory costing. ©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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e. For 2018, the change in the LIFO reserve is an increase of $176 million. Pretax income has been decreased by this amount, thus decreasing taxes by $176 million x 0.25 = $44 million. Observation: If Deere’s inventory were at some future date to be more highly valued under LIFO than under FIFO, the company could reduce its tax expense by switching to FIFO costing. This is, however, unlikely for Deere or other industries facing continued price increases or even essentially constant prices. f. In 2016 and 2015, Deere liquidated some LIFO layers, meaning that it sold more inventory than it bought (of a certain type) and thus older costs assigned previously assigned to inventory are now assigned to cost of goods sold as that inventory is sold. In periods of rising costs that means old, lower costs are assigned to cost of goods sold and matched with revenues from the current period. As a result, higher profits are recorded than would have been recorded if new inventory (purchased at higher prices) would have been bought and assumed to have been sold. Companies are required to disclose this when it happens because it shows a higher profit merely for depleting inventory layers. Deere states that they recorded $4 million in pretax profit attributable to such LIFO liquidations in 2016 ($22 million in 2015).

E7-31. (20 minutes) LO 2, 4, 5 a. ($ millions) $517 + Purchases - $10,633 = $471. Purchases = $10,587. b. ($ millions) Sales revenue Cost of goods sold Gross profit

As reported (LIFO) $16,030 10,633 $ 5,397

Pro forma (FIFO) $16,030 10,628 $ 5,402

$10,633 - ($47 - $42) = $10,628 c. As reported (LIFO): $5,397 / $16,030 = 33.67% Pro forma (FIFO): $5,402 / $16,030 = 33.70% The small differences between LIFO and FIFO reflect both the rate of price change for Whole Foods’ inventories and the fact that its inventory moves through very quickly (about 21 times per year).

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E7-32. (30 minutes) LO 5 a.

Revenue COGS Gross profit Gross profit margin (GPM)

Tiffany 2017 2016 $4,170 $4,002 1,565 1,512 2,605 2,490 62.5% 62.2%

Best Buy RH 2017 2016 2017 2016 $42,151 $39,403 $2,440 $2,135 32,275 29,963 1,591 1,455 9,876 9,440 849 680 23.4% 24.0% 34.8% 31.9%

b.

COGS Average inventory Inventory turnover Average inventory Average daily COGS AIDO

Tiffany 2017 1,565 2,206 0.71 2,206 4.29 514.2

Best Buy 2017 32,275 5,036.5 6.41 5,036.5 88.42 57.0

RH 2017 1,591 639.5 2.49 639.5 4.36 146.7

c. These three retailers offer very different products (jewelry, consumer electronics, and furniture) and thus have different gross profit margins and inventory turnover ratios. All three have seen their gross profit margins improve slightly from 2016 to 2017. Comparing the three retailers, each has ratios that are consistent with the type of product they sell. Tiffany’s GPM is quite high, but its inventory turnover is very low. This is representative of jewelry retailers. Best Buy, a “big box” store chain, illustrates a more typical retail GPM and turnover. RH, which sells furniture, has ratios between the jewelry retailer, Tiffany, and Best Buy. The comparison illustrates that retailers of “big ticket” items tend to have inventory that turns slower but has higher gross profit per dollar of sales.

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PROBLEMS P7-33. (25 Minutes) LO 2, 4, 5 a. Caterpillar: INVT: $31,049 / [($8,614 + $10,018) / 2] = 3.33 AIDO: [($8,614 + $10,018) / 2] / ($31,049 / 365) =109.52 Komatsu: INVT: ¥1,765,832 / [(¥533,897 + ¥730,288) / 2] = 2.79 AIDO: [(¥533,897 + ¥730,288) / 2] / ¥1,765,832 / 365) =130.65 As calculated, Caterpillar’s turnover is about 0.54 times faster than Komatsu’s, and there is a 21-day difference in the companies’ average inventory days outstanding. This difference could be attributed to differential production efficiencies or to differential component sourcing strategies. Perhaps, Caterpillar purchased more components from outside suppliers. b. When there are no LIFO liquidation effects, decreases in the LIFO reserve can be attributed to changes in the company’s costs. Caterpillar’s LIFO reserve decreased in 2017, implying that its costs probably decreased. c. Pretax income has been reduced by $1,934 million cumulatively since CAT adopted LIFO inventory costing. This is because it has matched current inventory costs against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used. Each year, the difference between FIFO cost of goods sold and LIFO cost of goods sold is added to the LIFO reserve. Assuming a 25% tax rate, cumulative taxes have been reduced by $1,934 x 0.25 = $483.5 million by the use of LIFO inventory costing. d. For 2017, the change in the LIFO reserve is a decrease of $205 million ($1,934 million - $2,139 million). Pretax income has been increased by this amount (relative to FIFO), thus increasing taxes by $205 million x 0.25 = $51.25 million. e. Komatsu’s use of specific identification probably approximates a FIFO inventory costing method. As a result, the comparison in part a above is not valid because Caterpillar’s use of LIFO produces distortions. We should use the LIFO reserve information to construct Caterpillar’s inventory turnover based on FIFO. FIFO 2017 cost of goods sold = $31,049 – ($1,934 – $2,139) = $31,254 FIFO 2017 average inventory = [($8,614 + $2,139) + ($10,018+$1,934)]÷2 = $11,352.5 FIFO 2017 inventory turnover = $31,254 ÷ $11,352.5 = 2.75 times

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So, Caterpillar’s inventory turnover is 0.04 slower than Komatsu’s once we take into account the differences in their inventory cost flow assumptions.

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P7-34. (20 minutes) LO 2, 4, 5 a. $7,781 million - $1,248 million = $6,533 million b. $1,248 million c. $1,248 million x 0.25 = $ 312 million d. $1,907 million + [($1,248 million - $1,291 million) x (1 - 0.25)] = $1,874.75 million e. $95,662 / [($6,533 + $6,561) / 2] = 14.61 f. [$95,662 - ($1,248 - $1,291)] / [($7,781 + $7,852) / 2] = 12.24

P7-35. (30 minutes) LO 5 a. ($ millions) Samsung 2017

2016

Hewlett-Packard 2015

Apple

2017

2016

2015

2017

2016

2015

Revenue

239,575,376 201,866,745 200,653,482

58,472

52,056

48,238

265,395

229,234

215,639

COGS

129,290,661 120,277,715 123,482,118

47,803

42,478

39,240

163,756

141,048

131,376

Gross profit

110,284,715

81,859,030

77,171,364

10,669

9,578

8,998

101,639

88,186

84,263

40.4%

38.8%

38.5%

18.2%

18.4%

18.7%

38.3%

38.5%

39.1%

Gross profit margin (GPM)

b. COGS Average ending inventory Inventory turnover

Samsung 2017 2016 129,290,661 120,277,715 21,668,429 18,582,648.5 5.97 6.47

Hewlett-Packard 2017 2016 47,803 42,478 5,924 5,135 8.07 8.27

Apple 2017 2016 163,756 141,048 4,405.5 3,493.5 37.17 40.37

Average ending inventory Average daily COGS AIDO

Samsung 2017 2016 21,668,429 18,582,648.5 354,221 329,528 61 56

Hewlett-Packard 2017 2016 5,924 5,135 131 116 45 44

Apple 2017 2016 4,405.5 3,493.5 449 386 10 9

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c. Gross profit margins reflect the companies’ cost control, their product mix, and their relative ability to create differentiated products. Inventory turnover is much higher at Apple. This may be tied to Apple’s practice of outsourcing a great deal of its production to third party manufacturers in Asia. In fact, Apple reports “The Company’s inventories consist primarily of finished goods for all periods presented.” In addition, Apple seems willing to be out of stock following new product releases meaning they do not hold as much inventory at any particular time. P7-36.A (45 minutes) LO 2, 4, 6 ($ thousands) a. Inventories as a percent of current assets follow: 87.5% ($680,828/$778,012) of current assets in 2017 As long as Seneca has sufficient product to meet demand, a reduction of inventories represents efficient manufacturing processes, while an increase in inventories might reflect slowing demand, rising input prices, or production inefficiencies. b. The inventory turnover rate follows: 2018: $1,240,178/[($680,828+$628,935)/2]=1.89 2017: $1,150,194/[($628,935+$609,481)/2]=1.86 The inventory turnover rate has increased very slightly from 2017 to 2018. This increase, though very small, is positive because it represents increased manufacturing/retailing efficiency. c. Seneca uses the LIFO inventory costing method. The effect of LIFO was to reduce net earnings by $11.2 million relative to if the firm had used FIFO in 2018 and increased earnings by $6.6 million in 2017. This is because LIFO records newer (higher in 2018 and lower in 2017) costs in cost of goods sold which makes income lower in 2018 and higher in 2017. d. Seneca’s use of LIFO has led to a reduction of its taxes as indicated by the $158.8 million amount in the LIFO reserve. Seneca’s cash savings due to the use of assuming a constant tax rate of 25% amount to $39.7 million = $158.8M X (0.25).

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CASES and PROJECTS C7-37.A (30 minutes) LO 2, 4, 5, 6 a. In the year 2017, Exxon’s pretax earnings would be higher by the change in the LIFO reserve because the reserve increased. In 2017, the LIFO reserve increased from $8.1 billion to $10.8 billion, for an increase of $2.7 billion. The 2017 pretax income that would have been reported if FIFO had been used would thus be $18.7 billion + $2.7 billion = $21.4 billion. Note: The increase in the LIFO reserve is likely due to rising oil (and oil product) prices in the last year. b. The inventory turnover would be as follows: $128,217 [($12,871+$4,121) + ($10,877+$4,203)] / 2

= 8.0

c. BP’s inventory turnover is calculated as follows: $179,716 = 9.8 ($19,011+$17,655) /2 d. Based on calculations from their financial statements, it appears that BP’s inventory turns over more quickly than Exxon Mobil’s. However, Exxon Mobil’s use of LIFO makes such a comparison invalid, because BP is not allowed to use LIFO under IFRS. To make a better comparison, we adjust Exxon Mobil’s inventory turnover ratio to FIFO. In 2017 there was an increase in the LIFO reserve, so we need to decrease the cost of goods sold by the increase in the LIFO reserve and increase the value of the inventories by the balance in the LIFO reserve each year: $128,217 + $10,800 [($12,871 + $4,121 + $10,800)+($10,817 + $4,203 + $8,100)]/2

= 5.5

This ratio shows that Exxon Mobil’s inventory is turning over more slowly than the original calculation implied. e. The statement refers to the impact of LIFO liquidation on Exxon-Mobil’s profits.

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C7-38. (40 minutes) LO 2, 4 a. GAAP requires that LIFO abandonment decisions be presented using the retrospective method. That is, all of the financial statements that are presented must be restated using the new accounting method (FIFO). As a result, all of Virco’s statements – income statement and balance sheets - that are presented in the January 31, 2011 10-K are restated to reflect the switch to FIFO. Virco’s 10-K reveals that inventories increased by $7.6 million for the year ended January 31, 2011. This represents the LIFO reserve that is added to LIFO inventory value to get to the inventory valued at FIFO. The company states that $4.7 is added to equity. This adjustment reflects that LIFO reduces reported earnings by allocating higher cost goods (most recently purchased) in cost of goods sold and lower cost goods (earlier purchases). These lower earnings over time cause retained earnings to be lower. Thus, to adjust to FIFO retained earnings needs to be increased to get to what retained earnings would have been had the company been on the FIFO method of accounting for inventory all along. Finally, the increase to inventory and the increase to equity are not the same because of taxes. If the company would have been on FIFO they would have paid extra taxes over time. Upon the switch to FIFO the company has to pay tax on the LIFO reserve amount (but can spread the payments over time). Thus, the effect on equity will be net of tax on the earnings but the effect on inventory is not net of tax. b. Virco argues (correctly) that the FIFO method is better because all inventory will be on the same method of accounting for inventory, it results in a balance sheet that reflects current acquisition costs, and it increases comparability with companies on IFRS because IFRS does not allow LIFO. c. Note that Virco justified the use of LIFO in prior annual reports by saying it provided a better matching of current costs to current revenues in the income statement. This is a correct statement but in some contrast to the statements made in the year the company decided to switch to FIFO? Do they not care about matching anymore? One explanation is that the arguments in favor of FIFO outweighed the matching benefit of LIFO. The IFRS is potentially an explanation (although financial statement users should be able to adjust the inferences from the statements to use “as if FIFO” numbers). The company’s statement about the line of credit is interesting. It potentially suggests that the covenants in their debt agreement are affected adversely if the company uses LIFO (e.g., income is lower so the covenant more easily violated). Other potential explanations are that 1) the company may not expect prices to rise in the future which would negate the tax savings of LIFO, or 2) perhaps corporate performance is declining and management is switching off LIFO so stated results look better.

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Chapter 8 Reporting and Analyzing Long-Term Operating Assets Learning Objectives – coverage by question MiniExercises

Exercises

17

31

11,17

22

LO3 – Apply different depreciation methods to allocate the cost of assets over time.

12, 13, 16, 18, 19

22 - 28, 32

LO4 – Determine the effects of asset sales and impairments on financial statements.

14, 15

LO5 – Describe the accounting and reporting for intangible assets.

LO6 – Analyze the effects of tangible and intangible assets on key performance measures.

LO1 – Describe and distinguish between tangible and intangible assets.

LO2 – Determine which costs to capitalize and report as assets and which costs to expense.

Problems

Cases and Projects

22, 24, 26, 35

36, 38, 39

40, 42, 43

17, 21

31, 34

37

42

20, 21

29, 30, 33

40 – 42

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QUESTIONS Q8-1.

Routine maintenance costs that are necessary to realize the full benefits of ownership of the asset should be expensed. However, betterment or improvement costs should be capitalized if the outlay enhances the usefulness of the asset or extends the asset’s useful life beyond original expectations. As would be the case with any cost, an immaterial amount should be expensed as incurred.

Q8-2.

Capitalizing interest costs as part of the cost of constructing an asset reduces interest expense, and increases net income during the construction period. In subsequent periods, the interest costs that were capitalized as part of the cost of the asset will increase the periodic depreciation expense and reduce net income.

Q8-3.

As any asset is used up, its cost is removed from the balance sheet and transferred into the income statement as an expense. Capitalization of costs onto the balance sheet and subsequent removal as expense is the essence of accrual accounting. If the cost of a depreciable asset is recognized in full upon purchase, profit would be inaccurately measured: it would be too low in the year of purchase when the asset is expensed and too high in later years as revenues earned by the asset are not matched with a corresponding cost. In other words, expenses would not be recognized as assets are used up or as a result of earning revenue.

Q8-4.

The primary benefit of accelerated depreciation for tax reporting is that the higher depreciation deductions in early periods reduce taxable income and income taxes. Cash flow is, therefore, increased, and this additional cash can be invested to yield additional cash inflows (e.g., an "interest-free loan" that can be used to generate additional income). We would generally prefer to receive cash inflows sooner rather than later in order to maximize this investment potential.

Q8-5.

When a change occurs in the estimate of an asset's useful life or its salvage value, the revision of depreciation expense is handled by depreciating the current undepreciated cost of the asset (original cost – accumulated depreciation) using the revised assumptions of remaining useful life and salvage value. Present and future periods are affected by such revisions. Depreciation expense calculated and reported in past periods is not revised.

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Q8-6.

The gain or loss on the sale of a PPE asset is determined by the difference between the asset's book value and the sale proceeds. Sales proceeds in excess of book values create gains; sales proceeds less than book values cause losses. The relevant factors, then, are the depreciation rate and salvage values used to compute depreciation expense, accumulated depreciation and the net book value of the asset, as well as the selling price of the asset.

Q8-7.

A PPE asset is considered to be impaired when the sum of the undiscounted expected cash flows to be derived from the asset is less than its current book value. An impairment loss is calculated as the difference between the asset's book value and its current fair market value.

Q8-8.

Research and development costs must be expensed under GAAP unless they have alternative future uses. Equipment relating to a specific research project with no alternative use would, therefore, be expensed rather than capitalized and subsequently depreciated. Accounting standard-setters have justified this ‘expense as incurred’ treatment for R&D costs since the outputs from research and development activities are uncertain and thus there is not a way to know when the asset is used up or whether revenue will be earned from the R&D spending.

Q8-9.

The difficulty with amortizing intangible assets is estimating the useful life. For some intangibles, the useful life is limited and can be easily estimated. However, some intangibles have an indefinite life. This means that the useful life of the intangible is long and cannot be determined with any reasonable degree of accuracy. Under these circumstances, it is not appropriate to amortize the asset until the useful life can be determined.

Q8-10. Goodwill arises whenever a company acquires another company and the purchase price is greater than the fair value of the identifiable assets acquired. The amount of goodwill is the difference between the purchase price and the value assigned to the net assets of the acquired company. It is recorded as a long-term asset in the balance sheet. Since goodwill is assumed to have an indefinite life, it is not amortized. The only time that goodwill will affect the income statement is if it is determined that its value is impaired. In that case, an impairment loss is recorded in the income statement and the value of the goodwill asset on the balance sheet is reduced.

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MINI EXERCISES M8-11. (10 minutes) LO 2 a. Expense b. Capitalize c. Capitalize (the new equipment enhances the assembly line) d. Expense – this is routine maintenance of the building, unless it extends the building’s useful life e. Capitalize – the useful life is extended f. Capitalize – this is a purchased intangible asset

M8-12. (15 minutes) LO 3 a. Straight-line: ($18,000 - $1,500)/ 5 years = $3,300 for both 2019 and 2020. b. Double-declining-balance: Twice straight-line rate = 2 x 1/5 = 40% 2018: $18,000 x 0.40 = $7,200 2019: ($18,000 - $7,200) x 0.40 = $4,320 Notice that, over the first two years, the company reports $6,600 of depreciation expense under the straight-line method and $11,520 of depreciation expense under the double-declining-balance method.

M8-13. (15 minutes) LO 3 a. Straight-line: ($130,000 - $10,000)/ 6 years = $20,000 for both 2019 and 2020. b. Double-declining-balance: Twice straight-line rate = 2 x 1/6 = 1/3 2018: $130,000 x 1/3 = $43,333 2019: ($130,000 - $43,333) x 1/3 = $28,889 c. Units of production: ($130,000 - $10,000) / 1,000,000 = $0.12 per unit 2018: 180,000 units x $0.12 = $21,600 2019: 140,000 units x $0.12 = $16,800

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M8-14. (15 minutes) LO 4 Straight-line depreciation: $40,000/10 = $4,000; 8 years x $4,000 = $32,000. a. Cash (+A) .......................................................................................... 3,500 Accumulated depreciation (-XA, +A) ................................................. 32,000 Loss on sale of furniture and fixtures (+E, -SE) ................................. 4,500 Furniture and fixtures (-A) ................................................................40,000 b. Balance Sheet Transaction Sold furniture and fixtures for cash.

Cash Asset

Noncash + Assets

Contra Assets

+3,500 Cash

-40,000 Furniture and Fixtures

-32,000 Accum. Deprec.

-

Liabi= lities

Income Statement Contrib. + + Capital

Earned Capital

Net Income

Revenues - Expenses =

-4,500 Retained Earnings

+4,500 -4,500 Loss on Sale = of Furniture and Fixtures

M8-15. (15 minutes) LO 4 Twice the straight-line rate = 1/5 x 2 = 40% Year 1: $75,000 x .4 = Year 2: ($75,000 - $30,000) x .4 = Year 3: ($75,000 - $30,000 - $18,000) x .4 = Total accumulated depreciation

$30,000 18,000 10,800 $58,800

a. Cash (+A) ........................................................................................... 25,000 Accumulated depreciation (-XA, +A) .................................................. 58,800 Machinery (-A) .................................................................................. Gain on sale of machinery (+R, +SE) ...............................................

75,000 8,800

b. Balance Sheet Transaction Sold machinery for cash.

Cash Asset +25,000 Cash

Noncash + Assets -75,000 Machinery

-

Contra Assets

-

-58,800 Accum. Deprec.

Liabi= lities

Income Statement Contrib. + + Capital

Earned Capital +8,800 Retained Earnings

Revenues +8,800 Gain on Sale of Machinery

- Expenses =

Net Income +8,800

-

=

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M8-16. (15 minutes) LO 3 a. Straight-line depreciation 2018: ($145,800 - $5,400)/3 = $46,800; (8/12) x $46,800 = $31,200 (Note: 8/12 is the fraction of the year, May through December) 2019: $46,800 b. Double-declining-balance depreciation Preliminary computation: Twice straight-line rate = 2 x 1/3 = 66⅔% ($145,800 x 66⅔%) = $97,200 2018: (8/12) x $97,200 = $64,800 2019: ($145,800 - $64,800) x 66⅔% = $54,000

M8-17. (20 minutes) LO 1, 2, 5 a. Under U.S. GAAP, capitalization of development costs is not allowed and all R&D costs must be expensed. Under IFRS, development costs are capitalized if there is the intention, feasibility and resources to bring the asset to completion, there exists the ability to use or sell the asset to generate an economic benefit. Otherwise the costs must be expensed. b. Yes, impairment should be tested for annually (or sooner if there is an indication that goodwill is impaired).

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M8-18. (20 minutes) LO 3 a. Year 1 2 3 4

Book Value $50,000 25,000 12,500 8,000

Depreciation Rate 2 x ¼ = 0.5 2 x ¼ = 0.5

Depreciation Expense $25,000 12,500 4,500 0*

*No depreciation is recorded in Year 4 because the asset is depreciated to its residual value of $8,000.

b. Year 1 2 3 4 5

Book Value $50,000 30,000 18,000 10,800 6,480

Depreciation Rate 2 x 1/5 = 0.4 2 x 1/5 = 0.4 2 x 1/5 = 0.4 2 x 1/5 = 0.4

Depreciation Expense $20,000 12,000 7,200 4,320 3,480*

*$3,480 of depreciation is required in Year 5 to depreciate the asset to its residual value of $3,000.

Year 1 2 3 4 5 6 7 8 9 10

Book Value $50,000 40,000 32,000 25,600 20,480 16,384 13,107 10,486 8,389 6,711

Depreciation Rate 2 x 1/10 = 0.2 2 x 1/10 = 0.2 2 x 1/10 = 0.2 2 x 1/10 = 0.2 2 x 1/10 = 0.2 2 x 1/10 = 0.2 2 x 1/10 = 0.2 2 x 1/10 = 0.2 2 x 1/10 = 0.2

Depreciation Expense $10,000 8,000 6,400 5,120 4,096 3,277 2,621 2,097 1,678 5,711*

* $5,711 of depreciation is required in Year 10 to depreciate the remaining value of the asset. Alternatively, DeFond could switch to straight-line depreciation in Year 7, recording $3,027 of depreciation in Years 7 through 10.

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M8-19. (15 minutes) LO 3 a. Year 2019 2020 2021

Barrels Extracted 300,000 500,000 600,000

Depletion per Barrel $32,000,000 / 4,000,000 = $8 $32,000,000 / 4,000,000 = $8 $32,000,000 / 4,000,000 = $8

Depletion $2,400,000 $4,000,000 $4,800,000

b. i.

Oil reserve (+A) ......................................................... 32,000,000 Cash (-A) ..............................................................

ii. Oil inventory (+A) ...................................................... Oil reserve (-A) ......................................................

32,000,000

2,400,000 2,400,000

c. + i. Balance +

Oil Reserve (A) 32,000,000 2,400,000 29,600,000 Cash (A) 32,000,000

Balance

+ ii.

Oil Inventory (A) 2,400,000

Balance

2,400,000

-

ii.

i.

32,000,000

M8-20. (15 minutes) LO 6 a. Texas Instruments Intel Corp.

PPE Turnover Rates for 2018 $15,784 / [($3,183 + $2,664) / 2] = 5.40 $70,848 / [($48,976 + $41,109) / 2] = 1.57

Texas Instruments turns its PPE more quickly than does Intel. b. PPE turnover rates increase with increases in sales volume relative to the dollar amount of PPE on the balance sheet. The PPE turnover rate is often a very difficult turnover rate to change, and typically requires creative thinking. Many companies are outsourcing the manufacturing process in whole or in part to others in the supply chain. This is beneficial so long as the savings realized by the reduction of manufacturing assets more than offset the higher cost of the goods as these are now purchased rather than manufactured. Another approach is to utilize long-term operating assets in partnership with another firm, say in a joint venture. ©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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M8-21. (15 minutes) LO 5, 6 a. $2,300 / $30,578 = 7.52%. Abbott’s R&D expenditure level could be compared to the R&D expenditure level for its competitors to gain a sense of the appropriateness of its R&D expenditures. Roche Holding AG has historically spent 20% of its revenues on R&D while Teva Pharmaceutical Industries Limited has a research and development intensity ratio of about 7% (note both of these companies are listed as primary competitors on Yahoo Finance). b. R&D costs must be expensed when incurred unless they are expenditures for depreciable assets that have alternative future uses (in which case the depreciation is expensed as recognized). As a result, the balance sheet does not reflect the costs incurred for long-term R&D assets. In addition, operating expenses are increased, thus reducing retained earnings. ($ millions)

Balance Sheet

Transaction

Cash Asset

R&D expenditures

-2,300 Cash

Noncash Liabi+ Assets = lities =

Contrib. + Capital +

Income Statement Earned Capital -2,300 Retained Earnings

Revenues

Net - Expenses = Income -

+2,300 R&D Expense

=

-2,300

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Financial Accounting, 6th Edition

EXERCISES E8-22. (15 minutes) LO 2, 3, 4 a. Machine (+A) ..................................................................................... 89,500 Cash (-A) ($85,000 + $2,000 + $2,500) ............................................ 89,500 b. ($89,500 - $7,000) / 5 = $16,500 per year. Depreciation expense (+E, -SE) ........................................................ 16,500 Accumulated depreciation (+XA, -A) ................................................. 16,500 c. Cash (+A) ........................................................................................... 12,000 Accumulated depreciation (-XA, +A) ($16,500 x 4) ............................ 66,000 Loss on sale of machine (+E, -SE) .................................................... 11,500 Machine (-A) ..................................................................................

89,500

E8-23. (20 minutes) LO 3 a. Straight line: ($80,000 - $5,000)/5 years = $15,000 per year b. Double declining balance: Twice straight-line rate = 2 x 1/5 = 40% Year

Book Value x Rate

1 2 3 4 5 Total

$80,000 x 0.40 = ($80,000 - $32,000) x 0.40 = ($80,000 - $51,200) x 0.40 = ($80,000 - $62,720) x 0.40 =

Depreciation Expense $32,000 19,200 11,520 6,912 5,368 (plug) $75,000

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E8-24. (25 minutes) LO 3, 4 a. 1. Accumulated depreciation on the date of sale: [($800,000-$80,000)/10 years] x 6 years = $432,000 2. Net book value of the plane at date of sale: $800,000 - $432,000 = $368,000 b. 1. Cash (+A) ........................................................................................ 368,000 Accumulated depreciation (-XA, +A) ............................................... 432,000 Plane (-A) .....................................................................................

800,000

2. Loss on sale of: $195,000 - $368,000 = $173,000 Cash (+A) ....................................................................................... 195,000 Accumulated depreciation (-XA, +A) ............................................... 432,000 Loss on sale of plane (+E, -SE) ...................................................... 173,000 Plane (-A) ....................................................................................

800,000

3. Gain on sale of: $600,000 - $368,000 = $232,000 Cash (+A) ....................................................................................... 600,000 Accumulated depreciation (-XA, +A) ............................................... 432,000 Gain on sale of plane (+R, +SE) .................................................. Plane (-A) ....................................................................................

232,000 800,000

E8-25. (15 minutes) LO 3 a. Straight-line: 2019 and 2020 ($218,700 - $23,400)/6 years = $32,550 b. Double-declining-balance: twice straight-line rate = 2 x 1/6 = 33⅓% 2019 $218,700 x 33⅓% = $72,900 2020 ($218,700 - $ 72,900) x 33⅓% = $48,600

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E8-26. (15 minutes) LO 3, 4 a. Depreciation expense to date of sale is [($27,200 - $2,000)/6] x 3 = $12,600. The net book value of the van is, therefore, $27,200 - $12,600 = $14,600. b. 1. $0 2. $400 gain ($15,000 - $14,600) 3. $2,600 loss ($12,000 - $14,600)

E8-27. (20 minutes) LO 3 a. Straight line: ($110,000 - $15,000) / 6 = $15,833 each year. b. Double-declining-balance: rate = 2 x 1/6 = 1/3 2019: $110,000 x 1/3 = $36,667 2020: ($110,000 – $36,667) x 1/3 = $24,444 2021: ($110,000 – $36,667 – $24,444) x 1/3 = $16,296 c. Straight line: [$110,000 – ($15,833 x 2) – $10,000] / 5 = $13,667 in 2021 and each subsequent year. Double-declining balance: rate = 2 x 1/5 = 40%. ($110,000 – $36,667 – $24,444) x 40% = $19,556 in 2021

E8-28. (20 minutes) LO 3 a. Straight-line: $6,000,000 / 30 = $200,000 per year each year. b. Double-declining balance: rate = 2 x 1/30 = 1/15. 2019: $6,000,000 x 1/15 = $400,000 2020: ($6,000,000 – $400,000) x 1/15 = $373,333 c. The revised depreciation rate = 2 x 1/23 = 8.7% 2021: ($6,000,000 – $400,000 – $373,333) x 8.7% = $454,720* *$454,493 (using unrounded depreciation rate)

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E8-29. (10 minutes) LO 6 Percent depreciated = Accumulated depreciation / Asset cost = $7,095 million / ($12,916 - $283 - $619) million = 59% Note: We eliminate land and construction in progress from the computation because these assets are not depreciated. Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% depreciated, on average. Deere’s 59% is slightly higher than this level. If the percentage depreciation were high, one possible concern is that it often requires higher capital expenditures in the near future to replace aging assets.

E8-30. (25 minute) LO 6 a. 2017

2018

Receivable Turnover Rate $31,657 = 6.81 $4,911+$4,392 2 $32,765 $5,020+$4,911 2

=6.60

Inventory Turnover Rate $16,055 = 4.33 $4,034+$3,385 2 $16,682 $4,366+$4,034 2

= 3.97

PPE Turnover Rate $31,657 = 3.64 $8,866+$8,516 2 $32,765 $8,738+$8,866 2

= 3.72

b. 3M’s Receivable and Inventory turnover ratios have declined from 2017 to 2018, while its PPET improved. 3M’s revenues increased in 2018, and that increase is likely to account for the increase in the PPET. PPE turns can also be improved by off-loading manufacturing to other companies in the supply chain and acquiring longterm operating assets in partnership with other companies, for example, in a joint venture. Receivable turnover decline indicates that receivables have increased faster than sales. This could indicate a need to monitor more closely the quality of customers to which credit is granted, implement better collection procedures, or offering discounts as an incentive for early payment. Inventory turnover rates can be improved by weeding out slowly moving product lines, by reducing the depth and breadth of products carried, and by implementing just-in-time deliveries.

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Financial Accounting, 6th Edition

E8-31. (10 minutes) LO 1, 5 a. Fair Value (Capitalized)

Useful Life

b. Amortization Expense for 2019

Patent

$200,000

3 years

$66,667

Trademark Noncompetition agreement

$500,000 $300,000

Indefinite 5 years

$60,000 $126,667

E8-32. (15 minutes) LO 3 a. Cost of resource property: $7,200,000 + $420,000 + $50,000 + $800,000 = $8,470,000 Residual value: $1,200,000 Depletion base: $8,470,000 – $1,200,000 = $7,270,000 Depletion rate: $7,270,000 / 500,000 tons = $14.54 per ton 2019: 60,000 x $14.54 = $872,400 2020: 85,000 x $14.54 = $1,235,900 b. 2019: Inventory (+A) ................................................................................... 872,400 Resource property (-A) ..................................................................... 872,400 2020: Inventory (+A) ................................................................................... 1,235,900 Resource property (-A) ..................................................................... 1,235,900

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E8-33. (15 minutes) LO 6 a. PPET: $21,461,268 / [($11,330,077 + $10,027,522)/2] = 2.0 times b. Percent depreciated: $2,699,098 / ($14,029,175 - $807,297) = 20.4% The cost of construction in progress is subtracted in the denominator because this amount represents PPE assets that are not currently in the base of depreciable assets. The cost of land should also be subtracted, but because Tesla lumps land and buildings together, this is not possible. Therefore, the actual percent depreciated ratio should be a little higher than the 20.4% we calculated. c. Tesla’s assets are about one fifth depreciated at the end of 2018. This results in an extremely low percent depreciated ratio and PPE turnover ratio (PPET). Tesla’s useful life assumptions could affect these ratios. For example, Tesla uses a units-of-production approach to depreciate tooling. In the auto industry, companies retool each time they make major design changes to a model. Years ago, this would happen annually, but in more recent years, automakers may retool only every three to five years. Tesla’s depreciation for tooling costs depend on its assumptions about sales of each model. So, it assumes 325,000 units for the expensive Models S and X while the (relatively) less expensive Model 3 has a projected demand of 1,000,000 units. Ultimately, the accuracy of these sales estimates will have an effect on depreciation expenses and, in turn, Tesla’s ratios.

E8-34. (15 minutes) LO 5 a. The list illustrates the wide range in expenditures for R&D (as a percent of sales) across firms. Note the large amount spent by Intel (19.11%) and pharmaceutical companies Pfizer (14.92%) and Merck (23.06%), compared to the amount spent by Apple (5.36%), Deere (4.97%) or Callaway Golf (3.28%). The companies in the list are to some extent paired by industry. It is interesting to see how similar some firms in the same industry are. For example, Apple and Samsung spend almost the same percentage of sales on R&D. b. Beside industry affiliation, the differences in R&D expenditures as a percent of sales is due to differences in markets, product mix, and other strategic considerations. As suppliers of technology (hardware and software), Intel and Microsoft depend very heavily on their intellectual property. As a result, their expenditures on research and development are among the highest of established firms. Apple has established itself as an innovator in technology and design and has spent billions of dollars developing unique products such as the iPad®. Apple’s research intensity looks relatively low but the company has tremendous sales revenue (the denominator in the R&D intensity ratio). In addition, the company has increased their spending on R&D. ©Cambridge Business Publishers, 2020 1-126

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E8-35. (20 minutes) LO 4 a. Yes, the equipment is impaired at July 1, 2020 because its book value is not recoverable through future cash flows. Specifically, on July 1, 2020, its book value is $145,000 ($225,000 initial cost less $80,000 accumulated depreciation*) and the estimated future (undiscounted) cash flows are only $125,000. *4 years of [($225,000-$25,000)/10 years].

b. The impairment loss in a is computed as the equipment's book value minus its current fair value: $145,000 − $90,000 = $55,000 Impairment loss (+E, -SE) .................................................................. 55,000 Equipment* (-A) ................................................................................

55,000

*Accumulated depreciation is sometimes credited for the loss. c. Assuming that the salvage value remains the same after the impairment (this is not likely given the decline in market value of the asset), the annual depreciation expense would be ($90,000 - $25,000) / 6 = $10,833 per year. Depreciation expense (+E, -SE) ....................................................... 10,833 Accumulated depreciation (+XA, -A) ................................................

10,833

d. ($000) Transaction b. Impairment charge.

Income Statement

Balance Sheet Cash Asset

+

Noncash Assets -55,000 Equipment

c. Depreciation expense.

-

Contra Assets

-

-

+10,833 Accum. Deprec.

=

Liabilities

+

Contrib. Capital +

Earned Capital

Revenues

Net - Expenses = Income

-55,000 Retained Earnings

+55,000 -55,000 - Impairment = Loss

-10,833 Retained Earnings

-

+10,833 Deprec. Expense

=

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Financial Accounting, 6th Edition

-10,833

PROBLEMS P8-36. (20 minutes) LO 4 In order to determine the entries for the sale of property, plant and equipment, we need to “fill in the blanks” for the PPE and accumulated depreciation accounts. Once we record the purchases and the depreciation expense, we can determine the cost and accumulated depreciation for the assets sold. (i)

Property, plant and equipment (+A) ................................................. 72 Cash (-A) ......................................................................................

72

Depreciation expense (+E, -SE) ....................................................... 54 Accumulated depreciation (+XA, -A) ............................................

54

(iii) Cash (+A) ......................................................................................... 4 Accumulated depreciation (-XA, +A) ................................................ 23 Property, plant and equipment (-A) .............................................

27

(ii)

+ Property, Plant and Equipment (A) Balance 803 (i) 72 27 Balance 848

-

(iii)

-

(iii)

Accumulated Depreciation (XA) + 450 Balance 54 (ii) 23 481 Balance

The net book value of the assets that were sold was $4 million. If Hilton sold the assets for more (less) than $4 million a gain (loss) would have resulted equal to the difference between the sale price and the net book value. A gain would be recorded as a credit entry in the journal entry (iii) and a loss would be recorded as a debit entry.

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P8-37. (20 minutes) LO 5 a. $385 million / $4,914 million = 7.8% b. R&D costs are expensed in the income statement except for the portion relating to depreciable assets that have alternate uses. Expensing (rather than capitalizing and depreciating) reduces assets, and the additional expense reduces profit and equity (via the reduction in retained earnings). In addition, expensing R&D as incurred means that potentially valuable intangible assets are omitted from the balance sheet. c. Agilent has reduced its R&D spending as a percent of revenues in recent years and, as a result, increased its earnings. This has turned operating losses into an operating profit for the company. However, Agilent is dependent upon technology in order to maintain its market position, and R&D is critical to its very existence. Agilent divested itself of some high-intensity R&D businesses between 2003 and 2011. Changes in R&D spending, as a percent of revenues, is affected by R&D spending and also by revenues. Agilent’s revenues have decreased from 2014 to 2018 but its R&D expenditures have decreased at a faster rate. A company can maintain its investment in intellectual capital and reduce expenses by outsourcing the activity to other countries where the intellectual resources are less expensive.

P8-38. (20 minutes) LO 4 ($ millions) a. i. Depreciation expense (+E, -SE) ...................................................... 2,460 Accumulated depreciation (+XA, -A) ................................................ ii.

2,460

Property and equipment (+A) ........................................................... 3,516 Cash (-A) ..........................................................................................

3,516

iii. Cash (+A) ......................................................................................... 85 Accumulated depreciation (-XA, +A) (see T-account) ...................... 2,171 Property and equipment (-A) (see T-account) ..................................

2,256

iv. Impairment and writedown charges (+E, -SE) Property and equipment (-A) + Property and Equipment (A) Balance 42,934 (ii) 3,516 2,256 92 (b) 118 Balance 44,220

-

-

(iii) (iv)

(iii)

92 92 Accumulated Depreciation (XA) + 18,398 Balance 2,460 (i) 2,171

18,687

Balance

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b.

The problem provides information directly to make entries (i), (ii), (iii) and (iv) in part a. For part (iii), we can infer the accumulated depreciation on disposed property and equipment as being the amount ($2,171) that makes that account balance. Since no gain or loss was reported on these disposals, the credit to property and equipment in part (iii) is the amount that balances the disposal transaction ($2,256). However, this leaves the property and equipment T-account unbalanced. A likely reason is that Target acquires some property and equipment without an expenditure of cash. (Chapter 10 will cover capital lease transactions, which play a role in Target’s operations.) Based on the information in the problem, we would estimate that $118 million of property and equipment was acquired through such transactions, because that amount balances the property and equipment T-account.

P8-39. (20 minutes) LO 4 The process used in this question is to fill in the entries for property and equipment and for accumulated depreciation in parts a, b and c, and then to use the “plug” figures in the T-accounts to determine the values in part d. ($ thousands) a. Depreciation expense (+E, -SE) ....................................................... 182,533 Accumulated depreciation (+XA, -A) ................................................

182,533

b. Property and equipment (+A) ............................................................ 190,102 Cash (-A) ..........................................................................................

190,102

c. Loss on impairment of property and equipment (+E) ........................9,639 Property and equipment (-A) ............................................................

9,639

d. Cash (+A) ......................................................................................... 8 Loss on disposal of property and equipment 570 Accumulated depreciation (-XA, +A) (see T-account) ....................... 56,595 Property and equipment (-A) (see T-account) ..................................

57,173

+ Property and Equipment (A) Balance 2,619,112 (b) 190,102 9,639 57,173 Balance 2,742,402

-

-

(c) (d)

(d)

Accumulated Depreciation (XA) + 1,686,829 Balance 182,533 (a) 56,595 1,812,767

Balance

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Financial Accounting, 6th Edition

CASES and PROJECTS C8-40. (90 min) LO 4, 6 a. PPE Turnover: $15,740.4/[($4,047.2 + $3,687.7)/2] = 4.07 The firm appears to be as capital intensive as others in the industry based on a similar PPE turnover ratio to its closest competitors. However, if the assets are older (more depreciation) the denominator will be smaller and could cause the PPE turnover to be higher. Thus, the age of the assets can affect the ratio as well. b. Accumulated depreciation / Depreciable asset cost $5,596.0/ ($10,003.2 - $77.7*- $692.9*) = 0.606 or 61%

*Note: We eliminate land from the computation because land is never depreciated. We eliminate construction in progress because these represent assets that the company is building. These assets are not yet in service and are consequently not yet depreciable. This elimination is also used in part c.

If plant assets are replaced at a constant rate, we would expect those assets to be about 50% “used up,” on average. A substantially higher percentage “used up” indicates that the assets are closer to the end of their useful lives and will require replacement (and usually higher maintenance costs near the end of their useful lives). Such a situation would negatively affect future cash flows. c. Average depreciable assets = [($10,003.2 – 77.7 – 692.9) + ($9,526.6 – 79.8 – 553.0)] / 2 = $9,063.2 Average depreciable assets/ Depreciation expense = $9,063.2 / $589.0 per year = 15.4 years. d. Depreciation expense (+E, -SE) ....................................................... 589.0 PPE accumulated depreciation (+XA, -A) .........................................

589.0

PPE (+A) ........................................................................................... 622.7 Cash (-A) ..........................................................................................

622.7

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C8-41. (40 minutes) LO 6 Reducing operating assets is an important means of increasing performance measures including the return on net operating assets. Most companies focus first on reducing receivables and inventories. This is the so-called low-hanging fruit that can lead to quick results. Some possible actions include those listed. Students will think of additional possibilities. a. Reducing receivables through: 1. Better underwriting of credit quality 2. Better controls to identify delinquencies, automated over-due notices, and better collection procedures 3. Increased attention to accuracy in invoicing 4. Offering early payment incentives b. Reducing inventories and inventory costs through essentially eliminating nonproductive activities including inspection, moving activities, waiting setup time: 1. Use of less costly components (of equal quality) and production with lower wage rates 2. Elimination of product features not valued by customers 3. Outsourcing to reduce product cost 4. Just-in-time deliveries of raw materials 5. Elimination of manufacturing bottlenecks to reduce work-in-process inventories 6. Producing to order rather than to estimated demand to reduce finished goods inventories 7. Eliminating defects c. Reducing PPE assets is much more difficult. The benefits, however, can be substantial. Some suggestions are the following: 1. Sale of unused and unnecessary assets 2. Acquisition of production and administrative assets in partnership with other companies for greater throughput 3. Acquisition of finished or semi-finished goods (sub-components) from suppliers to reduce manufacturing assets d. Reducing unnecessary intangible assets that are reported on the balance sheet is the most difficult. 1. Sale of assets no longer relevant to company plans 2. License intangibles to other companies ©Cambridge Business Publishers, 2020 1-134

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C8-42. (30 minutes) LO 4, 5, 6 a. Take-Two (TTWO) spent $326,909 in 2018 on software development. TTWO’s amortization and write-downs were $77,887 in 2018. Using EA’s method, the money spent on additions would be expensed, and the amortization and write-downs would disappear. The result is that if TTWO used EA’s approach, 2018 expenses would increase by $249,022 ($326,909 – 77,887). Net income would decrease by $186,766.5 [$249,022 X (1-0.25)] in 2018.

C8-43. (20 minutes) LO 4 a. DreamWorks would have recorded a pretax profit of $10.6 million for 2014. [($86.26 million) + $66.5 million + $30.3 million] = $10.6 million. b. DreamWorks capitalizes film production costs and amortizes them over the life of the film, meaning over the time period of the expected revenue stream. The unamortized asset (that is, the unamortized capitalized costs) have to be tested for impairment each reporting period. c. Loss due to impairment (+E, -RE) Mr. Peabody and Sherman (-A) The Penguins of Madagascar (-A)

96.8 million 66.5 million 30.3 million

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Financial Accounting, 6th Edition

Chapter 9 Reporting and Analyzing Liabilities Learning Objectives – coverage by question MiniExercises

Exercises

Problems

18, 19, 21, 25, 33

38 - 40, 43

51, 59

LO2 – Describe and account for current nonoperating (financial) liabilities.

20, 21

49

LO3 – Explain and illustrate the pricing of long-term nonoperating liabilities.

22, 31, 32, 34 - 37

41, 42, 44 - 48, 50

52 - 58

60, 61

LO4 – Analyze and account for financial statement effects of longterm nonoperating liabilities.

20, 23, 24, 26 - 29, 34 - 36

41, 44 - 50

51 - 58

60, 61

LO1 – Identify and account for current operating liabilities.

LO5 – Explain how solvency ratios and debt ratings are determined and how they impact the cost of debt.

22, 30

Cases and Projects

60, 61

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QUESTIONS Q9-1.

Current liabilities are obligations that require payment within the coming year or operating cycle, whichever is longer. Generally, current liabilities are normally settled with use of existing current assets or operating cash flows.

Q9-2.

If a company fails to take a cash discount that is offered by a supplier, it is effectively paying a penalty for taking additional time to pay the account payable. Depending on the size of the discount, this penalty (an implicit interest rate) can be quite high. The net-of-discount method records the inventory at the purchase cost less the discount. If the discount is lost, the extra cost is treated as part of interest expense for the period. This has two benefits: (1) the lost discount is not capitalized as part of the cost of inventory, and (2) the lost discount is highlighted, which is useful information that may be helpful in managing accounts payable.

Q9-3.

An accrual is the recognition of an event in the financial statements even though no actual transaction has occurred. Accruals can involve both liabilities (and expenses) and assets (and revenues). Accruals are vital to the fair presentation of the financial condition of a company as they impact both the recognition of revenue and the matching of expense.

Q9-4.

The coupon rate is the rate specified on the face of the bond. It is used to compute the amount of cash interest paid to the bond holder. The market rate is the rate of return expected by investors that purchase the bonds. The market rate determines the market price of the bond. It incorporates expectations about the relative riskiness of the borrower and the rate of inflation. In general, there is an inverse relation between the bond’s market rate and the bond’s market price.

Q9-5.

Bonds sold at face (par) value earn an effective interest rate equal to the bonds’ coupon rate. Bonds are sold at a discount when the effective interest rate is higher than the coupon rate. Bonds are sold at a premium when the effective interest rate is lower than the coupon rate.

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Financial Accounting, 6th Edition

Q9-6.

Bonds are reported at historical cost, that is, the face amount plus (minus) unamortized premium (discount). The market price of the bonds varies inversely with the level of interest rates and fluctuates continuously. Differences between the market price of a bond and its carrying amount represent unrealized gains and losses. These unrealized gains (losses) are not reflected in the financial statements (although they are disclosed in the footnotes). They must be recognized upon repurchase of the bonds, the point at which they become “realized.” If the bonds are refunded (that is, replaced with new bonds reflecting current market values and interest rates), the gain (or loss) that is recognized in the current period will be offset by correspondingly higher (lower) interest payments in the future. The present value of the future interest payments, along with the present value of the difference between the face amount of the new bond and the former face amount, exactly offset the reported gain (loss).

Q9-7.

Debt ratings reflect the relative riskiness of the borrowing company. This riskiness relates to the probability of default (e.g., not repaying the principal and interest when due). Higher (greater quality) debt ratings result in higher market prices for the bonds and a correspondingly lower effective interest rate for the issuer. Lower (lesser quality) debt ratings result in lower market prices for the bonds and a correspondingly higher effective interest rate for the issuer.

Q9-8.

Reported gains or losses on bond redemption result from changes in the market price of the bonds and the use of historical cost accounting. Because bonds are typically reported at historical cost, fluctuations in bond prices are not recognized until they are realized when the bonds are redeemed or refunded. If the bonds are refunded (new bonds are issued), the gain or loss is offset by the present value of lower (higher) future interest payments on the new bond issue. (If the liabilities are reported at fair value, the gain or loss is the difference between the last reported fair value and the sales price (assuming all the fair value changes were recorded in income – meaning were not due to instrument-specific credit risk changes.)

Q9-9.

(a) Bonds payable – the liability account used to record the face value of bonds issued by a company (b) Call provision – the right for the bond issuer to repurchase the debt, before it matures, at a predetermined price. (c) Face value – the predetermined amount (typically $1,000) that must be repaid when a bond matures (d) Coupon rate – the rate specified on the face of the bond that determines the periodic interest (coupon) payment (e) Bond discount – the difference between the face value of the bond and the market price when the price is lower than the face value; recorded as a contra-liability

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(f) Bond premium – the difference between the market price of a bond and the face value when the market price is higher than the face value; recorded as an adjunct-liability (g) Amortization of premium or discount – the periodic reduction of the balance in the premium or discount account recorded each time interest expense is accrued; equal to the difference between the accrued interest and the coupon payment (or payable) Q9-10. The advantages of issuing bonds are (1) the interest payments are limited to the predetermined amount specified on the bond; (2) the interest is tax deductible; (3) bondholders do not have a vote when it comes to electing directors and managing the company; (4) the additional financial leverage created when bonds are issued increases profits in good years. The disadvantages of bonds include (1) bonds must be repaid while common stock is issued with an indefinite life; (2) bondholders can impose restrictive covenants in the loan indenture; (3) the additional financial leverage created when bonds are issued decreases profits in lean years. Q9-11. $3,000,000 x [.98 + (.09 x 3/12)] = $3,007,500 Q9-12. The contract rate (or stated rate or coupon rate) determines the periodic coupon payment. If this rate is not equal to the rate required by the market, the bond price is adjusted to the present value of the cash payments from the bond discounted at the applicable market rate of interest. If the market rate is higher than the coupon rate, then the periodic coupon payments are insufficient and the bond will be priced lower than the face value (a discount). If the market rate is lower than the coupon rate, then the periodic coupon payments will be higher than required by the market, and the bond will sell for a premium. Q9-13. When the bonds mature, the book value of the bonds will be equal to the face value. Over the life of the bonds, the change in the book value of the bonds will be equal to face value less the market value at the time that the bonds are issued. Q9-14. When the effective interest method is used to amortize a bond discount or premium, the effective rate is multiplied by the net balance in bonds payable (bonds payable plus/minus the premium or discount). If the bond is issued at a discount, the balance increases over the life of the bond; the interest expense will increase as the balance increases. If the bond is issued at a premium, the balance decreases over the life of the bond; the interest expense will decrease as the balance decreases.

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Financial Accounting, 6th Edition

Q9-15. Bonds payable is presented in the balance sheet net of any discount or plus any premium. Q9-16. The loss is the difference between the retirement value and the book value of the bond: (101% x $200,000) – $197,600 = $4,400. Q9-17. Each payment includes both interest on the outstanding balance and repayment of the principal. As each payment is made, the principal balance is reduced. As a consequence, the interest component of the payment is smaller each period.

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MINI EXERCISES M9-18. (15 minutes) LO 1 a. 11/15

11/23

Inventory (+A) Accounts payable (+L)

6,076

Accounts payable (-L) Cash (-A)

6,076

6,076

6,076

$6,076 = $6,200 x 0.98

b. + 11/15

Inventory (A) 6,076

-

11/23

+

Cash (A)

Accounts Payable (L) 6,076 6,076

+ 11/15

6,076

11/23

c. [($6,200 - $6,076)/$6,076] x [365/(30-10)] = 37.25%. (With interest compounding, the annual rate of interest r can be solved from (1+r)(20/365)=1.02. The value that solves this relationship is r = 43.5%.)

M9-19. (15 minutes) LO 1 a. 1/20

2/15

Inventory (+A) Accounts payable (+L)

12,250

Accounts payable (-L) Interest expense, discounts lost (+E, -SE) Cash (-A)

12,250 250

12,250

12,500

$12,250 = $12,500 x 0.98

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Financial Accounting, 6th Edition

b. +

Inventory (A) 12,250

1/20

-

2/15

+

Cash (A)

12,500

Accounts Payable (L) 12,250 12,250

+ 1/20

+ Interest Expense, Discounts Lost (E) 2/15 250

2/15

-

c. [($12,500- $12,250)/$12,250] x [365/(60-15)] = 16.55%. (With interest compounding, the annual rate of interest r can be solved from (1+r)(45/365)=1.02. The value that solves this relationship is r = 17.4%.)

M9-20. (10 minutes) LO 2 a. Interest expense (+E,-SE)…………………… Interest payable (+L)…………………….

24 24

$7,200 × 8% × (15/365) = $24

b. -

Interest Payable (L)

+

24

+

a.

a.

Interest Expense (E)

-

24

c. Balance Sheet Transaction Accrued $24 interest on note payable

Cash Asset

+

Noncash Assets

Liabilities +24 = Interest Payable =

+

Income Statement Contrib. Capital +

Earned capital -24 Retained Earnings

Revenues

- Expenses +24 Interest Expense

Net = Income -24 =

M9-21. (15 minutes) LO 1, 2 a. Accounts Payable, $110,000 (current liability). b. Not recorded as a liability; an accountable transaction has not yet occurred. c. Estimated liability for product warranty, $2,200 (current liability). d. Bonuses Payable, $30,000 (current liability)—computed as $600,000  5%. This liability must be reported since its payment is “probable” and can be “estimated.” ©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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M9-22. (10 minutes) LO 3, 5 a. Microsoft is offering bonds with a coupon (stated) rate of 3.3%% when the market rate (yield) is higher (3.383%). In order to obtain this expected rate of return, the bonds sell at a discount price of 99.31 (99.31% of par). b. The first bond matures in 2027 while the second matures in 2057. There is, generally, a higher rate (yield) expected for a longer maturity.

M9-23. (10 minutes) LO 4 Amount paid to retire bonds ($400,000 x 102%).............................................. Book value of retired bonds, net of $3,000 unamortized discount ................... Loss on bond retirement ..................................................................................

$408,000 397,000 $ 11,000

M9-24. (10 minutes) LO 4 a. The $3,546 million of debt that is due in 2018 is already listed as the current portion of long-term debt in Pfizer’s current liabilities. b. Pfizer will need to pay off the bonds when they mature. This will result in a cash outflow that must come from operating activities if the bonds cannot be refinanced prior to maturity. However, most of Pfizer’s long-term debt matures more than 5 years after the financial statement date (December 31, 2017). Thus, Pfizer’s nearterm cash needs for covering long-term debt should not place a significant burden on the company’s operations.

M9-25 (10 minutes) LO 1 a. Gain on Bond Retirement: In the other (nonoperating) income and expenses section of the income statement. b. Discount on Bonds Payable: Deduction from Bonds Payable; thus, a (contra) long-term liability in the balance sheet (e.g., it is netted in the presentation of long-term liabilities). c. Mortgage Notes Payable: Long-term liability in the balance sheet. d. Bonds Payable: Long-term liability in the balance sheet.

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e. Bond Interest Expense: In other (nonoperating) income and expenses section of the income statement. f. Bond Interest Payable: Current liability in the balance sheet. g. Premium on Bonds Payable: Addition to Bonds Payable; thus, part of a long-term liability in the balance sheet (e.g., it is included in the presentation of long-term liabilities). h. Loss on Bond Retirement: In the other (nonoperating) income and expenses section of the income statement.

M9-26. (10 minutes) LO 4 a. Restrictive loan covenants are typically designed to protect the bond holders against actions by management that they feel would be detrimental to their interests. These covenants might include restrictions against the impairment of liquidity, restrictions on the amount of financial leverage the company can employ, and restrictions on the payment of dividends. In addition, bond holders usually impose various covenants prohibiting the acquisition of other companies or the divestiture of business segments without their consent. All of these covenants, by design, restrict management in its actions. b. Management, facing imminent violation of one or more of its bond covenants, may be pressured into taking actions in order to avoid default. These may include, for example, foregoing profitable investments, reduction of discretionary spending such as R&D or advertising in order to improve profitability, missing opportunities to take cash discounts and other methods of “leaning on the trade,” or reduction of receivables (via early payment incentives) and inventories (by marketing promotions or delaying restocking) in order to boost cash balances. Actions may also include questionable accounting measures, such as improper recognition of revenues or delayed recognition of expenses. c. When evaluating solvency, analysts should compare a company’s position relative to its restrictive covenants. A company may appear solvent, but in fact may be in close proximity to a restrictive covenant. Also, analysts should be aware of the potential effect that restrictive covenants can have on management decisions (see the answer to requirement b). Restricted assets, such as cash or securities, should not be considered as general assets in an analysis of the firm’s liquidity or solvency because they are not available to management for general corporate uses.

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M9-27. (15 minutes) LO 4 a. 1/1/2013

1/1/2019

Cash (+A) ……………………………………..... Bonds payable (+L) ………………..…… Bond premium (+L) ………………..……

432,000

Bonds payable (-L) ………………………..….. Bond premium (-L) ……………………..…….. Cash (-A) ………………………………..... Gain on retirement of bonds (+R, +SE)

400,000 27,809

400,000 32,000

412,000 15,809

b. + 1/1/13

-

Cash (A) 432,000 412,000

-

-

1/1/19

1/1/19

Gain on Retirement of Bonds (R) + 15,809 1/1/19

1/1/19

Bonds Payable (L) 400,000 400,000

+

Bond Premium (L) 32,000 27,809

+

1/1/13

1/1/13

c. Balance Sheet Transaction 1/1/13 Issue bonds at a premium.

Cash Asset

Noncash + Assets

432,000

=

Liabilities

=

+400,000

Cash

Income Statement Contrib. + Capital +

Earned Capital

Revenues

-

Expenses

Net = Income

-

=

-

= +15,809

Bonds Payable +32,000 Bond Premium

1/1/19 -412,000 Retired Cash bonds issued on 1/1/13.

=

-400,000

+15,809

+15,809

Bonds Payable

Retained Earnings

Gain on Retirement of Bonds

-27,809 Bond Premium

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Financial Accounting, 6th Edition

M9-28. (15 minutes) LO 4 a. 7/1/2012

7/1/2019

Cash (+A) ……………………………………. Bond discount (+XL, -L) …………….….…. Bonds payable (+L) …………………..

240,000 10,000 250,000

Bonds payable (-L) ………………………… Loss on retirement of bonds (+E, -SE) … Bond discount (-XL, +L) ……….…… Cash (-A) ……………………………….

250,000 9,314 6,814 252,500

b. + 7/1/12

Cash (A) 240,000 252,500

7/1/19

Bonds Payable (L) 250,000 250,000

7/1/19

+ Loss on Retirement of Bonds (E) 7/1/19 9,314

+ 7/1/12

Bond Discount (XL) 10,000 6,814

+ 7/1/12

7/1/19

c. Balance Sheet Transaction 7/1/12 Issue bonds at a discount

Cash Asset

+

Noncash Assets

+240,000

= Liabilities =

Cash

7/1/19 Retired -252,500 bonds issued Cash on 7/1/12

=

-

Income Statement

Contra Liability +

Contrib. Earned Capital + Capital

+250,000

+10,000

Bonds Payable

Bond Discount

-250,000

-6,814

-9,314

Bonds Payable

Bond Discount

Retained Earnings

Revenues

- Expenses = -

-

=

+9,314

=

Loss on retirement of Bonds

M9-29. (10 minutes) LO 4 Nissim:

$18,000  0.10  40/365

=

$197.26

Klein:

$14,000  0.09  18/365

=

62.14

Bildersee:

$16,000  0.12  12/365

=

63.12 $322.52

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Net Income

1-147

-9,314

M9-30. (10 minutes) LO 5 a. Unless there has been a decline in the General Mills’ operating liabilities, the Debtto-Equity ratio (D/E) will increase. The net effects of financing cash flows are to increase financial liabilities and decrease shareholders’ equity. (although net income would then increase equity, but still by an amount less than the increase in debt). Times interest earned will likely decrease as additional interest cost on new borrowing is added to the denominator. How much of an effect this will have depends on the size of the change in net income. b. Generally, the higher (lower) the firm's solvency measures, the higher (lower) the firm's debt rating. In financial leverage terms, the higher (lower) the firm's leverage the lower (higher) the firm's debt rating. Increasing the amount of debt while decreasing equity may harm General Mills’ debt ratings, though increases in operating results , could support additional financial liabilities.

M9-31. (15 minutes) LO 3 a. Selling price of 9% bonds discounted at 8% Present value of principal repayment ($500,000  0.45639) Present value of interest payments ($22,500  13.59033) Selling price of bonds

$228,195 305,782 $533,977

b. Selling price of 9% bonds discounted at 10% Present value of principal repayment ($500,000  0.37689) Present value of interest payments ($22,500  12.46221) Selling price of bonds

$188,445 280,400 $468,845

M9-32. (15 minutes) LO 3 a. Selling price of zero-coupon bonds discounted at 8%: Present value of principal repayment ($500,000  0.45639)

$228,195

b. Selling price of zero coupon bonds discounted at 10%: Present value of principal repayment ($500,000  0.37689)

$188,445

c. Based on the debt-to-equity ratio, financial leverage would increase from 2.0 [=($3 $1)/$1] to 2.19 [=($3 - $1 + $0.188)/$1)

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Financial Accounting, 6th Edition

M9-33. (15 minutes) LO 1 a. Month Income statement: Revenue Cost of goods sold Operating expenses Income Operating cash flows Receipts Payments to suppliers Payments for operating expenses Net cash flow from operations

1

2

3

4

$420 300 110 $10

$420 300 110 $10

$420 300 110 $10

$420 300 110 $10

$420 300 110 $10

$420 300 110 $10

$420 300 110 $10

$420 300 110 $10

1

2

3

4

$420 300 110 $10

$420 300 110 $10

$420 300 110 $10

$420 300 110 $10

$420 0 110 $310

$420 300 110 $10

$420 300 110 $10

$420 300 110 $10

b. Month Income statement: Revenue Cost of goods sold Operating expenses Income Operating cash flows Receipts Payments to suppliers Payments for operating expenses Net cash flow from operations

The CFO’s proposal would increase the cash generated by operations, but only for one month. Then the cash flows would revert to their original pattern. Therefore, “leaning on the trade,” (deferring payables) is not likely to produce a steady source of cash for expansion of the business.

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M9-34. (30 minutes) LO 3, 4

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Financial Accounting, 6th Edition

M9-35. (15 minutes) LO 3, 4 a. Gain on bond retirement

Reported in the income statement under other (nonoperating) income

b. Discount on bonds payable

Contra-liability netted against bonds payable under long-term liabilities in the balance sheet

c. Mortgage notes payable

Long-term liability in the balance sheet; the amount due within one year would be reported as a current liability

d. Bonds payable

Long-term liability in the balance sheet; the amount due within one year would be reported as a current liability

e. Bond interest expense

Nonoperating expense reported in the income statement

f. Bond interest payable

A current liability in the balance sheet

g. Premium on bonds payable

Adjunct-liability added to bonds payable under long-term liabilities in the balance sheet

M9-36. (15 minutes) LO 3, 4 a. 12/31/18

6/30/19

12/31/19

Cash (+A) …………………………………….. Mortgage note payable (+L) …………..

700,000

Interest expense (+E, -SE) ……………………. Mortgage note payable (-L) …………………… Cash (-A) …………………………………..

42,000 8,854

Interest expense (+E, -SE) …………………… Mortgage note payable (-L) ………………….. Cash (-A) ………………………………….

41,469* 9,385

700,000

50,854

50,854

* $41,469 = ($700,000 – $8,854) x 12%/2.

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b. + 12/31/18

Cash (A) 700,000

50,854 50,854

+ 6/30/19 12/31/19

Interest Expense (E) 42,000 41,469

-

6/30/19 12/31/19

Mortgage Note Payable (L) + 700,000 12/31/18 6/30/19 8,854 12/31/19 9,385

-

c. Balance Sheet Transaction 12/31/18 Borrow $700,000 on a 15-year mortgage note payable.

Cash Asset

+

Noncash Assets

+700,000

= Liabilities +

-50,854

12/31/19 Interest payment on note.

-50,854

Earned Capital

Revenues

-

Expenses

-

Net = Income =

Mortgage Note Payable

=

Cash

Cash

Contrib. Capital +

= +700,000

Cash

6/30/19 Interest payment on note.

Income Statement

=

-8,854

-42,000

Mortgage Note Payable

Retained Earnings

-9,385

-41,469

Mortgage Note Payable

Retained Earnings

-

+42,000

= -42,000

Interest Expense -

+41,469

= -41,469

Interest Expense

M9-37. (5 minutes) LO 3 $900,000 x 0.55839 + [(900,000 x 10%/2) x 7.36009] = $833,755. $833,755 / $900,000 = 92.6% of par value.

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Financial Accounting, 6th Edition

EXERCISES E9-38. (15 minutes) LO 1 a. Total expected failures from units sold in the current period .............

1,380*

Average cost per failure ...................................................................... Total expected warranty costs for current period sales ......................

 $50 $ 69,000

Plus beginning warranty liability..........................................................

$ 30,000

Minus warranty services provided ...................................................... Ending warranty liability ......................................................................

$ 27,000 $ 72,000

*(69,000 x 0.02)

The product warranty liability must be increased by $69,000 to cover the expected repair costs of products sold during the period, and that amount would be recognized as expense. With the opening liability balance of $30,000 and warranty services provided of $27,000, the ending liability balance would be $72,000. b. The warranty liability should be equal, at all times, to the expected dollar cost of future repairs. Waymire Company should conduct an analysis similar to an aging of accounts to determine which products are still under warranty and what the expected cost will be. That estimate will provide the correct value for the warranty liability and determines any required adjustments in the period’s warranty expense. Analysis issues relate to whether the warranty liability exists and, if so, whether it is at the correct amount. Understating (overstating) the accrual overstates (understates) current period income at the expense (benefit) of future income. c. The debt-to-equity ratio will increase and the operating cash flow to liabilities will decrease. The times-interest earned ratio will decrease, because the increase in liability causes an increase in warranty expense, which decreases earnings before interest and taxes.

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E9-39. (10 minutes) LO 1 Item

Accounting Treatment

a.

Neither record nor disclose (neither probable nor reasonably possible)

b.

Record a current liability for the note, no liability for interest until incurred as time passes.

c.

Disclose in a footnote (at least reasonably possible) (Also, if Shevlin is an SEC registrant and the amount is material, the line item “Commitment and contingencies” may need to be shown on the face of the balance sheet, with no associated amounts for that line item.)

d.

Record warranty liability on balance sheet and recognize expense in income statement (costs are probable and reasonably estimable).

E9-40. (15 minutes) LO 1 The company must accrue the $25,000 of wages that have been earned by employees even though these wages will not be paid until the first of next month. The required accounting accrual will: • Increase wages payable by $25,000 on the balance sheet • Increase wages expense by $25,000 in the income statement Failure to make this accounting accrual (called an adjusting entry) would understate liabilities, understate expenses, overstate income, and overstate stockholders’ equity.

E9-41. (15 minutes) LO 3, 4 a. Selling price of bonds: Present value of principal repayment ($300,000  0.30832) Present value of interest payments ($16,500  17.29203) Selling price of bonds

$ 92,496 285,318 $377,814

b. 1/1/19

6/30/19

Cash (+A) …………………………………….. Bond premium (+L) …………………… Bonds payable (+L) ……………...…… Interest expense (+E, -SE) ………………… Bond premium (-L) ……………...………….. Cash (-A) ………………………………..

377,814 77,814 300,000 15,113 1,387 16,500

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Continued next page

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b. continued 12/31/19 Interest expense (+E, -SE) ………………… Bond premium (-L) …………………………. Cash (-A) ………………………………..

15,057 1,443 16,500

$15,057 = ($377,814 – $1,387) x 8%/2.

c. + 1/1/19

Cash (A) 377,814

16,500 16,500

+ 6/30/19 12/31/19

Interest Expense (E)

-

Bonds Payable (L) 300,000

+

Bond Premium (L) 77,814 1,387 1,443

+

1/1/19

6/30/19 12/31/19 -

-

15,113 15,057

6/30/19 12/31/19

1/1/19

d. Balance Sheet Transaction 1/1/19 Issue bonds at a premium.

Cash Asset

+

Noncash Assets =

Liabilities

=

+300,000

+377,814 Cash

Income Statement +

Contrib. Capital +

Earned Capital

Revenues

Net - Expenses = Income -

=

Bonds Payable

+77,814 Bond Premium 6/30/19 Interest payment on bonds.

-16,500

12/31/19 Interest payment on bonds.

-16,500

=

Cash

Cash

=

-1,387

-15,113

Bond Premium

Retained Earnings

-1,443

-15,057

Bond Premium

Retained Earnings

-

+15,113

= -15,113

Interest Expense

-

+15,057

= -15,057

Interest Expense

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Financial Accounting, 6th Edition

E9-42. (10 minutes) LO 3 Selling price of bonds Present value of principal repayment ($900,000  0.44230) Present value of interest payments ($49,500  9.29498) Selling price of bonds

$398,070 460,102 $858,172

E9-43. (15minutes) LO 1 a. Additions to the Warranty provision would be reflected in Warranty expense. Warranty expense (+E, -SE) ………………………. Warranty provision (+L)……………………

1,786 1,786

b. Usage of the warranty provision would reflect Siemens providing warranty services to its customers. The provision liability would be reduced, as would balances in cash and perhaps inventory reflecting the resources needed for the warranty work. Warranty provision (-L) …………………………….. Cash or inventory (-A)…………………….

993 993

c. It can be useful to report the additions and reversals separately for a couple of reasons. First, the reversals would reflect past periods’ errors in estimates, while the additions could reflect the expected cost of providing warranty service for sales made in the current period. In addition, it may provide insights into whether Siemens tends to be systematically optimistic or pessimistic in its estimates. The numbers reported indicate that Siemens tends to overestimate its warranty expenses. d. 2018: €1,786/€83,044 = 2.15% 2017: €1,820/€82,863 = 2.20% Warranty expense appears to have increased in 2014 as a percentage of sales revenue.

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E9-44. (15 minutes) LO 3, 4 a. Cash (+A) ………………………………………... Bonds payable (+L) ……………………….

500,000

10/31/18 Interest expense (+E, -SE) ……………………. Cash (-A) …………………………………...

22,5001

Bonds payable (-L) ……………………………... Loss on retirement of bonds (+E, -SE) ………. Cash (-A) ……………………………………

300,000 3,000

5/1/18

11/1/19

500,000

22,500

303,0002

1

$500,000 x 0.09 x 1/2 = $22,500 interest expense. Because the bonds were sold at par, there is no discount or premium amortization.

2

Cash required to retire $300,000 of bonds at 101 = $300,000 x 1.01 = $303,000. The difference between the cash paid and the carrying amount of the bonds is the gain or loss on the redemption. In this case, the loss is $3,000. This calculation assumes that the interest was paid on 10/31/19, so accrued interest is not recorded.

b. + 5/1/18

Cash (A) 500,000

-

22,500 303,000 + 10/31/18

Interest Expense (E) 22,500

10/31/18 11/1/19 -

11/1/18

Bonds Payable (L) 500,000

+ 5/1/18

300,000

+ Loss on Retirement of Bonds (E) 11/1/18 3,000

c. Balance Sheet Transaction 5/1/18 Issue bonds.

Cash Asset

+

Noncash Assets = Liabilities +

+500,000

-22,500

11/1/19 Early retirement of bonds.

-303,000

Earned Capital

Revenues

- Expenses

=

-

=

Net Income

Bonds Payable =

-22,500

Cash

Cash

Contrib. Capital +

= +500,000

Cash

10/31/18 Interest payment on bonds.

Income Statement

-

Retained Earnings = -300,000 Bonds Payable

-3,000 Retained Earnings

+22,500

=

-22,500

=

-3,000

Interest Expense -

+3,000 Loss on Retirement of Bonds

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Financial Accounting, 6th Edition

E9-45. (25 minutes) LO 3, 4 a. Selling price of bonds Present value of principal repayment ($250,000  0.41552) Present value of interest payments ($10,000  11.68959) Selling price of bonds

$103,880 116,896 $220,776

b. 1/1/19

6/30/16

Cash (+A) ………………………………………. Bond discount (+XL, -L) ……………………… Bonds payable (+L) ……………………..

220,776 29,224

Interest expense (+E, -SE) …………………… Bond Discount (-XL, +L) ………….……. Cash (-A) …………………………………..

11,039

250,000 1,039 10,000

$11,039 = $220,776  0.05

12/31/19 Interest expense (+E, -SE) …………………. Bond Discount (-XL, +L) …………….…. Cash (-A) …………………………………..

11,091 1,091 10,000

$11,091 = [$220,776 + $1,039]  0.05

c. +

Cash (A) 220,776 10,000 10,000

1/1/19

+

-

-

+ 1/1/19

6/30/19 12/31/19

Interest Expense (E)

6/30/19 12/31/19

Bonds Payable (L) 250,000

-

+ 1/1/19

Bond Discount (XL) 29,224 1,039 1,091

11,039 11,091

6/30/19 12/31/19

d. Balance Sheet Transaction

Cash Asset

+

Noncash Assets

= Liabilities =

-

Income Statement

Contra Contrib. Liability + Capital +

+220,776

6/30/19 Interest payment on bonds.

-10,000

-1,039

-11,039

+11,039

Cash

Bond Discount

Retained Earnings

Interest Expense

12/31/19 Interest payment on bonds.

-10,000

-1,091

-11,091

Bond Discount

Retained Earnings

Cash

=

+29,224

Bonds Payable

Bond Discount

Revenues - Expenses

1/1/19 Issue bonds at a discount.

Cash

+250,000

Earned Capital

-

-

Net = Income =

-11,039

+11,091

= -11,091

Interest Expense

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Financial Accounting, 6th Edition

E9-46. (25 minutes) LO 3, 4 a. Selling price of bonds: Present value of principal repayment ($800,000  0.20829) Present value of interest payments ($36,000  19.79277) Selling price of bonds

$166,632 712,540 $879,172

b. Cash (+A) ………………………………………... Bond premium (+L) ……………………… Bonds payable (+L) ………………………

879,172

6/30/19 Interest expense (+E,-SE) ……………………. Bond premium (-L) …………….……………… Cash (-A) …………………………………..

35,167 833

1/1/19

79,172 800,000

36,000

$35,167 = $879,172 x 0.04

12/31/19 Interest expense (+E,-SE) ……………………. Bond premium (-L) …………….……………… Cash (-A) …………………………………..

35,134 866 36,000

$35,134 = ($879,172 - $833) x 0.04

c. + 1/1/19

Cash (A) 879,172

36,000 36,000

+ 6/30/19 12/31/19

Interest Expense (E) 35,167 35,134

-

Bonds Payable (L) 800,000

+ 1/1/19

Bond Premium (L) 79,172 6/30/19 833 12/31/19 866

+ 1/1/19

6/30/19 12/31/19 -

-

d. Balance Sheet Cash Noncash Transaction Asset + Assets = 1/1/19 +879,172 = Issue Cash bonds at a premium.

6/30/19 Interest payment on bonds. 12/31/19 Interest payment on bonds.

Liabilities +800,000 Bonds Payable +79,172 Bond Premium

Income Statement +

Contrib. Capital +

Earned Capital

Revenues

-

Expenses

= =

Net Income

-36,000 Cash

=

-833 Bond Premium

-35,167 Retained Earnings

-

+35,167 Interest Expense

=

-35,167

-36,000 Cash

=

-866 Bond Premium

-35,134 Retained Earnings

-

+35,134 Interest Expense

=

-35,134

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Financial Accounting, 6th Edition

E9-47. (20 minutes) LO 3, 4 a. There is an inverse relation between interest rates and bond prices (examine the increasing discount rates as the yield increases in present value tables). Since the bonds now trade at a premium and assuming that Deere’s credit ratings have not changed, we can conclude that interest rates have fallen since the bonds were issued. b. No, once the bond is initially recorded, neither the coupon rate nor the yield used to compute interest expense is changed. Bonds are recorded at historical cost (like most other balance sheet assets and liabilities). As a result, changes in the general level of interest rates have no effect on interest expense (or the interest payment) that is reflected in the financial statements. c. Because the bonds trade at a premium in the market, Deere would be paying more to retire the bonds than the amount at which they are carried on its balance sheet. This would result in a loss on the repurchase that would lower current profitability. d. The face amount of the bonds will be paid at maturity. As a result, the market price of the bonds must also equal their face amount ($200 million) at that time.

E9-48. (25 minutes) LO 3 4 a. Selling price of bonds Present value of principal repayment ($600,000  0.09722) Present value of interest payments ($33,000  15.04630) Selling price of bonds

$ 58,332 496,528 $554,860

b. 1/1/19

Cash (+A) …………………………………….. Bond discount (+XL, -L) ………………..…… Bonds payable (+L) ……………………

554,860 45,140 600,000

6/30/19 Interest expense (+E, -SE) …………………. Bond discount (-XL, +L) ………………. Cash (-A) …………………………………

33,292 292 33,000

$33,292 = $554,860  .06.

12/31/19 Interest expense (+E, -SE) ………………… Bond discount (-XL, +L) …………….…. Cash (-A) ………….…………………….

33,309 309 33,000

$33,309 = ($554,860 + $292)  0.06.

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c. + 1/1/19

+ 6/30/19 12/31/19

Cash (A) 554,860 33,000 33,000 Interest Expense (E)

-

-

Bonds Payable (L) 600,000

+ 1/1/19

Bond Discount (XL) 45,140 292 309

+ 1/1/19

6/30/19 12/31/19 -

33,292 33,309

6/30/19 12/31/19

d. At December 31, 2019 (after the coupon payment recorded in b), the book value of the bonds would be $554,860 + $292 + $309 = $555,461. The market value would be $600,000 X 1.01 = $606,000. Thus, a fair value adjustment of $50,539 (=$606,000-$555,461) would be recorded as follows: 12/31/19 Loss due to adjustment of bonds to fair value +E, -SE) Fair value adjustment (+L)

50,539 50,539

The loss would be reported in net income for the period. e. Coupon payments ($33,000 X 2) Discount amortization ($292 + $309) Total interest expense Fair value adjustment (loss) Total effect on income (deduction)

$ 66,000 601 66,601 50,539 $117,140

E9-49. (10 minutes) LO 2, 4 Current liabilities: Bond interest payable Current maturities of long-term debt: 10% bonds payable due 2019 Total current liabilities Long-term debt: 9% bonds payable due 2020, net of $19,000 discount Zero coupon bonds payable due 2021 8% bonds payable due 2023, including $2,000 premium Total long-term debt

$ 25,000 500,000 $525,000

$581,000 170,500 102,000 $853,500

©Cambridge Business Publishers, 2020 1-164

Financial Accounting, 6th Edition

E9-50. (20 minutes) LO 3, 4 a. 12/31/18 Cash (+A) …………………………………………… Mortgage note payable (+L) ……………….

500,000

Interest expense (+E, -SE) ………………………. Mortgage note payable (-L) ……………………... Cash (-A) ………………………………………

10,000 8,278

Interest expense (+E, -SE) ………………………. Mortgage note payable (-L) ……………………... Cash (-A) ………………………………………

9,834 8,444

3/31/19

6/30/19

500,000

18,278

18,278

$9,834 = ($500,000 – $8,278) x 8%/4.

b. + 12/31/18

Cash (A) 500,000

18,278 18,278

+ 3/31/19 6/30/19

Interest Expense (E) 10,000 9,834

-

3/31/19 6/30/19

Mortgage Note Payable (L) + 500,000 12/31/18 3/31/19 8,278 6/30/19 8,444

-

c. Balance Sheet Transaction 12/31/18 Borrow $500,000 on a 10-year mortgage note payable.

Cash Asset +500,000

+

Noncash Assets

= Liabilities

-18,278

6/30/19 Payment on note.

-18,278

Contrib. Capital +

Earned Capital

Revenues

-

Expenses

-

Net = Income =

Mortgage Note Payable

=

Cash

Cash

+

= +500,000

Cash

3/31/19 Payment on note.

Income Statement

=

-8,278

-10,000

Mortgage Note Payable

Retained Earnings

-8,444

-9,834

Mortgage Note Payable

Retained Earnings

-

+10,000

=

-10,000

=

-9,834

Interest Expense -

+9,834 Interest Expense

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PROBLEMS P9-51. (20 minutes) LO 1 a. -

Hewlett-Packard Enterprise Company Accrued Warranty Liability (L) + 475 17 bal. 265 18 exp. 310 430 18 bal.

-

Cisco Systems Accrued Warranty Liability (L) + 407 17bal. 582 18 exp. 630 359 18 bal.

Hewlett-Packard incurred $310 million in warranty repair costs and settlements in 2018 while Cisco Systems, Inc. incurred costs of $630 million. b. HPE’s ratio of warranty expense to sales was 1.40% in 2018 ($265/$19,504) down slightly from 1.7% in 2017 ($292/$17,597). Cisco’s ratio was 1.59% in 2018 ($582/$36,709) and 1.94% ($691/$35,705) in 2017. Cisco’s warranty expense is slightly higher relative to sales revenue than that of HPE. In general, reasons for the higher warranty expense-to-sales ratio include: (1) perhaps Cisco products require more repairs than HPE products or (2) HPE may have a less generous warranty policy than Cisco, resulting in fewer warranty repairs, even if the quality is the same. The slight decrease in HPE’s warranty expense as a percent of sales indicates that either (1) warranty costs have gone down, (2) the company overestimated warranty costs in the past and needed to record smaller than normal accruals in 2018 to correct the overestimation; or (3) HPE was building up a “cookie-jar reserve” by increasing its warranty liability in past years.

P9-52. (20 minutes) LO 3, 4 a. Cash (+A) ………………………………………….. Accrued interest payable (+L) …………… Bonds payable (+L) ………………………..

518,750 18,750 500,000

$18,750 = $500,000 x .09 x 5/12

b. Interest expense (+E, -SE)………………………. Accrued interest payable (-L) ………………….. Cash (-A) ……………………………………..

3,750 18,750 22,500

$22,500 = $500,000 x 9% x 6/12

c. Interest expense (+E, -SE) ……………………… Accrued interest payable (+L) ……………

7,500 7,500

$7,500 = $500,000 x 9% x 2/12 ©Cambridge Business Publishers, 2020 1-166

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d. Fair value adjustment (+XL, -L) ……………….. Gain from adjustment of bonds to fair value (+R, +SE) ……………………………..

5,000

e. Interest expense (+E, -SE) ……………………… Accrued interest payable (-L) ………………….. Cash (-A) ……………………………………..

15,000 7,500

Bonds payable (-L) ………………………………. Loss on retirement of bonds (+E, -SE) ………. Cash (-A) …………………………………….. Fair value adjustment (-XL, +L) … *($15,000 x 60%) = $9,000

300,000 12,000

f.

5,000

22,500

303,000 9,000*

g. If gains/losses on bond revaluations were reported in other comprehensive income rather than net income, Eskew, Inc.’s December 31, 2018 income statement would be lower because it would not include the $5,000 gain from part d above. The $5,000 gain (after accounting for expected taxes) would increase the balance in an account entitled accumulated other comprehensive income in Eskew, Inc.’s shareholders’ equity, so shareholders’ equity would be unchanged. (Such gains/losses would go through the income statement when Eskew, Inc. redeems the bonds.)

P9-53. (15 minutes) LO 3, 4 a. CVS reports interest expense of $1.04 billion, plus $8 million in capitalized interest, giving a total interest cost of $1.048 billion on average debt of $27,266.5 million ([$27,002million + $27,531million]/2) for an average rate of 3.8%. Using interest paid ($1.07 billion) instead of interest expense yields 3.92%. See the answer to c below. b. CVS reports coupon rates of 1.9% to 6.25%. In addition, no rates are reported for capital leases, mortgage notes, commercial paper, or the floating rate notes. So, the average rate seems reasonable given the information disclosed in the long-term debt footnote. c. Interest paid can differ from interest expense if bonds are sold at a premium or a discount. It can also differ because of capitalized interest. CVS reported capitalized interest of $8 million in 2017. Thus, CVS apparently amortized $22 million in net bond discounts ($1,070 million - $1,040 million - $8 million).

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Financial Accounting, 6th Edition

P9-54. (25 minutes) LO 3, 4 Cash (+A) ……………………………………. Accrued interest payable (+L) ……. Bonds payable (+L) …………………

a. 7/1/19

824,000 24,000 800,000

$24,000 = $800,000 x .09 x 4/12

Interest expense (+E, -SE) ……………..… Accrued interest payable (-L) ……………. Cash (-A) ………………………………

b. 9/1/19

12,000 24,000 36,000

$36,000 = $800,000 x 9%/2

Interest expense (+E, -SE) ………………… Accrued interest payable (+L) …….

c. 12/31/19

24,000 24,000

$24,000 = $800,000 x .09 x 4/12

d. 3/1/20

e. 3/1/20

+ a.

+ b. c. d.

Interest expense (+E) ……………………… Accrued interest payable (-L) ……………. Cash (-A) ………………………………

12,000 24,000

Bonds payable (-L) ………………………… Loss on retirement of bonds (+E, -SE) … Cash (-A) ……………………………..

200,000 2,000

Cash (A) 824,000

36,000 36,000 202,000

Interest Expense (E) 12,000 24,000 12,000

b. d. e. -

e. -

36,000

202,000 Bonds Payable (L) + 800,000

a.

200,000 Accrued Interest Payable (L) b. 24,000 24,000 d. 24,000 24,000

+ a. c.

+ Loss on Retirement of Bonds (E) e. 2,000

continued next page

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e. continued Balance Sheet Transaction a. 7/1/19 Issue bonds.

Cash Noncash Asset + Assets +824,000 Cash

= Liabilities = +800,000 Bonds Payable

+

Income Statement Contrib. Capital +

Earned Capital

Revenues

- Expenses = =

Net Income

+24,000 Interest Payable b. 9/1/19 Interest payment on bonds.

-36,000 Cash

c. 12/31/9 Accrued interest on bonds.

=

-24,000 Interest Payable

-12,000 Retained Earnings

-

+12,000 Interest Expense

=

-12,000

=

+24,000 Interest Payable

-24,000 Retained Earnings

-

+24,000 Interest Expense

=

-24,000

+12,000 Interest Expense

=

-12,000

+2,000 = Loss on Retirement of bonds

-2,000

d. 3/1/20 Interest payment on bonds.

-36,000 Cash

=

-24,000 Interest Payable

-12,000 Retained Earnings

-

e. 3/1/120 Early retirement of bonds.

-202,000 Cash

=

-200,000 Bonds Payable

-2,000 Retained Earnings

-

P9-55. (20 minutes) LO 3, 4 a. Period 0 1 2

Interest Expense

Cash Interest Paid

$40,722 $40,790

$39,600 $39,600

Discount Amortization $1,122 $1,190

Discount Balance $41,292 $40,170 $38,980

Bond Payable Net $678,708 $679,830 $681,020

$40,722 = $678,708 x 12%/2 $40,790 = $679,830 x 12%/2

b. 12/31/18 Cash (+A) ………………………………….. Bond discount (+XL) ……………………. Bonds payable (+L) ………………..

678,708 41,292

Interest expense (+E,-SE) ………………. Bond discount (-XL) ……………….. Cash (-A) ……………………………..

40,722

12/31/19 Interest expense (+E,-SE) ………………. Bond discount (-XL) ……………….. Cash (-A) ……………………………..

40,790

6/30/19

720,000 1,122 39,600 1,190 39,600

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c. + 12/31/18

Cash (A) 678,708 39,600 39,600

+

-

Bonds Payable (L) 720,000

+ 12/31/18

6/30/19 12/31/19

Interest Expense (E)

6/30/19 12/31/19

-

-

+ Bond Discount (XL) 12/31/18 41,292 1,122 1,190

40,722 40,790

6/30/19 12/31/19

d. Balance Sheet Cash Asset

Transaction

+

Noncash Assets

= Liabilities

-

Contra Contrib. Retained Liability + Capital + Earnings Revenues

12/31/18 +678,708 Issue bonds Cash at a discount.

= +720,000

+41,292

Bonds Payable

Bond Discount

6/30/19 Interest payment on bonds.

-39,600

=

12/31/19 Interest payment on bonds.

-39,600

Cash

=

Cash

Income Statement - Expenses = -

-1,122

-40,722

Bond Discount

Retained Earnings

-1,190

-40,790

Bonds Discount

Retained Earnings

-

Net Income

=

+40,722

=

-40,722

=

-40,790

Interest Expense -

+40,790 Interest Expense

P9-56. (20 minutes) LO 3, 4 a. Period 0 1 2

Interest Expense $8,271 $8,302

Cash Interest Paid

Discount Amortization

$7,500 $7,500

Discount Balance $43,230 $42,459 $41,657

$771 $802

Bond Payable Net $206,770 $207,541 $208,343

$8,271= $206,770 x 8%/2 $8,302 = $207,541 x 8%/2

b. Cash (+A) …………………….……….………..…… Bond discount (+XL, -L) …………………………. Bonds payable (+L) …….……………………

206,770 43,230

10/31/19 Interest expense (+E, -SE) ………………..….….. Bond discount (-XL, +L) ……………………. Cash(-A) ………………………………………..

8,271

4/30/19

250,000

771 7,500

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b. continued 12/31/19 Interest expense (+E, -SE) ………………..….….. Bond discount (-XL, +L) ……………………. Accrued interest payable (+L) ……………..

2,767* 267 2,500

Interest expense (+E, -SE) …………………...….. Accrued interest payable (-L) ………..….………. Bond discount (-XL, +L) ……………………. Cash(-A) ………………………………………..

4/30/20

5,535** 2,500 535 7,500

Within each six-month period, interest is apportioned to individual months on a straight-line basis:

*$2,767 = ($8,302 x 2/6) **$5,535 = ($8,302 x 4/6) c. + 4/30/19

Cash (A) 206,770

7,500 7,500

+

Bonds Payable (L) 250,000

+ 4/30/19

10/31/19 4/30/20

Interest Expense (E)

10/31/19 12/31/19 4/30/20

-

-

+ Bond Discount (XL) 4/30/19 43,230 771 267 535

8,271 2,767 5,535

10/31/18 12/31/18 4/30/20

-

Accrued Interest Payable (L) + 2,500 12/31/19 4/30/20 2,500

d. Balance Sheet Transaction 4/30/19 Issue bonds at a discount. 10/31/19 Interest payment on bonds.

Cash Asset

Noncash + Assets = Liabilities

+206,770

=

Cash

-7,500

4/30/20 Interest payment on bonds.

+43,230

Bonds Payable

Bond Discount

=

=

-7,500

=

Cash

Contra Liability

+250,000

+

Contrib. Capital +

Earned Capital

Revenues

Net - Expenses = Income -

-771

-8,271

Bond Discount

Retained Earnings

+2,500

-267

-2,767

Accrued Interest Payable

Bond Discount

Retained Earnings

-2,500

-535

-5,535

Accrued Interest Payable

Bond Discount

Retained Earnings

Cash

12/31/19 Accrued interest on bonds.

-

Income Statement

-

=

+8,271

=

-8,271

=

-2,767

=

-5,535

Interest Expense -

+2,767 Interest Expense

-

+5,535 Interest Expense

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P9-57. (20 minutes) LO 3, 4 a. Payment x 12.46221 = $500,000; Payment = $500,000/12.46221 = $40,121. b. 12/31/18

6/30/19

Cash (+A) ………………………………………..…… Mortgage note payable (+L) …………………

500,000

Interest expense (+E, -SE) ………………………… Mortgage note payable (-L) ………………………. Cash (-A) …………………………………..……

25,000 15,121

500,000

40,121

$25,000 = $500,000 x 10%/2

12/31/19

Interest expense (+E, -SE) ……………………….… Mortgage note payable (-L) ……………………….. Cash (-A) …………………………………..……

24,244 15,877 40,121

$24,244 = ($500,000 – $15,121) x 10%/2

c. + 12/31/18

+ 6/30/18 12/31/18

Cash (A) 500,000 40,121 40,121

6/30/19 12/31/19

Interest Expense (E)

-

Mortgage Note Payable (L) + 500,000 12/31/18 6/30/19 15,121 12/31/19 15,877

-

25,000 24,244

d. Balance Sheet Transaction

Cash Asset

Noncash + Assets

Contrib. = Liabilities + Capital +

12/31/18 +500,000 Borrow Cash $500,000 on a 10-year mortgage note payable.

= +500,000

6/30/19 Interest payment on note.

-40,121

=

12/31/19 Interest payment on note.

-40,121

Revenues

- Expenses

Net = Income

-

=

Mortgage Note Payable

Cash

Cash

Income Statement Earned Capital

=

-15,121

-25,000

Mortgage Note Payable

Retained Earnings

-15,877

-24,244

Mortgage Note Payable

Retained Earnings

-

+25,000

=

-25,000

=

-24,244

Interest Expense

-

+24,244 Interest Expense

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P9-58. (20 minutes) LO 3, 4 a. Payment x 16.35143 = $950,000; Payment = $950,000/16.35143 = $58,099. b. 12/31/18 Cash (+A) ………………………………………..…… Mortgage note payable (+L) ………………… 3/31/19

Interest expense (+E, -SE) ………………………… Mortgage note payable (-L) ………………………. Cash (-A) …………………………………..……

950,000 950,000 19,000* 39,099 58,099

* $19,000 = $950,000 x 8%/4

6/30/19

Interest expense (+E, -SE) ………………………… Mortgage note payable (-L) ………………………. Cash (-A) …………………………………..……

18,218* 39,881 58,099

* $18,218 = ($950,000 – $39,099) x 8%/4.

c. + 12/31/18

+ 3/31/19 6/30/19

Cash (A) 950,000 58,099 58,099

Interest Expense (E)

-

-

3/31/19 6/30/19

Mortgage Note Payable (L) + 950,000 12/31/18 3/31/19 39,099 6/30/19 39,881

-

19,000 18,218

d. Balance Sheet Transaction

Cash Asset

Noncash + Assets

= Liabilities

12/31/18 +950,000 Borrow Cash $950,000 on a 5-year mortgage note payable.

= +950,000

3/31/19 Payment on note.

-58,099

=

6/30/19 Payment on note.

-58,099

+

Earned Capital

Revenues - Expenses = -

Net Income

=

Mortgage Note Payable

Cash

Cash

Income Statement Contrib. Capital +

=

-39,099

-19,000

Mortgage Note Payable

Retained Earnings

-39,881

-18,218

Mortgage Note Payable

Retained Earnings

-

+19,000

=

-19,000

=

-18,218

Interest Expense

-

+18,218 Interest Expense

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Financial Accounting, 6th Edition

P9-59. (10 minutes) LO 1

a. BP recorded the $9.2 billion estimate as an expense on its 2010 income statement. This increased the company’s liabilities. b. If BP had prepared its financial statements in accordance with U.S. GAAP, the accrual would most likely have been at the low end of the range -- $6 million, instead of the expected amount (best reliable estimate), or mid-point in the range.

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CASES and PROJECTS C9-60. (30 minutes) LO 3, 4, 5 a. The difference between interest expense and interest paid can be caused by three factors: (1) interest capitalized as part of self-constructed assets is paid but not part of interest expense (a detailed discussion is beyond the scope of this text); (2) coupon payments differ from interest expense charged on bonds due to amortization of discounts or premiums; (3) interest payments may not coincide with the fiscal period, thus requiring the company to record accrued interest payable. b. In 2017, Comcast’s debt had a fair value of $71.7 billion while its historical cost was $64.6 billion. Thus, Comcast would report a fair value adjustment as a credit in its balance sheet of $7.1 billion ($71.7 - $64.6). In 2016, the fair value was $66.3 billion and the historical cost was $61.0 billion yielding a credit balance in the fair value adjustment account of $5.3 billion ($66.3 - $61.0). The change in the fair value adjustment from 2016 to 2017 ($1.8 = $7.1 – $5.3) would be recorded as follows: 12/31/17 Loss due to adjustment of bonds to fair value (+E, -SE) Fair value adjustment (+L)

1.8 1.8

c. Debt-to-equity: $117,500 million/$69,449 million = 1.69 Times interest earned: ($15,322 million + $3,086 million)/$3,086 million = 5.97 Creditors are naturally concerned about the risk of default. The debt-to-equity ratio measures the extent to which a company is relying on debt financing and the higher the ratio, the greater chance of default. In addition, the times interest earned ratio measures the company’s ability to pay the interest on the debt. d. Management may bypass profitable investment projects or cut discretionary expenditures such as R&D or advertising. It may also engage in questionable accounting practices in an attempt to manage the ratios. e. Note16 for Comcast discusses various contractual commitments – payment schedules for future cash outflows as a result of their contractual agreements. These are not recorded liabilities on the balance sheet, however. (We discuss these more in Chapter 10). Comcast also discusses various contingent liabilities that it may have, often as a result of litigation.

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C9-61. (20 minutes) LO 3, 4, 5 a. The gain results from the difference between the book value of the debt ($3,000,000) and the current redemption (market) value ($2,200,000). The gain would be reported in the income statement under other (nonoperating) income. The source of the gain should be adequately disclosed in the notes. b. Currently, Foster is paying 4% interest on the $3,000,000 of long-term debt, or $120,000 per year. Under the proposed refinancing, Foster would pay 8%, or $240,000. The refinancing would generate an additional $800,000 in cash. However, because interest costs are increasing by $120,000 per year ($240,000 $120,000), Foster is effectively borrowing the additional $800,000 at a rate of almost 15% ($120,000 / $800,000). As such, Foster would be paying in the future (in the form of higher interest costs) for a one-time boost in current earnings. c. The potential ethical conflict exists because Foster’s president is concerned that his job might be dependent on producing short-term earnings. Because of this, he might be tempted to accept this proposal and boost current earnings at the cost of lower earnings in future years. This thinking is misguided because, given adequate disclosure, analysts and investors would be able to identify and discount the source of the earnings boost. The most serious unethical act would be to try to hide (or obfuscate) the bond refinancing with inadequate disclosure.

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Chapter 10 Reporting and Analyzing Leases, Pensions, Income Taxes, and Commitments and Contingencies Learning Objectives – coverage by question MiniExercises

Exercises

LO1 – Define off-balance-sheet financing and explain its effects on financial analysis.

22

27

LO2 – Account for leases using the finance lease method and the operating lease method. Compare and analyze the two methods.

13 – 17

24, 26, 27

36 – 37

46

LO3 – Explain and interpret the reporting for pension plans.

18 -21

25, 30, 31

39, 40

45

LO4 – Analyze and interpret pension footnote disclosures.

19 – 21

25, 30, 31

39, 40

45

23

32 – 35

41 – 44

47, 48

28, 29

38

LO5 – Describe and interpret accounting for income taxes. LO6 – Describe disclosures regarding future commitments and contingencies. Analyze financial statements after converting offbalance sheet items to be considered on the balance sheet.

Problems

Cases and Projects

46

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Financial Accounting, 6th Edition

QUESTIONS Q10-1. Under the old lease accounting standard for an operating lease, the lessee did not record either the leased asset or the lease liability on the balance sheet, and normally charged each lease payment to rent expense. Under the new lease accounting standard, the lessee in an operating lease contract records a right-of-use asset on the balance sheet as well as a lease liability on the balance sheet. The expense is a straight-line lease expense (total cost of the lease divided by the number of lease payments). Under the old standard, the other type of lease was a capital lease and under the new standard the other type is a finance lease. The lessee accounted for a capital lease by recording the leased property as an asset and establishing a liability for the lease obligation. The leased asset was subsequently depreciated, and interest expense accrued on the lease liability. Under the new standard, the other type of a lease is a finance-type lease. The lessee records a lease asset and a lease liability on the balance sheet -- the lease asset is amortized and amortization expense is recorded, and in addition, interest expense is recorded, and the lease liability is reduced as payments are made. Q10-2. As adoption occurs, the year of adoption (and years after adoption)_ will be presented using the new standard, while prior years will likely be presented using the old standard. Thus, financial statement users will need to compute ratios for analysis after adjusting the year(s) prior to adoption to have “as-if” capitalized operating leases. For the years presented before the new leasing standard is adopted, the leasing footnote is reasonably complete to allow for capitalization of operating leases for analysis purposes. Q10-3. In general, yes. Over the term of the lease the straight-line lease expense for an operating lease will be equal to the sum of the interest and amortization on a finance lease. Only the timing of the expense recognition changes. Q10-4. Under defined contribution plans, companies and employees make contributions to the plans which, together with earnings on the amounts invested, provide the sole source of funding for payments to retirees. Under defined benefit plans, the obligations are defined with payment to be made in the future from general corporate funds. These plans may or may not be fully funded. Since the company’s obligation is extinguished upon contribution for a defined contribution plan, the accounting is relatively simple: record an expense when paid or accrued. Defined benefit plans present a number of complications in that the liability is very difficult to estimate and involves a number of critical assumptions. In addition, companies lobbied for (and the FASB agreed to) various mechanisms to smooth the impact of pension costs on reported earnings. These smoothing mechanisms further complicate the accounting for defined benefit plans vis-à-vis defined contribution plans.

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Q10-5. Although the accounting can get complicated, a net pension asset will be reported if the fair market value of the plan assets exceeds the plan obligation. Otherwise, a net liability will be reported on the balance sheet to represent the underfunding of the pension obligation. Q10-6. Service cost, interest cost and the expected return on plan investments (a reduction of the pension cost) are the basic components of pension expense. Companies might also report amortization of deferred gains and losses. Q10-7. The use of expected returns and the deferral of unexpected gains and losses act to smooth corporate earnings by removing the effects of swings in the market values of investments and variation in pension liabilities resulting from changes in actuarial assumptions or plan amendments. Q10-8. For a finance or operating lease, the initial value of the lease liability is determined by calculating the present value of the remaining lease payments. The remaining lease payments include those payments that are not subject to options or contingencies, including any guaranteed residual value. The initial right-of-use asset value for both types is the lease liability computed as just described, adjusted for some items occurring at or before the lease commencement date (e.g., add lease prepayments, subtract lease incentives, and add initial direct costs). Q10-9. Retirement benefits are normally expensed in the period in which they are earned by the employee, not when they are paid. Some benefits are calculated for periods of employment prior to the inception of a pension plan or prior to a plan amendment. The cost of these benefits (called prior service costs) is expensed by amortizing the cost over the average expected future period of employee service. Q10-10. Income tax expense is a financial accounting expense measured using accrual accounting. Thus, the expense includes the cash taxes paid but also includes accruals for future tax payments and future tax benefits that result from transactions in the current period. Q10-11. A tax payment would be recorded as a deferred tax asset or liability under two situations. First, if the company is required to make a tax payment based on a temporary difference that makes taxable income reported on the tax return higher than the income reported for financial accounting. In this case, the tax on the temporary difference would not be recorded as tax expense. Recall that tax expense is the expense related to the accounting income. For example, consider a company that receives a cash payment in advance of delivering a service. For financial accounting this is recorded as unearned revenue and not recognized as revenue until earned and thus is not in accounting earnings. However, generally for tax purposes such a payment would be included in taxable income. Thus, a cash tax payment would be required to be made on this amount. For financial accounting, this would increase current tax expense continued ©Cambridge Business Publishers, 2020 1-184

Financial Accounting, 6th Edition

but a deferred tax asset and corresponding deferred tax benefit (negative tax expense) would need to be recorded yielding a zero effect on total income tax for the year. The second situation arises when a deferred tax liability reverses. In this situation, tax expense has been recognized in excess of tax payments in prior years. When the tax return “catches up with” the income statement, the tax deferral reverses and the deferred tax liability is reduced (debited). Consider the example of depreciation discussed in the text. In the later years of the asset’s life, taxable income will be higher than book income. The cash tax payments related to that temporary difference will be recorded as current tax expense. In addition, the deferred tax liability will also be reversed along with a reduction to deferred tax expense, thus, again, the net effect on the total tax expense will be zero. Q10-12. An unrecognized tax benefit is recorded as a liability on a firm’s balance sheet (and on the income statement increases to the unrecognized tax benefit account are recorded as additional tax expense). The unrecognized tax benefit (UTB) is essentially a contingent liability. It represents management’s estimate of the amount that is more likely than not going to be owed to tax authorities in the future (e.g., upon audit) for tax positions taken to date.

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MINI EXERCISES M10-13. (35 minutes) LO 2 a. i. 1/3

Right-of-use asset – operating lease (+A) ................... Operating lease liability (+L) ...................................

57,198 57,198

$57,198 = $12,000 x 4.76654

12/31 Operating lease liability (L) .......................................... Cash (-A) ................................................................

12,000

12/31 Operating lease expense (+E) ..................................... Operating lease liability (+L) ................................... Right-of-use asset – operating lease (-A) ...............

12,000

Right-of-use lease asset – finance lease (+A) ............. Finance lease liability (+L) ......................................

57,198

12,000

4,004 7,996

ii. 1/3

57,198

$57,198 = $12,000 x 4.76654

12/31 Amortization expense – finance lease (+E, -SE).......... Accumulated amortization – finance lease (+XA) ...

9,533 9,533

$9,533 = $57,198 / 6 (note that the company could choose to credit the right-of-use asset for the finance lease directly)

12/31 Finance lease liability (-L) ............................................ Interest expense (+E, -SE) .......................................... Cash (-A) ................................................................

7,996 4,004 12,000

$4,004 = $57,198 x 0.07; $7,996 = $12,000 - $4,004

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b. Operating Lease (i): +

Cash (A) 12,000

Operating Lease Liability – (L) + 57,198 1/3 12/31 12,000 4,004 12/31

-

-

12/31

+ Right-of-use Asset (A)—Operating Lease 1/3 57,198 7,996 12/31 + Lease Expense – Operating Lease (E) 12/31 12,000

Finance Lease (ii): +

Cash (A) 12,000

-

-

Finance Lease Liability (L) 57,198 12/31 7,996

12/31

+ Right-of-use Asset (A) – Finance Lease 1/3 57,198

-

+ 12/31

- Accumulated Amortization – Finance + Lease (XA) 9,533 12/31

Interest Expense (E) 4,004

+ 1/3

-

Amortization Expense – Finance Lease (E) 12/31 9,533

+

c. Operating Lease (i): Balance Sheet Transaction

Cash Asset

Operating lease commences.

Lease payment.

Noncash + Assets +57,198 Right-of- use asset – Operating lease

-12,000 Cash

Record lease expense and changes to asset and liability.

-

Contra Assets

Income Statement

= Liabilities + = +57,198 Operating Lease Liability

-

=

-12,000 Operating Lease Liability

-7,996 Right-of-use asset – Operating lease

=

4,004 Operating Lease Liability

Contrib. Capital

+

Earned Capital

Revenues -

- Expenses = =

-

-12,000 Retained Earnings

-

=

+12,000 Lease Expense

=

continued

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Net Income

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-12,000

c. continued Finance Lease (ii): Balance Sheet Transaction Finance lease commences

Cash Asset

+

Noncash Assets +57,198 Right-ofuse asset – Finance lease

Amortization of leased asset.

-

Made annual -12,000 lease payment. Cash

-

Contra Assets

+9,533 Accum. Amortization.

= Liabilities + = +57,198 Finance Lease Liability =

=

-7,996 Finance Lease Liability

Income Statement Contrib. Capital

+

Earned Capital

Revenues

Net - Expenses = Income =

-9,533 Retained Earnings

-

+9,533 Amort. Expense

=

-9,533

-4,004 Retained Earnings

-

+4,004 Interest Expense

=

-4,004

d. The amount of interest plus amortization expense in the finance-type lease is greater early in the asset’s life than the straight-line lease expense amount under the operating lease. This is driven by the amortization portion meaning that the net rightof-use asset value on the balance sheet for an operating lease will be higher than for the finance-type lease early in the asset’s life.

M10-14. (20 minutes) LO 2 Right-of-use asset – finance lease (+A) 123,100 Finance lease liability (+L) .................................

a. 7/1

123,100

$123,100 = $4,500 x 27.35548

b. 9/30

Amortization expense (+E, -SE) Accumulated amortization (+XA, -A) ................. $3,078 = $123,100 / (10 x 4)

3,078 3,078

(note the company could directly reduce the right-of-use asset value)

9/30

Finance lease liability (-L) ....................................... Interest expense (+E, -SE) ..................................... Cash (-A) ...........................................................

2,038 2,462 4,500

$2,462 = $123,100 x (0.08/4); $2,038 = $4,500 - $2,462

12/31 Amortization expense (+E, -SE).............................. Accumulated amortization (+XA, -A) .................

3,078

12/31 Finance lease liability (-L) ....................................... Interest expense (+E, -SE) ..................................... Cash (-A) ...........................................................

2,079 2,421

3,078

4,500

$2,421 = ($123,100 - $2,038) x (0.08/4); $2,079 = $4,500 - $2,421 ©Cambridge Business Publishers, 2020 1-188

Financial Accounting, 6th Edition

c. +

+

Cash (A) 4,500 4,500

-

9/30 12/31

Right-of-use Asset – Finance Lease (A) 7/1 123,100

Finance Lease Liability (L) 123,100 2,038 2,079

9/30 12/31

+

- Accumulated Amort. – Finance lease (XA) + 3,078 9/30 3,078 12/31

9/30 12/31

Interest Expense (E) 2,462 2,421

+ 9/30 12/31

Amortization Expense (E) 3,078 3,078

+ 7/1

-

-

d. Balance Sheet Transaction

Cash Asset

7/1/20 Finance lease commences.

+

Noncash Assets

-

+123,100

-

Liabilities

=

+123,100

+3,078

=

Net - Expenses = Income -

-3,078

-

=

-2,038

-2,462

Finance

Retained Earnings

Lease Liability -

+3,078

=

-3,078

Accum. Amort.

Cash

Revenues

-

-

Retained Earnings

Cash

-4,500

Earned Capital

=

Lease Liability

Accum. Amort. -4,500

Income Statement Contrib. + Capital +

Finance

-

12/31/20 Amortization on leased asset. 12/31/20 Made quarterly lease payment.

=

Right-of-use asset – finance lease

9/30/20 Amortization on leased asset. 9/30/20 Made quarterly lease payment.

Contra Assets

-2,079

-2,421

Finance

Retained Earnings

Lease Liability

= -3,078

Amort. Expense -

+2,462

= -2,462

Interest Expense

-

Retained Earnings =

+3,078

+3,078

= -3,078

Amort. Expense -

+2,421

= -2,421

Interest Expense

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M10-15 (10 minutes) LO 2 a. Right-of-use asset – finance lease (+A)............................. Finance lease liability (+L) ......................................

74,520

b. Right-of-use asset – operating lease ................................. Operating lease liability (+L) ...................................

5,853

Operating lease liability (-L) ............................................... Cash (-A) ................................................................

1,000

74,520

5,853

1,000

M10-16. (25 minutes) LO 2 Determine the PV of the lease payments → $130,000 X 4.10020 ((or use excel or a financial calculator) = $533,026. Note: Table amounts may not compute precisely and all totals may not foot, due to rounding. a. Operating Lease Liability Amortization Schedule Date

Lease Payment

January 1, 2020 December 31, 2020 $ December 31, 2021 December 31, 2022 December 31, 2023 December 31, 2024 $

Interest on Liability

Reduction of Lease Liability $

130,000 130,000 130,000 130,000 130,000

$ $ $ $ $

650,000 $

37,312 30,824 23,881 16,453 8,505

$ $ $ $ $

92,688 99,176 106,119 113,547 121,495

116,974 $

533,026

Lease Liability 533,026 440,337 341,161 235,042 121,495 0

b. Right-of-Use Asset Amortization Schedule Date

Straight-line Expense

Interest on Liability

Amortization of Right-of-Use Asset

January 1, 2020 December 31, 2020 $ December 31, 2021 December 31, 2022 December 31, 2023 December 31, 2024

130,000 $ 130,000 130,000 130,000 130,000

37,312 $ 30,824 23,881 16,453 8,505

92,688 99,176 106,119 113,547 121,495

$

$

650,000 $

116,974 $

533,026

Right-of-Use Asset 533,026 440,338 341,161 235,043 121,496 0

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Financial Accounting, 6th Edition

c. Journal Entries January 1, 2020 Right-of-use asset – operating lease (A) ........................... Operating lease liability (L) .....................................

533,026

December 31, 2020 Operating lease Liability .................................................... Cash .......................................................................

130,000

December 31, 2020 Operating lease expense ................................................... Operating lease liability ........................................... Right-of-use asset – operating lease ...................... December 31, 2021 Operating lease liability ..................................................... Cash ....................................................................... December 31, 2021 Operating lease expense ................................................... Operating lease liability ........................................... Right-of-use asset – operating lease ......................

533,026

130,000

130,000 37,312 92,688

130,000 130,000

130,000 30,824 99,176

M10-17. (20 minutes) LO 2 Determine the PV of the payments – annuity due → $130,000 X 4.3872 (or use excel or a financial calculator) =$570,377. a. Operating Lease Liability Amortization Schedule Date

Lease Payment

Interest on Liability

Reduction of Lease Liability

January 1, 2020 January 1, 2020 $ January 1, 2021 January 1, 2022 January 1, 2023 January 1, 2024

$ 130,000 $ 130,000 130,000 130,000 130,000

$ 30,824 23,881 16,453 8,505

130,000 99,176 106,119 113,547 121,495

$

650,000 $

79,663 $

570,337

Lease Liability 570,337 440,337 341,161 235,042 121,495 0

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b. Right-of-Use Asset Amortization Schedule Date

Straight-line Expense

Interest on Liability

Amortization of Right-of-Use Asset

January 1, 2020 Year 2020 $ Year 2021 Year 2022 Year 2023 Year 2024

130,000 $ 130,000 130,000 130,000 130,000

30,824 $ 23,881 16,453 8,505 -

99,176 106,119 113,547 121,495 130,000

$

650,000 $

79,663 $

570,337

$

Right-of-Use Asset 570,337 471,161 365,042 251,495 130,000 0

c. Journal entries January 1, 2020 Right-of-use asset ................................................................ Operating lease liability .............................................

570,337

January 1, 2020 Operating lease liability ........................................................ Cash..........................................................................

130,000

December 31, 2020 Operating lease expense ..................................................... Operating lease liability ............................................. Right-of-use-asset – operating lease ........................ January 1, 2021 Operating lease liability ........................................................ Cash.......................................................................... December 31, 2021 Operating lease expense ..................................................... Operating lease liability ............................................. Right-of-use asset – operating lease ........................

570,337

130,000

130,000 30,824 99,176

130,000 130,000

130,000 23,881 106,119

M10-18 (10 minutes) LO 3 a. Pension expense (+E, -SE) ....................................................... Cash (-A) .............................................................................. $16,000 = $400,000 x 0.04

16,000 16,000

b. Bartov would report a net liability of $450,000 ($625,000 - $175,000) in its 2019 balance sheet. Because Bartov is effectively self-insured, it must report the estimated death benefit obligation net of any assets set aside to meet that obligation.

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Financial Accounting, 6th Edition

M10-19. (10 minutes) LO 3, 4 a. Exxon Mobil is reporting $2,769 million in pension expense for 2017. b. Expected returns are an offset to service and interest costs and serve to reduce reported pension expense. c. “Expected” refers to the use of long-term average returns for the investment portfolio. Expected returns are used in the computation of pension expense, rather than actual returns, in order to smooth reported income.

M10-20. (10 minutes) LO 3, 4 a. Yum! Brands is reporting $17 million of pension expense for 2017. b. Expected returns are an offset to service and interest costs and serve to reduce reported pension expense. c. “Expected” refers to the use of long-term average returns for the investment portfolio. Expected returns are used in the computation of pension expense, rather than actual returns, in order to smooth reported income.

M10-21. (10 minutes) LO 3, 4 a. A&F maintains a defined contribution plan for the benefit of its employees. b. Contributions are expensed when made. The entry to record expenses for 2014 was ($ millions): Pension expense (+E, -SE)..................................................... Cash (-A) ...........................................................................

14.4 14.4

c. Only the unpaid contribution, if any, appears on the A&F balance sheet.

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M10-22. (15 minutes) LO 1 a. The use of contract manufacturers removes the manufacturing assets and related liabilities from Nike’s balance sheet. Because sales are unaffected, PPE turnover is increased by the removal of assets. The effect on net operating profit after taxes (NOPAT) is uncertain; depreciation is removed (interest on the liabilities incurred to purchase the manufacturing assets is also removed, but this is a nonoperating expense and, therefore, does not affect NOPAT), but Nike will pay a higher price for its manufactured goods in order to provide the manufacturer with a return on its investment. If the contract manufacturer is more efficient than Nike, however, the price increase is mitigated. Profitability will increase if the turnover effect more than offsets the negative effect on NOPAT and profit margin, which is likely. b. Executory contracts are not recognized under GAAP. As a result, the use of contract manufacturers achieves off-balance-sheet financing. This is one motivating factor for their use.

M10-23. (20 minutes) LO 5 a, b, and c. Year

Book Value

Temporary Difference

Tax Rate

Deferred Tax Liability

2021

$300,000

$173,000

$127,000

25%

$31,750

2022

$200,000

$173,000 - ($100,000 - $31,000) = $104,000

$96,000

25%

$24,000

2023

$100,000

$104,000 - ($100,000 - $31,000) = $35,000

$65,000

25%

$16,250

Tax Basis (after depreciation deduction)

d. Deferred tax assets and liabilities are all recorded as non-current assets and liabilities.

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Financial Accounting, 6th Edition

EXERCISES E10-24. (45 minutes) LO 2 a. Present value of operating leases = $4,897, 005 , computed using the PV function in Excel: =PV(0.04,5,1100000,0) or using the PV of annuity table in Appendix A: 4.45182 X $1,100,000 (or using a financial calculator or the formula for PV of an annuity) [Note there will be small rounding differences between the methods.] This amount is both the value of the asset and the liability (because there are no payments already made or other complicating terms of this lease). b. Lease liability amortization schedule Date Lease Payment 01-Jan-20 31-Dec-20 $ 1,100,000 $ 31-Dec-21 1,100,000 31-Dec-22 1,100,000 31-Dec-23 1,100,000 31-Dec-24 1,100,000 Total $ 5,500,000 $

Interest on Liability

Reduction of Lease Liability

195,880 $ 159,715 122,104 82,988 42,308 602,996 $

904,120 940,285 977,896 1,017,012 1,057,693 4,897,005

Lease Liability $4,897,005 $ 3,992,885 3,052,601 2,074,705 1,057,693 0

Right-of-use Asset Amortization Schedule – operating lease Date 01-Jan-20 31-Dec-20 $ 31-Dec-21 31-Dec-22 31-Dec-23 31-Dec-24 $

Straight-line Expense 1,100,000 1,100,000 1,100,000 1,100,000 1,100,000 5,500,000

Interest on Liability $

$

195,880 159,715 122,104 82,988 42,308 602,996

Amortization of Right-of-Use Asset $

$

904,120 940,285 977,896 1,017,012 1,057,693 4,897,005

Right-of-Use Asset $4,897,005 $ 3,992,885 3,052,601 2,074,705 1,057,693 0

*Note: there are some small differences due to rounding in the tables above.

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c. Entries if a finance lease: January 1, 2020 Right-of-use asset – finance lease .......................... Finance lease liability ....................................

4,897,005

December 31, 2020 Amortization expense .............................................. Accumulated amortization – finance lease....

979,401

4,897,005

979,401

$4,897,005 / 5 (note that company could choose to reduce the asset value directly)

Finance lease liability .............................................. Interest expense ...................................................... Cash .............................................................

904,120 195,880 1,100,00

December 31, 2021 Amortization expense .............................................. Accumulated amortization – finance lease....

979,401 979,401

$4,897,005 / 5 (Note that company could choose to reduce the asset value directly)

Finance lease liability .............................................. Interest expense ...................................................... Cash .............................................................

940,285 159,715 1,100,00

Balance Sheet Equation: January 1, 2020 Balance Sheet Transaction

Cash Asset

+

Lease equipment using financetype lease

Noncash Assets

=

Liabilities

+4,897,005

=

+4,897,005

Right-of-use asset

Income Statement Contrib. + Capital +

Earned Capital

Revenues

Net Income

- Expenses = -

=

Lease liability

December 31, 2020 Balance Sheet Transaction

Cash Asset

+

Record amortization of asset

Noncash Assets

=

–979,401

=

Liabilities

Income Statement Contrib. + Capital +

Earned Capital –979,401

- Expenses = -

Accum. Amort. – finance lease

Cash Asset

+

Noncash Assets

Record –1,100,000 interest and cash payment

+979,401

= –979,401

=

Liabilities

=

–904,120

Income Statement +

Contrib. Capital +

Earned Capital –195,880

Revenues

- Expenses = -

+195,880 Interest expense

©Cambridge Business Publishers, 2020 1-196

Net Income

Amort. expense

Balance Sheet Transaction

Revenues

Financial Accounting, 6th Edition

Net Income

= –195,880

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d. Entries if an operating lease January 1, 2020 Right-of-use asset – operating lease ................................. 4,897,005 Operating lease liability ...........................................

4,897,005

December 31, 2020 Operating lease liability ..................................................... 1,100,000 Cash .......................................................................

1,100,000

Lease expense .................................................................. 1,100,000 Operating lease liability ..................................................... Right-of-use asset – operating lease ......................

195,880 904,120

(note company could choose to maintain an accumulated amortization account)

December 31, 2021 Operating lease liability ..................................................... 1,100,000 Cash .......................................................................

1,100,000

Lease expense .................................................................. 1,100,000 Operating lease liability ........................................... Right-of-use asset – operating lease ......................

159,715 940,285

Balance Sheet Equation January 1, 2020 Balance Sheet Transaction

Cash Asset

+

Lease equipment operating-type lease

Noncash Assets

=

Liabilities

+4,897,005

=

+4,897,005

Right-of-use asset

Income Statement Contrib. + Capital +

Earned Capital

Revenues

- Expenses = -

Net Income

=

Lease liability

December 31, 2020 Balance Sheet Transaction Record payment

Cash Asset

+

Noncash Assets

–1,100,000

=

Liabilities

=

–1,100,000

Income Statement Contrib. Capital +

Earned Capital

Contrib. + Capital +

Earned Capital

+

Balance Sheet Transaction Record lease expense, reduction in asset value & adjust liability for interest

Cash Asset

+

Noncash Assets

=

Liabilities

–904,120

=

+195,880

Right-of-use asset – operating lease

Lease liability

Revenues

- Expenses =

Income Statement

–1,100,000

Revenues

- Expenses =

Net Income

- +1,100,000 = –1,100,000 Lease expense

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Net Income

Financial Accounting, 6th Edition

continued

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d. continued Alternative Entry for Dec. 31, 2020 Because this lease has no prepayments and no incentives and payments are at the end of the year, the entries could be recorded as follows (they are equivalent): Operating lease liability ............................................... Lease expense ............................................................ Cash ................................................................. Right-of-use asset – operating lease ................

904,120 1,100,000 1,100,000 904,120

e. Operating lease treatment and finance lease treatment both require the recording of a lease liability at the present value of the remaining lease payments. Both types of leases require the recording a right-of-use asset for the total cost of the lease. Thus, both types of leases are now ‘on-balance sheet’. However, the income statement treatment differs between the two types of leases and the asset amortization differs. Finance leases record amortization expense for the straight-line amortization of the right-of-use lease asset. Finance leases also record interest expense on the lease liability. In contrast, operating lease treatment involves one straight-line lease expense amount each period. There is no separate amortization expense and no separate interest expense. As a result, whereas a finance lease records interest expense in non-operating expenses, an operating lease will record one lease expense in operating expenses. Overall, expenses are greater in the early part of the asset’s life for finance leases relative to operating leases. As a result, the asset value on the balance sheet will remain higher over the term of the lease for operating leases relative to finance leases as can be seen in the table below: Right-of-Use Asset Balance Finance Lease

Operating Lease

January 1, 2020

4,897,005

4,897,005

December 31, 2020

3,917,604

3,992,885

December 31, 2021

2,938,203

3,052,600

December 31, 2022

1,958,802

2,074,704

December 31, 2023

979,401

1,057,692

December 31, 2024

0

0

Amounts may differ slightly due to rounding.

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Financial Accounting, 6th Edition

E10-25. (15 minutes) LO 3, 4 a. Target maintains only a defined contribution plan for the benefit of its employees. b. Contributions are expensed when made. c. Only the unpaid contribution, if any, appears on Target’s balance sheet. d. First, employees who do not meet the unspecified eligibility requirements will not be covered. Second, matching contributions can be reduced or eliminated in bad times. Third, employees covered by defined contribution plans must choose how those funds are invested and, consequently, they bear all of the risks of price volatility.

E10-26. (20 minutes) LO 2 a. JetBlue will record $1.2 billion more in assets, thus total assets would be $1.2 billion + $10.426 billion for a total of $11.626 billion. JetBlue will also have $1.2 billion more in liabilities, thus total liabilities would be $1.2 billion + $5.815 billion for a total of $7.015 billion (again, assuming nothing else changed for JetBlue). •

Total debt-to-equity based on recorded numbers is 1.26 or 126% computed as $5.815 B/ $4.611 B.

•

Using the numbers after operating lease assets and liabilities are added to the balance sheet, the debt-to-equity ratio would be 1.52 or 152% computed as $7.015/$4.611B.

The increase is quite significant – nearly a 21%increase of the debt-to-equity ratio! b. Delta already adopted the lease standard. Thus, to make a correct comparison between Delta and JetBlue – one that adopted the standard and one that did not – the analyst will need to adjust JetBlue’s financial statements to be comparable to Delta’s. One step, and likely the most important as JetBlue states, is the step in part a above, putting the assets and liabilities on the balance sheet. Some companies do not provide such clear disclosures of what the amounts will be. In that case, the analyst needs to find the present value of the future minimum lease payments as disclosed in the notes to estimate the liability (and asset) to add to the balance sheet. Any difference would likely affect equity.

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E10-27. (25 minutes) LO 1, 2

a. According to Verizon’s lease footnote, it has both capital and operating leases. As of the end of 2018, the company states that only the capital leases are reported onbalance sheet: a liability in the amount of $905 million ($316 million in current liabilities and $589 million as long-term liabilities). However, this is not the total obligation to its lessors. Verizon also has a significant amount of leases that it has classified as operating, which before the recent changes to the accounting for leases were “offbalance sheet”. Looking at the 2018 data, we can see that in fact, the minimum lease payments under operating leases are more than 26 times that for capital leases!

b. Verizon states in their disclosures that do not know for certain what the amounts will be, but that their estimates are that the new standard will require the addition of somewhere in the range of $21.0 billion and $23.0 billion in additional assets and liabilities.

c. Debt-to-equity as reported = $210,119 M/$54,710 M = 3.84 or 384%. Debt-to-equity after adjusting for estimating operating leases = $232,119/$54,710 = 4.24 or 424%

d. Return-on-assets will likely decline because assets will be much larger but the income statement effect will not be very large. Rent was already being expensed and FASB settled on straight-line-expensing for the operating leases under the new standard. Thus, essentially the same income will be compared to a larger asset base and ROA will likely decline (based on reported numbers).

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Financial Accounting, 6th Edition

E10-28. (25 minutes) LO 6 a. The payments promised to sponsored athletes are economically similar to a liability in many ways. The payments do not rise to the level of a recognizable liability for GAAP because the athlete is yet to wear the product and be sponsored (and Under Armour has not taken control of an asset at the point when the sponsorship contract begins). Yet, an analyst may want to consider these payments as economically equivalent to liabilities for at least some analysis purposes. Arguably, there is an “asset” related to these expenditures – but advertising is expensed as incurred for financial accounting so an asset would not be considered for analysis purposes most likely. b. The estimated amount would be the present value of the future payments. •

First we need to specify the future payments (in thousands) o o o o o o

o o

•

2019 $126,221 2020 $106,782 2021 $101,543 2022 $98,353 2023 $91,337 Then for 2024 and after, we can estimate by dividing the total by the payment in 2023 ▪ $210,634/$91,337 = 2.3 years. ▪ Round to 2 years for simplicity and find the payment for the next two years: $210,634/2 = $105,317 2024 $105,317 2025 $105,317

Using Excel’s NPV function to estimate the amount, using the 3% interest rate stated in the problem: [NPV(0.03, 126221,106782,101543,98353,91337,105317,105317) = $656,130 thousand.

}

c. Under Armour does not record a liability for the lawsuit. The accrual of an expense and recording of a liability would occur if the loss was estimable and probable, and if the amount is material. The company says the amount is likely not material and that the company has insurance that will cover the costs.

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E10-29. (30 minutes) LO 6 a. The present value of the future payments at 2.5% using Excel’s NPV function and assuming the “thereafter” amount on the table is all paid in 2024 is: NPV(0.025, 2447,3202,1749,1596,268,66) = $8,799 million.

b. An analyst might consider this to be essentially equivalent to a liability. The company has promised future payments. We do not have additional information to estimate any associated assets, however. c. Apple has recorded a liability with respect to the Qualcomm royalty payments (and an associated accrued expense). Apple does not disclose the amount of the liability it has recorded, just that it has accrued its “best estimate” of the amount it will have to pay for the resolution of the dispute.

E10-30. (15 minutes) LO 3, 4 a. Service cost is the increase in the pension obligation resulting from employees working another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation. b. Payments to retirees are made from the pension investment account. There is a corresponding reduction in the pension obligation. c. The funded status is the pension obligation less the fair value of the plan assets. In this case $1,007 million (pension obligation) – $864 million (plan assets) = $(143) million funded status (when pension obligations are greater than the plan assets it is an underfunded amount). d. A $143 million net pension liability is reported in the balance sheet.

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Financial Accounting, 6th Edition

E10-31. (20 minutes) LO 3, 4 a. Service cost is the increase in the pension obligation resulting from employees working another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation. b. Payments to retirees are made from the pension investment account. There is a corresponding reduction in the pension obligation. c. The funded status is the pension benefit obligation less the fair value of the plan assets. In this case $21,531 million – $19,175 million = $(2,356) million funded status (underfunded amount). d. A $2,356 million net pension liability is reported on the balance sheet.

E10-32. (20 minutes) LO 5 a. In 2019, the temporary difference is $8,000. $8,000 x 25% = $2,000. In 2020, the temporary difference reverses and no liability would be reported as of the end of the year. b. 2019 Income tax expense (+E, -SE) ................................................ Income taxes payable* (+L) ............................................... Deferred income tax liability (+L) .......................................

57,000 55,000 2,000

*($236,000 - $16,000) x 25% = $55,000

2020 Income tax expense (+E, -SE) ................................................ Deferred income tax liability (-L) ............................................. Income taxes payable* (+L) ...............................................

59,250 2,000 61,250

*($245,000 - $0) x 25% = $61,250

c. 2019 Income tax expense (+E, -SE) ................................................ Income taxes payable* (+L) ............................................... Deferred income tax liability** (+L) ....................................

57,800 55,000 2,800

*($236,000 – $16,000) x 25% = $55,000 **($8,000 x 35% = $2,800)

2020 Income tax expense (+E, -SE) ................................................ Deferred income tax liability (-L) ............................................. Income taxes payable* (+L) ...............................................

82,950 2,800 85,750

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Financial Accounting, 6th Edition

10-33. (15 minutes) LO 5 a. $12,000 x 25% = $3,000. (None would be depreciable for book purposes b. The entire amount will be a non-current liability. c. $8,000 x 25% = $2,000.

E10-34. (15 minutes) LO 5 a. Balance Sheet Transaction To record income tax expense

Cash Asset

Noncash + Assets

Contrib. = Liabilities + Capital + = +1,745 Taxes Payable

Income Statement Earned Capital -2,392 Retained Earnings

Revenues

-

Expenses +2,392 Income Tax Expense

= =

Net Income -2,392

+647 Deferred Tax Liability

b. Income tax expense (+E, -SE) .......................................... Income taxes payable (+L) .......................................... Deferred income tax liability (+L) .................................

2,392 1,745 647

(Note that if you assume the taxes due are paid in cash in the reporting period, the account Income taxes payable used above would be replaced with Cash—Cash would be reduced. Either is correct.)

c. An expense of $2,392 million is recorded in the income statement, thereby reducing both net income and retained earnings. Liabilities are increased by $2,392 million, $1,745 million in income taxes payable (assuming the amount due this year has not been paid yet) and the increase of of $647million in deferred income tax liability. d. 2016: 18.67% ($863/$4,623) 2017: 13.22% ($646/$4,886) 2018: 55.31% ($2,392/$4,325) Nike’s tax rate is much higher in the year ended May 31, 2018 because the TCJA was passed during this fiscal year for Nike. Examining their disclosures, they state that they accrued an additional tax expense of $1.8 billion because of the one-time Transition Tax (aka mandatory deemed repatriation tax) on unremitted foreign earnings prior to the TCJA. In addition, they had an additional expense of $158 million because all their deferred tax assets and liabilities had to be re-measured at the new tax rate.

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E10-35. (15 minutes) LO 5 a. Balance Sheet Transaction a. To record income tax expense.

Cash Asset

+

Noncash Assets

= Liabilities + = +2,139 Taxes Payable

Income Statement Contrib. Capital +

Earned Capital -1,144 Retained Earnings

Revenues

-

Expenses +1,144 Income Tax Expense

= =

Net Income -1,144

-995 Deferred Tax Liability

b. Deferred tax liability (-L)............................................................. Income tax expense (+E ) ......................................................... Income tax payable (+L ) .....................................................

995 1,144 2,139

(Note that if you assume the taxes due are paid in cash in the reporting period, the account Income taxes payable used above would be replaced with Cash—Cash would be reduced. Either is correct. Also, in this problem if you increased a Deferred Income Tax Asset for $995 million rather than decrease the Deferred Tax Liability that is acceptable as well because the disclosures are not presented that show whether the company has a net deferred tax asset or liability. )

c. An expense of $1,144 million is recorded in the income statement, thereby reducing both net income and retained earnings. This total tax expense is composed of two parts – current tax expense and deferred tax expense. The current portion ($2,139 million) approximates income taxes on the tax return for the current year (ignoring some more complicated factors like unrecognized tax benefits, a detailed discussion of which is beyond the scope of this text). Boeing also records an decrease in deferred tax liabilities (or an increase in deferred tax assets) of $995 million and a deferred tax benefit of $955.

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Financial Accounting, 6th Edition

PROBLEMS P10-36. (25 minutes) LO 2 a. $5,262 million ($2,380 + $2,882). b. $5,995 million ($719 +$5,276) c. Net book value of $346 ($992 - $646) for the asset. The liability is $347 ($123 + $224) d. Operating leases were previously ‘off-balance’ sheet. Thus, companies often structured their lease contracts to obtain this ‘off-balance’ sheet outcome. These numbers tell us that operating lease liabilities are roughly 17 times the liability for finance-type leases. How United and other companies adjust their use of operating leases following the implementation of the new standard remains to be seen. e. Reported ROA = 0.0475 or 4.75% ( $2,129/$44,792) Reported Debt-to-equity = 3.48 or 348% ($34,797/$9,995) Adjusted ROA = 0.0425 or 4.25% ($2,129/($44,792 + $5,262)) Adjusted Debt-to-Equity = 4.40 or 440% (($34,797 + $5,995)/($9,995 + (-$733*))) *($2,380 + $2,882 -$719 - $5,276 = -$733)

P10-37. (60 minutes) LO 2 a. $9,151 million b. $545 million d. $9,556 million. The amount is the present value of the remaining lease payments. e. Amortization expense for finance leases is $78 million. Amortization expense for operating leases is zero. There is no separate amortization expense recorded for operating leases, only a straight-line ‘lease expense’ that expenses to the total cost of the leased asset over the lease term.

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f. Interest expense for the finance lease is $48 million. Interest expense on the operating leases is zero. There is no separate interest expense recorded for operating leases, only a straight-line ‘lease expense’ that expenses the total cost of the leased asset over the lease term. g. Right-of-use asset – operating lease ...................................... Operating lease liability ...........................................

$10 B $10 B

P10-38. (40 minutes) LO 6 a. The use of contract manufacturers removes the manufacturing assets and related liabilities from Cisco’s balance sheet. Because sales are unaffected, PPE turnover is increased by the removal of assets. The effect on net operating profit after taxes (NOPAT) is uncertain; depreciation is removed (interest on the liabilities incurred to purchase the manufacturing assets is also removed, but this is a nonoperating expense and, therefore, does not affect NOPAT), but Cisco will likely pay a higher price for its manufactured goods in order to provide the manufacturer with a return on its investment. If the contract manufacturer is more efficient than Cisco, however, the price increase is mitigated. Profitability will increase if the turnover effect more than offsets the negative effect on NOPAT and profit margin, which is likely. b. The estimate of the present value given the assumptions in the problem is $6,163 million. c. Cisco states that it has accrued $159 million – meaning it has reported that amount as a (current) liability on its balance sheet.

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Financial Accounting, 6th Edition

P10-39. (30 minutes) LO 3, 4 a. Hoopes Corporation recognized $543 million as pension expense in 2019. b. The expected return is computed as the beginning fair market value of the pension plan assets multiplied by the long-term expected return on these investments. For 2019, this is computed as $13,295  8% = $1063.6, slightly more than the reported amount of $1,062 million. The plan assets reported an actual return of $2,425 million. U.S. GAAP permits the use of the expected long-term rate of return in order to smooth earnings. If actual returns were to be used, corporate profits would fluctuate greatly with swings in investment returns. The logic behind using the long-term rate is that investment returns are expected to fluctuate around this average and its use more accurately captures the average cost of the pension plan. (It is similar to the logic of reporting held-to-maturity bond investments at historical cost rather than current market value.) c. The pension liability is increased by the service and interest costs and decreased by any payments made to plan participants. The actuarial loss (gain) relates to the effects on the pension obligation of changes in assumptions used to compute it, such as the discount rate or the rate of expected wage inflation. The pension plan assets are increased (decreased) by investment gains (losses), are increased by company contributions and are decreased by benefits paid to plan participants. d. The “funded status” is the excess (deficiency) of the pension obligation over plan assets. If plan assets exceed pension obligation, the funded status is positive or overfunded. If pension obligations exceed the fair value of plan assets, the funded status is negative or underfunded. The funded status of the Hoopes Corporation pension plan is $(1,531) million at the end of 2019. Pension obligations are $17,372 million and plan assets are $15,841 million. Hoopes should report its net funded status as a net pension liability of $1,531 million on its balance sheet. e. Because the pension obligation is the present value of expected pension payments, a decrease in the discount rate increases the present value reported on the balance sheet. The effect on the income statement is more difficult to predict (when the same discount rate is used to compute interest expense and the PBO). The interest cost component of pension expense is the product of the beginning of the year pension obligation and the discount rate. In 2019, the effect of a decrease in the discount rate is to apply a lower discount rate to a higher pension obligation. These two effects are offsetting, but usually result in lower interest cost. f. The estimated wage inflation rate is used to project future benefit payments. Decreasing the estimated inflation rate decreases the pension obligation because a lower amount of payments to plan participants is projected. Decreasing the expected wage inflation rate reduces service cost and decreases the pension obligation reported on the balance sheet and, consequently, the interest component of pension expense. It is an income-increasing action. ©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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P10-40. (20 minutes) LO 3, 4 a. Service cost is the increase in the pension obligation resulting from employees working another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation. b. The “actual” return on plan assets is $4,274 million in 2017. c. Actuarial losses (gains) generally arise as a result of decreases (increases) in the discount rate used to compute the pension obligation (PBO). Because the PBO is the present value of expected future payouts to retirees, a decrease in the discount rate results in an increase in the PBO. This decrease is recorded as an actuarial loss. d. Payments to retirees are made from the plan assets account. There is a corresponding reduction in the pension obligation. e. Johnson and Johnson contributed $664 million to its pension plans in 2017. f. Johnson and Johnson paid $1,050 million in benefits to its retirees in 2017. g. The funded status is the pension obligation less the fair value of the plan assets. In this case $33,221 million – $28,404 million = $(4,817) million underfunded amount. h. A $4,817 million net pension liability is reported on the balance sheet.

P10-41. (20 minutes) LO 5 a.

Tax expense – 2018: $1,727 million; 2017: $971 million; 2016: $700 million. Current tax expense – 2018: $247 mil.; 2017: $871 mil.; 2016: $417 mil. Deferred tax expense – 2018: $1,480 mil.; 2017: $100 mil.; 2016: $283 mil.

b.

2018: $1,727 / $4,070.7 = 42.43% 2017: $971 / $3,153.8 = 30.79% 2016: $700 / $2,224.0 = 31.47%

c. Deferred tax liabilities are created when a company reports greater revenues and/or lower expenses in the income statement than are reported on the tax return. The most common cause is the use of accelerated depreciation for taxes and straightline depreciation for financial reporting. When these deferred taxes reverse (late in the asset’s life) the deferred tax liability is reduced.

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Financial Accounting, 6th Edition

P10-42. (15 minutes) LO 5 a. Temporary differences 2019: $32,000 - $24,000 = $8,000; 2020: ($32,000 + $37,000) – ($24,000 + $26,000) = $19,000. b. Deferred tax liability 2019: $8,000 x 25% = $2,000; 2020: $19,000 x 25% = $4,750 c. $12,000 + ($4,750 – $2,000) = $14,750 d. Income tax expense (+E, -SE)................................................... Income taxes payable (+L)................................................... Deferred tax liability (+L) ...................................................... + Income Tax Expense (E) (d) 14,750

14,750 12,000 2,750

- Income Taxes Payable (L) + 12,000 (d)

- Deferred Tax Liability (L) + 2,750 (d)

(Note that if you assume the taxes due are paid in cash in the reporting period, the account Income taxes payable used above would be replaced with Cash—Cash would be reduced. Either is correct.)

P10-43. (15 minutes) LO 5 a. Temporary differences 2019: $140,000 - $130,000 = $10,000; 2020: ($140,000 + $122,000) – ($130,000 + $128,000) = $4,000. b. Deferred tax liability 2019: $10,000 x 25% = $2,500; 2020: $4,000 x 25% = $1,000 c. $45,150 + ($1,000 – $2,500) = $43,650 d. Income tax expense (+E, -SE)................................................... Deferred tax liability (-L)............................................................. Income taxes payable (+L)................................................... + Income Tax Expense (E) (d) 43,650

- Income Taxes Payable (L) + 45,150 (d)

43,650 1,500 45,150 - Deferred Tax Liability (L) + (d) 1,500

(Note that if you assume the taxes due are paid in cash in the reporting period, the account Income taxes payable used above would be replaced with Cash (Cash would be reduced). Either is correct.)

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P10-44. (20 minutes) LO 5 a. Macy’s reported an income tax benefit of $571 million. b. Macy’s reported a benefit because its deferred income tax liabilities are greater than its deferred income tax assets. When the value of the liabilities is reduced to the new lower rate, this reduces deferred tax expense (creates a benefit). Recall that when the liability was originally recorded it was recorded as follows (in general form): Deferred tax expense (+E) …………………. Deferred tax liability (+L) …………….

XX XX

Now upon the TCJA enactment, the net liability is devalued to a new lower rate; the entry is as follows (in general form): Deferred tax liability (+L) ………………….. Deferred tax expense (-E)……………..

YY YY

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Financial Accounting, 6th Edition

CASES and PROJECTS C10-45. (30 minutes) LO 3, 4 a. DowDuPont reported net pension expense of $58 million for 2018. b. The expected rate of return is computed as the beginning fair value of the pension plan assets multiplied by the long-term expected return on these investments. For 2018, expected return was $2,846 on assets of $43,685 million. This implies an expected rate of return of 6.51% ($2,846 / $43,685). c. The pension liability is increased by the service and interest costs and decreased by any payments made to plan participants. The actuarial loss (gain) relates to the effects of changes in assumptions used to compute the pension obligation, such as the discount rate or the rate of expected wage inflation. The pension plan assets are increased (decreased) by investment gains (losses), are increased by company contributions, and are decreased by benefits paid to plan participants. d. The “funded status” is the excess (deficiency) of the pension obligation over plan assets. If plan assets exceed pension obligation, the funded status is positive. If pension obligations exceed the fair value of plan assets, the funded status is negative. The funded status of DowDuPont’s pension plan is $(11,552) million at the end of 2018. Thus, the pension is underfunded and the balance sheet should show a net pension liability of $11,552 million. e. Since the pension obligation is the present value of expected pension payments, an increase in the discount rate decreases the present value reported on the balance sheet (and a decrease in the discount rate increases the present value reported on the balance sheet). The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning-of-the-year pension obligation and the discount rate. The effect of an increase (decrease) in the discount rate is to apply a higher (lower) interest rate to a smaller (larger) pension obligation. Interest expense on the pension liability will usually increase (decrease) in this circumstance. However, the actuarial “gain” or “loss” resulting from the change in the liability amount may offset the differential interest cost f. An increase in expected return unambiguously increases profitability as pension cost is reduced. This result occurs because the long-term expected rate of return is used to compute the expected return that is subtracted in the computation of pension expense.

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g. Inflation rates differ from country to country. For 2018, those rates are generally higher outside the U.S. where Dow operates. Inflation is expected to increase in the U.S. and could exceed the rates in other countries implying relatively higher compensation levels. Discount rates vary across countries as well, due in part to differences in inflation.

C10-46. (40 minutes) LO 1, 2 a. $1,965 million b. $872 million (net of amortization) c. $2,170 million. The amount is the present value of the remaining lease payments. d. $65 million e. $42 million f. Lease expense of $251 million. g. Amortization expense (+E) ........................................................ Accumulated Amortization – finance lease (+XA) ..........

65

Finance Lease liability (-L ) ........................................................ Interest expense (+E) ................................................................ Cash (A) .........................................................................

83 42

65

125

h. The lease expense for operating leases is all recorded in SG&A, which is included in operating income. For finance leases, the amortization expense may be included in Cost of Goods sold (thus reducing gross profit) or in SG&A, or partially in both (as it looks like the expense for Target is). For finance leases, interest expense is reported as non-operating on income statement. Thus, finance leases have 1) a greater annual expense amount early in the asset’s life, 2) lower net book values early in the asset’s life, and 3) expenses allocated to various parts of the income statement in each reporting period (whereas operating lease expense is in one place, SG&A). i.

Target has reported debt-to-equity of 2.65 or 265% ($29,993/$11,297). Without operating leases being “on balance sheet” Target would have had a reported debt-toequity of 2.51 or 251% (($29,993 - $2,170)/($11,297 + (- $205*))). Debt-to-equity is higher when the operating leases are capitalized because there are significant liabilities added to the balance sheet. More specifically these are debt-financed assets essentially, thus adding substantial amounts to assets but also often very similar amounts to liabilities. Thus, the debt-to-equity ratio rises when operating leases are recorded on the balance sheet. *($1,965 - $166 - $2,004 = -$205)

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C10-47. (45 minutes) LO 5 a. $192,894 thousand b. 2018: $192,894 / $452,439 = 42.63%. 2017: $166,524 / $471,911 = 35.29%. 2016: $177,839/488,007 = 36.44% Current US: $97,202 / $379,000 = 25.65% Deferred US: $62,893 / $379,000 = 16.59%; Total US rate: $160,095/$379,000 = 42.24%. c. $23,245 - $56,783 + $129,513 = $95,975 thousand d. Income tax expense (+E, -SE)................................................... Deferred tax liability (+L)................................................. Income taxes payable (+L) .............................................

192,894 63,381 129,513

e. $932,283 – ($17,361/0.21) = $849,612 thousand. f. Prepaid catalog expenses are capitalized and amortized for financial reporting purposes. However, for tax reporting purposes, the costs are expensed when paid. Consequently, the tax deduction is recognized before the expense is recognized in the income statement. The prepaid catalog expense of $58,693 thousand represents a temporary difference between financial and tax reporting. The resulting deferred tax liability shown of $5,386 thousand offsets the current deferred tax assets in the balance sheet. g. $13,200 thousand. This amount increased income tax expense in the year ended January 2018 (likely by the full amount because the company says they did not have any U.S. tax accrued prior to the TCJA.) h. A valuation allowance is a contra-asset account related to deferred tax assets. Management establishes a valuation allowance if it thinks the deferred tax assets will not be realized in the future. That is, management does not think the company will generate enough future taxable income to be able to offset the future deductions represented by the deferred tax assets. Recognizing a valuation allowance lowers the amount of deferred tax assets recognized and reduces income (increases tax expense). i. Williams Sonoma recorded $28.3 million in additional tax expense related to the devaluation of its net deferred tax assets from the U.S. statutory tax rate of 33.9% to the new, lower rate of 21%. Deferred tax assets and liabilities are to be valued at the enacted rate expected to be in effect with the deferred tax item reverses. In a big picture sense, an asset the company has is now worth less. ©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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C10-48. (30 minutes) LO 5 a. Domestic: 2018: ($2,153 + $907) / $15,800 = 19.4% 2017: ($12,608 + $220 ) / $10,700 = 119.9 % 2016: ($3,826 - $70 ) / $12,000 = 31.3% Foreign: 2018: ($1,251 - $134) / $19,100 = 5.85% 2017: ($1,746 - $43) / $16,500 = 10.32% 2016: ($966 - $50) / $12,100 = 7.57% Total: 2018: $4,177 / ($34,900) = 12.0% 2017: $14,531 / ($27,200) = 53.4% 2016: $4,672 / ($24,100) = 19.4% b. Alphabet states that they have $10.2 billion due for the one-time transition tax. This amount increased tax expense on the income statement, and reduced net income. The amount was not paid in cash (they have eight years to pay the tax) and thus, the company would have recorded a liability for this amount.

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Chapter 11 Reporting and Analyzing Stockholders’ Equity Learning Objectives – coverage by question MiniExercises

Exercises

Problems

Cases and Projects

LO1 – Describe business financing through stock issuances.

19, 37

41, 45

59

62, 63

LO2 – Explain and account for the issuance and repurchase of stock.

20 - 22, 24, 25, 36, 37

39 - 41, 45, 52, 54

55 - 59

62 - 65

LO3 – Describe how operations increase the equity of a business.

30, 37

48, 49, 51

55 - 57

63, 64

23, 26 - 31, 36

42, 44, 46 - 51, 54

56, 58

LO4 – Explain and account for dividends and stock splits. LO5 – Define and illustrate comprehensive income.

LO6 – Describe and illustrate basic and diluted earnings per share computations.

LO7 – Appendix 11A: Analyze the accounting for convertible securities, stock rights, and stock options.

56, 59, 60

24, 25, 32 - 34, 36 - 38

41, 43, 44, 50

55 - 57, 59

64

35

53

59, 60

61, 65

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QUESTIONS Q11-1. Par value stock is stock that has a face value printed (identified) on the stock certificate. From an accounting standpoint, the par value of the common stock is the amount added to the common stock portion of paid-in-capital upon the issuance of stock. The remainder of the issue price is added to the additional paid-incapital portion of paid-in-capital. There are no analysis implications of the par value of stock. Q11-2. Preferred stock usually takes priority over common stock in the receipt of a specified amount of dividends and in the distribution of assets if the corporation is ever liquidated. Also, preferred stock does not usually have voting rights. Typically, preferred stock has the following features: 1) Preferential claim to dividends and to assets in liquidation, 2) Cumulative dividend rights, and 3) No voting rights. Q11-3. Preferred stock is similar to debt when 1. Dividends are cumulative. 2. Dividends are nonparticipating. 3. It has a preference to assets in liquidation. Preferred stock is similar to common stock when 1. Dividends are not cumulative. 2. Dividends are fully participating. 3. It is convertible into common stock. 4. It does not have a preference to assets in liquidation. Q11-4. Dividend arrearage on preferred stock is the aggregate amount of dividends on cumulative preferred stock that has not been declared to date. The amount of dividends in arrears and a current dividend must be paid to preferred stockholders before common stockholders can receive any dividends. In the example, preferred stockholders must receive $90,000 in dividends ($500,000  0.06  3 years = $90,000) before common stockholders receive any dividends.

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Q11-5. A corporation's authorized stock is the maximum number of shares of stock it may issue. The authorized amounts and classes of stock are enumerated in the company's charter when the corporation is formed. A corporation can later amend its charter to change the amount of authorized capital, but such action must have the approval of the company’s shareholders. Shares that have been sold and issued to stockholders are the company's issued stock. Shares that have been sold and issued can be subsequently reacquired by the corporation—called treasury stock. When treasury stock is held, the issued shares exceed the outstanding shares. Q11-6. Contributed capital represents the total investment that has been paid in to the company by its shareholders as a result of the purchase of stock. Earned capital represents the cumulative net income that has been earned, less the portion of that income that has been paid out to shareholders in the form of dividends. When profit is earned, shareholders have the option of paying out that profit as a dividend or reinvesting the earnings in order to grow the company. In fact, many companies title the Retained Earnings account as Reinvested Earnings. Earned capital, thus, represents an implicit investment by the shareholders in the form of forgone dividends. Q11-7. Paid-in capital is divided into two accounts: the common or preferred stock account and additional paid-in capital. The common stock or preferred stock accounts are increased by the par value of the shares issued and the additional paid-in capital account is increased for the balance of the proceeds received from the sale of the shares. The balance of the paid-in capital account is affected by the par value of the stock; the higher (lower) the par value, the lower (higher) the additional paid-in capital. Although paid-in capital will, in general, be higher if the stock price is higher, the breakdown of paid-in capital between the common or preferred stock accounts and additional paid-in capital does not yield any inferences regarding the financial condition of the company. Q11-8. A stock split refers to the issuance of additional shares of a class of stock to the current stockholders in proportion to their ownership interests, normally accompanied by a proportionate reduction in the par or stated value of the stock. For example, a 2-for-1 stock split doubles the number of shares outstanding and halves the par or stated value of the shares. Consequently, there is no change in the amount of contributed capital associated with that class of stock. The major reason for a stock split is to reduce the per-share market price of the stock. Another possible reason is to influence shareholders’ in believing there has been some distribution of value.

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Q11-9. Treasury stock is a corporation's issued stock that has been reacquired by the issuing corporation through purchases of its stock from its shareholders. A corporation often purchases treasury stock for distribution to employees under stock option plans or to offset dilution resulting from such sales. It is also used by management to prop up stock price when management believes its stock is inappropriately underpriced. On the balance sheet, treasury stock should be carried at its cost and is shown as a deduction in deriving the total stockholders' equity—known as a contra equity account. Q11-10. The $2,400 increase should not be shown on the income statement as any form of income or gain. The $2,400 is properly treated as additional paid-in capital and is shown as such in the stockholders' equity section of the balance sheet. The latter treatment is justified because treasury stock transactions are considered capital rather than operating transactions. Q11-11. The book value per share of common stock is the total stockholders' equity divided by the number of shares outstanding, or $4,628,000/260,000 = $17.80. Q11-12. A stock dividend is the distribution of additional shares of a corporation's stock to its stockholders. A stock dividend does not change a stockholder's relative ownership interest, because each stockholder owns the same fractional share of the corporation before and after the stock dividend. There is empirical evidence, however, suggesting that the stock price does not decline fully for the additional shares issued—various hypotheses, such as signaling theory, have been asserted as explanations of this phenomenon. Q11-13. The stock dividend transfers capital from retained earnings to contributed capital. For a small stock dividend, this transfer is recorded at the market price of the shares at the time of the dividend. For a large stock dividend, the transfer is made at the par value of the stock. Q11-14. Many companies repurchase shares (as Treasury Stock) in order to offset the dilutive effects of exercised stock options which increase the number of outstanding shares. This repurchase results in a cash outflow, and has been used by those arguing for the expensing of employee stock options as evidence of the cash effect of these options and linkage to the payment of wages. Q11-15. The statement of stockholders' equity analyzes and reconciles changes in all major components of stockholders' equity for an accounting period. The statement begins with the beginning balances of those key stockholders' equity components, reports the items causing changes in these components, and ends with the period-end balances.

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Q11-16. Other Comprehensive Income (OCI) represents changes in stockholders’ equity that are caused by factors other than profit (loss) and the sale (repurchase) of equity securities. Some examples include unrealized gains (losses) on available-for-sale debt securities, foreign currency translation adjustments, unrealized gains (losses) on some derivatives, and pension liability adjustments. Q11-17. A stock option vesting period is a period of time after the grant date that an employee must wait before exercising stock options. For example, a company may grant five-year options that vest in three years. An employee would then be able to exercise the options in Years 4 or 5, but not before. Typically, the vesting period requires that the employee remains employed at the company until the options vest; otherwise he/she forfeits the options. GAAP requires that the fair value of the option be recorded as a compensation expense ratably over the vesting period. Q11-18. When a convertible bond is converted, both the face amount and any associated unamortized premium or discount are removed from the balance sheet. The stock is, then, issued considering the “purchase price” to be the book value (face amount ± an unamortized premium or discount) of the bond. This purchase price is, then, allocated to common stock and additional paid-in capital. No gain or loss is reported upon the conversion.

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MINI EXERCISES M11-19. (10 minutes) LO 1 a. These transactions increase Beatty Corp.’s contributed capital. Earned capital is affected by net income, other comprehensive income and dividends. b. Transactions between a company and its shareholders do not affect the income statement. c. Preferred stock has priority over common stock in the payment of dividends and in liquidation. That is, a company cannot pay common dividends until after it has fulfilled its preferred dividend obligation. And, if a company liquidates, the claims of the preferred shareholders are met before those of the common shareholders.

M11-20. (15 minutes) LO 2 a. Balance Sheet Transaction Issue 18,000 shares of $10 par value preferred stock at $48 per share.

Issue 120,000 shares of $2 par value common at $37 per share.

Cash Asset +864,000 Cash

Noncash + Assets

= Liabilities =

Income Statement

Contrib. + Capital + +180,000 Preferred Stock

Earned Capital

Revenues

-

Expenses

Net = Income =

+684,000 Additional Paid-in Capital +4,440,000 Cash

=

+240,000 Common Stock

-

=

+4,200,000 Additional Paid-in Capital

b. 9/1

Cash (+A) ......................................................................................... 864,000 Preferred stock (+SE) ...................................................................... 180,000 Additional paid-in capital (+SE) ........................................................ 684,000

9/1

Cash (+A) ......................................................................................... 4,440,000 Common stock (+SE) ....................................................................... 240,000 Additional paid-in capital (+SE) ........................................................ 4,200,000

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c. +

Cash (A) 864,000 4,440,000 - Common Stock (SE) + 240,000

9/1 9/1

- Preferred Stock (SE) + 180,000

9/1

- Additional Paid-in Capital (SE) + 684,000 9/1 4,200,000 9/1

9/1

M11-21. (10 minutes) LO 2 (in millions) Common stock ....................................... $ 4.614a Additional paid in capital......................... 42,815.39 Total ....................................................... $42,820 a 4,614

million shares issued  $0.001 par value.

M11-22. (15 minutes) LO 2 a. Income Statement

Balance Sheet Cash Transaction Asset Issue 5,000 +1,250,000 shares of $100 Cash par value preferred stock at $250 per share.

Repurchase 5,000 shares of $1 par value common stock at $83 per share.

Noncash + Assets = =

-415,000 Cash

Liabilities

+

Contrib. Capital +500,000 Preferred Stock

Earned + Capital -

Contra Equity

Net Revenues - Expenses = Income =

+750,000 Add’l Paid-in Capital =

- +415,000 Treasury Stock

-

=

b. 1/1

Cash (+A) ................................................................................... 1,250,000 Preferred stock (+SE) .................................................................. 500,000 Additional paid-in capital (+SE) .................................................... 750,000

3/1

Treasury stock (+XSE, -SE) ......................................................... 415,000 Cash (-A) ....................................................................................

415,000

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c. 1/1

+ Cash (A) 1,250,000

415,000

3/1

- Preferred Stock (SE) + 500,000

1/1

3/1

+ Treasury Stock (XSE) 415,000

- Additional Paid-in Capital (SE) + 750,000 1/1

M11-23. (10 minutes) LO 4 A stock split that is affected as a large stock dividend requires an entry into the accounting records. The number of outstanding shares must be changed in the parenthetical note to the common and preferred stock accounts in the stockholders’ equity section of the balance sheet. The par value of the new shares must be taken out of retained earnings and put into the common stock at par account. In the two-for-one stock split effected by Aflac, each shareholder receives one additional share for each share owned, thus doubling the outstanding shares, and – because the split was effected as a large stock dividend – the par value of the shares is unchanged. The dollar amount of total paid-in capital increases, but the total dollar amount of stockholders’ equity is unchanged. Earnings per share is recomputed for all years presented in the income statement to reflect the additional shares outstanding.

M11-24. (15 minutes) LO 2, 6 a. Basic EPS: [$501,000 – (16,000 x $2)] / 134,000 = $3.50 Calculation of weighted average shares outstanding: 120,000 130,000 146,000 140,000

x x x x

2/12 5/12 3/12 2/12

= = = =

20,000 54,167 36,500 23,333 134,000

b. Diluted EPS: $501,000 / (134,000 + 16,000) = $3.34 c. Given a simple capital structure, only basic EPS need be reported.

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M11-25. (10 minutes) LO 2, 6 a. Treasury shares are deducted from issued shares to yield outstanding shares. The outstanding shares are, therefore: Shares outstanding = 3,262,997,492 – 353,073,500 = 2,909,923,992 b. If the stock repurchase took place on July 1, 2017, three months after the end of the previous fiscal year, the denominator of the basic EPS calculation would decrease by 353,073,500 x 9/12. That is, the weighted average shares outstanding would be 3,262,997,492 – [353,073,500 x (9/12)] = 2,998,192,367 shares.

M11-26. (15 minutes) LO 4 a. Balance Sheet Cash Asset

Transaction

Noncash + Assets

Declared and paid cash dividend on preferred stock.

-18,000

Declared and paid cash dividend on common stock.

-88,000

= Liabilities + =

Income Statement Contrib. Capital +

Earned Capital -18,000

Cash

Revenues

-

Expenses

Net = Income

-

=

-

=

Retained Earnings

=

-88,000

Cash

Retained Earnings

b. Preferred dividend: 12/31 Retained earnings (-SE) ........................................................ 18,000 Cash (-A) ......................................................................................... 18,000 Common dividend: 12/31 Retained earnings (-SE) ................................................................... 88,000 Cash (-A) ..........................................................................................88,000 c. +

Cash (A)

18,000 88,000

12/31 12/31

- Retained Earnings (SE) + 12/31 18,000 12/31 88,000

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M11-27. (15 minutes) LO 4 Because this is a small stock dividend (4%), retained earnings is debited for the market value of the 2,800 additional shares of stock (70,000 x 4% x $21). a. Balance Sheet Transaction

Cash Asset

+

Declaration and distribution of stock dividend.

Noncash Assets

= Liabilities + =

Income Statement Contrib. Capital +

Earned Capital

+14,000

-58,800

Common Stock

Retained Earnings

Revenues

- Expenses

=

-

=

Net Income

+44,800 Additional Paid-in Capital

b. 12/31 Retained earnings (-SE) .............................................................. 58,800 Common stock (+SE) .................................................................. 14,000 Additional paid-in capital (+SE) .................................................... 44,800 c. 12/31

Retained Earnings (SE) 58,800

+

- Common Stock (SE) + 14,000

12/31

- Additional Paid-in Capital (SE) + 44,800 12/31

M11-28. (10 minutes) LO 4 a. Immediately after the 3-for-2 stock split, the company has 375,000 shares of $10 par value common stock [250,000 shares  (3/2) = 375,000 shares] issued and outstanding. b. The dollar balance in the Common Stock account is unchanged by the stock split; the balance remains at $3,750,000 (375,000 shares at the new $10 par value per share). c. The usual reason for a corporation to split its stock is to reduce the per share market price of the stock and, therefore, improve the stock's marketability. The market price of the common stock prior to the split is $165 per share, which is somewhat high. Splitting the stock would reduce the per-share price (though not the total market value).

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M11-29. (15 minutes) LO 4 Distribution to Preferred Common a. $1,000,000  6% ........................................................... $60,000 Balance to common ....................................................... $100,000 Per share $60,000/20,000 shares ....................................... $3.00 $100,000/80,000 shares ..................................... $1.25 b. $1,000,000  6%  2 years............................................ Balance to common ....................................................... Per share $120,000/20,000 shares ..................................... $40,000/80,000 shares .......................................

$120,000 $40,000 $6.00 $0.50

M11-30. (10 minutes) LO 3, 4 MAFFETT COMPANY Statement of Retained Earnings For the Year Ended December 31, 2019 Retained earnings, December 31, 2018 .................................................. Add: Net income ...................................................................................... Less: Cash dividends declared ................................................. $35,000 Stock dividends declared ................................................ 28,000 Retained earnings, December 31, 2019 ..................................................

$347,000 94,000 441,000 63,000 $378,000

M11-31. (10 minutes) LO 4 a. No entry is made when the dividend is declared; an entry is required only when the additional stock is issued. Because this is a large stock dividend, the dividend is recorded at par value: Retained earnings (-SE) .............................................................. 400,000 Common stock (+SE) ...................................................................400,000 b. The stock split would reduce the par value, but no journal entry would be recorded. As a consequence, neither the common stock nor the retained earnings accounts are affected. Neither method changes total shareholders’ equity. ©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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M11-32. (10 minutes) LO 6 a. Basic EPS: [$440,000 – (10,000 x $50 x 8%)] / 50,000 = $8.00 per share b. Diluted EPS: $440,000 / [50,000 + (10,000 x 3)] = $5.50 per share

M11-33. (15 minutes) LO 6 a. Basic EPS: $234,000 / 45,000 = $5.20 Calculation of weighted average shares outstanding: 38,000 48,000 49,000

x x x

4/12 4/12 4/12

= = =

12,667 16,000 16,333 45,000

b. Basic EPS: [$234,000 – (6,000 x $50 x 6%)] / 45,000 = $4.80

M11-34. (15 minutes) LO 6 a. Basic earnings per share is computed as net income less any preferred dividends divided by the weighted average number of common shares outstanding for the period. Diluted earnings per share adjusts for dilutive securities (such as convertible securities or employee stock options) by including the securities in the denominator and also adjusting for any effect on the numerator. Consequently, diluted earnings per share is always less than or equal to basic earnings per share. b. In the case of Siemens, it has 815,063 thousand weighted average common shares outstanding, and an additional 13,253 thousand weighted average common shares that could potentially be issued (dilutive). These dilutive shares relate to employee stock options warrants, that potentially could be converted into common shares. (Note: with 815,063 thousand shares and a basic EPS of €6.97, the implied earnings number is €5,680,989 thousand, computed as 815,063 thousand  €6.97. For diluted EPS, 828,316 thousand times €6.86 implies earnings of €5,682,248 thousand, a difference of €1,259 thousand. This difference is likely due to the interest/dividends on convertible securities and rounding of EPS.) c. While diluted EPS is favored over basic EPS by analysts, the data reflect events that have not and may never occur. In addition, the dilution is assumed to be made at the year’s start. ©Cambridge Business Publishers, 2020 1-232

Financial Accounting, 6th Edition

M11-35. (15 minutes) LO 7 a. No entry is required when the options are granted. The compensation expense is recognized ratably over the vesting period. As the options vest, the following entry is required (assume one-third vested in 2017): Compensation expense (+E, -SE) ................................................ 9,931,093 Additional paid in capital (+SE) ............................................... [(($7.04 X 4,232,000)/3) = $9,931,093]

9,931,093

b. Granted stock options (whether vested or not) are included in the denominator of diluted EPS whenever the stock price is greater than the exercise price. These options would reduce diluted EPS but have no effect on basic EPS. c. Cash (+A) ................................................................................... 499,000,000 Contributed capital (+SE) ........................................................

499,000,000

The details of the credit to contributed capital would depend on where the shares came from. If they had been held as treasury shares, the credit would have been to the treasury shares contra asset, with either a debit or credit in additional paid-in capital. If the shares were newly issued, the credit would have been to the par value and additional paid-in capital for Merck’s common stock. d. When options are exercised, the number of outstanding shares increases. This would reduce basic EPS. It might also lower diluted EPS, though most likely to a lesser degree. This is because the dilutive effect may already be reflected in diluted EPS prior to exercise.

M11-36. (10 minutes) LO 2, 4, 6

Year 1 ….. 2 ….. 3 …..

Total Assets

Total Liabilities

Total Stockholders’ Equity

EPS

Operating Income

Increase Decrease No effect

No effect No effect Increase

Increase Decrease Decrease

Decrease Increase No effect

No effect No effect No effect

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M11-37. (15 minutes) LO 1, 2, 3, 6 a. $30 = $18,000,000 / 600,000 shares b. $10 = $6,000,000 / 600,000 shares c. $12,000,000 = $18,000,000 - $6,000,000 d. $4,000,000 = $5,000,000 – $1,000,000 e. 50,000 shares = 600,000 – 550,000 f. $8.70 = $5,000,000 ÷ (600,000 + 550,000)/2. 600,000 shares were outstanding for the first half year but only 550,000 during the second half of the year.

M11-38. (10 minutes) LO 6 a. The diluted EPS calculation is made to reflect a worst-case scenario (conservative) EPS figure. b. $759/326.5 = $2.32 per share c. $761/342.2 = $2.22 per share d. When the options are not in-the-money. Options that are “under water” (the stock price is below the exercise price) are not included in the calculation of diluted EPS. This is because diluted EPS is supposed to be a conservative possible outcome, but not so conservative that it assumes “under water” options would be exercised.

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EXERCISES E11-39. (15 minutes) LO 2 a. Balance Sheet Transaction Issue 10,000 shares of $1 par value common stock at $25 per share.

Cash Asset +250,000 Cash

Noncash + Assets = =

Liabilities

+

Contrib. Capital +10,000 Common Stock

Income Statement Earned + Capital -

Contra Net Equity Revenues - Expenses = Income =

+240,000 Add’l Paid-in Capital

Issued 15,000 +4,125,000 shares of Cash $100 par preferred stock at $275 per share.

=

Purchased 2,000 shares of treasury stock at $15 per share.

-30,000 Cash

=

Sold 1,000 shares of treasury stock at $21 per share.

+21,000 Cash

=

+1,500,000 Preferred Stock

-

-

=

- +30,000 Treasury Stock

-

=

-

-

=

+2,625,000 Add’l Paid-in Capital

+6,000 Add’l Paid-in Capital

-15,000 Treasury Stock

b. 2/20

Cash (+A) ......................................................................................... 250,000 Common stock (+SE) .......................................................................10,000 Additional paid-in capital (+SE) ........................................................ 240,000

2/21 Cash (+A) ......................................................................................... 4,125,000 Preferred stock (+SE) ....................................................................... 1,500,000 Additional paid-in capital (+SE) ........................................................ 2,625,000 6/30

Treasury stock (+XSE, -SE) ............................................................. 30,000 Cash (-A) ........................................................................................... 30,000

9/25

Cash (+A) ......................................................................................... 21,000 Treasury stock (-XSE, +SE) ............................................................. 15,000 Additional paid-in capital (+SE) ........................................................6,000

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c. +

Cash (A) 250,000 4,125,000

2/20 2/21

-

30,000 9/25

6/30

6/30

21,000 + Treasury Stock (XSE) 30,000 15,000

9/25

- Preferred Stock (SE) + 1,500,000

2/21

- Common Stock (SE) + 10,000

2/20

- Additional Paid-in Capital (SE) 240,000 2,625,000 6,000

+ 2/20 2/21 9/25

E11-40. (20 minutes) LO 2 a. Balance Sheet

Transaction

Cash Asset

+

Noncash LiabilAssets = ities

Issue 25,000 shares of $5 par common stock at $17 per share.

+425,000 Cash

=

Issued 6,000 shares of $50 par preferred stock at $78 per share.

+468,000 Cash

Repurchased 3,000 shares of treasury stock at $20 per share.

-60,000 Cash

=

Sold 2,000 shares of treasury stock at $26 per share.

+52,000 Cash

=

Sold 1,000 shares of treasury stock at $19 per share.

+19,000 Cash

=

+

Income Statement

Contrib. Capital

Earned + Capital -

Contra Equity

+125,000 Common Stock

-

-

=

-

-

=

Revenues

Net - Expenses = Income

+300,000 Add’l Paid-in Capital =

+300,000 Preferred Stock +168,000 Add’l Paid-in Capital

-

+60,000 Treasury Stock

-

=

+12,000 Add’l Paid-in Capital

-

-40,000 Treasury Stock

-

=

-1,000 Add’l Paid-in Capital

-

-20,000 Treasury Stock

-

=

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b. 1/15

Cash (+A) ......................................................................................... 425,000 Common stock (+SE) ....................................................................... 125,000 Additional paid-in capital (+SE) ........................................................ 300,000

1/20

Cash (+A) ......................................................................................... 468,000 Preferred stock (+SE) ...................................................................... 300,000 Additional paid-in capital (+SE) ........................................................ 168,000

3/31

Treasury stock (+XSE, -SE) ............................................................. 60,000 Cash (-A) ..........................................................................................60,000

6/25

Cash (+A) ......................................................................................... 52,000 Treasury stock (-XSE, +SE) ............................................................. 40,000 Additional paid-in capital (+SE) ........................................................ 12,000

7/15

Cash (+A) ......................................................................................... 19,000 Additional paid-in capital (-SE) ......................................................... 1,000 Treasury stock (-XSE, +SE) ............................................................. 20,000

c. + 1/15 1/20

Cash (A) 425,000 468,000

-

60,000 6/25 7/15

3/31

3/31

52,000 19,000 + Treasury Stock (XSE) 60,000 40,000 20,000

6/25 7/15

- Preferred Stock (SE) + 300,000

1/20

- Common Stock (SE) + 125,000

1/15

- Additional Paid-in Capital (SE) + 300,000 1/15 168,000 1/20 12,000 6/25 7/15 1,000

E11-41. (20 minutes) LO 1, 2, 6 a. 7,040 million - 2,781 million = 4,259 million shares outstanding. b. ($1,760 million + $15,864 million) / 7,040 million shares = $2.50 per share. c. $50,677 million / 2,781 million shares = $18.22 per share. d. EPS is computed based on the number of shares outstanding. The number of shares in treasury stock is subtracted from shares issued to get the number of

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shares outstanding. Thus, the number of treasury shares is subtracted from the denominator in computing EPS.

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Financial Accounting, 6th Edition

E11-42. (20 minutes) LO 4 Dividend Distribution

a.

2018 2019

2020

Preferred Common Arrearage on preferred [7%  (20,000  $60)] Current year on preferred [7%  (20,000  $60)] Remainder to common Total distribution Per share Preferred ($168,000/20,000) Common ($15,000/100,000) Current year on preferred [7%  (20,000  $60)] Remainder to common Per share Preferred ($84,000/ 20,000) Common ($116,000/100,000)

Preferred $0

Common

Preferred per Share $0.00

$0

Common per Share $0.00

$84,000 84,000 $168,000

$15,000 $15,000 $8.40 $0.15

$84,000 $116,000 $4.20 $1.16

b. 2018 2019

2020

Preferred Common Arrearage on preferred [7%  (20,000  $60)] Per share Preferred ($84,000/20,000) Common Arrearage on preferred [7%  (20,000  $60)] Partial current year on preferred Total distribution Per share Preferred ($150,000/20,000) Common

$0

$0.00 $0

$0.00

$84,000 $4.20 $0.00

$ 84,000 66,000 $150,000 $7.50 $0.00

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E11-43. (15 minutes) LO 6 a. Basic EPS: [$230,000 – (5,000 x $4)] / 30,000 = $7.00 Calculation of weighted average shares outstanding: 25,000 x 4/12 = 8,333 34,000 x 2/12 = 5,667 28,000 x 2/12 = 4,667 34,000 x 4/12 = 11,333 30,000 b. Diluted EPS: $230,000 / [(30,000 + (5,000 x 2)] = $5.75 c. If Soliman Corporation had a simple capital structure, only basic EPS ($7.00) would be reported.

E11-44. (25 minutes) LO 4, 6

a. Year 1

Distribution to Preferred Common $ 0 $ 0

Year 2: Arrearage from Year 1 ($750,000  8%) Current year dividend ($750,000  8%) Balance to common Total for Year 2

60,000 _______ $120,000

$160,000 $160,000

Year 3: Current year dividend ($750,000  8%)

$ 60,000

$

0

$

$

0

b. Year 1 Year 2: Current year dividend ($750,000  8%) Balance to common Year 3: Current year dividend ($750,000  8%)

$ 60,000

0

$ 60,000 $220,000 $ 60,000

$

0

c. Because the preferred stock is not convertible, Potter Company has a simple capital structure and would only report basic EPS. Basic EPS would be reduced in Years 2 and 3 when the preferred dividends are subtracted from net income in the numerator. ©Cambridge Business Publishers, 2020 1-240

Financial Accounting, 6th Edition

E11-45. (20 minutes) LO 1, 2

a. 35,852 thousand  $0.01 = $358.52 thousand rounded to $359 thousand. b. ($359 thousand + $1,305,090 thousand) / 35,852 thousand shares = $36.41 per share

c. 35,852 thousand shares issued – 7,826 thousand shares in treasury = 28,026 thousand shares outstanding

d. $2,334,409 thousand / 7,826 thousand shares = $298.29 per share e. Companies repurchase stock for a variety of reasons: 1. To offset the dilutive effects of shares issued to employees as part of equitybased compensation plans. 2. To mitigate a takeover threat by concentrating the remaining shares in “friendly hands.” 3. To send a signal to the market that the company feels its shares are undervalued.

E11-46. (30 minutes) LO 4 a. Preferred 2018 Current year on preferred [6%  (18,000  $50)] Remainder to common Per share Preferred ($54,000/18,000) Common ($9,000/90,000) 2019 Preferred Common 2020 Arrearage on preferred [6%  (18,000  $50)] Current year on preferred [6%  (18,000  $50)] Remainder to common Total distribution Per share Preferred ($108,000/18,000) Common ($270,000/90,000)

Dividend Distribution Preferred Common per Share

Common per Share

$54,000 $9,000 $3.00 $0.10 $0

$0.00 $0

$0.00

$54,000 54,000 $108,000

$270,000 $270,000 $6.00 $3.00 ©Cambridge Business Publishers, 2020

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b. Preferred 2018 Preferred Common 2019 Arrearage on preferred [6%  (18,000  $50)] Current year on preferred [6%  (18,000  $50)] Common Total distribution Per share Preferred ($108,000/18,000) Common 2020 Current year on preferred [6%  (18,000  $50)] Remainder to common Per share Preferred ($54,000/18,000) Common ($135,000/90,000)

Dividend Distribution Preferred Common per Share

$0

Common per Share

$0.00 $0

$0.00

$ 54,000 54,000 $0 $0

$108,000

$6.00 $0.00

$54,000 $135,000 $3.00 $1.50

E11-47. (15 minutes) LO 4 a. Balance Sheet Transaction Declared and paid cash dividend.

Cash Asset

Noncash + Assets

-47,500 Cash

Declared and issued stock dividend.

Income Statement

Contrib. = Liabilities + Capital +

Earned Capital

=

-47,5001 Retained Earnings

-

=

-35,0002 Retained Earnings

-

=

=

+10,000 Common Stock

Revenues

-

Expenses

=

Net Income

+25,000 Additional Paid-in Capital 1

$1.90  25,000 = $47,500.

2

Retained Earnings is reduced by the market price of the shares distributed (25,000 shares  4%  $35 market value = $35,000). Common Stock is increased by the par value with the balance of the market price reflected in an increase in Additional Paid-in Capital.

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Financial Accounting, 6th Edition

b. 1)

Retained earnings (-SE) ................................................................... 47,500 Cash (-A) .......................................................................................... 47,500

2)

Retained earnings (-SE) ................................................................... 35,000 Common stock (+SE) ....................................................................... 10,000 Additional paid-in capital (+SE) ........................................................ 25,000

c. +

Cash (A)

47,500

1) 2)

Retained Earnings (SE) 47,500 35,000

- Common Stock (SE) + 10,000

1) +

2)

- Additional Paid-in Capital (SE) + 25,000 2)

E11-48. (20 minutes) LO 3, 4 a. Balance Sheet Transaction

Cash Asset

Declared and paid stock dividend.

+

Noncash Assets

= =

Liabilities

+

Income Statement Contrib. Capital + +56,000 Common Stock

Earned Capital

Revenues

-

Expenses

=

-100,8001 Retained Earnings

-

=

-64,2002 Retained Earnings

-

=

Net Income

+44,800 Add’l Paid-in Capital Declared and issued cash dividend.

-64,200 Cash

=

1

The 7% dividend is a small stock dividend and, accordingly, Retained Earnings is reduced by the market value of the shares distributed (7%  80,000 shares  $18 = $100,800). Common Stock is increased by the par value of the shares ($56,000) and Additional Paid-in Capital in increased by the remainder ($44,800).

2

Retained Earnings is reduced by $0.75 per share on 85,600 shares outstanding and Cash is decreased by the payment.

b. 5/12

Retained earnings (-SE) ............................................................... 100,800 Common stock (+SE) .................................................................. 56,000 Additional paid-in capital (+SE) .................................................... 44,800

12/31 Retained earnings (-SE) .............................................................. 64,200 Cash (-A) .............................................................................

64,200

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c. +

5/12 12/31

Cash (A)

64,200

Retained Earnings (SE) 100,800 64,200

- Common Stock (SE) + 56,000

12/31 +

5/12

- Additional Paid-in Capital (SE) + 44,800 5/12

d. PALEPU COMPANY Statement of Retained Earnings For the Year Ended December 31, 2019 Retained earnings, December 31, 2018 Add: Net income

$305,000 283,000 588,000

Less:

Cash dividends declared Stock dividends declared Retained earnings, December 31, 2019

$ 64,200 100,800

165,000 $423,000

E11-49. (20 minutes) LO 3, 4 a. Balance Sheet Transaction

Cash Asset

Noncash + Assets

Declared and paid 100% stock dividend.

Income Statement

Contrib. = Liabilities + Capital + =

Declared and paid 3% stock dividend.

Earned Capital

+250,000 Common Stock

-250,0001 Retained Earnings

+15,000 Common Stock

-42,0002 Retained Earnings

Revenues

-

Expenses

=

-

=

-

=

Net Income

+27,000 Additional Paid-in Captal Declared and issued cash dividend.

1

2

3

-102,400 Cash

=

-102,4003 Retained Earnings

The large stock dividend is reflected as a reduction of Retained Earnings at the par value of the shares distributed (50,000 shares  100%  $5 par value per share = $250,000). Common Stock is increased by the same amount. This is a small stock dividend. As a result, Retained Earnings is decreased by the market value of the shares to be distributed (3%  100,000 shares  $14 per share = $42,000). Common Stock is increased by the par value of the shares distributed (3%  100,000  $5 = $15,000) and Additional Paid-in Capital is increased by the balance ($27,000). Total dividends are 4,000  $5 = $20,000 for the preferred shares and 103,000  $0.80 = $82,400 for the common shares. Retained Earnings and Cash are reduced to reflect the payment.

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Financial Accounting, 6th Edition

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b. 4/1

Retained earnings (-SE) ............................................................... 250,000 Common stock (+SE) ................................................................... 250,000

12/7

Retained earnings (-SE) .............................................................. 42,000 Common stock (+SE) .................................................................. 15,000 Additional paid-in capital (+SE) .................................................... 27,000

12/20 Retained earnings (-SE) .............................................................. 102,400 Cash (-A) .................................................................................... 102,400 c. +

4/1 12/7 12/20

Cash (A)

102,400

Retained Earnings (SE) 250,000 42,000 102,400

12/20

+

- Common Stock (SE) + 250,000 15,000

4/1 12/7

- Additional Paid-in Capital (SE) + 27,000 12/7

d. KINNEY COMPANY Statement of Retained Earnings For the Year Ended December 31, 2019 Retained earnings, December 31, 2018 Add: Net income Less:

Cash dividends declared Stock dividends declared Retained earnings, December 31, 2019

$656,000 253,000 909,000 $102,400 292,000

394,400 $514,600

©Cambridge Business Publishers, 2020 1-246

Financial Accounting, 6th Edition

E11-50. (15 minutes) LO 4, 6 a. Immediately after the stock split, 800,000 shares (2 x 400,000 shares) of $10 par value common stock are issued and outstanding. b. The stock split does not change the Common Stock account balance. The account balance is $8,000,000 just before and immediately after the stock split. c. The stock split does not change the Paid-in Capital in Excess of Par Value account. The account balance is $3,400,000 just before and immediately after the stock split. d. The 2-for-1 split will reduce EPS by half. The EPS numbers currently reported in previous years’ income statements would also be reduced by half for comparison purposes.

E11-51. (20 minutes) LO 3, 4 a. Beginning retained earnings + Net income – Dividends = Ending retained earnings, so $7,297 million + $1,211 million – Dividends = $8,101 million. Dividends = $407 million. b. The change in shares outstanding was 258,616 thousand – 255,668 thousand = an increase of 2,948 thousand shares. Therefore, Intuit must have issued 1,078 thousand shares for the exercise of stock options. c. When a company reissues treasury shares, the difference between the value received and the treasury share cost is either put in or taken from Additional paid-in capital (APIC). In this case, the option exercises increased APIC, implying that the average exercise price exceeded the average cost of the treasury shares.

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E11-52. (20 minutes) LO 2 a. Shares issued  Par value = Common Stock amount 3,577 million shares  $0.50 = $1,788.5 million b. (Common Stock + Other Paid-In Capital)/Shares issued = Average Issue price ($1,788 million + $39,902 million) / 3,577 million = $11.66 per share c. Treasury Stock / Treasury shares = Treasury cost per share $43,794 million / 880.5 million = $49.74 per treasury share d. Shares issued – Treasury shares = Shares outstanding 3,577,103,522 – 880,491,914 = 2,696,611,608 shares outstanding

E11-53. (15 minutes) LO 7 a. Using diluted EPS and average shares outstanding, ($1.27) per share × 235 million shares = a loss of $ 298.45 million. This amount is after tax. Stock options and restricted stock units are not outstanding shares of stock and are thus, not included in the basic EPS computation. They are, however, potentially dilutive securities because when the holder of the security can exercise the option or when the restricted stock unit becomes a share, then more shares will be outstanding. Thus, both of these need to be considered when computing diluted EPS. b. In 2018, the assumed conversion of Class B stock into Class A stock results in a reallocation of income, meaning more income allocated to Class A stockholders, of $3,701 million. This amount increases the numerator for the diluted EPS calculation. The number of Class A shares assumed to be outstanding is also increased (the ‘asif converted amount’), and in 2018 the increase in the number of shares due to the assumed conversion of Class B shares is 484 million shares.

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Financial Accounting, 6th Edition

E11-54. (20 minutes) LO 2, 4 a. Yes, the number of shares outstanding increased by 6 million from “equity compensation activity”. b. Net income + other comprehensive income = total comprehensive income. $12,598 million + $ 431 million = $13,029 million. c. Balance Sheet Cash Asset

Transaction

+

Noncash LiabilAssets = ities

-3,577

=

Cash

+

Contrib. Capital

Income Statement Earned + Capital -

Contra Equity

-

+3,577

Revenues

Net Expenses = Income

-

=

Treasury Stock

Treasury stock (+XSE, -SE) .......................................................... 3,577 Cash (-A) ..................................................................................... +

-

Cash (A)

3,577

3,577

+ Treasury Stock (XSE) 3,577

d. The $14 million difference between $2,529 million and $2,515 million went into the Common Stock account. Perhaps Disney paid some portion of its dividends into a dividend reinvestment account that effectively provides a stock dividend.

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PROBLEMS P11-55. (45 minutes) LO 2, 3, 6 a.

Transaction

Cash Asset

+

Noncash Assets

=

1/10: Issued common stock.1

+476,000 Cash

=

1/23: Purchased treasury stock.2

-152,000 Cash

=

3/14: Sold treasury stock.3

+84,000 Cash

=

7/15: Issued preferred stock.4

+128,000 Cash

=

11/15: Sold treasury stock.5

+24,000

Balance Sheet LiabilContrib. + ities Capital +280,000 Common Stock

Income Statement Earned + Capital

Contra Equity

Revenues

-

Expen -ses

=

-

-

=

- +152,000 Treasury Stock

-

=

+8,000 Additional Paid-in Capital

-

-

=

+80,000 Preferred Stock

-

-

=

-

=

Net Income

+196,000 Additonal Paid-in Capital

-76,000 Treasury Stock

+48,000 Additional Paid-in Capital =

+5,000 Additonal Paid-in Capital

-

-19,000 Treasury Stock

1

Total proceeds of 28,000  $17 = $476,000 are reflected as an increase in Cash. Common Stock is increased by the par value of the shares issued (28,000  $10 = $280,000) and Additional Paid-in Capital is increased for the balance ($196,000).

2

Cash is decreased and Treasury Stock is increased by the purchase price of 8,000 shares  $19 = $152,000. The increase in Treasury Stock reduces contributed capital.

3

Cash received is 4,000 shares  $21 = $84,000. Treasury Stock is reduced by the original cost of $19 per share and the remainder of $8,000 is reflected as an increase in Additional Paid-in Capital.

4

Cash received is $128,000. The Preferred Stock account is increased by the par value of the preferred shares issued (3,200  $25 = $80,000) and Additional Paid-in Capital is increased for the balance.

5

Cash received is 1,000 shares  $24 = $24,000. Treasury Stock is reduced by its original cost of 1,000 shares  $19 = $19,000, thus increasing contributed capital, and Additional Paid-in Capital is increased for the balance ($5,000).

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Financial Accounting, 6th Edition

b. 1/10

Cash (+A) ................................................................................... 476,000 Common stock (+SE) .................................................................. 280,000 Additional paid-in capital (+SE) .................................................... 196,000

1/23 Treasury stock (+XSE, -SE) ......................................................... 152,000 Cash (-A) .................................................................................... 152,000 3/14

Cash (+A) ................................................................................... 84,000 Treasury stock (-XSE, +SE) ......................................................... 76,000 Additional paid-in capital (+SE) .................................................... 8,000

7/15

Cash (+A) ................................................................................... 128,000 Preferred stock (+SE) .................................................................. 80,000 Additional paid-in capital (+SE) ..................................................... 48,000

11/15 Cash (+A) ................................................................................... 24,000 Treasury stock (-XSE, +SE) ......................................................... 19,000 Additional paid-in capital (+SE) .................................................... 5,000 c. 1/10 3/14 7/15 11/15 + 1/23

+ Cash (A) 476,000 84,000 128,000 24,000

152,000

1/23

Treasury Stock (XSE) 152,000 76,000 3/14 19,000 11/15

-

Common Stock (SE) + 280,000

1/10

Preferred Stock (SE) + 80,000

7/15

- Additional Paid-in Capital (SE) + 196,000 1/10 8,000 3/14 48,000 7/15 5,000 11/15

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d. 1/10:

Decrease basic EPS

1/23:

Increase basic EPS

3/14:

Decrease basic EPS

7/15:

Decrease basic EPS

11/15:

Decrease basic EPS

Note: These answers ignore the effect of cash balances on earnings. Each transaction changed the cash balance. If cash is invested in operations or in securities to earn a return, net earnings would be affected by each transaction.

e. Stockholders’ Equity Paid-in capital 8% Preferred stock, $25 par value,50,000 shares authorized; 10,000 shares issued and outstanding Common stock, $10 par value, 200,000shares authorized; 78,000 shares issued, of which 3,000 shares are in treasury

$ 250,000 780,000

$1,030,000

Additional paid-in capital Paid-in capital in excess of par value—Preferred stock

116,000

Paid-in capital in excess of par value—Common stock

396,000

Paid-in capital from Treasury stock Total paid-in capital Retained earnings

13,000

525,000 1,555,000 329,000 1,884,000

Less: Treasury stock (3,000 common shares) at cost Total stockholders’ equity

57,000 $1,827,000

©Cambridge Business Publishers, 2020 1-252

Financial Accounting, 6th Edition

P11-56. (30 minutes) LO 2, 3, 4, 5, 6 a. Balance Sheet Transaction

Cash Asset

+

Noncash Assets =

Purchased -100,000 10,000 shares Cash of treasury stock for cash.

=

Sold 1,500 +18,000 shares of Cash treasury stock.

=

Issued 5,000 shares of common stock.

=

+55,000 Cash

Sold 1,200 +10,800 shares of Cash treasury stock.

Liabilities

+

Contrib. Capital

Income Statement Earned + Capital -

Contra Equity

Revenues

Net - Expenses = Income

-

+100,0001 Treasury Stock

-

=

+3,000 Add’l Paid-in Capital

-

-15,0002 Treasury Stock

-

=

+25,0003 Common Stock

-

-

=

-

=

+30,000 Add’l Paid-in Capital =

-1,200 Add’l Paid-in Capital

-

-12,0004 Treasury Stock

Notes: 1

The stock is acquired for 10,000 shares  $10 = $100,000. This is reflected as a reduction in Cash and a corresponding increase in the Treasury Stock account, a contra-equity account which reduces contributed capital.

2

Cash received is 1,500 shares  $12 per shares = $18,000. Treasury Stock is reduced by its original cost of $10 per share and the balance ($3,000) is reflected as an increase in Additional Paid-in Capital.

3

Cash received is 5,000 shares  $11 per share. Common Stock is increased by the par value of the shares issued (5,000  $5 = $25,000) and Additional Paid-in Capital is increased by the balance ($30,000).

4

Cash received is 1,200 shares  $9 = $10,800. Treasury Stock is reduced by the original cost of the shares (1,200 shares  $10 = $12,000) and Additional Paid-in Capital is reduced by the balance ($10,800 - $12,000 = -$1,200).

b. 1/12 No entry is required for the 3-for-1 stock split. 9/1

Treasury stock (+XSE, -SE) ......................................................... 100,000 Cash (-A) ....................................................................................

100,000

10/12 Cash (+A) ................................................................................... 18,000 Treasury stock (-XSE, +SE) ......................................................... 15,000 Additional paid-in capital (+SE) .................................................... 3,000 11/21 Cash (+A) ................................................................................... 55,000 Common stock (+SE) ................................................................... 25,000 Additional paid-in capital (+SE) ..................................................... 30,000 12/28 Cash (+A) ................................................................................... 10,800 Additional paid-in capital (-SE) ..................................................... 1,200 Treasury stock (-XSE, +SE) ......................................................... 12,000 ©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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Financial Accounting, 6th Edition

c. 10/12 11/21 12/28 + 9/1

d. 1/12: 9/1: 10/12: 11/21: 12/28:

+ Cash (A) 18,000 100,000 55,000 10,800 Treasury Stock (XSE) 100,000 15,000 12,000

9/1

10/12 12/28

- Common Stock (SE) + 25,000

11/21

- Additional Paid-in Capital (SE) + 12/28 1,200 3,000 10/12 30,000 11/21

stock split – decrease basic EPS purchase treasury stock – increase basic EPS sold treasury stock – decrease basic EPS issued common stock – decrease basic EPS sold treasury stock – decrease basic EPS

e. Stockholders’ Equity Paid-in capital 7% Preferred stock, $100 par value, 20,000 shares authorized; 5,000 shares issued and outstanding Common stock, $5 par value, 300,000 shares authorized; 125,000 shares issued, of which 7,300 shares are in the treasury Additional paid-in capital Paid-in capital in excess of par value—Preferred stock Paid-in capital in excess of par value—Common stock Paid-in capital from treasury stock Total paid-in capital Retained earnings

$500,000

625,000 24,000 390,000 1,800

Less: Treasury stock (7,300 common Shares) at cost Total stockholders' equity

$1,125,000

415,800 1,540,800 408,000 1,948,800 73,000 $1,875,800

f. Because Sougiannis did not pay the 7% dividend on its preferred stock, ROCE is computed as follows: $83,000 / [($1,875,800+$1,809,000)/2 -$500,000] = 0.062 or 6.2%

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P11-57. (45 minutes) LO 2, 3, 6 a. Balance Sheet Transaction

Cash Asset

Noncash Liabil+ Assets = ities

Issued +120,000 10,000 shares Cash of common stock.1

=

Purchased 4,000 shares of treasury stock.2

-56,000 Cash

=

Sold 1,000 shares of treasury stock.3

+17,000 Cash

=

Sold 500 shares of treasury stock.4

+6,500 Cash

+175,000 Cash

Issued 5,000 shares of preferred stock.5

1

2

3

4

5

Income Statement

Contrib. + Capital

Earned + Capital -

+50,000 Common Stock

-

Contra Equity Revenues

Net - Expenses = Income -

=

+70,000 Add’l Paid-in Capital -

+56,000 Treasury Stock

-

=

+3,000 Add’l Paid-in Capital

-

-14,000 Treasury Stock

-

=

=

-500 Add’l Paid-in Capital

-

-7,000 Treasury Stock

-

=

=

+125,000 Preferred Stock

-

-

=

+50,000 Add’l Paid-in Capital

Cash is increased by the proceeds from the stock sale (10,000 shares  $12 = $120,000). Common Stock is increased by the par value (10,000 shares  $5) and Additional Paid-in Capital for the balance ($70,000). Cash is reduced by the cost of the Treasury Stock (4,000 shares  $14 = $56,000). The Treasury Stock account is increased accordingly. Since this account has a negative balance in stockholders’ equity, contributed capital is reduced. Cash is increased by the proceeds from the sale of the Treasury Stock (1,000 shares  $17 = $17,000). The Treasury Stock account is reduced by the original cost of the shares (1,000  $14 = $14,000) and Additional Paid-in Capital is increased for the balance. Cash is increased by the proceeds from the sale of the Treasury Stock (500 shares  $13 = $6,500). Treasury Stock is reduced by its original cost (500 shares  $14 = $7,000) and Additional Paid-in Capital is reduced for the balance. Cash is increased by the proceeds from the sale of the Preferred Stock (5,000 shares  $35 per share = $175,000). Preferred Stock is increased by its par value (5,000 shares  $25 = $125,000) and Additional Paid-in Capital is increased for the balance ($50,000).

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Financial Accounting, 6th Edition

b. 1/5

Cash (+A) ................................................................................... 120,000 Common stock (+SE) ................................................................... 50,000 Additional paid-in capital (+SE) ..................................................... 70,000

1/18

Treasury stock (+XSE, -SE) ......................................................... 56,000 Cash (-A) ....................................................................................

56,000

3/12

Cash (+A) ................................................................................... 17,000 Treasury stock (-XSE, +SE) ......................................................... 14,000 Additional paid-in capital (+SE) .................................................... 3,000

7/17

Cash (+A) ................................................................................... 6,500 Additional paid-in capital (-SE) ..................................................... 500 Treasury stock (-XSE, +SE) .........................................................

10/1

7,000

Cash (+A) ................................................................................... 175,000 Preferred stock (+SE) .................................................................. 125,000 Additional paid-in capital (+SE) .................................................... 50,000

c. 1/5 3/12 7/17 10/1 + 1/18

+ Cash (A) 120,000 17,000 6,500 175,000

-

56,000

1/18 -

Treasury Stock (XSE) 56,000 14,000 3/12 7,000 7/17

Common Stock (SE) + 50,000

1/5

Preferred Stock (SE) + 125,000

10/1

- Additional Paid-in Capital (SE) + 70,000 1/5 7/17 500 3,000 3/12 50,000 10/1

d. Stockholders’ Equity Paid-in capital 8% Preferred stock, $25 par value, 50,000 shares authorized, 5,000 Shares issued and outstanding Common stock, $5 par value, 350,000 shares authorized; 160,000 shares issued; 2,500 shares in treasury Additional paid-in capital Paid-in capital in excess of par value—Preferred stock Paid-in capital in excess of par value—Common stock Paid-in capital from Treasury stock Total paid-in capital Retained earnings Less: Treasury stock (2,500 shares) at cost Total stockholders' equity

$125,000 800,000 50,000 670,000 2,500

$ 925,000

722,500 1,647,500 418,500 2,066,000 35,000 $2,031,000

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e. The transactions on January 5 (stock issue), March 12 and July 17 (both treasury stock sales), and the transaction on October 1 (issued preferred stock) would decrease basic EPS. The transaction on January 18 (treasury stock purchase) would increase basic EPS.

P11-58. (30 minutes) LO 2, 4 a. See explanations in part b below. Balance Sheet Transaction

Cash Asset

Noncash Liabil+ Assets = ities

Issued 1,000 shares of preferred stock.

+62,000

=

Issued 4,000 shares of common stock.

+144,000

Issued 2,000 shares of common stock.

+60,000

Purchased 2,500 shares of treasury stock.

-45,000 Cash

=

Sold 900 shares of treasury stock.

+18,900 Cash

=

Issued 500 shares of preferred stock.

+29,500 Cash

=

+

Contrib. Capital +50,000 Preferred Stock

Income Statement Earned + Capital -

Contra Net Equity Revenues - Expenses = Income

-

-

=

-

-

=

-

-

=

+12,000 Additional Paid-in Capital =

Cash

+80,000 Common Stock +64,000 Additional Paid-in Capital

=

Cash

+20,000 Common Stock +40,000 Additional Paid-in Capital

-

+45,000 Treasury Stock

-

=

+2,700 Additional Paid-in Capital

-

-16,200 Treasury Stock

-

=

+25,000 Preferred Stock

-

-

=

+4,500 Additional Paid-in Capital

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b. 1/15

Cash (+A) ................................................................................... 62,000 Preferred stock (+SE) .................................................................. 50,000 Additional paid-in capital (+SE) ..................................................... 12,000

Cash is increased by the proceeds from the sale of the Preferred Stock (1,000 shares  $62 per share = $62,000). The Preferred Stock account is increased for its par value (1,000 shares  $50 par = $50,000) and Additional Paid-in Capital is increased for the balance ($12,000).

1/20

Cash (+A) ................................................................................... 144,000 Common stock (+SE) ................................................................... 80,000 Additional paid-in capital (+SE) ..................................................... 64,000

Cash is increased by the proceeds from the sale of the Common Stock (4,000 shares  $36 = $144,000). Common Stock is increased by its par value (4,000  $20 = $80,000) and Additional Paidin Capital is increased for the remainder ($64,000).

5/18 6/1

No entry is required for the 2-for-1 stock split Cash (+A) ................................................................................... 60,000 Common stock (+SE) .................................................................. 20,000 Additional paid-in capital (+SE) ..................................................... 40,000

Common Stock is increased by its par value (2,000  $10 = $20,000) and Additional Paid-in Capital is increased for the balance ($40,000).

9/1

Treasury stock (+XSE, -SE) ......................................................... 45,000 Cash (-A) ...................................................................................

45,000

Cash is reduced by the cost of the Treasury Stock (2,500 shares  $18 per share = $45,000). The Treasury Stock account is increased by its cost, thereby reducing contributed capital.

10/12 Cash (+A) ................................................................................... 18,900 Treasury stock (-XSE, +SE) ......................................................... 16,200 Additional paid-in capital (+SE) .................................................... 2,700

Cash is increased by the proceeds from the sale of the Treasury Stock (900  $21 = $18,900). The Treasury Stock account is reduced by its cost (900  $18 = $16,200), thereby increasing contributed capital, and Additional Paid-in Capital is increased by the balance ($2,700).

12/22 Cash (+A) ................................................................................... 29,500 Preferred stock (+SE) .................................................................. 25,000 Additional paid-in capital (+SE) ..................................................... 4,500

Cash is increased by the proceeds from the sale of the preferred shares (500  $59 = $29,500). The Preferred Stock account is increased for its par value (500 shares  $50 = $25,000) and Additional Paid-in Capital is increased for the balance ($4,500).

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c. + Cash (A) 62,000 144,000 60,000

1/15 1/20 6/1

-

45,000 10/12 12/22

9/1

18,900 29,500 +

9/1

-

Treasury Stock (XSE) 45,000 16,200 10/12

-

Common Stock (SE) + 80,000 20,000

1/20 6/1

Preferred Stock (SE) + 50,000 1/15 25,000 12/22

- Additional Paid-in Capital (SE) + 12,000 1/15 64,000 1/20 40,000 6/1 2,700 10/12 4,500 12/22

P11-59. (50 minutes) LO 1, 2, 5, 6, 7 a. 2018: 4,009.2 – 1,511.2 = 2,498 million 2017: 4,009.2 – 1,455.9 = 2,553.3 million Estimated average shares outstanding: ($9,750 - $265)/$3.75 = 2,529.33 million. Average shares outstanding is slightly greater than the number of shares outstanding at year-end because P&G has more shares in treasury stock at the end of 2018 than at the end of 2017. Meaning, P&G repurchases shares during the year. b. 2018: $99,217/1,511.2 = $65.65 2017: $93,715/1,455.9 = $64.37 c. Preferred stock (-SE) ……………………………………… 39 Additional paid-in capital (+SE) ............................................. Treasury stock (-XSE, +SE) .........................................................

6 33

The reported value for preferred stock includes additional paid-in capital. This fact can be discerned by noting that 600 million of class A preferred shares are authorized and if all 600 million shares were issued, the stated value of $1 per share would yield $600 million of preferred stock. But if the $967 million is assumed to be the stated value, the number of issued shares exceeds the number authorized. Therefore, the $967million figure must include additional paid-in capital and the additional paid-in capital account refers only to common stock. d. P&G’s diluted EPS reflects the effects of convertible preferred stock and, most likely, outstanding stock options and other equity-based pay. e. 2018 ($millions): ($9,750 - $265) / [($52,293-$967+$55,184-$1,006)/2] = 0.18 or 18% ©Cambridge Business Publishers, 2020 1-260

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P11-60. (50 minutes) LO 5, 7 a. Class A and B common shares are identical except for voting rights. Class A shares have 1 vote per share while class B shares have 10 votes per share. This means that class B shareholders have greater control in the governance of the corporation. Presumably, class B shares were retained by the original management team of the firm when the class A shares were offered. Class C capital shares have no voting rights at all, though they participate in any dividends declared for common shares. Class C shares allow Alphabet executives to continue using shares to make acquisitions and motivate employees, while ensuring that the Class B shares retain more than 50% of the voting power. b. Retained Earnings Capital Stock Cash

8,499 576 9,075 (millions)

c. RSUs vest over 4 years. The fair value of the RSUs at grant date = 12,669,251 shares x $1,095.89 average FV per share = $13,884,105,478. Assume pro-rate vesting: $13,884,105,478/4 = $3,471,026,370 Compensation expense (+E, -SE) Paid-in Capital – Restricted Stock (+SE)

3,471,026,370 3,471,026,370

This entry would reduce Alphabets’ income before tax by $3,471,026,370. d. This cost is related to RSUs that are granted but not vested and not yet recorded as compensation cost yet (the cost related to the latter part of the vesting period that has not occurred yet). The unrecognized compensation cost related to unvested employee RSUs is not a liability because Alphabet has not incurred the cost yet — the employees have not worked yet. In addition, the amount is recorded as an increase to equity (not an increase in liabilities) when the compensation expense is recorded because the company is issuing equity shares to the employees. e. $30,736 million / $44.22 = 695 million shares. Alphabet had 694.8 million shares outstanding at the end of 2017 and 695.6 million shares outstanding at the end of 2018.

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f. If all outstanding stock options were exercised, basic EPS would decrease. Assume Alphabet had 15.0 million options outstanding at the end of 2018. If all of these options had been exercised and added to shares outstanding, basic EPS would have been $30,736 / (695 + 15.0) = $43.29 per share (compared to $44.22). g. The diluted EPS figure includes an adjustment only for outstanding options that are not “under water,” i.e., are anti-dilutive. But this would cause the diluted EPS to be higher than the amount calculated in part f. The difference is due to the fact that Google has stock-based compensation besides stock options, like restricted stock units.

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CASES and PROJECTS C11-61. (30 minutes) LO 7

a. Mandatorily redeemable means that the issuing company can decide to repurchase all of the remaining shares that have not been converted before the redemption date specified in the preferred issue contract. Prior to that date, holders of the preferred shares can convert their shares to common stock. Northrop Grumman preferred holders converted most of their shares and the rest were redeemed by the company. “Convertible” means that the preferred stock can be exchanged for common stock. Usually this option rests with the holder of the preferred stock. Sometimes, companies retain an option to force the conversion. Northrop Grumman did so. This option is spelled out in the preferred stock contract. The issue may also include a “liquidation preference”, which would indicate the amount that will be paid to the preferred shareholders in the event that the company fails. This amount must be paid in full before the common shareholders can be paid anything in the event of the liquidation of the company.

b. $350 million/$3.5 million = $100 c. The conversion option has increased substantially in value since issue. This increase is likely due to an expected new government contract most likely for an aircraft.

d. The answer depends on whether the remaining preferred shares are redeemed for cash or converted into common shares. If Northrop Grumman pays for the conversion in cash, cash is reduced, as is preferred stock. If converted into common, the preferred stock is removed from the balance sheet and the common stock is “sold” for the book value of the preferred; that is, the par value and additional paid-in capital accounts increase as if the common were sold for the book value of the preferred.

e. Outstanding convertible preferred shares need to be considered in our analysis of the company, as the potential shares to be issued represent a contingent claim to the future cash flows of the company. Convertible preferred shares are considered in the computation of diluted EPS, which assumes conversion at the earliest possible opportunity. The forgone preferred dividends are removed from (added back to) the numerator, and the additional shares issued are added to the denominator. The net effect is a reduction in the diluted EPS over basic EPS.

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C11-62. (15 minutes) LO 1, 2 King’s responsibility is to the shareholders of Image, Inc. Hatcher’s offer is beneficial to the shareholders, so, in theory, King should support Hatcher’s efforts. However, since it is likely that King and other managers will lose their jobs if Hatcher’s takeover attempt is successful, King’s inclination may be to resist Hatcher’s move. It would be unethical to pay Hatcher 50% above current market price to repurchase his stock. This would harm the remaining shareholders in two ways. First, blocking the takeover would deprive shareholders of the opportunity to sell their shares at a price that is substantially higher than current market price. Second, King would be using company funds to purchase Hatcher’s stock, so the other shareholders are essentially paying for King’s job security. A tactic that would be ethical and beneficial to shareholders is for King, along with other managers and directors, to make a competing offer to shareholders for the outstanding stock. In that way, shareholders benefit by receiving the higher stock price (whether from King or Hatcher) and if King acquires the company, he keeps his job.

C11-63. (30 minutes) LO 1, 3 a. There are no cash proceeds from the stock dividend. b. 2018: $9,450,000 / 250,000 = $37.80 per share 2019: $10,285,000 / 275,000 = $37.40 per share c. Because of the stock dividend, the number of shares you own increased by 10% to 8,250 in 2019. Your percentage ownership in Pillar has remained the same. The market value of your shares at the end of 2019 is $214,500 (8,250 x $26). At December 14, just prior to the stock dividend, your shares were worth $210,000 (7,500 x $28). d. Stock dividends, like stock splits, do not increase the book value of stockholders’ equity. Stock dividends are paid to indicate a continued expectation of earnings and earnings growth in periods when cash must be maintained for investment needs. Stock dividends also serve to keep the per share price of the stock at manageable levels during growth periods. e. Retained earnings are restricted as to the amount of cash dividends that Pillar can pay. Except for this restriction, paying a cash dividend then allowing shareholders to purchase additional shares would have accomplished the same thing as a stock dividend. However, some of the shareholders may have chosen not to purchase the additional shares. If this had happened, the company would have to make a public offering in order to raise the required cash. A public offer that is this small is not economical. ©Cambridge Business Publishers, 2020 1-264

Financial Accounting, 6th Edition

f. The dividend cut is due to the restrictions on retained earnings and the amount of cash needed to fund the plant addition. g. Retained earnings are not the same as cash. The company is borrowing $500,000 cash because that is how much additional cash will be needed to build the plant addition. The restriction on retained earnings simply prevents the company from using available cash to pay cash dividends.

C11-64. (20 minutes) LO 2, 3, 6 The projected 5% decline in net income will reduce net income from $7,800,000 last year to $7,410,000 this year. The proposed stock buyback of 600,000 shares at midyear would reduce the weighted average shares outstanding from 4,000,000 to 3,700,000 (4,000,000 x 6/12 + 3,400,000 x 6/12). The resulting earnings per share would be $7,410,000 / 3,700,000 = $2.00 per share. Plummer is likely concerned about the proposal because the stock repurchase appears to manipulate EPS in order to achieve the goal of increasing EPS each year, earning management a nice bonus. This raises ethical concerns, since the cash might be better used to make profitable investments or pay a cash dividend to shareholders. A less obvious question is why Sunlight has so much “excess cash?” If the cash that would be used to repurchase stock (600,000 shares x market price per share) were invested in a profitable investment, management may be able to make up for the expected decline in earnings. It would be hard to believe that no profitable investment opportunities exist. Even a short-term investment in marketable securities might make up for the $390,000 decrease in earnings.

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C11-65. (20 minutes) LO 2, 7 a. The shares were listed in the mezzanine section of the balance sheet – between liabilities and equity. The preferred stock was contingently convertible – the shares were potentially redeemable upon the occurrence of events outside the control of the issuer. b. $3,000 million. ($43.775848 x $68,530,939 shares) c. $547 million ($3,297 - ($3,000 - $250)). This amount was recorded as a reduction in income. d. Answers may vary here. FASB requires that these shares be in the mezzanine section of the balance sheet, meaning that they have characteristics of both debt and equity. Some idicia that one might consider them more debt-like are that 1) they are not convertible into common shares, and 2) the company increased the carrying value to the redemption value in 2014. Another indicator – though only known after the redemption - is that the company funded the redemption by issuing debt.

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Financial Accounting, 6th Edition

Chapter 12 Reporting and Analyzing Financial Investments Learning Objectives – coverage by question MiniExercises

Exercises

Problems

Cases and Projects

LO1 – Explain and interpret the three levels of investor influence over an investee – passive, significant, and controlling.

11

24, 25, 27, 32, 33 35 - 38

45, 47, 48

49 - 52

LO2 – Describe the term “fair value” and the fair value hierarchy.

14

37

45, 47

51, 52

LO3 – Describe and analyze accounting for passive investments.

12, 13, 20, 21, 22

24, 25, 27, 29, 32, 33, 35 - 37

45, 47

49 - 52

LO4 – Explain and analyze accounting for investments with significant influence.

15, 16, 19

30 - 32, 37, 38

47, 48

50 - 52

LO5 – Describe and analyze accounting for investments with control.

17,18,19, 23

26, 28, 34, 41, 42

46, 48

51

LO6 – Appendix 12A – Illustrate and analyze accounting mechanics for equity method investments.

43

48

LO7 – Appendix 12B – Apply consolidation accounting mechanics.

39, 40, 42

46, 48

LO8 – Appendix 12C – Discuss the reporting of derivative securities.

44

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QUESTIONS Q12-1. (a) Trading securities are reported at their fair value in the balance sheet. (b) Available-for-sale securities are reported at their fair value in the balance sheet. (c) Held-to-maturity securities are reported at their amortized cost in the balance sheet. Q12-2. An unrealized holding gain (loss) is an increase (decrease) in the fair value of an asset (in this case, an investment security) that is still owned. Investments in equity securities should be reported at their fair value on the balance sheet, with unrealized holding gains and losses reported in income in the period that they occur. There is a provision for non-marketable securities to use when the cost of estimating fair value is prohibitively expensive. Q12-3. Unrealized holding gains and losses related to trading securities are reported in the current-year income statement (and also retained earnings). Unrealized holding gains and losses related to available-for-sale securities are reported as a separate component of stockholders' equity called Other Comprehensive Income (OCI). Q12-4. Significant influence gives the owner of the stock the ability to significantly influence the operating and financing activities of the company whose stock is owned. Normally, this is accomplished with a 20% through 50% ownership of the company's voting stock. The equity method is used to account for investments with significant influence. Such an investment is initially recorded at cost; the investment is increased by the proportionate share of the investee company's net income, and equity income is reported in the income statement; the investment account is decreased by dividends received on the investment; and the investment account is reported in the balance sheet at its book value. Unrealized appreciation in the market value of the investment is not recognized. Q12-5. Yetman Company's investment in Livnat Company is an investment with significant influence, and should, therefore, be accounted for using the equity method. At year-end, the investment should be reported in the balance sheet at $258,000 [$250,000 + (40%  $80,000) - (40% x $60,000)]. Q12-6. A stock investment representing more than 50% of the investee company's voting stock is generally viewed as conferring “control” over the investee company. The investor and investee companies must be consolidated for financial reporting purposes. Q12-7. Consolidated financial statements attempt to portray the financial position, operating results, and cash flows of affiliated companies as a single economic unit so that the scope of the entire (whole) entity is more realistically conveyed.

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Financial Accounting, 6th Edition

Q12-8. The $750,000 investment in Murray Company appearing in Finn Company's balance sheet and the $300,000 common stock and $450,000 retained earnings appearing on Murray Company's balance sheet are eliminated. The two balance sheets (less the accounts eliminated) are then summed to yield the consolidated balance sheet. Q12-9.B The $75,000 accounts payable on Dee's balance sheet and the $75,000 accounts receivable on Bradshaw's balance sheet are eliminated. In a consolidation, all intercompany items are eliminated so that the consolidated statements show only the interests of outsiders. Q12-10. Limitations of consolidated statements include the possibility that the performances of poor companies in a group are "masked" in consolidation. Likewise, rates of return, other ratios, and percentages calculated from consolidated statements might prove deceptive because they are composites. Consolidated statements also eliminate detail about product lines, divisional operations, and the relative profitability of various business segments. (Some of this information is likely to be available in the footnote disclosures relating to the business segments of certain public firms.) Finally, shareholders and creditors of subsidiary companies find it difficult to isolate amounts related to their legal rights by inspecting only consolidated statements.

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MINI EXERCISES M12-11. (10 minutes) LO 1 a. SI

Griffin owns > 20% of Wright.

b. P

Bond investments are always classified as passive.

c. P

2,000 shares of Google is well below the number necessary to exert influence

d. C

Watts owns more than half of Zimmerman stock

e. SI

Even though Shevlin owns less than 20% of Bowen, the fact that it buys 60% of Bowen’s output means it is capable of exercising significant influence.

M12-12. (10 minutes) LO 3 a. Available-for-sale securities are reported at fair value on the balance sheet. For 2018, this is equal to the original cost ($37,512 million) plus unrecognized gains ($44 million) and less unrealized losses ($547 million), or $37,009 million. b. Unrealized gains (and losses) on available-for-sale securities are reported as a component of Accumulated Other Comprehensive Income (AOCI) in the shareholders’ equity section of the balance sheet.

M12-13. (15 minutes) LO 3 Investments in equity securities must be reported at fair value, with all gains and losses (realized and unrealized) recognized in income. Wasley will report $6,600 of dividend income plus income relating to the increase in the market price of the stock of $6,000 ($13 - $12 price increase for 6,000 shares). Total investment income is $12,600.

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Financial Accounting, 6th Edition

M12-14. (10 minutes) LO 2 a. All of these investments are marked to fair value, but the determination differs. Level 1 fair values are determined by reference to an active market where identical assets are traded. Level 2 fair values are determined by using a model (discounted cash flow, prices of similar assets, etc.) for which the inputs and assumptions can be found from observable value. Level 3 fair values are also determined by using a model, but the inputs and assumptions are not observable except to the reporting company. b. All are marked-to-fair-value, but only Level 1 investments are marked-to-market, the others are marked-to-model. Level 1 values would be the most objective since they come from an active market. Level 3 would be most subjective because they depend significantly on management’s judgments. c. Level 1 assets are most liquid, because they are traded in active markets. Level 3 assets are likely to be least liquid because their value depends significantly on information that is not publicly available.

M12-15. (20 minutes) LO 4 a. Given the 30% ownership, “significant influence” is presumed and the investment must be accounted for using the equity method. The year-end balance of the investment account is computed as follows: Beginning balance ....................... % Lang income earned ................ % Dividends received .................. Ending balance ............................

$1,000,000 30,000 (12,000) $1,018,000

($100,000  0.3) ($40,000  0.3)

b. $30,000 ($100,000  0.3) - Equity earnings are computed as the reported net income of the investee (Lang Company) multiplied by the percentage of the outstanding common stock owned. c. (1) In contrast to the market method, the equity method of accounting does not report investments at market value. The unrealized gain of $200,000 is not reflected in either the balance sheet or the income statement.

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d. 1.

Investment in Lang Company (+A) ................................................... 1,000,000 Cash (-A) .......................................................................................... 1,000,000

2.

Investment in Lang Company (+A) ................................................... 30,000 Investment income (+R, +SE) ..........................................................

30,000

Cash (+A) ......................................................................................... 12,000 Investment in Lang Company (-A) ....................................................

12,000

3.

e. + 3. + 1. 2.

Cash (A) 1,000,000 12,000

1.

Investment in Lang Company (A) 1,000,000 30,000 12,000

Investment Income (R) 30,000

+ 2.

-

3.

f. Transaction Purchase stock in Lang Company.

Cash Asset -1,000,000 Cash

Recognize share of Lang income. Receive dividend from Lang.

+12,000 Cash

+

Noncash Assets

Balance Sheet LiabilContrib. = ities + Capital +

+1,000,000 Investment

=

+30,000 Investment

=

-12,000 Investment

=

Income Statement Earned Capital

+30,000 Retained Earnings

Revenues

+30,000 Investment Income

-

Expenses

Net = Income

-

=

-

= +30,000

-

=

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M12-16. (10 minutes) LO 4 Equity income on this investment is computed as the investee company (Penno) earnings multiplied by the percentage of the company owned. In this case, equity earnings equal: $600,000  40% = $240,000 Note that dividends are treated as a return of investment (reduce the investment balance by $80,000, computed as $200,000  40%), and not as income. Also, the investment is recorded at adjusted cost, not at market value, and unrealized gains (losses) are neither recognized on the balance sheet nor in the income statement.

M12-17. (10 minutes) LO 5 The $600,000 investment in Hirst Company appearing on Philipich Company's balance sheet and the $300,000 common stock and $450,000 retained earnings of Hirst Company would be eliminated. In addition, a $150,000 noncontrolling interest [20% of ($300,000 + $450,000)] would appear on the consolidated balance sheet as part of shareholders equity.

M12-18. (10 minutes) LO 5 Benartzi Company consolidated net income .............................. less net income attributable to noncontrolling interests.............. Net income attributable to Benartzi Company shareholders ......

$750,000 15,000 $735,000

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M12-19. (20 minutes) LO 4, 5 a. If DeFond purchases 100% of Verduzco’s common stock, then it must produce consolidated reports.

Current assets

DeFond Company

DeFond Company

(before investment)

(after investment)

Verduzco Company

Eliminating Entries

DeFond Company (Consolidated)

$ 800

$ 500

$ 100

–

300

–

Noncurrent assets

2,000

2,000

900

2,900

Liabilities

2,200

2,200

700

2,900

600

600

300

Investment

Shareholders’ Equity

$ 600 –

(300)

(300)

600

b. If DeFond purchases 50% of the common stock of Lin Company, it uses the equity method. DeFond Company

DeFond Company

(before investment)

(after investment)

Lin Company

$ 800

$ 500

$ 200

–

300

–

Noncurrent assets

2,000

2,000

1,800

Liabilities

2,200

2,200

1,400

600

600

600

Current assets Investment

Shareholders’ Equity

c. If we compare DeFond’s consolidated balance sheet to the equity method balance sheet, we can see that the total assets are higher and the liabilities are higher. DeFond’s stockholders’ equity accounts are the same. So, the Debt-to-Equity ratio will be higher if DeFond purchases the subsidiary rather than investing in the joint venture. If reported profits are the same under either scenario, then purchasing the subsidiary would produce a lower Return on Assets than the joint venture. Other ratios would change as well (like the Current Ratio), but not in a predictable direction.

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M12-20. (40 minutes) LO 3 a. 2018 10/1

Investment in Skyline, Inc. (+A) ........................................................ 486,000 Cash (-A) ....................................................................................486,000

12/31 Interest receivable (+A) ..................................................................... 8,750 Interest revenue (+R, +SE) .........................................................

8,750

12/31 Investment in Skyline, Inc. (+A) ........................................................ 4,000 Unrealized gain (+R, +SE) ..........................................................

4,000

2019 3/31

4/1

Cash (+A) ........................................................................................ 17,500 Interest receivable (-A) ............................................................... Interest revenue (+R, +SE) ........................................................

8,750 8,750

Cash (+A) ........................................................................................ 492,300 Realized gain (+R, +SE) ............................................................. 2,300 Investment in Skyline, Inc. (-A) ................................................... 490,000

b. Assuming the firm’s fiscal year ends 12/31, the unrealized gain of $4,000 in Skyline Inc. bonds is closed to retained earnings in 2018 increasing net income and retained earnings. +

-

Interest Revenue (R) 8,750 8,750

+ 12/31/18 3/31/19

+ Investment in Skyline Bonds (A) 10/1/18 486,000 12/31/18 4,000 490,000 4/1/19

-

Unrealized Gain (R) 4,000

+ 12/31/18

+ 12/31/19

-

Realized Gain (R) 2,300

3/31/19 4/1/19

Cash (A)

486,000

10/1/18

17,500 492,300

Interest Receivable (A) 8,750 8,750

3/31/19

+ 4/1/19

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c. Transaction 10/1/18 Purchase $500,000 of Skyline bonds at 97.

Cash Asset -486,000 Cash

+

Noncash Assets

Balance Sheet Liabil= ities +

+ 486,000 Investment

=

12/31/18 Recognize interest revenue.

+8,750 Interest Receivable

=

12/31/18 Record unrealized gain.

+4,000 Investment

=

3/31/19 Recognize interest income.

+17,500 Cash

4/1/19 Sold Skyline investment.

+492,300 Cash

-8,750 = Interest Receivable

-490,000 Investment

=

Income Statement Contrib. Capital +

Earned Capital

Revenues

-

Expenses

=

Net Income

-

=

-

=

+8,750

+4,000 Unrealized Gain

=

+4,000

+8,750 Retained Earnings

+8,750 Interest Revenue

-

=

+8,750

+2,300 Retained Earnings

+2,300 Realized Gain

-

=

+2,300

+8,750 Retained Earnings

+4,000 Retained Earnings

+8,750 Interest Revenue

M12-21. (40 minutes) LO 3 a. 2018 11/15 Investment in Lane, Inc. (+A) .................................................. 171,200 Cash (-A) ................................................................................

171,200

12/22 Cash (+A) ...............................................................................10,000 Dividend income (+R, +SE) ....................................................

10,000

12/31 Unrealized loss (+E, -SE) .......................................................16,200 Investment in Lane, Inc. (-A) ..................................................

16,200

2019 1/20

Cash (+A) ......................................................................................... 150,000 Loss on sale of investment in Lane, Inc. (+E, -SE) ........................... 5,000 Investment in Lane, Inc. (-A) ............................................................. 155,000

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Financial Accounting, 6th Edition

b. Assuming the firm’s fiscal year ends 12/31, the unrealized loss of $16,200 is closed to the income summary in 2018, reducing net income and retained earnings. + Cash (A) 10,000 171,200 150,000

12/22 1/20

11/15

11/15

+ Investment in Lane Inc (A) 171,200 16,200 155,000 +

1/20 + 12/31

Unrealized Loss (E) 16,200

-

Loss (E) 5,000

12/31 1/20

-

- Dividend Income (R) + 10,000

12/22

c. Balance Sheet Transaction

Cash Asset

11/15 Purchase 10,000 shares of Lane Inc common.

-171,200 Cash

12/22 Dividend income.

+10,000 Cash

12/31 Decrease in Investment. 1/20 Sale of Lane common.

+

Noncash Assets +171,200 Investment

Contrib. + Capital +

Income Statement Earned Capital

Revenues

-

Expenses

=

=

-16,200 Investment +150,000 Cash

Liabil = -ities

=

-155,000 = Investment

Net = Income =

+10,000 Retained Earnings -16,200 Retained Earnings -5,000 Retained Earnings

+10,000 Dividend Income

= +10,000

+16,200 Unrealized Loss +5,000 Realized Loss

= -16,200

=

-5,000

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M12-22. (30 minutes) LO 3 The main effect is to defer the gain in value experienced in 2018 to the year 2019. a. 2018 10/1 Investment in Skyline, Inc. (+A) ........................................................ 486,000 Cash (-A) ....................................................................................486,000 12/31 Interest receivable (+A) ..................................................................... 8,750 Interest revenue (+R, +SE) .........................................................

8,750

12/31 Investment in Skyline, Inc. (+A) ........................................................ 4,000 Unrealized gain AOCI (+SE) .......................................................

4,000

2019 3/31

4/1

Cash (+A) ........................................................................................ 17,500 Interest receivable (-A) ............................................................... Interest revenue (+R, +SE) ........................................................

8,750 8,750

Cash (+A) ........................................................................................ 492,300 Unrealized gain – AOCI (-SE) 4,000 Realized gain (+R, +SE) ............................................................. 6,300 Investment in Skyline, Inc. (-A) ................................................... 490,000

b. Assuming the firm’s fiscal year ends 12/31, the unrealized gain of $4,000 in Skyline Inc. bonds is closed to retained earnings in 2018 increasing net income and retained earnings. + 3/31/19 4/1/19

Cash (A)

486,000

10/1/18

17,500 492,300

+ Investment in Skyline Bonds (A) 10/1/18 486,000 12/31/18 4,000 490,000 4/1/19

+ 12/31/19

Interest Receivable (A) 8,750 8,750

3/31/19

-

Interest Revenue (R) 8,750 8,750

+ 12/31/18 3/31/19

Unrealized Gain (AOCI) + 4,000 12/31/18 4,000

4/1/19

-

Realized Gain (R) 6,300

+ 4/1/19

Note that most of the gain occurred in 2018, but was not recognized on the income statement until management decided to sell the securities in 2019.

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Financial Accounting, 6th Edition

c. Transaction 10/1/18 Purchase $500,000 of Skyline bonds at 97.

Cash Asset -486,000 Cash

+

Noncash Assets

Balance Sheet Liabil= ities +

Income Statement Contrib. Capital +

Earned Capital

+ 486,000 Investment

=

12/31/18 Recognize interest revenue.

+8,750 Interest Receivable

=

+8,750 Retained Earnings

12/31/18 Record unrealized gain.

+4,000 Investment

=

+4,000 Unrealized Gain-AOCI

3/31/19 Recognize interest income.

+17,500 Cash

4/1/19 Sold Skyline investment.

+492,300 Cash

-8,750 = Interest Receivable

-490,000 Investment

=

Revenues

+8,750 Interest Revenue

-

Expenses

=

-

=

-

=

-

=

Net Income

+8,750 Retained Earnings

+8,750 Interest Revenue

-

=

+8,750

+6,300 Retained Earnings

+6,300 Realized Gain

-

=

+6,300

-4,000 Unrealized Gain-AOCI

M12-23. (10 minutes) LO 5 Halen Inc. now owns all of Jolson. The company reports will be consolidated. The total in the consolidated stockholder’s equity section on 1/1 is the stockholders’ equity section of the parent company, determined as follows: Common stock Retained earnings Total Equity

$600,000 310,000 $910,000

Jolson’s equity accounts are eliminated in the consolidation process.

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1-279

EXERCISES E12-24. (30 minutes) LO 1, 3 a. Trading securities 1.

Investment in US Treasury bonds (+A) ........................................ 407,000 Cash (-A) ...................................................................................... 407,000

2.

Cash (+A) ..................................................................................... 8,000 Interest income (+R, +SE) ............................................................

8,000

Investment in US Treasury bonds ................................................. 4,000 Unrealized holding gain (+R, +SE) ...............................................

4,000

3.

4a. Cash (+A) ..................................................................................... 8,000 Interest income (+R, +SE) .............................................................

8,000

4b. Cash (+A) ..................................................................................... 408,000 Realized loss on sale of investment (+E, -SE) .............................. 3,000 Investment in US Treasury bonds (-A) ..........................................411,000 b. + Cash (A) 8,000 407,000 8,000 408,000

2. 4a. 4b

+ 3.

Unrealized Gain (R) 4,000

1.

1. 3.

4b.

+ Investment in Liu (A) 407,000 4,000 411,000

4b.

- Interest Income (R) + 8,000 8,000

2. 4a.

+ Realized Loss on Sale (E) 3,000

©Cambridge Business Publishers, 2020 1-280

Financial Accounting, 6th Edition

c. Balance Sheet Transaction

Cash Asset

1. Purchase bonds for $407,000

-407,000 Cash

2. Receive interest payment of $8,000

+8,000 Cash

3. Year-end market price of bonds is $411,000 4a. Receive interest payment of $8,000 4b. Sell bonds for $408,000

+

Noncash Assets

Contrib. + Capital +

Income Statement Earned Capital

Revenues

- Expenses =

+407,000 = Investment

Net Income

=

=

+8,000 Retained Earnings

+8,000 Interest Income

=

+8,000

+4,000 = Investment

+4,000 Retained Earnings

+4,000 Unrealized Holding Gain

=

+4,000

=

+8,000 Retained Earnings

+8,000 Interest Income

=

+8,000

-411,000 = Investment

-3,000 Retained Earnings

=

-3,000

+8,000 Cash +408,000 Cash

Liabil= ities

+3,000 Realized Holding Loss

d. Available-for-Sale Securities 1.

2.

Investment in US Treasury bonds (+A) Cash (-A)

407,000 407,000

Cash (+A)

8,000 Interest income (+R, +SE)

3.

8,000

Investment in US Treasury bonds Unrealized holding gain - AOCI (+SE)

4a. Cash (+A)

4,000 4,000 8,000

Interest income (+R, +SE)

8,000

4b. Cash (+A) Unrealized holding gain – AOCI (-SE) Investment in US Treasury bonds (-A) Realized holding gain (+R, +SE)

408,000 4,000 411,000 1,000

continued next page

©Cambridge Business Publishers, 2020 Solutions Manual, Chapter 1

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d. continued + Cash (A) 8,000 407,000 8,000 408,000

2. 4a. 4b.

4b.

1.

- Unrealized Gain AOCI (SE) + 4,000 4,000

Transaction

Cash Asset

1. Purchase bonds -407,000 for $407,000 Cash

2. Receive interest payment of $8,000

4b. Sell bonds for $408,000

Balance Sheet LiabilContrib. = ities + Capital +

=

+4,000 = Investment

+8,000 Cash

+408,000 Cash

3.

+ Investment in Liu (A) 407,000 4,000 411,000

4b.

- Interest Income (R) + 8,000 8,000

2. 4a.

- Realized Gain (R) + 1,000

=

-411,000 = Investment

4b.

Income Statement Earned Capital

Revenues

+407,000 = Investment

+8,000 Cash

3. Year-end market price of bonds is $411,000

4a. Receive interest payment of $8,000

+

Noncash Assets

1. 3.

-

Expenses =

Net Income

=

+8,000 Retained Earnings

+8,000 Interest Income

+4,000 AOCI

+8,000 Retained Earnings

+1,000 Retained Earnings -4,000 AOCI

=

+8,000

=

+8,000 Interest Income

=

+8,000

+1,000 Realized Holding Gain

=

+1,000

©Cambridge Business Publishers, 2020 1-282

Financial Accounting, 6th Edition

E12-25. (30 minutes) LO 1, 3 a. Equity investments measured at fair value, with all gains/losses recognized in income. 1.

2.

3.

4.

2. 4.

Investment in Freeman, Co. (+A) ............................................80,000 Cash (-A) ................................................................................

80,000

Cash (+A) ............................................................................... 6,250 Dividend income (+R, +SE) ....................................................

6,250

Investment in Freeman, Co. (+A) ............................................ 7,500 Unrealized gain (+R, +SE) ......................................................

7,500

Cash (+A) ...............................................................................86,400 Loss on sale of investment (+E, -SE) ...................................... 1,100 Investment in Freeman, Co. (-A) ...................................

87,500

+ Cash (A) 6,250 80,000 86,400

1.

- Unrealized Gain (R) + 7,500

3.

1. 3.

+ Investment in Freeman (A) 80,000 7,500 87,500

4.

- Dividend Income (R) + 6,250

2.

+ Loss on Sale (E) 1,100

4.

Balance Sheet Transaction 1. Ohlson Co. purchases 5,000 common shares of Freeman Co. at $16 cash per share. 2. Ohlson Co. receives a cash dividend of $1.25 per common share from Freeman. 3. Year-end market price of Freeman common stock is $17.50 per share.

Cash Asset -80,000 Cash

Noncash + Assets +80,000 Investment

+6,250 Cash

4. Ohlson Co. sells +86,400 all 5,000 common Cash shares of Freeman for $86,400 cash.

Liabil= ities =

Income Statement

Contrib. + Capital +

=

+6,250 Retained Earnings

+7,500 = Investment

-87,500 Investment

=

Earned Capital

+7,500 Retained Earnings +

-1,100 Retained Earnings

Expenses

Net = Income =

Revenues

-

+6,250 Dividend Income

-

= +6,250

+7,500 Unrealized Gain

-

= +7,500

-

+1,100 Loss

= -1,100

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Financial Accounting, 6th Edition

E12-26. (15 minutes) LO 5 a. The annual growth rates in revenues are (110,360/96,571)-1 = 14.3% for 2018 and (96,571/91,154)-1 = 5.9% for 2017. The cumulative average growth rate (CAGR) is (110,360/91,154)^0.5 - 1 = 10.0%. b. Microsoft’s acquisition of LinkedIn was completed in December 2016, and it was at that point that Microsoft began to include LinkedIn’s revenues in its income statement. Let’s say December 31, 2016 just to be concrete. As a result, 2016’s revenue included a full year of Microsoft’s revenues, 2017’s revenues included a full year of Microsoft’s revenues plus a half year of LinkedIn’s revenues, and 2018’s revenues included a full year of each of Microsoft’s and LinkedIn’ revenues. As a result, the growth trends over this period intermix the “organic growth” of these companies with the “acquisition growth.” The former is likely to continue, while the latter is dependent on acquisitions of other companies. c. The footnote information provides revenues for 2016 and 2017 as if Microsoft and LinkedIn had been one organization over this period. That is, the “acquisition growth” can be set aside to focus on the “organic growth.” In this case, the revised growth rates would be the following: The annual growth rates in revenues are (110,360/98,291)-1 = 12.3% for 2018 and (98,291/94,490)-1 = 4.0% for 2017. The cumulative average growth rate (CAGR) is ((110,360/94,490)^0.5) - 1 = 8.1%. So “acquisition growth” added about 2% to the growth pattern in reported revenue.

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E12-27. (30 minutes) LO 1, 3 a. 2018 11/1

Investment in Joos, Inc. (+A) .............................................. 306,900 Cash (-A) ............................................................................

306,900

12/31 Interest receivable (+A) ...................................................... 4,500 Interest revenue (+R, +SE) .................................................

4,500

12/31 Unrealized loss (+E, -SE) ................................................... 5,400 Investment in Joos, Inc. (-A) ...............................................

5,400

2019 4/30

5/1

Cash (+A) ........................................................................... 13,500 Interest receivable (-A) ....................................................... Interest revenue (+R, +SE) .................................................

4,500 9,000

Cash (+A) ........................................................................... 300,900 Loss on sale of investments (+E, -SE) ............................... 600 Investment in Joos, Inc. (-A) ................................................

301,500

b. 4/30 5/1

12/31

+ Cash (A) 13,500 306,900 300,900 + Unrealized Loss (E) 5,400

11/1

11/1

-

- Interest Revenue (R) + 4,500 9,000

12/31

+ 12/31 4/30

5/1

+ Investment in Joos Inc. (A) 306,900 5,400 301,500

12/31 5/1

+ Interest Receivable (A) 4,500 4,500

4/30

Loss on Sale of Investments (E) 600

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Financial Accounting, 6th Edition

c. Balance Sheet Transaction 11/1 Buy $300,000 Joos bonds @102.

Cash Asset -306,900 Cash

+

Noncash Assets

=

+306,900 Investment

=

12/31 Accrue interest.

+4,500 Interest Receivable

=

12/31 Recognize decline in value of bonds.

-5,400 Investment

=

4/30 Receive interest.

+13,500 Cash

5/1 Sold Joos bonds.

+300,900 Cash

-4,500 Interest Receivable -301,500 Investment

Liabilities

Income Statement Contrib. + Capital +

Earned Capital

+4,500 Retained Earnings

Revenues

+4,500 Interest Revenue

-5,400 Retained Earnings

=

+9,000 Retained Earnings

=

-600 Retained Earnings

+9,000 Interest Revenue

- Expenses

Net = Income

-

=

-

=

+4,500

-

+5,400 = Unrealized Loss

-5,400

-

=

+9,000

=

-600

-

+600 Loss

E12-28. (10 minutes) LO 5 Baylor Company now owns 75% of Reed. The company reports will be consolidated. The total in the consolidated stockholders’ equity section on 1/1 is determined as follows: Common stock………………………………………… Retained earnings………………………………….…. Baylor Company shareholders’ equity Noncontrolling interests Total equity

900,000 440,000 $1,340,000 200,000 $1,540,000

E12-29. (15 minutes) LO 3 a. The fixed-maturity (debt) investment portfolio is reported in the balance sheet at its current fair value of $39,546 million. The cost of the portfolio is $38,085 million, there are $1,982 million in unrealized gains and $521 million of unrealized losses. b. Because the fixed-maturity (debt) investments are accounted for as available-for-sale, unrealized gains (losses) on investments are reported in Accumulated Other Comprehensive Income (AOCI), rather than current income. The investments are reported on the balance sheet at current market value on the statement date.

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c. Impairment losses are recognized in current income when the securities decline in market value and the decline is deemed to be other than temporary. Gains and losses realized from the sale of securities are recognized in current income. A reclassification adjustment is required in Other Comprehensive Income. Because the gains and losses from the sale of securities will be recognized in current income (and retained earnings), they need to be removed from AOCI to avoid double-counting the gains and losses in stockholders’ equity.

E12-30. (30 minutes) LO 4 a. 1. Investment in Barth Co. (+A) ............................................................ 108,000 Cash (-A) .........................................................................................108,000 2. Cash (+A) ......................................................................................... 15,000 Investment in Barth Co. (-A) ............................................................ 15,000 3. Investment in Barth Co. (+A) ............................................................ 24,000 Investment income (+R, +SE) .......................................................... 24,000 4. Cash (+A) ......................................................................................... 120,500 Gain on sale of investment (+R, +SE) .............................................. 3,500 Investment in Barth Co. (-A) ............................................................117,000 b. 2. 4.

+ Cash (A) 15,000 108,000 120,500

1.

- Gain (R) + 3,500

1. 3.

4.

+ Investment in Barth (A) 108,000 15,000 24,000 117,000

2. 4.

- Investment Income (R) + 24,000

3.

c. Balance Sheet Transaction

Cash Asset

+

Noncash Assets

=

Liabilities

Income Statement Contrib. + Capital +

Earned Capital

Revenues

-

Expenses

Net = Income

1. Buy 30% of Barth stock.

-108,000 Cash

+108,000 Investment

=

-

=

2. Receive dividend.

+15,000 Cash

-15,000 Investment

=

-

=

+24,000 Investment

=

+24,000 Retained Earnings

=

+3,500 Retained Earnings

3. Recognize share of net income of Barth. 4. Sold Barth investment.

+120,500 Cash

-117,000 Investment

+24,000 Investment Income +3,500 Gain

-

= +24,000

=

+3,500

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Financial Accounting, 6th Edition

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E12-31. (30 minutes) LO 4 a. 1. Investment in Palepu Co. (+A) .................................................. 120,000 Cash (-A) ..................................................................................

120,000

2. Cash (+A) .................................................................................12,000 Investment in Palepu Co. (-A) ...................................................

12,000

3. Investment in Palepu Co. (+A) ..................................................30,000 Investment income (+R, +SE) ...................................................

30,000

4. Cash (+A) ................................................................................. 140,000 Gain on sale of investment (+R, +SE) ...................................... Investment in Palepu Co. (-A) ...................................................

2,000 138,000

b. 2. 4.

+ Cash (A) 12,000 120,000 140,000

1.

- Gain (R) + 2,000

1. 3.

4.

+ Investment in Palepu (A) 120,000 12,000 30,000 138,000

2. 4.

- Investment Income (R) + 30,000

3.

c. Balance Sheet Transaction

Cash Asset

+

Noncash Assets

=

Liabilities

Income Statement Contrib. + Capital +

Earned Capital

Revenues

-

Expenses

Net = Income

1. Buy 25% of Palepu stock.

-120,000 Cash

+120,000 Investment

=

-

=

2. Receive dividend.

+12,000 Cash

-12,000 Investment

=

-

=

+30,000 Investment

=

3. Recognize share of net income of Palepu. 4. Sold +140,000 Palepu Cash investment.

-138,000 Investment

=

+30,000 Retained Earnings

+2,000 Retained Earnings

+30,000 Investment Income

+2,000 Gain

-

= +30,000

=

©Cambridge Business Publishers, 2020 1-290

Financial Accounting, 6th Edition

+2,000

E12-32. (40 minutes) LO 1, 3, 4 a. 1. Fair Value Method 1.

Investment in Leftwich Co. (+A) ..................................... 150,000 Cash (-A) .......................................................................

150,000

2.

No entry

3.

Cash (+A) ....................................................................... 11,000 Dividend income (+R, +SE) ...........................................

11,000

Investment in Leftwich Co. (+A) ..................................... 40,000 Unrealized gain (+R, +SE) .............................................

40,000

4.

2. + Cash (A) 11,000 150,000

3.

1.

- Unrealized Gain (R) + 40,000

1. 4.

+ Investment in Leftwich (A) 150,000 40,000 -

4.

Dividend Income (R) + 11,000

3.

3. Balance Sheet Transaction 1. Purchase Common shares.

Cash Asset -150,000 Cash

2. No entry. 3. Received a cash dividend of $1.10 per common share.

+11,000 Cash

4. Recognize increase in investment value at year end .

+

Noncash Assets

=

Liabilities

Contrib. + Capital +

Income Statement Earned Capital

Revenues

-

Expenses

=

Net Income

+150,000 = Investment

-

=

=

-

=

+11,000 Dividend Income

-

=

+40,000 Unrealized Gain

-

= +40,000

=

+40,000 = Investment

+11,000 Retained Earnings

+40,000 Retained Earnings

+11,000

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b. 1. Equity Value Method 1. Investment in Leftwich Co. (+A) ................................................................ 150,000 Cash (-A) .................................................................................................. 150,000 2. Investment in Leftwich Co. (+A) ................................................................ 24,000 Investment income (+R, +SE) ................................................................... 24,000 3. Cash (+A) ................................................................................................. 11,000 Investment in Leftwich Co. (-A) ................................................................. 11,000 4. No entry

2. 3.

+ Cash (A) 11,000 150,000

1.

1. 2.

+ Investment in Leftwich (A) 150,000 11,000 24,000

3.

- Investment Income (R) + 24,000

2.

3. Balance Sheet Transaction 1. Purchase Common shares.

Cash Asset -150,000 Cash

2. Recognize 30% portion of Leftwich net income. 3. Received a cash dividend of $1.10 per common share.

+11,000 Cash

+

Noncash Assets

=

+150,000 Investment

=

+24,000 Investment

=

-11,000 Investment

4. No entry.

Liabilities

Contrib. + Capital +

Income Statement Earned Capital

Revenues

Net - Expenses = Income -

=

-

= +24,000

=

-

=

=

-

=

+24,000 Retained Earnings

+24,000 Investment Income

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Financial Accounting, 6th Edition

E12-33. (15 minutes) LO 1, 3 a. The amounts reported for all these separately-identifiable assets and liabilities must be fair values at the date of the acquisition. So, any property, plant and equipment would be reported at what we would expect to get for it, rather than historical cost. Any financial liabilities would be estimated at the value required to discharge them at the date of the acquisition. In the fair value hierarchy, most of these amounts will be determined using Level 2 or Level 3 approaches. b. Goodwill is equal to the amount of consideration given for the transaction minus the fair value of the net assets acquired. Other than goodwill, the asset fair value is $8,432 million and the fair value of liabilities is $3,970 million. So, the fair value of separately-identifiable net assets is $4,462 million (= $8,432 million - $3,970 million). As a result, the goodwill is $9,501 million (= $13,963 million - $4,462 million). This amount would not be amortized in the future, but Amazon would have to assess its value annually for impairment. If the goodwill value is impaired, the goodwill asset is reduced and a charge is recognized in income. c. Investors are likely to prefer acquisitions of identifiable net assets (even if intangible), rather than vaguely-defined “synergy effects.” When the acquired company goes to the highest bidder, there is a real risk that the highest bidder was the one that most overestimated the potential for future synergies. When purchase price allocations are disclosed subsequent to the acquisition, stock prices respond favorably (unfavorably) to the disclosure that less (more) goodwill was acquired

E12-34. (25 minutes) LO 5 a. The amounts reported for all these separately-identifiable assets and liabilities must be fair values at the date of the acquisition. So, any inventory would be reported at what we would expect to get for it, rather than historical cost. Any financial liabilities would be estimated at the value required to discharge them at the date of the acquisition. In the fair value hierarchy, most of these amounts will be determined using Level 2 or Level 3 approaches. b. Goodwill is equal to the amount of consideration given for the transaction minus the fair value of the net assets acquired. Other than goodwill, the asset fair value is $5,079 million and the fair value of liabilities is $487 million. So, the fair value of separately-identifiable net assets is $4,592 million (= $5,079 million - $487 million). As a result, the goodwill is $10,283 million (= $14,875 million - $4,592 million). This amount would not be amortized in the future, but Intel would have to assess its value annually for impairment. If the goodwill value is impaired, the goodwill asset is reduced and a charge is recognized in income.

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c. Investors are likely to prefer acquisitions of identifiable net assets (even if intangible), rather than vaguely-defined “synergy effects.” When the acquired company goes to the highest bidder, there is a real risk that the highest bidder was the one that most overestimated the potential for future synergies. When purchase price allocations are disclosed subsequent to the acquisition, stock prices respond favorably (unfavorably) to the disclosure that less (more) goodwill was acquired. E12-35. (30 minutes) LO 1, 3 a. 2019: 11/15 Investment in Core, Inc. (+A) ............................................... 80,900 Cash (-A) ..............................................................................

80,900

12/22 Cash (+A) ............................................................................6,250 Dividend income (+R, +SE) ..................................................

6,250

12/31 Investment in Core, Inc. (+A) ...............................................6,600 Unrealized gain (+R, +SE) ...................................................

6,600

2020: 1/20 Cash (+A) ............................................................................ 86,400 Loss on sale of investment (+E, -SE) ..................................1,100 Investment in Core, Inc. (-A) ................................................

87,500

b. Assuming the firm’s fiscal year ends 12/31, the unrealized gain of 6,600 increases net income and retained earnings in 2019.

12/22/19 1/20/20

+ Cash (A) 6,250 80,900 86,400

11/15/19

11/15/19 12/31/19

+ Investment in Core Inc (A) 80,900 6,600 87,500 1/20/20

+ Loss on Sale of Investment (E) 1/20/20 1,100 -

Unrealized Gain (R) 6,600

+ 12/31/19

- Dividend Income (R) + 6,250

-

12/22/19

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c. Balance Sheet Transaction

Cash Asset

11/15 Purchase 5,000 shares of Core Inc common.

-80,900 Cash

12/22 Dividend income.

+6,250 Cash

+

12/31 Increase in Investment. 1/20 Sale of Core common.

Noncash Assets +80,900 Investment

Liabilities

+

Contrib. Capital +

Earned Capital

Revenues

Net - Expenses = Income

=

=

=

+6,600 Investment +86,400 Cash

=

Income Statement

+6,250 Retained Earnings

=

+6,600 Retained Earnings

-87,500 = Investment

+6,250 Dividend Income

=

+6,250

+6,600 Unrealized Gain

=

+6,600

=

-1,100

-1,100 Retained Earnings

+1,100 Loss on Sale

E12-36 (30 minutes) LO 1, 3 a. 2018: 11/15 Investment in Core, Inc. (+A) ............................................... 80,900 Cash (-A) .............................................................................

80,900

12/22 Cash (+A) ............................................................................6,250 Dividend income (+R, +SE) .................................................

6,250

12/31 Investment in Core, Inc. (+A) ...............................................6,600 AOCI (+SE) .........................................................................

6,600

2019: 1/20 Cash (+A) ............................................................................ 86,400 AOCI (-SE) ……………………………………………….. 1,100 Investment in Core, Inc. (-A) ................................................

87,500

+ Cash (A) 12/22/18 1/20/19

6,250 86,400

1/20/19

AOCI 1,100

80,900

+ 6,600

+ Investment in Core Inc (A) 11/15/18

12/31/18

11/15/18 12/31/18

80,900 6,600

87,500

1/20/19

- Dividend Income (R) + 6,250

12/22/18

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a. continued

Transaction

Cash Asset

11/15 Purchase 5,000 shares of Core Inc common.

-80,900 Cash

12/20 Dividend income.

+6,250 Cash

12/31 Increase in Investment. 1/20 Sale of Core common.

+

Noncash Assets

+80,900 Investment

+6,600 Investment +86,400 Cash

Balance Sheet LiabilContrib. = ities + Capital +

Income Statement Earned Capital

Revenues

=

=

+6,250 Retained Earnings

=

+6,600 AOCI

-87,500 = Investment

-1,100 AOCI

+6,250 Dividend Income

Net - Expenses = Income

-

=

-

=

-

=

-

=

+6,250

b. Some companies complained that marking equity investments to fair value and reporting fair value changes in the income statement did not fit their business model. They wanted to make smaller investments in companies with whom they had a strategic relationship or a continuing interest, but falling short of the significant influence needed for the equity method. These companies said that they were not interested in the possible holding gains that they might achieve. So, the IASB allowed IFRS companies to make an irrevocable choice at the time of investment. If they chose FVOCI, all holding gains and losses will end up in AOCI and never go through the income statement.

E12-37. (30 minutes) LO 1, 2, 3, 4 a. The trading stock investments will be reported at $225,300. This amount is computed using their market values at year-end; specifically, $65,300 + $160,000, or $225,300. b. The available-for-sale debt investments will be reported at $346,700. This amount is computed using their market values at year-end; specifically, $192,000 + 154,700, or $346,700. c. The equity method stock investments will be reported at $236,000. This amount is computed using their equity method value at year-end; specifically, $100,000 + $136,000, or $236,000.

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d. Unrealized holding losses of $5,200 will appear in the 2019 income statement. These losses relate to the trading securities; specifically— Barth: $68,000 - $65,300 = $2,700; Foster: $162,500 - $160,000 = $2,500; total of $2,700 + $2,500 = $5,200. e. Unrealized holding losses of $7,300 will appear in the stockholders' equity section of the December 31, 2019, balance sheet under other comprehensive income. These losses relate to the available-for-sale debt securities; specifically— 30-Year Treasury Bond: $197,000 - $192,000 = $5,000; 10-Year Treasury Note: $157,000 - $154,700 = $2,300; total of $5,000 + $2,300 = $7,300. f. A fair value adjustment to investments of $7,300 will appear in the December 31, 2019, balance sheet. This adjustment relates to the available-for-sale securities. See part (e) for the supporting computations. The fair value adjustment decreases the book value of the available-for-sale securities to their year-end market value.

E12-38. (30 minutes) LO 1, 4 (Entries in $ millions) a. Record share of income: Investment in affiliates (+A)……………………………. Income from affiliates (+R, +SE)…………...

42 42

b. Record receipt of cash dividends: Cash (+A)………………………………………………… Investment in affiliates (-A)……………………

2 2

c. The ending balance should be $715 million + $42 million - $2 million = $755 million. The actual balance, $767 million, was $12 million higher. The difference could be due to advances (loans) made to the affiliates, foreign currency changes or AOCI adjustments at the affiliates or some other transactions (or adjustments) besides the ones described above.

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E12-39.B (40 minutes) LO 7 1. & 2. Consolidating Adjustments

Healy $1,700,000 500,000

Miller $120,000

Plant assets .................................

3,000,000

410,000

15,000

3,425,000

Goodwill .......................................

_________

________

45,000

45,000

Total assets .................................

$5,200,000

$530,000

$5,290,000

Liabilities ......................................

$ 700,000

$ 90,000

$790,000

Contributed capital ......................

3,500,000

400,000

(400,000)

3,500,000

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

1,000,000

40,000

(40,000)

1,000,000

Total liabilities & stockholders’ equity ........................................

$5,200,000

$530,000

Current assets Investment in Miller

Consolidated $ 1,820,000 0

$(500,000)

$5,290,000

3. Miller contributed capital (-SE) ........................................................... 400,000 Miller retained earnings (-SE) ............................................................. 40,000 Plant assets (+A) ............................................................................... 15,000 Goodwill (+A) ..................................................................................... 45,000 Investment in Miller Co. (-A) ............................................................. 500,000 4. + Investment in Miller Co. (A) 500,000 1/1

+ Goodwill (A) 45,000

1/1 -

Miller Contributed Capital (SE) + 400,000

-

Miller Retained Earnings (SE) + 40,000

1/1

1/1

+ Plant Assets (A) 15,000

1/1

5. Balance Sheet Transaction

Cash Asset

1/1 To consolidate Healy & Miller.

+

Noncash Assets -500,000 Investment in Miller +45,000 Goodwill +15,000 Plant Assets

= =

Liabilities

+

Income Statement Contrib. Capital +

Earned Capital -400,000 Miller Contributed Capital

Revenues

- Expenses

Net = Income

-

=

-40,000 Miller Retained Earnings

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E12-40.B (30 minutes) LO 7 1. & 2. Rayburn Company purchased all of Kanodia Company's common stock for cash on January 1, after which the separate balance sheets of the two corporations appeared as follows:

Investment in Kanodia ................ Other assets ................................ Goodwill ....................................... Total assets ................................. Liabilities ...................................... Contributed capital ...................... Retained earnings ....................... Total liabilities & stockholders’ equity ........................................

Rayburn $ 600,000 2,300,000 . $2,900,000 $ 900,000 1,400,000 600,000

Kanodia $700,000 . $700,000 $160,000 300,000 240,000

$2,900,000

Consolidating Adjustments (600,000) 20,000 40,000

Consolidated $ 0 3,020,000 40,000 $3,060,000 $1,060,000 1,400,000 600,000

(300,000) (240,000)

$700,000

$3,060,000

3. Kanodia contributed capital (-SE) ...................................................... 300,000 Kanodia retained earnings (-SE) ........................................................ 240,000 Other assets (+A) ............................................................................... 20,000 Goodwill (+A) ..................................................................................... 40,000 Investment in Kanodia Co. (-A) .........................................................600,000 4. + Investment in Kanodia Inc. (A) 600,000 1/1

+ Goodwill (A) 40,000

1/1 -

Kanodia Contributed Capital (SE) + 300,000

1/1

1/1

+ Other Assets (A) 20,000

1/1

Kanodia Retained Earnings (SE) + 240,000

5. Balance Sheet Transaction 1/1 To consolidate Rayburn & Kanodia.

Cash Asset

+

Noncash Assets -600,000 Investment in Kanodia +40,000 Goodwill +20,000 Other Assets

Liabil= ities =

Contrib. + Capital +

Income Statement Earned Capital -300,000 Kanodia Contributed Capital

Revenues

-

Net Expenses = Income =

-240,000 Kanodia Retained Earnings

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E12-41. (20 minutes) LO 5 a. The investment is initially recorded on Engel’s balance sheet at the purchase price of $16.8 million, including $6.6 million of goodwill. Because the fair value of Ball is less than the carrying amount of the investment on Engel’s balance sheet, the goodwill is deemed to be impaired. To determine impairment, the imputed value of the goodwill is determined to be 12.5 million - $10.2 million = $2.3 million. b. Goodwill must be written down by $4.3 million. The write-down will reduce the carrying amount of goodwill by this amount, and the write-down will be recorded as a loss in Engel’s income statement, thereby reducing retained earnings by that amount.

E12-42.B (60 minutes) LO 5, 7 a. Cash paid .......................................................................... Fair market value of shares issued ................................... Purchase price .................................................................. Less: Book value of Harris ................................................ Excess payment................................................................

$210,000 180,000 390,000 280,000 110,000

Excess payment assigned to specific accounts based on fair market value: Buildings ........................................................................... 40,000 Patent ............................................................................... 30,000 Goodwill ............................................................................ $ 40,000 $110,000 b. Accounts Cash Receivables Inventory Investment in Harris Land Buildings, net Equipment, net Patent Goodwill Totals

Easton Company $ 84,000 160,000 220,000 390,000 100,000 400,000 120,000 0 $1,474,000

Harris Co. $ 40,000 90,000 130,000

Consolidation Entries

[S] [A] 60,000 110,000 50,000 ---$480,000

$(280,000) (110,000)

[A]

40,000

[A] [A]

30,000 40,000

Consolidated Totals $ 124,000 250,000 350,000 160,000 550,000 170,000 30,000 40,000 $1,674,000

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b. continued Table continued from previous page Accounts Accounts payable Long-term liabilities Common stock Additional paid-in capital Retained earnings Totals

Easton Company $ 160,000 380,000 500,000 74,000 360,000 $1,474,000

Harris Co. $ 30,000 170,000 40,000 240,000 $ 480,000

Consolidation Entries

[S]

(40,000)

[S]

(240,000)

Consolidated Totals $ 190,000 550,000 500,000 74,000 360,000 $1,674,000

c. The tangible assets are accounted for just like any other acquired asset. The receivables are removed when collected, inventories affect future cost of goods sold, and depreciable assets are depreciated over their estimated useful lives. Intangible assets with a determinable life are amortized (depreciated) over that useful life. Finally, intangible assets with an indeterminate useful life (such as goodwill) are not amortized, but are either tested annually for impairment, or more often if circumstances require. E12-43.A (20 minutes) LO 6 a. Investment in Harris Company (+A) ................................................... 28,800 Equity in earnings of Harris Company (-SE) ......................................

28,800

The equity in earnings of Harris Company is calculated as follows: 40% x [$80,000 – ($40,000  20) – ($30,000  5)] = $28,800 b. $156,000 + $28,800 – 40% x $40,000 = $168,800.

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E12-44.C (20 minutes) LO 8 a. Companies use derivative securities in order to mitigate risks, such as commodity price risks, risks relating to foreign exchange fluctuations, or risks relating to fluctuations in interest rates. b. Derivatives are reported on the balance sheet as are the assets or liabilities to which they relate. Generally, derivatives and the related assets/liabilities are reported on the balance sheet at their fair market value. c. The unrealized gains (losses) on HPE’s derivatives are reported in the Accumulated Other Comprehensive Income section of its stockholders’ equity. This reporting indicates that the underlying item being hedged has not yet affected HPE’s profits. Once the underlying item appears in income, these unrealized gains (losses) will be removed from AOCI and transferred into current income, thus affecting HPE’s profitability.

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PROBLEMS P12-45. (50 minutes) LO 1, 2, 3 a. Available-for-sale investments are reported at market value on the balance sheet. Thus, Met Life’s bond investments are reported at: $308,931 million as of 2017 $289,563 million as of 2016 b. Net unrealized gains (losses) at the end of 2017 are: $22,820 million ($24,765 million - $1,945 million) Net unrealized gains (losses) at the end of 2016 are: $17,880 million ($21,826 million - $3,946 million) Because the investments are accounted for as available-for-sale, these unrealized gains (losses) did not affect reported income for 2017 and 2016. (Note: Had these investments been accounted for as trading securities, those unrealized gains (losses) would have affected reported income.) c. Realized gains (losses) are gains (losses) that occur as a result of sales of securities. These are reported in the income statement and affect reported income. Unrealized gains (losses) reflect the difference between the current market price of the security and its acquisition cost. Only unrealized gains (losses) from trading securities are reported in income. If MetLife had sold all of the AFS securities on which it had gains, its pre-tax income would have increased by $24,765 million. d. The evaluation of investment performance is difficult as companies have discretion over the timing of realized investment gains (losses) and can, thereby, affect reported income. By including unrealized gains (losses) in the analysis, we are able to get a clearer picture of overall investment performance—albeit, with an understanding that these gains and losses are not yet realized. These returns could then be compared with those of competitors and market rates in general for investments of comparable risk. We believe this reporting metric provides useful insights as noted.

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P12-46.B (30 minutes)

Current assets ............................. Investment in Alpine ................... Plant assets (net) ....................... Total assets ................................. Liabilities ...................................... Common stock ............................ Retained earnings....................... Noncontrolling interest ................ Total liabilities & stockholders’ equity ........................................

Gem $258,000 392,000 265,000 $915,000

Alpine $160,000

$ 50,000 700,000 165,000

$ 60,000 420,000 140,000

$915,000

$620,000

Consolidating Adjustments $(392,000)

460,000 $620,000

(420,000) (140,000) 168,000

Consolidated $ 418,000 0 725,000 $1,143,000 $ 110,000 700,000 165,000 168,000 $1,143,000

P12-47. (40 minutes) LO 1, 2, 3, 4 a. The trading security investments will be reported at $375,300. This value is computed using their market values at year-end; specifically, $105,300 + $270,000. b. The available-for-sale investments will be reported at $359,000. This value is computed using their market values at year-end; specifically, $199,000 + 160,000. c. The held-to-maturity bond investments will be reported at $237,200. This value is computed using their amortized cost value at year-end; specifically, $101,200 + $136,000. d. Unrealized holding gains of $10,400 will appear in the 2019 income statement. These gains relate to the trading securities; specifically— Ling: $105,300 - $102,400 = $2,900 gain; Wren: $270,000 - $262,500 = $7,500; total of $2,900 + $7,500 = $10,400. The calculation is only possible because this is the first year the bonds have been held. Therefore, the entire price difference occurred this year. e.

Unrealized holding gains of $8,000 will appear in the stockholders' equity section of the December 31, 2019, balance sheet under accumulated other comprehensive income (AOCI). These losses relate to the available-for-sale securities; specifically — Olanamic: $199,000 - $197,000 = $2,000; Fossil: $160,000 - $154,000 = $6,000; total of $2,000 + $6,000 = $8,000.

f.

A fair market value adjustment to investments of $8,000 will appear in the December 31, 2019, balance sheet. This adjustment relates to the available-for-sale securities. See part (e) for the supporting computations. The fair value adjustment increases the book value of the available-for-sale securities to their year-end market value.

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P12-48.A,B (60 minutes) LO 1, 4, 5, 6, 7 a. Yes, each individual company (e.g., parent and subsidiary) maintains its own financial statements. This approach is necessary to report on the activities of the individual units and to report to the respective stakeholders of each unit. The purpose of consolidation is to combine these separate statements to more clearly reflect the operations and financial condition of the combined (whole) entity. b. The Investment in Financial Products Subsidiaries is reported on the parent’s (Machinery and Power Systems’) balance sheet at $3,672 million. This amount is the same balance as reported for stockholders’ equity of the Financial Products subsidiary. This relation will always exist so long as the investment is originally purchased at book value (e.g., the parent created and funded the subsidiary). c. The consolidated balance sheet more clearly reflects the actual assets and liabilities of the combined company vis-à-vis that revealed in the equity method of accounting. That is, it better reflects operations as one entity as far as investors and creditors are concerned. The equity method of accounting that is used by the parent company to account for its investment in the subsidiary reflects only its proportionate share (100% in this case) of the investee company stockholders’ equity and does not report the individual assets and liabilities comprising that equity. d. The consolidating adjustments generally accomplish three objectives: (i) They eliminate the equity method investment on the parent’s balance sheet and replace it with the actual assets and liabilities of the investee company to which it relates. (ii) They record any additional assets that are included in the investment balance that may not be reflected on the subsidiary’s balance sheet, like goodwill, for example. (iii) They eliminate any intercompany sales and receivables/payables.

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e. The consolidated stockholders’ equity and the stockholders’ equity of the parent company are equal. This equality will always be the case. The consolidation process replaces the investment account with the assets and liabilities to which it relates. Thus, stockholders’ equity remains unaffected. f. Consolidated net income will equal the net income of the parent company. The reason for this result is that the parent reflects the income of the subsidiary via the equity method of accounting for its investment. The consolidation process merely replaces the equity income account with the actual and individual sales and expenses to which it relates. Net income is unaffected. g. The equity method of accounting reports investments at adjusted cost (beginning balance plus equity earnings and less dividends received)—this contrasts with the market method. Unrealized gains for a subsidiary are, therefore, not reflected on the consolidated balance sheet and income statement. Instead, the subsidiary is reflected on the balance sheet at its purchase price net of depreciation and amortization, just like any other asset. The consolidation process merely replaces the investment account with the actual assets and liabilities to which it relates. Thus, there can exist substantial unrealized gains subsequent to the acquisition that are not reflected in the consolidated financial statements.

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CASES C12-49. (60 minutes) LO 1, 3 a. Return on assets: ROA =

$59,531 + (1 – 0.25)*$3,420 ($365,725 + $375,319)/2

=

0.168 or 16.8%

=

9.196 or 919.6%

b. Return on net operating assets RNOA =

(1 – 0.25)*$70,896 ($10,443 + $1,121)/2

RNOA above 900% is a very high number. One factor contributing to this return is Apple’s well-known use of contract manufacturers. Apple concentrates on the product design, but they let other companies do much of the manufacturing. Another factor is that Apple develops much of its intellectual property in-house, which means that it doesn’t show up on the balance sheet. Apple reports no goodwill asset in its balance sheet and no intangible assets, meaning that it does not buy other companies to acquire intellectual property. This reduces the company’s reported assets and increases its RNOA. c. Apple is using the available-for-sale method to account for its fixed-income investments. The value that will be used on the balance sheet is the fair value at the end of the fiscal year. The unrealized gains and losses are reported in the accumulated other comprehensive income section of the shareholders’ equity. d. Return on financial assets: The return on financial assets is measured as the income from interest and dividends divided by the average balance of financial assets (which Apple refers to as marketable securities). Return on Financial Assets =

(1 – 0.25)*$5,686 ($211,187 + $248,606)/2

=

0.019 or 1.9%

Apple’s return on its financial assets is much lower than its return on its operating assets. And, the dividend and interest income doesn’t tell the whole story. The unrealized holding gains (losses) have decreased (increased) over 2018, meaning that the value of the portfolio has dropped, but the decrease is not being reported in income (as it would be if the investments were accounted for using the trading method. The other comprehensive income (OCI) disclosure that there was a $3,407 million loss (after a provision for taxes) means that the total income from this portfolio (average value almost $230 billion) was less than a billion dollars after provision for taxes. ©Cambridge Business Publishers, 2020 1-310

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C12-50. (50 minutes) LO 1, 3, 4 a. 2019: 1/2 Investment in Dye, Inc. (+A) ............................................................. 420,000 Cash (-A) .......................................................................................... 420,000 12/31 Dividend receivable (+A) .................................................................. 16,000 Dividend income (+R, +SE) .............................................................. 16,000 12/31 Unrealized loss (+E, -SE) ................................................................. 60,000 Investment in Dye, Inc. (-A) .............................................................. 60,000 2020: 1/18 Cash (+A) ......................................................................................... 16,000 Dividend receivable (-A) ................................................................... 16,000 b. + Cash (A) 16,000 420,000

1/18/20

1/2/19

+ Investment in Dye Inc. (A) 420,000 60,000 12/31/19

1/2/19

12/31/19

12/31/19

+ Unrealized Loss (E) 60,000

+ Dividend Receivable (A) 16,000 16,000 - Dividend Income (R) + 16,000

1/18/20

12/31/19

c. Balance Sheet Transaction 1/2/19 Buy 20,000 shares of Dye.

Cash Asset

Noncash Assets

=

+420,000 Investment

=

12/31/19 Declare dividend $.8/share.

+16,000 Dividend Receivable

=

12/31/19 Recognize decline in investment.

-60,000 Investment

=

1/18/20 Receipt of dividend.

-420,000 Cash

+

+16,000 Cash

-16,000 = Dividend Receivable

Liabilities

Contrib. + Capital +

Income Statement Earned Capital

+16,000 Retained Earnings

-60,000 Retained Earnings

Revenues

+16,000 Dividend Income

-

Expenses

=

Net Income

-

=

-

=

+16,000

=

-60,000

-

-

+60,000 Unrealized Loss

=

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d. 2019: ½ Investment in Dye, Inc. (+A) ............................................................. 420,000 Cash (-A) .......................................................................................... 420,000 12/31 Dividend receivable (+A) .................................................................. 16,000 Investment in Dye, Inc. (-A) ..............................................................16,000 12/31 Investment in Dye, Inc. (+A) ............................................................. 112,000 Investment income (+R, +SE) ........................................................... 112,000 2020: 1/18 Cash (+A) ......................................................................................... 16,000 Dividend receivable (-A) ...................................................................16,000 e. + Cash (A) 16,000 420,000

1/18/20

1/2/19

1/2/19 12/31/19

- Investment Income (R) + 112,000 12/31/19

+ Investment in Dye Inc. (A) 420,000 112,000 16,000 12/31/19

+ Dividend Receivable (A) 12/31/19 16,000 16,000

1/18/20

f. Balance Sheet Transaction 1/2/19 Buy 20,000 shares of Dye.

Cash Asset

Noncash Assets

=

Liabilities

Contrib. + Capital +

Earned Capital

Net

Revenues

- Expenses

= Income

+420,000 Investment

=

-

=

12/31/19 Declare dividend $.8/share.

+16,000 Dividend Receivable

=

-

=

12/31/19 Recognize income from investment.

+112,000 Investment

1/18/20 Receipt of dividend.

-420,000 Cash

+

Income Statement

-16,000 Investment

+16,000 Cash

=

-16,000 = Dividend Receivable

+112,000 Retained Earnings

+112,000 Investment Income

-

= +112,000

=

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C12-51. (15 minutes) LO 1, 2, 3, 4, 5 a. Consolidated statements present the total assets and liabilities of all firms in which the reporting firm has more than a fifty percent ownership with intercompany accounts and transactions eliminated. b. Demski has a controlling interest in Asare and Demski Finance. Therefore, their assets and liabilities are all added to those of Demski Inc. Demski does not have a controlling interest in Knechel. Therefore, it must show its investment in Knechel Inc. as a financial asset. c. This excess is the amount paid to Asare in excess of the net book value of Asare’s assets (assets less liabilities assumed) when Asare was acquired by Demski. The amount is known more commonly as Goodwill and reflects the fact that Demski believed the company was worth more than the net book value of its assets. d. The amount represents the outside ownership claim on Asare’s net assets, which are aggregated in the balances of Demski’s accounts.

C12-52. (30 minutes) LO 1, 2, 3, 4 a. While the approach recommended by Gayle is not disallowed by a specific accounting standard, it is not consistent with the intent of GAAP. Certainly from a position of representational faithfulness, it specifically does not represent how management regards the investment or intends to treat it in the future. The approach recommended is a flagrant attempt to violate the spirit of GAAP in order to manage earnings. Such practice may get by the firm’s auditors once or twice, but failure to be consistent in the accounting treatment over time is unlikely to be tolerated under SOX and the increased scrutiny applied by the SEC in the wake of the numerous accounting scandals of the recent past. Further, such practice can lead to lawsuits by investors who can argue that management was not accounting truthfully. b. We believe the suggested approach to be highly unethical.

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Appendix A Compound Interest and the Time-Value of Money EXERCISES EA-1. a. Future value, 4%, 6 years: $4,000 x 1.26532 = $5,061.28 b. Future value, 6%, 6 years: $4,000 x 1.41852 = $5,674.08 c. Future value, 8%, 6 years: $4,000 x 1.58687 = $6,347.48

EA-2. a. Future value, 12%, 4 years: $7,500 x 1.57352 = $11,801.40 b. Future value, 3%, 16 quarters: $7,500 x 1.60471 = $12,035.33 c. Future value, 1%, 48 months: $7,500 x 1.61223 = $12,091.70 The last calculation relies on a future value factor that is not in the table at the end of Appendix A. The solution can be determined using a financial calculator or using Excel. The Excel calculation is as follows:

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EA-3. Present value, 1% per quarter, 8 quarters: $14,000 x 0.92348 = $12,929.

EA-4. Present value, 6%, 4 years: $24,000 x 0.79209 = $19,010.

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EA-5. PV annuity, 1%, 36 months: $12,500/30.10751 = $415.18

EA-6.

The interest for the first month would be $12,500 x .01 = $125. The remaining $290.18 would go to reduce the loan balance.

EA-7. a. PV annuity, 2%, 24 quarters: $40,000 / 18.91393 = $2,114.84.

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EA-8. This problem requires computation as the future value of an annuity. This can be calculated from Table 1 as follows: Future value, 6%, 5 years ………. Future value, 6%, 4 years ………. Future value, 6%, 3 years ………. Future value, 6%, 2 years ………. Future value, 6%, 1 years ………. Total ………………………………...

1.33823 1.26248 1.19102 1.12360 1.06000 5.97533

Annual deposit x Future value factor = Future value Deposit x 5.97533 = $20 million; $20 million / 5.97533 = $3,347,095.47 per year.

EA-9. PV of an Annuity, 9%, 7 years: $60,000 x 5.03295 = $301,977.

2019 Revenue: In 2019 Ott, Inc. would recognize the present value of $301,977 as sales revenue, plus interest income for eight months (May 1 through December 31. Interest income would be equal to $18,119 ($301,977 x 9% x 8/12). 2020 Revenue: in 2020, Ott would recognize interest income of: ($301,977 x 9% x 4/12) + {[$301,977-($60,000 - $301,977x9%)] x 9%x8/12} = $25,209.

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EA-10. First, we must compute the payment due on December 1, 2021: Future value, 5%, 3 years: $10,000 x 1.15763 = $11,576.30. Next, we compute the present value of that payment at the market interest rate of 8%: Present value, 8%, 3 years: $11,576.30 x 0.79383 = $9,189.61. Finally, we compute the interest from December 1 through December 31, 2018: $9,189.61 x 0.08/12 = $61.26 Thus, in 2018, Rex Corporation would recognize sales revenue of $9,189.61 and interest income of $61.26.

EA-11. Present value, 12%, 10 years: $50,000 x 0.32197 = $16,099. PV annuity, 12%, 10 years: $200,000 x 5.65022 = $1,130,044. Maximum price Rye Company should be willing to pay is $1,130,044 + $16,099 = $1,146,143. Using Excel:

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EA-12. If Debra Wilcox chooses 26 payments, she will receive $7 million/26 = $269,230.77 per year for 26 years, with the first payment due today. This is an annuity due. Equivalently, this can be structured as an annuity in arrears by recognizing that the present value factor for the first payment is 1.0. Thus, the annuity factor is 1.0 plus the present value of an annuity for 25 payments. a. PV annuity due, 8%, 25+1 payments: $269,230.77 x (1 + 10.67478) = $3,143,210.01 b. PV annuity due, 4%, 25+1 payments: $269,230.77 x (1 + 15.62208) = $4,475,175.40 c. If her opportunity cost of capital is 8%, Debra Wilcox should choose the lump sum of $3,500,000 rather than take the annuity. On the other hand, if her discount rate is 4%, the annuity gives a higher present value. One way to examine this problem is to ask what opportunity cost of capital (or discount rate) would make her indifferent between the two options. This is answered by solving for the rate at which the present value of the annuity is equal to $3,500,000. Using the rate function in Excel:

So, the rate at which Debra Wilcox would be indifferent between $3,500,000 as a lump sum payment and an annuity due of $269,230.77 for 26 payments is approximately 6.68% per year.

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EA-13. The answer depends on Ms. Reed’s opportunity cost of capital (discount rate). To determine the rate at which she would be indifferent between these two options, we divide the present value by the future value and consult Table 2: $60,000/$100,000 = 0.60000. From Table 2, the present value of $1 received five years in the future discounted at 10% is 0.62092. At 11%, the present value is 0.59345. Thus the discount rate at which she would be indifferent is between 10% and 11%. Alternatively, we can use the rate function in Excel:

The rate at which she would be indifferent is 10.76%. So, if her discount rate is higher than that, she should accept the $60,000 today. If her rate is less than 10.76%, she should choose the deferred payment of $100,000.

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EA-14. This calculation (and the calculation in A13) can be done with either the present value or future value tables, depending on which value is placed in the numerator and which is in the denominator. Using the present value tables: $400,000/$955,000 = 0.41885 The present value factor for 11%, 8 years is 0.43393. The present value factor for 12%, 8 years is 0.40388. Hence, the required rate of return on the investment is between 11% and 12%. Using Excel, we can determine the exact rate:

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EA-15. This question can be answered by adding the future values at 12%:

Amount Deposited

Date: July 1, 2019 …………….. June 30, 2020 ………….. June 30, 2021 ………….. June 30, 2022 ………….. June 30, 2023 ………….. Value on June 30, 2023

Future Value Factor

$360,000 60,000 60,000 60,000 60,000

Future Value

1.57352 1.40493 1.25440 1.12000 1.00000

$566,467 84,296 75,264 67,200 60,000 $853,227

EA-16. a. Present value of an annuity, 5% per half-year, 20 half-years: Payment = $10,000,000/12.46221 = $802,425.89 b. $10,000,000 x 5% = $500,000. c. Present value of an annuity, 5% per half-year, 10 half-years: $802,425.89 x 7.72173 = $6,196,116.07

EA-17. a. (i) Present value 2%, 10 periods: $200,000 x 0.82035 = $164,070 PV annuity, 2%, 10 periods: ($200,000x.05/2) x 8.98259 = $44,913 $164,070 + $44,913 = $208,983.

continued next page

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(ii) Present value 3%, 10 periods: $200,000 x 0.74409 = $148,818 PV annuity, 3%, 10 periods: ($200,000x.05/2) x 8.53020 = $42,651 $148,818 + $42,651 = $191,469.

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b. Present value 4%, 6 periods: $200,000 x 0.79031 = $158,062 PV annuity, 4%, 6 periods: ($200,000x.05/2) x 5.24214 = $26,211 $158,062 + $26,211 = $184,273.

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EA-18. a. PV annuity, 9%, 20 years: $450,000 x 9.12855 = $4,107,847.50

b. PV annuity due, 9%, 19+1 years: $450,000 x (1+ 8.95011) = $4,477,549.50

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EA-19. a. A: 1 + PV annuity, 5%, 5 years: $8,000 x (1 + 4.32948) = $42,635.84 B: PV annuity, 5%, 5 years: $9,000 x 4.32948 = $38,965.32 PV annuity, 5%, 2 years: $2,000 x 1.85941 = $3,718.82 $38,965.32 + $3,718.82 = $42,684.14 at 5% interest. Alternative A appears to be the cheaper alternative. b. A: 1 + PV annuity, 7%, 5 years: $8,000 x (1 + 4.10020) = $40,801.60 B: PV annuity, 7%, 5 years: $9,000 x 4.10020 = $36,901.80 PV annuity, 7%, 2 years: $2,000 x 1.80802 = $3,616.04 $36,901.80 + $3,616.04 = $40,517.84. Alternative B appears to be the cheaper alternative at 7% interest.

EA-20. A: PV annuity 2%, 24 quarters: $3,000 x 18.91393 = $56,741.79 B: PV annuity 8%, 5 years: $14,300 x 3.99271 = $57,095.75 Payment alternative A appears to be cheaper at an 8% discount rate. However, this is misleading because the effective discount rate is higher in alternative A. If the same discount rate (2% compounded quarterly) is used for both calculations, the annuity factor for alternative B would be lower. To compute the appropriate discount rate, add the present value of a single payment for each of the five payments as follows: 2%, 4 quarters 2%, 8 quarters 2%, 12 quarters 2%, 16 quarters 2%, 20 quarters Total

0.92385 0.85349 0.78849 0.72845 0.67297 3.96725

$14,300 x 3.96725 = $56,731.68, hence, alternative B is slightly cheaper.

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EA-21 a. The future value factor from Table 4 for 40 periods and 4% interest is 98.8265, so the future value of Samuel’s $2,400 annual contributions would be $237,183.60. b. If Samuel waits 10 years, then the accumulation will only be over 30 years, which has a future value factor of 58.3283 in Table 4. Therefore, the accumulation will be $139,987.92, almost $100,000 less. c. If Samuel can earn 5% per year on his investments, then Table 4 shows a future value factor of 126.8398, which would turn the $2,400 investments into $304,415.52.

EA-22 The Table 4 future value factor for 36 periods at 1% interest per period is 43.5076, so Janice Utley’s $1,000 monthly investments would accumulate to $43,507.60 after 36 months.

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